I admire Morningstar for its January 16 confession, an article on its site entitled Our Biggest Mistakes of 2008. To err is human. To forgive is divine. To learn is even better. Unfortunately, from reading the article, I suspect Morningstar may have missed its biggest mistake: too much youth and too little experience.
Morningstar cited seven lessons which, however new they may have been to the author of the article, are old hat to anyone who’s been around the block a few times. The numbered subject headings below are quoted directly from the article.
- Watch Out for Correlated Risks
This lesson comes as a great surprise to present and recent students, but it’s business-as-usual to market veterans, many of whom are well familiar with the adage “In times of crisis, all the correlations go to 1.00.” This isn’t simply a cute saying. It’s fundamentally inevitable.
The normal state of affairs for a healthy market is disagreement. After all, every transaction has someone who thinks it’s smart to buy, and someone else who thinks it’s smart to sell. Price movement occurs when there’s more of one than the other. But as long as there’s a reasonable body of opinion on either side, we’ll have healthy, liquid markets.
Such difference of opinion does not occur because one person is smart and another person is dumb. Although it’s fun for pundits to suggest Wall Street is an ignorant mob, etc., the reality is that most people in this arena are at least competent and many are downright brilliant. Disagreement is normal because the world is an incredibly complex place, one in which reasonable arguments can be made for both sides of a question.
Things change in times of crisis. As conditions become more extreme, it becomes harder and harder to justify one side of the argument. Eventually, conditions become so intense, pretty much all of the market’s generally-rational participants see things the same way. Hence a reduction in liquidity and exceptional price movements.
This, along with interconnectedness (to be discussed below) pushes those correlations toward 1.00. We’ve seen it in crises of the past. And we’ll see it again and again in crises of the future.
- Conditions Can Change Rapidly, Radically
Morningstar learned this in 2008. I learned it in 1982. Others who’ve been in the business longer learned it earlier.
Back in the early ‘80s, during that housing crisis, I, a junior analyst, covered homebuilding stocks. I still recall how, in August 2002, a peer panned my 3- to 5-year projections as being way too optimistic. As it turns out, the company beat my estimates in one year and the stock blew past my projections within 3- to 5-weeks.
I have more anecdotes like that, both upside and downside. So, too, I would assume, does anyone else who’s been around.
This isn’t just one of those things. It stems directly from the way forecasting is done. Quant models one way or another seek to smooth rough edges by finding something, a line or whatever, that cuts through the chaos and describes some sort of overall tendency.
That’s all well and good for forecasting. But in the real world, it’s the jagged edges that rule the day. Our ability to create nice, neat, functions does not alter the fact that the world remains as sloppy as ever.
So we need to take projections which often call for gentle downturns and gradual recoveries with a grain of salt. Things go down fast when the real-world jaggedness works against us. We’ve been seeing plenty of that lately. The good news is that things also go up faster than forecasts expect. So if you’re young and this is the first crisis you’re seeing, learn now that the upturn, whenever it arrives, will probably be much sharper and more vigorous than any respectable prognosticator will dare predict.
- Liquidity Concerns Can Be a Self-Fulfilling Prophecy
This is not a new lesson. It’s the real-world essence of liquidity. It has little to do with financial ratios and much to do with sentiment. I learned that the hard way, when I managed a junk bond fund during the Drexel era.
If the financial community in general and creditors in particular believe in a company’s future, it will survive no matter what. If it runs out of cash, more will be supplied. If falls into violation of covenants, then they’ll be waived or amended. If debt can’t be repaid, the obligations will be restructured. And if creditors insist on playing hardball, management will often threaten bankruptcy, causing creditors who think they can negotiate perhaps 50-70 cents on the dollar to fear a much worse outcome from a prolonged court battle.
At present, we’re seeing a close variation of this; companies that by any objective standard are truly dead, but not dying because there are other agendas that compel other to make them survive one way or another (major banks, and possibly the Big Three automakers).
Conversely, if sentiment turns negative, even good ratios won’t keep the bankruptcy lawyers at bay. Even if creditors look to be wrong when the facts are viewed objectively, if they think they’re right, then it’s all over for the company.
Look carefully at any set of financials, especially the footnotes. Notice how even strong companies often presume an ability to get financing when needed especially as debt obligations come due. Such faith is usually well placed. But if something happens to the business that causes creditors to worry about the future, watch how quickly even a supposedly healthy firm can careen toward oblivion.
