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Reproduced from  a private email by Mahesh Johari:

For most of the last 25 years we (as a nation) have been sold a story about investing in stocks for the long run.  Invest steadily, mindlessly, and over the long run stocks will earn almost 10% annual returns.  By the time this bear market has ended, this notion will be questioned by a great many.

I’ll give all of you a head start.

Let’s quickly review one of the greatest achievements of the past 15 years – the rise of the personal computer and the growth of the Internet.  During this time we saw two giants dominate this market – Intel (NASDAQ: INTC) and Microsoft (NASDAQ: MSFT).  They were the veritable Pippen & Jordan of the tech Bulls dynasty: nearly pure monopolists with gigantic profit margins, huge revenues, and fantastic cash flows.

Today, Intel’s share price closed at $12.08, the same level it was at when I turned 25 years old.  That was almost 12 1/2 years ago.  Let’s look at Intel closely and see what they have to show for this incredible run.

At the end of September in 1996, Intel’s share price was $12.08.  Adjusted for splits, there were 7.14 billion diluted shares outstanding.  The book value per diluted share was $2.09.

We could go into a brief academic debate about why I’m using book value instead of some other measure.  Book value is the accounting net worth of the company.  With some caveats, it is a reflection of value that takes into account all of what the company owns and all of its obligations.  The book value reflects the amount of capital the company has available to deploy productively in the course of business.

I use book value per share because one share of Intel essentially grants you ownership to that amount of book value.  If you simply hold that share, you could imagine that the value backing that share of Intel is growing by the same rate as the book value.  Book value is not influenced by the share price, which can fluctuate wildly with the market.

Compare it to your own situation.  If I asked how you have done financially over the last 12 years, I could look at your net worth 12 years ago, compare to what it is today, and have a pretty good idea of how you fared financially.  It’s the same idea.

Today, Intel’s book value is $6.80 per diluted share.  Over the last 12 1/2 years, it means that Intel has grown book value per diluted share at an annual rate of 9.94%.  Some of you will argue that I am not including dividends that were paid out.  Those dividends have totalled $2.25 over that time frame.  Including dividends, Intel generated annual rates of return of 12.50% over the last 12 1/2 years (assuming you didn’t reinvest the dividends).

That number sounds pretty good.  Until you realize that Intel was a near monopolist operating through one of the highest growth phases of their industry.  Think about that for a minute – a monopolist in a boom was only able to generate 12.50% per year in returns.  What does this imply for the 495 companies in the S&P 500 that are NOT monopolies, and are NOT going to be going through an incredible boom in demand?  A 10% annualized rate of return for the entire market suddenly sounds like a fantasy, doesn’t it?

So what the heck happened?  What about all those studies that touted how stocks would make 9-10% over long periods?  Is 12 1/2 years not long enough?

What happened is what always happens when people blindly follow historical statistics en masse.  The underlying behavioral model changes.  As naive shareholders piled in and stopped paying close attention to how the company was run, profits got transferred from shareholders to employees through stock options and bonuses.  Additional billions were blown on share buybacks at much higher prices.  Looking at the result after more than a decade of shareholder un-friendly behavior, it’s no wonder Intel’s results are mediocre.

The time to buy stocks for the long run will be when those that bought for the long run realize they have been fleeced.  When those people are so disgusted that they sell at low prices and the shareholder outrage forces companies to change their behavior – that is the time to buy stocks for the long run.  Price matters.  That’s how it has always been.

For those who like to check the numbers, I suggest the following:
Intel 2008 Annual 10-K:
http://idea.sec.gov/Archives/edgar/data/50863/000089161809000047/f50771e10vk.htm#301
Intel Q3 2006 10-Q:
http://idea.sec.gov/Archives/edgar/data/50863/0000050863-96-000040.txt
Intel splits (shown on chart):
http://finance.yahoo.com/q/bc?s=INTC&t=my

As a side note, if you actually bought that share of Intel in September of 1996, your rate of return was not 12.50% but 1.38% annually, assuming you didn’t reinvest dividends.  Ouch!

