This week’s essay

July 17, 2011

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Some commentators (e.g. Mark McKinnon writing in the Daily Beast) are pleading for us to take Michele Bachmann seriously.  However, they do not always make clear if we should credit her candidacy or her ideas.  She might be politically successful, but she will never be a credible leader and her political ideas are simply crazy talk.

McKinnon quotes Bachmann speaking about America’s economic problems as follows.

“I don’t believe that the solutions to our problems come from Washington. More than ever, Washington is the problem, and the real solutions will come from our businesses, our communities, our schools, and the most basic and powerful unit of all—our families.”

It seems impossible that simple ignorance could produce, in such a short statement, so many errors of fact and judgment.

Bachman does not believe “the solutions to our problems come from Washington.”  However, Washington was certainly the solution to the recent banking crisis.  No other entity, certainly not Business, could have bailed out the nation’s leading banks.  So crucial and so successful was Washington’s rescue package that the nation’s most successful investor, Warren Buffett, publically thanked the government in a New York Times op-ed titled “Pretty Good for Government Work”.

Bachman says that “More than ever, Washington is the problem.  However, the government played no role in precipitating the banking crisis, except that it failed to regulate the mortgage brokers and investment banks that did create the crisis.  The phrase “Washington is the problem” was made famous by Ronald Reagan, who began the era of deregulation.  We can certainly suspect that had the Government not been hobbled by years of deregulation, under regulation, and lax regulation, it might have prevented the financial crisis.  In his testimony before congress, Allan Greenspan agreed that as chairman of the Federal Reserve, he had been too lax in regulating banks and had placed too much faith in the supposed self-correcting nature of the market.  He said, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Bachman says that “the real solutions will come from our businesses, our communities, our schools, and the most basic and powerful unit of all—our families.”  What is it about recent history that would give anyone a shred of hope that business is the solution to any problem, much less the current economic slump that it created?  Furthermore, the nation’s major economic problem is high unemployment and it is unlikely in the extreme that international corporations, even those based in the U.S., will hire American workers when they can hire labor more cheaply abroad.

Charles E. Wilson, President of General Motors and President Eisenhower’s Secretary of Defense, famously remarked that he thought “what was good for the country was good for General Motors and vice versa.” Because our corporations are now international players, Wilson’s remark is no longer true either in its specific or in its general, metaphorical sense.

As for our communities and our schools, because of the business-induced economic downturn, they are underfunded and barely able to provide basic services, much less provide a solution to the nation’s current economic woes.

Similarly “the most basic and powerful unit of all—our families”, are in no position to help.  It is not clear how Bachmann thinks families could increase employment when nearly 10% of them are being undermined by unemployment.  If Bachman believes that the American family is important, she should be (but is not) a champion of government programs that strengthen most of America’s families: progressive taxation, day care, health care, etc.

The misrepresentations packed into this short quote are unlikely to be the result of ignorance.  At best, they are cynical propaganda.  At worst they are the ravings of a crazed charlatan.

True Believers

June 19, 2011

Commentators tend to describe political confrontations (e.g. the upcoming fight in Congress over raising the debt ceiling) as negotiations among rational institutions (e.g., the Republican and Democratic Parties).  The implication is that the parties will reach a rational agreement and in particular will not do something that his mutually self destructive.  By this simplistic reasoning, Republicans and Democrats will reach a debt ceiling deal before the impasse causes real problems.  Unfortunately, the lack of a deal and the specter of an American government that is irrational and self-destructive are already causing problems and are likely to cause more.

The rational-institutions model covers up an important complication.  Institutions do not negotiate; only the people who lead those institutions negotiate.  A negotiation cannot produce an agreement that is good for the institutions, unless that agreement is also good for the leaders.   

As a description of the Republican and Democratic Parties, the rational-institutions model is particularly misleading because the American political process increasingly selects politicians that are not rational people, but are true believers.  The selection process is particularly acute in primary elections where voter turnout is thin and dominated by the ideologically committed.  To win in such an election a politician must be seen as an absolutely reliable advocate for whatever issues dominate the ideology.  Ideological voters seek, not representatives who are smarter and wiser than themselves, but uncompromising zealots.

The political parties cannot act rationally unless their leaders are rational.  Unfortunately, it is unlikely that an institution made up of zealots will select rational leaders.  The leaders of both political parties (particularly the Republican Party) are not fully rational.  They are not seeking the interests of their Party or even their own selfish interests.  They are instead people who are animated by their faith in an ideal.

Niccolò Machiavelli’s friend Francesco Guicciardini put the issue nicely in the following quote.

“The pious say that faith can do great things, and as the gospel tells us, even move mountains.  The reason is that faith breeds obstinacy. To have faith means simply to believe firmly – to deem almost a certainty – things that are not reasonable; or, if they are reasonable, to believe them more firmly than reason warrants.  A man of faith is stubborn in his beliefs; he goes his way, undaunted and resolute, distaining hardships and danger, ready to suffer any extremity.”
Francesco Guicciardini, Maxims and Reflections (Ricordi), Pennsylvania Paperbacks edition 1972, p 39

On the rational-institutions view, Republicans and Democrats should nearly always reach a mutually beneficial compromise, and it should be very unlikely that they stubbornly set themselves on a course of action that is destructive to both parties.  However, the abysmal approval ratings that American voters give the U.S. Congress suggest otherwise.  

