Archive for the ‘What we do’ Category

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

As those of you who follow our thinking know, we are hardly in the “perma-bull” category of the financial services world. We remain concerned about the fundamentals and valuations, along with the somewhat limited prospects for growth. We try to be realists, rather than bulls or bears.

Doomsday marketers are everywhere now and they are succeeding in their marketing efforts. One famous doomsday fellow predicts the Dow will fall to 1000! That would mean that stocks would fall by over 90%. If earnings were flat, that would mean that the return on your investment (earnings versus investment) would be over 50% per year when the market is at 1000.

We don’t know about you, but we would gladly put all of money into stocks well before our return would be need to be 50% per year. Alternatively, we might consider that earnings would have to fall 90% from current levels. As current earnings are rebounding from rather low levels, it is hard to imagine that scenario either. Anything can happen, but this is about as likely as being struck by lightning.

But the doomsday crowd is succeeding in frightening people and we are getting calls about how to invest in the likely fall of the market. We don’t say that a market crash is impossible or that a decline will not take place. We do say that profiting from a market decline is the most difficult strategy to employ and that the skill and timing required to do so successfully is daunting.

First, stocks have an upward bias. This is just common sense. A big company makes money every day, so it is literally “worth” more each day. The counter balance to this is that the market has over valued the stock (i.e. investors are paying too high a price in order to own part of the company) and so it will fall even though its worth is increasing daily. So, our common sense means it is relatively harder to make money on stocks falling as opposed to their increasing in value.

Second, let’s go back to the notion that we are market realists. One of our favorite market realists is Jeremy Grantham. He has long produced his 7-year market forecast with astonishing accuracy. He basically normalizes earnings and uses them to figure out likely returns over 7 years given current valuations. His latest forecast shows positive real returns (above the rate of inflation) for all stock classes over the next 7 years.

Many are below normal, but all are positive. These seven years will likely include some big plus and some big minus periods. But, if at the end of the day returns for the period are positive as he predicts, you are once again swimming upstream by trying to invest in a market fall.

We believe we are in a difficult environment and that you need to take more risk when stocks are cheap and rising and less risk when stocks are expensive and falling. To try to make money based on the doomsday scenario,…….., just doesn’t make much sense to us. It is betting on a long shot.

We all know the story of the tortoise and the hare. Most of us have seen examples of  this concept in action at times during our lives. Now may be one of the times to see the tortoise beating the hare at investing.

Let take two investors, each of whom has $100,000 to invest. Investor A (the tortoise) gets 20% of market up and 20% of market downs. Investor B (the hare) gets 100% of market ups and 100% of market downs. Now, let’s add some volatile market returns (certainly not beyond the realm of possibility). The market goes up 50% and falls 40% in year 2.

Investor B has a lot more fun at cocktail parties than Investor A. Our hare (B) gets to brag about the huge returns in year one, while the tortoise (A) tries his best not to discuss his portfolio. Arithmetically, our hare ends up with a 5% annual average return (up 50% and down 40%). Our poor tortoise averages only 1% per year (up 10% and down 8%).

The hare, unfortunately, has only $90,000 of his original $100,000 investment left after year 2. Perhaps his excitement was worth $10,000 but we are not that interested in excitement here at Capstone. The tortoise has $101,200 to show for his investment. He averaged less arithmetically, had less excitement, but saw the return of his principal along with a small return on his principal.

When the odds of favorable outcomes are heavily on your side, it may be better to be a hare. When the odds are more neutral or against you, think hard about being a tortoise. The tortoise can make a bit of money in a turbulent environment while the hare loses his.

We have finished one of the most disappointing decades for investors imaginable. In real terms (i.e. taking into account the decade’s inflation), the returns on stocks were negative for the decade. Those investors who sprinkled in bonds did a bit better, but may or may not have kept up with inflation. Those investors who veered from the traditional and had the vision to add commodities, real estate, etc. probably were able to actually experience growth for the decade. However, they still a rather muted return.

The “sales forces” of financial services are out there now beating the drums for this new decade. Surely after a poor decade we should return to the norm by having excellent returns on our investments, shouldn’t we? Unfortunately, this decade is not really setting up to be any easier for investors than the previous one.

Stocks are certainly not beginning the decade by being cheap by historic measures, so we should expect an average to below average return. Thus, the range bound or secular bear market is likely to continue for some time in equity markets. Unfortunately, commodities and bonds are no longer cheap like they were at the beginning of the past decade. So, returns will be still tough to come by moving forward.

We think the key moving forward will be to be tactical with your risk budget. By that, you or your advisor needs to keep an eye on what are the risks and what are the potential returns of investments. So, if the stock of a great company has fallen to a very low price, buying the stock may increase your risk but be justified by potentially large gains. On the other side, if a stock is very expensive by historic measures it may have rather limited potential appreciation and considerable potential loss. To sell that position and reduce your risk may be the prudent decision. 

