From time to time we have attempted to come up with a pithy saying or motto that captures what we do in a way that makes it clear to even those who have no interest in or knowledge of investment affairs, but somehow “thundering individual” or “when Centre Street talks, people listen” just doesn’t to cut it. Failing that we have instead tried to define a few basic principles, each of which captures certain aspects of our methodology. One of these principles is if there’s nothing to do, do nothing. We think this brief imperative illustrates the most obvious characteristic of our approach—one which a client could point to as typical of their experience, or any outside observer would see upon examination of our work over time. We are very picky about investing, and if we are unable at a particular time to find investment ideas that we are comfortable with, we’ll simply wait. Importantly, this rule also helps guide client expectations: in “frothy” markets we can be expected to do little and perhaps fall behind the indexes and our competitors, but during “bad” markets we will generally be more active planting the seeds for good future results. Not surprisingly we are prone to holding significant amounts of cash when opportunities for more productive investment are rare.
Flexibility in all things. We firmly believe in the virtues of this philosophical stance as a modus operandi for investment operations. Beyond certain basic tenets, such as don’t speculate, we shun rigid investing formulae. Take, for example, so-called “target date” funds, a popular fund category during the past few years (most often used in retirement planning), but one that has proven very disappointing. The theory behind the construction of these products is based on the perfectly sensible concept that as they grow older, investors should have declining exposure to “risky” assets such as stocks. These funds (which have designated “target dates” that correspond to, say, an investor’s expected year of retirement) change their asset mix over time to include an increasing proportion of “safer” assets, such as bonds, as investors draw nearer to retirement age. While in principle this approach has some merit, in reality the simplistic manner in which it is carried out primes it for mediocrity; the fund may, for example, sell stocks and buy bonds at a very inopportune time. At a more fundamental level the basic approach lacks nuance in that it ignores the varying risk profiles of investable assets through the inevitable market cycles to come. Put simply, what is “risky” at one price can be “safe” at another, much as standing on top of a stepladder is highly inadvisable, while confining oneself to the first couple of steps is usually harmless. In a similar fashion, a stock market in the final phases of a bubble, as in 1999, is very different than one selling at book value and producing an average dividend yield of 5% or 6%, as happens on occasion. In the latter situation an investor can, with reasonable safety, acquire a significant exposure to stocks at cheap prices, even when his or her absolute age would suggest a more “prudent” stance. In our view, even retired persons would be better off shifting at least a modest amount of additional funds into equities at such times.
Along with patience and flexibility, we believe that having the proper focus is another important part of an effective investment methodology, and we properly focus our efforts on what we can understand, act on, and control. No one really knows what the economy will do next year, nor can analysts project a company’s earnings for the next quarter with any degree of certainty. Whether or not the U.S. goes over a “fiscal cliff” is a roll of the dice as far as we can tell. In our view, making capital allocation decisions based on such insubstantial grounds is nothing more than speculation. However, for businesses that we study with care and whose economics we come to understand, we can develop a good idea of what they can earn under normal circumstances, hence what they are worth. We also know that while the economy may run in more or less severe cycles, it will eventually return to some modicum of health. And although incompetent leadership in governmental bodies may be reason for some volatility at times, that too will pass. Most importantly, we can pick and choose our commitments as well as determine the price we pay, which is the most important factor in determining an investment’s ultimate outcome.
Musings at Year-End
Probably the most widely known of all equity-market barometers among the general public, the Dow Jones Industrial Average, has doubled since March of 2009. Yet judging by the figures on stock ownership, a large segment of that same public has apparently been unaware of the Dow’s good fortune. $300 billion has been withdrawn from equity mutual funds since 2009, and according to the Federal Reserve, stocks now make up 37.9% of the average U.S. household’s financial assets, down from 50.5% in 2000. Recent Gallup polling indicates that 53% of U.S. households own stocks (in the form of direct share ownership, 401k investments, mutual funds and the like), compared with 65% in 2007.