On the rational-institutions view, Republicans and Democrats will reach a compromise on a bill to extend the debt ceiling.  They will not be so obstinate that they will extend negotiations so long that the uncertainty spooks the market and they will not attach to the bill austerity measures that are so severe that they choke off the economic recovery.   Unfortunately, given the high numbers of true believers, obstinacy is exactly the outcome that we can expect.

U.S. banks believe that the actions of the Congress have already been self destructive.  Because of the protracted negotiations over the debt ceiling, the banks are curtailing their use of U.S. Treasury bond.  Banks use Treasury bonds as collateral for financial transactions because the bonds carry an excellent credit rating and they are so plentiful that they are easy to sell and thus make attractive collateral. 

If banks believe that U.S. bonds are becoming unattractive as collateral, it is a safe bet that demand for U.S. government bonds will decrease and that interest rates will have to rise to spur demand.   This will, of course, increase the cost of financing the debt and do measurable harm not only to both political parties, but to the U.S. economy.

Last week’s blog described several trends that will likely influence the success of investment opportunities to a far greater degree than the actions of corporate management.  This week I will look at the implications of those trends for investment strategy.  That strategy has two main principles: invest skeptically and favor well positioned companies.

Invest Skeptically

Favor Small and mid-cap stocks

Owing to the hijacking of big corporations and the fraud plagued U.S. economy, small and mid-cap stocks will probably outperform large-cap stocks. These smaller firms will have the agility and motivation to respond to the new trends and opportunities.   In contrast, large cap firms even when they are doing well, have substantial hidden risks.  Executives may operate these companies in their own short-term best interests at the expense of the long term best interests of the shareholders.    Consequently, we must suspect that these large cap firms may under invest in development and may take on too much risk.  

This does not mean avoid large cap stocks.  However, if you consider a large cap stock you must actively eliminate the possibility that the company looks good but is actually being run into the ground.

Avoid High-price Stocks

Do not pay a premium for fashionable or recommended stocks.  A high price to earnings (PE) ratio relative to the industry is very likely to indicate, not a good investment, but merely a good story.  At best the story may be simply fashionable buzz.   However, because of the pervasive fraud in the American financial system, there is substantial risk that a good story may also be the work of Wall Street promoters who are selling greedy investors the next big bogus investment. 

Well Positioned Companies

The following groups of companies are well positioned to benefit from virtual slave labor, accelerating trade, continuing devaluation of the U.S. dollar, and high cost energy.

U.S. Brand Resellers

Businesses that buy goods at virtual slave labor prices and sell them at luxury goods prices should be highly profitable.     Top American brands will also benefit from the ongoing devaluation in the U.S. dollar. 


Aeropostale Inc Common Stock (ARO)

Urban Outfitters, Inc. (URBN)

Hard Assets

As the value of the American dollar disintegrates under the burden of debt, the dollar value of basic materials will increase dramatically.  At the same time, supplies of basic materials will remain under pressure for many years as India and China develop their infrastructure and manufacturing base.  American, Canadian, and Australian materials companies should prove very attractive because they will remain safer investments than companies that are located in unstable countries where there is a greater risk of fraud and government intervention.

Example: Silver Standard Resources, Inc (SSRI)

Integrated Value-added Manufacturing

Developing Asian economies lack the infrastructure for manufacturing products that require layers of subcontractors and a network of tightly integrated manufacturing processes.  In addition, knowledge workers will prefer to live in developed economies.  As social unrest grips the third world, Europe and the U.S. will become the preferred places to produce complex, highly engineered products. 

Integrated value-added manufacturing companies also stand to benefit dramatically from any declines in the U.S. dollar.  Any dollar crisis could breathe new life into several sectors.  American semiconductor businesses are obvious beneficiaries.  Medical equipment manufactures stand to benefit not only from the weak dollar but also from de facto subsidies provided by American University research and by America’s uniquely high cost medical delivery system.

Look for companies that (A) make highly engineered products with a high information content, (B) benefit from an efficient transportation, financial, and information infrastructure (C) export worldwide and can therefore benefit from the weakening dollar.


Regal Beloit Corporation Common (RBC)

Enersys Common Stock (ENS )

Oshkosh Corporation Common (OSK ) – I own stock in this company

AngioDynamics, Inc. (ANGO) – I own stock in this company


The American biotech industry is well positioned to take advantage of technical and political trends.  Biotech companies benefit from two external resources: the American university system, and government funding of medical research, such as the Human Genome Project.  State governments subsidize the American university system and the Federal Government subsidizes much of the research, which biotech companies can leverage into products.  The university system constitutes a huge shared virtual laboratory for small and midsized biotech companies. 

