If you don’t understand what caused the bull market of the 80s, here’s your chance to catch up:

HAZELWOOD, MO—Twenty-six years after Ronald Reagan first set his controversial fiscal policies into motion, the deceased president’s massive tax cuts for the ultrarich at last trickled all the way down to deliver their bounty, in the form of a $10 bonus, to Hazelwood, MO car-wash attendant Frank Kellener.

The $10 began its long journey into Kellener’s wallet in 1983, when a beefed-up national defense budget of $210 billion enabled the military to purchase advanced warhead-delivery systems from aerospace manufacturer Lockheed. Buoyed by a multimillion-dollar bonus, then-CEO Martin Lawler bought a house on a 5,000-acre plot in Montana. When a forest fire destroyed his home in 1986, Lawler took the federal relief check and invested it in a savings and loan run by a Virginia man named Michael Webber. After Webber’s firm collapsed in 1989, and he was indicted on fraud and conspiracy charges, he retained the services of high- powered law firm Rabin & Levy for his defense. After six years and $7 million in legal fees, Webber received only a $250,000 fine, and the defense team went out to celebrate at a Washington, D.C.-area restaurant called Di Forenza. During dinner, lawyer Peter Smith overheard several investment bankers at an adjoining table discussing a hot Internet start-up that was about to go public. Smith took a portion of his earnings from the Webber case and bought several hundred shares in Gadgets.com, quadrupling his investment before selling them four months later. Gadgets.com’s two founders used the sudden influx of investment capital to outfit their office with modern Danish furniture, in a sale brokered by the New York gallery Modern Now! in 1998. After the ensuing dot-com bust, Modern Now! was forced out of business, and Sotheby’s auction house was put in charge of liquidating its inventory. The commission from that auction enabled auctioneer Mary Schafer to retire to the Ozark region of Missouri in 2006. Last month, while passing through Hazelwood, she took her Audi to Marlin Car Wash, where Kellener was one of the employees who tended to her car. She was so satisfied with the job that she left a $50 tip, which the manager divided among the people working that day.

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SAC Capital can’t catch a public relations break. First, Steve Wynn puts his elbow through Le Reve, forcing him to cancel the sale of the painting to SAC boss Steve Cohen (I guess there was a MAC clause in the purchase agreement). Then, SAC was featured (and mentioned by name) in the worst piece of business journalism to appear this year, Tom Wolfe’s indulgent, second hand gab fest on the hedge fund world. And now, SAC has served up to the world a new vignette of over-the-top hedge fund life that is sure to end up written into the screenplay of Money Never Sleeps or Doug Ellin’s hedge fund version of Entourage. According to the New York Post, it seems that Ping Jiang, an SAC quant manager, forced one of his traders, Andrew Tong, to take some unorthodox steps to improve his alpha:

a trader there claimed in a Manhattan Supreme Court lawsuit that his boss forced him to take female hormones - and also to wear articles of women’s clothing at work - all of which eventually led to an alleged sexual relationship between the men, one of whom is married.

The bizarre behavior was ordered by the boss, it was alleged, to eliminate the trader’s aggressive male attitude so he could become a more obedient and detail-oriented player in the $2 trillion hedge fund world.

Surprisingly, this attempt at improving office productivity is grounded in good science. Behavioral economist Terrence Odean famously found that women investors outperform men, because they tend to avoid overconfidence bias, and because they trade less than men. So, will SAC’s legal counsel be able to spin this incident into a promotion and get the case dropped? Only on Wall Street.

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For years, people have wondered why the Big Three have failed, so consistently, at building cars that people want to buy. There have been structural issues with Detroit that have contributed to the problem: the higher profit on SUVs, the expensive union labor, the methodone-like habit of selling cars to rental fleets. But one of the things you always hear is that in Detroit, the “car guys” never win battles with the cost cutters, the bean counters, and the suits. Stop by Bob’s Big Boy in Toluca Lake on any Friday cruise night, ask the proud owner of a perfectly restored Corvette or Thunderbird about this issue, and you’re guaranteed to get stories about the cruel suppression of the true car guys in Detroit.

