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.
“When it comes to retirement, the old saying is true – there is more to life than money.”
“The investment world has a language all its own, and it gets used and abused..”
“We can’t control the score board; all we can do is keep playing the game…”
“Arrogance and self-awareness seldom go hand in hand.”
Rule Three: PRUDENT INVESTING IS RISK-AVERSE
In 1913 a great flood hit the state of Indiana. It started on March 21, which happened to be Good Friday. A windstorm hit the state followed two days later, on Easter morning, by rain. It rained for three days, causing the Wabash River to rise and flood by Tuesday morning March 25. The water continued to rise for two more days, completely flooding the town of Logansport and leaving many of the town’s residents stranded and fearing for their lives.
At approximately midnight on March 25 the mayor of Logansport sent out a distress call to General Leigh R. Gignilliat at nearby Culver Military Academy boarding school. Culver, which is located on a large lake, had just a few years earlier launched a summer Naval School where summer campers could learn to operate cutter boats. Culver’s boats were in dry dock for the winter. Each boat was twenty-eight feet long and eight feet wide and weighed approximately 3,000 pounds.
Gignilliat woke the corps of cadets and they started loading the cutters onto rail cars. By 3:00 a.m. on March 26 the boats were loaded and the cadets jumped on the train and headed to Logansport. They went as far as the train could go, unloaded the boats and began their rescue mission. Over the next two days those cadets saved the lives of more than 1,500 residents stranded by the floodwaters. The following year, in 1914, the town of Logansport commissioned and donated a bronze and brick memorial gate in appreciation for what
those cadets had done. Logansport Gate, as it is known today, now forms the back gate to Culver’s campus.
Seventy years later a young man named Chuck Osborne matriculated at Culver and was required to memorize that story, among others. It is a great story, and I still get emotional when I retell it. One can only imagine what it was like for those teenage boys to come to the rescue of so many. For Culver students then and now the story becomes ours, as it was a seminal event that helped shape the institution and its mission to create leaders who learn to lead by doing, or should I say lead from in front. That story helps to bring purpose and meaning to being part of the Culver institution.
We all have those kinds of stories. They may not involve saving lives (trust me I have never done anything that heroic), but they define our life stories. The groups we belong to, the people with whom we have shared fellowship, the places we have lived and things we have witnessed: These things bring meaning to our existence and most of the time they happen when we are doing something as part of a defined group. It could be our high school, like the story I shared, or it could be family, church, etc. However, for most of us we spend the majority of our lives, and therefore our stories, doing something we usually think of as work.
From the time we are in our early twenties until today, we have spent most of our time working. We are often defined by our work. “This is Chuck he manages money,” or “This is Susan, she is a lawyer,” or “This is Bob, he is the captain of a tug boat,” or maybe, “This is Dawn she is a stay-at-home mom.” Certainly there is more to each one of us than just our jobs, but our jobs are a significant part of our lives.
So what happens when it is time to retire?
Retirement is the number one goal that we hear from our clients. The vast majority of the money we manage is being accumulated for the purpose of providing retire- ment income. The two most frequent questions we are asked from our clients are, “Do I have enough for retirement?” and “How do I transition from accumulating a retirement portfolio to living off a retirement portfolio?”
In our experience most fear the first question more than they should. They hear claims like the one recently made by Senator Maria Cantwell who stated that “…92 percent of Americans are unprepared [financially] for retirement.” Of course the senator was quoting a study, and there are lots of them. Most claim that anywhere from 53 percent to 84 percent of Americans will have inadequate income in old age. Andrew Biggs and Sylvester Schieber recently co-authored an article in The Wall Street Journal claiming that “…these statistics are vast over- statements, generated by methods that range from flawed to bogus.” Biggs is a former principal deputy commissioner of the Social Security Administration and Schieber is a former chairman of the Social Security Advisory Board. They know a little bit about the subject of American retirement readiness.
Their claim matches what we have seen in our own client base. We help many of our clients with retirement and other forms of financial planning. There are certainly times when in doing so we must bring our clients bad news, but the majority of the time we deliver to our clients the news that they are better prepared then they originally thought. We can see the stress disappear from their faces as we go through the results.
The second question is easily answered. Several years ago now we created our income strategy. It is based on our belief that a prudent investor is absolute return-oriented and not concerned with the investment results of others. If a retiree needs to take income from her portfolio that equals 5 percent of the total, then we should invest that portfolio to achieve 5 percent income while taking as little risk as possible. In today’s market that means owning the stock of companies like AT&T that makes dividend payments equal to 5.19 percent of the current price of the stock, or in industry terms yields 5.19 percent. Should rates rise and the United States Treasury offer to pay 5 percent interest on its debt, then she would own Treasuries. The point is to get the retirement income in the safest way possible. It also has the side effect of leaning more to stocks when interest rates are low and toward bonds when interest rates are high, which just happens to be a logical way to maximize returns over time.
