Clarity

Part of the reason for this blog is to share my feelings about current events. Part is that I enjoy writing. Part is that I hope it helps to inform others about our firm and our philosophy.

This morning I feel moved to write, as I am reading a book and various thoughts came together and became very clear…..and provided some real clarity.

I’m reading The Big Short, by Michael Lewis. He is a terrific writer, who has written a number of financial and non-financial books, many magazine articles, as well as wrote the book The Blind Side, which became the movie.

I am only part way through the The Big Short, which describes how a number of individuals placed huge financial bets against the home mortgage markets in the late 2000s, and made fortunes. The book is fast paced and very interesting, and as of now, I highly recommend it.

Yesterday, in a office meeting, as a result of a number of seminars that Keith and I attended in May, the word clarity was brought up. While reading this book this morning, I looked up the word clarity (in an old fashioned real dictionary): the state or quality of being clear; transparency; a difficult idea presented with clarity.

In The Big Short, it describes how Wall Street firms, mostly Goldman Sachs and AIG, combined and restructured residential home loans, most of very poor credit quality, into what later became AAA loans (top rated and considered very safe). Essentially, these investments/products were the complete opposite of “clarity,” to everyone except for the few individuals who are featured in the book, who truly understood what a sham these products were, and were willing to bet against them. As Lewis describes it, Goldman and others took lead and turned it into ore, and then turned it into gold, then sold the gold to investors. If a portion of the lead was not immediately turned into gold, they would take the residual lead, and then turn that into gold also (from page 76).

This is meaningful to me, and thus my clients, as I consider the evolution of my firm and our investment philosophy from day one. One the fixed income side of investing, we have completely avoided corporate bonds (debt), due to the academic research that showed that the risk of default, while relatively low, was not worth the risk. When first presented with these concepts and information in 2002 and 2003, I was skeptical. I followed the advice, but did not completely buy into it. But it was totally correct. With new clients, we almost always sell many of their fixed income investments, as we do not think they are safe enough. On behalf of a non-profit that I’m involved with, I had many discussions about these matters with a top leader many years ago, who has since passed away. Fortunately, they agreed with me and we restructured their investments. We have almost always purchased only CDs, and top-rated municipal bonds and governmental agency bonds for our clients. We can understand these. They are clear and transparent.

When it comes to alternative investing, a phrase for hedge funds (which are mutual funds that are private, not like public mutual funds, in which the investors really don’t know what the manager is investing in), we have also avoided these, for many reasons. Most importantly, if you can’t see what you are investing in, and can’t understand it, why would you invest in it?

So back to clarity. The investments we use for our clients, to implement their investment plans, are clear and straightforward. They are not hard to understand. The result of this is the comfort that the clarity provides. By knowing and understanding what you are invested in, and that you have an investment plan, we have provided clarity and comfort.

In Michael Lewis’ book, I’m reading about the products and actions that Goldman Sachs and AIG and others are doing (or were doing a number of years ago). While I do understand it, it is beyond comprehension, in terms of rationality. There was not clarity to the American public. There was not even clarity to many of the people and companies that were involved. There certainly was not full disclosure (and Lewis has some strong comments about Goldman Sachs!).

Did You Learn from the Past?

As Warren Buffet has said, the stock market can be a great teacher. While the Gulf Oil spill is certainly a terrible environmental disaster, it also provides another vivid reminder of the risks of concentrating your portfolio in a few stocks or allowing one stock to become a huge portion of your wealth.

This story has been repeated many times in the past. Many well known names, that were considered safe, incur huge declines, sometimes in a day or two or within months, without any prior warning and certainly not predicted or knowable in advance.

Think of:

Merck and the Vioxx legal issues (dropped almost 50% in very short time period)

British Petroleum (down almost 50% since the oil spill occurred)

General Electric lost 88% from its peak in 2008 to early 2009

United Health Group, which lost 40% during 2006 due to corporate options issues

The key is to structure your portfolio so it can withstand an event such as the BP oil spill. By owning a broadly diversified global portfolio, your lifestyle will not be dramatically affected by the events (or failure) of one company or one industry.

Isn’t that the goal anyway? To reach a level of financial comfort, by saving and investing, so that you can enjoy your life, regardless of the success or failure of one or a few companies in your portfolio. For our clients, that would be our goal!

Wealthy Thoughts – 2

A collections of thoughts and ideas about various things…..

