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February 02, 2007

A Raging Bull
by John Mauldin

This week I am in South Africa. At the moment I am literally flying from Johannesburg to Durban in a single-engine Pilates PC 12, a very upscale Swiss-manufactured plane. I am told pilots will know and appreciate the plane. It is supposedly the safest plane in the world, which is somewhat comforting as we bounce through a few storm clouds (and thunderstorms later tonight of the way to Cape Town!). My business partners and hosts, Dr. Prieur du Plessis and Paul Stewart of Plexus Asset Management, have kept me busy, but it has been fun.

This week's letter is the text of the keynote speech I gave last night at the Raging Bull awards in Johannesburg. There are a number of awards given to the various mutual funds (called here a unit trust or a collective investment scheme) that had the best performance in their respective categories over the last 3-5 years. The winning funds had some very impressive performance indeed. It was a black tie dinner with about 400 attendees. It was one of the more elegant events I have attended in my life.

Before we get to the text of the speech, a few thoughts on my impressions of South Africa so far. It has been about 12 years since I have been here. My last visit I drove from Jo'burg to the administrative capital at Pretoria, a distance of about 30 miles. It was basically farm land between the cities.

Today it is one solid city, with new homes and businesses covering the landscape. Construction cranes are everywhere. There is an air of optimism and energy that is far different from 12 years ago. Johannesburg is a world-class city, the equal of New York or London or Sydney in its cosmopolitan feel. In round numbers, GDP has been growing at a hot 5% per year for the last few years and is on schedule to continue. But it may be better than the official numbers. There is a large informal economy in South Africa. Based on tax receipts, the economy may be growing at a torrid 7%. (Tax receipts are reliable indicators. No one pays more taxes than they have to!) I will write more on my thoughts next week, but let's go on to my speech.

A Raging Bull

I want to thank the Raging Bull organizers for allowing me to come tonight to share a few thoughts on the challenges we face as an investment industry. It is good to be back on the African continent. Prieur warned me that Africa is not for sissies. But I already knew that, having been to 15 countries in Africa and to South Africa in particular on numerous occasions. Africa has been the source of some of my best memories and greatest adventures as well as some of my more intense moments. You haven't lived until you have tried to do business in Zaire or Tanzania as a naive young Texas businessman. But that was a few decades back, and those stories are best told at night over an adult beverage, so we will forego my stories. Anyway, one thing I did learn is that every South African has better stories than a simple Texan. First liar never wins. But story telling is a different sort of challenge than what we will deal with this evening.

Tonight we rightly celebrate those managers who were the best at their game over the past 3-5 years. But the true celebration is among their clients who were the beneficiaries of their success. In what has been a difficult period, these managers have been able to navigate through the challenges they faced to deliver returns to their clients that were the best in their respective fields.

Now, a word of encouragement for the rest of us who will not go home with a Raging Bull award. Most of us in this room think we are better than the average investment manager. We aspire to be the best. I would suggest to you that maybe a less lofty goal will get you to your desired end results.

If you asked your clients if they would be satisfied to be among the top ten percent of investors in terms of returns over the next ten years, only a handful would be so greedy as to want something better. For most, they would readily accept that level.

So, how do you achieve the lofty goal of being in the top ten percent? By simply being better than average investment manager for the next ten years, each and every year. If you can simply beat the averages for ten years running, you will end up being in the top ten percent of all managers at the end of ten years.

Of course, by definition, 50% of all managers beat the average, and then again 50% are below average. Since I am sure that everyone in this room is well above average, if you are wondering who is in the bottom 50%, just look around and note who is not here.

Balancing Risk and Reward

And while being above average is no challenge for the worthies in this room, it is a lot more difficult in practice than it sounds. The balance of risk and reward is a delicate one. Let's look at a few of the challenges and opportunities that we will face over the next ten years as we try to find our own balance and be in that top ten percent.

The first problem we face is a world of low yields and high valuations. Most of the developed-world stock markets are in the top 20% of their long-term highs in terms of valuation. Numerous studies show that stocks offer lower than normal returns after such periods of high valuations.

Dividends are at the low end of historical yields, and bonds offer little growth potential after accounting for inflation and risk. The spreads between high-yield debt, otherwise known as junk bonds, and the best of solid government debt are at historically very low levels. Indeed, the gap between US government debt and emerging market debt fell to its lowest level last week. A mild global recession would push the yield spreads back to normal levels, thus making high-yield bonds or emerging market debt a low-total-return asset.

And it is not just in the world of stocks and bonds that valuations are at historical highs. As a report from Goldman Sachs noted, how can someone pay $135 million for a Gustav Klimt painting? Almost $1,000,000 for a little black dress worn by Audrey Hepburn in Breakfast at Tiffany's? How do you buy an office building in New York with no leases expiring for ten years for $1.2 billion with an internal yield of 4%, which is 50 basis points less than a 10-year US bond? And that is before maintenance reserves! The long list of somewhat dubious, if spectacular, purchases illustrates that valuations in all sorts of markets have simply pulled loose from their moorings. It is a world awash in capital looking for a home.

