Austrian Economics & Investing Austrian Economics & the Financial Markets May 22, 2010

1. Austrian Economics & InvestingAustrian Economics & the Financial MarketsMay 22, 2010 Joseph Calandro, Jr.

2. Contents • Background • Introduction – Austrian Economics & Investing • Investing & “Value Investing” • Benjamin Graham • Bottom-up v. Top-down • Principle 1: Knowledge & the Circle of Competence • Principle 2: Risk & the Principle of Conservatism • Principle 3: Risk & the Margin of Safety • Entrepreneurship & Franchise Value • Franchise Value: Management • Boom-Bust • Conclusion • Recommended Reading • About the Presenter

3. Background • I traded currencies & commodities in the 1990s, & did exceptionally well for 4 years; year 5, I was caught in the “Asian Contagion”… • Examining the mistakes I made led me to the study of Austrian Economics & value investing, which was fortunate timing-wise (in a sense) • In the late 1990s the “new economy” was booming: strong parallels with the “new era” of the 1920s • “Austrian Business Cycle Theory” predicted the boom & bust waves of both business cycles, which is useful information for practicing investors • Research published academically—including in the QJAE—which was expanded & published in book form:Applied Value Investing (NY: McGraw-Hill, 2009) 2 This presentation is my opinion only. Not to attributed to any organization I am or have been affiliated with

4. Introduction – Austrian Economics & Investing • Good economics facilitates good investing • “… investment students need only two well taught courses—How to Value a Business, and How to Think About Market Prices.”-- Warren Buffett, 1996 Berkshire Hathaway Annual Report • “Where there is no free market, there is no pricing mechanism; without a pricing mechanism, there is no economic calculation.”-- Ludwig von Mises, Economic Calculation in the Socialist Commonwealth (Auburn: LvMI, 1990 [1920]), p. 28 • “Economics is the science which studies human behavior as a relationship between ends and scare means which have alternative uses.”-- Lionel Robbins, An Essay on the Nature and Significance of Economic Science (Auburn: LvMI, 2007 [1932]), p. 15 3

5. Investing & “Value Investing” • “The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest.”-- Murray Rothbard, Man Economy & State (Auburn: LvMI, 2004 [1962]), p. 510 • “The books and the balance sheets are the conscience of business. They are also the businessman’s compass.”-- Ludwig von Mises, Bureaucracy (Spring Mills, PA: Libertarian, 1996 [1944]), p. 35 • Modern value investing “continuum” • Net Asset Value – balance sheet reproduction • Earnings Power Value – based on a level of historical earnings that should be sustainable into perpetuity • Franchise Value – sustainable competitive advantage • Growth Value – least tangible & thus most risky 4

6. Value Investing: Benjamin Graham • Benjamin Graham founded value investing in the 1920s-1930s • Heavily influenced by the “new era” boom of the 20s & the subsequent bust/Great Depression • Price discrepancy-based strategy: buying assets < liquidation value resulted in a significant price discrepancy or “margin of safety” • Cornerstone of the approach, to this day, & is what differentiates an “investment” from a “speculation” for Graham & his students • Most famous student is Warren Buffett; others equally as successful, e.g., Seth Klarman, Mario Gabelli, Mitch Julis, etc. • Many value investors have substantially outperformed market averages over time 5

7. Value Investing: Bottom-up v. Top-down • Micro v. Macro • Action v. Aggregates • Fundamental analysis v. Portfolio analysis • Price discrepancies v. “efficient frontiers” • “It is certainly legitimate and necessary for economics, in working out an analysis of reality, to isolate different segments for concentration as the analysis proceeds; but it is not legitimate to falsify reality in this separation, so that the final analysis does not present a correct picture of the individual parts and their interrelations.”-- Murray Rothbard, Man Economy & State (Auburn: LvMI, 2004 [1962]), p. 270 6

8. Principle 1: Knowledge & the Circle of Competence • “The recognition of the insuperable limits to his knowledge ought indeed to teach the student of [investment] a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to [achieve quick & easy returns]...”-- F.A. Hayek, Nobel Prize Lecture (December 11, 1974), words in redfont were inserted by me • The “circle of competence”: focus on what you know • “The size of that circle is not very important; knowing its boundaries, however, is vital.” -- Warren Buffett, 1996 Berkshire Hathaway Annual Report • Validating assumptions via the selective use of experts • “Pawn Stars” • “Indirect experts”: the Sears case 7

9. Principle 2: Risk & the Principle of Conservatism • “… man does not always act correctly from the objective point of view… either from ignorance of casual relations or because of an erroneous judgment of the given situation, in order to realize his ends he acts differently from the way in which he would act if he had correct information.”-- Ludwig von Mises, Epistemological Problems of Economics (Auburn: LvMI, 2003 [1960]), p. 34 • You could be wrong for any number of reasons: quantitative, qualitative &/or behavioral • Address all assumptions/adjustments (B/S, P&L, strategic, & growth-related) in each valuation conservatively 8

10. Principle 3: Risk & the Margin of Safety • “… this world is a world of uncertainty. We shall never be able to forecast the future course of the world with precision. Every action, therefore, involves risk. This risk cannot be eliminated. The man who keeps cash balances suffers the risk that [his] purchasing power may dwindle; the man who invests suffers the risk of loss; and so forth.”-- Murray Rothbard, Man Economy & State (Auburn: LvMI, 2004 [1962]), p. 510 • “They discover discrepancies between present prices of the complementary factors of production and the anticipated prices of the products minus the market rate of interest, and are eager to profit from them.” -- Ludwig von Mises, Human Action (Auburn: LvMI, 1998 [1949]), p. 544 • “Margin of Safety”: rule of thumb, price should be at least 30% less than estimated value 9

