Chapter 3
The Second Call -- Valuing bonds blindfolded
Shortly after finishing my call with Mrs. Hagedorn, I received a call from a friend and fellow employee of the Indianapolis-based investment firm I was with at the time. He was a broker, and I was in the money management department. He explained that he needed to sell some Indiana University bonds for a customer who was in a panic about the crash. When I asked him why he called me and not the bond desk, he said it was shut down. Actually, what was happening was that the stock market crash overloaded the quotation systems, and no one knew if the prices of stocks or bonds we were seeing on our Quotrons were current or hours old.
The collapse in stocks had caused a flight to the perceived safety of Treasury bonds, which caused them to soar in price. Under normal circumstances, municipal bonds trade with a spread to U.S. Treasury bonds. Thus, prices of municipal bonds like the Indiana University bonds should have been rallying along with Treasury bonds. But correctly valuing municipal bonds in the middle of a stock market crash was next to impossible. Additionally, no one knew if the normal spread between Treasuries and municipals was holding steady. As a result, many bond desks at firms across the country suspended operations.
When I heard the news that our bond desk was not bidding on bonds, my heart sank. It further opened my eyes to how big the crash was. It was starting to shut down the whole system. Shutting down the bond desk was like the power company shutting down one of its generating plants; the only reason they would do that was to salvage the system.
Stocks were collapsing and bond desks nationwide were suspending trading. Momentarily, I was seized with the notion that maybe this was another 1929-type crash, and everyone would lose everything. I quickly shook off that thought and steadied myself. The fact was that the economy was strong. And, since only about 25 percent of Americans owned stocks at that time, most people would wake up the next day, shower, brush their teeth, get dressed, get in their car, and stop for an Egg McMuffin on their way to work. Life would go on as usual. I paused right then to add Colgate, Procter and Gamble, and McDonald’s to Mrs. Hagedorn’s “best company” list.
My friend said that the seller of the bonds was a long-time client who was convinced a 1929-type depression was imminent and he wanted to raise his level of cash. He stressed that he really needed the favor. I told him I could not do favors with other people’s money. “All I want is a bid to show my client, not necessarily a favorable one,” he said.
I asked him how I was supposed to know where the market was trading if the bond desk didn’t even know. He responded that he thought maybe one of my firm’s money management clients might be interested in his client’s bonds. In fact, several of my clients had told me during the day to keep an eye out for bargains on bonds. I agreed to think about it and asked him to call back within the hour.
By law, the State of Indiana cannot have direct debt. The law was the result of the Wabash and Erie Canal debacle of the 1840s, which forced the state into bankruptcy and produced an 1851 statute prohibiting any future issuance of debt by the state. The prohibition meant that Indiana had one of the strongest financial conditions of any state in the nation.
As I thought about the bonds, I realized that Indiana University was as close to state debt as you could get. The good citizens of the Hoosier state would sell off their family jewels before they would let Indiana University go under. In addition, Bobby Knight and his Hoosiers basketball team had won the NCAA basketball championship the preceding March, and the state would likely have sold off the Capitol rotunda rather than give up the basketball arena. The bonds were safe. But what were they worth?
In valuing the bonds, the toughest hurdle to get over was that they were 20 years from maturity. Life and taxes would go on no matter what happened in the crash, and the tax-exempt interest the bonds paid would always be prized by investors in high income tax brackets. U.S. Treasury bonds had started the day yielding about 10.25 percent, and bond prices were rallying, so the yields were probably near 10 percent. If I could buy the IU bonds to yield the same amount as U.S. Treasury bonds, I would have a real bargain because in normal times tax-free bonds yielded approximately 80 percent of Treasury bonds.
When the broker called back, I told him I would buy the bonds to yield 10 percent, then told him to call the bond desk and get their approval before he told his client about my bid. The head of the bond desk called me immediately and began to explain what was happening with the bond market and his inability to bid. I stopped him and said I was aware of what was going on and was willing to buy the bonds if he approved it. He said he thought 9 percent might be a better level for the bonds, but I held firm at 10 percent and said my bid was good until the close of business. The broker called back in minutes to say the bond desk would not approve the 10 percent level but would allow it at 9.40* percent. I agreed to buy the bonds at that level, then called the bond desk to say I would offer a bid for any other bonds people wanted to sell.