We live in a world where there is an increased appetite for yield by investors at all levels; and armed with growing liquidity, they chase those yields down to a point where traditional risk-reward measures would suggest the potential for problems.

Let me give you a preview of a coming scandal, just to illustrate the chase for yields. In the US, about 25% of the mortgages on new homes are what is known as sub-prime mortgages. These are mortgages that are slightly less creditworthy and therefore offer higher interest rates. In the beginning this was a good thing, as first-time owners and those just starting out in life were given an opportunity to own their own homes.

But then came a world of liquidity looking for yield. Investors demonstrated a large appetite for these mortgages. Investment banks would buy those high-yielding sub-prime loans and package them into something called Residential Mortgage Backed Securities. Now, a sub-prime loan is not considered an investment-grade security. But when you put a group of them together into a pool and break them up into various sub-groups or tranches, through the alchemy of high finance, you turn lead into gold. You create high-grade bonds from sub-prime debt. In fact, 80% of those grouped together get a AAA rating, because that tranche gets the first monies paid back to the debt pool. And it probably is pretty safe money. No problems yet.

Then the investment bank starts slicing smaller parts of the pool and eventually ends up with the final 4% getting a below-investment-grade BBB rating. Again, this is all a good thing as it allows investors to buy the risk they want and makes for a more liquid real estate market. But then we start to get cute with alchemy. Not content with turning lead into gold, we start trying to do the magic on sewage.

Investment banks pool all these BBB tranches into yet another pool called a Collateralized Debt Obligation or CDO. The rating agencies have sophisticated models which tell them that with the increased diversification, 87% of these former BBB bonds can now be sold as AAA or AA investment-grade bonds. Only 4% is considered actual BBB debt. So we have taken an original security that is not investment-grade and turned all but less than 1% into an investment-grade bond.

Again, if all those mortgages pay off like they have in the past, then not too much problem. But recent research suggests that as many as 20% of these mortgages sold in 2005 and 2006 are going to default or foreclosure. But the CDOs assume that less than 1% will default. If the number of defaults is even half of that predicted, then someone is not going to get their full capital back, let alone the interest. And we are seeing home foreclosures at record levels in every part of the United States due to the large number of sub-prime mortgages.

Why such a growing default rate? Because investors kept throwing money at mortgage bankers, who found out they could sell mortgages with little documentation. For instance, you could get a loan without actually having to prove your income. So the bankers said, "Let's take the fees and run. Bonuses all around for selling more mortgages." Now there is anecdotal evidence that a small but significant portion of these low-documentation loans had some items that were misrepresented. You know, little things like whether you were actually going to occupy the home.

Who bought these CDOs? Again, my sources say it was primarily Asian and European institutions, which simply looked at the rating on the bond and bought them. There will be lots of finger pointing over this one. Look for massive lawsuits and a major scandal to start up by the end of this year.

But this highlights the next challenge to our industry, and one that is a bit of a paradox. The investment world has many more opportunities for both the average investor and institutions than even a mere ten years ago. And I think we can count on that innovation to continue over the next ten years.

And that is a good thing for investors, as these innovations offer opportunities for diversification, risk control, and hopefully smoother and higher returns. But it also puts demands on investors and advisors, as each innovation offers yet more complexity and different risks that must be understood. To eschew innovations and funds simply because of the complexity means potentially lost opportunity. If your peers are availing themselves of these innovations and you are not, it may be hard to stay in the top 50%.

But to invest in something without understanding the risks involved is an even greater predicament, one which almost certainly guarantees an eventual below-average year, if not a disastrous one. And while not all individual investors will be able to understand the details of these innovations, let alone the standard offerings available to them, they are certainly going to expect their investment advisors to be able to do so.

And that means that one of the great challenges of the future will be the same as in the past. Constant education, research, and study, while trying to balance the day-to-day work loads of running an investment business, will be requisites for each and every one of us. The minute any investor or investment advisor becomes complacent is the minute the market will turn on them with a vengeance.

This also means that the investment community is going to have to work even more closely with regulatory authorities to make sure that these innovations and funds are available to all investors and not just a privileged few. Trying to stay on top of an ever-changing investment frontier will be a major challenge for the investment authorities around the world.

An Ever Accelerating Pace of Change

The final challenge we will look at today, among the many that we do not have the time to deal with, is the accelerating pace of change we will have to face in the coming decades. Again, this is both opportunity and challenge.

We are going to see as much technological change in the next 20 years as we have seen in the entire 20th century. It is as if we are going back to 1930 and an entire century of new developments are all in front of us.

