Photo Credit: Fabricio Olivetti || Beware situations where some governmental entity thinks that they have unlimited power…
This is the fourth in a series of posts regarding the Fed’s balance sheet, and quantitative easing. Unlike the first three, I’m not going to do the graphs of the composition of the Fed’s balance sheet that I did before, because I’m not sure it’s relevant to the present argument.
I want to quote a few passages from prior articles, because it has been so long. From the conclusion of article 3:
My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can?t control.
The main thing that I got wrong in the prior parts of this series was assuming longer interest rates would rise, leading to a tightening of short-term interest rates. I expected my scenario 2 ( Growth strengthens and inflation rises), and we got scenario 3 ( Growth weakens and inflation remains low). Regarding scenario 3, I said:
3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.
I also thought that the Fed would have a hard time taking back the policy accommodation:
But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.
The hullabaloo over raising the fed funds rate over 3% has passed. A debt-laden economy slowed down faster than expected, leading long rates to fall, and the yield curve inverted. The Fed has been loosening amid an economy that is middling-to-weak, grudgingly, because unlike most other loosening cycles, nothing has blown up yet.
(An aside: The Fed could have fought back via a balance sheet-neutral swap of all their bonds longer than 10 years for an equal amount of T-bills,and short T-notes. That would have steepened the yield curve.)
But we are in an environment where the Fed is trying to deal with everything, like an overworked superhero. Repo markets having trouble? Flood the short-term lending markets with liquidity, and reverse the shrinkage of the Fed’s balance sheet.
By removing risk from the repo markets, it incents players there to get more aggressive, because they know the Fed has their backs. Better to let the players know that the repo market is subject to considerable volatility. They need to consider liquidity conditions like any other prudent investor, realizing that losses are indeed possible.
Summary
The Fed needs to return to the days of Volcker and Martin, where they let risk markets go their own way, and focus on the real economy only. They won’t do that, because past Fed easy accomodation has led to a lot of debts, both public and private.
Monetary policy accommodation is “easy going in, but hard going out.” The financial markets now think of low rates and ample liquidity as a birthright, not a temporary accomodation, partially because servicing the debt in a low interest rate environment is a lot easier. It is also partially because rates were so low for so long that expectations have adjusted.
I don’t see how the Fed gets out of this situation. Sitting and waiting, swapping away the long Treasuries would not be the worst idea in the world. But when there is a lot of debt, it tends not to get paid down in a orderly way during a recession. Defaults will come cheaper by the dozen.
I don’t think avoiding financial fragility at this time is the best long-term option. The banks are in decent shape, despite the repo market. Corporate bonds and loans and low-end consumer loans will bear most of the losses in the next recession. Best to take the hit, and let everyone know that the Fed does not exist to facilitate speculation, but to restrain inflation, and promote labor employment.
Then maybe, post recession, we can get a growing economy, a normal-shaped yield curve, and a less-indebted economy… excluding the indebted US and municipal governments, which truly are hopeless.
A while ago I wrote two pieces called “Easy In, Hard Out.” ?The main idea was to illustrate the difficulties that the Federal Reserve will face in removing policy accommodation. ? In the past, the greater the easing cycle, the harder the tightening cycle. ?I don’t think this time will be any different.
In the last two pieces, I showed three graphs to illustrate how the Fed’s balance sheet has changed. ?I’m going to show them again now, updated to 11/11/2015. ?Here’s the graph showing the liabilities of the Federal Reserve — i.e. what the Fed eventually has to pay back, occasionally with interest:
I’ve added a new category since last time — reverse repurchase agreements (“reverse repos”) because it has gotten big. ?In that category, you have money market funds (etc.) lending to the Fed to pick up a pittance in interest.
As you might note — as the balance sheet has grown, all categories of liabilities have grown. ?The pristine balance sheet composed mostly of currency is no more — it is only around 30% of the liabilities now. ?The biggest increase in reserve balances at the Fed — banks lending to the Fed to receive a pittance in interest, because they have nothing better to do for now.
I’ve considered doing an experiment, and I might do it over the next few weeks. ?I went to my copy of AAII Stock Investor, and pulled out the contact data for 336 banks with market capitalizations of over $100 million. ?I was thinking of calling 10 of them at random, and asking the following questions:
What has the Fed’s ZIRP policy done to your business?
Do you have a lot of money on deposit at the Federal Reserve?
When the Fed raises the short-term interest rate, what do you plan on doing?
Then, the same questions asking them about their competitors.
Finally, who has the most to lose in this situation?
It could be revealing, or it could be a zonk.
One more interesting note: reverse repos and my “all other” category have become increasingly volatile of late.
Here’s my next graph, with the asset class composition of the Fed’s balance sheet:
The Fed has gone from a pristine balance sheet of 95% Treasuries to one of 60/40 Treasuries and Mortgage-backed securities [MBS]. ?MBS are?considerably less liquid than Treasuries, particularly when you are the largest holder of them by a wide margin — I’ve heard that it is 25% of the market. ?The moment that it would become public knowledge that you were a seller, the market would re-rate down in price considerably, until holders became compensated for the risk of more MBS supply.
Finally, here is the maturity graph for the assets owned by the Fed:
The pristine balance sheet of 2008 was very short in its interest rate sensitivity for its assets — maybe 3?years average at most. ?Now maybe the average maturity is 12? ?I think it is longer…
Does anybody remember when I wrote a series of very unpopular pieces back in 2008 defending mark-to-market accounting? ?Those made me very unpopular inside Finacorp, the now-defunct firm I worked for back then.
I see three hands raised. ?My, how time flies. ?For the three of you, do you remember what the toxic balance sheet combination is? ?The one lady is raising her hand. ?The lady has it right — Illiquid assets and liquid liabilities!
In a minor way, that is the Fed now. ?Their liabilities will reprice little as they raise rates, while the market value of their assets will fall harder if the yield curve moves in a parallel shift. ?No guarantee of a parallel shift, though — and I think the long end may not budge, as in 2004-7. ?Either way though, the income of the Fed will decline rapidly, and any adjustment to their balance sheet will prove difficult to achieve.
