Mike Price sends: My opinions on investment and the world have changed so dramatically over the past twelve months that I have decided to divide my investment ‘philosophy,’ into two separate sections I think it’s fitting to start this new manifesto at the apex of the former section.

My investment career up ‘til this point had been full of disappointments and hypocrisy, I read and wrote about the virtue of doing your own work and investing, not speculating; but all this time I borrowed ideas from others and rarely did the amount of work necessary to justify taking a position. This had all started to change after I stopped working as much and was able to plow all the excess time into investing, to great result (unfortunately the result for my physique was the opposite).

Ironically, the leftovers in my portfolio from my earlier ‘borrowing,’ stage (AXP, SHLD and TLF) were the stocks that were consistently down and out for me and the stocks I did the most work on (OSTK, NFLX, WEST, KSWS, various special situations and SNS at times) were the best performers in my portfolio.

My approach at the time was as dogmatically ‘value,’ as it comes, I did strictly bottom-up analysis, and tried to project the future valuations of individual businesses. This did very well for the first half of 2008:

· Netflix (NFLX) – I found this idea reading Matt Richey’s VIC write-ups, did my research and scuttlebutt and bought it in August of 2007 at about $17 per share, in June 2008 I bought more shares at $31 and it went as high as $32 during the month.

· Overstock.com (OSTK) – This was the first company I really dug down into and went against the crowd in buying. I tried to look at it in a different way from all the other analysts I read who couldn’t seem to get over Patrick Byrne’s past antics. I saw an amazingly efficient business model that could produce huge returns when it made a profit. I originally purchased in August of 2006 and averaged down at $18 in December 2007 and $10 in March 2008. The stock was hugely volatile and went over $28 per share during June – almost becoming my first triple.

· K-Swiss (KSWS) – K-Swiss is easily the biggest disappointment of my investment career, I wrote a 12 page analysis of it as early as July 2005, and bought it five different times from October ’04 to April ’08. My average buy price in it was about $21; it was around $17 in June 2008. Here are my thoughts on K-Swiss: My initial analysis was theoretically correct, but my premises were not, I vastly overrated management’s ability to turn the company around and keep its growth up - I believe this is a result of an attachment I felt to the company, I still only wear K-Swiss shoes and the investment was always my pick, I found it, I analyzed it, I listened to every conference call - I knew it in and out, but I did not know my own psychology, unfortunately.

· Western Sizzlin’ (WEST) & Steak - ‘N- Shake (SNS) – I had and still have two great passions with investing learning about amazing investors who find and unlock value on a regular basis and special situations, I had both of these with Western Sizzlin’. I bought in June 2007 after reading about Biglari’s former moves in taking over Western Sizzlin’ and then Friendly’s and about the returns he had with both. I did some calculations and found WEST was roughly only priced at the value of the restaurant business at Western Sizzlin’ and the Cash on its books – nothing was assigned the value creation Biglari had shown in the past. Steak- ‘N – Shake was Biglari’s newest activist play, the business was great and the cash flow should have been excellent, but SNS’ management spent way too much on new locations instead of allowing the good returns to flow, Biglari would unlock this value. I still believe these two investments would be way up today had the whole market not exploded. I was up about 20% on my positions throughout June.

My portfolio was relatively focused; I only had eight total positions, with Netflix only occupying 4% of the portfolio during June after I sold half of it and Overstock routinely rising above a fourth or more of the portfolio. This concentration combined with some actually good picks and a general market rise put my portfolio up 40% for the year, the losses from five frivolous years of investing into more than $10,000, on just over $8,800 of investment. I took the confidence gained from this experience and transformed it into a part-time job with the Motley Fool.

The Motley Fool is where I learned the majority of my investment knowledge at the time. For a period of about three years I read many message boards every day, a couple newsletters every month and posted all my ideas for others to analyze. For the summer in between my senior year of high school and my freshman year of college, I had a job as a ‘Community-Analyst, where I followed 4 of the selections from their ‘Inside Value,’ newsletter on the discussion boards (the companies I followed were: McGraw-Hill, Gap, Rent-a-Center and Corporate Executive Exchange Board). To start I put each company through my checklist, then posted on the quarterly results during the summer, answered questions on the discussion boards of these companies and generally tried to help with questions on other boards where I was knowledgeable. When my posts were included in the weekly e-mails for each newsletters I made a freelance fee, but I was mostly doing the job because it came with a free subscription to each of TMF’s products which I read with great interest when they came out that summer.

