Investment Change for the Better

Change. Progress. Risk.

Gradually, typewriters became word processors and computers. That was progress and made our lives better.

Phones used to be stationary, immovable objects. They were tethered to a desk or attached to a wall. Then phones were introduced which you could walk around your house with. This did not involve much risk, so most people quickly adopted them. They made your life easier and better.

Bag phones were introduced. These were the first “car” phones most people used. They were large and bulky. Then came flip phones, which were used only for calls. In the past 10 years, cell phones became smart phones, with the introduction of the iPhone and similar devices.

Technology gradually evolves. Progress occurs. Our habits change. We get used to the new innovations. They have made our lives better (mostly!) and enabled us to communicate, share information and always be in touch.

In terms of investing, some people have long held individual stocks and watched these stocks grow over the decades. They rely on the dividends these large US companies regularly pay. Others invested in actively managed mutual funds, which have investment managers and researchers to hopefully outperform others, or at least to try to beat an appropriate benchmark or index.

The investment industry has changed over the last few decades. Academic research regarding stocks and investment management has spurred on these changes.

One of the implications from extensive research is that professional money managers cannot consistently outguess and beat the stock market. This is supported by years of industry performance data. (See further data below**) This is one of the core investment principles which we believe.

Our firm adopted this philosophy, based on evidence and much research in 2000-2003, that using globally diversified asset class mutual funds, similar but different than index funds, was better than holding individual stocks or actively managed stock mutual funds.

If you have always held individual stocks, this may seem counter-intuitive. Like transitioning to new technology or other innovations, it may at first seem risky or uncomfortable. Over time, we feel that our investment approach should provide you with greater expected returns and less risk through better diversification.

Another core investment belief is derived from academic research done in the 1980 and 1990s, which showed that stocks have higher expected returns than bonds, that small companies have higher expected returns than large companies and “value” companies have higher expected returns than “growth” companies.  Subsequent research showed that these concepts apply also to international stocks. This research, done by Eugena Fama, led to him being awarded the Nobel Prize in Economic Sciences in 2013. He is a co-founding member of the DFA Board of Directors and he serves on DFA’s Investment Policy Committee. DFA is the primary mutual fund firm we use to implement our stock investment philosophy.

If you own mostly large US “legacy” stocks, which I refer to as some of the large US companies of the past 10-40+ years, this research and our real world interactions over the past 15 years shows that you are missing out on significant long-term growth opportunities in your portfolio. You would be missing higher expected returns by not having allocations to small, value and international asset classes. You are also missing investments in other companies, by not diversifying your legacy holdings.

When I considered starting this firm around 2000, I was not aware of this research and this approach to investing.  We adopted concepts that were different than how most people then invested. When we first began working with DFA in 2003, they were large, maybe the 38th largest mutual fund company in the US. Today, DFA manages $460 billion in the US, and more globally, and DFA is the 8th largest mutual fund company in the country.

We were curious back then. The more questions we asked, the more we read, the more logical and rational this approach appeared. Now we are quite confident. We still ask questions. We still challenge conventional wisdom. That is part of our job.

Just as technology and the world changes, the financial world is continuously changing. We keep learning, researching and monitoring, all with the goal of providing you and your family with a better investment experience.

Have you and your investments evolved and changed for the better over time? Are you using the optimal method?

Are you using a “bag phone” or a “smart phone”?

**From Dimensional Fund Advisors website, only 15% of US equity and fixed income funds that were around in 2000 beat an industry benchmark, 15 years later. Over the same time period, 82% of US equity and fixed income Dimensional funds outperformed their benchmarks.

Source: Some of the above information is from DFA’s book, 35 Quotations on a Better Way to Invest.


Why our philosophy makes sense

A number of examples in the past week again confirm why our investment philosophy makes sense.

In Tuesday’s Wall Street Journal, a “Streetwise” column stated that “the overwhelming consensus before Christmas” was the dollar would take off, the euro would fall and emerging stock markets “needed to brace for turmoil…”

“Three months later, the dollar’s weaker, the euro is up strongly,…” and emerging stock markets are showing triple the gains of the broad US stock market.