So, while investors traditionally have to decide on how much risk to take and stuck with that decision, we believe the prudent course is to adjust your risk budget by the opportunity available to garner good returns. You might still average the same amount of portfolio risk through a market cycle, but get to that average in a way that benefits your bottom line.

Sounds like the credo of the ultimate workaholic! But we don’t think so.

We have long held that for us personally retirement was not a goal. Restylement, with its ability to give you more time to pursue the things that are most important to you, is what appeals to us. There is something that we don’t like about retirement- there is a connotation of withdrawing in the word that does not appeal to us. We know retirement will still be the goal for many, but others will increasingly choose restylement as their goal. The ability to do the things you are passionate about and spend less time doing the things that you don’t enjoy.

This past week we were on “vacation”, but it did not work out that well. We found there were pressing work issues that needed to be dealt with during our time away. So, it occurred to us to re-think vacation a bit also. It seems to us that “vacation” is a corollary to “retirement”. The root word “vacate” has to do with leaving, emptying, etc. Our goal when we go away is really not vacating, but recreation. We want to re-create, not merely empty. Our goal in getting away is to refresh, step back, enhance, get new ideas flowing, etc. So, we did not really have our “vacation” spoiled by having to do a bit of work while away. We were still able to enjoy all the benefits of the time away and have it serve us well in “re-charging” for the road ahead. So- no retirement and no vacation, but bring on restylement and recreation. They both sound good to us.

This past week not one but two clients asked if they shouldn’t be selling all their bonds now. Odd question and the second one sent off our radar. We smelled something rotten in Denmark, or maybe somewhere a bit closer to home. Which of the two sources was responsible? Jim or Suzie? We correctly guessed Jim. Yes, the client admitted, they had been watching Jim Cramer who suggested they dump all their bond holdings. We are going to say this to all who will listen-JIM CRAMER AND SUZIE ORMAN ARE NOT YOUR FRIENDS!!!!!

Their approaches are extremely different (Jim is certainly the more offensive of the two to us), but ultimately they both share only one goal-self promotion. They are the anti-fiduciaries. They do not put your best interests first. They are all about promoting themselves. If you perish as fodder in their self promotion scheme, they will not miss a meal nor feel a moment’s sorrow.  I am pretty sure if Warren Buffet listened in daily to Mr. Cramer and followed all his advice he could have had his home foreclosed upon by now. Cramer uses the shotgun approach, trying to hit a home run by taking 100 swings in every direction. So, he usually has a home run or two to remind you about. The other ideas strike out and are replaced by another hundred swings for the fences.

Suzie’s approach is far more demure but just as lacking in ultimate usefulness. She likes to make sweeping generalizations (“X is a bad thing to do as an investor”). The problem is she has not taken the time or effort to understand your unique situation and needs, so her “advice” might be right for over 50% of listeners but dead wrong for you. You become the fodder in her fame.

A fiduciary, plain and simple, is charged with putting your interests first. The person may be inept and may not give you good counsel. However, they at least must attempt to give you good counsel. That would seem like a good first step in evaluating who you should listen to.

We know it is a little late for New Year’s Resolutions, but………..How about it! Why not tune out Jim and Suzie and devote that time to something that will add to the quality of your life?

In the end, 2009 was a year for the markets that truly surpassed everyone’s wildest dreams. When markets were down almost 30% in March, there was nobody out there who saw a year in which the S&P 500 would finish with a positive 26.5%. We were amongst those who saw a buying opportunity. We were buying for what we saw as a positive opportunity that would play out in a one to five year time frame. For it to play out in a nine month time frame was beyond anything we considered.

Despite the fantastic finish of 2009, the S&P is still off 24.9% from its October 2007 peak. That is still a huge drawdown (i.e. loss from peak to now) that investors cannot afford. That is why we still believe that active investment management using a wider playing field than the traditional stocks, bonds, and cash is required in order to help you achieve your financial goals. Our management style has worked well through this period and we feel it will continue to produce results in 2010 and beyond.

In terms of what to expect in 2010, we do not know what the market will serve up. There is still momentum in the equity market and lots of money on the sidelines that could push prices higher as it comes into the market. It is our feeling, however, that it is a time for caution. While very high quality investments seem to be priced around their historic averages, poor quality companies seem very expensive and at risk of a large tumble. So, we believe that quality large companies are the area to overweight going forward and low quality investments should be underweighted.

We expect there to be some opportunities to enter into investments at low prices as the year goes on. As always, we will try to take advantage of inefficient market pricing of assets.

Lastly, we want to thank each and every one of your for your loyalty and faith in us over the years. As we look at the millions and millions of your dollars that we are entrusted to manage, we are truly honored by your commitment to us. Every day we feel fortunate to be where we are in this difficult environment and seek to continue to earn your continued loyalty. We really mean it- Thank you!!  

