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2013 January Newsletter

Paul Sutherland, CFP®
By: Paul Sutherland, CFP®

2013’s Upside-Down World

It’s 2013 … which means 29 years of writing client newsletters. From the perspective of a Baby Boomer (like me), today’s world seems upside down. Upside down, of course, depends on your perspective. The Southern Hemisphere map looks funny and maybe even unsettling to us Northerners who think the world is supposed to be, well, upright.

My wife, Amy, and I saw the movie Lincoln a few weeks ago, and found it inspiring. Lincoln made me proud to be an American. Without revealing too much, the movie centers around the ratification of the 13th Amendment – ending servitude/slavery. In opposition to the amendment, one person argued that “If we end servitude, then four million blacks get free, soon they will want to vote, and then we will have to let women vote … and the whole order of things [will change] and we can’t have that, so vote against this folly.”

Today we have lots of follies that are unsettling depending on perspective. Being 57 years old, loving history, and believing my job is to humbly and continuously learn and challenge what I know allows me to see this all as unexceptional. As our Wisconsin partner Jeff Lokken likes to say, “The only constant is change.” 2013 is going to be about change, but in “the more things change the more they stay the same” kind of way.

Success

I had an opportunity to spend a couple of days at IDEO, a global design consultancy, where I experienced more about their process. I have admired the founders and the wisdom they shared in some of their publications. But nothing teaches better than being immersed in the process. At IDEO I was able to sit in on a live client consultancy process. I only can say that I was truly inspired. I really believe that the success of any company depends on its processes, systems and the ability to stay close to its customers needs, wants, dreams and desires.

So for every company in which FIM Group invests, we spend a great deal of time assessing its products and product strategy. The world is one substantial cyclical process of growth and erosion of growth. For example, who would have thought, that two of the three companies that controlled 64% of the mobile phone market five years ago (Research in Motion/BlackBerry, Motorola and Nokia) would be replaced by Apple and Samsung (Nokia is still in the top three)?

Online education is disrupting the “how to” of skill-building and eroding the value of what it means to be a “university graduate.” Digital teaching concepts and interactive technology are challenging the future of many of our classroom-centric beliefs about education (as we know it now). Online banking is making the “branch bank” system seem less relevant. Even as I drive through small and large towns, the locals will point out beautiful, old buildings that “used to” be a bank. The technology internet bust of 2000 did not tell us that “technology was not the future.” Rather, it told us that many investors succumb to group think and do not look at price, value, management, product, markets, competitive forces and a host of other things before investing. 2008’s crash and those who jumped out of long-term investments and stayed out were equally naive. Things change. Opportunities are always knocking at the door. Creative destruction is reality.

What Next? The Fringe, the Subtle …

Laptops, seatbelts, cable/satellite TV, vitamins, mobile phones, e-books, fitness studios and recycling seem so commonplace now, but they were not always the norm. I remember when one of my grade school teachers got out of his new car by un-clicking a “seatbelt.” Of course, my five siblings and I would climb all around in our Pontiac station wagon while driving to church and to Grandma’s each Sunday, never even thinking about safety. We all have similar stories, but we can all remember life before cell phones. More pertinent, real money was made not by investors or companies that saw opportunity after everyone else, but well in advance. As a Detroit boy, I watched with a feeling of disgrace as gas-sipping Japanese and German cars took the place of gas- guzzling American-made “sofas on wheels.” Innovation often appears easy. Our egos and brains, are wired to long for the predictability of an earlier age … but that is not where success comes from in the hyper-dynamic world we live in today.

2013: The Forecast

Disclaimer: I like to forecast only what I know is true.

Fundamentals Do Matter

  1. The numbers – Balance sheet, capital structure, cash flow and value creation all matter in investing.
  2. The values and culture of a company’s management matter. Things like leadership, ethics, sustainability, resilience, innovation, open and emotional intelligence, flexibility.
  3. The product and product strategy of a company matter. Competition, products that meet consumers’ needs, innovation and being close to the customer are part of a successful strategy. Management needs to be practical, and product developers must stand in the future.
  4. Things change.
  5. Economics is about people.
  6. People are inherently good, but sometimes they behave badly. You don’t have to “play” with those who behave badly.
  7. Some investments will thrive in 2013 and some won’t.
  8. Investors that are short-term oriented create a huge advantage for long-term, patient investors.
  9. Price matters. The price you pay for an investment is a top determinant of your performance – so buy at the right price
  10. Investing and portfolio construction are about needs – for example; if you are retired your portfolio’s goal is to allow you to have lifetime income security
  11. There are always opportunities.
  12. Buying an investment is easy – investing to make money takes skill.

