I got home late last night from two weeks with the kids in Europe, and jet lag is kicking in. Since I should not be allowed to make any investment observations in this state, I am going to do something for which I constantly get requests and that I have wanted to do for quite some time. This week I give you my list of recommended books along with a little commentary on them, starting with a few new ones. Let's jump right in.
The World Is Flat
My must-read book of the summer may surprise a few of you. Thomas Friedman is a columnist for the New York Times and has annoyed me on more than a few occasions. So it was with some skepticism (based on a recommendation from a friend) that I picked up his latest book, "The World Is Flat." Thomas has given us a very readable, packed-with-insights account of the growth and extent of globalization. Actually, the book is more than readable. Friedman is a helluva writer and has never been better than in this book.
Globalization refers to the increasing economic integration and interdependence of countries. Economic globalization in this century has proceeded along two main lines: trade liberalization (the increased circulation of goods) and financial liberalization (the expanded circulation of capital). Friedman starts with insights on the ten forces that flattened the world. Things like: the fall of the Iron Curtain, search engines, out-sourcing and in-sourcing, the development of software which controls supply chains, a wired and wireless world and more.
We are familiar with the problem of manufacturing jobs in the US going to China, as well as service jobs being outsourced to India. Each factory which closes down has the local news team at its door when the announcement is made.
But what we do not focus on is the fact that more jobs get outsourced to the United States from foreign countries than the other way around. Globalization has many aspects, but it means that everything is going to change even faster. Friedman notes that new technologies have enabled new processes which make it easier to do business anywhere in the world. The playing field for business has become horizontal. And (quoting):
"Just as we finished creating this new, more horizontal playing field, and companies and individuals primarily in the West started quickly adapting to it, 3 billion people who had been frozen out of the field suddenly found themselves liberated to plug-and-play with everybody else.
"Save for a tiny minority, these 3 billion people had never been allowed to compete and collaborate before, because they lived in largely closed economies with very vertical, hierarchical political and economic structures. I'm talking about the people of China, India, Russia, Eastern Europe, Latin America and Central Asia. Their economies and political systems all opened up during the course of the 1990s, so that their people were increasingly free to join the free market game. And when did these 3 billion people converge with the new playing field in the new processes? Right when the field was being flattened, right when millions of them could compete and collaborate more equally, more horizontally, and with cheaper and more readily available tools than ever before. Indeed, thanks to the flattening of the world, many of these new entrants didn't even have to leave home to participate.... the playing field came to them!
"It is this triple convergence - of new players, on a new playing field, developing new processes and habits for horizontal collaboration - that I believe is the most important force shaping global economies and politics in the early 21st century. Giving so many people access to all these tools of collaboration, along with the ability through search engines and the Web to access billions of pages of raw information, ensures that the next generation of innovations will come from all over Planet Flat. The scale of the global community that is soon going to be able to participate in all sorts of discovery and innovation is something the world is simply never seen before."1
The pace of globalization is going to change. Apart from governments interfering with protectionist legislation, there is little to stop the trend. But this has produced some severe imbalances in the world. Right now, the US is running a huge trade deficit, absorbing the products and the savings of the developing world. This is a trend that simply cannot go on forever. The shift from a US-Centric world to a more balanced world is going to create a great deal of pain and opportunity, but when the world does sort it out (and it will, if not easily!) we will have a more balanced world economy.
For those investors who are trying to understand the changing times, I think "The World Is Flat" is a must-read. It will not always make you happy, but it will offer you some insights. And let me point out I do not agree with all his conclusions or prescriptions, and I doubt you will either. But he has done a great deal of thinking on a subject that affects us all. This book will make you think as well.
How We Got Here
How did we get to a world that is flat when only 200 years ago we were still trying to figure out how to use a steam engine? I have mentioned this book before, but Andy Kessler has written a dynamite and really fun book called "How We got Here: A Slightly Irreverent History of Technology and Markets." Expanding on themes first raised in his tour-de-force, "Running Money," Andy Kessler unpacks the entire history of Silicon Valley and Wall Street, from the industrial revolution to computers, communications, money, gold and stock markets. These stories cut [by an unscrupulous editor from Running Money] from the original manuscript were intended as a Primer on the ways in which new technologies develop from unprofitable curiosities to essential investments.