Once the ability is calculated and the strategy understood, the conversation usually ends. But, it should not. There are two other questions that few ask, but everyone should. The first deals with health. Remember the story of Tithonus in Greek mythology: Tithonus was kidnapped by Eos, Titan of the dawn, to be her lover. Eos asked Zeus to grant Tithonus immortality, but she forgot to ask for eternal youth. Tithonus indeed lived forever but became old and frail and eventually was too weak to move his limbs. He begged for death but it would not come. The moral of the story is be careful for what you wish.
Retirement may seem great but one needs to plan for keeping in shape. For many Americans what little exercise they get comes from work. When they stop working they stop moving, and when that happens they start falling apart like Tithonus. In their book, “Younger Next Year,” authors Chris Crowley and Henry Lodge do a great job of discussing the importance of staying active as we age. Lodge is a doctor in New York and Crowley is one of his patients. They discuss the importance of exercise in retirement.
Our joints need to be moved and our muscles used or they lock up and deteriorate. The older we get, the faster that starts happening.
The second unasked question is perhaps even more important: What am I going to do to bring meaning to my life? Work provides purpose. We get up in the morning because we have to get to work. I am reminded of the simple prayer written by John Wesley, founder of the Methodist church. “God, grant that I may never live to be useless.” People need to be useful, helpful, needed. If you don’t believe me, watch the crowd on the plane the next time you fly. It starts in the security line as the person in front of you is unprepared to take his shoes and belt off and get out his laptop and quart-sized bag of allowed liquids, because he just had to check all of his messages instead of getting prepared while he meandered through the line for the last twenty minutes. I have often thought that airports should have signs that read, “If your email is so important that it can’t wait 20 minutes then you would be flying private. Put the iPhone away!”
Of course it doesn’t stop there. The minute the plane lands everyone has their phones back out, off of “airplane mode” and seeing what they missed over the last hour in flight. It makes them feel needed. It makes them feel important. While we may not need as much of that as we get with our electronically connected society, we do need some of it and for most of us it comes primarily from work.
Being prepared for retirement is not just about having the money. One needs a plan to stay active, to be involved and to create that sense of purpose. What am I going to do to keep my body active and healthy? What am I going to do for social interaction, fellowship and purpose? When faced with these questions many may come to the conclusion that the supposed bliss of retirement is nothing but a myth. When forced to fill their days, some will choose to play golf and other stereotypical retirement activities, but most will decide that work isn’t all that bad. They may want different work – fewer hours or more flexibility. They may want something more dear to their hearts, like volunteering at a charity, their church, the hospital or some other worthy institution. A person turning sixty-five years old today has a life expectancy of more than twenty years. We all love vacations, but a twenty- year vacation is a bit much.
I can only imagine the sense of purpose and fulfillment that those young Culver cadets felt with every life they saved. They were just boys. The gate that was given to Culver in recognition of their efforts is now more than 100 years old. For those unaware of its history and meaning, today the gate is the place where hungry students go to pick up the pizza they just ordered from local favorite Papa’s Pizza. Even in old age we all need a purpose.
It is our job to help our clients meet their financial goals, the most important of which is usually retirement. This may seem strange coming from someone who manages money for a living, but when it comes to retirement the old saying is true: There is more to life than money. We would be remiss in our duty if we didn’t remind you of that from time to time.
Charles E. Osborne, CFA, Managing Director
~The Retirement Myth
Do you really write “The Quarterly Report”? I get that question a lot. The answer is yes. Most people who know me well think my wife actually writes the report. Her career has been in corporate communications and she is a good writer, but she simply edits. (She will actually tell you she only proof reads my writing, but that is just because she is too modest.) In my opinion it takes two skills to be able to write well: First, you have to be able to tell a story; I learned that from my father. Second, one needs knowledge of language and something we are increasingly destroying in our 140-character culture: grammar.
I learned most of what I know about grammar in the eighth grade. My eighth grade English teacher was a volunteer; her husband was a successful doctor and she didn’t need to work. She volunteered her time at my church-run school because she felt it was her calling to teach middle schoolers how to speak and write in proper English. My hands are beginning to shake just thinking about it now – she was the toughest teacher I ever had, and my first report card that year had on it something that my mother had never seen: a letter other than A – and it wasn’t B either. Mom threatened to not let me play basketball. My father interceded on my behalf and made a deal – I could play my favorite team sport as long as I got that grade back up where they expected it.