Which makes the current situation in Detroit all the more interesting. As the New York Times points out in this recent article, there is something new going on in the management of Michigan’s finest. Most notably, Ford and Chrysler are recruiting executives from unlikely places. Chrysler, of course, hired Bob Nardelli to be its CEO. Nardelli, an alum of General Electric and former CEO of Home Depot, is a strong operator with a history of wringing greater efficiency and discipline out of his companies, including even Home Depot, where he was run out due to his excessive pay and a flat stock price. Nardelli is a disciplined, rigorous executive, but a car guy he is not; in fact, he’s about as far as you can get from a legendary car guy like Harley Earl.

In addition to Nardelli, Chrysler and now Ford have both poached senior executives from Toyota. While Toyota is a car company, it’s run by process engineers and marketers, not by designers (just look at a Toyota dealer lot). Yet Toyota is the most wildly successful car company in the world, so it’s just possible that an automobile company can succeed without tapping the animal spirits of a car guy.

In Detroit, we now have a perfect natural experiment developing, with Ford and Chrysler run by outsiders, and General Motors in the hands of the most alpha of America’s car guys, Vice Chairman Bob Lutz. Lutz has sprinkled pixie dust all over the GM lineup, making the cars higher quality, more desirable, and simply better than they’ve been in a long time. Don’t believe me? Look at what Dan Neil, probably the best car critic in America, has to say about the Saturn Vue and the Saturn Sky. Chrysler and Ford vehicles don’t fare so well under Neil’s examination. So the experiment, properly understood, is not whether GM succeeds because it has a car guy and the other two companies fail because they don’t. It may be presumptuous to say at this point, but I think that the long term revitalization of GM is already in the bag, what with the improved product (thanks to Lutz), the new contract, and the massive efficiency and quality gains that GM has quietly, but steadily amassed this decade. The experiment, rather, is wholly with Chrysler and Ford. Can they possibly succeed without the magic of a car guy? Will they be able to turn around while offering products that ignite barely more emotion than a hiccup? Can they take a page from Toyota, and focus on production efficiency and overall quality, and succeed in spite of their blandness?

I suspect that the answer is yes; I suspect that having a Bob Lutz around sure is great, but it’s not necessary in order to turn around a member of the Big Three. Give it five or ten years and we can see the answer together. Meanwhile, Harley Earl is rolling over in his grave.

Disclosure: At the time of posting, we held no positions in any of the companies mentioned in this article.

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In the recent New Yorker, John Cassidy pens a must-read profile of the infamous trader Victor Niederhoffer. Niederhoffer could be the very antithesis of a value investor — consider some of his investment methodologies, as related by Cassidy:

Before long, Niederhoffer cheered up a bit. “There have been three big down opens in a row, which is unusual,” he said. “The market doesn’t like to do the same things repeatedly.” He turned to Alex Castaldo, a thin, bespectacled fifty-three-year-old Italian who has a degree in electrical engineering from M.I.T. and a Ph.D. in finance from CUNY, and asked him to compile some data. “Doc,” he said to Castaldo, “what does the market do when it opens down a lot three days in a row?” A few minutes later, Castaldo handed Niederhoffer a computer printout, which showed that since the start of 2003 there had been just ten occasions on which, for three consecutive days, the S. & P. 500 had fallen sharply in the first hour and a half of trading. On eight of those occasions, stocks had bounced back, with the average market rise by the end of the following trading day amounting to three tenths of one per cent. For a trader like Niederhoffer, who uses leverage—borrowed money—to scale up his bets, the ability to predict even relatively small changes in the market can pay off handsomely…

Niederhoffer’s investment philosophy is based on a belief that over the long term the market goes up, but over the short term it constantly reverses itself. In his books—his second, “Practical Speculation,” was published in 2003—he compares the behavior of investors to that of herds of rampaging elephants that retrace their steps over and over….Niederhoffer doesn’t claim to be able to say what the Dow or the S. & P. 500 will do next week or next month, but he believes that over shorter periods—hours or days—there are sometimes predictable patterns that can be exploited. In “The Education of a Speculator,” he devotes an entire chapter to this notion, comparing the market’s movements to some of his favorite pieces of classical music, and juxtaposing pages of sheet music with stock charts. “When the markets are moving in my favor in a nice, gentle way—never below my initial price—I often think of the ‘Trout Quintet,’ ” he writes. “Another frequent work I hear in the market is Haydn’s Symphony No. 94. . . . Right after lunch, or before a holiday, the markets have a tendency to meander up and down in a five-point range above and below the opening. The pattern is similar to the twinkling C-major fifths of Haydn’s symphony….”

