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The Quarterly Report

  • The Quarterly Report
  • Third Quarter 2007
  • Chuck Osborne

Stop Investing in The Market. Own Companies Instead.

WHERE HAVE ALL THE OWNERS GONE? Do you miss the days when you went to the hardware store and the owner was standing behind the counter? Or what about going out to eat? Certainly there are some good chain restaurants, but my favorites are still places where the owner is on site and comes by your table to see how everything is going. Owners make a big difference.

If you don’t believe me look at any franchised business. Let’s take Holiday Inn for example. I travel a lot and have stayed in all sorts of hotels, and I can tell you that some Holiday Inn’s are fantastic, and others are a little scary. It all depends on the individual owner. Holiday Inn’s corporate office knows this. They have found that one of the main reasons their market share of hotel nights has fallen is because the frequent traveler never knows what they are going to get from one Holiday Inn to the next. As a result, Holiday Inn is weeding out bad owners from their system. OWNERS MATTER. So who owns corporate America?

Do you know? Do you care? I argue that you should. Being in this business I always hear about how mad people are about CEO compensation, ethical breaches and yes, even six years later, I still get an earful about Enron. I usually just listen politely and agree with most of what people are saying. Then I might ask how they invest their money, and I hear things like, ‘I have it all in index funds.’ More and more, they tell me about this great hedge fund, or about the virtues of commodities and of course the new ETF they just bought. What I never hear anymore is something like, “I own Coke.” Somewhere along the line, Wall Street seems to have convinced people that they should stop investing in companies and start investing in markets. John Boggle is probably as responsible for this as anyone else. If you don’t recognize the name, Mr. Boggle is the founder of Vanguard, the indexing king of the mutual fund world. He popularized the notion that most active money managers don’t beat the market and therefore one should simply invest in the market and not try to pick companies. In the boom years of the 1990s, this notion became conventional wisdom.

Of course, like most conventional wisdom, there is some truth to what Mr. Boggle suggests. Especially in very efficient markets and in markets that are being driven by irrational forces. For example, in the late 1990s when most active managers were avoiding technology stocks due to their valuations, the S&P 500 looked unbeatable. In July of 1997 less than 6% of active managers benchmarked to the S&P 500 were outperforming the index for the three year period that had just ended. Contrast that to January of 1982, when 81% of active managers outperformed the “market.” Thirty-five percent of managers beat the S&P 500 over three year periods on average. So, like most conventional wisdom, it isn’t completely true.

There is of course one investor who is known for his ability to beat the market. Warren Buffett is not only the second wealthiest man in America, but also the most famous of all investors. The annual report of his company, Berkshire Hathaway, is a must-read for anyone interested in investing. Buffett made his name by investing in the stocks of publicly traded companies, and his firm has grown to the point where he now mainly buys companies in their entirety. However, he still runs the stock portfolio, and this is where I think the greatest lessons lie for average investors who don’t have a few billion dollars at hand. I was reading the 2006 Berkshire Hathaway Annual Report earlier this year, and something jumped out at me: Buffett went through the entire discussion of the stock portfolio without once mentioning what had happened to the price of any of the individual stocks he owns. He talked about the various companies’ earnings and cash flow, and he spent the greatest amount of time talking about the CEOs and how talented they were. Not once did he mention whether the price of the stocks had gone up or down, or by how much.

I don’t know why this jumped out at me this year, because it is nothing new for Buffett. He has many famous quotes about how important it is to ignore the market, but for some reason this year it really struck a chord with me. This man does not invest in the market, he owns companies. This is at least part of what has made him so successful.

Contrary to his legend, he is not alone either. There are actually several legendary investors who can rival Buffett; they just don’t have his fame or his personal wealth because unlike Buffett, they mainly invested other people’s money – people like Buffett’s mentor, Benjamin Graham; Philip Fisher; Peter Lynch; Bill Miller; Ralph Wanger; and more. There is actually a long list. Each of these investors is unique. Graham is the father of security analysis and of what we today call value investing. Fisher is the father of what we now call growth investing. Peter Lynch ran portfolios with hundreds of stocks, while Bill Miller has never owned more than 40 or 50 stocks. Ralph Wanger was a small stock specialist.

Very different men with very different approaches, yet they all have two things in common. First, they were/are owners of companies. Good companies with solid fundamentals and good managers. Second, they bought these companies at good prices, then held on to those companies for a long time. It is that simple. You are probably thinking, “It can’t be that simple.” Well in the words of Buffett himself, “There seems to be some perverse human characteristic that likes to make easy things difficult. It’s likely to continue that way. Ships sail around the world, but the Flat Earth Society will flourish.”

Michael Mauboussin in his book, More Than You Know, looked at the characteristics of mutual funds that had beaten the market over the decade that ended in 2004. Those funds had an average portfolio turnover of 27% versus the average equity mutual fund, which had a turnover rate of 112%. That means the average mutual fund manager owned the stocks in his portfolio for less than a year, while the average manager who actually outperformed owned his stocks for an average of four years. Most money managers did not own companies, and instead were simply “renting” the stock. The successful money managers were owners.