What’s that, you say? ?The Fed doesn’t mark its assets to market? ?You got it. ?But cash flows don’t change as a result of accounting.
Now, there is one bit of complexity here that was rumored at the Cato Conference — supposedly the Fed doesn’t use a prepayment model with its MBS. ?If anyone has better info on that, let me know. ?If true, the average life figures which are mostly in the 10-30 years bucket are highly suspect.
As a result of the no-mark-to-market accounting, the Fed won’t show deterioration of its balance sheet in any conventional way. ?But you could see seigniorage — the excess interest paid to the US Treasury go negative, and the dividend to its owner banks suspended/delayed for a time if rates rose enough. ?Asking the banks to buy more stock in the Federal Reserve would also be a possibility if things got bad enough — i.e., where the future cash flows from the assets could never pay all of the liabilities. ?(Yes, they could print money together with the Treasury, but that has issues of its own. ?Everything the Fed has done with credit so far has been sterile. ?No helicopter drop of money yet.)
Of course, if interest rates rose that much, the US Treasury’s future deficits would balloon, and there would be a lot of political pressure to keep interest rates low if possible. ?Remember, central banks are political creatures, much as their independence is advertised.
Conclusion?
Ugh. ?The conclusions of my last two pieces were nuanced. ?This one is?not. ?My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can’t control.
My view is that there is no such thing as a free lunch, not even for governments or central banks.? Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others.? So it is for the Fed.? At the beginning of 2008, they had a small, clean, low duration (less than three years) balance sheet on assets.? Today the asset side of their balance sheet is much larger, long duration (over 6 years), negatively convex, and modestly dirty as a result.? Let me give you a few graphs created from the H.4.1 data, obtained via the poorly designed and touchy Data Download Program at the Fed?s H.4.1 portion of their website.
The first graph gives the liabilities of the Fed over the last 5+ years.? The data is taken from table 1 in the H.4.1 release.? You can see the massive expansion of the liabilities, and the way the crisis unfolded.? Currency, and ?Other Liabilities & Capital? build ?slowly,? i.e. 6.9%/yr and 10.2%/yr, respectively.? The US Treasury steps in with the Supplementary Financing Account at a few points where the Fed could use money deposited there for further expansion of quantitative easing, and leaves when they are no longer needed.
But the real growth comes in the ?Everything else? which grew at 37%/yr, and reserve balances with Federal Reserve Banks, which you can calculate an annualized rate of growth for (112%/yr), but a rate doesn?t do justice to the process, because it grew due to the three events ? QE1, QE2, and QE3.? The Fed bought assets from various parties, who now deposit at banks inside the Federal Reserve System.
The next two graphs come from Table 2 of the H.4.1 report.? These describe the assets that have a maturity, which comprise over 80% of the Fed?s assets over the time of the graph, and over 90% at present.? First, you can see the growth of the assets bought through QE, Treasuries, Agencies, and MBS.? Second, you see the crisis responses: 1) the loan programs in the US, which explode and trail away and 2) the Central Bank Liquidity Swaps, which explode, trail away, and have come back in a muted form in late 2011 to early 2012.
Perhaps the bigger change is that the Fed?s balance sheet has a lot more long-maturity assets than it used to.? This stems from the quantitative easing they have done, as well as their efforts to play God flatten the Treasury yield curve.
Now, almost all of the assets underlying everything 10 years and shorter pay out their principal all at the end, with no right of prepayment.? For 10 years and longer, at present 70% are Mortgage Backed Securities [MBS].? Those have average lives (weighted average time for payment of principal) considerably shorter than a bond that pays all of its principal at the end for three reasons:
Principal gets paid down slowly due to normal amortization.
Prepayments get made when it is advantageous to the borrower, which not only pays off principal today, but shortens the term of the loan, which accelerates the normal repayment of principal.
The final maturity of the longest loan in the pool is the final maturity of the pool.
So, in terms of actual interest rate sensitivity, the over 10 years bucket is probably only a little more sensitive to change in rates than the 5-10 year bucket.
In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.? Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.? Staying short maintains flexibility.
Yes, the Fed does not mark its securities or gold to market.? Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.? Rare exceptions ? home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.? (Hey, the central bank has been eliminated twice before.? It could happen again.)
The only real effect is on how much?seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.? This isn?t trivial; when people hear the central bank is ?broke,? they will do weird things.? To avoid that, the Fed?s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.? Can you imagine what the replacement cost of the NY Fed building is?? The temple in DC?
Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.
Back to the main point.? What effect will this abnormal monetary policy have in the future?
Scenarios
1) Growth strengthens and inflation remains low.? In this unusual combo, it will be easy?for the Fed to collapse its balance sheet, and raise rates.? This is the dream scenario; and I don?t think it is likely.? Look at the global economy; there is a lot of slack capacity.
2) Growth strengthens and inflation rises.? The Fed will likely raise the interest on reserves rate, but not sell bonds.? If they do sell bonds, the market will back up, and their losses will be horrible.? If don?t take the losses,?seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.? This is where the asset-liability mismatch bites.
If the Fed doesn?t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery ? because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.
3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.
4) Growth weakens and inflation rises, i.e. stagflation.? There?s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.? If it doesn?t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.? (As I?ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can?t be done.? The pains of bad debt have to go somewhere, where it goes is the argument.)
I?ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.? I accept that, and I could be dead wrong, as I sometimes am.? Comment as you like, with grace and dignity, and let us grow together in our knowledge.? I?ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.
Summary
During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.? In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can?t imagine, or non-inflationary growth).? But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.
Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.? Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the ?Great Moderation? beguiled so many.
Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.? Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.? Please, Mr. Bernanke, take some blame there on behalf of the Fed ? the credit boom could never have happened without the Fed.? Painting the Fed as blameless is wrong; the ?Greenspan put? landed us in an overleveraged bust.