I had budged on the yield I was willing to take on the bonds but reasoned that getting 94 percent of Treasury yields was still a good deal. I was also confident that buying Indiana University bonds when no one else would make a bid was sure to be a good buy, ultimately. In addition, the destruction of hundreds of billions of dollars by the stock market crash was a deflationary event that I was convinced would cause interest rates to fall.
As I returned to my blinking phone, I paused for a moment. I had just done something that I had never done before -- value a bond in the absence of a trading market. I had just committed my clients to up to 20 years of ownership of this bond, and I had done it in the middle of a panic unlike anything I had ever witnessed. What surprised me was that I was almost intuitively able to clear away all of the clutter and zero in on just the few details I needed to make the decision. But that wasn’t all. Without realizing it, I was following the investment strategy Mrs. Hagedorn said she and her husband had used for many years: Buy the best when nobody else wants it.
The Third Call -- A Good Argument
The third call I received on Black Monday that set me on a different path came just as I was going to bed. It was from a client whom I had not spoken to during the day. He was very troubled. After trying to calm him with rational arguments, I realized that he could not hear me over the sound of his extreme fear and agitation. The more I tried to reason with him the further apart we drifted, like two people receding into a dense fog.
Billy Behr was, in his own words, “large and loud.” He had one of the keenest minds of anyone I had ever known and was a voracious reader, student of history, and the owner of a very successful information technology consulting firm. He often reminded me that he did not need a money manager, but I continued to manage a seven figure portfolio for him for more than 20 years.
Billy was a mystery. He was my best friend one day and my interrogator the next. He delighted in telling me that the portfolios he managed were outperforming the one I managed for him. When asked why he kept doing business with me, he would only say that he needed me to manage his conservative money.
On Black Monday, I missed calls from Billy all day. These were the days before cell phones, and he was on a business trip around the Midwest, hop-scotching across the countryside from pay phone to pay phone. He knew I was not selling into the crash. My assistant had informed him of this decision when he had called the first time. He agreed with that strategy but needed to speak with me as soon as possible. So, just before I left the office, I called his home and left a message saying that he could call me at home any time up until midnight.
When my phone rang at 11 p.m., I did not recognize the voice on the other end. It was very faint and strangely childlike. “Gregor,” the voice said. “Glad I caught you. I just got in and I’m shell-shocked at my losses. How far down is my account with you?” I told Billy somewhere between 20 and 25 percent. He said he was down much more than that in his other accounts, which were fully margined. He was sure he would have margin calls in the morning, and he wanted to know what I thought was going to happen in the next few weeks. I told him my best guess was that the market would continue its volatility, and that I would be surprised if it did not go at least 10 percent lower before finding its footing. I added that big sell-offs are usually followed by a rally, then a retesting of the bottom.
Billy said he was stunned by the day’s events and feared he had probably lost a million dollars. He asked me to remind him why I had decided not to sell into the crash. I repeated the talking points that I had been using all day -- we owned many of the greatest companies in America, and it was not prudent to throw good companies at bad prices, particularly when there seemed to be no economic reason for the selloff. Furthermore, it was becoming increasingly clear that Black Monday’s crash had been caused by a structural malfunction in the market that had been set in motion by computerized trading. The financial media were full of stories of how this programmed trading had careened out of control. And there was talk that the New York Stock Exchange was going to suspend such trading before the market opened in the morning.
Billy said one of the gurus whose telephone hot line he subscribed to was calling for a bottom of 400 points for the Dow Jones 30. That was more than 1,300 points lower than Black Monday’s close of 1,738 for the Dow. I asked who was making the prediction. When he told me who the advisor was, I said the guy had never seen a sunny day in his life and had been predicting the sky would fall for 20 years. Billy said that the advisor had been predicting a crash for a long time, and he should have listened to him earlier. It was clear that Billy was not listening to me.
