The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
Dorian Gray is a fascinating character. For those who can’t quite place him, he is the guy who had a magical self-portrait. He stayed young while his portrait aged As long as he did not look at his portrait he could do whatever he pleased without ever facing the consequences.
A few years back I had the pleasure of meeting Emanuel Derman. A pioneer in the movement of physicists migrating to Wall Street, Derman was there when investors started using sophisticated mathematical models to make investment decisions. Derman has a Ph.D. in theoretical physics from Columbia University and had been a scientist at Bell Labs before […]
The team broke huddle and came to the line of scrimmage. Their star quarterback, Osborne, took the snap and dropped back to pass.
“You should never be proud of doing the right thing. You should just do the right thing.”
“We live in a connected world.”
Dorian Gray is a fascinating character. For those who can’t quite place him, he is the guy who had a magical self-portrait. He stayed young while his portrait aged As long as he did not look at his portrait he could do whatever he pleased without ever facing the consequences. It was his portrait that aged and carried the marks of hard living, until one day he saw his portrait and what he had really done to himself. Beneath his youthful facade he had turned to ash. The sight of his portrait, of facing the truth, destroyed him.
From a line in this story we get the cliché, “the price of everything and the value of nothing.” An old friend of mine was fond of saying that clichés exist for a reason. They are often true, and 2015 was certainly a year where we saw this particular cliché alive and well in the financial markets. The S&P 500, the most watched and quoted index, finished the year up 1.38 percent. However, if one were to take away the four top gainers, the index would have finished the year down 4 percent. Beneath the positive facade was really nothing but ash.
The top two stocks for the year were Netflix and Amazon. Both are good companies, and I am personally customers of both. My wife and I don’t know how we could pull off Christmas without the convenience of Amazon Prime. Just about every day in December we came home to find a brown box with a smile on the side (never mind how many we sent), then after Christmas one of those familiar boxes arrived with the book I asked for that Santa forgot (and no, it wasn’t available on the Kindle).
Meanwhile, my eight-year-old son is into Pokémon. Pokémon is a trading card game based on a cartoon and video game that came out about twenty years ago. My son has discovered that he can watch all of the original cartoons on Netflix; in fact, he can watch just about any cartoon he wants whenever he wants on Netflix. If he is being nice, he can even start Barbie cartoons for his little sister.
These are great companies with excellent products. However, there is more to being a good investment than just being a great company; investors usually want a business to be profitable and sustainable. This is one thing the anti-capitalist crowd never seems to understand: any organization must be profitable if they wish to be sustainable. A few years ago I was on the board of a not-for-profit organization that actually understood this fact. They presented the board with their five-year plan and the budget portion was entitled, “Not-for- profit is a tax status, not a business plan.”
I think this is an important point, because profit has become a dirty word ever since the financial crisis. A company’s profit is the difference between revenue (money in) and expenses (money out). To be profitable simply means that an organization, or a person for that matter, spent less money than they had. That is really not such an evil thing, and in fact it really doesn’t matter what kind of organization one runs; spending less than you have is essential for long-term survival.
While I was glad to know that this small local organization understood the importance of spending less money than they had, the large boards at places like Amazon and Netflix don’t seem to think such laws apply to them. Netflix does show some profit, but not much, while Amazon has not been profitable for most of its history and doesn’t seem to care. As a result, an investor who wishes to purchase a share of stock in Netflix must pay $284.25 for $1 of earnings. If you think that sounds expensive, Amazon’s stock cost $929.35 for $1 of earnings. Both stocks more than doubled in value last year.
That is great if one took a gamble on these two one year ago, but is it real? Is it sustainable? No, it is not. Benjamin Graham, the father of security analysis, used to say that, “In the short-term the market is a voting machine; in the long-term it is a weighing machine.”
Popularity, momentum, and the madness of crowds can drive the price of investments in the short term, but eventually value matters. Those who invested in Netflix and Amazon last year will say otherwise. They will brag that they made money while just about everyone else lost it. They will say this time it is different. How do I know? Because that is what they said in the late 1990s when the tech bubble was still building. That is what they said in the 1960s with the “nifty fifty.” That is always what they say when, in the midst of an otherwise down market, a few companies whose stocks make absolutely no sense seem to standout. Let us not forget that most of the wisdom of Benjamin Graham came from the fact that he witnessed, and survived, the bubble of the 1920s and the subsequent Great Depression.
They were saying it back then too – “This time it is different.” The Amazons and Netflixs of the world are too cool to worry about old-fashioned ideas like value. At least they are today, but what is cool today often looks, well…I’m trying to think of a word nicer than stupid…several years later. If you don’t believe me, just try to explain to your children how cool that outfit you were wearing in high school was when the picture was taken.
Part of the issue today is that many of the decisions being made about investing in the market are being made by machines and not humans. This is a key distinction. The machines I am referring to are computer programs run to trade into and out of stocks very rapidly, often based on breaking news. So if the news for a company is positive the computer buys, and if the news is negative the computer sells.