From the perspective of a skeptical, Machiavellian investor, biotech companies are ideal.  The regulatory filings process makes the biotech product development process transparent to the investor to a degree found in no other industry.   

Finally, biotech company products are patentable.  Patent protection gives these companies a unique asset, a legal monopoly that is transferrable.  Biotech startups can convert their research into cash much more quickly than can any other startup.  


Momenta Pharmaceuticals, Inc. (MNTA )

ViroPharma Incorporated (VPHM) – I own stock in this company.

Energy Saving Technology

Energy saving technology is attractive for three reasons.  (1) It requires no change in the energy exploration, producing, or marketing infrastructure.  (2) The energy production process is very inefficient.  Saving the energy equivalent of 1 gallon of gas at the point of use (e.g. the wheels of a car or the room that is heated or illuminated) saves the energy equivalent of 10 gallons of gas in the ground. (3) Energy saving devices may be eligible for patent protection.


Ameresco, Inc Class A Common St (AMRC)

Orion Energy Systems, Inc. (OESX) – I own stock in this company.

Alternatives to Oil

We may be able to power our cars by electricity or hydrogen (from electrolysis of water), but these options are impractical because they require a massive change in the producing, distribution, and marketing infrastructure.  Electric cars would require a complete retooling of the auto industry.  Hydrogen fueled cars would also require retooling of the fuel distribution infrastructure.  Normal economic forces cannot induce this sort of revolutionary change.  There is no evolutionary development path from today’s auto and oil economy to an electric or hydrogen economy. 

The oil price will rise to the level of the next cheapest substitute. This will guarantee that some alternative fuel technology will succeed.  The following two technologies can develop through incremental changes to the existing infrastructure.

Marginal Sources of oil

Major oil and gas companies are already investing heavily in land and facilities to produce oil from oil sands in Canada, and from the oil shale in the western U.S. 

In addition, exploration companies are developing shale oil deposits in the continental U.S.  Oil in shale is tightly packed and extracting it requires fracking, a technique currently used to extract natural gas from shale.  Fracking involves drilling down (through the water table), and then horizontally into the shale bed.  As the well is drilled the fracking process uses controlled explosions to blast holes in the pipe and into the rock.  Then drillers force slurry under high pressure through the holes to produce fractures between the rock layers and to hold them open.   Oil then flows through the fractures into the well.

There is risk that once disrupted by fracking, the oil and gas trapped in the shale may rise and contaminate the water table. However, the political power of the major oil companies will likely be sufficient to overcome environmental objections and to develop needed road and rail connections. 


Suncor Energy Inc. (SU ) – I own stock in this company

Chesapeake Energy Corporation (CHK) – I own stock in this company


Ethanol is promising for two unrelated but important reasons. 

First, the U.S. farm lobby is very powerful on a state and national level. Ethanol qualifies as an alternative fuel (eligible for federal subsidies).  Most farm states have local programs that encourage ethanol production and provide incentives for filling stations to install ethanol pumps. 

Second, biotechnology has every incentive to produce genetically engineered plants for feed stocks and enzymes that can digest a wide variety of plant materials (containing cellulose) into starch or directly into sugar.  The economics of corn ethanol are only marginally viable, but genetic engineering should be viable in the next few years.

There are no good examples of ethanol stocks, but I will be keeping an eye on enzyme technology.

Energy Efficient Transportation

High velocity trade will strain transportation systems as (A) raw materials flow into the third world (B) cheap (labor-intensive and knowledge-intensive) products flow into developed economies, and (C) importers will struggle against high energy costs to distribute these goods in their own countries. These trends will favor modes of transport that are inherently fuel-efficient.


Ship companies that transport bulk raw materials should do will in the long run.  However, at the moment shipping supply seems to have outstripped demand.  I will be looking for a good entry point in the following.


Navios Maritime Holdings Inc. (NM ) – I own stock in this company.

Frontline Ltd. Ordinary Shares (FRO) – I own stock in this company.


Rail freight rates are already climbing and capacity is tight. In addition, coal fired electricity generators need as much as a trainload of coal per day.  Rail companies that own rights of way should be able to add capacity at a small marginal cost and enjoy years of profitability.  Goods, especially food, will flow from the Midwest by rail to the Eastern U.S. where it will be shipped to Asia. The big rail company stocks have been “picked over”, but I think the suppliers to the rail industry may offer some good opportunities.


Westinghouse Air Brake Technology (WAB )


Europe has an excellent rail system, because in Europe (especially France and Germany), railroads were a military asset.  The U.S. has not had a similar need to move troops rapidly inside its borders.  In addition, because of its sparse population, rail has less economic value for public transport than it does in Europe. 

However, during World War II, trucks played a critical role in military supply operations.  After the war, President Eisenhower and the Congress found it easy to agree to build the U.S. Interstate Highway system.  This effort has left the U.S. with an extraordinary road infrastructure, which is underused as an asset for mass transit.  We are already seeing a proliferation of special purpose bus operations and we can expect to see more of this as fuel prices remain high.


