I am not a legal scholar by training, but I have read our Constitution. Nowhere in it does it say that we have the freedom to succeed but not to fail. I have also not been able to find passages that say we can have corporations buy elections, require universal health care, or send our sons and daughters to build nations and police the world with violent force. And while it does lay out a list of explicit rights, our Constitution does not delineate specific responsibilities. Rather, it presumes that citizens will, among other things, act lawfully, serve on juries impartially, and exercise our rights to vote.
The Constitution was purposefully designed to be a “living” document that would change as society developed. This adaptability has kept it resilient and relevant amid major changes to societal values over time including the issues of slavery and women’s right to vote. We are a melting pot of immigrants despite what some twitter users have said about our 2013 Miss America.
Since the framing of our Constitution, America has grown to become a nation of more than 300 million people. One-third of us live in just five states. We have can-do, live on the land “pro-sumers” who grow their own stuff, fix their own cars and build their own homes wondering why anyone would want to live in a walk up apartment condo in Manhattan or a four bedroom home in a clean suburban neighborhood and vice versa. Our national DNA is a blend of dozens of races, ethnicities, values, cultures, and religions.
Governing such a melting pot is, understandably, a messy proposition. Compounding such a messy endeavor is decades of policy-maker focus on symptoms rather than root causes of our major challenges. Instead we seem to have a citizenry that is either polarized into opposing “camps,” or just plain more interested in other matters like who the next American Idol winner will be or how to improve their lagging Fantasy Football teams.
In our team’s professional world of investing, we see the interaction of messy government, global economies, and diverse financial market participants every single day. The government, with its ability to regulate, levy taxes, set interest rates, print money and champion major wealth distribution programs, seems to have lulled the average investor to behave in a way that is, well, “un-American.”
Early in my career (1980s), I remember chatting with a fellow manager who would not invest in any industry that was government-regulated – he did not want the companies he bought to have a cap on their ability to generate profits. Today, many investors seem to favor government intervention and policies that aim to put a cap on risk. We’ll take our volatility on the upside, please. But feel free to put in a nice high floor to any downside that tries to threaten our portfolio. If the price for such “policy insurance” is more national debt, more “malinvestment” from the deluge of artificially low credit, or more unknown consequences for the next generation, so be it.
Indexing strategies seem to be a perfect fit for such investors. Why pay for thoughtful, proactive management when Uncle Sam continues to offer a “free lunch” of reward without risk? Invest in one holding at a time after a disciplined analysis of price and the fundamental quality of real businesses? Nah. Just position the portfolio with a little bit of everything and bank on the extraordinary policies spawned during the crisis to remain intact forever. No work, no company-specific analysis, and “poof,” returns aplenty.
Common sense and centuries of market history tell us there is no free lunch and that unsustainable trends are unsustainable. That blindly owning a “market,” and expecting the returns to flow irrespective of valuation and quality assessments is an irrational long-term strategy, and one that can be financially devastating.
Our approach, of course, is the polar opposite of index investing. Among thousands of global companies, we handpick the ones whose stocks and bonds we believe offer the most compelling future risk-adjusted returns. There are many great businesses out there, most of which spend very little time worrying about 23% taxes going to 35% or what short-term interest rate changes mean for their cash balances, or if Yellen is going to succeed Big Ben at the Fed. Great businesses worry about selling goods and services. They worry about competition. They worry about their products and their product strategy and how to come up with great products and services in the future to serve their customers well. We invest in a select number of companies with strong, flexible business models run by real business people that get up full of vigor each morning, grateful that they have opportunities to pursue on behalf of their employees, shareholders and communities they serve.
I sometimes find myself thinking about the past with rose-colored glasses. I think about the nice, simple past, and how it seems different, more challenging now. As my mother, born in the Great Depression says, ”Paul those good ol’ days weren’t all that good!” Mom grew up with stories about the ravaging effects World War I had on families, the Great Depression pulling at our pride, World War II, segregation, and such. My past is an innocent time of riots, presidents being assassinated,18% interest rates,10% inflation, gas lines, and the Vietnam War.
While we want to believe that the past was without gut- wrenching challenges and that today’s challenges are somehow exceptionally fierce, the reality is that challenges have always been and always will be part of life. The future will no doubt have its messy moments, it will not be simple, and it will not be boring. Like our Constitution and the high quality companies that we choose to invest in, resilience to this future will be driven, at least in part, by the ability to flex and adapt to ever-evolving conditions. Staying disciplined, realistic, and optimistic, traits that permeate through our team, will also help.