As those of you who have been acquainted with us for long know well, we believe avoiding the Style Box approach to investing that is promoted by Morningstar is the best thing you can do. Style boxes provide very little true diversification and drag down portfolio results by as much as 3% per year.

Now, Advisor Perspectives has published an interesting study showing that the Morningstar Star Ratings fail to predict performance through a market cycle. So, moving from a “3 star” fund to a “4 star” fund is no better than flipping a coin to decide which fund to hold. Russel Kinnel of Morningstar admits the star rating is “not a forward looking measure”.

This finding does not surprise us at all. Investing with style boxes and star ratings using a rear view mirror approach is a losing concept, particularly in a secular bear market. You need strategies and tactics that make sense moving forward, emphasizing return of capital as well as return on capital.

The rally continues against all odds at present. The oddest part of it is that the lower the quality, the higher the gains year to date. The Russell 2000 index (an unmanaged index of 2000 small companies) is now up 22% through September. The price to earnings ratio for the index, according to the Wall Street Journal Market Data Center, is……………………………NIL!!! The 2000 stocks combine to have a loss, so……no ratio of price to earnings as there are no earnings. Forward looking estimates for the next year give the Russell 2000 a price to earnings ratio of over 44. So, if things go really well you will have a net earnings return of just over 2% on your investment for the next year. Do you want to invest in a basket of risky stocks so that you can hopefully earn a bit over 2% if things go well? This is not to say that these stocks can’t get more overpriced in the next year, giving you a terrific return. They can. It is just that the odds are not with you, they are against you.

On the other side of the coin, let’s consider the SPDR Global Titans ETF, made up of the largest multinational companies. It is up just over 16% year to date through September . Nothing to sneeze at, but a far lower return than the Russell 2000. This investment, made up of the highest quality companies from both the United States and other countires, has a price to earnings ratio of just over 15 and a dividend of over 3.5%. So, this investment is priced around historic norms, has a nice dividend return, and is filled with companies who are well poised to survive (and possibly thrive) potential economic problems should they arise.

As a rational investor (investing in often irrational markets), I can’t help but think that the odds are overwhelming from here. You should buy the highest quality, most reasonably priced investments you can find. You may suffer in the short term but should be fine longer term. At the same time, you should be considering taking profits and possibly shorting in the lowest quality parts of your portfolio. Warren Buffet famously said “it is not until the tide goes out that you know who is swimming without trunks.” The tide is likely to go out. It may be very soon or it may be much later. Don’t get caught again.

On reflection, it was an astounding quarter. Last year, we saw a meltdown in asset prices like no other since the great depression. No matter what the type of asset, if it involved any level of risk nobody wanted it and selling it was a painful event. This event took market prices far lower than rationale evaluations and we tried to take advantage of that by buying assets that we thought were extremely undervalued.

A year later, the trend has reversed in a shocking manner. Almost all assets had headed back up in prices at a speed that seems turbocharged. While we expected an initial rebound followed by slow growth, we have witnessed what Vinny Catalano has called a “melt up”. Money has come in from the sidelines and forced asset prices to keep ascending at a rate that seems removed from the reality of our lives. The “new normal” is a world in which a slow economy will not be buoyed by consumers spending money they don’t have to buy things they don’t need. The piggy bank (i.e. home equity withdrawals) is closed and does not appear as if it will be opening any time soon.

Even more astounding, the huge rally has been focused on all risk being rewarded the most. Low quality stocks and junk bonds have led the way, gaining more than high quality stocks and better quality debt instruments. How long can this go on and how will it end? If we knew the answer to those two questions, we could solve all your problems easily and could sit back and watch the unfortunates struggle to not stub their toes. How long can it go on? As long as people continue to pour in from the sidelines and pay little or no attention to fundamental values, the market can continue to go up. How will it end? It can end peacefully if it ends soon-markets can take a breather and allow valuations to catch up slowly to current prices. If the market continues to skyrocket, the end could be less pleasant-another meltdown seems unlikely but can’t be ruled out entirely.

How should we position portfolios moving forward? The answer is cautiously. The gains we expected to see over a period of years have come to us in  a period of months. There are some assets that appear to us to be fairly valued and there are some assets that now appear to us to be somewhat overvalued. We believe that the way forward is to overemphasize quality (which has now gone up as quickly), hold on to assets that appear to be fairly valued, and selectively take some profits in areas that are now overvalued. Couple this will a discipline that includes stop sell limits should the market begin a free fall and some hedging that reduces portfolio risk a bit at this time and you have our strategy moving forward. The game can change quickly from here and we must be ready to react to what is no longer a rally driven by fundamentals. It is a more dangerous moment now- the tail end of a huge rally in what is most likely still a secular bear market.