So I did just that. I worked harder in that class than I probably did in any other class until I got into my major in college. Along the way something happened that I really didn’t appreciate until many years later: I learned the English language. While that skill can be very helpful in one’s career it does have one very negative side effect: I get chills up and down my spine when people abuse our language, which they increasingly do on a daily basis.
Some things one just has to learn to live with, such as the misuse of good and well, especially in sports. Golfers, for example, will start their post-round interview saying, “I hit the ball really good today,” and I want to stand up and scream at the TV, “No you didn’t! You hit it WELL!!” But, I resist that urge because the proper use of well and good is a battle that cannot be won. Please don’t misunderstand, I am not judging; it is just a knee-jerk reaction ingrained in me by teachers who would respond to the question, “Can I go to the restroom?” with, “I don’t know. Can you?” Then one would sit there holding it in until the correct, “May I…” was presented. I suppose those teachers would be brought up on child abuse charges in today’s schools.
What really bothers me is when people use words that are not really words, especially in an effort to seem more intelligent. Irregardless is a classic example. The fact that it isn’t a word does not seem to discourage those who either do not know what regardless means or just feel that it is not sophisticated enough. Resiliency is another good example. A few months ago I was watching a sports event and the announcer kept saying it: resiliency. It was like fingernails on a chalk board. As it turns out, resiliency is a word. It means resilience, but people stopped using it a few hundred years ago because why in the world would one use a four-syllable word when three syllables do the job. It has unfortunately returned to some popularity thanks to the pseudosophistication movement. Resiliency, it seems, has a great deal of resilience due to its more sophisticated sound.
This poor use of language is not just a problem for those of us who enjoy watching sports. It is rampant in corporate America, where it is seemingly more important to be able to construct sentences with nonsensical industry speak than it is to actually know anything. Branding was the first example I experienced at my first annual conference with Aetna Retirement. Until that time I thought branding was something a cowboy did to a cow in an old western, but there I was listening to some guy high-up in the marketing department who talked for 40 minutes, used the word brand or branding 250 times and somehow said nothing. I felt like Tom Hanks in the movie “Big.” He was a young boy who woke up in the body of a grown man after wishing to be big. In his first business meeting he simply raised his hand and said, “I don’t get it.”
In no industry is this truer than in ours. The investment world has a language all its own, and it gets used and abused. The degrees of abuse range from simple confusion to practical dishonesty. It starts with how we refer
to ourselves: In the good old days when people spoke plain English the investment world was made up of bankers, brokers and investment advisers. Bankers helped companies raise capital to get started or more often to expand operations. Brokers brought buyers and sellers of investments together. Investment advisers managed other people’s investments. It was fairly simple.
Then technology brought buyers and sellers together without the middle man, and the broker, instead of going away, became the financial adviser. They used that term because they were prohibited from calling themselves investment advisers. Investment advisers really didn’t mind however, because they had long been known as money managers. So financial advisers became wealth managers. Every time I have heard someone use the term “wealth management” I have asked what it means. No one has yet given me an intelligent answer.
This is not all harmless marketing spin. Most of our individual clients come to us with accounts from the big brokerage firms, Merrill Lynch, Morgan Stanley etc. Clients over a certain age will say, “I manage my money, and Bob at Merrill Lynch is my broker.” Younger clients will say, “Morgan Stanley manages my money.” They say that because they don’t understand the difference between wealth management and money management. Well, it is the same as the difference between irregardless and regardless. One is a real word, the other isn’t.
Understanding how our industry works is confusing enough. Understanding who is in the business of giving advice versus the business of selling products is a huge step. However the language barrier doesn’t stop there. Regardless (notice: no ir needed) of whether an investor wishes to DIY – that is the contemporary non-English way of saying do it yourself – with the help of a broker or to use an adviser, she must navigate a labyrinth of industry speak in order to build a simple portfolio. Concepts such as risk are described as “beta” and “standard deviation.” Philosophy and process are described as “value, growth, or GARP” – growth at a reasonable price. Portfolio construction is described as “diversification” and investments that cost more are called “alternative.”One is then told that the alternatives he invested in are losing money because they have a low “correlation,” and that is evidently something he should want. Following an index that constantly changes is described as “passive” while owning the same core companies for several years is “active.” The newest thing is “smart beta.” I’m not sure if that means regular old beta is dumb, but I saw an article just last week saying that “smart beta” is here to stay, so we better get some.
All of this is designed, whether purposefully or just by the subconscious habit of human nature, to make those of us in the industry look smart and you, the clients, feel dumb. But don’t! Albert Einstein once said, “If you can’t explain it to a 6-year-old, you don’t understand it yourself.” As I understand it Einstein was a pretty smart guy.
