The Fundamental Value of ‘The Long and the Short of It’

First trip to the RSA of 2009 was to see John Kay talk about his new book ‘The Long and the short of It’ I went with Mike who I met though fleshisgrass and who coincidentally joined the RSA at roughly the same time as me, so after a somewhat prolonged absence this has galvanised me to write another post.  Things that tipped the balance included the fact that the economy has got to be worth thinking about, Stephanie Flanders has returned to work and I can’t wade through the 100’s of comments on Robert Peston’s blog to make any sense of what is going on.

The main room at the RSA was packed to the rafters with people who as I found out may have been been there expecting advice rather than education and debate.  Because it seems John Kay has written a self help book for people with money to invest (is this still a large enough target audience?  I wonder sometimes when you read some of the worst predictions about the economy).  Mr Kay believes that the time has come for us to stop relying on the professionals and take responsibility for what happens to our own money.  Difficult to argue with the principle of this but the wilful ignorance that a lot of people have when it comes to finance makes me doubt this will take off in a big way.  However this didn’t stop the event being both educational, interesting and at times amusing.

A slight diversion here to talk about the chair for the evening Peter Jay who is a marvellously posh and well connected chap who must be fairly unique in having a career that spans the Royal Navy, HM Treasury, Journalism, Rupert Maxwell and being UK Ambassador to the United States.  Since 2003 he has been a non-exec at the Bank of England, none of this stopped both Mike and I remarking that he reminded us of the recently departed John Mortimer.  All of this meant that any thoughts about the links between his background and career trajectory were swiftly forgotten about.

Anyway returning to the main business of the evening.  The lecture was structured around explanations of what has caused the current financial crisis, what the Government (or Governments) could do about it and what we can do about it ourselves.

The explanation of how we have got into this mess was one of the clearest I have seen put forward.  We learned the difference between investors who are interested in fundamental value and those who are interested in the current and short term value of assets.  Basically if you invest based on Fundamental Value then it’s a long term game where you are interested in the income stream that asset will bring you over it’s life.  If you are more short  term then you will be into Mark to Market which is the value that people will pay for the asset on the current open market.  To  illustrate the differences in this approach Mr Kay talked about Warren Buffett as the archetypal fundamentalist and George Soros the marked market man.

Whilst these 2 different approaches aren’t necessarily right or wrong – if you want to measure success in financial terms Buffett and Soros have been just as successful as each other – they will deliver different outcomes over different timescales.  And when you start to think about it like that you can see how having complicated financial assets, so complicated nobody understood them, the value of which is based on what people are prepared to pay can very quickly lead to big problems.  Problems that quickly get out of control and seem to bear no relation in scale to the event that triggers them.  This actually has a link to structural engineering where various previous failures, most famously in this country Ronan Point flats in East London,  mean that buildings are now design to avoid disproportionate or progressive collapse.  This means damage to a a small part of the structure should not lead to collapse of all or even a large part of the building.  Now obviously there are limits to this otherwise we would all live and work in concrete bunkers but there are other precautions taken to further protect vulnerable buildings which are exposed to greater levels of risk than normal.  It seems to me that the we could do with something like this type of approach when designing the new regulatory system for the financial sector, the regulation of structural design has not stopped innovation but has provided clear boundaries and guidance on what is acceptable.

The vulnerability of complex financial markets to disproportionate collapse is one thing but John Kay offered an impressive degree of clarity on the main cause of the failure .  Which as with most things in life wasn’t that complicated when all was said and done, a bit like Bill Clinton’s rallying cry ‘it’s the economy stupid’  Mr Kay repeated several times the cause of failure was the banks investment in the international money markets.  A lot of which went spectacularly wrong.  I think this where my point above comes in whilst it was the massive securatisation of debt that is now being acknowledged as the route cause of the problem, what is need now is regulation that prevents  financial structures so vulnerable to progressive collapse following failure of one or two elements – in this case the American sub-prime mortgage market.

Because this post is getting quite long and because he didn’t talk about it very much I won’t be dealing with John Kay’s second point which dealt with what Government or society should do to prevent similar occurrences in the future, although it is probably clear from the statements above that I think there needs to be afundamentally different approach to regulation, governance and oversight.  However, one anecdote did stick with me which was about how when John Varley from Barclay’s complained on the Today Show about poor regulation Mr  Kay felt it was a bit like burglars blaming the police for not stopping them stealing from houses.

The final part of the talk concentrated on what seems like (I say seems because I haven’t read the book yet) the aspect which is most like a self help manual.  This is advice about how we might invest on our own behalf as we are the only ones we can really trust.  I hope Mr Kay didn’t mean this as if I can only trust myself life is going to be quite disappointing.  However, he seemed like a reasonable and sensible chap so I will assume we don’t have to take this too literally.  The real meat of this sections was about how the average member of the audience (of member of the public? as discussion for another time would be comparing the RSA audience to the general public) could manage their investments better than the professionals.  If this sounds interesting I suggest you buy the book where it will be explained much better than I will here.  To my mind however it would have been better to get views on whether there are some more radical options for the future of the financial system.  The worst of the predictions about the state of the economy would mean that a completely different model is required rather than more active engagement from ordinary investors.

During the Q/A Mr Kay managed to avaoid his self imposed rules (don’t make predictions or offer investment advice) for the most part but he did also avoid explanning why the owners of shares would want to lend them to traders who want to short sell them.  The questioner pointed out that by lending your shares to a short seller you are encouraging the destruction of the fundamental value.

I seemed to have ended more critically than intended because this was an informative and interesting talk by the end of which I found myself agreeing with Peter Jay that John Kay is a highly intelligent chap who can explain complex ideas in a engaging, clear and straightforward fashion.  Also I have the topic for another post which will be finding out why owners lend their shares to short sellers.


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