Do you have a net worth of $1 million? Own a hedge fund? If the answer to one of those questions is "yes," then chances are that you know John Mauldin -- president of Millennium Wave Advisors, author of the weekly e-letter "Thoughts from the Frontline," and perhaps the leading proponent of the theory that America is in the midst of what he calls a secular bear market. When you need a big-picture view of what's going on in the economy, John Mauldin is the guy to ask. Fool contributor Rich Smith did just that.
Rich Smith: John, let's start with a get-to-know you question -- it's actually a compound question. What is Millennium Wave, why did you set it up, and what do you all do there?
John Mauldin: Millennium Wave is a "manager of managers" for accredited investors, primarily individuals. We evaluate the performance of hedge fund managers and firms investing in alternative investments and help our clients find the good ones.
As for why I set it up, in 1998, I became convinced that we were entering a bear market cycle, and that investors needed to shift their focus to investing on an absolute return basis -- where you try to beat zero, or not lose money to the bear. That's as opposed to investing on a relative return basis, where you try to beat a certain benchmark like the S&P 500.
As you saw in 2000 and subsequent years, and I think as you're seeing in today's market as well, that can be easier said that done. Some people lost as much as 80% of their investments in the last bear market, and when that happens, even beating the index can cost you a lot of money.
Rich: I'm a big fan of your weekly emails, where you digest incredible volumes of data into five to six pages of easy-to-understand thoughts on the state of the economy. (Fool readers can sign up for a free subscription at www.2000wave.com.)
How did you get started doing this?
John: It got started as a way to synthesize what I was reading on a day-to-day basis, just trying to make sense of the big picture. I'd write these letters and send them out to people I thought might find them helpful. We started out with about 2,000 readers in August 2000 and it just took off from there.
The response has been overwhelming. I've been very grateful for the feedback I get from the readers, and I meet a lot of contacts and develop business opportunities from our readership. These days, the letter is sent out to about 1.5 million readers in a typical week. Sometimes more, because our readers will often forward the letter out to their own clients, or other publishers will include it in their letters.
Rich: Your letters often refer to a "$1 million net worth" requirement for individual investors to attend such-and-such conference or invest in certain fund. Can you briefly tell us what this requirement is, who sets it, and why you don't seem to entirely approve of it?
John: It's a requirement that originates with Congress, and it basically relates to hedge funds. The rules limit the number of investors in private funds to 99 investors worth $1,000,000 or more or 500 investors worth $5,000,000 or more, with a number of variations for certain types of funds, which can be very confusing to the individual. Take away the net worth requirement and the investor limits, and anyone could invest in a hedge fund, just like anyone can invest in stocks, options, real estate, commodities, and similar "risky" investments. I testified to Congress a few years ago that they should create a new class of regulated hedge fund so that smaller investors could invest on a level playing filed with the richer investor.
Congress also restricts the right of "registered investment advisors" to charge an "incentive fee" -- that's the 20%-of-the-profits take that you hear about all the hedge funds charging their clients. Basically, the rule is that you have to restrict your clients to persons with a net worth of $1.5 million before you're entitled to charge the incentive fee. Now, since hedge funds have to register, the minimum net worth is essentially $1.5 million.
Personally, I think the rule is profoundly unfair. It means the rich get the best deals. I mean, are hedge funds really more risky than stocks, commodities, futures, real estate, or other kinds of investments? And who is Congress to tell people with less than $1.5 million or $5 million, "No, you can't invest your own money in funds the rich get to use?" If Congress said that women and minorities couldn't invest in it, there'd be rioting in the streets. But for some reason, it seems Congress is happy to discriminate against "poor" people and only let the "rich" invest in hedge funds. It's insanity.
Rich: What is the rationale behind the rule?
John: Lobbyists from the mutual fund industry tell congressmen that hedge funds are too volatile and risky for the average person, who has to be protected. Congress doesn't know any better and so, like useful idiots, they pass the laws they're told to.
So the intentions are good, but the result is most profoundly unfair. If individuals could invest in hedge funds -- which outperform mutual funds with comparable investment styles by as much as 300 to 400 basis points by the way -- then mutual funds would get beaten hands down. Investors would flock to hedge funds in droves because they're simply doing a better job of earning people money, especially in down markets. Mutual funds would lose market share and that is why they oppose such changes in the rules.
Rich: Speaking of funds, let's talk about a trend that's been popping up in the news a lot lately: private equity buyouts and mergers and acquisitions. There seem to be a lot of companies buying other companies lately: Procter & Gamble (NYSE:PG) buying Gillette, Service Corp (NYSE:SCI) buying Alderwoods (NASDAQ:AWGI), and Mittal (NYSE:MT) buying everyone. Plus a whole host of companies going private. Any thoughts on why this is happening?
John: You're right. There have been a ton of private equity buyouts over the past year or so. My feeling is that there are several factors at work here. On the sellers' side, in the wake of Sarbanes-Oxley and related legislation, management looks at the costs of being a public company -- compliance costs and the like -- versus what they could do with their money if they weren't public. Often, they decide they'd rather be private.
On the other side of the equation, there are a lot of potential buyers these days. The world is awash in cash looking for a home. M&A guys have access to more capital than ever before. But that poses its own problems. Say a private equity fund has the chance to raise $10 billion. Once it's levered those funds, it'll have $30 billion to $40 billion in buying power. Now that it's got tons of money, it's going to be looking for bigger and bigger deals.
I see this as a long-term trend, too. There is a lot of capital out there. The Fed opened the spigots in 2001 and has only recently begun closing them off, so it's going to be a multi-year process, putting all this cash to work. Don't expect the wave of going-private deals to end anytime soon.
As for mergers and acquisitions, that's a different story. Often, those are just deals where two bloated companies are strategically positioning themselves to survive, like with Alcatel (NYSE:ALA) and Lucent (NYSE:LU). There might be some synergies there, but there's a real difference between these kinds of deals and the buyouts. Just because one company buys another doesn't mean it's getting a good deal, but when buyouts happen, it's usually because they see an undervalued asset and finally have the cash to capitalize upon the opportunity.
Stay tuned for parts 2 and 3 of Rich's talk with John Mauldin.
Fool contributor Rich Smith owns shares in Alderwoods. Alderwoods is a recommendation of Hidden Gems,Mittal Steel is an Inside Value pick. The Motley Fool has a disclosure policy.