This job combined with a growing interest in economics which was catered to while listening to a 600 page book (Basic Economics by Sowell) and painting the ceiling in the basement, took away the time I had previously used to write on my blog and report on my portfolio each month and started me down the slippery slope of indifference toward my portfolio.

At the end of August I started school (anticipating an Economics/Finance double major) and at that point Economics had taken over investing as my top interest and had annexed my spare time. In November I got a job and started working 30+ hours per week; this basically spelled the death for keeping track of my portfolio.

Portfolio Restart

My mild obsession with economics started with my conversion to libertarianism in February 2008 (after reading a Neal Boortz book of all things). I was attracted to the logic and common sense employed by the libertarians I had read, and naturally flowed into the economics aspects with my past obsession with business.

The school of economics that interested me the most was the Austrian School, so called because its founders and first four generations were from Austria. The Austrian school believes Economics is an ‘a priori,’ science, starts with the basic axiom that humans act in pursuance of goals and logically concludes all of economics from this inarguable point.

The school’s foremost members in the 20th century include Ludwig von Mises, F.A. Hayek (who value investors will remember from Eddie Lampert’s most recent letter to shareholders) and Murray Rothbard. The school is as laissezfaire as it gets and today is predominantly anarchist.

My research into the school lead me to Peter Schiff (of the famous YouTube videos where he is repeatedly laughed at for predicting basically exactly what has happened) not only has revolutionized my investment thought, but helped in my understanding of the current crisis.

ABCT and the Current Crisis

Before I move into my story I want to explain the Austrian Theory of the Business Cycle and the excellent explanatory power it has in our current depression.

The Austrian Theory of the Business Cycle

In a dynamic market economy entrepreneurs are constantly adjusting to allocate the scarce resources of the economy. The entrepreneurs have a measuring stick for this – profit/loss if they are allocating the resources correctly, as the market wants, they will show a profit and continue what they are doing, however, if they allocate resources incorrectly they will lose money and will be run out of business or will necessarily adjust how they allocate these resources.

It follows logically from this that in a dynamic market economy there would be no mass error by entrepreneurs (remember the bad ones are weeded out) leading to a boom that creates a bubble and its inevitable bust. For the proper explanation of the boom-and-bust cycle one must then look not at anything inherent in the market system, but instead away from it and at the state.

To start, in a market there is a structure of production, capital is not just one big blob (as Keynesians and monetarists would like to assume), but is instead divided in a structure of production from lower order goods to higher order goods (think from seeds to a happy meal and so on).

Next, people naturally have a ‘time-preference,’ that is they prefer something now over later. This is why interest is charged on loans (be it loans to businesses for investment, or loans from entrepreneurs to employees in equipment and current paychecks, the interest here being paid in the profit that goes to the entrepreneurs). The interest in a market illustrates the current time preference in that economy and coordinates savings with investment.

This coordination is a must, because when people save they are necessarily forgoing consumption, so as their excess savings pushed down the interest rate entrepreneurs will have easier money to borrow and invest in lower order goods to provide supply not now, when consumers don’t want it, but in the future when the demand will come.

This is where the state comes in. When the money supply is artificially increased through fiat money and fractional reserve banking the increased amount of loans available for entrepreneurs pushes the interest rate below its natural level, and changes the structure of production.

So the result is mass investment in lower order goods to create supply in the future, when the demand is for now. This creates tons of malinvestments (think houses…) which need to be liquidated for the market to return to its natural level.

According to the Austrian School, the bust part of the cycle is not the bad part, the bad part happened when the fake money was pushed into the wrong areas of the economy creating a bubble, the bust is the necessary, though hard, part that returns the market back to where it should be.

The Current Crisis

There are three parts to the current crisis:
1. The Fed creating credit
2. The government forcing it into the housing industry and
3. The government not allowing the market to re-adjust following the bursting of the bubble.

The Fed Creating Credit

Most conservative commentators will get the story part, right, but they all ignore the fact that the credit had to come from somewhere, in a country where the savings rate has been negative this decade all the credit to create a bubble did not appear naturally.

The economy was in a recession following September 11, after the last boom and bust cycle had ended with the dotcom bubble’s bursting and the aftermath of 9/11, but Alan Greenspan did not want this to tarnish his reputation, so he lowered the interest rate to 1% for a year from June of ’03 to ’04 (the real rate was negative), and in the process increased the money supply from 2000 to 2007 more than it had been increased in the total of American History to that point.