This makes perfect sense on the surface, however, the one thing that is not accounted for is that news is often priced into the stock already. What does that mean? If one invests in Amazon at $929.35 for every $1 in earnings, that implies that he has a very optimistic view of Amazon’s business. One willing to pay such a price is assuming that the earnings will grow at a substantial rate. Thus most investors would say that a lot of good news has been priced into the stock. When news breaks and it is positive a human being would say, of course we are expecting positive news, but a computer program isn’t that clever. Expectations don’t seem to matter to the computerized traders, and as a result the winners keep on winning.
This works for losers as well. For example, that investor who paid $929.35 for Amazon’s $1 in earnings could have paid $1.56 for $1 in earn- ings at Atwood Oceanics. Atwood is an off-shore oil drilling company. Most of the news in the oil business has been negative. Of course, when an investor is paying less than $2 for every $1 in earnings, it would seem that a lot of negative news has been priced into the stock already. The price of oil has been dropping over the last year. At some point it would seem that this ceases to be a surprise, which is true for humans but computers…not so much. (By the way, Atwood’s earnings are not only still positive, they are still growing.)
This is textbook market overreaction in both directions. What is unusual is that it is happening at the same time, and it just keeps going. Of course it will stop. The only way it doesn’t stop is if Amazon literally takes over the world and we are not allowed to purchase anything that does not get delivered in a brown box with a smile on the side, and simultaneously we stop using oil forever. Understanding that these are ludicrous assumptions is what separates prudent humans from simple computer models.
Prudent investing is not always as easy as it sounds. Paying attention to what one owns and understanding why she owns it sounds simple, but it is work. Focusing on hitting an absolute rate of return over time can be tough when it seems that nothing which would provide that return is popular at the moment. The hardest thing to do, though, is to understand the risk. What could be risky about owning the stock of two of the most popular companies in America today?
What could risky about buying a house? How could one go wrong investing in this internet thing? What does Chuck mean when he’s talking about value, doesn’t he know this is a brave new world?
One of my favorite quotes from Mark Twain is, “History doesn’t repeat itself, but it does rhyme.” The last time Amazon was this popular it was 1999. 2015 was no exact repeat of 1999, but there may be a little rhyme. Amazon lost more than 80 percent of its value back then and it took a decade to recover. That time was a brave new world as well. Joel Greenblatt, Columbia University professor, hedge fund manager and author of “The Little Blue Book That Beats the Market,” said it best; what we call prudent investing always works over time precisely because it doesn’t work all the time. If everyone was prudent, then there would be no investing opportunities to be had.
But there are opportunities. Cheap prices mean low risk of losing money, but the stocks that are cheap are always the ones that are not popular. It is hard to conceive of a world where investing in a profitable company for $1.56 per $1 earned isn’t a long-term winner. It is also hard to like the oil business. What seems risky is often safe and what feels safe is often risky. That dynamic is one of the toughest things to overcome when trying to invest prudently.
Substance and value didn’t seem to matter in 2015. That does not mean that the world has changed. We have seen this before and we know how it ends; eventually what one pays for an investment is what determines its long- term success. If being prudent is out of style, then so be it. Fashion has a way of drifting back toward the classic faster than most believe. Patience is in order for the prudent investor.
Charles E. Osborne, CFA, Managing Director
A few years back I had the pleasure of meeting Emanuel Derman. A pioneer in the movement of physicists migrating to Wall Street, Derman was there when investors started using sophisticated mathematical models to make investment decisions. Derman has a Ph.D. in theoretical physics from Columbia University and had been a scientist at Bell Labs before moving on to a career in investing. We met at a lunch where he spoke about the difference between models in finance and models in physics.
As part of the talk he went through the history of thought in physics and the great thinkers who had changed people’s view of how the world works – people like Newton and Einstein. The one interesting thing I took away was that each individual that had furthered the science of physics had first spent an entire lifetime doing little but studying physics as it was understood before them. In other words, the true pioneers that really did think “outside the box,” as we are so fond of saying today, first dedicated their lives to learning more about the box itself than anyone else who had come before.
This revelation really hit me. It makes complete sense, but it is completely foreign to the world we live in today. Social media is about shouting your opinion and having it confirmed by like-minded friends, not about understanding. Unfortunately this phenomenon is not isolated to the lowest common denominator that often drives pop culture.
We have interns here at Iron Capital. Typically we will have one undergraduate and one grad student per semester. It is a very popular program because we actually let them see under the hood– they get to analyze investment opportunities using the models we have created. Most of our interns are very good, and we have hired more than one after their graduation, but occasionally we get one who does not get it. Once we had one who really enjoyed thinking outside the box. He decided that he could drastically improve the model we use to analyze the stocks of growth companies. Sales growth should be the only thing we look at because, he informed me, it was the only thing that really matters. Grow sales and everything else falls in place.
I then asked him whether he had heard of Webvan? Of course he was too young to remember the pioneer if Internet- based grocery delivery. Webvan is a great example of a company that imploded because they grew sales too quickly. The service was fantastic. I remember within months after it came to Atlanta the vans would be in my neighborhood almost every evening delivering groceries to my neighbors. It cost no more than the regular grocery store, which ultimately was the problem. Webvan grew sales like crazy, and lost money on just about every delivery right up until the day it disappeared.
I explained to our intern something that his self-esteem generation ears were not used to hearing: more than 20 years of investing experience had gone into these models, and when he had been running these models for that long, then he could tweak them. In the meantime he needed to learn. I came from a generation in which this was made clear to me. I didn’t need my first boss to tell me that I didn’t know anything; I knew that I didn’t know anything. This intern wasn’t interested in understanding what went into our models, but he was interested in expressing his own opinion.