I?m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust ? too much bad mortgage debt, with a government whose budget is out of balance.? (In the bust, there are no good solutions.)? I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.? But now we live with the results of prior bad policy, and may the current Fed not compound it.
Postscript
The main difference between this time and the last time I wrote on this is QE3.? What has been the practical impact since then?? The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.
Banks use this cheap funding to finance other assets.? But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).? The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.? Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.
Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.? Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.? Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.? And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.? At present, my suspicion is that we still have more trouble to come in banking sector.? Here’s why:
We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.? This is why I believe that any removal of policy accommodation will prove very difficult.? The greater the amount of policy accommodation, the greater the difficulties of removal.? Watch the fireworks, if/when they try to remove it.? And while you have the opportunity now, take some risk off the table.
My view is that there is no such thing as a free lunch, not even for governments or central banks.? Any action taken may have benefits, but also imposes costs, even if those costs are imposed upon others.? So it is for the Fed.? At the beginning of 2008, they had a small, clean, low duration balance sheet on assets.? Today the asset side of their balance sheet is much larger, long duration, and modestly dirty.? Let me give you a few graphs created from the H.4.1 data, obtained via the poorly designed and touchy Data Download Program at the Fed’s H.4.1 portion of their website.
The first graph gives the liabilities of the Fed over the last 4+ years.? The data is taken from table 1 in the H.4.1 release.? You can see the massive expansion of the liabilities, and the way the crisis unfolded.? Currency, and “Other Liabilities & Capital” build “slowly,” i.e. 6.9%/yr and 14.1%/yr, respectively.? The US Treasury steps in with the Supplementary Financing Account at a few points where the Fed could use money deposited there for further expansion of quantitative easing, and leaves when they are no longer needed.
But the real growth comes in the “Everything else” which grew at 33%/yr, and reserve balances with Federal Reserve Banks, which you can calculate an annualized rate of growth for, but a rate doesn’t do justice to the process, because it grew due the two events — QE1 & QE2.? The Fed bought assets from various parties, who now deposit at banks inside the Federal Reserve System.
The next two graphs come from Table 2 of the H.4.1 report.? These describe the assets that have a maturity, which comprise over 80% of the Fed’s assets over the time of the graph, and over 90% at present.? First, you can see the growth of the assets bought through QE, Treasuries, Agencies, and MBS.? Second, you see the crisis responses: 1) the loan programs in the US, which explode and trail away and 2) the Central Bank Liquidity Swaps, which explode, trail away, and have come back in what is presently a muted form today.
Perhaps the bigger change is that the Fed’s balance sheet has a lot more long-maturity assets than it used to.? This stems from the quantitative easing they have done, as well as their efforts to play God flatten the Treasury yield curve.
Now, almost all of the assets underlying everything 10 years and shorter pay out their principal all at the end, with no right of prepayment.? For 10 years and longer, at present 75% are Mortgage Backed Securities [MBS].? Those have average lives (weighted average time for payment of principal) considerably shorter than a bond that pays all of its principal at the end for three reasons:
Principal gets paid down slowly due to normal amortization.
Prepayments get made when it is advantageous to the borrower, which not only pays off principal today, but shortens the term of the loan, which accelerates the normal repayment of principal.
The final maturity of of the longest loan in the pool is the final maturity of the pool
So, in terms of actual interest rate sensitivity, the over 10 years bucket is probably only a little more sensitive to change in rates than the 5-10 year bucket.
In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.? Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.? Staying short maintains flexibility.
Yes, the Fed does not mark its securities or gold to market.? Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.? Rare exceptions — home soil wars that fail, orpolitical repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.? (Hey, the central bank has been eliminated twice before.? It could happen again.)
The only real effect is on how much?seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.? This isn’t trivial; when people hear the central bank is “broke,” they will do weird things.? To avoid that, the Fed’s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.? Can you imagine what the replacement cost of the NY Fed building is?? The temple in DC?
Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.
Back to the main point.? What effect will this abnormal monetary policy have in the future?
Scenarios
1) Growth strengthens and inflation remains low.? In this unusual combo, it will be easy? for the Fed to collapse its balance sheet, and raise rates.? This is the dream scenario; and I don’t think it is likely.? Look at the global economy; there is a lot of slack capacity.
2) Growth strengthens and inflation rises.? The Fed will likely raise the interest on reserves rate, but not sell bonds.? If they do sell bonds, the market will back up, and their losses will be horrible.? If don’t take the losses,?seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.? This is where the asset-liability mismatch bites.
If the Fed doesn’t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery — because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.
3) Growth weakens and inflation remains low.? This would be the main scenario for QE3, QE4, etc.? We don’t care much about the Fed’s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.
4) Growth weakens and inflation rises, i.e. stagflation.? There’s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.? If it doesn’t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.? (As I’ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can’t be done.? The pains of bad debt has to go somewhere, where it goes is the argument.)
I’ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.? I accept that, and I could be dead wrong, as I sometimes am.? Comment as you like, with grace and dignity, and let us grow together in our knowledge.? I’ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.
Summary
During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.? In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can’t imagine, or non-inflationary growth).? But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the “policy accommodation.”? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.
But under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the “Great Moderation” beguiled so many.
Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.? Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.? Please, Mr. Bernanke, take some blame there on behalf of the Fed — the credit boom could never have happened without the Fed.? Painting the Fed as blameless is wrong; the “Greenspan put” landed us in an overleveraged bust.
I’m not primarily blaming the Fed for its current conduct; today, it is trying to deal with a lending bust — too much debt, and much of it is bad, with a government whose budget is out of balance.? (In the bust, there are no good solutions.)? I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.? But now we live with the results of prior bad policy, and may the current Fed not compound it.
I wrote the following article for RealMoney in August 2005. ?I don’t like handing out individual stock ideas. ?I would rather teach people how to think about stocks and other assets, because my individual ideas will be wrong 30% of the time, and I will garner a lot of complaints from them. ?I will get few thanks from the 70% I got right. ?The ratio corresponds to that which Jesus had healing the lepers.