I conclude this note with a few quotes on successful investing and successful life that have influenced our team over the years. If more Americans followed the wisdom of these influencers, We the People, would likely be much more closer to achieving the perfect Union conceived by our founders. And if our financial house as a nation were in better shape as a result of acting on this wisdom, The Blessings of Liberty they aimed to secure would likely face far fewer threats than they face today.
“Happiness and moral duty are inseparably connected.”
- George Washington “An investment in knowledge pays the best interest.”
- Benjamin Franklin
Paul’s Note: Which goes along with “Invest in yourself. Your career is the engine of your wealth.” - Paul Clitheroe
Your work and how you use your time and resources is the engine of any success in life. Our choices decide our fate.
“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”
- Warren Buffett
Paul’s Note: Realize that financial media is just reporting news-do not mistake this for investing advice– investing is a disciplined process – it is not watching a TV channel or reading a internet blog.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.”
- Phillip Fisher
Paul’s Note: Identifying dislocations between value and price is always where the real money is made. Buying assets that are bargained price and patiently waiting for others to realize the value has always been the winning strategy of investors.
“In investing, what is comfortable is rarely profitable.”
- Robert Arnott
Paul’s Note: Common sense tells us that investments will fluctuate up and down. Realizing this requires that investors have patience. Can you handle staying in when everyone else is selling? Or can you sell when others are saying buy? The best investment strategy can turn into the worst if you don’t have the stomach to see it through.
“How many millionaires do you know who have become wealthy by investing in savings accounts [or annuities or insurance products]? I rest my case.”
- Robert G. Allen
Paul’s Note: Annuity salespeople are licking their chops at the opportunity to sell to frightened boomers. Be very wary of these pitches.
“The individual investor should act consistently as an investor and not as a speculator.”
- Ben Graham
Paul’s Note: It seems that everyone wants to “time” the market and make money on short term fluctuations. Everyone portrays themselves as long term investors while things are going up. Have a few months of testing times like we had this summer with fixed income, income stocks and interest rate sensitive investment and the “long term investor” heads for the hills. That market panic behavior creates bargains for the disciplined, savvy, true long term investor.
”Financial peace isn’t the acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.”
- Dave Ramsey
Paul’s Note: By being modest, living within your means, and not being “flashy” so to speak in your spending, you can ensure you will have enough and can give back to family and the community as well.
“The four most dangerous words in investing are: ‘this time it’s different.’”
- Sir John Templeton
Paul’s Note: Follow markets, scenarios, trends and history. Don’t speculate that this particular time will be any different-prove it is different with realistic, thoughtful analysis. And when you have conviction, invest. History shows that it is better to be early than late.
“Wide diversification is only required when investors do not understand what they are doing.”
- Warren Buffett
Paul’s Note: Many investors own assets that are of poor quality, overpriced or just “dumbing” their portfolio down – held in the name of “diversification”. In past newsletters I have said if any one tells you to just go with a simple asset allocation / indexing scheme RUN. Asset allocation or diversification is a tool of investing-not a viable strategy on its own.
“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.”
- Peter Lynch
Paul’s Note: When hit with downdrafts, poor performance or periods of declines, investors must stay the course. Economies and markets are cyclical. History shows that markets recover. Investors must be invested to participate in those recoveries!
“Associate with men of good quality if you esteem your own reputation; for it is better to be alone than in bad company.” - George Washington
Paul’s Note: This goes for investing too; Why invest in companies whose management have cooked the books, produce products that kill people or have a history of not being guided by a moral, ethical compass?
“Responsibility is the price of freedom.”
- Elbert Hubbard
Growing up on a small lake in Southwest Michigan meant plenty of on-water adventures with my younger brother, Ben. One of our favorites was to see how many times we could turtle our family Sunfish sailboat on the windiest summer days. We sought out conditions offering the fiercest tailwinds and ran that little boat as hard as we could. When the wind finally defeated us, we bailed overboard, dug the mast out of the weeds and muck, and started all over again. More than once, Mother Nature decided to leave us windless and stranded in the middle of the lake. For those occasions, we usually remembered to bring along two critical items: a coin to flip and a small wooden paddle by which the loser brought us back to shore.
