Geoff Gannon March 17, 2008

On Ignorance Admitted

In finance, liquidity is not a physical state it is a psychological state. Liquidity is a state of mind. Worse yet, liquidity is in the eye of the beholder. That is not merely to say that liquidity is subjective. Liquidity is subjective, but it’s also more than subjective – it exists in the minds of others – others who can and do transact business with you. So liquidity is – to a great extent – uncontrollable.

Good assets may not necessarily be liquid assets. As a result, good decisions do not necessarily lead to good outcomes when an actor is dependent upon liquidity. An actor is dependent upon liquidity whenever liabilities are great relative to assets. However, an actor can avoid insolvency and make good decisions that will almost certainly lead to good outcomes if the actor can studiously avoid disbursing cash or other assets to meet obligations in the near-term. An actor who can finance an asset by selling a thirty-year zero-coupon bond does not have to worry much about liquidity. Any actor so financed weds its destiny almost entirely to the intrinsic value of the asset – and only the intrinsic value of the asset. All other worldly concerns seem to melt away. This sort of financial nirvana is rarely achieved by any actor who has tasted of the sweet, sweet nectar known as debt.

Actors – like addicts – can develop a dependence through regular use. There is no such thing as non-habit forming debt. Debt is so addictive precisely because it is so useful.

Wonderful businesses have been brought down by a lack of common sense and an abundance of debt. Great businesses – even some simple, great businesses – have been brought down by debt.

What their competitors could never do to them, these great businesses did to themselves.

Berkshire Hathaway (BRK.B) bought Fruit of the Loom out of bankruptcy. It’s hard to bankrupt an entrenched underwear business. Only debt could kill a business like Fruit of the Loom or Hanes (HBI).

So how can investors evaluate a debt-laden liquidity whore? For the most part they can’t.

Investors never like to hear that. But it’s true.

Hanes may have debt; but at least its business isn’t directly dependent on liquidity. Like Fruit of the Loom, Hanes can go bankrupt, but Hanes can also be evaluated without reference to all sorts of variables beyond the company’s control. An investor can decide if the company has too much debt without giving much thought to capital markets, interest rates, commodity prices, and all the other much discussed macro variables. The further an investor ventures from the specifics of the business he is evaluating the more unstable all of his assumptions become. As he stacks unstable assumption upon unstable assumption, he builds a teetering tower crowned with an intrinsic value estimate that could prove perilous.

If you can make successful macro bets, make them. If that’s your strong suit, stick with it. But don’t confuse the business of evaluating businesses and picking stocks with the business of guessing which way the macro winds will blow.

You don’t need to have an opinion on every stock out there. It’s no mark of shame to admit you can’t come to actionable conclusions within whole industries. If you knew Bear Stearns (BSC) was a short – good for you. If you could admit Bear Stearns was beyond your comprehension – even better.

Investors have a hard time roping off the areas they can work within from those they can’t. Too many of us venture too far afield. A few good decisions can make a fortune. A few bad decisions can lose one.

You’re going to make mistakes. But there’s no need to make them in unfamiliar territory.

The temptation to take a stand, either with the market or against it – with the bulls or with the bears – is always great. Too great for most investors.

In the days and weeks ahead, most people will be focusing on Bear Stearns. However, most investors would do better to focus on themselves.

Now is a good time to examine how honest you are with yourself. Admitting when you’re wrong is good. Admitting when you don’t know is better.

What lesson will you learn from all this? How will you become a better investor?