That said, those that invested in this portfolio for two years did well. ?Okay, read on:
==-=-==-=–=-==-=-=-=-=-=-=-=–=-=-===-=-=-=-=-=-=-
I’m not crazy about giving individual stock ideas on?RealMoney?because all investing is best viewed in a portfolio context. Individual stock ideas are important, but I believe portfolio construction and management are more important.
Too many investors are looking for the next hot company when they should really be looking for a consistent theory of how to produce reliable returns while minimizing downside risk.
In my column?Evolution of an Investment Style, I tried to describe how I achieve above-average returns while trying to squeeze out risk. This is not an easy process, but it is achievable if you think about investing in the same way an intelligent businessman thinks about his own firm.
That’s what my seven rules from that column are all about.
One of the first things you’ll notice is that there doesn’t seem to be any rhyme or reason to the order in which the stocks are listed. There is a logic here, but the order is based on the timing of initial purchases. Stocks that I have held the longest are on top, and stocks that I have bought for the first time most recently are at the bottom.
This helps me see on a day-to-day and week-to-week basis, which group of ideas are doing well. If my newest are doing well, there may be some mean-reversion happening in valuations.
If my oldest are doing well, there may be a bit of momentum happening for those that have already reverted to the mean. Because I tend to make shifts to the portfolio quarterly in groups of four or so stocks, I can see themes working out as I look at performance in the order that stocks were purchased.
The Current Portfolio
Listed below are the stocks in my portfolio. They are roughly equal-weighted.
Value With a Twist David Merkel’s current holdings
Name
Aug. 10 Close
P/E
Yield
Market Cap
P/E (This Year)
P/B
P/S
Cemex (CX:NYSE)
46.94
6.99
2.51
16.80
8.98
1.83
1.45
Dycom (DY:NYSE)
23.50
21.08
–
1.15
20.98
2.01
1.13
Cytec (CYT:NYSE)
48.25
14.87
0.83
2.22
14.26
1.81
1.18
Ameron (AMN:NYSE)
37.25
21.08
2.14
0.32
10.35
1.14
0.49
Allstate (ALL:NYSE)
58.04
11.62
2.04
38.79
9.33
1.74
1.13
Unilever PLC (UL:NYSE)
41.19
19.40
3.51
66.36
13.18
6.90
1.32
Liz Claiborne (LIZ:NYSE)
41.80
14.18
0.54
4.57
13.71
2.43
0.94
Fresh Del Monte (FDP:NYSE)
25.46
10.80
3.91
1.47
10.97
1.37
0.46
Montpelier (MRH:NYSE)
34.27
11.12
4.08
2.17
7.53
1.49
2.36
PartnerRe (PRE:NYSE)
62.92
7.43
2.26
3.47
8.84
1.00
0.84
ConocoPhillips (COP:NYSE)
65.64
9.66
2.07
91.39
8.42
2.00
0.71
SPX Corp. (SPW:NYSE)
45.36
3.75
2.22
3.41
17.43
1.21
0.76
Canadian National Railway (CNI:NYSE)
67.44
16.43
1.26
18.57
15.36
2.44
3.23
Petro Canada (PCZ:NYSE)
79.42
18.95
0.74
20.83
12.13
2.78
1.67
Stone Energy (SGY:NYSE)
53.71
9.63
–
1.44
7.86
1.51
2.34
Barclays PLC (BCS:NYSE ADR)
42.39
12.67
4.22
68.39
11.54
2.20
2.85
Valero Energy (VLO:NYSE)
90.77
10.74
0.49
23.30
10.14
2.92
0.37
Toyota (TM:NYSE ADS)
78.42
11.93
1.24
128.10
11.12
1.53
0.75
Sappi (SPP:NYSE ADS)
10.88
51.92
2.78
2.46
90.00
1.13
0.50
Apache (APA:NYSE)
71.93
11.09
0.46
23.61
9.46
2.48
3.60
Premcor (PCO:NYSE)
81.05
9.80
0.08
7.24
9.91
2.75
0.38
Ryerson Tull (RT:NYSE)
19.37
6.05
1.28
0.49
5.13
1.05
0.10
Jones Apparel (JNY:NYSE)
29.03
13.14
1.79
3.44
12.10
1.31
0.70
Neenah Paper (NP:NYSE)
31.45
20.09
0.93
0.46
20.09
2.40
0.63
Johnson Controls (JCI:NYSE)
57.46
12.39
1.70
11.03
12.83
1.91
0.39
Japan Smaller Capitalization Fund (JOF:NYSE)
11.81
5.20
–
0.19
50.00
0.98
108.19
Pfizer (PFE:NYSE)
26.39
20.04
3.43
196.20
13.39
2.92
3.70
Sara Lee (SLE:NYSE)
20.02
13.31
3.83
15.76
13.51
4.61
0.80
Repsol (REP:NYSE)
29.61
14.95
2.19
36.15
8.98
2.00
0.80
Premium Standard (PORK:Nasdaq)
14.76
6.70
0.41
0.46
9.07
1.10
0.40
Anglo American (AAUK:Nasdaq ADR)
26.72
11.68
2.62
39.62
10.32
1.59
1.53
ABN AMRO (ABN:NYSE)
24.73
11.54
7.52
41.28
10.25
1.78
1.61
Gold Kist (GKIS:Nasdaq)
18.93
8.60
–
0.97
7.86
2.46
0.90
Dana (DCN:NYSE)
15.01
11.73
3.12
2.26
12.92
0.98
0.24
SABESP (SBS:NYSE)
17.14
8.00
4.52
1.95
10.05
0.54
0.98
11.68
2.04
4.57
10.97
1.81
0.90
Source: David Merkel, Yahoo!