In addition to speculating on short-term market movements, Niederhoffer frequently sells financial contracts, called “put options,” which, in the event of a steep fall in the market, would oblige him to pay out large sums of money. The buyers of these options are usually other investors seeking to hedge their positions, and in a sense Niederhoffer acts like an insurance company: in return for a premium—the price of the option—he agrees to bear the risk of a market crash. Often, this is a good business; but whenever the market enters a volatile period he is in peril. (“He is his own worst enemy,” Nassim Taleb, the author and derivatives trader, says of Niederhoffer. “One of the most brilliant men I have ever met, and he wastes his time selling options—something nobody can have any skill in—and it leaves him vulnerable to blowing up.”)

Tolstoy said happy families are all alike; every unhappy family is unhappy in its own way. When it comes to investing, unhappy families are failed hedge funds. And they may be different in the particulars — some might be undone by a Russian default, others meet their denouement in the form of an Asian central bank, and more recently, others have been left with the keys to a worthless house by subprime borrowers — but all share several key factors in their demise. Cassidy’s piece on Niederhoffer illustrates many of them: leverage, complex trades, unknowable correlations, and no fundamental resiliency provided by a concept like Graham’s margin of safety.

The problem with trading systems that are built like this is that when they work, they are glorious. They make traditional value investing appear out of step with new realities, unable to compete against new methodologies. Niederhoffer’s record is a case in point: he was up over 40% in 2003, again up over 40% in 2004, up 57% in 2005, flat in 2006, and up between 30% and 40% in the first six months of 2007. Such a record trounces anything I, or most of my value investing colleagues, can put up. But Niederhoffer’s returns are built on risks that would be unacceptable to a value investor. In 1997, Niederhoffer’s fund evaporated due to bad bets on the Thai stock market and the U.S. futures markets, bets that went against him at the same time, forcing a firm-ending margin call. This year, as the subprime lending fiasco rolled through Wall Street, bringing with it the return of volatility and a new direction for interest rates, Niederhoffer was again caught the wrong way:

Later in August, after the Federal Reserve cut the discount rate—the rate at which it lends to banks—the markets calmed down; but Niederhoffer’s woes continued. In September, he was forced to close two of his funds, including his flagship, Matador, which had declined in value by more than seventy-five per cent. After cashing out many of his investments, Niederhoffer repaid his lenders and returned what money was leftover to his clients. He laid off several employees and consulted with his lawyers. Meanwhile, rumors circulated on the Internet that, for the second time in a decade, his funds had “blown up.”

Saying that a fund has blown up is one thing; understanding the meaning for wealth destruction is another. Consider an investor who had invested with Niederhoffer from 1990 onwards. For most of that time, the outside investors were earning over 30%, according to Cassidy. Then, in 1997, Niederhoffer lost it all, and we are to presume that most outside investors were left with losses of around 100%. Three years later, many of those same investors had become convinced that Niederhoffer had learned from his mistakes, and that his systems were now resilient to such setbacks. They invested with him again — using new money, since their original investments were reduced to nothing. Now, in 2007, the funds have been unmasked for the second time, leaving Niederhoffer’s credulous true believers with losses of over 75%. Repeat investors have thus lost over 100% of their money — potentially much more, depending on the timing of their individual investments. Some who invested a large portion of their net worth into Niederhoffer’s funds are unlikely to recover, ever. All would have been better, back in 1990, to have invested in simple treasury bills.

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Have you seen those ubiquitous ads in financial magazines for Gorilla Trades? So has Business Week.

