Entrepreneurial InvestingAuthor(s): JOHN RUTLEDGESource: ABA Journal, Vol. 73, No. 4, 1987 Financial Planning Guide for Lawyers (MARCH 15,1987), pp. 6-8, 10Published by: American Bar AssociationStable URL: http://www.jstor.org/stable/20759215 .

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Entrepreneurial

Investing BY JOHN RUTLEDGE

If you ask most people what makes a successful investor, they will tell you it is lots of money, access to

hot tips about the market, and the ability to get in or out of the market quickly.

The truth is quite different. It's great to have a lot of money, but that doesn't mean you're a good investor. It just means you're rich.

These days the small investor has access to the same investments as the fattest cat on Wall Street. And you don't need hot tips. The most impor tant information is available free to anyone who wants it.

A successful investor has the skills of a successful entrepreneur: a good pair of eyes, a healthy disrespect for what the experts say, a certain amount of courage and patience, and most of all, a ton of humility.

Peter Drucker has published a seminal work on entrepreneurial ac tivity, the book Innovation and En trepreneurship (Harper & Row). Until now, most people who have writ ten about entrepreneurs have treated them as geniuses gifted with powers of creativity that the rest of us lack.

Drucker debunks that notion. "The entrepreneur," he says, "always searches for change, responds to it, and exploits it as opportunity."

This is a very important distinc tion for investors. An entrepreneur is not a creator of change; he is an ex ploiter of change that has been cre ated by others. He is not a source of

John Rutledge is chairman of Claremont Economics Institute, an economic forecasting and consult ing firm, and is chairman of The Claremont Company, which man ages a family of no-load mutual funds. Both companies are located in Claremont, Calif.

energy, he is a user of energy. That means ordinary humans can learn to be entrepreneurial investors.

As investors, we don't have to create good investments from whole cloth. We simply have to sweep the ho rizon continuously for impending changes in the world, then position our portfolios so that when those changes occur we improve our

wealth.

POLITICIANS AND GURUS We have been blessed with two

powerful allies: the Washington politi cians and the Wall Street gurus. Thanks to the politicians, there is no lack of change.

In the 1980s the twin engines of deflation and tax reform have forced the complete repricing and restruc turing of the country's $32 trillion balance sheet.

During this decade, the owners of tangible assets like oil, farmland and real estate lost more than $1 trillion of net worth and, at the same time, the owners of bonds and stocks made more than $1 trillion in gains in the biggest bull market of the 20th cen- >

tury. Any investor who can't find op portunities in all that turmoil isn't looking very hard.

Investors in the 1980s also have had the advantage of having a big, dumb, slow-moving competitor. Wall Street gurus?often wrong but never in doubt?and the sheep-like market consensus that follows them about, pout on every important change in politics, economics and demograph ics, five years after it happens.

After spending the past six years worrying about how the budget deficit was going to push interest rates higher, Wall Street discovered disin flation and falling interest rates late in 1986, five years after it began.

Back in graduate school at the University of Virginia, I had a wonder ful professor named Rutledge Vining.

I-?--is

Each morning, Professor Vining would make the long walk from his home to the economics department in Rouss Hall, then to the graduate school in Cabell Hall, then on to our classroom, altogether a distance of perhaps a quarter mile.

And each day, precisely 15 min utes later, his loyal bloodhound, "Daisy," would follow the same route to end up at the foot of his chair mid

way through his class. Following Daisy around the Uni

versity of Virginia didn't tell you any thing about where Professor Vining was going, it only told you where he

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U

had been. Daisy always caught up with him, but she was always late?just like Wall Street.

Large institutions are always slow to perceive and use economic change. In 1977 at the beginning of the Carter inflation, I was virtually thrown out of the board room of a Midwestern bank for suggesting a set of strategies based on the idea that inflation would exceed 10 percent by 1980.

After living through the inflation of the late 1970s, that same bank shifted to an inflationary strategy in the early 1980s, just as the inflation rate started moving down. The en

ergy, agriculture and real estate loans made during that period ultimately led to a run on the bank. Responding too late to change is worse than miss ing it altogether.

OBSERVE AND ACT The first ingredient in entrepre

neurial investing, of course, is the identification of an important change before the big boys get there. Don't wait for Wall Street to send you a re port about it or you will be playing the game like Professor Vining's dog.

And don't wait for it to show up in government reports. They show

J

you what might have happened nine months ago, not what's happening now. I have found that it is much bet ter to use my own eyes and ears, and to rely on my own judgment.