The consensus predictions were all wrong.

We remained invested in emerging stock markets for those clients which they are appropriate and our clients have benefited. We don’t make bets on currencies, as they are too hard to predict.

Last Wednesday, the Federal Reserve increased short term interest rates by .25%. Most would have predicted or thought that the 10 year Treasury note would have risen that day. Not only did the 10 year rate decrease on Wednesday, it has continued to fall from around 2.5% to 2.398 as of Wednesday.

Predicting the direction of interest rates is very difficult. This is why we do not make bets on interest rate movements. When we purchase fixed income investments for our clients, we buy varying maturities of high quality bonds. We are investing to provide the portfolio stability, not to gamble on the direction of interest rates.

In March of 2010, when the Affordable Health Care Act, or Obamacare, was enacted, few would have recommended investing in managed health care stocks. As discussed in a New York Times column in Sunday’s business section, this conventional wisdom would have been very wrong.

“The numbers are astonishing. The Standard & Poor’s stock index returned 135.6 percent in those seven years through (last) Thursday…But the managed care stocks, as a whole, have gained nearly 300 percent including dividends…UnitedHealth, the biggest of the managed care companies, with a market capitalization that is now more than $160 billion, returned 480 percent, dividends included. An investment of $100 in the company’s stock when Obamacare was signed into law would be worth more than $580.50 today.”

We do not let political views influence our decision making. We do not generally recommend individual stock picking and this is why. Because we recommended that our clients own broad asset classes, one of which is large US company stocks, our clients benefited by owning these managed health care stocks and they reaped the rewards.

We cannot predict the future. We don’t try to. It is not a winning strategy.

We can help your long term investment performance by avoiding making bets and predictions. We will continue to invest for the long-term in a disciplined, rational and low-cost manner, which has been successful in an always uncertain future.

When Should Strategy Be Changed

Yesterday, the Federal Reserve increased short term interest rates for the first time in 2017 and just the third .25% increase in short term rates since 2009.

Prior to the Fed announcement, I was contacted by a Detroit Free Press personal finance reporter for my comments. She wanted to know what would happen to the stock market, are we changing our investment strategy and our outlook for future interest rates.

Our reply to the Detroit Free Press was the following:

“We expected very short term interest rates to rise by .25% at this week’s Federal Reserve meeting. We anticipate that there will be at least two-three additional .25% short term interest rate increases during the remainder of 2017. We view these as positive, as the economy continues to be strong and not headed into a recession. While it is difficult to predict the future, it is reasonable that the Fed will continue to increase short term rates throughout 2018, if the economy continues to remain strong and there is an infrastructure plan enacted.

We are not changing our investment strategy based on the Fed actions. We have a long term investment strategy to have our client’s very diversified, both in the US and internationally, so we would not recommend changes based on just today’s Fed actions. We have recommended that client’s should refinance mortgages, if they have not done so already. While we are positive about US and global stock markets for the long-term, we have been reminding clients that there has not been a significant stock market correction in over 9 months. Thus, a temporary decline, in the midst of a long-term rising market, should be expected and considered a normal occurrence.”

We were quoted in the Detroit Free Press article on the Federal Reserve action, which you can read here.

Changing a strategy should be based on evidence that a current strategy is not working or that evidence exists that modifications would be necessary or a better strategy exists.  The principles and general investment philosophy which we adopted when we formed our firm in 2003 are still valid and have stood the test of time.

We are disciplined and have a strategy that is well defined and transparent, which we adapt to the individual needs of our clients. The stock mutual funds that we have utilized since inception have excellent track records, over the long and short term, especially when compared to their respective category peers. They are some of the lowest cost mutual funds in the industry as well as provide excellent tax management, to minimize your taxes, as applicable.

We have avoided hedge funds, alternative investments and junk bonds (higher risk fixed income products) and making bets on certain sectors, such as energy. We are confident that these decisions were correct and have been significantly to your advantage. As Warren Buffett and a great deal of other evidence shows, most alternatives and hedge funds do not provide the long-term performance or diversification benefits which they claim.

