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The Quarterly Report

  • The Quarterly Report
  • First Quarter 2008
  • Chuck Osborne

Is That Tail Wagging That Dog?

Those who know me well know that I love dogs, and especially my dogs. For years most people in my neighborhood knew me as The Guy With The Two Old English Sheepdogs, Mookie and Sydney. I rescued them from a shelter when they were puppies and never had their tails cropped, as is the custom for sheepdogs with better pedigrees, and I wouldn’t change that for the world. Every day when I got home from work, I was greeted by these two huge, hairy dogs who would practically fall down the steps into our garage, furry tails going 100 miles per hour all the way. No matter how hard my day had been, that sight always put a smile on my face. I swear there were times when I thought that if I could just grab that tail and hold it, the dog would certainly start to wag. So I tried. It became one of my favorite games, but no matter how excited I got them, I could not get the tail to wag the dog. It just won’t happen.

If only humans could actually learn from their pets. However, we seem constantly to let our tails wag our dogs. You can see the phenomenon everywhere in our society. Look at the current election cycle. You can watch election news coverage for hours and hear about this poll and that poll. You will learn that young people and Blacks are voting for Obama, that older people and women support Hillary, and that although the Republican Party has a very low approval rating, people still like McCain as a candidate. You will hear about inconsistent speeches, and this flub and that mistake.

However, you won’t hear a thing about what any of these people actually propose to do if they get elected President of the United States. You won’t hear about education, health care, economics or national security. In other words, you will see, in living color, the tail wagging the dog.

While this is a poor commentary on our political system, it is not the only place you will see this phenomenon, and actually in my opinion, not even the worst example. The place where you will see this most is in the financial markets. Everywhere you look these days, you see tails wagging dogs.

Earlier this quarter I met with an attorney who specializes in helping people with trusts and wills and other estate planning matters. We often refer clients to such attorneys and they often refer their clients to us as well. I was explaining to this attorney our investment process, and we showed him our track record of success. His response was that our process seemed very impressive, and moreover the returns which we have generated extremely impressive. Then he said something that almost dropped me on the floor. He said, “But none of that really matters.” What did matter to him was whether or not the little old lady he might introduce us to would like us.

I understand his point; it is important to like your advisers, to trust them and feel comfortable with them. (And for the record, I’d like to think the little old lady would like us.) However, let’s say we are talking about brain surgery and not investment management. Is it more important to like your surgeon, or is it more important that she is the best neurosurgeon you can find? Ideally, of course, we all want both. You want the best surgeon who also has a great bedside manner,but if that were not possible and your life were on the line, I think most would agree that they want the most skilled surgeon.

The same should be true with managing your money. Of course servicing is important. Service is one of Iron Capital’s core values, but then tails are important too. You can’t win a dog show if you don’t have a proper tail. They just are not as important as the dog itself. Likewise, what really matters in money management is the skill of your adviser. Because skill combined with a disciplined investment process it what produces long-term outperformance. For example our flagship growth strategy, which is 100% equities, has outperformed the S&P 500 by 3.2% annually net of our highest fee, since inception through March 31, 2008. Now that might not sound like a lot to a lay person, but if you invested $100,000 and got the S&P return for the next 30 years you would have $395,508.70 in your account. On the other hand if you got the Iron Capital return, you would have $975,968.50 in your account.

That 3.2% is the difference between retiring and having to keep working. That is the difference between touring Europe and moving in with your kids. That is the difference between fishing and playing golf everyday and greeting people as they enter Wal-Mart. 3.2% is the difference between living your dream, and just getting by. However, long-term outperformance is still not the dog.

Skill combined with a disciplined investment process is the dog. Long-term outperformance is what happens when you let the dog wag the tail. Unfortunately, this is increasingly rare on Wall Street today. There is no greater example of the tail wagging the dog than the current credit crisis, and more specifically the response to the current credit crisis. I recently had breakfast with Andrew Phillips, the co-head of US fixed income at Blackrock. Andrew, like most, was blaming the mortgage banks for the crisis. The mortgage banks were providing mortgages to people with less than perfect credit so they could buy a house. Instead of keeping these mortgages on their books, the banks were packaging them together with several other mortgages and selling them as securities to mostly institutional, sophisticated investors – hedge funds, pension plans, etc. Because they were selling these mortgages and not keeping them, the banks did not care about underwriting standards, and continued to loan money to people who traditionally could have never qualified to get a mortgage. Now some of these people are unable to pay their mortgage and the financial market is in crisis, and everyone thinks it is the banks’ fault for not doing their job to underwrite these securities properly.

