Back-to-Basics Investing

America's markets would be better off if we focused on: What does the company produce? What is its market? And how well is it run?

By Kelly Candaele, Los Angeles Times, September 22, 2008



As a trustee of the Los Angeles City Employees' Retirement System, every week I receive materials in the mail from money mangers imploring me to consider investing in their strategy for generating high returns for our $10-billion pension fund. One of the most fascinating -- and revealing -- set of marketing materials comes from a company that lists the following options for investing our fund's money: credit default swaps, merger arbitrage strategies, collateralized debt obligations, interest rate contracts. You get the picture. Or perhaps, like most Americans not involved in the arcane "science" of finance, you don't get the picture.

It's unfortunate that it takes a financial crisis for Americans to divert their attention from what kinds of glasses Alaska Gov. Sarah Palin wears to issues that really matter, but a reevaluation of priorities may be the only upside to a meltdown that the news media is now desperately trying to explain.

In the so-called old economy, investors looked at the health of a company, the skills of management, potential market opportunities and the quality of the products produced. If, for instance, Harley-Davidson motorcycles looked as if it were producing high-quality bikes, investing in new engineering and training skilled workers, then that company could be a solid investment. Your investment was a wager, of course -- like all stock investments -- but nonetheless based on some modicum of analysis and solid research. If Harley-Davidson sold more motorbikes, then profits were made, investment was plowed back into the company and more jobs were created. Americans understand that basic logic of capitalism.

But try explaining a credit default swap -- the financial instruments now collapsing -- to your neighbor. Here is how one popular website defines the strategy: "A credit default swap is a credit derivative contract between two counterparties, whereby the 'buyer' or 'fixed rate payer' pays periodic payments to the 'seller' or 'floating rate payer' in exchange for the right to a payoff if there is a default or 'credit event' in respect of a third party or 'reference entity.' " At what point in this elaborate series of maneuvers is the economy enhanced and American workers' standard of living increased?

It is easy to parody the language quoted above. And Karl Marx did so in his mid-19th century writings by referring to various paper transactions as "fictitious capital." In our "postmodern" economic system, money makes money through speculation without the arduous process of actually producing anything.

It is firmly established that hedge-fund strategies, arbitrage arrangements and other complex investments have made a great deal of money for money managers and institutional investors who have embraced them. And some of these approaches can help hedge against risk, an important component in any large portfolio.

But more economists, writers and thankfully the American people are beginning to ask what these largely unregulated and opaque financial operations mean for the economy as a whole. In his recently published book, "Bad Money," historian and political commentator Kevin Phillips points out that if you include mortgage lending and real estate operations, financial services has grown from 11% of our gross domestic product in 1950 to more than 20% today, dwarfing manufacturing. As more and more of our economy is given over to financial machinations, inequality grows and working people's faith in the direction of the economy declines.

And Nouriel Roubini, an economics professor at New York University who predicted the current crisis, points out that the financial meltdown is much more than simply the product of a few overzealous and incautious executives. "We have a subprime financial system," he told the New York Times Magazine, "not a subprime mortgage market." Capitalism has come off its leash.

President Clinton famously declared that the "era of big government" was over during his 1996 State of the Union address. History often contrives to upend our most firmly held beliefs. The government now owns a big chunk of our financial system, and our congressional leaders are scrambling to design appropriate regulations to impose on the financial industry. Even Republican presidential nominee John McCain is repudiating his previous anti-regulatory convictions. It is more likely that what is "over" is Reaganism, the facile faith that the unfettered market offers the only path to economic prosperity.

The evolution from a manufacturing-based economy to a financial service-oriented one was not caused by institutional investors. But we do have a responsibility not to encourage it.

Sophisticated and reasonable regulations will help our economy as a whole and provide more transparency for investors -- like pension funds -- that are looking for good investments that also strengthen our economy. We would all be better off if the most common economic questions were the fundamental ones: What does this company produce? What is its market? And how well is the company run?

Kelly Candaele is a trustee of the Los Angeles City Employees' Retirement System.