conventional wisdom

IT WORKS UNTIL IT DOESN’T
the photo shows a wooden desk with a keyboard, notepad, pen, and balled up pieces of paper

We’re contrarians. We are not satisfied with conventional thinking that portfolio management requires plugging in the right numbers and then following the formula.

It’s not that simple—and it can actually lead investors astray.

Here’s the deal. Modern portfolio theory—one version of the conventional wisdom—uses rigorous statistical models that attempt to quantify volatility and risk in their many forms. The idea is that if you can measure and predict volatility then you can construct a portfolio that has only as much volatility as you desire.

We believe there are a lot of problems with this approach. These models all rely on the assumption that the market will continue to behave rationally. So when the market experiences irrational exuberance, statistical models quickly lose their meaning and begin producing nonsense.

For example, one measure of a stock’s volatility is called its “beta.” The more correlated a stock’s movement is to the broader market, the higher the beta. A high beta stock tends to be a big winner or big loser based on what the market is doing, while a low beta stock generally moves less than the market. A stock can even have a negative beta, where it tends to move the opposite way from the rest of the market!

Under normal circumstances, volatile stocks tend to have a high beta. But when a hot stock gets caught up in a speculative bubble, it can take on a life of its own. A stock on a hot streak that goes up even on days when the market is down will show a lower beta than stocks that follow the market but may still be volatile.

In cases like this, investment managers that are chasing “low beta” may end up with some very volatile holdings in a portfolio that claims to prioritize stability and low market correlation. And investors that are looking to avoid the roller coaster of the stock market may find themselves on an even bigger ride without realizing it.

We believe statistical analysis can be useful, but it cannot compete with timeless investment principles. Trying to quantify volatility exposure can lead to ugly surprises when the underlying models break down.

We think there’s another way. Instead of trying to mathematically capture and avoid it, we believe in living with volatility. If you are investing for the long haul and you know where your cash flow is coming from, you do not need to fret about day-to-day price action.

Clients, if you have questions about this or anything else, please give us a call.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Making Money the Old-Fashioned Way

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Years ago, the Wall Street firm of E.F. Hutton advertised “We make money the old-fashioned way. We earn it.” This tag line evoked a world of indepth research into securities and markets, and investment analysis by experienced professionals.

E.F. Hutton disappeared into a series of mergers, and making money the old-fashioned way is increasingly scarce. One popular theory now is that security selection does not matter, only the allocation of money across the different sectors of the market.

Combined with the idea that past patterns of volatility and past returns by sector should dictate what one should own for the future, many modern ‘investment advisors’ pay no attention to individual company stocks or bonds.

It seems to us that owning stock in a failing chain of department stores is a lot different than owning the world’s largest online retailer. A few automakers survived, hundreds did not. Buying a corporate bond for 50 cents on the dollar is a totally different proposition than selling it for 50 cents on the dollar. Owning some of everything is different than being selective.

Our experience says security selection DOES matter.

One of our strategies is to try to find ownership in great companies at decent prices, to buy and hold. Looking for cyclical companies at low points in the cycle is another strategy. And simply seeking bargains anywhere in the investment universe is a third.

This is not easy. Conditions are always uncertain. There are no guarantees. It takes a lot of effort and energy. There is no assurance that the old-fashioned way will make money, as E.F. Hutton claimed.

But we are trying.

Clients, if you would like to talk about this or anything else, please email us or call.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Two Economists

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The story goes like this. Two economists are walking down the street. One says, “Look! A $20 bill, just lying there!” and reaches to pick it up. The other says, “You fool! If that was really a $20 bill, somebody would have picked it up already.”

The underpinnings of this joke might be what is called the Efficient Markets Hypothesis, or EMH. It holds that all available information is already in the price of every security, so it is not possible to ‘beat the market.’ Related notions include the idea that investment selection does not matter, only the asset class or investment allocation.

Of course, our experience tells us that at times, certain investments do get mispriced. Condos in Las Vegas in 2007, tech stocks during the dot-com era, oil at $140 per barrel in 2008: all of these things seem to be examples of when the market was not efficient at all.

At these times, consensus expectations drifted far from the unfolding reality. “You can’t lose money in real estate” and “We’re in a new era, tech stock valuations don’t matter” and “Oil will never trade below $100 again” were the refrains of those faulty expectations. You may remember them.

Of course, we believe that the crowd can be wrong. That space between consensus expectations and the unfolding reality is where profit potential lives. One of our jobs is to try to find those exploitable anomalies and invest in them. Another is to go against the crowd when we believe it is wrong.

