2007 Review: Turning Point
[this letter was emailed to clients January of 2008]
2007 Review: Turning Point
A Glance Back, A Look Forward & Philosophy
2007 was a very eventful and fitful year in the stock and bond markets around the world. Credit markets finally started to shake the fleas that had taken residence over several years of record breaking money creation by government, lending institutions and a quasi-banking system composed of hedge funds and private equity firms. The volatility we saw in 2007 is not likely to subside in the short run. In fact, I believe that the problems at Bear Stearns are the tip of the iceberg regarding problems that are likely to emerge in the financial sector.
Rather than bore you with a rehash of what went on specifically (there are plenty of out there), I am going to talk instead about our investment philosophy and how I look at investing- which is how I think you should look at investing.
When I was in college, my first landlord was an older gentleman named Bill who owned a lot of property in the University of Wisconsin-Milwaukee area. One day I asked Bill about property ownership and he was kind enough to discuss the process of buying, fixing up and renting out apartments. When I offered up some bad information regarding the process I had gotten from a friend, Bill offered me some advice that is the best advice I have ever gotten from a non-family member. He said, “Kirk, if you want to learn how to do something, learn from people who have done it. Don’t ask your friends or your neighbors, ask somebody who has done it, learn from their experience.”
To that end, I believe that there is a pretty good shortcut out there to doing well with investing.
My “shortcut” formula is as follows.
- I use general economic analysis culled from academics and respected sources to find the broad based systemic risks in the markets and economy, for example an inflated loose money supply fueling subprime credit risks to financial, building, real estate and consumer stocks (investments which we have largely avoided).
- I then use the same analysis to see where the best broad opportunities lie, for example energy, materials and telecom the past few years (investments which we have been heavily weighted in).
- After finding generally attractive areas of investment, I apply over a dozen financial screens to thousands of potential investments to cull a small universe to choose from.
- Finally, I study a number of billionaires and managers of billions that I both understand and who have phenomenal track records. If my analysis is similar to theirs, I know to a very high degree of confidence that you and I are on the right track.
In many cases, we end up owning the same things that the billionaires own. What is most amazing is that sometimes that isn’t even good enough in any particular year or two. Over longer periods however, it appears to be a very good strategy.
One thing that I would point out here is what this process leads to: the conclusion that “all-in” investing is rarely a good idea. By that I mean, being fully invested in the stock markets. I have run into many investors, heard from a multitude of media as well as financial planners, who believe that being almost fully invested in the stock markets almost all of the time is the right way to make market returns. Well, I guess it is “a” way to get market returns. But we need to remember that being fully invested works not only when the broad market is going up, but also when it is going down. That is, almost fully invested accounts share almost FULLY, or more if the portfolio is concentrated in a crashing sector (i.e. technology from 2000-2002), in market losses when corrections and crashes occur. My question to those who advocate being all-in would be: where is the risk management in that approach?
As recently as five years ago we got to see a perfect example of why being “all-in” is exceptionally risky. Take Buffett for example (sorry for name dropping again), he has historically carried very large cash stockpiles and invested only when there was an easy to understand and identify opportunity. He doesn’t chase markets, he waits for opportunities. He trailed the S&P 500 for a few years in the 1990s incidentally. Market and return chasing is in most great investor’s opinions the most common sin committed by the broader investment population. Also know that Buffett and most highly successful investors do not own shares of 500 plus companies. They own a much smaller number, often around 100 to 200 companies, and very many times even fewer, sometimes down to a just a handful of carefully selected investments.
Depending on the type of account you have with me, you rarely see me fully invested. Also, my portfolios are more concentrated than many magazines and financial sales people say to be- though we are still diversified. The last time I was almost fully invested in equities was 2003 and 2004. I began rebalancing to less aggressive allocations and selling into strength in 2005. This was the same time frame that Warren Buffett warned that America was "selling the farm" to live "high on the hog" and equated derivitives to weapons of mass destruction. At that time he was expanding his cash and fixed holdings despite the stock market rebounding. Some of our equity accounts (using various types of investment funds and a handful of stocks in appropriate accounts) have lagged by a few points per year due to a similar thought process for a couple years now.
We haven’t trailed by a lot in the equity accounts, but a few points that it doesn’t feel good not to get. My educated assessment is that we will make that money back as we work through a turbulent market as we have cash to invest into cheapening assets that many others do not. I hope you understand how badly I want to get back ahead of the markets like we were from 2003 to 2005. However, I don’t want to do it at the risk of overextending and trying to outguess a market that appears to have been acting irrationally positively the past couple years. Also, very importantly, although we would like to see the stocks we buy go up within a year or two, we are usually betting on the come three to five years into the future. All good things in time.
In many accounts, you should notice that we have only been 60-80% invested in equities for over two years now and still made almost the same returns as the S&P 500. This is a very good risk to reward trade-off by all estimations. I believe that those accounts should also do well in down markets as we have dry powder protecting us and waiting to be invested on corrections.
Remember that one, two or even three years, unless horribly negative or exceptionally positive are almost worthless measures of performance. Five (as a sort of half-time report) and ten years, if you are going to be in the stock markets, are the appropriate measuring sticks for performance. Try to understand risk avoidance as your primary investment goal, not making a few extra percentage points in the short run. We can swing for extra returns on some aggressive picks made out of gains on safer investments from time to time as we see opportunities.
So in summary, our investment philosophy revolves around managing risk, having a moderately diversified and specifically weighted asset allocation, having a few home-run potential investment picks, only being fully invested after corrections and crashes, and having a longer term patient perspective.
Obviously, there are NO guarantees of doing well in any particular year, cycle or investment. However, I am not being highly original in anything I am saying or doing, and believe the people I am largely plagiarizing are fairly astute with the billions they oversee. I am striving to be forward looking and prudent in working with you on your investments using similar strategies as those people who have already done it.
As a financial advisor I have the opportunity to talk with a lot of people about their finances. The most pervasive real concern we all have, is: “what will my/our income be in retirement?” In general, it will be about 5% of your invested assets plus any other income you have, such as Social Security, pensions and real estate income. As many of my clients close-in on retirement age, or are already there, the 5% rule of thumb, which is based on the assumption that we don’t want to use our principle until very late in life, is a good one that you can use when you do your estimates. Income planning for retirement is a very important part of my financial practice. We will be talking about it at your reviews.
Another large concern is the cost of healthcare in retirement, both regular health insurance and potential long term care expenses. For the most part, we must estimate 10% inflation in healthcare until it is proven otherwise lower. We also need to very seriously consider long term care insurance as a hedge against a potential catastrophe. In general, buying long term care insurance by age 59 is a great idea as you are likely to be healthier than at later ages (which allows for the company to underwrite and issue the insurance) and the coverage will come at a lower price.
Happy New Year and all my best wishes on for 2008. We’ll talk soon.