This has long been an issue with fast-talkers who are really more interested in making a sale and gaining a commission then they are in understanding what they are selling, or more importantly in understanding their client’s actual needs. Increasingly, however, it seems to be an issue with actual investors. We often meet people who are just dying to use the five industry terms they picked up to impress us, and I can almost feel their disappointment when we ask them to describe their objectives in plain language.
In plain language people don’t want exposure to beta, smart or otherwise; they want to stay in their home during retirement. They don’t want an uncorrelated alternative portfolio; they want to provide their children with an education. They don’t want market neutral alpha; they want a reasonable certainty that they will not outlive their assets. A 6-year-old can understand that.
Plain, correct language that any 6-year-old would understand is always the best way. An investor always plays one of two roles: she either owns something that she believes will increase in value over time, or she loans money to someone else who promises to pay it back plus interest. We call those roles equity and debt, respectively. Risk to an investor is losing money, not some mathematical formula. This is what we do at Iron Capital. We are investment advisers, or money managers if you will. We represent our clients, not any financial institution. We invest our clients’ money in things we understand. We know what we own and to whom we have loaned. We make prudent investments and structure portfolios to meet real needs while avoiding any permanent losses. It may be considered old-fashioned or boring, but it works. It is a lot like grammar.
Of course there will always be those who are too hip to speak properly and too self-important to speak simply. Irregardless of the truth, the folks who come up with smart beta and reverse CDOs and alternative strategies of every sort have a great deal of resiliency in their ability to produce marketing spin. Why wouldn’t they? After all, they do it so good.
Charles E. Osborne, CFA, Managing Director
~The Things People Say
Have you ever noticed how wise coaches seem to be? The good ones, at least. They give us little bits of wisdom that last a lifetime. Even the run-of-the-mill coach will tell you things like: “Practice doesn’t make perfect, it makes permanent; only perfect practice makes perfect.” Or, “There is nothing wrong with getting knocked down as long as you get back up.” Or, “There is no ‘I’ in ‘team’.” The legendary coaches, however, are much more original and impart enough wisdom to fill a book – in some cases, multiple books. Don’t believe me? Go to the self-help and/or business management section of the bookstore and you will find a myriad of books written by coaches.
John Wooden, Dean Smith, Bill Walsh and Vince Lombardi have all written books. One gets the idea that these are truly singular men and special leaders. I know I thought so, and then last fall I agreed to coach my son’s youth basket-ball team. I was born in North Carolina, played high school basketball in Indiana, and went to college on Tobacco Road. In Georgia – where the two most popular sports are football and football tailgating – that makes you a basketball expert. I took the job, and I am not sure how much the kids learned, but their coach learned a great deal.
Mostly I learned that the old cliché about there not being any such thing as great men, only ordinary men who are thrown into great circumstances…it may be true. Within a few weeks of being named head coach of the Sharks (that was the name the kids picked) I started saying all kinds of really deep, life-altering stuff. The most significant moment came in a game when one of our players had scored and the volunteer scorekeeper was not as fast at updating the scoreboard as the guys who work the big television networks. The other team is driving down the court and my star point guard is pointing at the scoreboard instead of playing defense. At that moment in the heat of battle, if you will, I yelled, “Don’t worry about the score, play this possession. Win this possession.”
After the game I had two thoughts. First, there actually is something intrinsic to coaching that brings out the inner philosopher. Secondly, I can write a news- letter on that one. I am certainly not the first person to speak to the importance of always staying in the present. From Buddhism to our Western Judeo-Christian tradition, this is a concept that is universal in major religion and philosophy. You have probably heard the saying, “Yesterday is history, tomorrow is a mystery, but today is a gift. That’s why they call it the present.” Even a long time ago in a galaxy far, far away, this principle held true. Jedi Master Yoda scolds the young Luke Skywalker about his fantasies of the future, saying never was his mind on where he is, what he is doing.
In economics they speak of the concept of sunk cost. An economic decision must be made in the present, with no regard for how we got here. The great example they use is a story about Andrew Carnegie. Carnegie’s steel company was building a new factory. While the factory was under construction, new technology emerged that would make the factory obsolete upon opening. His managers wanted to open it anyway, after all the company had made a large investment in its construction, but Carnegie understood that this past did not matter. That was sunk cost. In other words, it was in the past and there is no way to go get it back. That investment did not matter now, because facts had changed, and Carnegie ordered the factory to be rebuilt with the new technology.
In our world we are not running steel companies and investing in factories and equipment; we are investing our clients’ portfolios in various securities. The concept is still the same. One of our favorite maxims is that long-term investing is a mindset, not a time frame. I think many people struggle with this concept. We hear people all the time who have made investing mistakes and watched the value of their portfolio drop and they say, “Well I’m in it for the long term.” Behavioral finance teaches us that the usual immediate reaction to bad news about an investment is denial. We want to believe we make good decisions and if we have made an investment then it will work out in the end. If the drop is due to nothing but market noise then it will work out, but when facts have changed the rational investor must change with them.
It is really a simple concept. We make a decision today based on what we believe the long-term future holds. Tomorrow we have to do the same thing, and the day after that. The big picture does not change all that quickly, but it does change. There are lots of people who have made good livings on Wall Street by being “consistent.” They are either consistently optimistic, or consistently pessimistic. They are both right about half the time. They come across as brilliant because they will tell you about how they predicted this bull market, or that bear market. What they don’t tell you is that the optimist has predicted twenty of the last twelve bull markets and the pessimist has predicted twenty of the last five major crashes. A broken watch is correct twice every day. A consistent thought process applied to dynamic information will yield dynamic outcomes. Someone who is truly consistent and in the present will accept new information and allow that information to change his mind. One may invest in a company believing that the long-term return will be fifty percent. If the stock of that company then goes up fifty percent over a short period of time, assuming nothing has actually changed at the company, then the long-term investor should sell.
In another scenario, a long-term investor invests in the stock of a company that she believes has solid management whose interests are in line with shareholders’ as they hold large quantities of the stock themselves. If that management resigns, gets caught in a scandal or simply sells all their shares, then the facts have changed. She may have just made the investment a week ago, but it doesn’t matter. The long-term view is now different and action is required.
It really is simple. However, many people confuse simple with easy. If staying in the present were so easy there wouldn’t be so much written about it. It is really a very hard thing to do. The past clouds our judgment, and the future can cause problems as well. In sports it is very easy for teams to get ahead of themselves. I can recall clearly one of my most embarrassing moments from my college days. I was in the Dean Dome in Chapel Hill, NC, sitting with several Tar Heel friends while my Wake Forest Demon Deacons built a twenty point half time lead. I could see the future of a wonderful upset victory only made better by the fact that we were in Chapel Hill. The Wake team must have had the same vision because they came out in the second half prepared to ease into the victory. Unfortunately for them, and for me, Dean Smith’s Tar Heels did not stop playing just because they were down big. Slowly but surely they marched back and as they got closer the future began to dim, panic set in, and the thought of “we could blow this” could practically be seen on the Deacons’ faces. Carolina took their first lead of the entire game with seconds remain- ing. It was the largest comeback of Dean Smith’s coaching career to that point – thankfully for our pride the Georgia Tech Yellow Jackets gave up an even bigger lead a few years later.
How does a team get that far ahead and then end up losing? They get out of the moment and are living in the future. It can happen the other way as well – a team gets down and then just gives up. It happens in investing, too. Just like in sports, people think whatever is happening right now is always going to continue. Why did people pile into technology stocks in 1999? Because they saw this fantastic future where everything tied to the Internet turns to gold. Why did they pile into housing in 2006? Because they saw a future just like the past, where no one ever loses money on houses.
It is hard to not allow the past to cloud our decision- making, and it is equally as hard to humble ourselves to realize that we really do not know what the future holds. All we have is today, right now. This is why prudent investing is so important. Who knows what the whole world will look like years from now, but we can know if a company’s stock looks undervalued today. Who knows how long markets will boost up the returns of overvalued assets, but chasing those returns usually ends poorly. What risk will actually raise its head tomorrow, we do not know, but we know the risk is there today and the prudent course is to avoid it. We can’t control the score board; all we can do is keep playing the game one possession at a time.
Play this possession. Win this possession. Go Sharks!
Charles E. Osborne, CFA, Managing Director
~Win This Possession
We live in the world of Facebook and Twitter. My generation grew up with the advent of fast food and McEverything. It is no surprise that today’s technology generation grew up with iEverything, starting with the iPod, iTunes, iPhone, iPad, iMac, etc. “Look at me” is the universal cry, so much so that I constantly see people so busy taking pictures of themselves and their friends in what look like fun places that I wonder if they might be forgetting to actually have fun.
Of course this is nothing new, it is the human condition. Our ancient myths are full of stories of prideful heroes being cut down to size and learning that a little humility is a good thing. Recall the story of Daedalus and Icarus from Greek mythology. Locked in a tower by King Minos, the great inventor, Daedalus fashioned wings for himself and his son Icarus so they could escape their prison. The wings were made of feathers held together with wax. Before taking flight Daedalus told his son, “Icarus, my son, I charge you to keep at a moderate height, for if you fly too low the damp will clog your wings, and if too high the heat will melt them. Keep near me and you will be safe.” Of course we all know how it ended: Icarus, so full of himself and the thrill of flying like a god, went higher and higher as if to reach heaven and his wings melted away. Daedalus, in grief over the loss of his son, made it onto Sicily, where he built a temple to the sun god Apollo and hung up his wings as an offering. The great concession: he was only human after all.