These sailing expeditions took place in the late ’80s, when tailwinds of a similar epic magnitude drove an incredible two-decade run for U.S. financial markets. If there ever was a heyday for passive, “buy the market” investing strategies in both stocks and bonds (or some “balanced” strategy combining the two), this period was it.
Take a look at Figure 1, which shows the year-by-year tally of U.S. stock and bond market returns over this 20-year period. The stock market was on fire, with 18 positive years (13 of which gained more than 15%!) and only two negative ones (both low single-digit declines). Bonds, meanwhile, had a party of their own, with plain-Jane “risk-free” U.S. Treasury bonds down only four of those 20 years, and 10 of the 16 positive ones offering more than 10% total returns to investors. Like Sonny Crockett’s daily commute-to-work options during this era (Testarossa or Scarab?), investors mulling stocks v. bonds had serious horsepower for their portfolios either way (cue the Miami Vice theme song...). Simply combine the two asset classes with a traditional 60/40 balanced split between stocks and bonds, and you batted 19-for-20 with a strong majority of these years double-digit to the upside!
So what were the tailwinds behind this run for the ages? Four interconnected biggies stand out.
Inflation is the enemy of bond and stock i
nvestors alike. After all, the fundamental value of a stock or bond is simply the sum of all expected future cash flows from the investment (whether these cash flows be interest and principal payments in the case of bonds or dividends and retained/reinvested earnings in the case of stocks). When inflation expectations rise, investors demand more compensation for the risk that inflation will erode the value of these future cash flows. This compensation is reflected in markets via discounted stock and bond prices.
Yet when inflation expectations fall, as they did throughout the ’80s and ’90s, the reverse takes place. Investors entered this golden era of investment returns with inflation running at levels not seen since the ‘40s. As inflation normalized lower throughout the ’80s and ’90s, so too did interest rates. Investors who could hold their nose and buy bonds in the early ’80s locked in not only the double-digit annual interest income on offer at the time, but also significant bond price appreciation as rates declined. Equity investors, too, demanded less inflation compensation as the horrors of the ’70s faded from memory. This, coupled with the Mega Tailwinds noted below, helped drive stock prices steadily higher. Figure 2 illustrates this by comparing the annual inflation rate versus the price-earnings ratio of the S&P 500.
Declining inflation was not the only reason stocks had such a fabulous run in the ’80s and ’90s. There was also a little dot-com mania that really stoked the speculative juices in the latter part of the ’90s. Remember stocks like Pets.com trading up to nosebleed levels before crashing and burning? Fervor for anything with an “e” or a “dot-com” in the business model drew a frenzy of buying activity. By 1999, as Prince foreshadowed with his hit anthem in 1982, the entire market had joined the party. Stock valuations surged, hitting levels never seen before in modern market history (see the late 1990s surge in the price-earnings ratio in Figure 2).
By now it is certainly not news that American debt levels began
their dramatic ascent in the ’80s and continued rising right into the big financial bust of 2008 (Figure 3). This debt supported an unsustainable arms race of sorts among the masses to build bigger McMansions, drive more expensive cars and buy all kinds of other stuff (including stocks) on borrowed money. Companies responded to this demand by taking on more debt of their own, investing globally in the materials and labor to produce this stuff, and presto, the global economy appeared to be booming. Wages went up, bonuses went up, demand for investments went up, and stocks and bonds rallied. How much of this “growth” was real and how much was just a function of financial steroids? Hard to say, but it seems pretty safe to surmise that the return numbers in Figure 1 would look a lot less robust in a world where leverage stayed on the modest growth path it traversed pre-1980.
In FIM Group’s August 2013 Current Observations (see “The Expectations Game”), I touched on the relationship between the so-called Yuppie/Nerd ratio and bond yields. This ratio measures the ratio of the population aged 20-34 (“Yuppies”) divided by those aged 40-54 (“Nerds”) and correlates quite nicely with bond yields. During times when the Yuppie/Nerd ratio has been on an upswing, bond yields have risen, and when the older demographic outnumbers the younger, yields have fallen.
Harry Dent is probably the most renowned demographer when it comes to financial market patterns like this, and he makes a pretty compelling case for the “demographics is destiny” argument on a wide range of economic and financial market trends. Dent’s examination of the impact that Boomers have had on the economy and financial markets over time, for example, links the surge of Boomers entering and exiting the workforce as a key force behind the inflation of the 1970s and the deflationary pressures of today (Figure 4).