Seek first to understand. Stephen Covey, in his book “Seven Habits of Highly Effective People,” lists habit number five as seeking first to understand, then to be understood. Of course that bit of wisdom did not begin with him; it is as old as the scriptures. I often tell my daughter that God gave her two ears but only one mouth, and she should learn to use them in the same proportion. (My son, on the other hand, I have to encourage to speak up, but that is a topic for another newsletter.) A thirst for understanding is helpful in every field I am sure, but it is crucial if one’s chosen profession is investment management.
Where does one go to obtain understanding? Many may think the university is a good place to start. I would suggest that this is certainly true in fields like dead languages, medieval Russian literature, or Egyptology; however, if one goes to school to learn about economics and finance, these are practical fields which can be practiced in real life. There was a time when I considered going back to school to get a Ph.D., and I was discussing this once with a hedge fund manager who had a PhD in mathematics. He asked me what I would study, and I said finance. “Why the hell would you do that?” was his response.
I was shocked, but he went on to say, “You can practice finance, you don’t need to study it in a university.” That made me think: Every really successful investor I knew of who had a Ph.D. had one in some field other than finance – most commonly in math, physics or psychology. Then I started thinking of other people I knew or knew of. My brother-in-law, a successful institutional bond trader for thirty years, has his MBA. I remember him telling me that he learned more the first six weeks of work than in the six years combined he spent in college and graduate school. Seth Klarman, the famous hedge fund manager, suggests the same thing in his book, “Margin of Safety.” Klarman has an undergraduate degree from Cornell and an MBA from Harvard, but says he learned more working for Max Heine and Michael Price at Mutual Shares (now part of Franklin Templeton).
Please do not misunderstand: I put a very high value on education. In fact, I believe in education for education’s sake. It is my opinion that an educated person will lead a more fulfilled life. I also recognize that there are many areas in life where the greatest minds probably are at the university. But when it comes to investment management, the old cliché holds true: those that can, do; those that can’t, teach.
Why is this important? Because most of what passes for financial education these days comes from higher education and is then filtered by Wall Street. Nowhere is this more prevalent than the cult of index investing. It stems from this idea that markets are “efficient.” I use quotation marks because what is meant by this is that markets are always correct, not that they operate in an efficient manner.
Of course this is complete nonsense. As C.S. Lewis liked to observe, this is an example of humankind’s propensity to be oblivious to the obvious. Oil cost more than $100 a barrel just a year ago and today costs $45. The actual supply and demand relationship has not really changed, so which is the correct price? If $100 was correct, why did it drop? If $45 is correct, why did it ever go to $100?
Even most academics have given up on the idea that markets are efficient all the time and recognize that at least occasionally market participants act irrationally. However they still won’t give up their holy grail of index investing. They continually site studies showing that the average manager underperforms. This is a fact; average is not very good in my business. Of course my business is not alone, and this is a little bit like making the bold prediction that C students don’t get straight As.
Iron Capital has been in business now for more than twelve years. One of our primary functions for both our insti- tutional and individual clients is to pick investment managers, usually through mutual funds. We track how well we do this task every quarter. On average 81 percent of the managers we selected at least five years ago are better than average over the five year period. Over 59 percent of the managers we select end up in the top quartile over five years, and a whopping 73 percent beat their index. So much for that “can’t identify superior managers” theory.
Of course, we have had a slight advantage – for a decade, from 2000 to 2010, almost every active manager beat his benchmark. The index crowd never admitted defeat, they just got quiet. However, over the last few years the indexes have been winning. I’ve been doing this for a long time, and these trends certainly do occur. What I have noticed is that the index will tend to outperform active managers when something is not right in the market, usually in the last phase of a bubble.
The index crowd does not seem interested in understanding why the aggregate of professionally trained investors, who through various techniques and strategies pick investments that seem sound, might be underperforming the index. They just wish to shout their opinion. It seems to me that one might ask why?
If active investment managers are doing worse than a market index, that means the managers either do not own or own less of the stocks within the index that are seeing the highest growth in price. It would seem to me that if we go through a period where almost no professional investor wishes to invest in these companies, then one should question whether something is amiss. That certainly happened in the late 1990s when this craze first took flight, and it turns out that most managers not buying worthless dot-com companies were pretty smart. The next time the largest index, S&P 500, had a solid winning streak was right before the 2008 crash. It was happening again over the past year and guess what, we are now in a downturn.
This will not convince any of the true believers – not the academics who can’t do it themselves and therefore believe no one can, or the Wall Street product-pushers who make more money the more people trade. Most managers own fewer stocks than are in the index, which means fewer trades and less money for Wall Street. Of course better, in their view, than the mutual fund is the exchange traded fund (ETF). Wall Street makes money on each trade into and out of these funds, as well as all the buys and sells which are created when the ETF sponsor must increase or decrease its holdings.
Carl Icahn has warned that ETFs will be the next bomb to blow up in Wall Street’s face. Who is he but an old-time active investor who has not been doing so well relatively speaking over the last year or so? Perhaps I’m wrong – are we the fools who fail to understand but delight in our own opinions? I don’t think so, if for no other reason than the fact I often ask myself that very question.
