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The Quarterly Report

  • The Quarterly Report
  • Fourth Quarter 2007
  • Chuck Osborne


“Can’t you see what is happening? Potter isn’t selling, Potter is buying and all because we are panicking and he isn’t.” – George Bailey (Jimmy Stewart), It’s a Wonderful Life.

This is one of my favorite quotes from one of my favorite Christmas movies. George Bailey and his new bride are on the way out of town for their honeymoon when they see a run on the bank. They give up their honeymoon budget to save the Bailey Building and Loan during the depression.

Fear and Greed: these are the emotions of the marketplace. Fear gripped the nation during the Great Depression and the runs on the bank that were illustrated in the classic film were commonplace. Franklin D. Roosevelt, in his first inaugural address on March 4, 1933, uttered these famous words, “So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning unjustified terror which paralyzes needed efforts to convert retreat into advance.” I would guess that most of you recognize that quote. I would also guess that most of you did not know that this was given in a speech in 1933, long before the onset of World War II, and FDR was not talking about facing Nazis or the Japanese. Later in the same speech he goes on to say, “In such a spirit on my part and on yours, we face our common difficulties. They concern, thank God, only material things.”

FDR was talking about economic fear. He was talking about the kind of fear we see today on Wall Street. Irrational, short-sighted fear. There is of course a difference between now and then. Now, we are just a few short months from all-time record highs on Wall Street, then we were suffering through the worst bear market of all time. Now we have 5% unemployment which is incredibly low on historic basis, then unemployment was rampant. Now we have had just a few mortgage companies go out of business, then more than 4000 banks went under in the first two months of 1933 alone. In other words, they actually had cause for fear; we do not.

The problem with fear and its evil twin greed for that matter is that it is almost always short-sighted. Wall Street has always suffered from this disease, but in recent years it has gotten much worse. The CFA Institute has even given it a name, Short-Termism. Short-termism results in the permanent destruction of wealth, or at least the permanent transfer of wealth. This was the conclusion drawn by Jack Gray, investment strategist at the firm of Grantham, Mayo, Van Otterloo and Company in Sydney, Australia. Gray presented his findings at the CFA Institute’s 2006 annual conference.

Gray points out that from 1945 to 2005 the average turnover of US equity mutual funds has gone from just over 20% to over 100%. In 2005 the average mutual fund held a stock for no more than 9 months. The results speak for themselves. Jack Bogle, founder of Vanguard, points out in his research that from 1983 to 2003 the average mutual fund had an average annual return of 10%, while the S&P 500 had an average annual return of 13%. The actual investor did even worse, with a 6% return according to Bogle. Not only are the mutual fund managers short-term focused with 9 month holding periods, but the mutual fund investor was also short-term focused holding their investment for only 2 years. Let me put this in perspective for you. If you invested $100,000 in a tax free account in 1983 and got the 13% return from the S&P 500, in 2003 you would have accumulated $1,152,309. If you got the 10% return from an average mutual fund you would have accumulated $672,750, and the 6% return of the average investor would net only $320,714. Those differences in percentage returns may not seem that great, but the difference in resulting wealth is huge.

Much of that wealth destruction can be blamed on shorttermism. Gray conducted a poll to determine who was responsible for short-termism and 89% of respondents selected the media. Mutual fund managers know they can get on the cover of Money magazine, or one of the other financial tabloids, only if they post huge short-term returns. You as an investor may have a time horizon of 10, 20 or even 30 years but no one in the financial system shares that view. Starting with government regulators, who are either political appointees whose time may be short, or are young attorneys padding the resume to make the big move to a Wall Street firm. Their time horizon may be 3 years if you are lucky. Investment managers are judged monthly by their institutional clients. The media may have a time horizon as short as hourly. The good people at CNBC want to know what is going to happen in the next 15 minutes. Finally, traders and hedge fund managers have the shortest time horizons of all. The system is heavily biased towards the short-term which causes what Gray refers to as a substantial principal-agency horizon misfit.

This leads us to the newly popular momentum investing fad, which is the quintessential form of short-termism. Momentum investors buy what has gone up and sell what has gone down. Momentum investing can be a self-fulfilling process as prices go up or down not because they should but because momentum carries them in that direction. This private gain comes at a public loss as the market ceases to be a mechanism to allocate capital efficiently in order to maximize total economic output, and becomes instead a ponzi scheme leading to bubble after bubble.

