Tuesday, October 14, 2008

To vote or to weigh?

In the short term, the market is a voting machine. In the long term, it is a weighing machine. Warren Buffett

(Explanation: The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine–assessing the substance of a company. The message is clear: What matters in the long run is a company’s actual underlying business performance and not the investing public’s fickle opinion about its prospects in the short run.)

Rome, it is said, was not built in a day. Crops do not emerge from seed and produce their fruit in a day either. Banks do not create profit in a day either, but only over time.

Time is the necessary ingredient which makes compound interest profitable. $100,000,000.00 invested in a 10% coupon bond is only worth $100,027,397.26 the next day. It will take 365 days for the value of the investment to grow to $110,000,000.

Remedial?

Yes.

Obvious?

Apparently not.

In optimal conditions, it will be many years before the financial sector generates sufficient profits to repay recent government investments. Those optimal conditions include a wide spread between short rates and long rates such that banks can borrow short and lend long. The bigger the spread, the greater the profit.

But it will take time- many years of a wide spread.

Judging by recent action in the equity markets, and assuming no helping government intervention (an erroneous assumption, in my view), recent policy choices of partial nationalization and recapitalization are popular. The votes, as per the opening Buffett quote, have been cast.

Yet, the weighing remains to be concluded.

In the late 90s billions of $s were invested in Tech companies. Few, despite tremendous popularity for the entire industry, survived the eventual weighing. Ultimately, running a profitable business became more important than the ability to attract investments.

The banks have proven quite adept at attracting investments. Whether they can run a profitable business remains to be seen.

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