There is no doubt that our approach at Iron Capital is currently considered out-of-the-box, but we have collectively studied that box for a long time. I think we have earned the right to step outside.
Charles E. Osborne, CFA, Managing Director
~Thinking Outside the Box
The team broke huddle and came to the line of scrimmage. Their star quarterback, Osborne, took the snap and dropped back to pass. The pocket broke down and he scrambled to his right. Seeing no one open for a pass Osborne tucked the ball for safety and decided to run for what yardage he could get. Then out of the corner of his eye he saw his fullback break open. He tried to get the ball back up in a throwing position but the defense was on him, so at the last second he attempted what could only be described as a basketball-style chest pass vaguely in the direction of his fullback. The ball floated right into the hands of the other team’s cornerback, who ran it back for a touchdown.
The rest of the Osborne family sat in the stands, somewhat in disbelief as to what they had just witnessed. An avid fan sitting directly behind them stood up and started shouting, “Stupid! Stupid!” Osborne’s loving and protective older sister had heard enough. She stood up, turned around and announced to the avid fan, “That’s my brother!” At this time, the senior Mr. Osborne put his arm around his daughter, tried to calm her down and said, “Well, you do have to admit, that wasn’t the smartest thing your brother has ever done.”
No, it wasn’t me. This true story was about my brother, who is a successful attorney in South Florida and, this one embarrassing episode aside, a very intelligent guy. But even the smartest among us occasionally does something that can only be described as, well, stupid. For most of my life I have assumed that everyone recognizes this as a fact of life. Then one day I was trying to put together one of those “some assembly required” toys for my son and I made a mistake. I looked at my son as I was fixing it and said, “That was stupid of me.” My son looked at me in horror and informed me that stupid is a bad word.
Until that moment I thought I knew all the bad words that I did not want my children to learn from their father (most of which have four letters, not six.) I tried to explain to him, as was taught to me in a different era, that calling some- one stupid is bad, but stupid itself is not a bad word. Smart people do stupid things all the time, usually when in a hurry or distracted and not fully thinking. I gave up and now try to use the word silly when describing stupidity.
I understand why a teacher would tell children that stupid is a bad word, especially at a young age, as one of the greatest ironies of childhood innocence is that children can often be cruel to one another. Of course, in the real world stupid happens all the time. We’ve all seen it and most of us have done it – I know I have. It happens in sports, when many games are determined by an opponent making a mistake in judgement. It happens in politics, when a promising politician says something carelessly and all of a sudden his career meets its end. The one place it may happen the most often is in my world: the world of economics and finance.
Traditional economics and finance assumes rational behavior. Of course humans are capable of being rational, but this often requires energy and focus. Many times in our busy lives we feel like that quarterback who is being rushed out of the pocket. Our modern lives do not usually lead to actually being chased down and tackled, but between work, family, and our “smart” phones that keep beeping and vibrating at us, constantly reminding of us of the twenty things we were supposed to do today that still are not done, we may feel just as overwhelmed.
It is no surprise then that experts have found that the first thing most people feel when presented with an investment opportunity is reluctance. How are we supposed to slow down enough to use our powers of rationality and make smart decisions? We feel like that is just too hard, so we are reluctant. We don’t want to make a mistake, and although at some level we may recognize that doing nothing might actually be the worst thing, we just feel more comfortable not having to move.
We are like that quarterback in the pocket protected by all those big linemen, but eventually that pocket of protection will start to break. Co-workers, friends, neighbors, or even family members who were not reluctant for whatever reason start pointing out how well they are doing. Our reluctance slowly turns to optimism.
Then we go online. Our modern world gives us the ability like never before to conduct what passes as research: “Google it.” We can post questions for our friends on social media. But there is a dark side. All of that connectivity can lead to seeking confirmation more than true enlighten- ment. One of my friends recently put it best when discussing social media: no one is out there seeking to under- stand; they are out there to have their views amplified, and if anyone dares question them then to shout them down. So people go out there seeking confirmation of their optimism, not seeking truth.
One of the quirks of the Internet is that it will give you what you seek. In this case that causes optimism to turn into excitement. As one stays in his echo chamber getting more and more positive feedback his excitement eventually turns to exuberance, and it is a this moment that the inaction ceases and the investor makes the investment.
All around in the busy world he will see glimpses of positive feedback. He will believe that he has done the right thing, the intelligent thing. Then reality hits home. Bad news, previously ignored, comes to light. Perhaps sub- prime mortgages start to default, or maybe a hedge fund run by a smaller Wall Street bank folds. The reaction will usually be to rationalize, “It’s just sub-prime and that is a small part of the market,” or “It is just one hedge fund.” In other words he is in denial. After all he is intelligent, he did his homework, there is no way he is wrong, there is no way he did something stupid.
Well the hits keep coming. That small firm that ran the failed hedge fund? Now the whole firm is in trouble. This is getting a little scary. Fear sets in, but fortunately regulators come to the rescue and arrange for that troubled firm to be bought by one of its stronger competitors. But, now an even larger firm is in trouble. So are two others. This is getting desperate, what does the investor do? He now has a loss and he doesn’t like taking losses, which is like admitting a mistake.