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Two interesting pieces for those of you who believe that you can’t believe everything the government tells you. First, Daniel Gross parses the difference between the core CPI and the actual CPI, which includes things that, you know, go up in price, like food and energy. And over in the Journal (soon to be free, we hope), we read about how the recent rise in the cost of food could be permanent. Of course, we know to be skeptical whenever we read an article whose fundamental thesis can be boiled down to “it’s different this time” — the four most dangerous words in business and investing. But we don’t see any reason for the price of food to be coming down any time soon, what with growing meat consumption in the developing world and the diversion of acreage to biofuel production. So — anyone want to tell us how, exactly, inflation is still under 3% per year?

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Today’s landmark GM/UAW announcement is a major accomplishment for Rick Wagoner, CEO of GM. Much maligned for GM’s troubles in recent years, Wagoner has nevertheless accomplished much in seven years he’s been running the company. When he took over, GM faced a yawning quality gap between its cars and those of Honda and Toyota, a disjointed platform and assembly system that took hours longer to produce cars comparable to Toyota, and the most vexing burden of “legacy costs” facing anyone in corporate America.

Today, GM is a very different company. GM has closed much of the gap between it and Toyota in initial quality, even if GM cars still leave something to be desired in the categories of fit and finish as wells as emotional desirability. The production process is now streamlined enough to compare well against any competitor, save Toyota, which still enjoys a (smaller) edge. And now the legacy costs are addressed, in what appears to be a permanent way.

With today’s deal still hot off the ringing anvil, it’s too early to assess the permanence of the change. Over the 40 years of its long term decline, Detroit has staged many impressive turnarounds that fizzled out after a few years (Chrysler in the 80s comes to mind). But it’s just possible that we may be witnessing today the beginnings of a permanent turnaround in Detroit.

As an investment, GM still leaves much to be desired — too much debt, declining sales, and much product improvement remaining for the company to be truly competitive again. So while I’m not in any way tempted to buy the stock, I sure hope Wagoner can build on this success.

Disclosure: At the time of posting, we held no positions in any of the companies mentioned in this article.

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Surowiecki’s pieces for the New Yorker have been hit or miss recently, but his recent article on the economics of imitation in the fashion business is definitely a hit. Surowiecki argues that imitation by low price knockoffs spurs innovation in fashion, since fashion’s currency is innovation and exclusivity, both of which are diluted by imitation. The result is a classic Red Queen style arms race, in which high end designers must innovate constantly to stay ahead of the imitators.

Incidentally, this can boost profits for all involved, since it leads to quicker cycles and more consumption by consumers desperate to keep up. Fortune suggests that bling beats the market, and it’s interesting to note that bling does indeed seem to win out, whether it’s high end original stuff or cheap knockoffs produced by fast followers. Indeed, it even appears that the fast followers and more accessible brands — H&M, Zara, and Coach — may be better investments than their more established competitors. I certainly wish I’d bought all of them in 2002!

Disclaimer: I own none of the stocks mentioned in this post at the time of writing.

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Reason Magazine has a great piece in their August/September issue on the issue of intangible capital — all forms of capital other than natural capital (oil, timber, etc.) and produced capital (factories, infrastructure, etc.). So what then is intangible capital? In the case of the Reason article, intangible capital is the institutions and norms that make a country stable and prosperous. Think of the difference between, say, Finland and Afghanistan, and you get the idea.

Investors benefit from intangible capital on both a macro level and a micro level. When we invest in a country, we are essentially going long the institutional capital of that country, and in many cases, investors get this part of their investment thesis incorrect — ask anyone who bought Argentine bonds before 2001. On a micro level, companies have intangible capital as well, and in most industries except natural resources, that intangible capital is more important than all forms of physical capital. Warren Buffett often talks about economic goodwill or a company’s “economic moat” — simply another word for for intangible capital. Some companies have more of this than others, and as a security analyst, a big part of my job is determining the size and strength of a company’s economic moat. Our portfolio contains many companies with what Morningstar would call “wide economic moats.” In a later post, I’ll go into detail about the different sources of, and different ways to use, an economic moat, and how investors can identify such.

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Welcome to home page and blog for Rubalcava Capital Management. With this blog, I hope to engage in an ongoing conversation with my existing clients, as well as introduce myself to anyone looking for a value-oriented money manager to help them with their investments. We’ll be discussing the stock market, economics, savings, and a whole lot more, so bookmark this page and check back often.

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