Even today in our often narcissistic culture we can see references to the wisdom of humility. In the 2006 hit James Bond movie “Casino Royale” Dame Judith Dench, playing the role of M, delivers what I think is one of the greatest lines in the whole James Bond series while speaking to Bond: “This may be too much for a blunt instrument like yourself to understand, but arrogance and self-awareness seldom go hand in hand.” C.S. Lewis, in “Mere Christianity,” was a little more blunt than M. He refers to pride as the “anti-God state of mind”. He believed it was the route of all evil. Whether that may be a little over-the-top is a discussion for another time, but he makes one of the most insightful comments I have ever read on the subject. “There is no fault which makes a man more unpopular, and no fault which we are more unconscious of in ourselves,” Lewis writes of pride. There is a reason the word arrogant is frequently followed by another word starting with a, which we won’t publish in our family newsletter, almost as often as the word fool.
I do not know if C.S. Lewis is correct about pride, arrogance, hubris or whatever you wish to call it, being the greatest sin overall, but I can guarantee you that it is the greatest sin in investing. It is incredibly dangerous, largely because it is so hard to see in ourselves. As a result it is the number one mistake made by professional investors. Amateurs make all kinds of mistakes; pros usually make only one, but it is a big one. The most notorious example was of course Long-term Capital Management, otherwise known as the hedge fund that almost destroyed the world. If you are interested you can read the book “When Genius Failed” by Roger Lowenstein. The short version is: Two Nobel laureates run a hedge fund that did great until it blew up and required a $3.6 billion bailout to keep the entire financial world from collapsing. It happened in the late 1990s, so much of the world was too wrapped up in the internet bubble to care, but those of us in the industry will never forget.
Not forgetting and learning are too often two different things. In the Spring of 2007, I attended a lunch presentation delivered by a money manager from Chapel Hill, NC. He was a great presenter. He said several things that were just plain wrong, but he said them with such confidence it was amazing. He was running a strategy that was popular at the time: purchasing mortgagebacked securities, which he promised were completely safe, and he was using leverage – which is industry speak for borrowing money for the purpose of investing it – to raise the rate of return to whatever percentage you wanted. To understand how this works let’s assume you had $100,000 to invest. You want to get a 10 percent return which would be $10,000 on a $100,000 investment. Mortgage-backed securities were paying approximately 5 percent. He then suggested you could just borrow another $100,000, invest the $200,000 in 5 percent mortgage bonds (5 percent of $200,000 would be $10,000) to make your $10,000 “without risk.” Of course you would also have to factor in the cost of borrowing the money etc., but this is the basic idea behind leverage.
There was just one problem: Mortgage bonds were not risk-free. Some went down in value well over 50 percent, and in this scenario that means your $200,000 investment would be worth less than $100,000, which is the amount you borrowed. You end up losing more than you ever had. I was in shock hearing this presentation, and then the person next to me looks over and says “Isn’t this guy great?” I told my fellow audience member as politely as I could – which in all honesty was probably less polite than I should – that our speaker was an arrogant fool. I don’t know if the gentleman next to me invested or not, but he was sold.
I have often wondered what ever happened to the speaker from that day in the aftermath of the financial crisis. I don’t wonder about his clients, because I know what happened to them. I do wonder about the arrogant fool. My guess is he is back at it. In my experience the problem with arrogant fools is that they never admit to themselves that they are arrogant or fools, and therefore no matter how many times it comes back to haunt them, they never cease to be either.
The other problem, especially in my business, is that arrogance can often be convincing. As Mohammed Ali once said, “It ain’t bragging if you can back it up.” He did back it up, and many people loved him for it. This is what happens on Wall Street. There has been a loud theme over the last several years that what caused the financial crisis was greed. I have worked in the investment world my entire adult life, and frankly I have not seen much greed. Sure I have seen some, but not like most claim and certainly nowhere near as much as I have seen pride. I could be accused of splitting hairs here, but even the seemingly never-ending appetite to make more money isn’t always rooted in greed. So many of them never spend the money, because that is not what it is about. It’s about pride – being able to claim that you are the best in a game where money is not something you make to enrich yourself but simply a way of keeping score. You are, as Ali was also fond of saying, the “Champ of the world!”
Some may not see the difference between pride and greed, but I think it is an important point. There are not nearly as many greedy crooks in my business as there are prideful fools who really begin to believe that they can do no wrong, and then all of a sudden they meet Joe Frazier. They get stunned in the 11th round by a left hook and then in the 15th another left and “Down goes Ali, down goes Ali!” They don’t intend to hurt anyone; they truly believe their own propaganda. They are blind to their hubris right up to the point when Frazier hits them with that left hook, or until the sun melts the wax on their wings, or until it turns out that even virtual companies have to make actual money, or when people who can’t afford the house they bought stop paying their mortgages.