This is a great book to give to your high school and college kids who assume that the internet has always been here. Because it is fun and easy to read, they might actually enjoy learning. I have actually read the book twice, which is rare for me.
And if you have not read Kessler's book "Running Money" on his days as a hedge fund manager, you really should. Andy ran $100 million into a cool $1 billion, starting with only a few million, and then got out at more or less the top.
George Gilder and the Silicon Eye
And speaking of books which tell stories, George Gilder has brought us a new book called "The Silicon Eye." It sounds like a detective story, and indeed Gilder writes it as such. It is the story of how a Silicon Valley company aims to make all current computers, cameras and cell phones obsolete. Gilder writes compellingly about two giants of the computer industry, Carver Mead of Caltech and Federico Faggin, who invented the CPU (central processing unit) which is the chip that runs every computer. They have teamed up to develop an entirely new type of camera that not only makes better pictures but also could become the eye for artificially intelligent machines. Gilder, giving us insights into the creative genius personalities that shape our world, offers us a rare opportunity to see how world class change comes about.
It is not an easy process. More companies fail than succeed. But the drive which compels people to build something new, against the odds of success, as a powerful story. I saw the technology demonstrated last year while speaking at Gilder's conference in Lake Tahoe. It is more than impressive. That digital camera we all love? We will one day wonder why we settled for such poor picture quality. Let me give you just a few paragraphs of the book as a teaser:
"... every technology company needs two kinds of leadership, coming from two kinds of men. Let's call them, for short, the Meads and the Faggins.
"One is mercurial, imaginative, philoprogenitive, conceiving of something new and bringing it to life, often initially malformed and precarious, but loving it as a mother does. He sees infinite potential in the balky bundle, in a fuzzy-faced sophomore with quirky design tools, in the noisy breadboard, in the oversized and slow imager chip, in the large young bio major with granny glasses, in the snarl of wires and switches. Optimistic, risk taking, often less than punctilious, sometimes sentimental, he pursues the top line - running from wistful hope to fitful revenues - and often wins the credit of the crowds if the venture succeeds. If it doesn't, don't bother him; he is off on something else.
"This man could not consummate his ideas without collaborators, also creative and resourceful, but at a lower level of abstraction. Where the Mead is visionary, the Faggin is skeptical. Where the Mead is seeing "zero-billion-dollar" markets, the Faggin is looking for initial nine-dollar sales. Where the Mead is all peripheral vision, seeing the interconnections among everything in his universe, the Faggin dons blinders and bends toward the bottom line, the goal line, profits now...And that baby in the bathwater, that recognizer chip with the blurry images, it was a hopeless kludge.
"Though needing each other, the two types may sometimes pretend to hold all the virtues in their singular selves. Even when the claims are true - both Mead and Faggin, after all, are Renaissance men of our era - they may not be able to combine the roles in practice during the course of eighteen-hour days. When these two types conflict, their company suffers. But when the two forms of leadership align themselves synergistically, they can unleash an unstoppable force."
Against the Gods and When Genius Failed
One of the really great books which I highly recommend is "Against The Gods" by Peter Bernstein. This exceptionally well written book tells the fascinating story of how risk has been dealt with through the centuries. This is one of my five you gotta read it classics.
The growth and wealth of nations and commerce has always and everywhere been accompanied by an increase in the ability of businessmen to control risk. When men are able to control their risk, they are ironically in a greater position to take risk.
It is hard to understand now, but any fourth grade student of math who could be shipped back to 10th century Europe would soon be rich. Back then, there was no understanding of something as simple as the odds on the roll of a dice. You could get the same bet on rolls with substantially different potential outcomes. Risk and rewards were determined by fate. The gods themselves determined who would win or lose.