The really big economic changes always have their roots in the prob lems being discussed by real people around their kitchen tables or by real managers around the board table. And if you can figure out the direction and rough magnitude of those few really big changes that happen once or twice each decade, you don't need to worry about the little changes. You will make so much money on the big ones that

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you won't even care.

My biggest success in the 1980s has been in identifying, forecasting and analyzing the way that persistent disinflation affects the investment market. My partner, Deborah Olivier, and I presented our first disinflation forecast in January .1980, and we have not wavered in our low inflation, fall ing interest rate, rising stock price views since that time.

DISINFLATION During the 1980s, the single most

important economic event turned out to be the ruthless purge of inflation from our economy, our companies and our lives. The budget deficit got most of the headlines, but disinflation did most of the damage. In fact, those who were wringing their hands over bud get deficits and the dangers of rising interest rates missed all the action as disinflation created bull markets in stocks and bonds.

During the 1970s, we built up a dependence on inflation in our com panies and our investments by bor rowing large amounts of money to buy tangible assets whose prices would rise during an inflation period. Then when inflation slowed we all tried to get out of our inflation hedges in order to get money to pay off our debts. But everybody cannot get out of the door at the same time, and hard assets suffered a severe drop in value.

As investors tried to unload their unwanted hard assets in the 1980s, the weak prices in many resale mar kets meant that you could buy many durable goods more cheaply than you could make them. This meant that new orders for durables were hard to come by, and that economic growth, especially in manufacturing, re

mained weak.

But it also meant that manufac turing companies were under pres sure to reduce costs to compete against the cheap products in the re tail markets. The result has been the phenomenal cost-cutting drive across all of manufacturing. This has greatly increased the chances for continued low inflation for the rest of this cen tury.

Disinflation also has meant falling interest rates and a booming stock

market. Since January 1982, the 30-year government bond rate has fallen about half, from above 14 per

cent to below 7-1/2 percent today, causing the price of bonds to increase and yielding a cumulative return of 160 percent for a bond owner.

Meanwhile, the total return on in vestment of the Standard & Poor 500 stocks has been 150 percent. This gain can be almost entirely attributed to falling interest rates and rising price/earnings multiples, because low inflation has prevented significant growth in earnings during this dec ade.

This fall in interest rates hap pened for two reasons. First, declining inflation made tangible assets less at tractive by reducing their total return. This made many managers and inves

tors shift their portfolios away from tangible assets and toward securities. This drove bond prices up.

Second, disinflation eroded the future income that investors could ex pect to receive from their two favorite holdings, real estate and money mar

ket assets. Their growing hunger for long-term income has led them to buy bonds and stocks in record numbers, averaging $15 billion in mutual funds per month during 1986. These pur chases have driven bond prices higher and interest rates lower.

WHAT IT MEANS Disinflation is not over yet. As

long as companies are still trying to shed more layers of surplus assets, and still trying to repay their exces sive debts, disinflation will continue.

Continued disinflation means that economic growth will remain rel atively weak, in the 0-2 percent range, as managers continue to cut costs by closing surplus capacity, selling as sets, cutting capital budgets and lay ing off production workers.

Continued disinflation also means that inflation will remain ex tremely low due to lower costs, slower

wage growth, and the downward pres sure that corporate restructuring ac tivities exert on fixed asset and durable goods prices. In 1985 and 1986, for example, Fortune 500 com panies unceremoniously dumped more than $200 billion in office build ings, plants and equipment onto the resale markets each year.

Dumping an old office building back onto the market depresses real estate prices in the same way as the construction of a new building does. That's why the historically high money growth rate of the past two years has failed to push prices higher. High money growth was needed to create the demand to take the incredi ble surge in supply off the market.

Finally, continued disinflation will cause interest rates to fall by at least another 2 percentage points over the next two years. That means 30-year Treasury bond rates will be at 5 percent, Treasury bills below 4 per cent, and mortgage rates will hit roughly 7 percent.

BACK TO THE '60s Those rates may seem low, until

you remember that in 1960, Treasury bills paid investors 2 percent per year, the long-bond yield was 4 percent, and 30-year mortgage money was available at just over 5 percent. These rates were achieved with economic fundamentals not so different from those we face today.

The inflation rate in 1960 was 1.6 percent, and the government debt, al though much smaller than today's debt in dollar terms, was almost three times larger than our current national debt relative to our net worth (11 per cent today, compared with 35 percent in 1960) or our incomes (about four

months' income today, against a full year's income in I960). I see no rea son why the interest rates of 1960 cannot be achieved again sometime in the next few years.

