Frank K. Martin, CFA

Gresham’s Law & Growing Weeds

Gresham’s Law, a principle only vaguely familiar to most today, is a monetary concept that claims “bad money drives out good.” Although named after the 16th-century English financier, Sir Thomas Gresham, its origins can be traced back to the Greek comic dramatist, Aristophanes, in the 5th century BC.

The principle applies to the debasing of coinage, the intentional reduction of precious metal content in a coin during the minting process. Because old and new coins had the same face values despite differences in their metal content, the old were hoarded out of existence.

Modern Systems and Gresham Today

As systems and institutions have become more complex over the centuries, the application of Gresham’s Law has morphed beyond coinage to include all manner of economic, social, and political endeavors in which the prevalence of the bad affects the presence of the good.

Iconoclast and future Buffet partner Charlie Munger, writing in the 1984 Chairman’s Letter to Wesco Financial Corporation shareholders, applied Gresham’s Law to the debasement of standards of conduct in the savings-and-loan industry of the 1980s.

Although interest rates have subsided from the 1981–82 peak … an agency of the U.S. Government continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham’s Law (“bad loan practice drives out good”) may take effect … through increased copying by cautious institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if “bold conduct drives out conservative conduct,” there eventually could be widespread insolvencies caused by bold credit extensions come to grief.

Exactly 1,043 out of 3,234 savings and loan associations in the U.S. failed between 1986 and 1995. In The Best Way to Rob a Bank Is to Own One, former bank regulator William K. Black recounts how so-called “bold” CEOs, abetted by complicit politicians and regulators, engaged in “control” fraud—using illegal accounting—that ultimately resulted in catastrophic failure.

Munger’s 1984 warning saw the handwriting on the wall. The S&L debacle was a gripping prequel to the Enron collapse in 2002, the subprime crisis in the mid-2000s, Lehman et al. in 2008, and, likely, the next, yet-to-be-exposed, fraudulent scheme-in-the-making. If significant financial deregulation becomes the new standard, Black’s exposé will surely serve as a primer for the next generation of miscreants. In each circumstance, “bold” behavior, just like debased currency, left “conservative conduct” and responsible investment managers in a conundrum: Lower your standards in order to compete or lose market share and eventually go out of business.

Investment Management Caught in the Weeds

Once bad behavior has taken hold, it is difficult to uproot. If the deeply established obsession with short-term performance does not give way to more sustainable investment philosophies, value investors and their commitment to rational long-term behavior may find themselves an endangered species.

In what now seems like a voice from antiquity, John Maynard Keynes in 1936 argued that the social object of skilled investment is to “defeat the dark forces of time and ignorance which envelope our future.” In contrast, investment today seeks mostly to outwit the crowd and pass the bad, or depreciating, half-crown to the other fellow. Through the Depression years and decades beyond, chastised speculators, contrite and repentant, took Keynes’ words to heart. Like an invasive weed, however, the pattern of “pass[ing] the bad, or depreciating, half-crown to the other fellow” has taken root again.

Professions with such regressive tendencies—those with no inclination toward self-regulation—must be subject to third-party oversight for the sake of consumers and clients. In a sad testimony to the state of ethics in our profession, the Department of Labor recently proposed a rule to minimize conflicts of interest between those giving financial advice and the retirees they counsel, proposing that the former act as “fiduciaries.”

Prior to its implementation, the DOL received more than 400,000 public comments, mostly from aggrieved advisors and their lobbyists. Originally slated for implementation mid-April, the rule was delayed because of post-election political posturing. Though now in effect, its future is uncertain. The objection to such client-centric practices demonstrates the inherent resistance that bad behavior harbors toward control.

Any career aspirations should be subordinated to the safety of our clients’ principal. The siren song of mature bull markets beguiles firms and clients alike toward complacency and the illusory returns of overvalued shares. Advisors must lash themselves to the mast of rationality and responsibility if they are to avoid snaring their rudder in weeds along the Sirens’ shore.

Such commitment is a rarity in these times when bad behavior is increasingly the norm. While the 2008–2009 financial crisis was Gresham’s Law writ large, the script being written and performed by our central bank today is a less discussed iteration of the same phenomenon. Low interest rates have encouraged bold and reckless behavior. Sensible practices have largely devolved into a Hobson’s choice between high-risk low returns[1] or none at all.

We need look no farther for confirmation than to the record-high commitment of 97% of equity mutual funds’ assets to low-return common stocks—this despite a late-March survey of fund managers by Bank of America Merrill Lynch that found 81% of respondents believed stocks are the most overvalued since 2000. Such a contradiction between asset allocations and equity prices is simply another among a host of examples that Gresham’s Law is alive and well.

 

 

[1] The current return from common stocks, the dividend yield, is knowable. Expected total returns, which include future price appreciation or depreciation, are not. What we do know is the S&P 500 dividend yield is 1.97%, roughly its average since 2009, yet one-half of the 4.03% average as recently as from 1970 to 1990. And today’s less than 2% yield is in spite of a 9.2% annual growth rate of the dollar amount of dividends paid ($2.8 trillion in total) from 2010 through 2017(e) and the contribution to the per-share dividend yield calculation by shrinking the denominator as $4.3 trillion in shares were repurchased. The two principal explanations given for the collapse in dividend yields are (1) Federal Reserve policy since 1987 and (2) the growing weight of technology stocks in the S&P that focused on growth over dividends. We wholly agree with the effect of Fed policy on dividend yields, but we think the technology argument is dated. In fact, of the 12 largest-cap technology companies, only Alphabet (#2) and Facebook (#4) pay no cash dividend, and the weighted average dividend yield of the other 10 is greater than the S&P.