“If the Dow Jones 30 falls to 400,” Billy sputtered, “I will be wiped out, and I just can’t take the chance of staying in the market.” Talking about the advisor’s doomsday prediction had sent him into a downward spiral. The fear in Billy’s voice caught me by surprise. Finally, after more disjointed chatter, he told me to sell everything at the opening of trading on Tuesday.
It was now 11:30 p.m. After a hard day of dealing with everyone’s emotions, including my own, and speaking with clients for nearly 17 hours, my voice and energy were spent. Billy’s irrational and morbid mood had begun to have a negative effect on the clarity and confidence I had felt all day. I knew that Black Monday would be the first of many long days and nights for me. In order to maintain enough mental and physical energy to make it through this dark time, I could not exhaust myself on one person. I muttered, “If that’s what you want, Billy, I’ll do my best…” but I immediately realized that I was doing him no favor. As the captain of one of his financial ships, I knew better than he did how to navigate this storm. I knew in the current market that there was a complete disconnect between prices and values. I did not know what the correct price for the Dow Jones 30 was, but I was sure that bailing out now was wrong. I also knew that trying to have an intelligent discussion with Billy in his present state was useless. So I decided to try another tactic.
“Billy, you realize in giving me these instructions to sell everything, you are firing me. We will never work together again.” He tried to protest, but I interrupted him. “If I am being fired I want you to understand that I think what you are doing is dead wrong, and you will soon be sorry.” He did not respond, so I continued. “As we have been talking, something keeps coming into my head. I’m not sure you will agree with it, but I cannot let our relationship end without telling you what I’m thinking.” He said that he was so worn out that he could barely stay awake but would listen as long as he could.
“Billy, you know there is a drought in this part of the country. Corn and bean crops are in bad shape and some farmers have plowed under whole fields. Have you seen that field at the corner of Highway 57 and Kansas Road?” “It’s burned up,” he replied. “Yeah, I know the farmer, and he said he’s going to plow it under. There is nothing to harvest. The sun has just roasted the beans. What do you think the odds are of anything ever growing in that field again?” I asked. “Better yet, are you willing to bet me that that field is somehow broken and will never produce crops again?”
Billy wouldn’t take the bet because he knew that the field would grow crops next year. I asked him on what basis he believed that. “It’s only natural,” he said, “Billy, think of everything that has to go right for that field to produce crops -- the right amount of rain all year, not too much or too little; the absence of a blight and destructive insects; the right seed; the right fertilizer; and the skill of the farmer.”
I asked Billy if he thought the value of the field had fallen because of the poor crop this year. He said he did not think so because in nine out of ten years the field would produce a crop, and some big crops would make up for the shortfall this year. “So from what you’ve just said, Billy, you have faith that the forces that have produced good harvests ninety percent of the time will re-establish themselves, and this year’s losses will be made up in the years to come?”
“Gregor, I know where you are going, but I’m just too tired to play logic games with you. Just do what I told you and sell all my stocks at the open tomorrow.”
“Billy, you hired me to manage a big portion of your assets, and I am going to do that until you tell me I am fired. I need to convince you that your cut and run action is not the right one.”
Billy’s temper flared. “Hey, man, don’t make things worse with cut and run talk. I’m not cutting and running. If this market keeps falling, I’ll be wiped out. I’ve worked a lot of years to build the assets I have. I don’t want to start at zero again.”
I then asked him why he was predicting a different ending for the stock market than he was for the farm ground. Fully awake now, Billy blurted out, “Because they are completely different animals. Farm ground did not fall by 23% today, and farm ground is a necessity to our way of life; stocks are not!”
“Billy, you are wrong when you say that farm ground and stocks are completely different animals. All farm ground is valued as a means of production for food, a basic necessity. How is that different from Southern Indiana Gas and Electricity? (SIGECO was the local electric and gas utility at the time. It is now Vectren.) SIGECO is a means of production of electricity, a basic necessity. Our society can no more live without electricity than it can without food. And how about Johnson and Johnson? It is one of the world’s largest pharmaceutical companies. If JNJ were to dry up and blow away, millions of people’s quality of life would go down hill in a hurry. Some might die. And how about Proctor & Gamble, Exxon, and General Electric? The fact that farm ground is tangible and stocks are not has nothing to do with how either one is valued or what they are ultimately worth. I recently saw where the total rate of return for farm ground in the United States over the last 50 years has been just modestly higher than inflation, whereas the rate of return for stocks during this same period has been five percent higher than inflation on an annual basis.”
