Thursday, May 27, 2010

And Now for Some Good News.....

For everyone who follows this blog, you know we have continually set forth the fundamental economic problems that burden the global economy. Excessive leverage and the uncomfortable consequences of reducing that leverage top the list. We have studied similar events in history to learn what could go wrong, as well as what could go right. We have stayed conservative since 2008, with a healthy cash position. Our stock and bond holdings have done very well during the recovery phase, surpassing our expectations.

Remember, our number one focus for the past year has been simple: invest conservatively to preserve capital, allowing for investment at a better time and price. After a relentless and unprecedented “bull” market for the last 14 months, investors are finally appreciating risk again. We welcome this change.

An appreciation for risk is exactly what allowed us to buy investment-grade corporate bonds in late 2008 and early 2009 at yields-to-maturity ranging from 8% to 12%. An appreciation for risk is what allows us to buy EVA companies with 3% to 5% dividend yields at reasonable prices. An appreciation for risk benefits the patient and conservative investor.

If people now question everything from whether markets are “rigged” to complete Armageddon in the global economy, then that is a change for the better. It is a shift in investor psychology that we have been expecting for some time. Without a healthy dose of skepticism, conscientious investors have no chance. Attention to risk does not spell disaster. It opens up opportunity.

Could markets go lower? Yes. Could we have market instability from “machine” trading? Yes. Do we face challenges from Europe, an over-indebted Japan, a bubble in China, persistent deficits and higher taxes at home? Yes. Those are issues we study every single day. They matter greatly to us and have kept us cautious. We factor them into the prices we are willing to pay. But there are solutions to each problem that are difficult but not catastrophic. The issues are clearly on the table and voted on every day in the market. Beyond those solutions we have a fundamental belief in the “going-concern”.

“Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.”

-Warren Buffett, Shareholder Letter, 2007

Households will always seek to maximize wealth and consumption, making the most of the resources available. Behavior won’t always be rational or predictable, but markets allow for our society to proceed in the most efficient way possible. Mistakes are made and corrected, confidence will rise and fall, and capital will be misallocated only to be reallocated. Politics and power will interfere, but society will continually pursue a better outcome. There is opportunity to invest for that future. If we didn’t believe in that, we would resign our role as investment managers to live on a farm near a reliable source of water and grow our own food.

Every doomsayer or perma-bear I know of at least acknowledges the going-concern concept and the fact that difficult issues can and will be resolved. In valuation analysis it is often called “terminal value”. That is an oxymoron because it actually represents continuing value. It measures what an asset is worth into perpetuity. While we don’t know exactly how the issues of today will be resolved and we expect it to be uncomfortable at times, markets need to simultaneously appreciate both risk and going concern.

For several months now risk has been underappreciated. It is indeed good to see assets start to re-price, even if our holdings are somewhat negatively affected. Since the market surpassed our expectations last year, it does not surprise us to see some of those gains retraced.

What is important is that we are here to take advantage of better prices as they develop. We have been prepared for a change in market character.

Expect us to maneuver by trimming certain positions into rallies and making investments in core EVA holdings at lower prices. Protecting capital is still our main priority today in an uncertain world, but our long-term goal is to make money and generate wealth for our clients. We are encouraged to see that goal come into focus. Don’t get me wrong, we can be as bearish as anyone; it is in our nature to be conservative. Much of what we are dealing with is slow to develop, requires patience, and a watchful eye. Just give us good value at a price that appreciates risk, and we can do more than just wait. That is good news.

Peter J. Falker, CFA

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Tuesday, May 11, 2010

Living in the Land of Oz

All those who said Greece did not matter (I guess it has something to do with its economy being only the size of Massachusetts) can finally face the truth that it matters by roughly $1 Trillion. I guess $1 Trillion is not what it used to be, especially when central banks can print money without limit to be administered by generous, bailout-minded custodians of taxpayer money. They must save their only son (the banking system) from the cruel realities of life on the street. Who’s looking out for the rest of us? I think we can only help ourselves.

From reading and listening to many market experts today, last week’s sell-off was supposedly an overreaction anyway. The 1,000 point drop was a “glitch” (actually it is a “yet to be discovered glitch”). The market simply corrected last week to set up the next leg higher. Greece really didn’t matter after all.

Actually, there is a grain of truth to thinking that Greece doesn’t matter. French and German bank exposure to the debt of weak Euro-zone economies is all that really matters. Pure and simple, this is a bank bailout by the European Union, with self-imposed rules being broken to maintain the status-quo. The IMF, funded largely by the U.S. taxpayer, is providing 33% of the money involved ($330 billion!). In an unprecedented move, the European Central Bank has announced it began buying an unspecified amount of debt of European countries. It will provide this money, as ECB President Jean-Claude Trichet remarked, “to re-establish a more normal functioning of the market in order to be sure that we have an appropriate monetary-policy transmission.”

“More normal functioning” depends entirely on your point of view. It is becoming the norm to bail out irresponsible and negligent behavior. The money provided by the ECB didn’t exist yesterday. The ECB isn’t a money making, high return on capital enterprise. They simply own a printing press. There is a certain gullibility required for people to believe in this magic. If it was Procter & Gamble, Clorox, Cisco, Microsoft, or Berkshire Hathaway making this type of investment, we might entertain it as a shrewd, well-reasoned move by a disciplined, value-creating business. But that is not the case. In fact, left to the market to decide, it is a very bad investment. Just last week, two-year Greek bonds were yielding 15%. Only someone with a printing press would make that bet.