This Portfolio Is Weird
Even though I manage this portfolio the same way that a “long-only” mutual fund manager would, because my portfolio is diversified by country and capitalization, it doesn’t fit any of the neat classifications common to mutual funds. I’m not running a mutual fund for which I’m anxious to gather assets, so this doesn’t bother me. Given that, I will now describe the way the portfolio breaks down by country, capitalization, sector and industry.
Sector Mix The makeup of this portfolio defies easy categorization
Source: David Merkel
A notable characteristic of the portfolio is that 34% of it is non-U.S. Even adding back the two Bermuda reinsurers (which only trade in the U.S.), the percentage foreign is 29%. This is high enough that it would be hard to call this a domestic fund, but low enough that it can’t be an international or global fund. Why do it this way? Because I believe it offers the best returns to a U.S. investor. I try to buy stocks that operate in stable parts of the world, with reasonable legal systems. I consider information, war and expropriation risks. When something outside the U.S. seems too cheap, I buy it, but I don’t force myself to stay inside or outside of the U.S.
My approach to market capitalization is not as idiosyncratic. I am “all capitalization,” which is done by a number of mutual funds. I am probably more large-cap now than I have been in years. Small-caps generally don’t offer the valuation discount that I like to see when buying something off of the beaten path. Mid-caps I normally like best, because they typically have the stability of large-caps, but still have enough potential to grow, like some small-caps do. At present, many large-caps seem quite cheap, so I have more of them than normal.
The most important thing to look for in market capitalization is rule No. 4 from the column I mentioned above: “Purchase companies appropriately sized to serve their market niches.” Some businesses need scale in order to be profitable. Other businesses favor the entrance of smaller competitors following a niche strategy. “Is the business the right size in order to prosper?” is a question that intelligent investors ask.
Sector/Industry Mix
Looking at both the sector and industry mix, Jim Cramer would probably gong me in his radio show’s “Am I Diversified?” segment. Well, no, I’m not diversified, at least not by sector and industry. I can hear the comments: Where’s the tech and telecom??Pfizer?is not enough for health care. Only one utility, and that one’s in an emerging market? You’re too overweight in materials and energy. Agriculture has been a loser for years. You’re joking, right?
I’ve always run an undiversified portfolio, because intelligent sector rotation can add value. Industries tend to trend in the short run and revert to the mean over the intermediate term. I try to analyze where the pricing power of industries is as I evaluate companies for investment. There are two things that get me primed for purchase:
Things are abysmal and no one wants to invest there. (Think of auto parts.)
Or, stock prices have not caught up to the industry pricing cycle. (Think of energy.)
That’s how I view it. I want to be in industries that are underrated, whether that’s due to a bruising bear market in an industry, or because of an abundance of skepticism in the face of improving fundamentals.
Valuation Parameters
The summary statistics of my portfolio are shown in the table below.
The Numbers at a Glance
Category
Median Value
P/E last year
11.7x
P/E this year
11.0x
P/E next year
10.4x
P/Book
1.8x
P/Sales
0.9x
Yield
2.00%
Range
72%
ROE
18%
Source: David Merkel
You can tell that my portfolio broadly fits into the “traditional value” style. I like my modified form of Graham and Dodd, with tweaks from Marty Whitman and a number of other notable value investors. That said, it’s my unique synthesis, and it has paid off for me in performance. Buying them cheap is critical to both good performance and risk control.
You might adopt my style or you might not; it takes some effort to do well with it. But the important thing is thinking through your portfolio management process to make sure that it’s fundamentally sound, businesslike, intelligently contrarian and something that fits into the way you live your life. Life is broader than investing, and management techniques must be small enough in time use for them to be a part of a broader, well-balanced life. You have my best wishes as you work out your own investment management style.
Before I start this evening, I want to say something about many investment books that I have been reading of late. ?In terms of information toward the stated goal of the book, there is often a lot of build up, some of it necessary, some not, some of it interesting, some not, occasionally some unique insights, but most of the time not. ?Much of it is filler that could be eliminated. ?And, if you eliminated the filler, and boiled down the part of the book that attempts to prove the stated goal, you would have something the size of a long-form blog post. ?That’s why there is the filler — you would have a hard time selling a single chapter book, even though that contains the real value of the book, and would save your reader the time of wading through filler material.
Also, when I review books, I read them in entire. ?If I don’t read them in entire, I state that plainly at the beginning of the review, along with why I thought I could review the book without reading it. ?But after some of the books I have read lately, editing to condense the volume and stick to the topic at hand would be a help.
Finally, if the author doesn’t prove his case in an ironclad way, maybe the book shouldn’t be written. ?I often get to the end of a book disappointed, because the author promised a significant result, and did not deliver.
Onto tonight’s topic:
When is the best time to invest? ?When everyone else is scared to death of investing. ?It’s when friends come up to you and say, “I’m never investing in stocks ever again.” ?When the magazine covers proclaim “The Death of Equities,” it is time to invest.
Guess what? ?Very few people do invest then. ?It’s too painful to contemplate throwing away your money when nothing is going right, and losses are cascading. ?Remember, we are not rational, we are mimics.
When do people like to invest? ?When it’s popular to do so. When prices have been rising for a while, and the lure of “free money” is in the air. ?Books on easy money flipping homes proliferate, and there is a brisk business in seminars teaching an easy road to riches. ?It’s that time when people say, “Let the market pay your employees.”
I’ve talked about the fear/greed cycle many times before. ?I’ve also talked about time-weighted vs dollar-weighted returns before. I’ve talked about vintage years in lending before, and about absolute return investors before. ?I’ve talked about industry rotation before, as well as long-term mean reversion. ?These are all manifestations of the same phenomenon in investing — it is best to invest in any given area when few are doing so, and worst to invest when almost all are doing so.
Let me give a bunch of parallel examples to make this clear.
Why do great mutual fund managers cease to be great? ?When they are great, they have less money to manage than their ideas could bear managing. ?But money follows performance because we are not rational, we mimic. ?Eventually enough money comes in ?such that the talented investor no longer has good places to put incremental money, and can’t just leave some of the money in cash, or an index fund… from a business angle, it would not fly.