Then it happens: the larger firm goes down, and another is on the brink. The pocket has completely broken down and big scary defensive linemen are on your tail. Panic sets in, he runs for it, and as all seems lost he finally capitulates, just throwing the ball up for grabs. The other team catches it and runs it back for a touchdown. The Monday morning quarterback in the stands starts shouting, “Stupid, Stupid!”
Sound familiar? It should, because it happened just a few years ago. That small firm was known as Bear Sterns, the larger one Lehman Brothers, the two others, Countrywide and Washington Mutual. This is what happened. I could do the same thing with the tech bubble, and we may be seeing something similar with Greece and China today.
Where do we go wrong? First of all we have too many Monday morning quarterbacks. I sometimes joke with friends that our national pastime used to be playing baseball, and now it is watching football. Technology has led us more and more to be spectators in life instead of participants. We have told that story about the fan calling my brother stupid so many times in my family that it seems like yesterday, but fortunately for my brother it happened in the mid-1970s. I can’t imagine what the reaction would be like today with social media. One thing that always helped with our family was that we understood that the fan really had no idea what it is like to actually be a quarterback.
Spectators sit back and offer criticism after the fact, which doesn’t take any courage, knowledge or understanding – it is easy. Let’s face it, the players usually cannot hear what the spectators are saying anyway. It’s just noise. This happens to the investor as well: Financial advisers who don’t practice what they preach, lecturing clients about this or that. Financial reporters, who know far more about journalism than investing, give advice that always sounds good in hindsight, even if it contradicts what they said last week. It’s all noise.
The reality of today’s world makes it increasingly difficult to overcome reluctance; at the same time, it makes it increasingly easier to fall into denial. All of the big mistakes investors make are driven by these two emotional states. I have long considered it our most important job to help our clients avoid these two things. This is why we emphasize prudent investing. It is much easier to avoid reluctance if one knows what one owns.
Investing from the bottom-up helps one gain an understanding of what is really happening; it gives us a tool to separate news from noise. Analyzing individual investment opportunities automatically drowns out the noise and helps guard against feedback bias. A company’s financial results are what they are regardless of what might be going around on social media.
Absolute return-orientation helps avoid the excitement trap. We don’t need to beat anyone or anything to get where we are trying to go. In this way investing is more like running a marathon than competing in a football game: for the vast majority of marathon runners, to finish is to win. If they beat their personal best, their personal goal that is victory regardless of what other runners are doing.
Risk aversion means never being in denial. Lots of things that shouldn’t have any impact on the markets end up causing havoc. Small things can have a big impact, and big things sometimes have little impact – one never knows how people will react. This is when it is important to know what one owns and understand that even if short-term trading turns negative, patience will be rewarded because what she owns still has value. This is also when it is impor- tant to have disciplined risk controls, realizing that it is better to sometimes be defensive and miss out on upside market reversals than it is to be in denial and end up capitulating.
How do intelligent people avoid doing stupid things? We take our time. We don’t get rushed or scared or distracted. We make prudent decisions. Is our
way of investing the only way? No. But it works for us and our like-minded clients. There are other strategies, alternatives, indexing, sector rotation, market timing, etc. But all of those run the risk that one day a Monday morning quarterback might look at what they’ve done, jump up and yell, “Stupid, Stupid!” I like our way better.
Charles E. Osborne, CFA, Managing Director
~Stupid Is as Stupid Does
Growing up in North Carolina in the 1970s there were two kinds of kids: those who worshiped the ground Dean Smith, legendary basketball coach of the North Carolina Tar Heels, walked on; and those who thought he was the devil himself. I was in the former camp right up until the day my beloved late Uncle Dag convinced me that I should get my education at Wake Forest and not that school on the other end of Tobacco Road.
For all of his success it is easy to forget that Smith was not hired because anyone thought he could win. He was a young assistant who had never been a head coach. He was asked to step up when Frank McGuire was forced to resign because of NCAA violations. Smith was hired the same day McGuire was fired and told that wins and losses didn’t matter as long as he ran a clean program and represented the university well. He went on to win more than 77 percent of the games he coached and 879 games total. He also lived up to his original mandate.
Smith was a man who was not afraid to stand up for what he thought was right. When he was still a young assistant coach he helped desegregate Chapel Hill. His minister had asked Smith if he would accompany him and a black member of their church to dinner at a white-only restaurant, and Smith agreed without hesitation. The restaurant they chose was one where the basketball team often had team meals. The owners knew Smith, who was not famous yet, and did not wish to risk losing the team’s business, so they served the trio and the desegregation of Chapel Hill was begun. That story remained largely unknown until author John Feinstein found out about it while researching a book on Smith. When Feinstein asked him to verify the story, Smith asked who had told him about it. Feinstein revealed his source and Smith said, “I wish he hadn’t done that.” Surprised, Feinstein said, “Dean, you should be proud of doing something like that.” Smith looked him in the eye and said, “John, you should never be proud of doing the right thing. You should just do the right thing.”
A few years ago I decided to volunteer to coach my son’s basketball team. I was telling a client about the decision and he said, “I bet you’ll be really good at it.”
I thanked him, then asked why he had that opinion. He told me that coaching is mostly about teaching and that is a lot of what we do as advisers. He is right – there are indeed many similarities between coaching and being an adviser. The skills needed to convince someone to save more money can be very helpful when convincing a young player that he needs to pass the ball every once and a while. One could argue that risk control in investing is a little like defense in sports: It may not be as exciting as offense, but it is often what wins championships.
Unfortunately for both sports and investing, the strongest link between the two may be the skewed incentives of those involved. Today the traditional financial adviser is really a salesperson whose world revolves around bringing in assets. This role evolved over time. Originally the term adviser was reserved for money managers, who were hired and paid a fee to make investment decisions on behalf of their clients. The clients who could afford such service were either institutions, such as corporate pension plans, or very wealthy individuals. Most investors went without the help of an adviser.
These investors purchased various investments through salespeople known as stock brokers. The role of the traditional stock broker has been eliminated by technology, however the salespeople have survived by re-branding themselves into financial consultants and eventually financial advisers. When we bring on a new client we ask them who manages their money now. Our older clients will answer, “I do, and John is my broker at Merrill Lynch.” Younger clients will say, “Merrill Lynch manages my money.”
In basketball, coaches like Dean Smith used to run summer camps, and elite young players spent their summers going to such camps. Many of these have been eliminated or greatly reduced. In their place we now have leagues, the largest of which is the Amateur Athletic Union (AAU). The issue with this transition is that the incentives of those who coach in camps and those who coach teams in a league are very different. The goal of a camp is to develop players, while the goal of a league team is to win games. If a young player with a lot of raw talent but poor footwork goes to a camp, the coaches will want to focus on that footwork and get him moving more efficiently. If that same player joins a summer team, that coach has other priorities. They must compete so the coach has to teach the players his offensive plays, which takes a lot of practice time away from fundamentals like footwork. Coach wants to help his kids, but the last thing he needs is his star player worrying about footwork in the middle of a tournament where they play two or three games a day. If he tries to fix the skill issue he is likely to see his star not play as well as the new footwork has not become natural yet, and therefore they will lose games and the coach will lose his job. As a result, college basketball is full of very talented players that have very little skill. The NBA has been forced to create a minor league system and employ “skills coaches.” The solution that gets talked about for this problem is rule changes to make it easier to score. Those may or may not be good ideas, but they do not address the real issue.
Similarly, in the investment world investment advisers who are paid a fee to manage a client’s portfolio are incented to manage that portfolio well and help it grow. Conversely, financial advisers are paid commissions for selling products and are incented to sell more products to more and more people. When I bring this to someone’s attention for the first time I usually get this look of astonishment. Most refuse to believe it, because no one in their right mind would design an industry like that. But remember today’s investment industry wasn’t designed; it evolved.
Investment advisers represent their clients as fiduciaries. According to Wikipedia, “A fiduciary is a person who holds a legal or ethical relationship of trust between himself or herself and one or more other parties…. Typically, a fiduciary prudently takes care of money for another person. In such a relation, good conscience requires the fiduciary to act at all times for the sole benefit and interest of the one who trusts.” This is exactly what investment advisers do – they manage the investments of others.
In the aftermath of the financial crisis many people were shocked to find out that this is not what financial advisers do. Financial advisers sell products and are no more responsible for those products than any other salesman in any other industry. People were shocked to find out that financial advisers might sell products they themselves would never buy, and were horrified to learn that financial advisers would agree to buy investments from one client in order to sell them to another. That is the definition of being a broker after all, but their business cards stopped using that word years ago.
In response our leaders in Washington have now decided that all advisers should have to be fiduciaries. Doesn’t that sound wonderful? Unfortunately, there are a multitude of problems with this, but for the sake of space we’ll just discuss the most obvious one: A commissioned salesperson cannot act in the sole interest of his clients, since the commission is a huge conflict of interest. I know what you are thinking: Sure the commission is a conflict, but my financial adviser is a good guy, he goes to my church and coached my son, he would never succumb to conflicts.
Issues like this are very interesting for people like Dan Ariely. Ariely, a professor at Duke University, is a pioneer in what we call behavioral economics, the study of how people actually act in real world settings as opposed to how traditional economic models suggest. Traditional economics assumes greed, and therefore would assume that a commission-based adviser would do whatever he could get away with to maximize his commissions. Behavioral economics show that, as you suspected, most people have a moral compass which prevents them from cheating to the maximum. In his book, “The Honest Truth About Dishonesty”, Ariely presents many studies which show that while most people will cheat if given the opportunity, they only cheat by a little. However, one of his findings is that conflicts of interest are stronger than most think.
The normal reaction to conflicts of interest from regulators is to demand disclosure. Ariely did this in one of his studies, and in fact the people who disclosed the existence of a conflict acted even worse. His theory is that the open acknowledgement that the conflict exists eased their conscience and allowed for greater cheating.
But wait, it gets worse. Another great contributor to cheating is the distance between the cheater and the ones being cheated. Financial advisers are sellers of products, and those products are designed and managed by people far removed from the actual investor. Finally, the nail in the coffin of moral behavior is witnessing someone else cheating and not only getting away with it, but being rewarded for it. Financial advisers are rewarded for selling more products and bringing in more clients. Your guy may be a straight arrow, but if there is one bad apple in his office whom he sees getting praised and rewarded, then your guy will likely follow suit, or leave the business in disgust.
In other words, Ariely suggests a list of things one can do to help promote honest behavior, and today’s traditional financial industry does just about every one of those things wrong.
Many sports pundits believe that the rules of college basketball need to be changed. They want to shorten the shot clock and make it easier for the offensive players to move. They believe that changing the rules will bring back the glory days when players actually made half or more of their shots and teams routinely scored eighty points or more in a game. These rule changes may or may not be a good thing, but one thing is certain: Changing a few rules is not going to magically enhance the skill level of the average college basketball player. To do that there will need to be more fundamental changes to the current AAU system.
In like fashion, Washington wishes to stamp the word fiduciary on anyone who calls themselves an adviser. That may or may not be a good thing, but one thing is certain: Calling a broker a fiduciary isn’t going to magically end conflicts of interest. To do that, we will need fundamental changes to the industry. Firms like Iron Capital are part of that fundamental change. I’m often asked if I’m proud of that. As Dean Smith said, “You should never be proud of doing the right thing. You should just do the right thing.”
Charles E. Osborne, CFA, Managing Director
~The Right Thing
We live in a connected world. I’m sure you know what I mean. You may be on a trip somewhere and you run into a neighbor, or you might meet someone for the first time and find out you grew up down the street from one another. This past fall my wife and I enrolled our son in a newly established charter school, and the wife of one of the founding board members was one of my Wake Forest classmates. I once boarded an airplane and sat down next to an old high school friend I had not seen in twenty years. When I was a young single professional I went out with a colleague in my office, and we were going to be joined by an old friend of his named Richard. I commented that I went to high school with a Rich who had the same last name, but my friend told me it couldn’t be the same person because his friend hated it when people called him Rich. A few minutes later Rich and Richard ended up being the same person after all. In the immortal words of come- dian Steven Wright, “It is a small world, but I wouldn’t want to have to paint it.”
I don’t know what is more amazing, how many times the world reminds us how connected everything is, or how many times we seem to forget. We seem to want to silo everything. We do it in our budgeting. I cannot tell you how many times I have spoken to people with spending problems and had a conversation that goes like this:
Me: You are spending more than you make, that must stop if you wish to get ahead.
Client: Well the problem is the price of gas went way up and I drive so far to work every day that it really has caused a big deficit in my budget for commuting.
Me: But what about this big vacation you took?
Client: Oh that is not a problem. I stayed within my vacation budget.
Clients like this fall into the trap of using complicated budgeting software that breaks everything down and completely forget that it is the whole that matters. The various budget categories are all connected. If one’s personal budget has ten categories and he runs a deficit in one of them then he must make up for that somewhere else. Otherwise he ends up spending more than he actually has. If day-to-day expenses increase, then he may not be able to spend as much as he otherwise would on vacation.
This siloed way of thinking impacts people’s investments as well as their budgets. Clients come to us all the time with portfolios that make no sense simply because they are all parts and no whole: They have an account for college funding for each child; his and her 401(k) accounts; old job retirement accounts; and that one stock Aunt Betsy left them. Each account has a different strategy, sometimes even different risk tolerances. Some folks have conservative money and risky money.
There are lots of reasons for this hodge podge approach to financial and investment planning. Some of it is simply the pace at which we live these days – everyone is moving so fast that nothing gets done correctly. We know things are not correct, but we just never seem to get around to fixing them. Some of it is that people really do silo these things in their minds. “The money Aunt Betsy left us is sacred because she was my favorite Aunt, so whatever you do, don’t lose a dime.” “The college fund for Sally? Well let’s face it, she is the youngest so we won’t be contributing a lot. Let’s roll the dice and see if we can’t win the lottery. If that doesn’t work out she can just live with her older brother, we sent him to Harvard.” Of course this is not logical when we stop and think about it, but when do we ever do that?
Most people conduct most of their financial dealings with their emotions, not their logic. They loved Aunt Betsy. They really want to go on that vacation. They love their kids and deep down just know that their kids will all get scholarships. This is where we come in.
I once heard a speech about the Declaration of Independence. How it starts with the line, “We hold these truths to be self-evident.” What does that mean, self-evident? The speaker said it meant that when one thinks about it for just a second she sits back and says, “Well duh.” The trick is that one has to take that second to actually think about it. Many simply never do that. They see a headline in a newspaper and never take a second to say does this actually make sense? In fact, to the extent most people do think, they tend to do it in reverse; they draw their conclusions and then search out evidence for those conclusions, ignoring all other evidence.
A few years ago in the heat of the financial crisis I got into a discussion with a friend about government deficits. I suggested that one should wait until the crisis had passed before worrying too much about the deficit. He sent me a paper written by an economist he had heard speak and highlighted a line about the long-term problems with deficit spending (with which I agreed, by the way). He failed to highlight the very next sentence which said that the middle of a big recession is not the time to deal with deficits. But that sentence did not fit his already drawn conclusion. I’m not even sure it ever registered with him.
That economist understood that the world is connected. Deficit spending is not a good thing, especially when done chronically year after year. There are, however, other issues. Spending more than one makes to take a fancy vaca- tion is one thing, but spending more than one makes because of an illness is an entirely different issue. Nothing can be intelligently analyzed in a silo.