I know the EU, the ECB, the Federal Reserve, and the U.S. Treasury are worried. They fear that a moment like last Thursdays “glitch” was actually real. After stumbling for weeks with words of confidence, the EU finally orchestrated a “Sunday Save”, taking a page from the U.S. crisis playbook. Greek riots and truth-seeking markets seemed enough to push the EU to extreme measures. Weekend elections in Germany indicate real political divisions over the European bailout. So, the time to act is now, before markets and democracies impose real discipline. Monday, we went from “Euro-phobic” to “Euro-phoric” (clever…my words) due to the bailout’s absolute size. Who doesn’t love free money? I understand the need for liquidity in a credit crunch, but what we are dealing with here is real, lending-based insolvency in the banking system.

Sometimes it feels like we live in the Land of Oz, with some lunatic calling the shots behind a curtain. Democracy and capitalism, however, reveal the truth, even if they take us on a long, winding, yellow-brick road. Indeed, that road might someday be made of gold. If we eventually find comfort in what Keynes called the “barbarous relic”, it would be an attempt to prevent us from acting likewise. If central bankers and legislators want to maintain order without returning to some type of money based on metal, they need to act in line with free market principles and remove the specter of continual bailouts.

The curtain has been pulled back. The Wizard has been revealed. The hot air balloon is on its way. Everyone must think for themselves, and be courageous and willing to take responsibility for their actions. That is what we do every day as fiduciaries. This is our livelihood and we invest our own capital alongside our clients. The companies we invest in must create value and we look to protect capital from the risks inherent in markets.

There is no magic (or bailout) in that.

Peter J. Falker, CFA

May 11, 2010

Friday, May 07, 2010

Why We Don't Panic

Yesterday the Dow Jones Industrial Average dropped nearly 1,000 points intraday. The market ended the day down roughly 350 points. It is still unclear what directly caused the freefall. The New York Stock Exchange said this morning that they could not identify an error, but certainly something or somebody created an automatic and overwhelming response from computer generated trading.

Hopefully, this event will receive a tremendous amount of scrutiny from traders, regulators, and exchanges. Most of the downturn was corrected quickly. The market went down 700 points in 15 minutes then recovered 600 points in the following 20 minutes. The exchanges have decided to cancel many of the trades that occurred in that time frame. We had no orders present in the market when this occurred. When buying or selling, our orders are small and incremental and manually entered by us. We never have open or standing orders in the market that would fill automatically.

Regardless of the technical aspects of the sell-off, stocks began moving lower over the past week. The last several days have seen rising market volatility and a rally in U.S. Treasury Bonds, indicating a correction with a concurrent flight to safety. This comes as little surprise to us as markets will continue to confront the consequences of global over-indebtedness and economic imbalances. As written in this blog many times, deleveraging at all levels of society is a major theme for us in managing client portfolios today. The markets will ultimately deliver the verdict on how deleveraging takes its course, despite the efforts of interventionist government policies to manufacture a sustainable recovery. Currently, Europe is providing the best example of this circumstance and was a significant contributor to the momentum that got out of control yesterday.

“Show me a hero, and I will write you a tragedy.”

-F. Scott Fitzgerald

We have dual investment goals: generate wealth and protect capital. Our equity and bond holdings have performed very well since the market started recovering 14 months ago. Our bond holdings were mostly purchased in the midst of market panic in 2009 for very attractive yields-to-maturity. As stocks have recovered, we have shifted a significant portion of our equity holdings to conservative, high dividend paying companies that generate long-term wealth with consistently high returns on capital. These stocks achieve both investment goals simultaneously. Notably, however, we have also maintained a significant cash position, invested in the Schwab U.S. Treasury Money Market Fund.

Along with our bond holdings, this cash position contributes meaningfully to our goal of protecting capital. Even with a low yield, it provides a very important component of return. While it gives us flexibility to invest when opportunities appear, it gives us great comfort on days such as this. To be sure, while the market was down 9% yesterday afternoon, our cash position was down 0%. If a correction continues, that cash component will become more and more valuable both in its ability, not only to protect capital, but also for reinvestment at reasonable prices, upon which we intend to act.

Up to this point in the market recovery, we have been glad to let our bond and equity allocations do the heavy lifting of generating capital appreciation. Our cash position has not significantly hindered overall returns. Its relatively low yield has been inexpensive insurance to protect against a volatile backdrop no less severe than what was witnessed in the 1930s.

We are not trying to be heroes in this environment, chasing higher returns into a vortex of uncertainty. We have too much respect for the challenges of today to be cavalier in taking unnecessary risk with our clients’ capital. When confronted with low rates of return, investors often make the mistake of taking added risk. (A phenomenon we have witnessed repeatedly over the last 10 years.) Without compensation for that risk, losses occur suddenly and usually by surprise. Yesterday’s market action, reminiscent of late 2008, demonstrated clearly how a market shock might quickly undermine confidence when returns are low and risks are elevated. This environment is very different from the 25 years that preceded the collapse of the tech bubble.

Managing a portfolio that balances the goals of generating wealth and protecting capital will continue to serve our clients well as investors become more familiar with the changing character of markets.

If you have questions or comments, please contact us.

Peter J. Falker, CFA