The simple rule, ‘never join a stampede in the markets,’ is one way we express this.

As a consequence, looking at the world with our own eyes, doing our own research, finding our own conclusions, this is what we do at 228 Main. It takes some courage to go against the crowd, to take unpopular actions, to stick with our strategies even when they require more patience than we had planned on. You and we are in this together: without your persistence, we could not do what we do over the long haul.

Hopefully from time to time we will find those $20 bills that others do not believe in.

Clients, if you would like to talk about this or anything else, please email us or call.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Magic Phrases

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A fresh-faced youngster in a cheap suit, I began in business working for a life insurance company. Its agent training program included the sales tactics common to that era, full of scripts and one-liners.

The conventional wisdom was that you had to take seven “no’s” from a prospect to get to the “yes.” Have you ever dealt with a sales person like that?

I learned how to irritate people to no end. Business was difficult.

It took me a while to realize that simply talking to people was a better way. The product was decent and had its uses: connecting in a genuine way made it possible to see if there was a fit or not. Trust went up, pressure went down. And there was no need to memorize sales tracks and magic phrases.

These early memories came back to me recently at a conference. One session featured a consultant who had some good ideas and interesting perspectives, though a lot of their program was never going to apply to us, since it was aimed at finding new clients. We strive to grow your buckets; new clients find us.

But their formula for greeting a referral for the first time took me back to those early sales days: “I’m calling as a courtesy…” In truth, the caller’s goal is to get in business with this prospective client. You know, close the deal, make the sale. Courtesy doesn’t enter into it.

This is how it sounded to me: “I’d like to start our relationship by pretending to do you a favor so you owe me one back.” This logic may work like magic on some people, but we are not here to manipulate anyone. The real magic is created together, through trust.

Clients, if you believe you would be helping a friend by introducing us, we will fit them in if they call. Or you can bring them along if we are having breakfast or lunch together. But we are not going to call them, nor pretend to do them a courtesy by doing so.

The better off you all are, the better off we will be, sooner or later. What goes around, comes around. When that is your agenda and your belief, pretense is unnecessary. Life is good—thank you for being part of ours. Email us or call if you would like to talk.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

The 61% Syndrome

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A few weeks ago we studied a report from a large institution. It stated that 61% of baby boomers preferred minimizing taxes to getting higher investment returns1. We wrote about this being a false choice: the rational object is to achieve the highest after-tax returns, thereby incorporating both goals sensibly.

But there is another problem with the 61% syndrome. There is a tendency for 100% of the attention to get focused on the 61%. It seems that the number is eventually forgotten. The formula is simplified to “The top priority of baby boomers is minimizing taxes.”

In other contexts, ugly words are used to describe the process of attributing perceived characteristics of a group to each individual in the group. Stereotyping and bigotry are costly to society to the extent that they hinder any of us from unlocking the highest fraction of our own potential, the secret sauce of American prosperity.

The forgotten 39% of baby boomers is 29 million people2. That is a lot of people to ignore.

We hear again and again that investors repeatedly do the wrong thing. But we don’t care whether most investors behave rationally; we just need you to do so. (In fact, when others behave foolishly that can create opportunities for us.)

It seems sort of insulting to start a relationship by attempting to prove to people that they will do stupid things and are incapable of learning. But when you attribute a perceived characteristic to every member of a group, you fail them in some way.

You may be familiar with Thoreau’s formulation: “If a man does not keep pace with his companions, perhaps it is because he hears a different drummer…” Many of you have seen the hand-lettered illuminated version of it hanging on my office wall. We are all about people as individuals, not stereotypes.

(Did you know my girlfriend lettered that saying and gave it to me when we were both seventeen? This has been fundamental for as long as I can remember. Extra credit question: what was the girl’s name?)

My unique story gives me respect for you and your unique story. It is how we aim to avoid the 61% syndrome and its related costs and lost opportunities. Clients, if you have questions about this or any other topic, please email us or call.

12016 U.S. Trust Insights on Wealth and Worth survey, U.S. Trust Bank of America Private Wealth Management

2Federal Reserve Economic Data, Federal Reserve Bank of St. Louis

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Classical Language, Mostly Classic Ideas

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A surprising number of Latin phrases are woven into modern society, considering the language has not been widely used for centuries. From simple truisms like tempus fugit (time flies) to mottos like e pluribus unum (from many, one), the wisdom and ideas of a civilization lost to antiquity survive.

