Are Your Investments Third Class?

By , Money Morning • August 27, 2007

By Martin Hutchinson
Director of Global Investing Research

Brazil President Luis Inacio “Lula” da Silva announced this week that “Brazil is not afraid” of the subprime mortgage crisis. Indeed, he said, it’s purely a U.S. problem, caused by people trying to make a lot of “third-class money.” That’s a concept so beautiful, and so inviting of analysis and commentary, that the statement alone must be gazed upon with wonder, gently caressed, and then swirled about the tongue and palate like a fine Chateau d’Yquem Bordeaux wine. Are we “class conscious” about our investments, and about the profits they bring? Is it wrong to invest “beneath your station?” Should we even care about this?

Class Conscious

The phrase “third class money” indicates to me that the supposedly proletarian Lula either had a surprisingly English – and clearly old-fashioned – education, or that he’s a closet Model Train / Railway history buff. You see, even back in Britain you haven’t been able to buy a “Third Class” railway ticket since 1956 or so. Perhaps the Brazilian railway system actually imported key operating practices – as well as rolling stock – from Britain, and then kept them unchanged throughout the entire 20th Century.

“Third Class” railway tickets didn’t just appear on their own; they were legally mandated by the Railway Regulation Act of 1844. Initially, trains had two classes: First Class, for the upper class and affluent professionals and Second Class, for shopkeepers, salesmen, skilled artisans and – very important – the servants of the aristocracy who were traveling with them. It was assumed that workers didn’t need to travel. The 1844 Act introduced the “parliamentary train” which lasted through the 19th Century, by which each line had to run one daily service including Third Class accommodation, at a price-controlled fare for working folk.

The Second Class accommodation was the first to disappear, abolished by the Midland Railway as early as 1875 (causing a national scandal, because the Duke’s valet didn’t want to travel in Third Class, and you couldn’t put him in First!). Third Class then lasted until the nationalized British Rail replaced it with “Standard Class.”

So what the devil is Lula talking about? Well, with a little thought, it becomes clear; just like an old-time train ticket, investment profits can be categorized by one of three classes:

• Second Class Profits: In contrast to Victorian trains, these are the most common profits in the investment realm. They consist of the regular dividends paid on common shares, and the “coupon,” or interest payment, on bonds, along with whatever returns you get via the “buy-and-hold” approach with stocks, bonds or index funds. They are the ubiquitous “cost of money” element in investment returns.

• First Class Profits: These are quite rare, but definitely delectable, as they are the profits obtained only through superior intellect and investment judgment: By buying Microsoft Corp. (Nasdaq: MSFT) in 1986, or Google Inc. (Nasdaq: GOOG) at the Initial Public Offering (IPO), or figuring out in 2001 that India is about to take off. In short, First Class Profits are the market victories you brag about at cocktail parties. The equivalent of the “big fish” that didn’t get away, you can recount the biggest victory and know you’ll be believed; if the proof isn’t mounted over your fireplace, then it’s evident from the turbo-lunged roadster you drive, the “named” estate you live on, the fact that the last name of every one of your friends and family members is followed by a set of professionally relevant abbreviations, socially relevant initials or Roman numerals – or the word “esquire.”

• Third Class Profits: These are the windfall, “funny money” gains many of the investing masses reap from the financial system’s imperfections – with no thought whatsoever of the questionable, ancillary social values, or to the very real human toll exacted on those who ultimately pay the price for these profits. You buy subprime-mortgage bonds, knowing that the underlying mortgages have no proper documentation and will lead the borrowers to eviction and misery. You buy Russian shares, knowing that Vladimir Putin is a monster who destroys property rights and kills people, but that the less-than-vigilant institutions will pile in anyway, and drive the price into the stratosphere, just because the numbers look good. You buy overpriced tech stocks, knowing full well that there’s a speculative bubble, but aren’t at all worried because you’re certain there’s a “Greater Fool” out there who will take the even-more-overpriced stock off your hands – and will end up as the person who has no place to sit down when the music stops playing. Because Third Class Profits rely on the “Greater Fool Theory.” The reality is that you’ll get lucky enough to notch a profit on a Third Class investment even just some of the time. Indeed, more often than not, you’ll be the one who discovers that he’s bereft of a seat when the financial market’s siren song suddenly stops.

Don’t Be Fooled

At the end of the day, that’s really what Brazil President Lula seemed to be saying, and quite correctly, too. The subprime mortgage market was driven almost entirely by the “Greater Fool Theory” – by investors who didn’t care that their mortgage-bond’s foundation was built of balsa, bamboo and bailing wire (with some “ABC” bubblegum acting as the binder). They cared only that there would be someone else to dump it off on just before the bubble burst and the music stopped. That’s just what happened with the market for high-tech (dot-com) stocks in the 1999-2001 period.

In a market like 1999 or, dare I say it, the United States in 2007, there are a lot of Third Class investments around, and we shouldn’t feel too sorry for people who ignore their better judgment, roll the dice, and roll snake eyes.

Here at Money Morning, we believe in First Class investments. And we don’t gamble. We do our homework, and utilize superior analysis to determine which stocks will do best and why. We know there’s a lot of randomness in life, so we don’t always win. But we do aim to win more than we lose. We accept, however, that some of the investments will turn out to be Second Class, and are happy with that – Second Class investments will inevitably be a valued part of everyone’s portfolio.

Maybe occasionally there will be an exciting Third Class opportunity to make a quick buck, but we will warn people of the dangers, and tell them to invest only a small part of their portfolio in such speculations. Normally, we will shun Third Class investments, warning readers why particular fashionable investments are in reality Third Class and should be avoided. We will miss some Third Class profits, but above all our aim will be to minimize Third Class losses.

That Lula’s smarter than he looks. Maybe he has a future in money management!

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