The Speculator’s Edge, Four

The Speculator’s Edge, Four

Basic Economic Concepts essential to Speculation

4) The Laws of Downward-Sloping Demand and Upward-Sloping Supply

Demand is the quantity of a good that buyers are willing and able to purchase at a given price.

Supply is the quantity of a good that sellers are willing and able to sell at a given price.

The law of downward- sloping demand says that, ceteris paribus (all things being equal), demand is inversely related to price. The law of upward-sloping supply says that, ceteris paribus, supply is directly related to price. In other words, in a free market, where the non-price determinants remain the same:

  

as price increases, demand decreases

as price increases, supply increases

as price decreases, demand increases

as price decreases, supply decrease

These relationships are often depicted in demand and supply schedules and charts. A demand schedule shows the relationship between the quantity of a good demanded and the price charged. The demand schedule includes not only the amount actually demanded at the current prevailing price, but also the amount purchasers would be willing to buy at different prices.

Price……………………..Quantity Demanded

$1.50/lb………………….500 lbs

$1.00/lb………………….1000 lbs

$.50/lb………………...…2500 lbs

$.25/lb…………………...5000 lbs

$.10/lb…………………...6000 lbs

Similarly, supply schedules show the relationship between price and the amount of a good that sellers are willing to sell.

Price……………………..Quantity Supplied

$1.50/lb………………….6000 lbs

$1.00/lb………………….5000 lbs

$.50/lb………………...…2500 lbs

$.25/lb…………………...1000 lbs

$.10/lb…………………...200 lbs

The laws of upward-sloping supply and downward-sloping of demand follow our common sense. In general, if the price of a good is high, we will buy less of it than if it is lower. By lowering prices, producers can frequently entice new purchasers to buy and existing purchasers to buy more.

It is extremely important to note that while demand is inversely related to price, the relationship is not necessarily one to one. Let’s take an example. A luxury car costs, perhaps $120,000. I do not own a luxury car. If they cut the price to $60,000, I would buy one. If they cut the price to $30,000, I might not buy a second, because its marginal utility to me is less than $30,000. But if they reduce the price to $1, I might want to buy seven of them.

The law of supply operates in the same fashion. If there is plenty of something around, we are unwilling to sacrifice much to get it. As the supply becomes scarce, what we are willing to pay will increase as well, though, again, not necessarily on a one-for-one basis.

There is another way of saying all this that you should consider. Everything else being equal, if producers decide to increase the quantity of goods sold, they can do so only by decreasing the price at which they offer their goods.

The Speculator’s Edge,

Albert Peter Pacelli

The Speculator’s Edge, Three

The Speculator’s Edge, Three

Basic Economic Concepts essential to Speculation

3) Money and Price

  

Now suppose Fred takes a box of burgers over to Murray, the roof repairman. As it turns out, Murray has just returned from the doctor, who told him to cut down on cholesterol. This puts Fred in a spot because, while Murray has something Fred wants, Fred doesn’t have anything Murray wants. Or does he? It turns out that Murray is a sportsman who likes to hunt on weekends for fun. Murray sees Fred’s new club and says he would gladly re-roof Fred’s hut in exchange for one just like it. So back Fred goes to Barney’s, where he trades the box of burgers for another club. Then he returns to Murray’s and makes the deal.

Something important has happened here. Instead of purchasing the second club for his own consumption, Fred traded first with Barney for the purpose of entering into a second transaction with Murray. In other words, Fred’s demand for the second club reflected nothing more than its exchange value to him. Its consumption value was important only to Murray. This is called an indirect exchange. Virtually all exchanges made in advanced society are of this nature.

Fred, Barney, and Murray now have a problem. Obviously, clubs and brontosaurus burgers are not particularly useful media of exchange. What is needed is something easier to carry, more durable, with generally recognized beauty or utility. Nails, gems, copper, nickel, silver and gold are all candidates, and, in fact, have been used by one society or another. One by one the alternatives get whittled down, usually not by any formalized decision process, but by custom and usage. Today the most universally recognized medium of exchange (excluding for the moment bank notes of the U.S. Federal Reserve and other currencies) is gold.