1% = 3>#/h2###

One concept that I think has helped our success is what I call “lazy assets.” This involves thinking that every investment in your portfolio is there because you are convinced it is beneficial for the portfolio. Consider, for example, an investment that is less compelling – one that does nothing or decreases in value. If this comprises 1% of your portfolio and it goes down to 0, you lost 1%. But is that the end of the equation? No. If you had invested in a “winner” that doubled in value, you would have your 1% become 2%, resulting in a 3% difference between the two outcomes. Of course this scenario is oversimplified, but the point is that small things in a portfolio add up to significant changes over time. A 3% difference over time can be the difference between retiring or not, or reducing the income from a retirement portfolio or not. If you have investments sitting in cash, CDs or investments that you have “just because,” a good New Year’s resolution might be to look them over. See if they are doing their job as part of your overall investing strategy or if they are being “lazy.” Investing success is hard enough without having “lazy assets” around.

Two Ears, One Mouth

I never get any smarter opening my mouth. I’d rather listen to people talk about their investments, though I am quite amazed at how little people know about investing. They may know what a bond is, but they have little understanding about how currency rates, interest rates, inflation, money supply, ratings and investor psychology influence a bond’s price. Since all things change and are thus cyclical, knowing if the price is right by knowing what influences the price action of an investment, to me, would seem of paramount importance. But no … it seems that people are happy to just buy investments from the sales guy whose job it is to sell the investment – without any contemplative framework to guide the investor to a “yes” or “no” on the investment.

To some investors the world is upside down and makes no sense. To others it is full of opportunities. Success, then, does not come to those that say it makes no sense. Rather, it comes to those who use tools like those I saw in action at IDEO. Achieving success is indeed hard work, and maintaining it is challenging. It requires humility, courage and emotional intelligence. The world is not upside down, and it is not more challenging today than it was 30, 100 or 500 years ago. It is just different, but the tools that lead to success are timeless.

Zach Liggett, CFA®
By: Zach Liggett, CFA®

Biomimicry and the Az-meister

Nature provides a treasure trove of lessons for those willing to pay attention. Observing and emulating, or taking inspiration from nature, a discipline now known as biomimicry*, is certainly nothing new to the business world. Take the case of Georges de Mestral. Back in 1941, this Swiss engineer started thinking that maybe he could learn something from the burrs stuck to his dog after walks in the wild. Before too long, Velcro was born. A more recent example is found in Whalepower (www.whalepowercorporation.com), a company that is shaking things up in the fields of fluid dynamics and biomechanics. After studying and being inspired by, you guessed it, the bumps on the flippers of giant humpback whales, Whale Power is now designing and bringing to market a whole new style of serrated fan and wind turbine blades.

When it comes to managing investment portfolios, adding a touch of biomimicry to the traditional analytical mix of fundamental, behavioral and technical analysis seems like it certainly can’t hurt. Taking a page from de Mestral, I’ve been attempting to do just that over the years, including closely observing and taking inspiration from our family’s nine-year-old dog, Azuki.

Azuki, who usually goes by “Oz” 
(and in his not-so-good moments other names unfit for this family-friendly publication), is as best we 
can tell at least part Labrador Retriever. The balance of his gene pool is a product of Northwest Michigan mongrel promiscuity, with quite possibly a dash of kangaroo thrown in somewhere along the way (even at age 63 in human years, this dog still hops!). The fact that Oz made it into our lives despite the daily pleas of Price is Right legend Bob Barker is a testament to the resilience of his ancestors. That kind of street smarts isn’t exactly taught in business school, so I thought I would share a few of Oz’s distinguishing traits that I try to emulate in my work as an investment manager.

Superior Noise Filtering

Just when I think Oz has gone deaf, he will pick up a sound he doesn’t like and go all guard-dog ballistic. He knows when someone is at our door well before we do and will make sure any guests pass his muster before entering (door charge usually waived with anything resembling a dog treat, but that’s another matter). Then there is the distinct sound registered by a scooped cup of Iams Medium Breed Chunks that will jolt him out of the deepest bunny-chasing dream-slumber in the farthest reaches of our home and bring him sprinting to his bowl. But if our two young children come racing through the house, or if my wife needs a stress release and cranks up her old Iron Maiden CDs, or if I chuck the remote against the wall after another 4th quarter Detroit Lions choke-fest, Oz doesn’t even flinch. He has a gift many investors don’t: the gift of filtering out the immaterial and honing in on what matters.