The Roman historian Tacitus wrote “experientia docet,” experience teaches. We must take issue with this one. Investors make a critical mistake in learning from experience, in our view. They often learn the wrong lesson.

People sometimes adopt tactics and strategies that would have worked great in the last cycle. Unfortunately, times change and the outdated strategies usually fail to perform like they did before.

In the year 2000, following the stock market bust stocks fell—but home values rose. This taught people the wrong idea that “you can’t lose money in real estate”, which caused a lot of damage during the 2007 financial crisis. Then, by 2009, lenders learned the wrong lesson again—because auto loans outperformed in the downturn. Today they may be setting up future losses by putting too much money into substandard auto loans.

A related problem is best illustrated by a product pitch we recently received from an investment sponsor. Their latest offering is based on “the top performing asset class of the last decade!”

Clients, you know what our issue is with this. We love to buy bargains. The best performer over the past decade is, by definition, no bargain. Piling in after a big runup may be jumping on the bandwagon right before it goes off a cliff. However, the experience of the last decade evidently taught many that the specific sector was the one to buy now. Wrong lesson, again.

One interesting facet of all this is that experience actually can teach us. We just need to be certain we are learning the right lesson.

There were useful and profitable lessons in the tech wreck of 2000 and the real estate bust that began in 2007. In our view, those lessons are that it is dangerous to invest in over-priced assets—and it doesn’t pay to join a stampede in the market. Those lessons help us live with attractively priced stocks, and avoid the flight to safety that made historically more stable assets overpriced (in our opinion.)

So let us leave you with a little Latin of our own devising: cognitio ad felicitatem. (Knowledge leads to prosperity.) Clients, if you have any questions, comments or insights please email us or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

No strategy assures success or protects against loss.

Stock investing involves risk including loss of principal.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Safe is the New Dangerous

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We strive to see the world as it is, and act accordingly. Going by the textbook and implementing conventional wisdom without testing it against actual conditions is not in our playbook. What we see today is nothing short of astonishing—for two reasons.

“Safe” has become the new dangerous. We are astonished at how the investment world appears to be upside down in some respects. And we are astonished that so few of us seem to have noticed.

During the year 2000, the technology-heavy Nasdaq Composite index fell over 39%1. This crushing of technology and growth stocks at the start of the millennium and the financial crisis that arose just seven years later drove fear of the stock market deep into the psyche of some investors. Consequently, we believe there has been a flight to safety that has created some real anomalies.

Yields on long term government bonds and high yield corporate bonds have fallen to near historical lows not seen in over 50 years2. It isn’t just in bonds, either. Supposedly safe stocks appear to be the most expensive part of the market.

Standard & Poors reports that the market average price to earnings (P/E) ratio is about 18. Food companies, shampoo makers, toothpaste sellers, medical supply companies and utilities are priced at a premium because those lines of business are assumed to be recession-proof…you know, safe. In an 18 P/E market, these companies are priced at 22, 25, 30, or 34 times earnings3.

We have owned many of these companies in the past at P/E’s of 10 or 12 or 14. Why anyone would own an electric utility when solar plus battery technology is bound to turn them upside down is beyond us. (We wrote about the coming change here.)

Consequently, we believe that allegedly “safe” stocks have become so expensive they are dangerous. The textbook says utility stocks are safe. We look at the world and say, “Not really.” Safe is the new dangerous.

Meanwhile, there are market sectors and companies priced below the market average P/E, including some with dynamic prospects in the years ahead. We believe the stocks we own are bargains. That’s an opinion, not a guarantee. You know we don’t offer guarantees, except that values will fluctuate.

Clients, if you would like a longer conversation about this upside down situation or any other topic, please email us or call.

1Nasdaq, Inc.

2Federal Reserve Economic Data, Federal Reserve Bank of St. Louis

3Standard & Poor’s, Inc.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Floating rate bank loans are loans issues by below investment grade companies for short term funding purposes with higher yield than short term debt and involve risk.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

Government bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

Change is the Only Constant

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The ability to adapt to changing conditions is what sets those who thrive apart from those who merely survive.

Our portfolio theory evolves over time as economic and market conditions unfold. The problem with the textbook approach in a changing world is that a textbook, once printed, never changes. Looking at the world as it is and doing our own thinking, we see things in a new way.

We believe that central bank intervention and counterproductive monetary policies have distorted pricing in the bond market and for other income-producing investments. By crushing interest rates and yields to very low levels, the old investment textbook has been made obsolete.