We are now in a position to define money…In the narrowest sense; money is a commodity that is universally employed as a medium of exchange. I say in the narrowest sense, because as we have become more sophisticated we have often replaced commodity money with other forms of money that have no underlying commodity value. Like dollar bills or the bits and bites in a computer and/or cyberspace that represent dollar bills.

 

It is astonishing that, for all the fuss we make about money, so few of us understand its nature or from whence its value derives. Money originated as commodity money. Initially, it had no value other than its consumption or production value. However, as its usefulness in facilitating indirect exchanges grew, its value also grew to a premium over its commodity value. It acquired money value. Unlike other goods, the value of money as money depends solely on its usefulness in facilitating exchange. Take away its exchange value, and the value of commodity money reverts back to its commodity value. From 1873 until the early 1930s, the value of silver declined as most countries demonetized it in favour of gold. During World War I, as many countries replaced gold with bank notes and Treasury notes, the value of gold declined as well.

The almighty dollar is the ultimate expression of the evolution from commodity money to what we call fiat money. Not long ago it was backed by silver – that is, the paper money could be exchanged for (substituted) for a given quantity of silver, a commodity that had both commodity value and money value. Once liberated from its precious metal backing, the dollar became nothing more than paper money – that is, its commodity value disappeared. The dollar is called fiat money because it is created out of paper by fiat of the United States government. Its current value is based on custom and belief only. If anything happened to destroy that belief, its value would revert to its consumption value only – that is, it would be worth the paper it is printed on, nothing more. 

Now that we know what money is, let’s return to our friends, Fred and company, to find out a little more about price and utility.

Let’s suppose Fred had five pieces of gold. Let’s suppose that Fred knew Barney would give him a club for ten pieces of gold and that Murray, who decided not to follow his doctor’s orders, would exchange five pieces of gold for a box of brontosaurus burgers. Obviously, Fred’s best course of action is to sell the burgers to Murray and then take the ten pieces of gold to Barney’s and buy a new club. We could say that one club cost two boxes of burgers, and indeed it did. We also could say that one club cost ten pieces of gold (or ten dollars if dollars happen to be the common medium of exchange), and we usually do. In other words, the price of a good can be expressed in terms of any other good for which it can be exchanged, or it can be expressed in terms of money. Remember, money is a commodity in most respects like any other commodity.

Now, is one club really worth two boxes of burgers simply because Barney said so?...Of course not.

Remember, it takes two to make a trade. A trade takes place when and only when there is disagreement on the utility of the goods exchanged. In fact, there is no such thing as fair value or true value in an economic sense. The market is nothing more than a series of trades among individuals who disagree as to the utility of the goods or services traded.

You now know all you need to know about what prices are and how they reflect the basic needs of the individuals who come to the markets. But what causes prices to be one thing and not another? What can we say about how objective prices are discovered?

Stay tuned…

The Speculator’s Edge,

Albert Peter Pacelli

The Speculator’s Edge, Two

The Speculator’s Edge, Two

Basic Economic Concepts essential to Speculation

2) Utility

  

Let’s see how these characteristics take effect in the real world.

Consider the case of Fred, a hunter. His basic economic needs include shelter, clothes, tools with which to hunt, and food. Since his society has achieved division of labour. Fred doesn’t expect to make his hut, clothes, or clubs; his job is to hunt. He is sufficiently proficient at it to kill more than he can eat. If he weren’t, he would have to find another job.

One afternoon, after a particularly tasty brontosaurus burger, Fred looks about and notices that his tiger-skin loincloth is going out of style, his club is splintering and needs to be replaced, and the roof on his hut is leaking. He goes over to the refrigerator and sees that he has stored up several boxes of brontosaurus burgers from his last hunting trip. He knows that Barney, the club maker, loves brontosaurus burgers, so Fred figures that Barney will be willing to trade a new club for a box of burgers. Since Fred needs a new club and since he can always get more burgers once he acquires one, he decides to make a trade on this basis. So he goes over to Barney’s and trades the burgers for the club.