Stagecoach Group Plc (SGC)

New Flyer Industries Inc. (NFI-UN.TO)

Azure Dynamics Corp. (AZD.TO)

Last week’s blog made the case for Machiavellian investing, outlined its skeptical investing assumptions, and drew the following important generalization.  Corporate management can do great harm, but little good.  When companies succeed, it is not due to dynamic leadership, but to external factors, such as political, and technical trends.  Here is a brief description of the most important trends that I believe will operate over the next several years.

Virtual slave labor

The world population is critically high and growing rapidly in the developing world (especially in India, Southeast Asia, China, North Africa, and the Middle East).   Employment will increase (perhaps dramatically in absolute numbers), but it will not keep pace with exponential population growth. Consequently, labor (skilled and unskilled) is cheap and getting cheaper.

In an area of over population and no employment laws, people must work at wages that are just above subsistence.  They are slightly less well off than slaves, because their employers are not required to feed them through slow periods in the business cycle.  If we over dramatize to have a concrete picture in our mind, we can think of this as virtual slave labor. 

The developed world will benefit.  Instead of importing the slaves (as America did before the Civil War) the developed world can leave the slaves in place and import the goods (both material and information products).  We in the developed world will benefit from cheap products, but we will also see higher unemployment and downward pressure on wages.

Political instability

Virtual slave labor will not be content labor.  The developing world, especially where populations are young, will likely see severe labor and political unrest for two reasons. First, as employment and consumption increase, food, energy, and basic material cost will skyrocket. This will hit the poor hardest.  At the same time, the infrastructure in the developing world will break down under the strain of the environmental effects of growth and the increased demand for infrastructure (such as, road, rail, sewer, and water).  Second, development will be inequitable.  Wealth will stay in families or benefit only the technical elite.  The lower class will sink into meager and arduous poverty. 

Asian nations will have prosperous economies that will function like the southern states in America before the Civil War.  Asia will be the major supplier of items produced by virtual slave labor.  These items will not be products of labor intensive agriculture, such as cotton, but mass produced industrial goods.  The profits will accumulate in the pockets of the ruling elites, but this will not bring political stability unless these national economies can achieve something approaching full employment. 

The Muslim Middle East will have a population that is so large, young, and unemployed that it will probably become chronically unstable.  Africa will likely stay mired in corruption.  Eastern Europe and South America will be better off but will not be as prosperous as either the old western economies or the new virtual slave labor economies.

Europe and North America will become the major consumers of Asian products and major exporters of integrated value added products.  Trade will flow between Asia and the West.

Because they are the beneficiaries of stable political systems and have advanced infrastructures, European and North American economies will likely continue to enjoy political stability.  However, they will probably be stressed by a decline in the standard of living. 


Deregulation will continue to increase in most national economies.  This trend has two causes: (1) the collapse of the Soviet Union as a political force and of Marxism as an intellectual force, (2) big-money politics in the first world. 

The demise of the Soviet Union led to an economic power grab that saw the rise of gangster capitalism in the former communist countries.  In Russia and the old East Block, the largest industries are now in the hands of former communist apparatchiks. 

We have big-money politics in the first world because we have rapidly increasing costs for political campaigns and increasing wealth concentration.  This means that the people who control big money control the U.S. government. These are not the big stockholders, but the people who manage those corporations. In America, both political parties have to beg for handouts from the same few hands. The people handing out the money want deregulation and are likely to continue to get it regardless of which party is in power.  For example, no new regulations were enacted after the Gulf Oil Spill.  Reforms that followed the 2007 financial crisis were superficial and even those reforms are under attack by the new Republican-controlled House.

Hijacking of the Fortune 500

Senior management is running America’s biggest corporations not for the long-term benefit of their shareholders, but for the short-term benefit of themselves. Hijacked corporations include not just those whose management has actually run their companies into the ground, but include most of our large cap companies, which are no longer globally competitive.  High labor costs are partly to blame, for the sorry state of America’s airlines, auto manufacturers, steel producers, and textile companies.  However, all these industries have failed to meet high labor cost with automation, and have failed to make even specialty products that consumers (even U.S. consumers) want to buy.  In addition, U.S. manufacturers are less competitive than some of their European counterparts who have to cope with stronger unions and more socialistic employment laws.

Fraud-plagued U.S. economy

The U.S. economy is plagued by deception and dishonesty at every level. Events leading up to the recent financial crisis illustrate the problem.

The Federal Reserve propped up the U.S. economy during most of the Administration of George W. Bush by keeping interest rates artificially low.  Low interest rates stimulated the housing market and encouraged consumer debt.  Conmen in the real estate and banks began to sell ignorant, envy-driven consumers mortgages that they could not afford.  Banks sold large numbers of bad mortgages to the financial services industry, who created dodgy bonds, collateralized debt obligations (CDOs). 

Regulators did not curb these practices because of the antigovernment stance of the Republican Party.  Republicans have consistently promoted deregulation, opposed new regulations, and underfunded the enforcement of existing regulations.