This inflation, as noted above in Mega Tailwind #1, was likely a major factor behind the subdued stock and bond returns of the ‘70s from which returns exploded in the ‘80s and ‘90s. Dent’s work and others also link the age-progression of the Boomers with rising stock market valuation multiples. They reason that not only did a Boomer spending wave in the 1980s and 1990s drive higher corporate earnings, but that their savings also found their way into stock and bond markets, pushing investment prices higher. Add sock puppet commercials into the mix along with easy access to debt, and by the end of this era the stock market was trading up in the stratosphere.
Fast forward to today and it should be clear that the tailwinds noted above ultimately proved unsustainable. Inflation reached stability at low levels, dot-coms became ubiquitous, the debt bubble popped and the Boomer spending wave crested. “Buy the market” strategies which worked so well for investors in the ‘80s and 90s have been far less fruitful since the turn of the century. And given the broad set of headwinds facing such strategies today, including above-average stock and bond market valuations, broad-scale deleveraging and aging Boomers, such strategies will likely continue to disappoint investors.
Fortunately, FIM Group’s Investing Without Borders philosophy permits a much more flexible and dynamic approach. Our investment team seeks compelling investment values across asset classes, market capitalizations, sectors and geographies. We focus not on matching or beating a popular index like the S&P 500, but rather on the generation of long-term returns that support the achievement of each client’s unique goals. Within our four core investing strategies, we embrace acceptable levels of short-term volatility to capture longer-term return opportunities, and we emphasize minimization of permanent losses as our primary risk management priority.
Although headwinds to the broad U.S. stock and bond markets remain challenging, we continue to find less noticed, but potentially powerful tailwinds at the company and sector levels. Some of these tailwinds come in the form of compressed valuation levels that we expect to normalize over time.
Heavily discounted closed-end bond funds such as the ACM Income Fund, special wind-down equity situations like Macquarie International Infrastructure and out-of-favor, deep restructuring stories, including the one underway at RHJ International, fit into this category.
Other tailwinds can be found that explicitly support earnings and cash flow growth. One example of this is when a fragmented industry consolidates, providing organic and acquisition-led market share growth opportunities. European fruit wholesalers Fyffes and Total Produce are two companies riding just such a tailwind. Another is a long-term positive macro economy and demographic backdrop such as the one in Indonesia benefiting hospital landlord First REIT and shopping center owner Lippo Malls. In our monthly Investment Team Spotlights and regular webinar series, we highlight holdings like these and our reasoning behind their inclusion in managed portfolios.
With the flexibility and experience to seek out such tailwinds, wherever they may be, our team remains confident in our positioning and optimistic toward the future. Taking a disciplined, thoughtful approach focused on investment price and investment quality one position at a time gives us an enduring advantage that is especially important in environments like the one we are in today. We buy positions and hold positions only when we feel valuation or growth (and often both) tailwinds remain solidly in place. When such tailwinds no longer look attractive, we sell, break out the paddle and navigate to better opportunities.
Andy Rooney was the TV personality who would critique the mundane while many folks watched 60 Minutes each week from 1978 into 2011. He was famous for being the cantankerous guy with the shaggy, unkempt eyebrows who would grouse on Sunday evenings about ridiculous things such as the difficulty of cracking nuts with nutcrackers and collecting useless kitchen gadgets. Yet, it was through Andy’s unique style of asking himself a series of questions on his subject matter that captivated the audience on whatever Andy happened to be kvetching about that week. After “A Few Minutes with Andy Rooney,” the viewers would decide if Andy either had a logically good or an irrationally bad philosophy on his chosen topic.
It is also through the use of questioning that discovery is made on an individual’s preference for risk tolerance. Physical, social, ethical and financial are the four main types of risk tolerance based on research studies. Notably, the person who is inclined to mountain climb (physical risk) is also the person who might be interested in driving a motorcycle (physical risk). However, the individual who is willing to attend a party on their own (social risk) may not necessarily be willing to employ significant levels of risk in their investment portfolios (financial risk). This tells us something about psychological risk patterns. Individuals are typically unvarying within their risk taking patterns among a singular risk type such a physical risk. Conversely, risk tolerance does not necessarily remain constant across risk types, e.g., social and financial.
Risk tolerance is an emotional feeling based on making educated decisions for which there is no certain outcome. Simply put, risk tolerance is based on an individual weighing the balance point of a multitude of factors and the potential gains and losses.
