Archive for the ‘Capstone’ Category

As we end a difficult year, we are left with a great deal of uncertainty as to where the short term will lead us.

This past year was one of the most confounding to market participants in memory. After a fairly positive start, the year turned into a nightmare of extreme volatility and market gyrations. Those who follow market trends or use fundamental analysis were left equally unhappy by year’s end. There was simply no rational formula or concept that would help you invest in this market.  It was a market that became dominated by emotions and headlines rather than economic and company fundamentals. As the year wore on, the only thing you could count on was for everything to reverse every few weeks. As a result, you needed to decide how much you cared to be involved in this market at all and to what degree you could focus on the long term versus the headlines and poor short term results.

Specifically, the year savaged international markets, including both developed and emerging markets. While that could continue into 2012, we think there are still compelling values in emerging markets for the long term. Emerging market countries have lower government debt, burgeoning middle classes and better demographics than the developed world. This should yield better long term results for their stock markets. However, we would still expect these markets to experience more volatility than developed markets going forward, giving you a rather rough ride as we move forward.

Domestically, we would suggest that a viable long term strategy is to stick with high quality stocks. These stocks are trading at rather low valuations compared to historic norms, some have attractive dividends, and the companies  have considerable cash and impressive balance sheets. If you are willing to purchase for the long term, now may be a buying opportunity. If you are expecting immediate results, maybe keeping your money in the mattress is still the best idea.

On the fixed income side of the equation, 2011 favored US Treasuries over all other assets. In a year in which US government debt was downgraded, this seems an odd outcome. We don’t know when, but…..someday we will see rising rates on US Treasuries and poor total returns on them. The area that seems to be most undervalued to us at this point is the municipal, tax free bond world. There is some added risk there, but it seems to us that investors are being richly rewarded for taking on that risk.

At any rate, we hope to keep our eyes on the longer term at this point. We don’t want to take on too much risk in this market, but believe that we should very selectively add risk for the long term.

There seems to be ever increasing rancor in our public arena. Investments seem to be more volatile with likely lower returns in the near future. People seem to all be, as per the famous line in Network, “mad as h*** and not going to take it anymore.” It is easy to get caught up in the dissonance and white noise that seems to permeate our lives. 

Yet, at every Thanksgiving, there is so much to be thankful for and to reflect upon. Despite the difficult moment we now live in, our lives are filled with riches that deserve to be appreciated. Bad times do not take away our capacity as humans to interact with each other in meaningful ways. We also get to enjoy nature’s bounties and those riches created by man. We take so many things for granted now that are wonderful enhancements to our lives that did not exist at the dawn of the previous century. The personal ability to interact with people all over the globe at little or no cost, the ability to carry the equivalent of a library in the palm of our hands, etc. We maintain all of the centuries old abilities to love and cherish, to reflect on the meaning of life, and to live in community as social beings.

This year we need to carry the spirit of Thanksgiving throughout the entire year rather and not just a day. It will be its own reward both for yourself and those who are important parts of your life.

How many times in the past few months have we heard the pat answer “the job creators aren’t creating jobs due to uncertainty”. This has become a fine “whine” so to speak. The dictionary defines an entrepreneur as” the owner or manager of a business enterprise who, by risk and initiative, attempts to make profits.” So, now we have entrepreneurs (also known as job creators) who want the profits but none of the risk?

Job creation is slow due to one essential fact-global demand is insufficient right now to cause businesses to hire. Of course, entrepreneurs are using their business acumen and initiative to try to gain an upper hand while h economy is slow. “Lower my taxes permanently, lower my risks, give me certainty”. You don’t get a risk premium on your investment without the risk, entrepreneurs.   It has always worked that way and it always should.

We have seen a lot of lists of questions you should ask your advisor over the years. They are useful and you should, in fact, ask many of them. The most important question for understanding who you are hiring is usually not on these lists. The question is-What do you do to manage my risk as an investor?

The answer will quickly tell you who you are working with. The “faith advisor” will answer about how you are in this for the long run, how you don’t make a lot of changes if you truly believe in America and in capitalism, etc. They buy into the full faith and credit of the financial services industry and are supported by many experts from the industry (kind of like lobbyists in their approach). On the other hand, the “business advisor” will be able to answer in terms of a process to manage risk as the future unfurls. We suppose there could be a third group who are not able to answer coherently on either side of this issue. That is an answer worth hearing and probably tells you to move on in searching for the “right person”.

The choice is yours. For us, we have a strong belief that you should manage your investments much like you manage a business. You need a process, you need beliefs, and you need to evaluate and adapt as you move forward. A business which does not do this is unlikely to succeed over the long haul.