The development of mathematical and analytical tools to predict the odds of certain events was a major factor in the growth of commerce.
For instance, let's say you are a ship merchant. Experience tells you that 1 in every 10 of your ships will not come back. You also know that you could have a period of bad luck where you lose three ships in a row. If you bet 1/3 of your wealth on each ship, you could lose everything if you had a run of bad luck. So you very cautiously invest your capital, wanting to make sure you will be able to stay in business.
But what if you could find a group of men willing to take the risk of your ship returning? You could pay them a fee, and then not worry about losing three ships in a row and being wiped out. Of course, your profits on any one venture might be less, as you are paying for insurance. But now you can confidently invest more in shipping, knowing that even if three ships in a row do not come back, you will still be in business. Your overall profits increase, and the entire economy is better off.
That is exactly what happened in London. Edward Lloyd, who opened a coffeehouse in London in 1687, began to compile data on risk, shipping, ports and the conditions abroad, which was used by investors to assess risk, buy ships, organize trade, etc. Of course, it became Lloyd's of London. It was at the vortex of an explosion of shipping and prosperity, and it grew because of an early form of derivatives.
Without derivatives, insurance and risk management, it is impossible to imagine a modern commercial society. These are crucial to our economic health. The wheels of commerce and investment would grind to a very slow pace if businesses and individuals could not control risk or take risk.
Every one of a variety of Spyders, Webs, Oats, Cubs (created by Bear Stearns), Steers (created by Merrill Lynch), Suns, strips, options, futures, swaps, CMOs, CBOs, and a hundred other acronyms for a contract which trades risk between two parties are fundamentally necessary in our economic world.
Could we live without them? Of course, but then we can live without a lot of things. But most people would be surprised at how much the very food we eat, the clothes we wear and the goods we use depend upon derivatives.
All of these types of derivative transaction are growing by leaps and bounds. But the real growth explosion is in credit risk derivatives. If you are a bank or a creditor, you can now buy credit insurance on the loans you have made. That can be a good thing, as banks lose less money and thus are more solvent after a recession than normal.
But after my breathless ode to the glories of derivatives, we come to the dark side.
The problem with derivatives is that while one party is hedging his risk, another party is taking a risk. Sometimes, as in the instance of two groups swapping currency risk, this is benign. At other times, if one party underestimates the nature of the risk, there can be significant losses involved. Much of the losses of various insurance firms and investment banks in recent months have been on the sale of insurance risks on loans. Insurance companies and others have sold such insurance, using models that they now find didn't adequately address the risk.
Let's look at the most spectacular instance of problems caused by derivativesm which is a subject of yet another great book by Roger Lowenstein called "When Genius Failed" about the collapse of Long Term Capital Management. LTCM was run by the smartest and brightest of financial minds: two Nobel winners and a host of similar worthies. They specialized in "convergence" trading on bonds, and clocked along making huge sums. They thought they were diversified by investing in the debt of many countries. In fact, they were making the same bet everywhere, and country diversification did not help when the Russian debt default threw the world into crisis. They were leveraged as much as 80 to 1, and even small movements were disasters for them. Once wind of their predicament hit the street, funds and traders on the other side of the trade lined up to take advantage.
LTCM used derivatives to build up such a leveraged portfolio. They would let no one look at their books. If an investment bank wanted to see their total portfolio as a condition of doing business, they said no. Since they were generating huge fees for these banks, everyone assumed these smart people knew what they were doing and continued to do business.
While each investment bank knew the exposure they had to LTCM, no one had the total picture, which was staggering. No bank would have done business with LTCM if they knew the true picture. The situation did indeed threaten to collapse the world financial markets.
In the end, the New York US Federal Reserve Bank President had to call the chairmen of the banks which had exposure to LTCM and say, in effect, "Be in my office tomorrow morning. Don't send your subordinates. Bring your checkbook." Disaster was averted, but the various banks took some huge hits. There were a lot of very unhappy bankers. Contrary to some reports, no tax dollars were used.