“The US has discovered nearly $1 trillion in untapped mineral deposits in Afghanistan… enough to fundamentally alter the Afghan economy and perhaps the Afghan war itself…,” the New York Times reported on June 13.

These mineral deposits are so big that Afghanistan could eventually be transformed into one of the most important mining centers in the world, according to an internal Pentagon memo. It states that Afghanistan could become “the Saudi Arabia of lithium,” a key raw material in the manufacture of batteries for laptops and cell phones. The article states that Afghanistan’s current gross domestic product is only $12 billion.

A Federal Reserve research paper released Monday by the Federal Reserve Bank of San Francisco indicates that the Federal Reserve is likely to wait until 2012 before it starts to raise interest rates. This paper does not represent the official position of the Federal Reserve, but it is notable. The author based his research on the relationship between consumer price inflation and unemployment statistics over the past 20 years.

The authors stated that given these historical relationships, the Fed in theory should have lowered short-term interest rates by another 5% in 2009. That was already impossible, as the short-term interest rates that the Federal Reserve controls were already near zero.

We do not view this research as a direct indication of what the Federal Reserve will actually do. Although we do not make investment decisions based on predictions of when or by how much interest rates will change in the future, this certainly gives credence to the concept that interest rates in general may remain very low, on a historical basis, for the next year or two.

Mortgage rates again near all-time lows
For the week ended June 11, Freddie Mac reported that interest rates on 15 and 30 year mortgages fell to their lowest level of 2010 and were just barely above their all-time lows.

The average for a 30 year fixed mortgage was 4.72% and 15 year mortgages averaged 4.17%, the lowest since this began to be reported in 1991. (per LAtimes.com, 6/11/10)

Sources:
The New York Times, US Identifies Vast Mineral Riches in Afghanistan, June 13, 2010
The New York Times, Fed Study Suggests Rates Will Stay at Record Lows until ’12, June 14, 2010

The Value of Real Research

Most traditional Wall Street research is based on an analyst making a prediction on a particular stock, usually by providing a rating on the stock and a future price target.

Our firm does not use this type of strategy. We focus on a client’s long-term goals, meeting their needs and determining an appropriate asset allocation. To implement their investment strategy, we rely on sound financial principles and academic data. Hopefully the following will clearly contrast this difference.

The Wall Street Journal reported on June 11 that Goldman Sachs was suspending coverage of many high-tech companies, after the departure of their lead analyst. This means “our current investment ratings and earnings estimates for the stocks are no longer in effect and should not be relied upon.”

The Journal stated: “clients have had reason to wonder whether they should have relied upon some of Goldman’s calls in the IT hardware sector. We previously highlighted the fact that Goldman’s stuck with its neutral rating on Apple from December 2008 to the present.” Goldman actually downgraded Apple in December 2008 to “neutral.” The shares are up more than 150% during this period. In changing its rating on December 15, 2008, Goldman cited weakening consumer demand for Apple’s products. This analyst could not have been more wrong in his analysis and future “prediction” (my term) for Apple.

When we implement a client’s stock portfolio, we generally utilize a fund manager that focuses on broad, global diversification. Their investment management is based on many years of rigorous academic research, not on predictions about specific stocks. As a result of their continuous research, they recently informed us that they will be excluding a certain segment of stocks from their small stock mutual fund.

This small cap strategy would currently hold about 2500 eligible stocks. Based on the new research, they will exclude approximately 240 stocks, which they have identified as “the worst of the worst.” They have identified the stocks to exclude based on specific financial criteria, not on the future predictions of the specific company. Over a 30 year period, from 1979 to 2009, this change would have resulted in an improvement of nearly 1.4% annually. This strategy would have had a return of 13.30% annually, versus the Russell 2000 index of 11.26%.

While we focus on meeting with clients, understanding their needs and determining an investment policy to help them reach their goals, we rely on the strength of this type of academic stock market research to implement the investment plan that we develop. As we don’t know of anyone who has an accurate crystal ball of the stock market, this is the most rational way of investing that we know of.

If you would like to know more about this topic, or our investment methodology, please contact us.

Sources: Wall Street Journal, June 11, 2010 “After Missing Apple’s Surge, Goldman Cuts Coverage” and April 21, 2010, Goldman on Apple: Yes, We’re Stickin’ to that “Neutral ” Rating