Lest you think that this does not happen to passive investing, money follows performance there also. ?It also happens in open-ended index funds, ETPs, and closed-end funds of any sort (expressed through the premium or discount).
This also applies to quantitative investment strategies — even those with broad themes like momentum and valuation. ?Let me illustrate this with a slide from a presentation I have done before a large CFA Society:
And this applies to lending whether securitized or direct. ?When money is being thrown at a sub-asset class, like subprime RMBS in 2006-7, or manufactured housing ABS in 2000-1, the results are bad. ?The best results occur when few are lending, and only the best deals are getting done. ?But that means that few get those high returns. ?That is the nature of the markets.
The same applies to corporate bonds. ?It is wise to avoid the area of the market where issuance is well above average. ?When I was a corporate bond manager, I sold out my auto bonds, and my questionable telecom bonds, amidst much issuance. ?I had many brokers puzzle over why I would not buy their deals, even though they were cheap relative to their ratings.
The same applies to private equity. ?When a lot of money is being applied there, it is a time to avoid it. ?As it is now, private equity is throwing money at promising companies, many of which hold onto the money for safety purposes, because they don’t have place to invest it. ?That doesn’t sound promising for future returns.
Finally, we have a few absolute return investors like?Klarman, Grantham, and Buffett. ?They are reducing allocations to risk assets, at least in relative terms. ?Opportunities are not as great, and so they wait.
Summary
The intelligent investor estimates likely returns, and invests if the returns are worth the risk. ?I am reducing my risk positions, slowly, as I see best for my clients and me.
Most profitable investing takes an uncomfortable view versus the consensus, and buys when the market offers good deals. ?If there are no good deals, profitable investing sits on cash, and waits for a better day.
I really enjoyed answering the “Ask Our Pros” questions at RealMoney.? I answered the following on May 11th, 2005, and would add in Jeff Gundlach and Ed Meigs as active managers:
Ask Our Pros is a service we provide to RealMoney subscribers that enables them to get answers to their investment questions from our contributors. To ask a question, you must be a RealMoney subscriber.? Please click here for information about a free trial.
Reader:
Can someone explain bonds, tax-free vs. taxable? What are some of the strategies that you use to purchase bonds, and what percentage of your portfolio typically should be in bond funds?
— A.A.
David Merkel:
Here is my simple advice for retail bond buyers:
Bonds are promises, from various entities, to pay back the money that you lent, plus interest. Most bonds are taxable. A few, like U.S. Treasury bonds, are exempt from state taxes, while many of the bonds of municipalities are exempt from federal taxes, state taxes (usually if the municipality is in your state) and city taxes (usually if it’s the city you live in).
With respect to taxability, what is best to buy depends on your marginal tax bracket. The higher your tax bracket, in general, the more municipal bonds can help. Beyond that, it is worthwhile to compare the after-tax yields on taxable and nontaxable bonds with equivalent risk. (As always, please be sure to check with a qualified tax professional for advice on your specific information.)
Now for the controversial bits. In general, I don’t recommend that individuals buy individual bonds, unless you are buying Treasury bonds and are following a simple strategy like a ladder.
A ladder is a set of bonds that mature sequentially. Say the ladder is five years long; each fifth of the bond money would be invested one, two, three, four and five years out. Each year, you would take the money from the maturing bond and buy a new bond five years out. Many bond managers pooh-pooh ladders because they think they can beat the performance of a ladder. But a ladder is the most robust bond strategy out there, period. I believe it gives the best return for the risk, particularly given the possibility of shifts in inflation, yield-curve twists, etc. But a bond manager can’t get paid for running a ladder.
There are other reasons for avoiding individual bonds: Bond dealers often rip off retail investors. I have stories, but they’ll have to wait for another day. Liquidity for retail investors is generally poor. Most of the bonds pitched to retail investors will be new issues, which aren’t necessarily the best bonds to buy; they just happen to be the bonds most available at a given moment. This is particularly true of municipal bonds. If you don’t believe me, read Joe Mysak’s column on Bloomberg for a while. The municipal market is a place you don’t want to go without an adviser.
Another reason you don’t want to buy bonds, single-issuer bond trusts or preferred stocks on your own is that many of them have funny features that make the yield look really good, but the bonds can be called away in low interest rate environments, leaving you to reinvest in that low interest rate environment. One dirty secret of bonds is that the excess yield inherent in callable bonds and residential mortgage-backed securities on average does not compensate for the call risk. Only a few experts win that game, and you likely are not one of them.
Finally, my word on bond funds: There are very few managers worth paying up for. Maybe Dan Fuss at Loomis Sayles, Bill Gross at Pimco and a few other, more obscure managers that I am less certain are worth paying up for. The only guarantee in bond funds is that low expenses win in the long run, so I’d go to Vanguard. Performance advantages are fleeting, and tend to revert to the mean, but expense advantages are permanent. Vanguard’s bond funds usually are in the top half each year; repeating that for 10 years makes them top decile.
So don’t take the hard road. I’d go to Vanguard and use their Total Bond Market index fund. Utterly unsexy, but a winner. The only place where Vanguard lacks is international bond funds; it has none. For that, if I want diversity, I go to T. Rowe Price, or buy a closed-end fund that doesn’t hedge currencies at a discount.
How much to invest in bonds? Consult your financial planner. This factor varies so much, it’s all over the map. The right proportion of bond investment depends on market conditions, investment horizon, your personal life factors, wealth level, risk aversion, etc. My experience is that most people are unbalanced in their asset mixes — too much is in stocks or too much is in bonds. The best default mix might be Ben Graham’s 50/50, or the pension mix of 60% stocks, 40% bonds. These are both very robust strategies, but again, what is best for you depends on your personal situation.