There are a number of forces behind these trends. Baby Boomers reaching retirement age and lightening-up on volatile securities probably plays a growing role. And despite the strong upturn since 2009, meager stock market returns over the last dozen years or so haven’t provided much encouragement. Recently, long-term bonds’ beating the returns on stocks over a ten-year period for the first time in memory provided impetus (if any was needed) for the continued movement into bonds at what is probably a peak for that asset class. The fin-de-siècle tech stock bubble of the 1990s, the market crash of 2000-2001, a more harrowing stock collapse in 2008-2009, and last year’s initial public offering busts, have conspired to make the public stock-wary. Lastly there is the suspicion, fed by high-speed trading pile-ups and banking scandals, that the markets are rigged in favor of powerful financial players.
The public’s skepticism about stocks and about Wall Street in general—an understandable response to misunderstood events—is ultimately self-defeating. A widespread disenchantment with equity-type investments raises the cost of capital for businesses, which is not in anyone’s best interest, and the impact can be long lasting—the 1929 crash inhibited capital formation for a generation or more. It can increase the difficulty of reaching financial goals that require long-term funding, such as retirement nest eggs. A recent Bloomberg report indicates that Americans have already lost out on about $200 billion in potential gains by pulling money out of the stock market since 2009. Indeed, it may be a good thing that so many people are unaware of what the market has been doing for the last four years, lest woe over opportunities lost add to the depressed mood caused by an underperforming economy and weak job market.
What are the lessons to be learned from the financial market and economic experiences of the last few years? 1) Our society as a whole needs to be reminded of the basic principle of financial planning: spend less, save more. We cannot rely on robust financial asset markets to bail us out of our problems and help us meet our obligations to the future. 2) Investors need to be aware that there are no magic formulae that will get them through a period of low returns and guarantee that they will reach their financial goals. 3) Finally, in a view that is perhaps to be expected from someone who operates a small firm, there is a lot to be said for small investment operations not beholden to the imperatives and rigid rules which encumber large, institutional players. We are nimble and able to take advantage of opportunities whenever and wherever they arise.
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The political stalemate over the federal government’s debt ceiling and the “fiscal cliff” astonishes the world and causes a great deal of anxiety in the financial markets. Not that we don’t think getting the nation’s finances in order isn’t a matter that requires action, at least for the long-term, but we have a different, perhaps somewhat unorthodox view of the matter. Our leading financial journal reported late last month that the U.S. now borrows money at an average rate of 2.534%. That is down from 5.034% at the end of 2006. It pays about 1.7% on ten-year notes, and less than 2.9% on thirty-year paper. We would venture a guess that the government could borrow large sums for 50 or 100 years at 5% or less. These are extraordinarily low rates, such as seldom seen in the past.
To take a page from the playbook of large corporate borrowers (who sold record amounts of debt last year), we would argue that the U.S. should be borrowing when the cost of debt capital is so low. Practically any worthwhile project could be undertaken at a net benefit to the public—rebuilding our bridges and roads, for example. Furthermore, the U.S. should be borrowing long-term. At about five years the government’s average debt maturity is low among its industrialized peers—U.K. debt matures in about 14 years on average, for example. Lengthening our debt maturities would make the country less susceptible to the financial stress that will otherwise be caused by the eventual and inevitable rise in interest rates. Instead, the Treasury is considering the issuance of floating-rate debt—in effect the shortest of maturities. This is not a step in the right direction in our view, for it violates a fundamental precept of finance: to quote Warren Buffett, “never a short-term borrower be.”
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Neither Americans’ on-going abandonment of equities, nor the political posturing of the Washington crowd were able to stop the stock markets from rising smartly last year. In fact, it was an outstanding year for most of the popular averages, in spite of a little nervousness at year-end. Held back by a few of its thirty components, The Dow Industrials rose 10.2%, but the broader S&P 500 gained 16%. It wasn’t supposed to happen this way. Financial crises in Greece, Italy, and Spain—and Europeans’ inability to form a united front to deal with them—stoked fears of a market cataclysm. Concern over an economic slowdown in China, one of the few engines of world growth since 2007, weighed on investors. Potential tensions over small islands in that part of the world also upset markets. Middle East conflicts, both potential and real, continued in their usual fashion with little hope of resolution. Finally, our own elections and general political dysfunctionality depressed market and business psychology, especially toward year-end. What better proof is needed of the validity of our third principle: focus on what is important, and on what we can control. Ignoring all the rest paid off in 2012.
Dennis Butler, MBA, CFA