“Farm ground and stocks are not the same thing,” Billy shouted. “Stocks fell today by 23%; farm ground probably did not move a penny.”
I shot back that “probably” was the operative word in his argument. “In the stock market, we live in a real-time quoted world. You can find out what any stock is selling for just by hitting a couple of buttons on a computer or reading it in the newspaper, and you can buy or sell millions of dollars worth of almost any stock on almost any day you choose. Write the check and you own it, or sell it and a check arrives in your mailbox in a week. It’s a real-time quoted live market; there is little or no ‘probably; about it. Farm ground is all about ‘probably.’ There is no real-time place where you can get a true selling price for that farm ground at Highway 57 and Kansas Road. There is no billboard on the corner showing the land’s moment-by-moment selling price, and there is no difference between tangible farm ground and intangible stocks.
“The moment-by-moment quoted market works for stocks 90% of the time, but because we humans are hardwired to fear loss, a sort of reverse alchemy occurs every time stocks go into a tailspin. Cascading markets transform our heretofore golden portfolios into junk. Almost magically vibrant and growing companies become nothing more than prices on a ticker tape, heading south. They are sold indiscriminately of their recent results or their prospects.
“Billy, you didn’t build a business as big as the one you own by cutting and running when the times got tough or someone threatened to sue you or run you out of business. Why are . . .
Billy interrupted me. “If you don’t stop this cut and run talk, I’m going to hang up this phone,” he growled. “You are preaching to the choir here, man. You know that my company is as big as it is because in recent years every time the IT market took a dive I stepped up and made acquisitions. I know how fear and greed can turn you into an idiot. That is why I keep an ongoing valuation metric for all of my important competitors in the Midwest. If any of them want to sell, I know exactly how much I will pay without stepping foot on the premises. If I get my price, I can clean up any problem they have.”
“Now we are talking,” I said with renewed fervor. “Would you mind sharing your valuation methodology with me?”
“Good grief, Greg, it’s midnight. You win, at least for tonight. Forget that I said sell everything. I’ll sleep on it and call you in the morning if I change my mind. But here is something that is non-negotiable. I’ve got enough risk in my trading accounts and in my businesses. I want you to reshape my portfolio to be entirely comprised of basic necessity companies. That is the only thing you have said tonight that has made sense to me.”
With that, Billy hung up. I lay in bed with questions running through my mind. I could not drive the race in front of me and read the roadmap at the same time. My purchase of the Indiana University bonds provided a yield above 9 percent, completely free of all taxes and backed by one of the most conservative states in the union. If that wasn’t a good buy, then what was? The next morning, I was going to tell the firm’s brokers to buy municipal bonds. Everyone would want to know what stocks to buy or sell, but it did not feel right to be jumping into the stock market until the bottoming process was further along, and it was too late to sell.
Then I began to think about the people I had spoken with that day. Among the scores of calls, the conversations with Mrs. Hagedorn, my friend with the IU bonds, and Billy Behr stood out. I knew they were seminal and would ultimately reshape my understanding of investing. Eventually, I would dig deeper into the impact of each call, but the one from my friend who wanted to sell the IU bonds took center stage. As I replayed the events surrounding the purchase of the bonds, I was struck by the fact that I’d been in the investment business for 12 years without knowing how to value a stock apart from its selling price on the exchange. Prior to Black Monday, I believed the market price dictated what a stock was worth. That is what I had been hearing for nearly a decade. On the night of Black Monday, I realized that the prevailing wisdom was nonsense. The average stock had fallen 23 percent. It was clear that investors were not trying to make informed decisions about the value of companies; they were just running from the storm. I was convinced of that, but I had no way to value a stock. Yet, today, I had priced a bond in the absence of a trading market.
Just before I dozed off, the only question on my mind was, “Is it possible to turn stocks into bonds?”