11. Value Investing: Entrepreneurship & Franchise Value (1) • “The business of the entrepreneur is… to select from the multitude of technologically feasible methods those which are best fit to supply the public in the cheapest way with the things they are asking for most urgently.” -- Ludwig von Mises, Profit & Loss (Auburn: LvMI, 2008 [1951]), p. 10 • “A profit-seeking enterprise is supported by the voluntary patronage of the public. It cannot subsist if customers do not pour in.” -- Ludwig von Mises, Bureaucracy (Spring Mills, PA: Libertarian, 1996 [1944]), p. 117 • “The elemental physical nature of the good may be only one of its properties; in [some] cases, a brand name, the ‘good-will’ of a particular company, or a more pleasant atmosphere in the store will differentiate the product from its rivals in the view of many of its customers.” -- Murray Rothbard, Man Economy & State (Auburn: LvMI, 2004 [1962]), pp. 665-666 10

12. Value Investing: Entrepreneurship & Franchise Value (2) • The GEICO case: Buffett’s franchise investment “masterpiece” • Paid ~$70/share--25.6% price premium at the time--growth reflected a 54% margin of safety (Source: Applied Value Investing, p. 56: valuation solely the work of the author) 11

13. Franchise Value: Management • “The profit motive is precisely the factor that forces the businessman to provide in the most efficient way those commodities the consumers want to use.” -- Ludwig von Mises, Bureaucracy (Spring Mills, PA: Libertarian, 1996 [1944]), pp. 24-25 • “One of the qualifications required for any higher position is precisely the ability to judge people correctly. He who fails in this regard jeopardizes his chances of success.” -- Ibid, p. 41 • Successful managers • Have entrepreneurial insight & discipline • Know how to select, incentivize, develop, & retain talent • Effectively assign decision rights • Are fanatical about P&L (very, very rare) 12

14. Boom-Bust (1) • “Buy during periods of pessimism & low prices; sell during periods of optimism & high prices.”-- Benjamin Graham, The Intelligent Investor (NY: Harper, 1949), p. 31 • It could be easier doing this if you understand the macroeconomic reasons for the pessimism & optimism • Macro-based insights could be used to screen for potential investment opportunities • “In broadest terms the Austrian [business cycle] theory is a recognition that an extra-market force (the central bank) can initiate an artificial, or unsustainable, economic boom. The money-induced boom contains the seeds of its own undoing: the upturn must, by the logic of the market forces set in motion, be followed by a downturn [or bust].” -- Roger Garrison, ”The Austrian Theory of the Business Cycle in Light of Modern Macroeconomics,” Review of Austrian Economics, Vol. 3, No. 1(1990), p. 7 13

15. Boom-Bust (2) • Invest into a boom & exploit under-priced risk prior to a bust • Sources: George Soros, The Crisis of Global Capitalism, p. 52 & Applied Value Investing, p. 133 14

16. Conclusion (1) • Pricing & valuation are predominantly about people voluntarily buying & selling, & the resources allocated to produce goods/services they want to buy & sell • Buying a security is like buying anything else… • … you likely would not buy a CD based on a cross-section of different musical genres (rock, country, rap, etc.) so why do that for securities? • As an investor you must know: what you’re buying, why, what you expect to get out of it, & when • Value investing is a proven method of doing this over time 15

17. Conclusion (2) • There could be value buying into a privilege early, e.g., business cycles, Burlington Northern (?), etc: be very conservative here • “The steel manufacturers seeking a tariff, the bankers seeking taxes to repay their government bonds, the rulers seeking a strong state from which to obtain subsidies, the bureaucrats wishing to expand their empire, are all professionals is statism. They are constantly at work trying to preserve and expand their privileges.” -- Murray Rothbard as quoted by Joseph Salerno in the Introduction to A History of Money and Banking in the United States (Auburn: LvMI, 2005 [2002]), p. 10 • Whenever the word “new” is used to describe market phenomena--especially by a government official--get ready for a bust (directionally, not timing-wise) 16

18. Conclusion (3) • Good economics--Austrian economics--facilitates good investing • But good investing does not necessarily equate to good economics • “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”-- F.A. Hayek, The Fatal Conceit (Chicago: U of Chicago, 1988), p. 76 17

19. Recommended Reading • Austrian Economics • Economics in One Lesson by Henry Hazlitt • The Mystery of Banking by Murray Rothbard • Economics 101 by Murray Rothbard (audio lectures) • The Root Causes of the Economic Crisis by Ludwig von Mises • America’s Great Depression by Murray Rothbard • Value Investing • Security Analysis 6th Ed. by Benjamin Graham & David Dodd (Seth Klarman, lead editor) • Margin of Safety by Seth Klarman • Buffett: The Making of an American Capitalist by Roger Lowenstein • Applied Value Investing (requires a working knowledge of accounting, finance & strategy; not for beginners) 18

20. About the Presenter Joseph Calandro, Jr. is the author ofApplied Value Investing(NY: McGraw-Hill, 2009). He is also the Enterprise Risk Manager of a global financial services firm & a finance department faculty member of the University of Connecticut where he designed & taught MBA courses on value investing & risk management. He was previously a financial consultant with IBM Global Business Services Joe has published widely in journals such as theQuarterly Journal of Austrian Economics, theJournal of Alternative Investments, Strategy & Leadership, & a number of others. A list of his publications is available at his SSRN author’s page: http://ssrn.com/author=357310He has also presented papers at conferences in the U.S., U.K., & Canada 19