This primitive trade is called a direct exchange. The important thing about it is that it takes place only because the utility of a new club is greater to Fred than a box of brontosaurus burgers, and the reverse is true for Barney. We can describe the trade as having taken place at a price: The Price of one club was one box of brontosaurus burgers. Note that while the price can be specifically described, the trade took place not because Fred and Barney agreed on the utility of the goods exchanged, but because they disagreed! If both Fred and Barney valued a club more than burgers, then no trade would have taken place.

Consider Fred’s position immediately before he goes over to Barney’s to buy a new club. Fred must engage in a little self-examination. Since his needs are many and his resources are scarce, he has to decide what his priorities are before he goes on a shopping spree. His decision is as follows:

1) a new club

2) a new roof

3) a new loincloth

4) a box of brontosaurus burgers

5) another box of brontosaurus burgers

6) another club

7) another loincloth

This list of priorities is based on the utility of the goods on the list. Since Fred just ate, the brontosaurus burgers are relatively far down the list. What Fred needs most right now is a new club so he can go hunting and obtain food to eat and to trade. The roof is next in importance, because Fred prefers to sleep in a dry hut. Next in importance is a new loincloth since the one he’s wearing is in tatters. Then comes a couple of boxes of brontosaurus burgers, which occupy their lower spot because Fred already has several  boxes in the refrigerator and he has just eaten.

Note that the additional club and loincloth are at the bottom of the list, since they are not needed as much as the identical items at the top of the list. This is an important point. While extra clubs and loincloths benefit Fred, the incremental benefit of each additional club or loincloth becomes smaller. Economists describe this phenomenon in an important law – the law of diminishing marginal utility. Simply stated, the law of diminishing marginal utility says that as the amount of a good consumed increases, the marginal utility of that good tends to decrease. So, economists like to say that the marginal utility of a second club is less for Fred than the other items above it on the list.

Of course, the list itself is a list of Fred’s subjective values. But Fred lives in an objective world. That is, the items on Fred’s list are also on other people’s lists, but not necessarily in the same order. For example, people who can’t hunt to save their lives have little desire for clubs at all, except to the extent that they can trade them for other goods that they do want. People who had their huts re-roofed just last week wouldn’t trade a berry for a new one this week. As all these people come to the market, they make trades that make sense to them subjectively, and just as important, they refuse to make trades that do not make sense. In other words, people allocate their own limited resources in such a way as to maximize their own subjective utility – they keep making trades until their schedule of assets conforms to their list of priorities. In the aggregate, the subjective needs of all of the participants in the market result in an objective hierarchy of goods. At any given moment, the prevailing hierarchy, regardless of what you or I think of it, is the hierarchy of objective values.

The Speculator's Edge,
Albert Peter Pacelli

The Speculator’s Edge

The Speculator’s Edge

The next few blog posts has to do with a generic way to approach the markets in general. The material is from a terrific book published back in 1989 by Albert Peter Pacelli called the Speculator's Edge. The book mostly pertains to the Futures market but has applications for any market..

Basic Economic Concepts essential to Speculation

1) The Economics of Scarcity

Let’s begin with a few simple observations. First of all, our world is, in some respects, imperfect. Specifically, we live in a world of scarcity – one in which unlimited supplies of everything are not accessible to everyone.

Our second observation is that we live in a society, in which labor is divided. This is so obvious the alternative seems impossible to us, but it is probable that for most of human history, man produced exclusively to meet his own needs (i.e, Fred not only hunted, but made the club he hunted with, the tiger-skin loincloth he wore while hunting, etc.). Human beings who produce goods for the consumption of others will behave in a manner different from those who produce solely for their own consumption. For one thing, these humans will trade.

A society with scarce goods and divided labor has several problems. It must decide what will be produced, who will produce it and how, and who will receive it. Various systems have been tried. The one our society selected is called a market economy.