That’s the way it’s always been. That’s the way it always will be. You don’t get that from the textbooks. But in real life, market veterans have seen it more times than they can count.
- Beware of Companies That Double-Down in Boom Times
Well duh! Even the textbooks will tell you about this.
Suppose a Widget Company A triples its capacity during a boom. What do you think will happen down the road?
Oh, I’m not going to belabor this. It’s too darn obvious.
The only ones who mess up on this issue are those who think the business cycle is tamed, and the only ones who don’t respect the full ravages of a business cycle are those who don’t care (IBGYBG: “I’ll be gone, you’ll be gone”) and those who haven’t been around long enough to see one.
- Never Lose Sight of Competitors
It appears 2008 will go down as the year Morningstar learned “that even wide-moat companies are still under constant assault from the competition.”
Experienced hands have known that for a long time.
Those who were adults before the 1980s undoubtedly remember the lengthy and costly litigation pursued by the U.S. Department of Justice to break up AT&T (T) and IBM (IBM) because they were, allegedly, powerful monopolies within whom nobody could ever compete. For those who are too young to remember, I’m not making this up. It really happened!
I can even remember a time when OPEC was such a powerful cartel, they could make the price of oil be anything they wanted it to be simply by having a meeting and taking a vote. Somehow, though, I doubt this is what recently caused oil to fall from over $140 to less than $40 almost overnight.
Skipping ahead a bit, I’m sure a larger number of readers can remember AOL’s iron-fisted grip on John Q. Public’s internet experience. So how’d that work out?
Then, too, there’s Microsoft (MSFT) and the operating platform dominance that’s so entrenched as to have warranted massive anti-trust litigation. So naturally Windows Mobile has an iron-clad grip on the emerging smart-phone category. Oh, wait. That’s actually not working out too well. Interestingly, the Morningstar analyst who assigns MSFT a wide-moat rating acknowledges this, and also worries about the company’s ability to handle the emerging server-based software-as-a-service business model. So what, exactly, is the point of a wide moat rating?
I don’t mean to pick on Morningstar’s MSFT analysis which, except for the moat rating, looks quite good. But for people who are relatively young, this is a company that bears close watching, as an example of how the passage of time and the natural evolution of business models, trends, etc. can devastate even the most seemingly invincible instances of corporate dominance. And while we’re at it, let’s watch wide-moat (per Morningstar) Google (GOOG) as well. Right now, it still has a lock on paid-search internet advertising. It’ll be interesting to see if business evolution cuts into this, too, as time passes.
I understand it seems odd for me to be panning Morningstar for inexperience while also taking shots at the concept of economic moats, which have been associated with Warren Buffett, If one is to learn from one’s elders, it seems Buffett is as good as it gets.
But before getting too deep in Buffettology, it’s important to dispassionately examine the relationship between what Buffett actually does and the rhetoric that surrounds him. This is a much more complex topic than can be properly addressed right now. For the moment, though, suffice it to say that much Buffettology does not come directly from Buffett but instead from a cottage industry of authors who write about him. Morningstar has clearly absorbed the folksy version. For another view, it may be interesting to check something like James Altucher’s Trade Like Warren Buffett (Wiley, 2005).
I’m especially amused by use of the word “moat” as a metaphor for the idea of having some sort of unassailable position. Think of the classic moats, those things that surrounded castles. How’d that work out? At first glance, they seemed formidable enough. But ultimately, they failed to prevent feudal fiefdoms from being overcome.
Economic moats sound great on paper. But market veterans who’ve seen enough big things come and go know that ultimately, every company must be evaluated in light of two kinds of competitors: the ones you see and can identify right now, and the ones who haven’t yet surfaced openly but eventually will come to light.
It’s nice to dream about sustainable competitive advantage. But let’s not lose reverence for the company that shows it’s ability to duke it out “mano a mano.”
- The World is Interconnected
It wasn’t always this way. Heck, there was once a time when you had to convert currency if you went from New York to New Jersey!
But the interconnectivity we’re seeing today is not something that materialized overnight. Quite to the contrary, it’s been pounding at us loudly for several decades.
Not everyone has been happy about it, but I strongly suspect that most members of the investment community are in the camp that has been cheerleading every step of the way, usually using such phrases as “free trade, ” “comparative advantage,” “outsourcing,” etc. So people who’ve been around cannot be surprised by its presence.