One of the best salesmen I have ever known used to tell me all the time that he was often wrong but never in doubt. I would laugh and respond that I try to be seldom wrong, but always in doubt. That is the way one must be if they are going to be making decisions about money, especially other people’s money.
Western culture used to value age. Youth was associated with arrogance, and “coming of age” often meant being humbled. With age comes humility and wisdom, and that is what we strive for everyday at Iron Capital. We will never be perfect but we keep striving, keep making progress. One might wonder why we would choose to write such a newsletter now. Certainly this message would be better suited for the end of 2008 than the end of 2013? Well, pride comes before a fall, and that is when one must be on guard. 2013 was a great year, but as Han Solo told the young Luke Skywalker after Luke shot down an imperial fighter, “Way to go kid. Now don’t get cocky.”
Charles E. Osborne, CFA, Managing Director
~Pride Comes Before a Fall
RULE THREE: PRUDENT INVESTING IS RISK-AVERSE
Defense wins championships! I don’t care which sport you are playing, the best always understand that defense is what makes the difference when it really counts. Everyone loves the homerun hitters, but come October it is usually the team with the best pitching staff that wins the World Series. Everyone loves scoring touchdowns and watching teams score 50-plus points, but in the BCS National Championship game it is almost always the team with the best defense that wins. Everyone loves the team that can run the fast break and punctuate it with the awe-inspiring slam dunk, but whether it is March Madness or the NBA Finals it is almost always the team that plays the best defense that wins. I could go on and on.
The reason this cliché represents a nearly universal truth is because it is based on the combination of simple math and human psychology. If you hold your opponent to fewer points scored, your offense doesn’t have to score that many to win. It isn’t a difficult concept to understand. In most sports defense is primarily about attitude and effort, which one should be able to manage with a degree of consistency. Offense, on the other hand, usually requires timing and touch, which can from time to time just disappear even in the most gifted of athletes and especially under the pressure of competition. The excitement of the championship usually makes it easier to “get up” for the moment, have the right attitude and give a full effort. That same excitement, however, often wreaks havoc with timing and touch, leading commentators to often use yet another cliché and explain that the offense just needs to “settle down” and get back to playing their game. The greater the pressure moment, the greater the advantage of the defensively minded team or athlete. Hence the reason for the cliché: Defense really does win when one is under the most pressure – during championships.
The same is true in investing. Defense wins in the end, and in the investing world that means being risk-averse. I know what you are thinking: you are thinking this means having to settle for lower returns, but that is not necessarily the case. Defense can often lead to offense, and I will get to that, but first we need to discuss why people think there is such a strong relationship between risk and return.
This confusion stems from modern portfolio theory. This is the theory that dominates academia, most regulators and the mass educational material that is disseminated from Wall Street. Modern portfolio theory defines risk as beta. Beta is a mathematical term that describes the relationship between the overall market and one particular investment. For those who remember introductory algebra, beta is the slope of the line. What that means is that if the market goes up 10 percent and the investment in question also goes up 10 percent then the beta of that investment is 1. If the investment goes up only 8 percent then its beta 0.8, and if it goes up 12 percent then it has a beta of 1.2 percent.
Any investment that outperforms in an up market by definition will have a high beta, which means that if beta is your definition of risk, then any investment that performs well when the market is up is risky. Conversely, should the market go down and the investment goes down less, it is deemed to have a low beta and therefore labeled safe.
The problems with this definition of risk are manyfold. First, beta is not causal. In other words the investment did not have a higher rate of return because it had a high beta; in fact it is just the opposite. It had a high beta because it had a high rate of return. Secondly, beta is not constant. The beta of an investment is calculated by historical returns, and those return patterns can change at any time. It is probable that an investment that outperforms in the future has a low beta today because most investments, particularly stocks, tend to go along with fairly flat returns for long periods of time until some positive developments occur and the market realizes that this investment is worth more, and then the price shoots up rather quickly. The opposite can happen as well. The point is that beta changes over time and always reflects things that have already happened, not what might happen in the future, which is what we care about as investors. Beta simply tells us what an investment looked like relative to the overall market in the past. It tells us nothing about the future riskiness of an investment and is therefore a poor measure of risk.
Another common measure of risk is volatility. Technically we call this standard deviation, but the concept is simple: the more an investment’s price moves from day to day, the higher the risk. If one uses this definition of risk, then there probably is a relationship between risk and return. The most attractive long-term investments are often companies facing short-term distress. Their prices can swing wildly as little tidbits of news flow regarding the stressful issues at hand. The problem with using volatility as a measure of risk is that volatility goes in both directions. In my experience no client is ever upset by upside volatility; the downside is what people care about.