In our society, private ownership of property is permitted and the means of production and distribution of goods are, at least in major part, left up to individuals. This is what we mean when we say that ours is a free market system. Our system stands in sharp contrast to others in which production and distribution are directed by the state.

The Speculator's Edge,

Albert Peter Pacelli

Better than Buffett

Better than Buffett

“never put yourself in a situation where you have to sell something in an environment where you should be buying."

Bruce Flatt, CEO of Brookfield Asset Management, taken from Forbes.

Thus read my note next to Bruce Flatt's name on our short list for potential CEOs of the Year. And indeed, when we first reached out to see if he would agree to be profiled, the billionaire CEO of Brookfield Asset Management was less than enthusiastic. "I don't like media focus on me and like awards less," he wrote, "but let me reflect on this over the week." "Flatt rarely does interviews--his last extended sit-down with a Canadian publication was years ago--so we were excited when he followed up a week later to say he was in. But there was a condition: He would only do it if we featured the other four CEOs at Brookfield as well.

What could we say? We had our misgivings, but it would be fruitless to haggle with such an effective negotiator. He'd win--and besides, he had a good point: Brookfield is unique in that it actually does have five fully functioning CEOs, each one running a separate listed company with its own ticker.

That's why, on page 26 of this issue, you'll find not one, but five CEOs of the Year. This is the first time the magazine has featured multiple winners, but I have no regrets. Award-winning journalist Eric Reguly has penned a fascinating profile of the CEOs and their respective companies.

In it, he shows how they have grown what was once a mangle of unrelated investments into one of the largest, most disciplined and most profitable asset managers in the world.

As an investor myself, I can't help but wonder how Flatt does it. It's true he invests in alternative assets rather than stocks, but many of the same basic principles apply. Below, I've had a stab at pinning down five investing rules he seems to follow that account for his stunning success.

- Never pay full price. Some investors make a lot of money by jumping on trends, buying up assets in hot markets and riding the surge. Not Flatt. Asked to describe what Brookfield does, he sums up how his hideously complex bundle of companies operates in 11 words: They buy high-quality assets for less than their replacement cost.

In other words, every time they buy a massive office tower or billion-dollar power company, they buy it on sale.

- Hunt where no one else is hunting . So how does Brookfield find shopping malls, wind farms, toll roads and cell towers at discount prices? They do it by looking for sellers who are under duress and situations in which there are few competing buyers. That's why Flatt is expanding around the world. Lately, he's been buying up infrastructure in places like Chile, Brazil and India, where there's less investable capital and less competition.

- Think long-term. If you're buying for a short-term flip, you can chase bubbles, and you don't have to be too picky about quality. But that kind of investing is risky: When the bubble pops, you might be left holding the bag. If, on the other hand, you always buy top quality (Brookfield prefers assets that appreciate over time) and pay less than the asset is worth, once the deal is signed, there's not much that can go wrong.

- Move fast. Just because Flatt and his fellow CEOs are risk-averse doesn't mean they dither and overanalyze. Once they spot an asset they like, they do their research and wait. And when opportunity knocks--such as when there's a forced sale due to a bankruptcy, merger or regulatory change--they strike like a viper.

- Don't invest to get rich. I've spent much of my career studying successful investors, and one of the central ironies I've discovered is that the best investors aren't focused on personal wealth. Greed can cloud your thinking, and the top performers look at the numbers dispassionately and are prepared to walk if they don't add up.

Just look at Warren Buffett: He lives in a comfortable, but not opulent, house, and he obviously doesn't spend great pots of money on his clothes or cars. Similarly, despite his estimated net worth of $1.4 billion (U.S.), Bruce Flatt's Toronto home is an unremarkable two-storey townhouse in Summerhill. He's been known to drive a beater--or take the subway--and, despite its CEOs trotting the globe almost constantly, Brookfield has no corporate jet.