Noise filters are quite valuable for investors today who must contend with a never-ending, 24/7 financial news cycle and “fear sells” media mentality. Ubiquitous access to financial news is a double-edged sword, especially if such information sparks emotional investment decisions, juices speculative impulses, or shrinks already diminished average investment holding periods (see Figure 1 on page 4).

Taking a page from Oz, we can boost our chances of long-term investment success by tuning out much of what passes as financial news today and focusing instead on developments most relevant to our holdings. For example, the relentless political bickering over fiscal cliffs, debt ceilings and the like will have minor if any bearing on what really drives the value of our portfolio companies: their long-term competitive positions and cash generation capability. The same might be said for the typical hubbub around quarterly financial results announcements. It is not unusual to see headlines declaring a penny “beat” or a penny “miss” of Wall Street earnings estimates trigger outsized, knee-jerk responses from investors. These manic share price moves, more often than not, prove short-lived and, if anything, provide opportunities for more rational investors to either buy cheap or sell dear.

Focused on Future Returns

Like a canine Wayne Gretsky (the hockey great famed for his ability to skate where the puck will be rather than where it has already been), Oz is well-skilled in anticipating and positioning for best risk-adjusted “investment” returns. In his world, such investment largely relates to efforts made to supplement his staple two squares a day. Oz knows, for example, that our five-year-old Maia is less likely to drop half a pancake on the floor than her three-year-old brother Noah who is still learning the concept of bite-sized pieces. So our crafty mutt has naturally shifted alliances and meal-time positioning to the other side of the table, staying laser-focused on Noah’s fork in anticipation of extra food scrap pay dirt.

Today, far too many investors drive by the rearview mirror, believing that what has worked in the past will produce similar results in the future. Unfortunately, our industry encourages this performance chasing with marketing that over-emphasizes past results and under-emphasizes investment process and philosophy. The end result is one where mutual fund investors, for example, historically tend to throw money at overheated markets and pull funds back after prices have already dropped (see Figure 2). This is, of course, exactly the opposite of what rational investors do (i.e., those who are more than happy to be sellers during market manias and buyers during market routs). Successful investors understand that the drivers of future stock and bond returns, such as initial valuation levels, inflation expectations, global economic growth prospects, and corporate competitive advantages, change all the time. Like Oz, we must shift when the (expected return) pickings get slim and position portfolios where risk-adjusted expected returns are most promising.

Ready to Work, Rain or Shine

In a former life, Oz may well have been a mailman, as he certainly seems to follow the motto inscribed on the James Farley Post Office in New York City:

Neither snow nor rain nor heat nor gloom of night stays these couriers from the swift completion of their appointed rounds.

Crummy weather conditions never seem to deter Oz from his “rounds,” which usually include a combination of running his masters to keep them in some semblance of shape, burying and unearthing tennis balls throughout the backyard, and marking the “guest books” of every mailbox on the block with his signature whiz. If performing these duties in driving rain or heavy snow means smelling like a wet sock for a few hours, then so be it.

Oz’s can-do work and play ethic regardless of external conditions makes him a model for investors, especially in the current environment where such conditions can seem so unpleasant. Suppressed interest rates, for example, make much of the government bond market practically uninvestable (if you desire positive, after-inflation returns that is, see Figure 3, on page 4). The global economic growth that helps drive future stock market returns, meanwhile, faces significant longer-term headwinds from bulging government debt burdens, shifting demographics and diminishing returns from globalization.

Although these poor external conditions present a massive challenge to the many managers leashed to rigid portfolio policy guidelines or efficient market investment philosophies, teams like ours retain the freedom to do what we are hired to do: minimize the risk of permanent capital loss and grow portfolios responsibly so that clients can reach their financial and life goals. We do this by building global portfolios one carefully selected position at a time with total return attributes expected to deliver over the long-term, rain or shine.

You can read about one of these positions here in this newsletter (see this month’s Portfolio Spotlight: Quest for Growth on page 7), and I will expand on how we can grow portfolios in a low-growth world in future articles. In the meantime, I would encourage each of you to look beyond the human world for new ideas and inspiration in your life. Observing the Azuki-meister over the years has provided multiple lessons that I’ve applied to my investing career, and I expect that closer attention to the natural world in the years ahead will provide many more.

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