Standard and Poor’s and other rating agencies, had a massive conflict of interests between honest ratings and high fee income. They chose the fee income and gave even the CDOs backed by many bad mortgages high ratings. 

Finally, financial institutions inflated their fee income by creating structured investment vehicles (SIVs) to buy the CDOs. To finance their purchases, the SIVs borrowed at cheap, short-term rates in the money market and thus pocketed the difference between their borrowing cost and the high yielding CDOs. 

Unfortunately, the SIVs left the institutions vulnerable to a liquidity crisis, but that was a threat to the share holders, not to management, who had already pocketed huge bonuses from stock options that were ultimately based on stock prices that could last only until the inevitable collapse.

The government bailout and stimulus package may have prevented the economy from going into shock, but the prognosis remains bleak.  The mortgage crisis is far from a one-time aberration.  On the contrary, it is typical and the congress has done nothing to curb deceptive financial practices.  Consequently, the U.S. economy is likely to continue to encounter frequent scandals, suffer market crashes, and recessions.

The U.S will also suffer from economic retardation that is the result of inefficient markets.  Each time that Wall Street whips up greed-fueled investment craze, savings flow into bad investments.  During the S & L crisis the bad investments were phony land deals.  In the dot-com crash, they were foolish business ventures like “”.  In the recent crash, they were bad mortgages, CDOs, and SIVs. When these bad investments bust the investment capital becomes, not productive capital or infrastructure, but non-productive junk or toxic assets that are sold at fire sale prices.  Meanwhile, valuable investment opportunities go unfunded.  The only people who profit from these bogus investments are the promoters. 

The hijacking of the Fortune 500 and the fraud plagued economy not only underline the imperative of skeptical investing, but they suggest the need for a a strategy that is actively defensive.

Currency devaluation

High trade and budget deficits are continually undermining the value of the U.S. currency.  Europe runs high budget deficits, but not high trade deficits.  The U.S. has a high trade (current accounts) deficit in part because it is a consumer driven economy and in part because it is now a massive oil importer.

As a result not only the government, but also business and consumers live on borrowed money.  This situation is analogous to removing parts of a building’s foundations and selling them.  We are creating a catastrophe scenario. The U.S. is still the single biggest political, economic, and military power.  We have the world’s largest building.  Consequently, we can borrow and undermine our foundations longer than can anyone else.  However, the longer we do it the greater the risk of a larger currency collapse. 

Fortunately, there are two potent, mitigating factors.

First, devaluation of the U.S. dollar will tend to reduce the real U.S. debt and thus tend to eliminate the causes of devaluation. This is possible because of the unique role of the dollar as the world settlement currency.  Most U.S. debt is denominated in its own currency.  Were it denominated in Euros, real American debt would skyrocket.

Second, dollar devaluation will make U.S. manufactured goods artificially cheep outside the U.S. and will stimulate U.S. exports. 

Because of these mitigating factors, it is in no one’s interest to prop up the U.S. currency and we can expect it to continue to decline.

Free knowledge capital

Knowledge once discovered is free.  Asia will exploit free knowledge capital to develop their economies rapidly.  Therefore, developing economies will compete not just in labor-intensive products, but also in knowledge-intensive products and service.  This will reduce the profitability of U.S. firms that provide consulting services and large-scale, stand-alone, high-tech manufacturing. In these businesses developing economies will be able to leverage free knowledge capital and enjoy a decisive advantage in cheap (virtual slave) labor.

Third world infrastructure problem

Asia, especially India and China, will need to build up their infrastructure in order to get their virtual slave labor products to market.  However, they will not be able to build their infrastructure as did the U.S. with energy from cheap oil.  The U.S. may enjoy a lead in the quality of its transportation, communications, and financial infrastructure for decades.  This lead will provide an advantage to U.S. manufacturers of products that require deep layers of subcontractors an efficient infrastructure to integrate the supply chain.  

Developed economies will specialize in integrated businesses that can thrive where there is a reliable and high speed infrastructure in place.  Developing economies will specialize in isolated businesses that do not depend on the infrastructure and can leverage virtual slave labor.

High velocity trade

Asia and second tier developing economies (such as Eastern Europe and South America) will need to import food, raw materials, and specialty equipment. By specialty equipment, I mean classes of equipment that are necessary for manufacturing and communications, but that developing economies cannot manufacture efficiently.  For example, India may build a highly competitive semiconductor fabricating plant, but it will be most cost effective to buy testing equipment from a supplier in the U.S. or in Europe.  Thus food, raw materials, and specialty equipment, will flow into developing economies, where virtual slave labor will turn them into inexpensive products.

At the same time, in order to maintain an acceptable standard of living, developed economies will have to import the cheap products produced by virtual slave labor.

Expensive energy

Several factors point to much higher energy costs. First, there is substantial risk that the Saudi government has over produced their oil fields, and that Saudi wells are pumping a large fraction of water.  This suggests that the fields are nearing their peak output.  Matthew R. Simmons book, Twilight in the Desert makes a persuasive case for this scenario.