If you are not a client of our firm, you may think you are doing well. But do you really know? That may be a relative term or feeling, until we meet and review how well your portfolio has performed or how your investments are structured.

  • When we meet with prospects, we nearly always find that their existing portfolios are:
    • taking too much risk in certain areas,
    • under-invested in asset classes that have higher expected returns
    • more invested in asset classes or individual stocks which have lower expected returns
    • paying more in fees than they should be
    • not being managed in a manner which reduces their taxes as much as they could be
  • All of our current clients were formally prospects. Nearly all of them formerly worked with other advisors, but after they met with us, they understood our rational approach to investing and the other benefits we could provide.

We are confident in the future and confident in our investment strategy.

The financial markets: where do they go from here?

The stock markets in the US and throughout the world have been performing very well.

Major US and global stock indices have risen nearly uninterrupted for months. There have not been any pullbacks, or even a minor correction, since the Brexit vote in late June, 2016.

As our clients know, we do not make predictions or believe that anyone can consistently and accurately predict the near term direction of stocks or stock markets. Our role is to work with you to develop a financial and investment plan which are appropriate for your goals and time frame. To implement this plan, we recommend a globally diversified portfolio of both US and International stock funds, with an appropriate allocation of fixed income investments.

Given that stock markets have increased without any correction in almost 9 months, you should be prepared for a pullback or correction in stocks, at some point. When that occurs, it should be viewed as normal. We are not basing this on an event which we expect or can predict. We are just being realistic and want you to be emotionally ready.

Remember, in almost every year, there is a time when stocks decline 10% or more from a peak to a bottom point, even in a year which is positive for stocks.

One “known” risk that could shake the market would be a delay or trouble in passing health care reform or tax reform legislation. However, it is often unexpected events which cause sudden market moves.

While we view a correction of some type in the near term as normal, we are still positive about US and global stock markets, for the long term. We expect very short term interest rates to rise again at next week’s Federal Reserve meeting. It is possible there will be at least two-three additional .25% short term interest rate increases, after next week’s meeting, during 2017. We view these as positive, as the economy continues to be strong and not headed into a recession.

We do not feel that US stocks are in “bubble” territory, which would warrant a major downturn, such as occurred in 2007-09. Stocks have increased because of expectations of corporate and individual tax reform, as well as continued positive corporate earnings reports and future earnings expectations.

Many have asked us whether the rise in stocks is just due to the November election. Trump’s election certainly caused stocks in general to increase late in 2016, but we feel that much of the further increases in 2017 are still stock specific. Individual stocks react or move based on a company’s future earnings expectations and reported results.

For example, if most of the earnings reports of companies in 2017 had been below expectations or most companies issued lower future earnings guidance, the major stock indices would be lower today, irrespective of Trump, future legislation and de-regulation. This has not been the case. Companies have reported good earnings and better future guidance.

Stocks which have not delivered good news have been punished, in spite of the election. For example, Target and Under Armour have decreased by 22% and 27% in 2017, respectively, after announcing poor earnings and guidance earlier this year. So not all stocks have risen along with the general market.

For further reading about how markets perform after reaching new highs, see our blog posts, Actionable Information and Dow 20,000: The Implications.

We continue to be confident in our strategy and recommendations.

  • We firmly believe that a globally diversified portfolio is very important, given the unknowns about so many issues, such as:
    • corporate tax reform legislation
    • the direction of oil prices
    • the direction of interest rates
      • How can you know who the winners or losers may be?
  • We actively monitor your accounts for rebalancing to keep your risk in stocks at the level which is appropriate for you. This discipline will provide you with the best chance for a successful investment experience.
  • We provide you with a rational approach for your financial future, rather than allowing emotions to dictate financial decisions.

We recommend investing in passively managed globally diversified funds, not in individual stocks or just in large US companies, such as are included in the S&P 500. The funds we recommend provide you with diversification and the best chance to perform well versus actively managed funds and their respective benchmarks, at low costs.

As further evidence of how difficult it is to beat a benchmark, I noted the following in preparing this essay.