There are other benefits to owning companies as well. When you own stock in a company, you have a vote – a voice in what direction the company decides to go. Granted, for the average investor your voice may be one of the quieter voices in the room, but it still exists. If you don’t like how the current management is running the company you can voice that opposition, and if there are enough other investors out there who share your concerns, you can effect change. If that change doesn’t occur you can sell your shares before the consequences of management’s actions come to roost. For example, many investors get upset when companies fire their CEO and pay them millions in severance. However, the owner who is actively paying attention knows that the real mistakes happen when that severance is promised upon hiring the CEO, not when it is paid out.

Ownership also tends to settle the nerves in the face of market turmoil. When stock prices drop, traders tend to panic, while owners ask themselves, “Has something really changed with this business, or is this just short-term market silliness?” Most of the time it is just silliness. To a large extent, this explains why owners do better in the long run.

I hear lots of stories about exciting investment products like hedge funds that promise huge returns with little risk. However, I have never met anyone who has gotten rich by investing in a hedge fund. If you have, please ask them to give me a call – I would like to meet that person, but I won’t be holding my breath. On the other hand, I have met lots of people who have come to me for advice in how to manage the large sums of money they have made from companies they invested in 20, 30 or even 50 years ago. Ownership works.

At Iron Capital, we believe in ownership. We agree with Peter Lynch when he said, “You should know what you own and know why you own it.” We use that philosophy not only in the equities our clients own directly, but also when picking mutual fund managers. We like managers who own companies, who understand the long-term strategy of a business, and who are not just guessing about what the stock will do over the next few months. This strategy doesn’t always outperform in every short-term interval, but it does in the long run, and in the end that is the only run that really matters.


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

In case you have not heard, there seems to be some trouble in the housing market. In fact if you listen to the news you would think housing is the only factor that drives the entire economy. That isn’t entirely accurate. GDP growth for the 3rd quarter is expected to come in at a very respectable 3.2%. Job growth slowed but was positive. The initial report of job declines in August was revised upward to a gain of 89,000 and the economy added 110,000 jobs in September. The overall unemployment rate rose to 4.7% from 4.6%.

The Fed lowered the fed funds rate by 0.50% to 4.75%, as the credit crunch in the financial markets overshadowed the risk of inflation. The problems that started in sub-prime home loans spread throughout the credit market and created a true panic.

Housing remains the biggest negative on the economy. Housing starts are at the lowest level in 14 years. The Mortgage Bankers Association is predicting a 22% drop in new home sales and a 12% drop in existing home sales this year and a further 10% drop in both categories in 2008. The housing market has not bottomed yet.

In 1940, 44% of households owned their house, by 2006 nearly 69% of households owned their house. In the middle you had a major move to suburbia and a something called the baby boom. Boomers have bought their last house, and when they go to sell it to Gen-X guess what they are going to find. Gen-X is one small generation of home buyers. Of course there is the so called echo-boom, but this is most likely the first generation in American history which will be left worst off financially by their parents (who after all were the “me” generation). Housing is going to take a while to recover.

Review of Market

The third quarter was boring, as always – with the S&P going up 2.03% for the quarter. Yeah right, if you were asleep. Three brutal days in August put several hedge funds out of business. The credit market came to a screeching halt, and mortgage lenders took it on the chin with only the strongest surviving.

What happened? Greed! A few years ago some smart people at various financial institutions figured out that they could bundle together a bunch of home loans and sell them in the securities market as mortgaged backed bonds. Always excited about anything new, the hedge fund community started buying these bonds which they considered to be almost as safe as treasury bonds. They thought they were so safe that they could borrow money themselves to invest more in these instruments in order to achieve as high a return as you could want, with “no risk.”

At least that is what they thought until investors started to get worried about people paying their mortgages. Fear quickly replaced greed and the value of mortgaged back securities dropped forcing brokerage firms to call back the money they had lent to hedge funds causing a fire sale in the stock market and crippling the credit market. These “no risk” strategies were in reality extremely risky and this realization panicked the market which is still trying to figure out how to price credit and how much risk is actually there.

In the end, the S&P500 was up 2.03% and the Bond market was up 2.85% as the Fed jumped to the rescue by lowering both the discount rate and the fed fund rate. The moral is, don’t get greedy and then you can just sleep through another boring quarter of ho hum returns.

Market Forecast

At the end of all the noise in the market, our forecast continues to be right on the mark. The S&P 500 is up 9.13% year to date and we still believe it will finish the year up 10-12%. The volatility we predicted has done anything but disappoint. Unfortunately we think it is here to stay for a while longer. 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 have also been right about international markets which we continue to like. The only flaw in our forecast so far this year is that we did not expect the amazing run in emerging markets. The MSCI Emerging Market index is up 34.85% year to date. We do not expect that kind of pace to continue.

We continue to expect modest returns from bonds. The yield curve has started to right itself with short rates dropping and long rates rising. This is painful for the moment but it is a necessary correction in our opinion. The outlook for bonds will improve, but we remain cautious in the short-term.