Second, American foreign policy has created a power imbalance in the Middle East by critically weakening Iraq and thereby strengthening Iran.  This will destabilize U.S. allied regimes throughout the region and Saudi in particular. The Saudi government and its oil infrastructure are no longer reliable.

To compound the problem, all regional oil facilities rely heavily on pipelines, which are long, vulnerable, and enticing targets for terrorists.  By a similar logic oil exports from the region depend on ships, which are already targeted by pirates and may also be targets for terrorists.

Iraq may at any time fall into civil war and if it does Iran may make a grab for the Basra oil field.  While American troops are in Iraq, Iran will not be able to move west to seize Basra or to make an alliance with the Shiite government in Syria to attack Israel.  However, once the U.S. pulls out its troops matters may take a dramatic turn for the worse.

Finally, as Asia builds out its infrastructure and its productive capital, it will dramatically increase the demand for oil.

All these factors imply that not only will oil consuming economies have to pay high prices for oil but will have to pay a premium for reliable supplies.

This is the first of a three-part series on Machiavellian investing.  How, you might ask could Niccolò Machiavelli, who died in 1512, tell us anything about investing in 2011?  The short answer is that Human nature has not changed.  Niccolò was famously skeptical about human nature and I have found that a good dose of Machiavellian skepticism is essential for distinguishing genuine from sham investment opportunities.

Princes of Commerce

Niccolò Machiavelli’s best known work, The Prince, provides advice for the princes of Renaissance Italy.   Today we have very few princes, at least in the realm of politics.  We do not believe that personal, autocratic rule is a good way to govern a country, but in business we believe that totalitarian rule is essential.  In fact, a CEO is a close modern equivalent of a Renaissance prince.  For that reason, Machiavelli’s advice to princes applies directly to CEOs. 

“How one lives is so far distant from how one ought to live, that he who neglects what is done for what ought to be done, sooner effects his ruin than his preservation; for a man who wishes to act entirely up to his professions of virtue soon meets with what destroys him among so much that is evil.”


This implies that, even if he wanted to, a CEO cannot be virtuous.   He must be at least as faithless, greedy, deceitful, and ruthless as his competitors.  In contemporary America (following the S&L meltdown, the dot com scandal, and the mortgage crisis), competition in the arena of corruption is especially intense. 

In practice he seldom has to worry about his reputation, because he will never be wanting for excuses.  

“Therefore it is unnecessary for a prince to have all the good qualities I have enumerated, but it is very necessary to appear to have them. And I shall dare to say this also, that to have them and always to observe them is injurious, and that to appear to have them is useful; to appear merciful, faithful, humane, religious, upright, and to be so, but with a mind so framed that should you require not to be so, you may be able and know how to change to the opposite.”


In other words, CEO’s by the nature of their job must be not only mendacious but hypocritical.   That is not to say that CEO’s are insincere.  Like most people, CEO’s convictions tend to follow their interests.  That is, they believe what it is in their interests to have other people think they believe. 

Since we assume that CEO’s are profoundly mendacious, we modern Machiavellians, base our approach to investing on profound skepticism.

As a starting point, we Machiavellian, skeptical investors are on the lookout for CEO mendacity, which takes the form of corporate public relations, advertising, and lobbying.  Corporate communications deliberately, cunningly, and persistently promote a self-serving view of reality in which nothing but interference comes from the government, all good things in life flow from business, and CEO’s are heroic figures who direct their corporations with all the decisive bravado of kings leading their troops into battle. Of course, the CEO’s critical role in leading these goodness-giving corporations fully justifies their salaries. We can dismiss this corporate propaganda straight off.

However, not only must we be incredulous of CEO propaganda, we must be skeptical of the rhetoric of people who depend on the good will of CEO’s or the corporations they control.  This includes politicians whose election depends on corporate contributions to their campaigns and more importantly, on the absence of corporate contributions to their opponent’s campaigns. 

We must also include among those who depend on CEO’s good will, mass news/entertainment media, and the financial press.   There is no such thing as the liberal media. Media companies are big businesses and they are not the only employers in the world that cannot get their employees to do what they want.  The financial press depends heavily (for its raw material) on access to corporate executives and depends on corporate advertising in their publications.

Rating agencies derive their income from the same firms that they rate. Hence their ratings are likely to be reliable only when the value of the financial instruments they rate is unimportant.  On the other hand, in a case, such as the mortgage-backed securities that became the toxic assets of the recent mortgage crisis and the ensuing great recession, their ratings are likely to be not just worthless, but actively misleading.    

Brokerage company analysts also have deep conflicts of interest in the ratings they give corporate equities.  Analysts cannot afford to give a bad rating to a company with whom their employer has a lucrative investment banking relationship.  This conflict was at the heart of the dotcom bust and caused such analysts as Henry Blodget to be banned from the securities industry.