On that point, Flatt is actually out-Buffetting Buffett. Years ago, the Oracle from Omaha famously capitulated on his "no corporate jet" rule, buying a Bombardier Challenger 600 he nicknamed "The Indefensible." Could Buffett be going soft? If so, he had better watch out. The performance of his company, Berkshire Hathaway, is legendary: It's up 120% over the past five years. But Brookfield's performance is even better--it's up by 150%.

/Duncan Hood (robmagletters@globeandmail.com)
© The Globe and Mail

Stock Profits Without Forecasting

Stock Profits Without Forecasting

During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn't worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favour of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose. In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top.

As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price—by hindsight your individual transactions will never look daring. But some of your profits will be large, and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.

Stock Profits Without Forecasting, by Edgar S. Genstein

Manager’s Quarterly Commentary – David Barr Q3, 2018 Penderfund Capital Management Ltd.

Manager’s Quarterly Commentary – David Barr Q3, 2018

Penderfund Capital Management Ltd.

The rest of the world is selling Canada…

…so we are buying it. Low oil and other commodity prices, uncertainty in global trade and fears about Canadian housing have all been key reasons that Canadian markets have effectively gone nowhere for the past two years. This has created the opportunity for us to increase our Canadian exposure from 13% at the beginning of the year to 38% at September 30 in the Pender Value Fund. We have been able to deploy capital into our historical Canadian small and microcap universe (more on this later), but we have also been active in the midcap space and in the energy sector, thanks to the contributions of Amar Pandya who joined us over a year ago to focus on these areas.

Déjà vu

In 2015 we started to deploy cash into US listed companies. As small and mid cap stocks became cheaper we were able to buy companies we liked at an attractive price. But as is usually the case, momentum continued to work against us and a lot of these stocks became even cheaper. We’re not market timers. We’re not going to time investments to hit the bottom, so we focus on paying the right price. Similarly, in Canada, as we rotated back into Canada, momentum acted against us and while our performance has been dragged down by our Canadian universe year to date, we remain comfortable in the long term because we own businesses we like and understand, at what we believe is an attractive price.

Small and microcap Canada has gone to pot

If you picked up a national newspaper in the last couple of weeks, you will probably have noticed a substantial part of the business section was dedicated to the impending legalization date (now passed) of cannabis in Canada. The excitement about being a potential global leader in this “new” industry has resulted in over $10.5 billion being raised to finance various stage business plans. That’s a lot of money. The lack of interest we are seeing in micro and small cap names in our universe is directly related to this. The capital base that traditionally invests in this market has joined the massive “I want to get rich quick party”, aka the cannabis trade. To quote a musician one of my best friends believes is the greatest of all time, “We’re going to party like its 1999”. We just hope the hangover is not as bad.

US small and mid cap

This part of the market has been very interesting this year to say the least. One aspect that is very attractive to us is the volatility we witness. As a refresher for first time readers, for us, volatility is a wonderful tool that “Mr. Market” provides so that we can buy businesses we know well at a price below what we believe they are worth, before trimming or selling them when they become priced at a premium to their value. The first half of the year drove strong performance in the Fund and a lot was from this exposure. This came off a bit in Q3 and then October hit. The Russell 2000 was down 9% in early October and we experienced some of this in our portfolios. During this time, we saw several names in our universe fall around 50% from their 52-week highs. That’s a buying opportunity and that’s what we did.

A rotation to quality

Finally, when the market experiences volatility it gives us a chance to make switches within portfolios and to increase the quality of our portfolios. For example, we have been able to increase the weighting in businesses we view as compounders to 60% of the Pender Value Fund portfolio.

The future?

Well, we truly have no idea what is going to happen over the next few months. Momentum has turned negative and this could continue to drive markets down. Investor sentiment indicators, like the CNN fear and greed index, keep on bouncing off the “extreme fear” indicator. It would not be unexpected to see more downside in this type of environment. But we are not market timers. What we do know is that as prices decline, risk is reduced and future prospects improve, all things being equal. The Pender Value Fund today is at historical lows in cash, historical highs in allocation to compounders and the margin of safety, as we measure it, is very attractive today.

David Barr

November 5, 2018