Therefore the classic advice about the proper balance between stocks and bonds brings new and perhaps unrecognized risks, with corresponding pockets of opportunity elsewhere. Yet the classic advice met a need which still exists: how to accommodate varying needs for liquidity and tolerance of volatility.

Our adaptation to this new world is the portfolio structure you see above. Our classic research-driven portfolio methods live in the Long Term Core. We believe our fundamental principles are timeless, and make sense in all conditions.

But people need the use of their money to live their lives and do what they need to do. So a cash layer is needed, tailored to individual circumstances.

The layer between is ballast. This refers to holdings that might be expected to fall and rise more slowly than the overall stock market. Ballast serves two purposes. It dampens volatility of the overall portfolio, thereby making it easier to live with. Ballast may serve as a source of funds for buying when the market seems to be low.

The client with higher cash needs or who desires lower volatility may use the same long term core as the one who wants maximum potential returns. One may want a ‘cash-ballast-long term core’ allocation of 10%-25%-65% and the next one 4%-0%-96%.

The adaptations we’ve made have generated efficiencies and therefore time—time to work individually with you on your plans and planning, time for more frequent portfolio reviews, time for more intensive research.

Clients, if you would like to discuss how this structure might fit your needs, please email us or call us.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Sell in May and Go Away?

© Can Stock Photo Inc. / photocreo

One popular piece of market lore revolves around the idea that virtually all of the stock market’s cumulative gains over large chunks of the past have come between November and May. The other half of the year, from May to November, has produced little in the way of gains, on average. Hence the saying, “sell in May and go away.”

There are three challenges facing anyone who seeks to act on this supposed wisdom. The first one is, any widely expected event gets discounted by the market as it gains currency with the public. If the saying works, it will get overexposed until it stops working.

The second challenge is, the statistics on which the lore rests are averages—they say nothing about what happens in any particular year, much less about what will happen this year.

The third challenge is the most interesting of all. When one examines the results of not selling in May and never going away, one wonders what more could be desired. I (Mark Leibman) was born in May 1956, when the S&P 500 Index stood at 44. As I write this, the index is 54 times higher. This calculation of a 5,300% profit excludes dividends, which would have added considerably. This tells us how not selling in May would have worked over the past nearly sixty years.

Our purpose in writing is to help you avoid being tricked by the “Sell in May” idea into a short-sighted investment decision. There are always reasons to worry about the future, developments which alarm people, and fear mongers peddling pessimism for profit. Against the dynamism and ingenuity inherent in human endeavors, these fears and worries have yet to produce a permanent downturn in the economy or the market.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss.

Indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

They Say You Can’t Handle the Truth!

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The conventional wisdom in the investment business is that you can’t handle the truth. Our whole business is built around the idea that you CAN handle the truth. Some were born that way, and others may be trained to handle the truth. The stakes are quite high, because those who can handle the truth about investing may be more likely to enjoy success at it.

We humans do have some tendencies which are both deeply rooted and counterproductive to informed investing. The easy path for us would be to pander to those tendencies, affirm them, pat you on the back and take your money. Here are some examples of that:

“They” (the adherents of flawed conventional wisdom) promote the idea that the pain of a loss is twice as great as the pleasure of a similarly sized gain.

“They” speak of temporary downturns as if they were actual losses, a disservice to long term investors.

“They” promote the idea that arithmetic works against investors, since a 20% loss must be followed by a 25% gain in order to break even.

“They” sacrifice total returns on the altar of expensive new products or stagnant investments in the hopes of reducing volatility.

We, on the other hand, believe you can handle the truth. Our experience confirms this. Here is the truth:

1. Long term investing always involves living with volatility, there is no way around it.

2. The ‘pain of a loss’ is optional—it may be offset by the joy of finding bargains, or ignored in the confident knowledge that downturns are temporary. The economy and markets always muddle through and eventually recover.

 3. According to Standard & Poor’s records, over the century’s experience with the Dow Jones Average, so far every 20% loss has been followed by a greater than 25% gain.

4. Investing for the long term in accordance with proven principles, using timeless strategies and timely tactics, in a manner that can get you to your goals, is the right way to do it.

We believe that people who keep some money in the bank, and who know where their needed cash flow will come from, can usually live with our methods and strategies with at least some part of their wealth. And we know that others may not be able to do it. Some lack the confidence that the system will endure, others just cannot tolerate fluctuating account values. It takes all kinds to make the world.

Our aim is to add value to those who can handle the truth, as we’ve defined it here. We work hard to educate and train and impart perspective and context…and it has worked. As always, if you have questions or comments, please write or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss.