The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
America is a special place. As a country, we used to understand that. It is not special because we are from here; it is special because it is truly different from the rest of the world. One act, by one extraordinary man, made America different. George Washington led a bunch of colonists against the world’s […]
Arnold Palmer passed away on Sunday, and the legendary golfer and Demon Deacon will be deeply missed by both communities. Golf, like most sports, can teach a lot of life lessons. Simple yet complicated, rewarding yet frustrating…yep, that pretty much sums it up.
Mylan hands us a perfect example of the dangers of living in an over-regulated society.
It is often said that our political choice is a choice between the lesser of two evils; this year that seems especially the case. Both candidates have been accused of being lose with the truth. I think New York Times columnist David Brooks said it best when he said that we seem to be living in a post-fact era.
Recapturing the glory days: This political theme is driving decisions everywhere. People don’t like the post-economic crisis world and they want to turn back the hands of time. The people of Great Britain want to be free of the EU. What will be the real impact?
America is a special place. As a country, we used to understand that. It is not special because we are from here; it is special because it is truly different from the rest of the world. One act, by one extraordinary man, made America different. George Washington led a bunch of colonists against the world’s preeminent military power and somehow won. After victory, the people of America did what people around the globe have done since the beginning of human history: They went to their leader and asked him to be their king. But, George Washington did what no other leader, of which I am aware, in all human history did: He said no.
Washington said that we didn’t need a king, and the American system of democracy was born. That one act makes us unique. It is not the only thing that makes us unique, but it may be the most important. We do not, have nor have we ever, had a monarch. We have a system of checks and balances made up of three separate but equal branches of government.
I believe we could use that reminder as we head to the polls. Friday on CNBC there was commentary about the economic ramifications of both major presidential candidates. One commentator asked what would happen if Trump wins and decides to shut down the Federal Reserve. One simply cannot make this up – this was not some “person on the street” clip where they make fun of the ignorance of the average bystander. These were the professional market pundits to whom investors listen every day. The Federal Reserve was brought into existence through an act of Congress. The president of the United States does not have the authority to abolish an act of Congress. Every American citizen who had a passing grade in 8th grade civics should know this. However, the college-educated broadcasters on CNBC seemed to be completely unaware.
People, frankly including myself, seem distressed about this election more so than any election in my lifetime. We have heard from many clients who are concerned about what will happen in the capital markets after the election. While I understand and share the unease with the two major candidates, when it comes to what will happen in the markets after Election Day there are three things to keep in mind.
First, we must remember our civics lessons. We are voting for the president, not the monarch. We are also voting for Congress and the Senate and state and local politicians. We may be voting for local ballot initiatives. We are voting for all of government, and our government is mostly decentralized. The two presidential candidates cannot do most of what they have promised to do without the consent of Congress. Donald Trump cannot shut down the Fed or ignore existing trade deals, and Hillary Clinton cannot raise taxes on anyone. Congress holds the power.
Second, while outside events can have temporary impacts on markets, ultimately we are investing in companies. Apple will continue selling iPhones regardless of who is in the White House. People will still drink Cokes and watch TV and go to the grocery store. Prudent investing is done from the bottom-up, so what matters is what is happening at specific companies. There may be some companies that are impacted by policy, but that always happens, and there are usually just as many winners as losers.
The market does have expectations. The market consensus belief is that Hilary will win and the Republicans will keep control of Congress. Mind you, this is not an indication of what Wall Street wants, it is simply what they believe will happen. The investment industry is a diverse industry, and like most industries it employs people of differing political views. However, when it comes to our day jobs it is a matter of understanding probabilities. The highest probability is Hilary wins a close election and Congress remains in the hands of the Republicans. If something other than that happens then, like any surprise, the market will likely react. That reaction will be short-lived and a few days later we will be back focused on company earnings.
Third, we have already had the reaction. The “smart” money has been on hold for the month of October. The market has had a stealth correction with stocks going down, but on very light volume. This means that most large investors have been simply sitting on the sidelines and waiting. No one has a crystal ball, but our best estimate is that the worst-case scenario is that the big investors just stay on the sidelines. The most likely scenario is that these investors have developed two different playbooks depending on the outcome of the election, and they start buying based on those playbooks once the outcome is known.
This election has been unique from the beginning. It may have an impact on future policy and the direction of our country. It is important. They all are. However, the world will not end if your candidate doesn’t win. We have a lot of problems in our country. We always do. We also have a lot of positives and sometimes we seem to forget that.
The Chicago Cubs just won the World Series. The Wake Forest Demon Deacons just won their 6th football game this season and are going to go to a bowl game. Michael Smith, our Director of Research, and his wife Sara just had a healthy baby girl. Good things are happening every day. We’ll get through this election one way or the other.
Chuck Osborne, CFA
“Golf is deceptively simple and endlessly complicated; it satisfies the soul and frustrates the intellect. It is at the same time rewarding and maddening – and it is without doubt the greatest game mankind has ever invented.” – Arnold Palmer, 1929 – 2016
Yesterday was a sad day for golfers and a sad day for the Wake Forest Demon Deacons, and since I am both, I’m sad. Arnold Palmer passed away on Sunday, and the legendary golfer and Demon Deacon will be deeply missed by both communities.
Golf, like most sports, can teach a lot of life lessons. If one were to take the quote above and replace the word golf with investing, and the word game with pursuit, then he would have pretty well summed up what it is like to be a professional investor. Simple yet complicated, rewarding yet frustrating…yep, that pretty much sums it up.
Just last week I welcomed a visit from the Chief Investment Officer of a New York-based investment firm that has a stellar long-term record but has been struggling in the recent environment. They are by no means alone. He was telling me that they have been losing clients and that the majority of them have been going to so-called passive index-based fund options. Of course this appears to be happening just as their results are improving. In fact, quarter to-date their flagship fund was well ahead of the index returns, but so many times decisions are made looking in the rear view mirror.
He and I lamented that we live in a world where few seem to ever slow down and ask the simple question, “Why?” For the last year and a half if not longer, the stock indexes have been delivering better investment results than the vast majority of quality investment managers. To be clear, I’m not talking about the average investment managers. Index true believers will tell you all the time that the index beats average. In other words, the index is usually a solid C+ student. However, lately the index has been getting an A+. Most people just look at this and say, “Those other managers are just too dumb to beat their benchmark.” We on the other hand want to ask, Why?
Why all of a sudden is the index beating the good managers? During Iron Capital’s 13-year existence, on average two thirds of the managers we use beat their benchmark for any given three-year period. Quality managers do exist, and they can be identified. So if they are smart when they succeed, did they all just simultaneously become dumb? I don’t believe that.
To get to the real answer one has to understand how an index return differs from that of an active manager. The return of a whole portfolio is simply the returns of the stocks of all the companies in that portfolio. If two portfolios differ in their returns, it is usually because they own different stocks. So, if the index is delivering better results this means that the stocks that are doing the best are stocks that no quality manager wishes to own.
That to me is a signal that something is wrong. The last time this happened was the internet bubble – that time when stock prices were being driven up by the excitement around the internet. Anything internet-related did well, while the stocks of other companies were ignored. Quality managers don’t typically chase pipedreams, so they didn’t keep up with the index. We remember how that ended. For a decade after the bursting of the bubble, almost every active manager (even the C students) beat the index.
Today it is all about the Fed. The Federal Reserve just met and decided to leave interest rates unchanged for now. That means record-low interest rates, and not just here in the U.S. Both Germany and Japan currently have negative interest rates – meaning that they are promising those who loan them money to pay back less than what they borrowed.
There are two beneficiaries of this policy. The most obvious is the dividend-paying stock. Retirees and other investors who need to produce income would normally invest in bonds. However, when bond yields are so low, they cannot produce adequate income to meet the needs of most retirees. This causes investors to abandon bonds for typical income-producing stocks, such as the stocks of utility companies. Many utilities are now selling for prices usually reserved for the fastest-growing technology companies.
The other area that has benefitted from recent Fed policy is the so-called FANG stocks. FANG stands for Facebook, Amazon, Netflix, and Google, but the phenomenon is not limited just to these four. Basically any company whose future is tied to either your mobile device and/or social media has seen its stock price rise. This is less obvious to many, but this is a result of low interest rates. Long-term interest rates are an indication of what investors believe about future growth. When our ten-year Treasuries are paying less than two percent, it indicates that investors believe growth will be less than two percent. In that environment investors look for companies they believe can grow regardless of economic conditions. The FANG stocks match that criteria.
Just like the late 1990’s, today all the stocks not meeting the criteria du jour have been ignored and that is where the quality managers find opportunities. Those opportunities can be rewarding, but it takes patience. In the meantime, the markets can be frustrating. There are signs that patience is beginning to be rewarded. My visitor last week informed me that I was the last stop on a three-day tour in Atlanta and I was the only one they met who was optimistic, which of course made me even more optimistic.
Arnold Palmer drew people to golf and to himself largely because of his optimism. There was never a spot on the course where he couldn’t see a way out. Sometimes this led to frustration, but it often led to reward. It was certainly part of what made him the King. We have been in a frustrating market, but the reward looks like it is coming. Mr. Palmer may have been talking about golf, but it could have been just as easily about investing, or for that matter life. Rewarding and maddening all at the same time, that just about sums it up.
Chuck Osborne, CFA
~Lessons for Investing from a Legendary Golfer
Last week as I was conducting a lunch-and-learn session for employees of one of our institutional clients, the subject of regulation came up and I pointed out the dangers of over-regulating an economy. No sooner did I get back to the office and what do you know: Mylan hands us a perfect example of the dangers of living in an over-regulated society.
I’m sure most of you have heard the story by now. Mylan is the pharmaceutical company that currently makes the EpiPen®. The cost of the EpiPen has gone from $100 in 2007 to $600 today, which is what one would call highway robbery. But how does this happen?
As we have written before, facts must be placed in full context. So the first thing one should ask is, what has changed in the healthcare industry since 2007? That answer should be obvious. The healthcare industry has seen huge change in the form of a massive increase in regulation. How does that impact how a company, like Mylan, operates?
Let’s start with the company’s chief executive officer. Heather Breech is the CEO responsible for this enormous price increase. Breech is the daughter of Joe Manchin, a Democratic U.S. Senator from West Virginia and the state’s former governor. Breech has been at Mylan since 1992 and worked her way up through the ranks. One might think that the CEO of a pharmaceutical company would come from a department like finance, sales, or research and development. Someone from finance would understand how the budgets worked and which departments were contributing financially, while someone from sales would understand the customer’s needs and how to grow the business. Someone from research and development would understand the product and what goes into the development of new products.
Breech came up a different path: she was the director of government relations. I’m not making this up. (This is why I never read fiction, truth is more amusing…who would ever make that up?) The daughter of a U.S. Senator becomes the most valuable employee at her company because she was good at government relations.
This brings us to how an EpiPen now costs $600.00. First, the company has a monopoly. Epipen is just about the only product of its kind, and as recently reported in the Wall Street Journal, the former head of government relations has done a good job keeping it that way. Even though the EpiPen has been around since the 1970’s, the FDA has been helpful to Mylan by thus far stonewalling any generic competition. For that matter, one might ask why a technology this old is not sold over the counter as it is in other countries? That is how the government relations department gets one of its own in the corner office.
Regulation is very helpful in limiting competition. It also helps in other ways; in this case it prevents what economists call price discovery. The price for EpiPens did not go up all at once. Most of the cost has been paid by insurance companies. In 2007 when the EpiPen cost $100, most consumers probably paid just their co-pay, back then you were talking about $10 or $15. Mylan got away with raising the price because most consumers didn’t see it; he insurance company paid it (of course that money comes from premiums so we all pay it – but that is another newsletter). It was not until co-pays and deductibles have risen so much that consumers became aware that an epipen cost $600.00. Hence the sudden, and justifiable, outrage.
For a market to function properly there must be competition and there must be price discovery. In other words, consumers must have a choice and they must be aware of those choices. This is why these stories never happen to companies like Apple. If one does not wish to buy an iPhone, then he can buy a Samsung. It is easy to discover the cost and determine what is best.
The EpiPen costs $3 to manufacture. Imagine if Mylan had to compete in a truly free market. The EpiPen could cost $10 to $20 over the counter and the company would still have a huge profit margin. And, here is the real kicker: if Ms. Breech had actually taken those MBA courses that she once lied about on her resume (again, can’t make it up), she might understand that the company could make even more money by expanding its market. If it cost only $10 over the counter, every parent in America would own several of them. My children thankfully do not suffer from severe allergies, but several of their friends do, and if children have never been stung by a bee or had a peanut butter sandwich, how do parents know? We would all make it part of our first aid kits. Every restaurant in America would have a supply on hand. Schools would not need to rely on Ms. Breech’s donations; the school nurse would order them right along with the Band-Aids and Tylenol. Mylan would still do great and Ms. Breech very likely could still pay herself $18 million. But, that would be work and the company would have to compete with a lot of other firms. They would have to really execute.
This is a classic case of what happens when a society becomes over-regulated. That will not be how the story will be told, however. This message and explanation, while accurate, isn’t tweetable. “Greedy capitalist” is tweetable. That is the sad thing. The likely reaction will be for even more regulation, and could lead to price-fixing. Price-fixing leads to shortages, and this isn’t gas in the 1970’s. Shortages won’t mean pushing your car to the gas station to wait in line. Shortages in this case mean someone will die, and it likely will be a child.
The solution is not more of what caused the problem. Allergy sufferers need choices, not more red tape. Regulation needs to encourage competition not eliminate it, and regulators need to be held accountable. Corporate government relations departments shouldn’t even need to exist, but the fact that this is now a pathway to become CEO should speak volumes. We have gone a long way from our capitalist roots, and we need to start heading back.
Chuck Osborne, CFA
Our presidential political season is now in full swing, and what an odd run we are about to have. It is often said that our political choice is a choice between the lesser of two evils; this year that seems especially the case as the two mainstream party candidates are polling as the least popular ever. Both candidates have been accused of being loose with the truth. I think New York Times columnist David Brooks said it best when he said that we seem to be living in a post-fact era.
He has a point. One would think that in the information age it would be harder for politicians to get away with fudging the truth. After all, we live in the era of instant fact-checkers. However, that is not the case, and I for one blame postmodernism. For those who are not familiar, postmodernism is the idea that truth is in the eye of the beholder. You have your truth and I have mine. This is contrary to the modern view which led the Western world out of the dark ages and up to the 1960s. Modernism believed truth existed on its own, independent of what you or I or anyone else thought. In a postmodern world if I believe the world is flat and the sun revolves around it, then that is my truth, facts be damned.
Worse than ignoring facts, this post-modern mindset is more likely to abuse them. It is a fact, after all, that the sun rises in the east and sets in the west. So I’m right, the sun obviously revolves around the earth. Except that it doesn’t. Facts taken out of context can be just as misleading as blatant falsehoods.
One great example of this is when people talk about what the stock market has done under one party versus the other. It doesn’t matter what party the president hails from; what matters is what policies actually come out of Washington. It didn’t matter that Kennedy was a Democrat and that Reagan was a Republican; what mattered is that both lowered taxes and the economy grew. It didn’t matter that Roosevelt was a Democrat and Nixon a Republican; both tried price controls and they both failed. (Price controls always fail, but that is a topic for another day.) It doesn’t matter that W. Bush was a Republican and Obama a Democrat; both never saw a regulation they didn’t love, and both saw inequality increase dramatically.
Taking facts out of context is not limited to politics. The investment world is increasingly being driven by facts taken out of context. My favorite recently has been the drumbeat of, “We are at record highs.” This is factual, however: it ignores that we have basically been at the same point for almost two years now. It also ignores that the valuation spread between the most expensive stocks and the cheapest is the largest it has been since the tech bubble of the late ‘90’s, and finally it ignores the rest of the world.
To search for truth, one cannot just look at random facts. One has to take facts in context and have a rational theory as to how these facts all relate. Milton Friedman, the late Nobel Prize-winning economist, used to say that we must reject theories without facts and we must reject facts without theory. Sometimes the stock market goes up or down during a President’s tenure based on nothing but coincidence.
If we want to know the truth about the market, then we just can’t look at the headline U.S. indices. We have to see the context. Most stocks in the U.S. have not done well over the last year, and stocks globally are even worse. Things have not been as good as “record highs” suggest.
Of course every cloud has a silver lining. This also means that those who are now talking about how expensive the market is and how overheated it may be are most likely wrong. At Iron Capital we do not see a market downturn in the immediate future. Much more likely in our view would be a reversion to the mean, which would say that stocks that are expensive need to be cheaper while cheap stocks rebound. The S&P 500 may be expensive with a price-to-earnings ratio near $20, but our core portfolio has a price to earnings ratio of $11.50. Cheap stocks are there to be had and that bodes well for investors going forward, regardless of which party is in the White House, or record highs, or any other random fact taken out of context. And that’s the truth.
Chuck Osborne, CFA
Yesterday I was watching interviews of people in Britain leaving the polls. The reporter asked one gentleman, who had voted to leave the EU, why he thought older voters were more inclined to vote “leave” than younger voters. He responded, “They have been in the EU their entire lives. They don’t remember life before the EU.”
Recapturing the glory days: This is a political theme that is driving decisions everywhere. People don’t like the post-economic crisis world and they want to turn back the hands of time. The people of Great Britain want to be free of the European Union (EU). They are, after all, a proud nation. Those of us who were born in the United States after World War II often fall into the trap of thinking that the U.S. has always been the great world power. The international language of business is English, and I have been told many times from intelligent people that this is because of America. But, that is incorrect. English is the international language because of the English. They built an empire on which the sun never set – an empire greater than Alexander the Great, greater than Caesar, greater than the Mongols or the Russians. An empire that peaked in population not in some far-off ancient time, but in 1938.
The reporter did not ask the gentleman his age, but I would guess that his parents were alive and well in those days before the second Great War. I would assume he has good memories of Britain before the EU, and probably some romanticized memories of the stories his parents told him about Britain’s glory days. Somewhere in his head he believes that if we just leave the EU, then Britain will be free to live those days again.
Are we that different? Many sociologists have suggested that America’s great political divide is two competing romanticized visions of the U.S. in the 1950s: Conservatives long to return to the days of traditional marriage, regular church attendance and a feeling of being safe in one’s community, while liberals want to return to a day of incredibly high tax rates and invasive regulation.
The problem is that one cannot go back. Dealing with the present is one of the hardest things for humans to do. We tend to dwell in the past or worry about the future, or both. It is hard to actually focus on now. This is certainly true in my world. Prudent investment decisions are made in the now. The past is past; good or bad, it is what it is. The future is unknown. Now is the only moment over which we have any control.
This brings us back to the Brexit. Now that Britain has voted to leave, what will be the real impact? There are lots of doomsayers out there, and the initial market reaction has been very negative. The reality is likely to be far less brutal. Some of the “leave” voters are likely to be disappointed. The British Empire is not going to magically rise from the ashes. Last century’s manufacturing jobs are not going to return. You can’t go home again.
As for the doomsayers: As of today, absolutely nothing has changed. Yes, change is coming. Britain has two years to renegotiate trade relations with the EU countries. Some of those countries may be mad now, but it is unlikely that they will hold a grudge for two years. New trade agreements will be negotiated. Britain needs German cars and Germany needs Britain’s banks. Over the next two years they can hopefully work out new agreements.
In the meantime, should the short-term sell-off continue for more than a day then opportunities will be there for the taking. As we said before the vote, Brexit will not cause Apple to sell fewer phones or Coke to sell fewer drinks, of Ford to sell fewer cars. Prudent investing is done from the ground-up. It is also done in the now.
Now is time to be patient.
Chuck Osborne, CFA
~You Can Never Go Home Again