The Quarterly Report

  • The Quarterly Report
  • Second Quarter 2007
  • Chuck Osborne

Independence

“When in the course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the power of earth, the separate and equal station to which the laws of nature and of nature’s god entitle them, a decent respect to the opinions of mankink requires that they should declare the causes which impel them to the separation . We hold these trutths to be self-evident, that all men are  created equal, that they are endowed by their creator with certain unalienable rights, that amonth these are life, liberty and the pursuit of happiness…”

With these words written by young Thomas Jefferson (and a few edits from Benjamin Franklin who didn’t think the document important enough to write himself) our founding fathers declared our independence from Great Britain and gave birth to our nation.

Independence is a trait that Americans value highly. It is closely related to our favorite value which is Freedom. You cannot be truly free if you are not first truly independent. In 2003 when I first envisioned the business plan that became Iron Capital the most important factor was that we had to maintain perfect independence. We adopted the tagline, “Your gateway to independent investment advice”. We placed independence first among our core values, with the guiding belief that one cannot serve two masters.

Unfortunately, the word “independent” is beginning to lose its true meaning. Earlier this year I saw a commercial on TV from Smith Barney claiming that their financial advisers were “independent”. I only saw the ad a few times so I believe someone may have wised up and pulled it, but Smith Barney is not alone. AG Edwards has long claimed that their advisers give “un-biased” advice. Raymond James has recently joined in as well. They all want to claim independence because they all know that is what their customers really want. If someone in the marketing department can make an argument for them being somewhat independent, then they will run with it.

The problem is that for most people the inner workings of the investment industry remain a mystery. The average investor has no idea if the advice he is getting is truly independent or if it is actually a sales pitch masked to look like advice. So I am going to try to shed some light on the industry and on how you can guarantee the advice you are getting is truly independent.

To understand the industry you must understand the roles played. The first role is what we refer to as custody. If you are going to invest your hardearned dollars, those dollars, and the investments you buy with them, have to be held somewhere. Custodian, as the name implies, is the person who actually holds the money. A custodian can be a bank, a trust company, or a broker/dealer. They hold your money and assure other parties in your financial dealings that you will pay for the various investments you wish to purchase. They are highly regulated but by different government agencies.

Once your money is at the custodian you can then transact – buy and or sell stocks, bonds, mutual funds etc. The role of transacting in the financial markets is done primarily through broker/dealers. Broker/dealers have two functions, they work primarily as a store (dealer) which has merchandise on its shelves that it wishes to sell to its customers. If what the customer wants is not on the shelf, then the salesperson can order it for them (broker), assuming they have the ability to sell the product in the first place. Broker/dealers, like retail stores, have professionals in their home offices who determine what should be on the shelves. They also have sales people in their stores who would be glad to find you a mutual fund or municipal bond in your size. They now even have computer-generated fitting rooms where you can see what your portfolio would look like in this season’s latest asset allocation models. Broker/ dealers are registered with the SEC and the National Association of Securities Dealers (NASD) and their sales people must be registered as their representatives. Registered representative is the official legal title of “financial advisers”. They are regisistered with the NASD, and they represent their broker/ dealer. They are salespeople in a store.

When you walk into a GAP clothing store the salesperson may be interested in fashion and design, but she has not designed or made any of the products on the shelf. That is left to professionals you never get to meet. The same is true if you walk into Smith Barney or UBS. The salesperson may be interested in investing, and may know more than you do, but they are not investment professionals. They are not trained to be investment professionals; they are trained to sell. There is not a financial advisor (registered representative) in the world who is judged and/or compensated by his employer (broker/dealer) based on how his client’s investment portfolios have performed. They are judged and compensated the way all sales people are judged and compensated: by how much product they have sold.

Of course not all stores are the same, and this is true for broker/dealers as well. Some stores like GAP and Old Navy sell products they make themselves under their own brand, while other stores like Macy’s or JC Penney sell many brands. This is how some broker/dealers claim to be independent, because they don’t sell their own branded products. This would be similar to someone at Macy’s telling you that they were independent because they carry multiple brands. I have also never been told by someone at Macy’s that I would look better in a suit from Brooks Brothers. Likewise, no registered representative will ever advise you to buy a product that their broker/dealer doesn’t carry. To assure this, broker/dealers have made doing so against NASD regulations. It’s called “selling away”.

There is only one way to get truly independent advice, and that is to separate advice from custody and from the transactions. Never allow your adviser to have custody of your assets. If everyone would follow that simple rule we would eliminate almost every possible investment scam. Never take investment advice from a registered representative. Fortunately for the average investor, it is easy to find out if your adviser is really a salesperson. Look at their business card, if they are a salesperson then the phrase “securities offered through…” will appear in fine print on the bottom or sometimes on the back. If it is there, than the advice you are getting is conflicted.