Here’s a simple example.
Americans love to buy a lot of stuff with credit cards, but most of us really hate to spend our days in factories making the stuff, so we won’t do it unless we get paid a wage that’s so high as to make the stuff unaffordable. Fortunately for us, there are plenty of Chinese workers willing to go to the factories to make the stuff and accept wages that allow the sellers to price it at levels we find attractive. But let’s remember that we’re talking about stuff (electronics, sneakers, whatever) and you can’t make stuff without commodities which, actually, is stuff sans the “value added”. And, of course, the Chinese can’t run the factories without energy, and we can’t get to the malls to buy anything unless we, too, have energy.
Suddenly, we have a credit crisis in the U.S. We’d love to keep buying stuff, but now we can’t because we’re tapped out on our credit cards and when we call the banks to ask for an increase in our credit lines, they tell us to drop dead but have a nice day.
Profits among U.S. companies fall and so, too, does our stock market. But that’s OK. Lots of writers have been telling us that emerging markets and commodities have low correlations with U.S. stocks.
If U.S. consumers aren’t buying stuff, then Chinese companies aren’t making as much money selling it, so their profits fall, and so, too, does their stock market. So much for that lack of correlation and score one for interconnected markets.
If Chinese factories aren’t cranking out as much stuff, then demand for commodities is falling and so, too, are prices. So much for that lack of correlation and score one for interconnected markets.
If Chinese factories are working so aggressively, and if U.S. consumers aren’t going to the malls so often, demand for energy is slackening, as are prices. So much for that lack of correlation and score one for interconnected markets.
Now, if we could turn back the clock, build some trade barriers and have each country be a self sustaining economic unit, we’d probably cut back on that interconnectivity and get back to low correlations. But that’s not happening.
More to the point, the situation I described represents a reality that has been conspicuously erected over a prolonged period. But then, to perceive that, it would help to have been around long enough to have actually seen those trends evolve.
- It’s the Economy, Stupid
Morningstar summed up this lesson rather concisely: “Macroeconomic events matter.”
The article explained by saying “Our approach at Morningstar is to focus on bottom-up analysis; the economy is just too big and complicated to try to second-guess its next move.”
Well yes it’s hard! Who ever said this is supposed to be easy? How can anyone who has ever seen a bear market believe even for a minute that the economy, no matter how complex and unpredictable, can simply be brushed aside?
Actually, that brings me back full circle to my original thesis. I have to assume that Morningstar is short on old timers who’ve lived through and felt the full brunt of an economic downturn. (I’m not talking about that little bitty teeny weenie baby recession we had in the early 1990s; I’m talking about a big one; a monster with fangs!) Financial theory makes it clear that it’s the long term that matters. But it takes real-world experience (and pain) to know that to enjoy the long term, you have to survive the short term.
I definitely appreciate Morningstar’s having undergone such introspection, and even more for having made it public. Many organizations fail to do either. So kudos to them.
But I would encourage Morningstar and others in the same boat to acknowledge one more lesson: a failure to sufficiently tap into the knowledge of those who’ve been there before. In some walks of life, youth is where it’s at. But investing is not among them. In this arena, age and experience count.
I know I’m speculating a lot regarding the demographic mix of Morningstar’s equity research department. I know there is a lot of youth because I’ve seen analyst pictures on their reports (including that of the author of the article in question) and I’ve seen their video interviews. More importantly, the seven lessons all stand out as symptoms of inexperience. Still, for all I know, there may be some older people there, and they may have been talking. If so, I can tell, from the seven listed lessons, that such messages, had they been delivered, have not been getting through.
Morningstar as a force in equity research is still a relatively new phenomenon. So I can sort-of support the 2008 learning process they describe. But having come through the rigors of 2008, it would be sad if, in the future, a different batch of youthful analysts would repeat this list as a description of lessons learned from the crisis of 2023, or something like that.
What have veterans learned?
I’m not just trying point fingers here. The events of 2008 have also taught bitter lessons to even to those of us who’ve been around. Just look at any charts you can find that track the performance of just about anything, a fund, a model, and so forth. Even battle-tested veterans who already knew the things Morningstar just now learned have still had their heads handed to them. I and many other who’ve fared well in past downturns were unpleasantly surprised at how poorly our playbooks served us this time around.
Opinions will vary widely as to what new lessons should be learned investment veterans. I’ll take my stab at this topic in a subsequent article.