I have to say, from the business side of the desk, I really loved managing a multibillion-dollar bond portfolio. I really did well at it, but the best part about it was interacting with my brokers, who all were stupendous to work with. I find that running equities is antiseptic, particularly as an analyst who has an exceptionally competent trader to execute his decisions. Running bonds is colorful because of the human interaction and all of the games that can arise from that. I learned how to haggle in the bond market, and for a nerd like me, becoming good at that was a surprise. Would I want to manage bonds again? Yes. It was fun.
Retirement.? A concept of the late 1800s to the present.? Easy to swallow when the population is growing rapidly.? Tough to do when populations are growing slowly, much less shrinking.? I would point you to two articles I have written:
With stock prices high and interest rates low, many people look at their portfolios and smile: high current market values.? But what would happen if you had to turn?it into income?? Interest rates are low.? Dividend yields, though better than the past, are still pretty low.? This is another place where total return blinds us to economic reality.? If market values have risen solely because people are desperate for yield, earnings, etc., and not because future productivity is likely to be far higher, the rise in asset values does not represent a rise in distributable cash flows, which is what investors truly need.
Think of this a different way, and ignore markets for a moment.? How do we take care of those that do not work in society?? Resources must be diverted from those that do work, directly or indirectly, or, we don’t take care of some that do not work.
Back to?markets: Social Security derives its ways of supporting those that no longer work from the wages of those that do work.? That’s one reason to watch the ratio of workers to retired.? When that ratio gets too low, the system won’t work, no matter what.? The same applies to Medicare.? With a population where growth is slowing, the ratio will get lower. If the working population is shrinking, there is no way that benefits for those retiring will be maintained.
Pensions tap a different sort of funding.? They tap the profit and debt servicing streams of corporations and other entities.? Indirectly, they sometimes tap the taxpayer, because of the Pension Benefit Guaranty Corporation, which guarantees defined benefit pensions up to a limit.? There is no explicit taxpayer backstop, but in this era of bailouts, who can tell what will be guaranteed by the government in a crisis?
Current low interest rates imply that there aren?t a lot of highly productive projects yearning for capital.? This is a product of overly easy monetary policy that never let recessions clear away bad projects.? Low interest rates make future promises more expensive for defined benefit plans, and make it harder to accrue assets for defined contribution plans.
Do you have one million dollars socked away yet?? No?? Under optimistic assumptions, maybe you can earn 4% on your money without touching the principal.? That would give you $40,000/year pre-tax.? Add in Social Security, and maybe you can make things work.
If you want to give up liquidity, and any sort of estate for heirs, you could annuitize all or part of your assets, bringing your yield up 1-2%.? For whose who have less money, that could make things work.
That said, inflation could throw a monkey wrench into all of this.? Buying inflation protection knocks around 0.5% off yields.? But who knows how much the government will encourage or discourage inflation?? That is the leading open question at present.
Summary
So long as interest rates remain low, and asset values high relative to replacement cost, funding retirement will be an expensive proposition.? Not many will be able to do it.? As population growth slows, government entitlements will prove difficult to maintain at current levels.
As such, we should expect older people to work longer than their parents and grandparents did.? In many cases it will be ?Work till you die.?? The idea of retirement as a long vacation at the end of life will only be true for the well-off, a minority of the population.
And compared to prior history, that?s how it should be.? A comfortable retirement is an expensive proposition, and not something that can be given to everyone by government fiat.? The economy only has so much productivity; to the degree that retirees suck off resources, there is that much less to help the economy grow.
I write this as a 52-year old man.? I have opportunities ahead, but for most people in the Western nations, as demographics lead to older populations, economies will decline unless something comes to revive growth in population.
To those who are older, I say ?Be ready to work.?? To those who are younger I say, ?Plan and prepare, save, and figure out how to supplant the oldsters who occupy the positions you want to have.?
It?s not going to be easy over the next forty years.? But if it were easy, everyone could do it.? Instead, those who are prepared will do it.? And so my readers, get ready to do it.
Most of Friday I spent as judge at the Global Investment Research Challenge for Washington, DC and Baltimore.? I really like working with students.? They are so earnest, and they work so hard.
Last year, the company was Under Armour, which was tough because it was a growth company.? Very difficult to value.? This year, the company was Marriott, which I think is even harder to value because of its asset-light strategy.?? Further, they have bought back so much stock that not only is the company’s tangible book value negative, but the unadjusted book value is negative too.
But for what it is worth, the students this year had similar views about the target company, and the range of target prices was small versus what I saw with Under Armour.
But when I listen to the students, I sometimes cringe, because I’ve studied statistics to a far higher degree.? Now, when I judge, I don’t take my views into account, because I know I am in the minority, and the students don’t know that they are getting bad methods for analysis.? Let them listen to their professors, who don’t have a clue as to how the economy really works, and express what they have learned.
But if I had control over what Finance students were taught, I would do the following:
1) I would reduce the math content for finance students and increase the qualitative understanding of markets.? No more MPT.
2) I would increase the level of understanding on how to relate with people, because that makes a big difference in negotiating trades.
3) I would want them to work in a simple business, like a hot-dog cart, or mowing lawns, so that they could begin to get an idea of how tough it is to earn a profit.? My best boss in my life grew up watching his parents’ delicatessen, and it shaped his view of how to make a profit.? I didn’t have that as a kid, but I did have two parents who pointed out to me that life wasn’t easy.? The profits of my Dad’s business were by no means certain, and evaporated in the early 80s.? My Mom reinvested much of my Dad’s earnings into her stock portfolio, far exceeding what most investors achieve, but with periods that would make you wonder.? I partly paid for some of my college education by encouraging my Mom to buy a company that she previously sold that several years later went private for a handsome price.
4) I would revise the concept of the cost of capital to make it credit-centric.? All the efforts to calculate the cost of equity capital from equity market correlations are bogus.? They don’t make any economic sense.? In most cases, the cost of equity should not exceed the yield on an average CCC bond.