  • Seventeen of the 30 large US stocks in the DJIA outperformed the S&P 500 (the respective benchmark) during 2016.
  • Of those 17 companies which outperformed the S&P 500 (the respective benchmark) during 2016, only 7 of these companies have outperformed the S&P 500 during 2017, through March 6, 2017.
  • Six of the 30 stocks have underperformed the S&P 500 during both 2016 and YTD 2017, through March 6, 2017.

While this is very short term evidence and a very small sample, it is further confirmation of why our investment approach makes sense in both the short and long term.

Lessons from Buffett and Our Market Thoughts

Warren Buffett’s Berkshire Hathaway Inc.’s Annual Shareholders Letter was released last Saturday morning.

As broad US stock market indices continue to reach new highs this week, Buffett’s thoughts and actions are important.

Much of what follows is Warren’s writing, quoted from his Annual Letter. These thoughts are important today and will be vital lessons in the years and decades to come.

Reading these highlights and following his wisdom will help you to be more disciplined, financially successful and a better investor.

  • Berkshire Hathaway is a very different company than it was in 1970s through the early part of this century. Berkshire grew in those years based on Buffett’s investing in stocks of many large US companies and the vast insurance companies and the huge float (cash) they generate.
  • Over the past decade, he has focused more on buying large companies outright, as well as making many opportunistic investments, particularly during times of crisis, such as during the financial meltdown of 2008-09.

What are the lessons from this year’s Buffett Annual Letter which impact you and your financial life?

The future, fear and costs:

After citing that the DJIA has grown over his lifetime from 66 to 11,497 by 12/31/1999, he stated how the growth continued through the end of 2016 to 19,763, another increase of 72%. (Today, the DJIA is above 21,000.) He then wrote about the future:
  • “American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that.  Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.”
  • “Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics -that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media…”
  • “During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.”

Even Buffett can’t always beat the benchmark

Warren Buffett is clearly recognized as being one of the top investors of our lifetimes, as he has built an extraordinary conglomerate of companies and stock holdings. In this year’s letter, he did not discuss his stock sales and new purchases. However, his actions provide more lessons.

As smart as Buffett is, he makes mistakes and not every stock he buys becomes a home run. During 2016, Buffett sold the 63.5 million shares of Wal-Mart that was owned at 12/31/15.  He accumulated $4 billion in Wal-Mart between 2005-2012, during which time the stock far underperformed the S&P 500, Buffett’s benchmark. In a CNBC interview this Monday, he said that it is just too hard for large retailers to compete against Amazon.

As I wrote about last year, Lessons from Warren Buffett which can help you, Buffett’s top 5 stock holdings as of December 31, 2015 have under-performed the S&P 500 over the past 5-10 years. He may have done great with these stocks since he bought them decades ago, but they have not performed as well in the last 5-10 years.

This shows how difficult it is to succeed over the long term in selecting and holding individual stocks. Even for an “expert,” it is very difficult to vastly outperform the stock market, let alone even matching the index.

Buffett clearly recommends others should use an investment philosophy which is consistent with our firm’s investment approach. He clearly states: “Both large and small investors should stick with low-cost index funds.”

This is further evidence of why we feel so strongly about our investment philosophy of utilizing broadly diversified mutual funds on a global basis, which are similar to indexes/ benchmarks with extremely low costs. We are confident that our investment strategy is the best way to capture the long-term expected returns of the world’s stock markets with the greatest chance for success. As even Warren Buffett has recently shown, trying to pick a group of individual stocks just isn’t the best approach.

He writes at length about why hedge funds and alternative investments, with very high fees, are terrible long-term investments. If these investments interest you at all, read pages 21-24 of this year’s Annual Letter, here. They will be of much less interest to you after you read about Warren’s 10 year $1 million charitable bet, which he clearly will win.

Stock Purchases in 2016-17 market: Apple and airlines

Even though the market is at all time highs, and has been for months, Buffett and one of his associates purchased 61 million shares of Apple in late 2016 for $6.7 billion. And before Apple announced their earnings on January 31, 2017, Buffett has purchased an additional 76 million shares of Apple during January, 2017.