I have often been asked how it is that Warren Buffett is able to do what he does, and my answer is simple. He never has to answer to clients or the media. He has the benefit of being able to think long-term. Long-termism has three distinct advantages to short-termism. First, there is better predictability. It is nearly impossible to accurately predict what the market will do next week or next month. However, in the long-run the market tends to get valuations right, therefore assets that are over-valued currently will tend to go down while assets that are under-valued currently will tend to go up. In fact Bill Miller of Legg Mason has suggested that the current short-termism epidemic has actually caused what he referred to as a “long-term arbitrage opportunity.” For investors who are brave enough to move against the grain, great long-term gains can be earned. However, the pull of short-termism is great. In late October, I was asked by a friend what we thought of the current market conditions and where we saw opportunities. I told him that we saw great opportunities in banks that have been overly beaten down by Wall Street short-termers. I saw my friend again over Christmas, and he told me that our bank idea had not turned out that well. I had to laugh. It had been less than two months, we won’t know how it “turns out” for several years. We are investing here, not speculating.

Long-termism also leads to lower cost because of lower turnover, and lower risk of real investment losses. As we discussed last quarter, long-term investors are owners who are less concerned about price fluctuations than they are about the fundamental health of the companies they own.

There is a scene later on in It’s a Wonderful Life when Potter offers George Bailey a job. Potter, singing George’s praises, remembers the depression and says that George and he were the only two who didn’t panic. “You saved the Building and Loan, and I saved the rest.” George responds, “…most say you stole the rest.” Potter retorts, “The jealous ones say that…” In our current environment gripped with fear of the short-term most will panic but we will not. A few years from now when we look at the gains we have achieved from this point, some may suggest that we stole them, but those will be the jealous people who didn’t have the courage it takes to think past this current crisis.


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

President Bush’s approval ratings continue to decline, which will not help his party in the upcoming election. The country is in the midst of a housing slump and there is a crisis in the banking sector. Most Americans believe we are in a recession, eve though we are not, by the true definition. The Federal government is trying to bail out homeowners and the banks that made these risky loans and no-one seems happy about it. This is the state of the world at the end of 200… wait a second, am I describing 2007 or am I describing 1991? If you sit back and look carefully, it seems as if we have been here before.

GDP growth for the 3rd quarter was an incredible 4.9%, but growth slowed in the 4th quarter to an estimated 1%. The job market took a turn for the worse with unemployment moving up from 4.7% to 5%.

The Fed lowered the fed funds rate by 1.25% to 3.5%, as the credit crunch in the financial markets overshadowed the risk of inflation. The problems that started in subprime home loans spread throughout the credit market and created a true panic.

Housing remains the biggest negative on the economy, and the continued bad news has created a fear of a recession. Fear of a recession usually causes a recession. Fortunately for us, we know how this story ends.

Review of Market

Fear ruled in the 4th quarter with the S&P dropping 3.3% for the quarter and ending the year up 5.49%. The bear is starting to raise his head on Wall Street as all the major indices were down for the quarter. For the year International was still the place to be especially emerging markets as the MSCI Emerging Market Index finished the year up 39.78% and the MSCI EAFE Index finished the year up 11.63%. Domestically large caps outperformed and growth stocks did better than value stocks. The Russell 1000 Growth Index, which represents large growth stocks, was up 11.81% while the Russell 2000 Value Index, which represents small value stocks, was down 9.78%.

It was also a good year for bonds as the Fed began to lower interest rates in the second half. The Lehman Aggregate Bond Index finished the year up 6.96%.

In the end 2007 was a wild ride. The story of the market this year was negative forecast followed by better than expected actual results, over and over again. At the end, the negative forecast seemed to win out. It reminds me of the old saying, “If you say it enough it will eventually be true.”

Market Forecast

Self-fulfilling Prophesy: There will be a recession in 2008. The cause of the recession is not the real estate market, the credit crunch, nor the high energy prices. The cause of the recession is a Money Magazine poll that says 75% of Americans believe we are in a recession. If they believe it, then it will happen, because they will cause it to happen. Don’t get me wrong, the fact that our ailment is psychosomatic does not in any way make it less real. If managers don’t hire people because they believe that the economy is slowing, then the economy will slow because unemployment will rise. If consumers don’t spend because they believe tough times are ahead, than tough times will be ahead because spending will slow. Negativity is a self-fulfilling prophesy.

Because of this we think the bear will roar on Wall Street in the first half of 2008. However, when the election cycle finally whines down and the Fed’s rate cuts along with the much talked about fiscal stimulus hits the economy the second half will be much better. We believe when the dust settles the broad market will finish the year up approximately 5%.

Large cap stocks remain far more attractive than small cap stocks. As predicted large cap growth stocks have faired much better this year and small cap stocks have suffered. We believe this trend will continue.

We expect international markets to fall in line with the US and we do not believe the emerging markets can continue at their current pace. Trees do not grow to the sky. Our outlook for bonds has improved. With the Fed in a rate cutting mode and most of Wall Street seeking shelter, bonds should hold up well. Longer term, mortgage backed securities which have been badly beaten down should bounce back as the actual damage from the housing slump will most likely be less than expected.