Furthermore, brokers are in the business of making commissions on trading stocks.  Successful investors are not active traders.  However, if an analyst’s recommendations did not promote active trading, he would not be serving the interests of his employers.  We can therefore expect analysts’ advice to be biased in favor of exaggerating trends, both positive and negative.  In fact, this is exactly what we see.  Analysts alternatively churn out scary stories (which promote panic selling), and enthusiastic reports on new investment opportunities (which prompt greedy buying). 

Finally, we must also be somewhat skeptical of those who depend for their livelihood and prestige on the high reputation of some industry or of business in general.  Some level of skepticism must extend to the business education establishment. 

All of the above-mentioned dependent groups have conflicts of interest and when it comes to business and economics, the things they say (and sincerely believe) are likely to be, in some important respects, self-serving rubbish.  

A Corrective

To compensate for pervasive mendacity, we Machiavellians challenge certain core tenants of corporate propaganda and adopt investment assumptions that compensate for them.

Myth:  In America economics is dominated by the Free Market.

Skeptical Assumption: There is no such thing as THE Free Market.  There are many markets and few of those markets are free either in the sense that they are open or highly competitive.  Barriers, such as high capital requirements, prevent new competitors from entering most markets.  Most real markets are oligopolies, that is, they have only a few sellers but many buyers.    For example, oil exploration and producing, auto manufacture, and health insurance are oligopoly markets.

In oligopoly markets, competition tends to be tame and limited to a few non-essential areas.  In a free market, all firms are price-takers, that is, they take the price as something that is given by the market, not something that they can influence.  However, in an oligopoly, individual firms’ actions can and do influence prices.  Further, they can and do cooperate by simple tit-for-tat reciprocity.  No firm wants to set off a destructive price war and for that reason price wars are rare.  Competition on price or quality is rare.  In real markets, firms tend to compete only in peripheral areas such as advertising or style.   

Myth: There are laws of economics, and it is silly to try to circumvent them.

Skeptical Assumption: Economics is not an independent scientific discipline analogous to physics.  Rather it is a special, albeit, important branch of political and social thought.  The “laws” of popular economics expressed by corporate executives, politicians, and business press is predominantly propaganda.

Myth: Corporate managers are highly skilled decision makers.

Skeptical Assumption:  Management is neither a science nor legitimate branch of knowledge (such as is the study of the law or even of numismatics).  Rather, management is a combination of institutional politics, industry expertise, and bookkeeping.  The idea that there is something like management skill in general, apart from its practice in specific industries, is a convenient myth that justifies astronomical executive salaries. 

Myth: New products come from visionaries in corporate marketing departments.

Skeptical Assumption:  New products come ultimately from new scientific knowledge.  This new knowledge comes from basic research, much of it at universities, which are funded by government.  We discover what we can discover, not what we want or need.  Corporations’ interest or effort in discovering new products is not fundamentally important. 

Big investment opportunities are simply applications of new scientific discoveries.  However, even when we find a promising application for a new scientific breakthrough, government programs (such as DARPA and NIH) are often a critical first step in commercializing the application.  Examples include mainframe computers with core random access memory, biotechnology advances such as mapping the human genome, and the Internet.

Myth: CEOs are heroic leaders

Skeptical Assumption:  Corporate leaders can do harm, but can do little good.  Corporate executives’ primary skills are political, not managerial.

Myth: The financial services industry spurs economic growth by developing innovative financial products.

Skeptical Assumption:  Financial innovations are suspect.  Commerce (as opposed to industry) does not lend itself to innovation.  On the contrary, we view a new financial instrument, or an innovative financing method as a harbinger of fraud.    

Myth:  Most corporations are honest, above board, and serve the best interests of the shareholders.

Skeptical Assumption: Corporate governance is almost completely a facade.  A corporation’s board of directors is seldom independent of the CEO.  The position of CEO and Chairman are often combined.  The Board of Directors has no source of financial information that is independent of management (as it would for example if the CFO reported directly to the Board). Share holders have no means of nominating Board members that are independent of management.  Management compensation is poorly supervised, and compensation programs reward management for creating short term profits (or the appearance of profits) at the expense of long term value. 


The above assumptions imply that in evaluating a company’s prospects for success and the prospects for your investment in that company’s shares, factors internal to that company are not likely to be critically important.  Furthermore, a business’s success has little to do with dynamic management, cleaver marketing, innovation, and its financial strength.  Many of the things that stock analysts do (e.g. analyzing financial ratios, making spreadsheets, and extrapolating future earnings based on management guidance) are of little value.  In the last three financial crises, stock analysts were the last to know.  In many cases, analysts were recommending the shares of companies that were later found to be insolvent. 

More important in predicting a company’s success is its positioning with respect to political trends, demographics, and scientific research done at universities and government laboratories. 

Part 2 of this series will examine some political and technical trends that are important and will continue to be important for the next 3 to 5 years.  Part 3 will pick some companies that, based on these trends, are likely to be winners and losers.

Because of the threat of partisan political deadlock, Credit rating firm Standard and Poor’s (S & P) downgraded its “outlook on the long-term rating of the U.S. sovereign to negative from stable”.  Press reports showed consistent right-wing bias, demonstrating again that the idea of the liberal media is a myth.