One’s financial risk tolerance can begin to be understood when the act of questioning unfolds. This allows an investor to gain self-knowledge of how much risk can be handled. Self-knowledge is a useful tool that can keep investors from making impulsive financial decisions that can lead to adverse effects on a portfolio. Most investors can easily stomach large upside swings in their portfolios; it is the downside drop that creates the indigestion. Financial risk tolerance is personal and uniquely belongs to each investor. There is no “right” or “wrong” answer. Only the individual can explain her or his attitudes about risk. According to the International Standards Organization, “risk tolerance is best defined as the extent to which a person chooses to risk experiencing a less favourable outcome in the pursuit of a more favourable outcome.”
At FIM Group there are four categories of risk tolerance used to manage client portfolios:
Growth investment portfolios are managed for favorable total returns from an actively managed, diversified global portfolio of equity (stocks and convertibles) and fixed-income (bonds and cash equivalent) investments. Our goal is to maintain, compound and enhance the Growth portfolio’s purchasing power. Over time the Growth portfolio will emphasize equity investments. Growth portfolios are managed with up to 100% equity investments for positive, consistent returns over rolling four- to five-year periods. A secondary goal is to limit the portfolio’s value at risk in any single year to approximately 35% through active management, careful security selection, diversification, asset allocation and other risk-management tools.
Balanced investment portfolios are managed for favorable total returns from an actively managed diversified global portfolio of equity (stocks and convertibles) and fixed-income (bonds and cash equivalent) investments.
Our goal is to maintain, compound and enhance the Balanced portfolio’s purchasing power. Over time the portfolio will emphasize equity investments. We are managing the portfolio for positive, consistent and compounding returns over three- to five-year periods. A secondary goal is to limit the portfolio’s value at risk in any single year to approximately 25% through active management, careful security selection, diversification, asset allocation and other risk-management tools.
Balanced Conservative investment portfolios are managed for favorable total returns from an actively managed, diversified global portfolio of equity (stocks and convertibles) and fixed-income (bonds and cash equivalent) investments.
Our goal is to maintain, compound and enhance the Balanced Conservative portfolio’s purchasing power. Over time the portfolio will primarily emphasize income-oriented, fixed-income and equity securities, and secondarily equity investments. Balanced Conservative portfolios are managed for positive, consistent and compounding returns over rolling three- to five-year periods. A secondary goal is to limit the portfolio’s value at risk in any single year to approximately 20% through active management tools.
Yield Income investment portfolios are managed for favorable total returns from an actively managed, diversified global portfolio of equity (stocks and convertibles) and fixed-income (bonds and cash equivalent) investments.
Over time the Yield Income portfolio will emphasize fixed-income and income-oriented equity investments. Yield Income portfolios are managed for positive consistent returns over rolling three- to four-year periods. A secondary goal is to limit the portfolio’s value at risk in any single year to approximately 15% through active management, careful security selection, diversification, asset allocation and other risk-management tools.
The answers to these questions are not always cut and dry. It is the self-discovery from the questioning process that leads an investor to understand how they personally feel about their tolerance for financial risk. For example, just because an individual has large income streams does not directly correlate to a willingness to take on large amounts of risk. One of Andy Rooney’s famous essays was titled “Type A, Type B Personalities.” He explained, “Each of us faces an important question … and that answer puts us in one of two categories.” Part of Andy’s shtick was to ask a litany of questions and have the viewer come to their own conclusion of their personality type. Unearthing the gut feelings each of us owns on financial risk tolerance is quite similar to Andy Rooney’s critiquing of personalities.
FIM Group encourages you to explore your personality by asking questions that can lead to discovering your personal financial risk tolerance. Asking hypothetical questions can often be the most telling. Try to think of experiences or situations in which you definitively felt one way or another. Getting a handle on your tolerance for financial risk can be an uplifting and gratifying experience. You may find yourself smiling once you experience a breakthrough and realize what feels financially right for you. And as Andy Rooney once said, “If you smile when no one else is around, you really mean it.”
Keep in mind, a portfolio meeting risk tolerance goals may not necessarily meet a client’s financial needs. If a risk-averse investor has specific retirement goals, they might not align with the portfolio being worth enough to adequately provide throughout retirement. If you had or are expecting to have a change in your financial situation that might influence your investment strategy, please contact us at FIM Group.
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