Computing power will continue along its exponential path of faster, more powerful, and cheaper. In the not-too-distant future, you will have computers more powerful than anything you now have on your desk but the size of your wallet. They will be connected to a cheap (yes, a word that we can use even in South Africa) high-speed wireless broadband that will change the ways we communicate. Remember the video phones that we were promised two decades ago? We are going to leapfrog right past that. You will soon be able to talk over the internet with family and friends in a rich video environment that will be three-dimensional in nature on your large, inexpensive plasma screen. Three billion new people will be active on the internet within ten years, as wireless broadband becomes ubiquitous.

That also means your clients will be able to talk with a much wider array of potential advisors on a personal eye-contact level. Surveys have shown that the top two reasons investors select an advisor is that they live close by and they like them. They are still going to have to like you in the future, but living near them is going to be so last century. Right now, video over the internet is in its early stages. Communication is uneven and uncomfortable. But it won't be so in ten years. You'd better be ready to adapt.

Biotechnology is just at the beginning of its innovation cycle. Think of the personal computer around 1980. Things got better quickly. That is where we are with biotechnology, at the beginning of a very rapid growth cycle. The good news is that many of us and our clients are going to live a lot longer and live a lot better than we now think. The bad news is that we have not planned financially for an extra 10-20 years. Most of our clients have not saved enough or planned for the extra costs of living longer.

My generation is going to break the deal each previous generation had with the younger one. Each generation in the past agreed to die at more or less a predictable rate. And pension funds and insurance companies could invest based upon that deal. Social Security and other government pensions assume a predictable mortality rate.

What if the average life span of your policy holders or pensioners grew by 5 or 10 years in the next 10-20 years? That would certainly qualify as a challenge to the investment industry, not to mention the governments that implicitly back the pensions. Experts tell us the first human being to live to 150 years of age is alive today, probably in his early 50s. He will retire in 15 years. That's all well and good, but will he get Social Security for 85 years of his longer life span, more than twice the number of years he worked?

Nanotechnology, robotics, artificial intelligence, and alternative energy sources such as hydrogen fuel cells and biomass will change the character of our world. Your car will be electric in less than 20 years, but the source of the power is still not certain. Each of these fields will produce new business giants which will give us new companies and industries into which we can invest. Of course, that will require even more research and study.

Africa is not for sissies. But neither will being an investment manager in a rapidly changing world. Getting a Raging Bull Award in ten years is going to be harder than ever.

South Africa and My Annual Investment Conference in La Jolla

The land between Johannesburg and Durban is quite beautiful. Mountains, plains, farms.

I missed my flight to Johannesburg last Thursday, as United was very late coming out of Dallas. So I had to fly from Washington, DC to London, lay over for ten hours, and then take South African Airways. SAA was one of the best carriers I have flown on. Quite impressive and comfortable.

We went straight to Itaga Private Game Lodge, a private game reserve about two hours from Johannesburg, where I spent two days trying to recover from jet lag. We went on a few "game runs." Lots of game everywhere. Black rhinos which posed for us and an encounter with a small herd of elephants. When one mother with her fairly new baby came to within two feet I was getting a tad nervous. When you can see your reflection in an elephant's eye, that is a closer encounter than I was expecting.

I will be holding my fourth annual Accredited Investor Conference, co-sponsored with my partners at Altegris Investments, April 19-21. It will be in La Jolla, California. Dennis Gartman, Louis Gave, Richard Russell, Woody Brock, George Friedman of Stratfor, Rob Arnott, Mark Finn, and my special guest Dr. Mike Roizen are all going to be speaking, as well as your humble analyst. I will be getting you more information in later letters, but just save the dates for now. As always, it will be limited to accredited investors because of regulatory requirements.

We just landed in Durban and are taxiing to the terminal, so it is time to finish. I have two speeches to give and then we fly to Cape Town tonight, getting in late and starting early. But Prieur has organized a great weekend of helicopter tours, exploring the wine country, and more, so there will be a little relaxation in an otherwise aggressive schedule. I leave here Wednesday and get back Thursday and expect to write next week's letter from my office. Have a great weekend. I certainly expect to.

Your finding South Africa quite amazing this time around analyst,

John Mauldin
Frontlinethoughts.com

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments who will share 1/3 of those fees with MWS and thus to Mauldin. For more information please see "How does it work" at www.accreditedinvestor.ws. This website and any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest with any CTA, fund or program mentioned. Before seeking any advisors services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Please read the information under the tab "Hedge Funds: Risks" for further risks associated with hedge funds.

If you would like to reproduce any of John Mauldin's E-Letters you must include the source of your quote and an email address (John@FrontlineThoughts.com) Please write to info@FrontlineThoughts.com and inform us of any reproductions. Please include where and when the copy will be reproduced.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

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