The other problem is that one is once again defining risk by looking backward, and saying that any investment that had a large return – high volatility = large price movement – is risky. Once again we are defining things as risky after the fact. The level of risk did not determine the return; the return determined what we are calling the level of risk. Just like with beta, it is probable that highly volatile investments were not so volatile before the big move in price. For example: Let’s look at bank stocks as an investment. For much of our history bank stocks were considered boring, safe, usually high dividendpaying stocks. This was true right up to the beginning of the financial crisis. These stocks hardly moved unless there was a merger, and many shareholders owned the stocks for years just collecting the steady dividends. In the beginning of 2007 banks stocks had low volatility and low beta; they were labeled safe. Then the financial crisis hit and these stocks took the worst of it right to the bottom in March of 2009. At that point their standard deviations and betas were very high and they were labeled risky. Wachovia’s stock fell to $2 before Wells Fargo bought them for $6. Wells Fargo, which trades for $40 today, went down to $7 per share. In March of 2009 the selloff had been overdone and these stocks came bounding back. Since then the volatility has been on the up side. It seems to me that in reality banks were risky in 2007 and safe in March of 2009, but these traditional measures had it the other way around.
I believe there is a better definition of risk. Risk in my opinion is the probability of losing money over a reasonable holding period. What constitutes a reasonable holding period can be in the eye of the beholder, but I would say for an investment it should be three to five years. I like this definition because it is real and constant. Losing money is what real people care about; I have never had a client call me to complain about making too much money. Not once have I had someone say, “Man, this upside volatility is driving me crazy!” When the market goes down, on the other hand, risk becomes important. This leads many people to think that they should alter their risk tolerance with the swings in the market. However, if one understands risk as the probability of losing money, then one will never ask for more risk regardless of what the market is doing. That makes it a better definition and one we can use.
That raises an interesting question: What does it mean to lose money? One might think that is an easy concept, but I can promise you that such a person has never managed someone else’s money. Many people think that one has not lost anything until he “realizes” that loss by selling the investment for less than he purchased it. This mentality leads to all sorts of investing mistakes, which could fill an entire newsletter. For now let’s just go with a definition of a loss as meaning the current market price is below what we originally paid.
This is important because even prudent investments with a low probability of losing money over three years are going to face short-term fluctuations, and clients do need to be able to withstand those fluctuations. This is why we ask our clients how much they are willing to lose over a twelve month period of time. We often then get asked what the right answer is. I have always refused to answer in the past but since I’m writing this newsletter on risk, I will tell you: The correct answer is approximately 20 percent. Why 20 percent? This is step one of why defense wins championships.
Math! To keep things as simple as possible we will assume a $100 portfolio. If we lose 10 percent, that is $10 so now we have $90. To get back to $100 we need to gain $10, which is an 11 percent return on $90. The gain needed to get back to even is not much greater than the loss. Let’s say we lose $20 which would be 20 percent of our original $100. That leaves us with $80 and needing a $20 dollar gain, which is a 25% return, to get back to even. This gain is a little higher percentage than the loss but still in the same ballpark. If we lose $30 or 30 percent, we then need to make $30 from the $70 left, a 42 percent return. If we lose $50 or 50 percent, we then need a 100 percent gain on the $50 remaining to get back to even. All that does is get us back, still not progressing to our ultimate goals. This is why defense wins championships.
As I mentioned there is a psychological advantage in many sports to being defensively minded, and the same is true here as well. Investors make their biggest mistakes when they let emotions control their decisions. After the market goes up they get greedy and tell their advisors that they want to take more risk. When the market goes down they get fearful and in a panic sell everything. Defining risk the way we do leads to the opposite behavior. The probability of loss is largely calculated by what Benjamin Graham called the margin of safety. This was also the title of Seth Klarman’s book that inspired this newsletter series. The margin of safety is the difference between what an investment is worth and the price at which it is currently selling. The larger that margin, the less likely one will lose money. Interestingly that is also how one calculates the expected return on an investment. Perhaps the relationship between risk and return is not as simple as we have been led to believe.
At Iron Capital we believe in prudent investing. To be prudent one must select investments from the bottom up, one at a time; one must have an absolute return mentality, largely ignoring the market; and, one must be risk-averse, avoiding meaningful losses of more than 20 percent. Investing prudently takes discipline and patience. Prudence can be out of style for seemingly long periods, but in the end the prudent investors usually win. After all, defense wins championships.
Charles E. Osborne, CFA, Managing Director
~The Three Rules of Prudent Investing