Today there is nothing that fits this description more than the price of oil. Oil has dropped in price by more than fifty percent and the explanations for this are incredible. According to the pundits and Wall Street apologists, this is a logical reaction to the plummeting demand for oil and the oversupply caused by America’s energy boom. This is when one should start to question the headline.
The drop in the price of oil has been taking place since June, and there have been no significant changes in supply or demand for oil since June. That does not stop those who have already drawn a conclusion from seeking out data to support that conclusion. Speculators are lining up to be quoted about the plummeting demand for oil. The only problem is that out in the real world, according to government organizations that track such things, there is no drop in demand.
The U.S. Energy Information Agency (EIA) projects global demand for oil growing in 2015 by nine hundred thousand barrels a day…yes, growing. This number corresponds to the estimate given by the International Energy Agency (IEA). It is true that their projections for next year were higher a few months ago, so if one assumes these organizations are actually correct in their forecasts – granted that is a huge leap of faith – then one could say the growth in demand is slowing, but demand is not shrinking in the least and it certainly isn’t plummeting.
Much has also been written about the “glut” in oil supplies. Currently the world is producing more oil every day than we consume, but that is not unusual. According to the EIA the world produced 91.96 million barrels a day in 2014 while we consumed 91.44 million barrels a day – a difference of 520,000 barrels a day. In 2012 the world produced 89.76 million barrels a day and we consumed 89.14 million barrels a day – a difference of 620,000 barrels a day. Of course 620,000 is more than 520,000 and there was no crash in the oil price in 2012. In 2013 the world consumed more than it produced as demand increased more than supply, and my bet is that happens once more.
People who live in New York and never drive anywhere may not under- stand this, but everyone else will use more oil if the price is cheaper. Consumer Reports recently named the new car models with the lowest consumer satisfaction. Guess what, they were all tiny, super fuel-efficient cars. Gas is a lot cheaper than it was when those disgruntled consumers settled for those models. The toe bone is connected the foot bone and the foot bone is connected to the heel bone. Don’t be surprised if consumers start going back to larger, less efficient cars.
Many of the pundits who go on and on about the plummeting demand for oil claim that it is because the global economy is evidently collapsing. A day later the very same pundits will talk about third quarter GDP for the U.S. coming in at 5 percent growth. The U.S. is the largest economy on the planet. We are the largest consumer of oil. We love our big cars and hate the tiny things high-priced oil made us buy. Yes, Europe has issues and China is growing up and no longer having pubescent growth spurts, but the heel bone is connected to the ankle bone and the ankle bone is connected to the shin bone. The U.S. economy has positive momentum and now the U.S. consumer has just been given a huge budget saving price cut at the pump.
Here is one of those self-evident moments: The economy of the United States cannot grow at five percent, or anywhere close to that, and the demand for oil drop. One of those big market- moving stories must be incorrect. After all the shin bone is connected to the knee bone. Everything we consume in the U.S. requires energy in order to be produced and transported. GDP (gross domestic product) is a measure of everything we produce and consume. The knee bone is connected to the thigh bone and the thigh bone is connected to the hip bone.
So what is really causing the price of oil to drop? In my opinion that is the wrong question. The question should be the same question we started asking in 2008: Why in the world did oil’s price go so high in the first place? In 2008 I wrote about the roaring price of oil. Once again, back then supply and demand were blamed. Of course it was true that demand from emerging markets had an impact, just as greater production from the U.S. is having one now, but then as now, the price jump happened rapidly while the supposed excuse had been around for years. The best research we could find in 2008 suggested that the supply and demand alone would justify a price in the $60 to $70 range. Nothing has happened since then which would substantially change that estimate. EIA data suggest that global supply and demand have grown slowly and largely together since 2008.
What has changed is institutional investors. I mentioned in 2008 that pension plans, endowments and other institutions were piling into oil. Stocks looked bad in their rearview mirror and commodities had been rising so they started selling stocks and adding commodities to their portfolios. Oil was trading at $140 per barrel when I wrote that. Those investors were a large part of the reason, because if everyone buys the same investment at the same time the price goes way up. You see, the hip bone connected to the back bone and the back bone is connected to the shoulder bone.
Fast forward six years and those stocks all those institutional investors got out of have come all the way back and then some. But those institutional investors and their retail financial adviser copy cats have been going into commodities. Oil was already down almost $40 per barrel over that time period. Once again with eyes glued to the rearview mirror these same institutions are now questioning their collective wisdom. Many have begun to exit such “alternative” strategies. The shoulder bone is connected to the neck bone and the neck bone is connected to the head bone. This ride in oil is far more about Wall Street than it is about Main Street’s demand for oil.
The problem with investing in commodities such as oil is that they are not really investments. As Benjamin Graham taught us, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” A commodity is simply worth what someone is willing to pay and that is a speculative operation. When one takes a moment to think it becomes self-evident: speculation is driving the price of oil.
The pundits don’t want you to see the connections. Wall Street makes money from trading – to them it makes no difference in which direction the price is going. Emotions drive trading, and in the case of oil, the emotion is fear. Those emotions are more easily manipulated when issues can be siloed. But, Dem Bones are connected. Whether it is budgeting or managing one’s investments or anything else, the more one understands that Dem Bones are connected, the more self-evident the prudent path becomes.
Charles E. Osborne, CFA, Managing Director