A good example might be a successful local coffee shop. The owners would have founded their business on a set of core beliefs and would have developed successful processes to implement their belief system. Now, imagine that they hear that that national coffee chain (yes, that one!) is going to open up in the next block. They could ignore this fact and rely on their faith in their current business model and clientele. A better course of action would be to assess the risks (and opportunities!) that will arise from their new competitor. Which business model would you choose and which business do you believe is more likely to survive?

You can (and we believe must) apply these same principles to your investment portfolio. You need to develop a set of beliefs, and then implement them as processes, but also make an ongoing assessment of risks and opportunities an important process which loops back to your portfolio design. In our opinion, investing with faith only is no way to run a portfolio. Or a business.

As many of you may know, Warren Buffet’s first rule of investing is- Don’t lose money! His second rule of investing is- Don’t forget the first rule! This is terrific advice save for one small detail. The detail is that we have never met anyone smart enough to follow these two simple rules. We have never met Mr. Buffet, but we are quite sure that he has not been able to follow these two rules without a few lapses during the past decade.

The third rule of investing is really the only one you need because- you can actually follow it!  Lose money as infrequently as possible and limit the amount of each loss!!

This gives you a plan for investing that you can execute (unlike the far more well known edicts of Mr. Buffet). The process needed to follow this rule will be challenging but you can do it. To lose money as infrequently as possible is to only enter into investments which have a reasonable expectation of being profitable. Buying a tech stock in late 1999  with a price-to-earning ratio of 400 was just not a reasonable concept. Could you have doubled your money as the P/E ration zoomed to 800? Of course, but this was not a likely or reasonable outcome. This investment was more likely to lose money than to make money and should have been avoided. If you did foolishly make this trade (an infrequent loss we hope!), what was your process to keep your loss small? If you allowed your tech stock to fall 90% in value (as most investors did!), you clearly had no process in place that was designed to limit the scope of your losses.

So, make it a mantra and figure out how you are implementing it-

Lose money as infrequently as possible and limit the amount of each loss!!

Americans are a people of faith and belief- that is one of the things that binds us together. Organized religion is an important part of most of our communities and a major social network for many people. Sports have become a second major source of faith and socializing for many. In baseball, who can forget Tug McGraw’s “Ya gotta believe” rallying cry for the New York Mets? How about the hapless New Orleans Saints uniting the hurricane ravaged city of New Orleans on their drive to become Super Bowl champions?  Or the way we root for “Cinderella” during March Madness? Our faith and emotional attachments do much to enrich our lives and are a precious commodity in our lives.

Unfortunately, emotion and faith have little place in our investments. We invest money with a fairly consistent objective- to fund future economic needs through investing our hard earned capital. Implicit in this process is that we invest in order to make a real return (something beyond inflation). Achieving this goal is not a given and usually requires us to take some risk and to carefully weigh that risk in light of potential returns. We refer to that process as Variable Risk Investing^SM.

The traditional world of investment advice is filled with emotion and faith. Primarily, this comes in the form of “experts” who are always of the opinion that now is the time to buy investments. There is never a year in which you are advised not to invest in equity markets. A lot of advisor “guru’s” declare that you should have “abiding faith” in the greatness of free-market democratic capitalism and should therefore fund all future needs by investing in equities. Our contention would be that your “faith” in America is a wholly different issue from the expected returns you have on your investments moving forward. If stocks are way overpriced and the economy is weakening, you are looking at lower than normal returns and higher than normal risk. Is it prudent to invest all of your capital in such a market? It would not be our recommendation and history shows the results can be disastrous.

The flip side of this phenomena are the marketers who make their money by predicting that disaster is lurking immediately ahead (the fear side of fear and greed is their forte). For them, the great reckoning is always upon us. Oddly, they always offer a solution that includes them profiting from you getting out of the way of the impending doom. Bear market funds, gold sellers, equity index annuity sellers and many others await you in this realm of the world. If they can get hold of your fear, they can do pretty well for themselves regardless of your fate.

We believe that realism (not faith or emotion) is the only course to steer to financial success. To participate in up markets and to avoid losses as often as possible is the road to success. To either let your emotions drag you down a dark alley or to always look at your portfolio through rose colored glasses is counter productive. Capital protection and growth is a serious business. Always treat investing as an objective task. It helps you “live long and prosper”.

Yes, new year, new acronym!! But I think this a crucial one.  For years, the tenets of mainstream investing have involved buy and hold and investing based upon your risk tolerance. The mainstream is moving towards accepting the concept that buy and hold is not a winning strategy to always pursue.

Regarding risk tolerance, an aggressive investor was counseled to take more risk than a conservative investor. In mainstream portfolio management this really meant that the aggressive investor owns more equities and the conservative investor owns more fixed income. It is time to end this myth also.