5)? I would tell them that changes in inflation and real GDP don’t have as large of an impact on corporate profits as is commonly thought, both positively and negatively.? I would tell them to focus on the stock, and drop the complex model.? Few in the investment business work off a complex model, and if you need one, you can buy Value Line, which I like, which tries to use a single macroeconomic model for 1700 popular stocks.? (and I get the model for FREE, because my county library subscribes to the WHOLE ENCHILADA, and I can ride on their back.? Morningstar too.)? I’m generous with my insights, but I rarely pay for services, because I know that they can be obtained cheaply, most of the time.
Positively
I would teach students to think on a higher level.? Not this causes that, but this influences that, and a lot of other effects occur as a result.? This is similar to Howard Marks’ concept of “second level thinking.”
By the way, I would do the same thing for the SOA and CFA syllabuses.? Modern Portfolio Theory is garbage, and needs to be abandoned.? We understood the markets better prior to MPT,
I would teach students that markets are not neutral, and that there are people out there trying to deceive you.? I’ve had more than my share of charlatans that I have had to oppose.
In place of randomness, and statistics that imply randomness, I would teach about margin of safety, and tell them, “Do your hard work.? Analyze likely profitability.? Analyze free cash flow.? Analyze the likelihood that you are correct; make sure the price at which you are buying includes a significant margin of safety.”
I would tell them to analyze free cash flow.? Today, with the company Marriott, that was the only thing that mattered.? One team hit the nail on the head. The rest did not.? The team that hit the nail on the head is going to Toronto to compete in the North American competition.? Should they win, they go to the final round, I know not where.
Anyway, that is a start.? As with Buffett, who always thinks of what is the best way to earn and compound earnings, it is far better to analyze successful businesses than to analyze what academics think about business.? After all, what, academic has created a successful business?? Few, if any.
This is a different book for me to review, but as my wife once said to me, “Only you could see the economic angles of ‘Little House on the Prairie.'”? Guilty as charged.
Many people have read “Cheaper by the Dozen,” and “Belles on Their Toes.”? Indeed, I read them as a child, and to my children as an adult.? That era in America had huge families as families moved from the country to the cities, and primitive methods of birth control were temporarily forgotten, often amid economic success.? Many people wanted large families if they could afford them.? Affording them was the problem.? My grandparents were kids in large families.? Seemed to be the rule back then.
What makes “Time Out For Happiness” special is that it traces the lives of Frank & Lillian Gilbreth, the parents, and explains why they were so special, not as parents, but as intellectuals that changed our world.
Frank Gilbreth was an ambitious young man who was always looking for a better way to do things.? In learning bricklaying, as an amateur, he analyzed what experts did, looking for the best way to do it.? The experts were annoyed at the neophyte who wouldn’t simply imitate, but had to think it through.? The neophyte was markedly worse initially, but then discovered an idea: if you set up the work to minimize unnecessary motion, a worker can work faster, and with less effort.? Frank devised a way of putting all that a bricklayer would need within easy reach, and he became the fastest bricklayer around.? He then made money selling his system, but then he went on to do the same for many building tasks, raising productivity dramatically, without demanding that workers work harder.
This contrasts with the ideas of Frederick Winslow Taylor, whose disciples measured employees with stopwatches, and urged that all work faster.? Gilbreth assumed that most workers wanted to do a good job; how could he make doing a good job easier.
Politically, Gilbreth was a centrist; he wanted the growth in productivity to be shared by all; he worked mostly with those that would deliver part of the increase in profits back to workers. As such, Gilbreth’s ideas were often supported by unions, and Gilbreth himself supported unions, so long as they limited themselves to the welfare of workers, and did not create onerous work rules that unnecessarily harmed productivity.
Phrasing it differently, the Gilbreths wanted the increase in productivity to result in greater happiness for all.? After all, if we are saving time by being more productive, what will we do with all the extra time or goods produced?? We should use them to be happy, owners and workers alike.
One key thing that Frank Gilbreth did was do time & motion studies.? With film being a new thing, and expensive, he measured the way people moved at work an analyzed it closely.? He did this with the interests of owners and workers at heart.? This enabled them to come up with process improvements that other experts could not.
As his ideas gain more respect, and as his corporate profits grew, he and Lillian wrestled with the question, “Run a company, or teach ideas?”? They both concluded that being consultants for improving productivity was the most desirable goal, though it took some struggle to give up the immediate profitability of the construction business.? The early days weren’t easy, and its took a while before they got any business, because the disciples of Taylor did not respect him.
When WWI arose, Frank volunteered to help make the military more efficient, and as a Major did so for four months before he became very sick, and Lillian dropped everything in order to save him.? She succeeded, and Frank lived for six more years, building the business, and benefiting their home.? He died while talking to her on a pay phone, traveling to give a talk.
This left her in a financial lurch.? She survived by getting advances on Frank’s inheritance, and building the business Frank left behind, including starting a school for efficiency.? There was no inheritance from here side, because they concluded she needed none, being married to the prosperous Frank.
But as she continued to speak, write and teach, she gained enough? to support the family and send her kids through college.? She received many awards where she was the first woman to receive them.? Lillian was different from Frank because though she knew most of what he knew, and vice-versa, her strength was the employer/employee relationship.? How do you create good relationships that create productivity, and good companies?
Both Frank and Lillian were driven; they worked hard, and focused on the public good.? Frank died working.? Lillian worked into her mid-80s, with her children protesting her demanding schedule.? She gave her last talk at age 90, to honor the work of Frank at his Centennial.? She lived four years beyond that.
She had many famous friends, including many US Presidents, on whose committees she served, from Hoover to LBJ.? Much of it dealt with disability, which both she and Frank had worked on, because they had an interest in helping those who had it bad.? Frank devised ways to aid the disabled to dress, and more.? Lillian improved on that.
Do you want to get to know two quirky humanitarian people who changed our society?? They created the coffee break (rest helps productivity) and anticipated many later improvements in the workplace.
Don’t Buy This Book
This book is too scarce.? Don’t buy it.? Use interlibrary loan to borrow it.? But it is a very good book, and I haven’t told you the half of it.