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The last 7 days of Internet blogging and searches have been dominated by Ponzi scheme debate and definition.

For reference, here’s Google Trends for Ponzi/Ponzi Scheme vs. Britney Spears.  I use Britney Spears as a proxy for actual volume because she’s been a top search term for 8 or 9 years.

Ponzi Searches on the Web

Ponzi Searches on the Web

On Time.com blog, Curious Capitalist, we see the commenters and the author trying to define and assign “good” and “bad” judgments to what happened with Madoff and what’s happening with Social Security.

The problem with all the debate, like many important debates, is that we’re arguing about definitions and phrasing, instead of analyzing the real issues and behavior.

Whether Madoff was running a Ponzi Scheme or whether social security is some enlightened version of one is irrelevant to what we do about the behaviors contributing to the financial mess we’re in.

In almost all the current financial situations (Social security, housing, credit slump, Madoff…), the contigency management is very inefficient.  The rewards and punishments for taking on big risk are many degrees removed from the risky behavior.  The reinforcers produced by the situations get lost in translation between computerized trading, industry memos, and the media.   We’re rewarding behaviors in one context and punishing them in another (spending without transparency – the bailout- is OK, but it isn’t OK for these businesses… which is it?)

The rules are not clear at all and so no one can play by them.

You can’t call any of this irrational either.  it’s perfectly rational to keep investing and spending when you get reinforced (returns on investment) over a long period of time.  You come to expect those returns and habituate to the risk involved in investing in companies, financial products and services that don’t have defined outcomes.  You can’t totally blame the originator of these investment vehicles either as people keep investing, further reinforcing the behavior of the originator.  (I’m simplifying a bit here).

Consider the life of Ponzi. (Find better sources than Wikipedia, but this will do for now because it’s online)  His history can be interpreted in many ways.  What strikes me is how it builds behavior by behavior.  All along the way as people wonder, they continue to make him rich, provide for him, write about him.  Even until his death he still found work, press and basically what he needed.  So, was it a character flaw in his gene code that created the great mail fraud, or was it the contingencies all along the way?

What’s to think this scenario, now played out with Paulson, Madoff, AIG… isn’t going to be played out again and again when we don’t change the environment?  The actors in this play are irrelevant pieces.  It’s the environment (the media, the surrounding people, the culture, the financial system..).

Do I have an answer? No.  You have to chip away by managing contingencies both with your own life and the wider public.  There’s no one set of rules or one policy or a perfect economic system.  We have to constantly pay attention and adjust.

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The news is a maniacal scramble to make sense of the current financial situation around the world.

Predictions, ____ expert from _____ investment research firm, advice, soothsaying, modeling, bear vs. bull, Fed should do this, Fed shouldn’t do this…. and so on.

A truth I got comfortable with a long time ago but had reinforced over the last three weeks in my life.

Your model can only be as predictive as the thing you are modeling.

– Jason Cawley, Wolfram Research (and probably others…)

That’s a stupid statement, right? Duh.  I know that.

Really think about it though.  and then consider these things and your interpretation of them

  • weather forecasts
  • endless dow jones index reports
  • Political polls
  • compatibility tests in online dating
  • SAT scores
  • TSA profiling at airports
  • Annual budgeting for businesses
  • Or go through the latest in the news

All of these “indicators” attempt to predict complex systems/situations.  Those systems have to show some stability, some simplicity to ever give way to useful prediction (useful = do you get info you can use elsewhere and with enough time/energy to use it).

There is potential to get some local or short term prediction due to local or short term stability.  However, to effectively use that over time you need to be able to predict when that stability yields to a new pattern. That is where it gets difficult.

Yes, you can aggregate a lot of these indicators to produce some sort of statistical sample.  Usually though, you’re simply hiding the intesting stuff in the errors in your statistical model.  Washing out the outliers as “noise”.  The problem is, especially in the indicators above, it’s the outliers that matter! But I digress…

Point for financial pundits: national and global economics itself is complex. no simple model, simple statement, simple index can accurately model it. not even poorly.

Agree or Disagree?  Let’s have a discussion.

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