Debt Is the Story

By April 1930, the US stock market had bounced 41% from its Nov. 1929 lows. Then the trouble began...

AFTER THE GREAT CRASH of 1929, the market had a nice recovery, writes Chris Mayer in the Rude Awakening.

By April 1930, the market was up 41% from its lows of Nov. 13th, and many people believed the worst was over. One of them was Benjamin Graham, the father of security analysis, Warren Buffett's teacher and a great investor in his own right.

In 1930, Graham was 36 years old, a near millionaire who had already enjoyed a lot of success in markets up to that point. So when he met with a successful, retired 93-year-old businessman named John Dix, Graham was full of "smug self-confidence" as he would admit in his memoirs.

Graham found Dix "surprisingly alert" as Dix peppered him with all kinds of questions. Then Dix asked him how much money Graham owed to banks. Dix didn't like what he heard.

That's because Graham used a lot of debt in his investment fund to finance stock purchases. When Dix heard this, he then offered him a grave warning with "the greatest earnestness."

Dix said:

Mr. Graham, I want you to do something of the greatest importance to yourself. Get on the train to New York tomorrow; go to your office, sell out your securities; pay off your debts, and return the capital to your partners. I wouldn't be able to sleep one moment at night if I were in your position in these times, and you shouldn't be able to sleep either.

I'm much older than you, with lots more experience, and you'd better take my advice.

Graham, of course, didn't take his advice. He even writes in his memoir that he "thanked the old man, a bit condescendingly, no doubt." But of course, Dix was right, and the worst was yet to come.

"I have often wondered what my life would have been like it if I had followed his advice," Graham muses. Graham suffered mightily in 1930, his worst year ever.

After that, he did unwind the debt he held in his account and he did much better thereafter in what was a mercilessly difficult market. And given that Graham's partnership had 44% of its assets financed by debt going into 1930, just pacing the market would have wiped him out.

Irving Kahn, another great old investor and student of Graham's, wrote of Graham's ordeal in the 1930s: "Keeping the fund alive was a great achievement. The small losses of 1931 and 1932 were especially impressive."

Graham's big mistake was using too much debt. That's why Dix told him he shouldn't be able to sleep at night. Dix appreciated just how dangerous all that leverage was. The inspiration in Graham's tale, though, is that he fought his way back and went on to earn good returns in the market in later years.

The lesson he learned is a lesson that we have to learn in every cycle, it seems. Fast-forward to today's calamity and enormous debts once again pose a great danger, despite the market's recovery.

After the crash of 2008, the market hit bottom on March 9, 2009, when the S&P 500 closed at 676.53. As I write, the market is up nearly 37% from those lows - and a similar view seems to be taking hold that the worst is behind us, just as it did in early 1930.

When the market recovered in early 1930, the failure of Creditanstalt, a big bank at the time, sent it lower. Banking troubles plagued the market for the rest of the year. Today, there is still an enormous amount of debt out there and certainly more bank failures to come.

One of the best pieces I've read about our financial crisis recently was "The Death of Kings: Notes From a Meltdown" by Nick Paumgarten in The New Yorker. It is certainly the best written. (It appeared in May and is worth tracking down.)

Paumgarten talks to a lot of interesting people in his efforts to understand the nature of the crisis. One of my favorites is a man named Colin Negrych, "part market philosopher, part screen savant – a nexus of market intelligence." Negrych advises some of the most respected investors in the world, who prize his secrecy and distinctive advice. He's made billions for them, and skimmed off some for himself, too. Negrych seemed to sum up the whole thing rather well:

"There seems to be an unwritten rule that this can't happen. So much effort is put into sustaining the stock market and home prices. This whole culture has been set up to see stocks and homes as annual riskless investments. They most assuredly are not.

Banks are going under because they are undercapitalized...The problem is too much debt...Debt is the story."

In Negrych's view, Wall Street churns out believable, but wrong, arguments for why these increasing levels of debt are sustainable. All the financial engineering "fills the gap between people's desires and their wherewithal."

So this is the problem. It's why I'm particularly averse to debt these days. To do well in this market, we'll need to raise the bar for what is cheap and what is in excellent financial condition.

It's also why I think it's especially important that investors stick with cash-rich, debt-light, tangible assets - rich in water rights, oil, natural gas, potash mines, gold mines and the like. We like assets that are inherently useful, even needed - like oil rigs, hydropower assets and methanol plants. Things hard to build, difficult to replace and costly to substitute.

Talented owner-operators with a track record help too. After all, Graham did quite well in asset-rich names, even in the 1930s, once he kicked the debt habit. As Negrych said, "Debt is the story." And it will be for some time yet.