First, we grant that the appetite for risk is a crucial ingredient in formulating portfolios. Someone whose goal is to grow their money at a faster rate will of necessity need to take more risk than someone who has a lower tolerance for loss or who simply does not need to grow their money as fast in order to meet their financial goals. The problem is that risk does not equal the proportion of equities and fixed income in a portfolio in a static balance. To make this traditional assumption is to totally ignore the potential reward of an investment!

For instance, Investment A has a potential loss this year of 15% of your principal. Should you make this investment? Would it make a difference to you whether the potential reward from this investment was 10% this year or 20%? It sure would to us!

The best way to understand the situation might be to look at the cost to purchase an investment per dollar of earnings. If it cost you $10 instead of $20 to purchase a dollars worth of earnings in the stock market this year, your reward is twice as large as when you have to pay double for that same amount of earnings. A rational person must include this in their calculations and be willing to adjust their risk accordingly. In order to grow money successfully, you increase risk when there is increased potential for rewards and decrease it when the potential rewards are smaller  We call this……. Variable Risk Investing (VRI)! We will be writing more on this topic in coming weeks and will also have some longer essays on this idea.

Near the end of last year, we saw a real gem on the internet. The internet job site Glassdoor.com had published some of the oddest and most difficult questions that job seekers were asked last year. This one caught our attention and we want to respond.

According to the article, a person applying to become an analyst at Goldman Sachs was asked:

“If you were shrunk to the size of a pencil and put in a blender, how would you get out?”

This really caught our attention as we were losing sleep over the very same question!! Really? Really? Your firm was in the mix of those who nearly brought on another great depression and that is what you need to learn about prospective employees? Why bother about fiduciary responsibility, ethics, morality, making sound decisions, or the Golden Rule?

Our mind wandered to the pharmacological state of the questioner? Would somebody grounded on our planet and able to pass a sobriety test really ask this of a prospective candidate? Probably not, but this is Hollywood……no, we meant Wall Street.

Next thing we know news broke of the questions surrounding the deal struck between Goldman Sachs and Facebook, involving Goldman Sachs’ wealthy  private clients. Take these sentences from the Facebook Offering documents:

“There may be conflicts of interest relating to the underlying investments of the fund and Goldman Sachs.” Material in the documents is described as “not guaranteed as to accuracy or completeness.”

Given what we have all gone through in our economic crisis, isn’t it good to affiliate yourselves with people who, if they were reduced to the size of a pencil and placed in a blender, could get out?

The older we get, the more we seem to be able to simplify life’s complexities. As those of you who follow our blog know, we think much of life is wrapped up in the Golden Rule. Recently, we have mused over the profound story of the tortoise and the hare. Now, we would like to give another profound and simple lesson its due.

Whether you are old enough to appreciate Pete Seeger or the Byrds, you are no doubt exposed to their classic, Turn!Turn!Turn! Taken from Ecclesiastes 3:

“To everything there is a season, and a time to every purpose under heaven: ….a time to plant, and a time to pluck up that which is planted;”

We still have a lot of “financial experts” explaining that the time to own a basket of stocks is now, in the future, and always. If they could only embrace the simple message of Ecclesiastes 3, they would begin to understand the folly of their advice

The debate rages on. The rise in stock this past year has caused the buy and hold folks to peak up from their gopher holes. They are once again touting their strategy (or is it the ultimate lack of strategy?). So, knowing that buying and holding the S&P 500 for the past decade was a very poor strategy, I decided to look back on an even more humorous concept, The Money Magazine list of 10 stocks to “buy and forget” for the last decade that they published in 2000.  A quick look at how we fared by buying and forgetting:

Stock                                       Price in 2000                          Price 12/31/2009

Nokia                                      $54                                          $12.85

Enron                                      $73                                          AARGH!!

Nortel                                      $77                                          $.002 (Wow!)

Oracle                                      $74                                          $24.53

Broadcom                               $237                                        $31.47

Viacom                                    $69                                          $31.50

Univision                                 $113                                        *(36.25)

Charles Schwab                      $36                                          $18.82

Morgan Stanley Dean Witter  $89                                          **$29.60

Genentech                               $150                                        ***(95.00)

• *Purchased by Broadcasting Media Partners in April, 2007 for $36.25 per share
• **Does not include value of Discover spinoff (not enough to avoid losing $$)
• ***Purchased by Roche in March 2009 at $95 per share

So, our version of the old joke- How do you become a millionaire investor? Subscribe to Money Magazine, cling to the buy and hold philosophy through thick and thin, have a 10 year time horizon, and……start with at least $4 million dollars!!!

Maybe take those buy and hold recommendations with a grain of salt???