I told Andrew that this sounded a lot like people blaming McDonalds for the fact that their pants don’t fit. After all, these are sophisticated investors with Ivy League educations, CFA designations and seven- to eight-figure salaries. When these investors were buying these mortgages, where was the buy side research, the responsibility to know what you own? Where was the responsibility of managers and advisers to understand the risk they were taking? Where was the credit analysis that you were taught at business school and tested on by the CFA institute?

It was not there, Andrew explained, and it still isn’t. The fact that no real research was done by so many is what caused the problem, and it has also made the problem much worse. The mortgage products that these banks created are, for the most part, doing exactly what they are supposed to do. Most mortgage securities are performing, or as the fixed income managers say, they are “money good.” In other words, these fixed income securities, which promise certain income payments, are making those payments as promised. The issue is that the market for the securities has completely gone away. It went away because all the people who were buying these securities without doing any research can’t tell which of these securities is a worthy investment and which is one of the few bad investments, so they just are not going to buy anything. When no one will buy anything, you have a crisis. And here we are.

The magnitude of this crisis has shed some light on how few people in the financial world actually do the required research that we are all taught to do. I asked Andrew if he thought we would ever learn. He laughed, and said, “We never do.”

That may be true of the market as a whole, but it is not true at Iron Capital. We do learn, and we pay very close attention to our process, to assure that the dog is indeed waging the tail and not the other way around.


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

Stop the presses! Ben Bernake finally got around to reading his copy of Iron Capital’s Quarterly Review from last quarter and has admitted that we could be in a recession. Big news, but as we said last quarter, this is a self-fulfilling prophesy driven mostly by media produced pessimism.

Unemployment has crept up to 5.1% in March. However, unemployment for people with a bachelors degree or higher is 2.1%, actually down 0.1% since the beginning of 2008.

Unemployment for those without a high school diploma is 8.2%, up 1.3% since last March. The education gap is the cause for the growing income gap in this country and it is the least educated that are suffering the most in this crisis.

GDP growth for the 4th quarter 2007 was an anemic 0.6%, and is expected to be barely positive in the 1st quarter 2008. The only real bright spot for the economy are exports which have been helped by the weak dollar. The Fed has slashed the fed funds rate by 2.00% to 2.25%, as the credit crunch in the financial markets overshadowed the risk of inflation. The credit market has still not bottomed.

Housing remains the biggest shadow over the economy, and the housing market is not even close to the bottom yet. Prices on houses nationwide must drop before the housing market can stabilize, but homeowners have been stubborn about lowering their asking price. Of course housing is always local and some locations are going to be better than others, but overall the current level of home prices is unsustainable.

Review of Market

Fear continues its hold on the market. The S&P dropped 9.4% for the quarter. As predicted the Bear has roared on Wall Street thus far this year.

Treasuries were the best place to be this quarter, and the Lehman US Aggregate Bond Index was up 2.17%. Small growth stocks performed the worst ending down – 12.83%. In general large caps out performed small caps, value outperformed growth, and domestic outperformed international.

The volatility has continued from last year, with the market swinging as much as 3 or 4% in one day, so don’t get too depressed or too happy from day to day because it may all change tomorrow. But, this too shall pass.

Market Forecast

Self-fulfilling prophesy: There will be a recession in 2008. This remains the theme. However, there are a few signs that a bottom may be near for the market, if not the economy as a whole. All self-respecting market crisis require a sacrifice, and Bear Stearns has stepped up to the plate this time around. Once the sacrifice is made, everyone starts to get serious. Banks have recently been able to obtain new capital, and money is beginning to move back into the fixed income market as many long-term investors see this as a rare opportunity to grab gains. We still believe when the dust settles the broad market will finish the year up approximately 5%.

We were right about large cap stocks over small caps and still believe that is the correct position. We were surprised about how poorly growth stocks have done and think they should bounce back, especially in the technology sector where global demand remains high.

We were right about international stocks coming back in line with domestic stocks and emerging market stocks dropping. We think those trends will continue. Our outlook for bonds remains positive. We do however believe the opportunities are shifting to the corporate bond market where a lot of babies have been thrown out with the bath water.

It is not clear that the worst is over, but of course once that is clear the opportunity for outsized gains will be gone. We believe that now is the time to ease into the high yield market.