Berkshire’s Apple purchases were in the range of $110-121 per share. They stopped buying when the share price rose to $130-140/share range, where it is now. Buffett has made a huge gain already, but he could have purchased Apple shares for much cheaper many times in the past, and anytime prior to 2015. He may do well in the long-term with Apple’s stock, but he clearly should have been an Apple buyer years ago, if he bought shares in the last few months.

Additionally, Berkshire purchased billions of dollars of 4 major US airline stocks during 2016. He has said for two decades that airlines are terrible investments. He wrote in 2007 that they are the “worst sort of business.” This shows that we all need to be flexible, that times and thought processes should change based on what is going on in the world now, not just what occurred in the past. Airlines are now profitable and producing free cash flow.

Buffett’s Apple and airline purchases shows that he feels it still makes sense to continue purchasing stocks in the current stock market, as long as he feels he is buying at a reasonable price and the companies have good long-term prospects.

Do not be afraid of downturns, be prepared
  • Buffet wrote: “Charlie (Munger) and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”
  • “The lesson for us is that we must be prepared and expect that there will be significant down periods in the markets. They will happen. They are buying opportunities or a time to just wait out the down cycle. They are not times to sell or panic.”
Focus on the long term positive progress, not on negative talk
  • Buffett repeated his message from last year, of the importance of long term focus and the dynamism of the US economy.
  • He wrote: “Our efforts to materially increase the normalized earnings of Berkshire will be aided – as they have been throughout our managerial tenure – by America’s economic dynamism. One word sums up our country’s achievements: miraculous. From a standing start 240 years ago – a span of time less than triple my days on earth – Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.”
  • “You need not be an economist to understand how well our system has worked. Just look around you. See the 75 million owner-occupied homes, the bountiful farmland, the 260 million vehicles, the hyper-productive factories, the great medical centers, the talent-filled universities, you name it – they all represent a net gain for Americans from the barren lands, primitive structures and meager output of 1776. Starting from scratch, America has amassed wealth totaling $90 trillion…. This economic creation will deliver increasing wealth to our progeny far into the future. Yes, the build-up of wealth will be interrupted for short periods from time to time. It will not, however, be stopped. I’ll repeat what I’ve both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history.”

Huge investments in wind energy and railroad infrastructure:

  • Berkshire owns BNSF, a huge railroad company, and Berkshire Hathaway Energy (BHE), a large multi-state energy company. Buffett and the executives of these two companies are so confident about the long-term future and their ability to generate reasonable returns that they invested $8.9 billion in plant and equipment in 2016. They know society will need transportation and energy.
  • Buffett cites the investments these companies have made in “planet-friendly technology.” He wrote: “In wind generation, no state comes close to rivaling Iowa, where last year the megawatt-hours we generated (from BHE) from wind equaled 55% of all megawatt-hours sold to our Iowa retail customers. New wind projects that are underway will take that figure to 89% by 2020.
  • “Bargain-basement electric rates carry second-order benefits with them. Iowa has attracted large high-tech installations, both because of its low prices for electricity (which data centers use in huge quantities) and because most tech CEOs are enthusiastic about using renewable energy. When it comes to wind energy, Iowa is the Saudi Arabia of America.”
  • “BNSF, like other Class I railroads, uses only a single gallon of diesel fuel to move a ton of freight almost 500 miles. Those economics make railroads four times as fuel-efficient as trucks! Furthermore, railroads alleviate highway congestion – and the taxpayer-funded maintenance expenditures that come with heavier traffic – in a major way.”

If you have read this far, we appreciate it. I have read every one of Buffett’s Annual Letter for decades and continue to find each year’s filled with many nuggetts of valuable advice.

We hope that you find this and each week’s essays valuable and informative.

Disclosure: Brad Wasserman, author of this blog post, owns a small number of Berkshire Hathaway shares, which were purchased years ago to enable me to attend the Berkshire annual meeting. All my other stock investments are in DFA mutual funds, as we recommend to our clients.

Source: Berkshire Hathaway 2017 Annual Letter, released February 25, 2017. See