Imagine this scenario: In the not-too-distant future, a man is cryogenically preserved until a cure can be found for his terminal disease. Before freezing himself, the man invests all of his money in real estate and stock market index funds. 200 years later, the defrosted man receives a pill that cures his disease. He runs immediately to a pay phone to check on his investments, and learns that his million-dollar investment has grown to 600 million dollars. Before he can enjoy a victory dance, however, the phone says, “Please insert $50 million for another three minutes.”

Inflation has been an all-purpose bogeyman since the 1970s, but a small amount of inflation comes with a healthy, growing economy. The Federal Reserve focuses on managing inflation, not preventing it. We have written often that we feel the government measures inflation incorrectly, since the Consumer Price Index undervalues food, healthcare and energy costs. As a result, excessive inflation builds for a while before the government acknowledges it, and comes as a surprise, despite our constant measurement and analysis.

What a year. Some say we are facing the greatest economic crisis in a century, but the situation is so complex, no one can really be sure. Some predict another Great Depression. Others warn of the potential for hyperinflation as the Federal Reserve’s printing presses shift into overdrive. Layoffs and bankruptcies make the front pages every week and no end appears in sight. Most economists assure us that the situation will get worse before it gets better.

But as you should know by now, we are contrarians. And we are diligent students. The economy has experienced dramatic downturns and lengthy recessions before. Often, the greatest surprise is how quickly we recover. As Warren Buffett noted in his October 16, 2008 New York Times editorial:

Some Days You Eat The Bear…

…and some days the bear eats you. This saying represents an old western philosophy that fate is fickle, life has its ups and downs – you win some and you lose some. Ultimately, how you manage life’s travails determines whether you win in the long run, and the long run is what matters. A bear market is not the end of the world. There’s no question that bear bites are painful, but pain endured is new strength found. Wounds heal, but how do you treat bear market injuries? Often, the best course is to patiently let them heal themselves.

Congress learned from the Great Depression that allowing banks to enter the investment business risked destabilizing them. In 1933, the Glass-Steagall Act prohibited bank holding companies from owning other types of financial services, asking banks to stick to banking business only. But 66 years later the lesson was forgotten, and in 1999 this provision was repealed. As the saying goes, if you give a mouse a cookie, he’s going to want a glass of milk.

Commercial banks, investment banks, insurance companies and brokerages started offering each other’s services. This may or may not have introduced unavoidable conflicts of interest, but it certainly introduced an unmanageable level of complexity in financial services. Exhibits A, B, C & D: the failure of Bear Stearns, rescue of Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG), rushed sale of Merrill Lynch (MER), and bankruptcy of Lehman Brothers (LEHMQ.PK). We could use more of the alphabet for examples, but you get the picture.

Audiences loved the knife-fight scene in Butch Cassidy and the Sundance Kid (1969, Campanile Productions). Smooth-talking Butch Cassidy faces huge, ugly Harvey Logan, who holds a gigantic Bowie knife. Butch says the fight cannot start until he and Harvey agree on the rules. Confused, Harvey barks that there are no rules in a knife fight, but before he can finish his sentence Butch kicks him hard between the legs. Harvey drops to his knees. “Well, if there ain’t going to be any rules, let's get the fight started. Someone count. 1,2,3 go,” says Butch. The Sundance Kid quickly complies, and Butch slams stunned Harvey in the head, knocking him out and ending the fight.

This is a pretty good example of using “rules” to alter outcomes rather than to ensure a fair competition, and a pretty good example of how regulators and politicians have been approaching financial markets. We support regulations that ensure a level playing field, and we are sympathetic toward those who have been harmed economically, but we feel that regulators and politicians consistently overreact to economic hardship.

Any experienced investor knows that no one can predict the future. Nevertheless, one should try to imagine many possible futures. Such mental agility helps an entrepreneurial investor develop contingency plans, as contingencies are the reality of every tomorrow. 

One of our coworkers teaches a Global Studies seminar at the University of California Santa Barbara, and every week he assigns several news articles and asks students to return the following week with questions inspired by each article. In effect, we perform this exercise on a larger scale every day, reading numerous newspapers, journals, newsletters, and blogs while formulating questions to stimulate our imagination. 

Entrepreneurial investors have a low tolerance for broad generalizations and so-called “conventional wisdom.” The frequent and sometimes fanatical debate over the pros and cons of dividends perfectly illustrates the reasons for our disgust with the passionately argued nonsense that so often passes for investment advice.  

Dividends have been in the news a lot this year. Companies like General Motors (GM) and Citibank (C) have been attacked in the press and blogosphere for continuing to pay dividends even as they rush to raise capital elsewhere. Other companies take heat for lowering or eliminating dividends (or for not paying them in the first place). We think it’s appropriate for shareholders to question these decisions, but one should fully understand the role of dividends and the company’s cash flow before jumping to conclusions. 

Between January of 2007 and January of 2008, home prices dropped by 11.4% nationwide, according to the Standard & Poor's/Case-Shiller index. Some communities, like Las Vegas and Miami, dropped by almost 20%.