The Republican Party is promulgating the idea that there is a deficit crisis that demands immediate action, a deficit of mass destruction. While the S & P rating concerned the long-term, and focused on political issues, press reports on the S &P rating change tended to reinforce the crisis atmosphere and hence support the Republicans.  Here are some representative headlines and summary quotes.


“S&P lowers U.S. debt rating to ‘negative’”

Apr 18, 2011 … Growing budget deficit puts U.S. on easy footing as credit rating agency drops long-term outlook.


“The situation in this country with entitlements is a big issue”


“S&P Cuts Long-Term Outlook for US Debt to Negative” 

From NEWS CORPORATION LTD (a foreign company) Fox:

“’Negative’ Outlook for U.S. Debt Sends Jolt Through Capitol Hill Debate on Debt Ceiling”

All of these headlines are misleading because they imply that the problem is urgent and economic, and concerns rating of U.S. debt.  In fact, S & P’s report actually said that the crisis was long-term, political in nature, and concerns its rating of the country (the “U.S. sovereign”), not specific debt instruments. 

The key points in the S & P report are as follows.

  • In the short term, the report says that the U.S has a “high-income, highly diversified, and flexible economy” that is “backed by a strong track record of prudent and credible monetary policy…”
  • After the worst recession, bailouts and stimulus measures created a budget problem. “In 2003-2008, the U.S.’s general (total) government deficit fluctuated between 2% and 5% of GDP. Already noticeably larger than that of most ‘AAA’ rated sovereigns, it ballooned to more than 11% in 2009 and has yet to recover.”
  • In the long term, S & P warns there is a risk that political factionalism may hinder the country’s ability to address the budget problem in a timely manner. 
  • “The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.
  • “Standard & Poor’s takes no position on the mix of spending and revenue measures the Congress and the Administration might conclude are appropriate. But for any plan to be credible, we believe that it would need to secure support from a cross-section of leaders in both political parties”.

In short the problem is not financial but political and it stems from Republican intransigence.

Based on the actual text of the report, the above headlines should have said something like “S & P condemns political deadlock.”  Instead, the headlines supported the Republican Party line about a debt crisis.  We should not be surprised that the media conglomerates show the same bias in their reporting that they show in their campaign contributions.  However conservative talk show hosts tell us the press has a liberal bias.  This is, of course, transparently silly. Media giants are not somehow the only corporations that are unable to make their employees do as they are told.  Furthermore, most employees do not need to be told what to do.  Media corporations hire editors who share their own conservative bias and who are anxious to please.

The current state of the media illustrates the wisdom of two tenants of the Machiavellian perspective. 

First, we view politics, not in terms of ideological conflicts or policy differences, but in terms of organizations and interests, conflicts and collaborations.  In this case, there are two clusters of organizations.  On the one hand there are organizations (such as international corporations and trade groups) that cluster around the Republican Party and that represent the interests of the oligarchy.  On the other hand, there are organizations (such as professional societies and associations) that cluster around the Democratic Party and that represent the interests of the productive professional class.  

The Republicans and Democrats have a deep conflict of interests about who will control the U.S. government and in whose interests (or against whose interests) that government will exert its coercive power.

Second, we believe that ideology and policy follows interests.  All of the above organizations have not only lobbyists but public relations firms whose job it is to manage the 24 hour news cycle. To understand what is happening, you must view a “news” story not primarily as information, but as a tactic.  

The Republican tactic is to create an artificial crisis (like the weapons of mass destruction tactic that launched the war in Iraq) and to use the crisis atmosphere to justify radical changes in the American political system.  The goal is to make the government serve the interests of the oligarchy and keep the government from “wasting” money on programs (such as medical care, consumer protections, and environmental regulation) that promote the interests of the professional class.  For this reason the Republican budget proposals favor high military expenditure, which is good for big business, but otherwise oppose government spending.  It advocates additional tax cuts, not just to line the pockets of the oligarchy, but to starve government agencies that regulate and therefore curtail corporate political power.

From the Machiavellian perspective, the likelihood of a budget deal is vanishingly small, because it is not in the interests of the Republican Party.  Delaying a budget deal will undermine confidence in the U.S. political system and that will create real problems in the country’s ability to refinance its debt. It will transform the political problem into a real economic problem. That would be bad news for the country, but good news for the Republican Party.  The Republicans can be sure that, owing to the conservative media bias, a real economic crisis will undermine the Obama administration.  Furthermore, a real refinancing problem will add to the deficit of mass destruction hysteria and make it easier to sell a radical solution.   

The Republicans may be correct that lower taxes, less government regulation, less social welfare for the middle class, but high defense spending is the optimal government policy.  They may even be correct that the country should be run by and for the few individuals that control giant corporations (the oligarchy).  However, that is not the decision that is being presented to the citizens.  In fact, given the ownership of the media and the degree of media manipulation, the whole premise of an informed electorate has been seriously compromised and for that the right wing press has much to answer.