My forecast is extremely bullish for the stock market. So far in the 1980s, interest rates have been the

most reliable indicator of rising stock prices. Bond and stock prices have risen in tandem, pushed along by these same deflationary adjustments. The reasons are quite simple. Bonds and stocks have value because they

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provide investors with streams of fu ture income: interest payments on bonds, and dividends on stocks.

In the 1970s, rising inflation cre ated two new classes of competitors for investors' affections: commercial real estate and rental properties, and

money market funds. Landlords began to look forward to raising rents by 10 percent each year for the rest of their lives, and enjoying capital apprecia tion to boot. And rising money market rates meant fat checks in the mailbox for money market fund investors.

These new beauties made inves tors lose interest in bonds and stocks as income producers. By the end of the 1970s, real estate and money mar ket investments had all but squeezed stocks and bonds out of investors' portfolios.

Changes in the tax code in the 1970s only intensified these effects. Rising tax rates and inflation-induced "bracket creep" penalized investors for income derived from stocks and bonds. Tax shelters further increased the attractiveness of real estate and other tangible investments.

But in the 1980s, the abrupt drop of inflation, reduction of tax rates, and repeal of tax shelters destroyed the attractiveness of these two competi tors to stocks and bonds.

Rents are no longer rising. Many properties are vacant and tax breaks are now less liberal on real estate in vestments. Money market investments now pay only 5 percent, instead of the 15-20 percent of just a few years ago. The fading income opportunities of real estate and money market invest

ments have made investors rediscover the attraction of bonds as a reliable source of future income.

Many analysts have argued that the tremendous increase in stock prices since 1982 will be short lived because it has not been accompanied by improvements in company earn ings performance. But I believe that the market gain has been based on a very solid set of fundamentals,

Stock prices have not been rising because investors expect to receive more dollars of future income. They have been rising because investors in creasingly perceive that each dollar of future income is more precious than it was in the inflationary 1970s, because dollars of future income are getting

more and more scarce.

With 5 percent long-term bond

rates, stocks should be selling at 20-22 times annual earnings, the way they did in the early 1960s, not 15-17 as they do today. This means the founda tion is already in place for an increase in the Dow Jones industrial average to

more than 3000 in the next two years, even without any major improvement in earnings performance.

Thereafter, investors who will have been spoiled in the 1980s will have to learn to live with more modest total returns. When interest rates have reached their bottoms, and price/earnings multiples have reached their new levels, stock prices will once again grow only when a company im proves its earnings. For the next year or so, however, we will continue to have a free ride as the multiples keep rising.

In normal times, when change is less violent and people are content to hold their existing assets, it is very difficult to come up with a smart in vestment strategy. That's because the professionals will have arbitraged away any obvious return differentials among assets. In such times, the best strategy, as all the textbooks tell us, is to buy a broadly diversified portfolio of assets and be content to earn the average rate of return.

NOT NORMAL TIMES Luckily, these are not normal

times. We are now midway along a wholesale repricing and restructuring of the country's asset base, which is producing extraordinary differences among the returns on different as sets.

The returns being earned in the stock and bond markets, for example, are abnormally high and won't last

forever. Investors should seize those returns while they are here by allocat ing an abnormally large portion of their portfolios to stock and bond in vestments over the next two years.

The returns on tangible assets will remain abnormally low, or even negative, for the next two years. For that reason, investors should consider reducing their holdings of tangible as sets until the deflation storm blows over. This doesn't mean that I don't like real estate investments.

In fact, the more that you like tangible assets, the more you should concentrate your portfolio in stock and bond investments in the 1980s, because ultimately you will have that much more capital with which to buy hard assets when the deflation is over.

I recommend you divide your se curities holdings as follows: 50 per cent in bonds, 35 percent in stocks and 15 percent in money market in vestments. The role of stocks in your asset mix is to protect your bond in vestments (government bonds only; I am too concerned about credit risks to feel comfortable with corporate bonds) against unexpected Federal Reserve tightening, which could hap pen should growth turn out to be stronger than we expect.

The role of the bonds is to pro tect your stock investments against the possibility that deflation could sig nificantly worsen, hurting profits, but pushing interest rates lower. In all, I expect both stocks and bonds to per form quite well over the next few years.

Above all, don't be caught fight ing the last war. Many investors have now grudgingly accepted the fact that things are different in the 1980s and that they must take deflation seri ously. But they are secretly waiting for a return to the good old days of the 1970s, and the kinds of investments that worked well for them then.

Even the most casual glance at history shows what is wrong with that idea. The 1970s were not the good old days. They were one of the most bi zarre periods of American history. During the 200 years leading up to 1960, the price level went down more years than it went up. The average in flation rate was zero. Don't get caught holding the bag when Wall Street fig ures out that the 1970s are gone for good.

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