This pain brought about a new fetish for transparency from their clients upon the part of banks. Investment banks now want to know what the total exposure of a client is, and will walk away from business if they cannot get it. It also helped spark an increase in credit insurance, as more and more groups wanted to hedge their exposure.
Lowenstein shows us how close we came to a system failure and yet how the system worked. It almost reads like a novel.
Where are the Bull Market Geniuses?
The bull market bubble made geniuses of many average investors and managers. They confused luck with skill. They assumed their brilliant technical analysis produced their wonderful results when in fact they were on the right side of a self-fulfilling prophecy. For a short while, people forgot how just #$#@$ hard it is to pick good stocks.
This reminds me of the study I cited a few years ago from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above average earnings growth for 10 years in a row. The chances of you picking a stock that will be in the top 25% of all companies every year for the next ten years is 50 to 1 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely they are to have an off year. Being on top for extended periods of time is an extremely difficult feat, and we are finding out now that companies which did perform so well frequently cooked their books - think Cisco -- or just outright lied. Think Enron.
Yet what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is over-priced? His staff will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that they will do so for the next five. The actual results for the last 50 years show the likelihood of that happening are small.
Tails You Lose, Heads I Win
I keep a marvelous must-read book by Nassim Nicholas Taleb called "Fooled by Randomness" on my desk. I read it often, simply opening it anywhere and reading a few pages. The sub-title is "The Hidden Role of Chance in the Markets and in Life." He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he does a very thorough treatment. While I have read many of his points elsewhere, he gives us several totally new (to me) concepts. He also has a gift for expressing complex statistical problems in a very understandable manner.
I think anyone who wants to trade the markets should read this book. If you still want to trade, then read it again. If you still want to trade, then put it on your desk and read it often.
Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their 7 figure salaries prove it. The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!
If you are an investor, you should read this book. Taleb will save you money. Again, this is one of my top five must-read again and again classics.
I will quit today but will take up this topic again at some future time when jet lag does not have me in its vicious grip. There are at least ten other "must-read" books which I will call to your attention.
I would be remiss (or my publishers would harass me) if I did not mention my own book, Bull's Eye Investing. You can read more about it here: http://www.absolutereturns.net/ and order it at http://www.amazon.com/exec/obidos/ASIN/0471655430/frontlinethou-20
Home Again, Home Again, Jiggety Jig
For some reason, I am sure ingrained in me as a kid, I cannot come home from a trip without the above line in the old nursery rhyme running through my head. And it was a tired crew which finally made it home last night. Seven kids and a daughter-in-law walking all over Paris and London, lolling in the lazy rhythms of the French countryside in Ouzilly, waiting on a plane part in Limoge to arrive from Dublin so we could take off five hours late from the south of France, then into a bomb scare in the train station as we arrived in London that chased away the taxis. Aah, the adventure of traveling. But it was a lot of fun.
Except maybe for the part where we spent almost $100 in a Subway Sandwich shop in London. The prices were almost the same as in Texas, just in pounds and not in dollars. But London is a wonderful place. And I went for the first time to the British Museum. It will not be my last. It is my new favorite museum. And the next time you are in Paris, visit the Rodin Museum. We all know him because of "The Thinker" but this small estate turned museum in the middle of Paris is packed with his greatness. And the grounds are beautiful.
It was an interesting contrast. For most of the trip, I was reading a book about the future by Ray Kurzweil called "The Singularity is Near," discussing how the coming rapid changes in technology will change our lives, and was surrounded by history on all sides. The book will be out in a month or so and I will spend a few weeks going over the implications. This is one of those books I need to think about.
And speaking of pounds, I brought a few extra back on my waist. I ate more bread in the last two weeks than in the last year and it shows. Next week we will get back into the workout groove. Now, I will hit the send button early and go home, have dinner with a few of the kids who have not yet departed for college and relax. I need to rest up this weekend from my vacation.
1 The World is Flat, Thomas L. Friedman, Farrar, Strauss and Giroux, 2005, Page 181.
Your more excited about the future than ever analyst,