This is when most people get bent out of shape. They say, “my adviser is a good person and she would never take advantage of me or give me bad advice.” And they would be right. Most advisers, just like most retail store sales people, mean well and would not purposely harm any of their clients. But they are not the people designing the products on the shelf. The people who design and manufacture the jeans at GAP don’t know you, they will never meet you and they don’t think about you when they decide to use thinner fabric that doesn’t cost them as much and wears out faster, making you buy jeans more often. Similarly, the investment professionals in back offices don’t know you, nor do they often think about you when they design profitable products and negotiate revenue sharing for shelf space in their store. I know this because I was one of them.

Last quarter I relayed a story about Richard Bernstein, the Chief Investment Strategist for Merrill Lynch. He was speaking at a dinner for investment professionals in Atlanta and he told a story about Brazilian Highway Bonds. He told the story as a joke. It is a common joke among investment professionals, the punch line is always, “what idiot is going to buy this?” Well, Merrill Lynch customers bought those Brazilian Highway Bonds, and I just hope they get some of their money back. They were sold because the underwriter was just doing his job, getting the product on the shelf. The adviser was told to sell the product, and assuming his company wouldn’t underwrite something recklessly he offered these bonds to clients who I am sure loved the promised payments which had to be high. The problem is not that any of these people are bad, the problem is that the system is bad.

Our founding fathers did not declare independence because King George was a bad King. They declared independence because monarchy is a bad system of government, and they replaced it not with a new King but with a Republic with checks and balances and a separation of powers. Similarly, Iron Capital and the hundreds of other firms like ours spreading throughout the country do not offer a better solution because we are better more moral people than your old adviser. We offer a better solution because we offer a better structure with checks and balances and a separation of powers. We are your gateway to truly independent investment advice.

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CHUCK OSBORNE, CFA, Managing Director

Review of Economy

If it isn’t bad, it isn’t a story. That must be the attitude of the media today because I cannot recall a quarter with so much bad economic news while GDP grew at approximately 3.5%. If you read the headlines you think we are doomed, but when you finally get to the facts hidden deep in the third paragraph, things don’t look so bad. Unemployment remains low at 4.5%, and consumers are making and spending more money. Retail sales were up 4.9% in May when compared to May of 2006.

Inflation is still a concern as energy prices continue to rise, energy prices were up 5.4% in May alone. Core inflation, or inflation adjusted for price movements in food and energy which tend to be volatile, is a modest 2.2%. The Fed remains on hold but is starting to soften their language a bit regarding inflation. The concern now may be more continued growth.

Housing remains the biggest negative on the economy. Housing starts are down 24% from last year, with new housing sells down 15.8% and existing home sales down 10.3%. With interest rates rising combined with the fallout of the sub-prime fiasco, buying a home is just going to get more difficult which will prolong the bad housing market.

Outside the US the global economy continues to boom. China revised 2006 GDP growth up to 11.1% from the original 10.7%. However, growth is not just in emerging markets like China. Europe is experiencing strong growth due to free market reforms of recent years. Unemployment in the 13 countries that make up the Eurozone is 7.1%. That sounds high to you and me, but that is the lowest in the Eurozone’s history. All this growth is stimulating central banks to raise rates to fend off inflation. So far they have not killed the golden goose; let’s just hope they can continue to walk that fine line.

Review of Market

And they’re off! The bulls got out the gate early this quarter, and although they were limping at the finish line in June they still delivered outstanding results. The S&P 500 was up 6.28%. Large Growth was the best place to be domestically as the Russell 1000 Growth index was up 6.86%.

This is a humbling business, but every once in a while you just get everything right. As predicted, International led the way with the MSCI EAFE up 6.67% for the quarter and the MSCI Emerging Markets index up an astonishing 15.05%. Large Caps outperformed Small Caps with the Russell 2000 up 4.41% versus the S&P 500 up 6.28%. Growth outperformed Value across the board. Stocks outperformed bonds, with the Lehman Brothers US Aggregate Bond Index posting negative returns, down 0.52% for the quarter.

In other words, the market did almost exactly what we said it would. We didn’t think emerging markets would be up 15%, but other than that we were right. Don’t worry, we have been around too long to let something like that go to our heads, but it is fun when everything clicks.

Market Forecast

Not much has changed in our forecast… why change when it is working? We increased our estimate on the S&P 500 slightly and think it will finish the year up 12%. However, it will continue to be a volatile ride. Stocks continue to look more attractive than bonds with interest rates still very low by historical standards and the threat of inflation on the horizon. Large cap stocks remain far more attractive than small cap stocks. The largest US companies remain inexpensive. The strong global growth will force most central banks to continue tightening the money supply, which will make it more difficult for small companies and emerging economies to raise capital needed to fuel growth. This gives higher quality, large companies in established economies a relative advantage.

We continue to be bullish on the international markets but not as much as we were this time last year. We do think developed nations are more attractive now than emerging markets, especially after a 15% run up in the MSCI Emerging Market index in the 2nd quarter.

We continue to expect modest returns from bonds. The yield curve remains flat and interest rates show no sign of dropping soon. Even if the Fed does begin to ease before the end of the year, we don’t see a drop in longer term rates. We expect no more than a 5% return on fixed income.