The Forcing of Credit into Real Estate

In Tom Woods’ magnificent book Meltdown (which I used for the above stats on the increase in money supply and interest rates) he shows how four government actions pushed the excess credit into the housing sector. Here’s an outline of each:

1. Fannie Mae (FNM)/Freddie Mac (FRE) – Fannie and Freddie basically bought mortgages from banks and either kept them or repackaged them and sold them off. They also started easing the requirements for the mortgages they bought as early as 1999 in an effort to allow more ‘disadvantaged,’ people to buy homes. These two were ‘Government Sponsored Enterprises,’ who everyone knew would be propped up by the government if they failed. These operations interfered with the market’s process and took away the profit/loss measuring stick from banks allowing them to issue mortgages to people who never should have received them.

2. The Community Re-Investment Act – The Community Re-Investment Act is Jimmy Carter-Era legislation that was brought back to life by Clinton’s administration, the Act together with other affirmative action measures forced banks to lend to people who they otherwise would not have. It is important to see here that regardless of bank’s reasoning for not lending as much to minorities as the government felt they should the government forced them to lend more than they would have under natural market conditions and this led to people who should not have had huge mortgages having huge mortgages.

3. Artificial Stimulus to Speculate – Not only were lending standards lowered for sub-prime candidates, but as they started buying houses with their new found easy credit the prices were pushed upwards and the lending standards for higher worth individuals were slacked allowing speculators to enter the market and push the housing price still higher as they acted on the greater-fool theory and created a bubble.

4. Pro-Ownership Tax Code – As if the government had not already interfered too much in the market City, County, State and Federal tax codes were all adjusted in many areas to give people incentives to own homes, this only to up the demand even more to an artificially high level.

Finally, the government not allowing the market to readjust:

As the Fed was creating excess credit and the government in general was pushing it into the housing sector to create a bubble in housing prices, entrepreneurs were also going into the housing industry and creating lower order goods (house being built) and the debt that went to people who couldn’t pay it back was rated as investment grade and sold in huge masses to investors the whole world was leveraged up to the point that when the bubble finally burst it looked as if it was the end of the world’s financial system.

However, the world’s whole financial system was already out of whack and trillions of dollars of resources had been allocated away from where the market would have allocated them, the bust was what needed to happen for the resources to be filtered back into their correct places. But, as is predictable the government came into the crisis with supposed good intentions and attempted to fix it.

As before mentioned in a dynamic economy entrepreneurs are guided by profits and losses. The bad entrepreneurs and the bad capital allocations are ferreted out through losses. But, when the government steps into ‘bailout,’ the losers, not only is a huge moral hazard created (if you don’t need to worry about a loss you will naturally invest in the riskiest thing with the highest potential returns, this is what happened with the S&L’s in the early 90’s) but the capital is allocated doubly bad, as its first allocated away from an efficient use and second to a use that the market believes is bad.

Back to Peter Schiff

Not only did Peter Schiff (and the rest of the Austrian School for that matter) predict our current crisis as the bubble was created, but he is a stock broker and showed how to invest as to not get caught in it. His thesis, which we’ll talk about later, is based on the devaluation of the dollar and he used it to invest in gold starting in 1999 when it was at $250 an ounce and oil when it was at $20 per barrel, not to mention numerous foreign companies which pay higher interest rates and have huge currency gains.

After I found Schiff I read his two books (Crash Proof and Bull Moves in Bear Markets), and all the info on his site and listened to all his podcasts, this huge downpour of investing combined with economic info pushed me to take a look at my portfolio, in February of 2009, which I had not done since the summer before school started.

It was not pretty! The portfolio which I had before bragged about, where I had a 40% gain in six months and where I made almost two thousand dollars had fallen 50% and was sitting below $5,500.

Netflix was the only position that made it out alive, it had actually risen. But, American Express (AXP) was down 70%, Overstock was back to where I had averaged down at $10, Western Sizzlin’ was down to $8 where I once bought it at a 50% discount in a rights offering, Tandy Leather (TLF) had basically fallen off the map and was trading for less than $2 per share, Sears Holding (SHLD) was almost literally $100 off of my investment price at $35 per share and K-Swiss was at half of my average purchases prices (though it had paid a big one-time dividend) some four years after my first investment.

So I sold all of it and started over.

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