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The Quarterly Report

  • The Quarterly Report
  • Fourth Quarter 2005
  • Chuck Osborne

The Iron Capital Story

Welcome to The Quarterly Report from Iron Capital. This is the first issue of what I hope you will find to be an interesting and informative investment newsletter. I must admit to being nervous as I began to write this first article for our first newsletter – strange, since I used to have my own column in an industry trade journal, and have written countless market commentaries. I now realize that writing on behalf of your own firm is different, because it’s personal. In future issues we will use this space to share our views on investing your assets in the current market environment, but I want to take this first opportunity to tell you the Iron Capital story.

We formed Iron Capital Advisors in 2003 when I left INVESCO Retirement and partnered with Larry Gray, founder of Gray & Company, to start a firm that conducts business in what I believe is the “right” way. Iron Capital is more than a firm to me; it’s my dream. Throughout my career, as I worked my way up through the investment industry, I was constantly disturbed by two major flaws:

1) the industry is ripe with conflicts of interest, and
2) the end investor often has no access to expert advice or guidance. The final straw occurred when we all witnessed too many people lose half or more of their assets in the bear market of 2000– 2002. I felt I had to do something to help, and from that desire, Iron Capital was born.

Our mission at Iron Capital is to provide truly independent, customized investment counsel and portfolio management to retirement plan sponsors, participants, and individual investors. We accomplish this by adhering to certain principles that I believe are largely missing in the financial industry.

First, we believe in independence. One cannot serve two masters; you cannot have the client’s interest at heart if you are getting paid by a third party. This may sound obvious, and you would think that no-one would take advice from someone who is getting paid by someone else. However, people seeking financial and investment advice do it all the time. Most investors get advice from someone who is paid by the institution whose products or services they are selling. Their titles are usually Financial Planners, Financial Advisors, Financial Consultants, Wealth Managers, or if they are old-fashioned they will still call themselves Stock Brokers. Regardless of title, the reality is that they are all salespeople.

There is nothing wrong with salespeople, as long as they are honest about what they do and where their financial interests lie. Historically the stock broker’s job was not that of an advisor, but rather to bring buyers and sellers together to execute trades for a commission. Over time, as technology has made trading easier and more efficient, brokers have started offering advice. Today, the stock broker or “financial advisor” role is like that of a pharmaceutical sales representative. Pharmaceutical sales reps, like financial advisors, are professional, generally well-educated and trained by their home office to understand the products they represent. They know how the drugs work and benefit patients, and if a doctor asks an unusual or difficult question, they call the home office and consult the scientist who created the drug to answer the doctor’s question. Pharmaceutical sales reps are good people who believe in the products they sell, but you don’t go to one of them when you are sick.

Financial advisors are good people who believe in the products they sell, but going to a financial advisor to help you build an investment portfolio would be like going to a pharmaceutical sales rep when you are sick. Financial advisors work for the brokerage firm and cannot recommend any product that is not on their firm’s platform. In addition they aren’t investment management professionals. Very few have either the education or investment management experience that would qualify them to create and manage a portfolio.

The second principle we live by at Iron Capital is trust. Trust denotes honesty and integrity, but it also goes one step farther for us. Our clients trust that the professionals at Iron Capital are making the best possible investment decisions, based on investment management knowledge and experience. Every investment decision is made with only the client’s interest at heart by professionals who have extensive investment industry experience – each of us has been that “scientist” in the home office who actually created the product.

Due to that experience, we understand that the key to investment success is following a disciplined process. We work with our clients to create custom investment policy statements, identify the appropriate asset classes to be represented within the portfolio and select the right investments to represent each asset class. We allocate their assets across those investments and monitor the portfolio for adherence to the strategy spelled out in their investment policy. We can do this because, at Iron Capital, you are dealing not with a salesperson but rather directly with an investment professional.

My desire in creating this firm was to provide conflict-free, professional investment counsel. I felt the time was right, and that there were enough people out there who realized that the old way of doing business was broken. Two and a half short years later, Iron Capital now advises more than four billion in assets. There must be something to our approach.

So that is our story. I hope I have communicated who we are and why we created this firm. If you are tired of the old way of doing business, please give us a call. We are your gateway to independent investment advice.

We will be in touch next quarter with some true investment insight. In the meantime, buy low, sell high, and if you take investment advice, make sure it is coming from someone with real investment management experience who has only your interest at heart.


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

Despite the problems caused by Hurricane Katrina, 3rd quarter GDP grew 4.1%, much higher than expected. Fourth quarter GDP growth is likely to be in the 2.8% to 3.0% range. Continued high energy prices, a slowing housing market, and higher interest rates are to blame for the expected slow down in the economy. Robust corporate profits and capital spending programs remain the economic bright spots.

Economists estimate that consumers spent $39 billion more than they earned in 2005, thus creating a negative savings rate for the first time since 1993. While consumers may have grown accustom to $2-plus a gallon gasoline and a doubling of natural gas prices, the higher energy costs have cut into their discretionary spending. Furthermore, rising interest rates have increased the cost of borrowing, making it more difficult for consumers to spend. As a result, retail sales only increased modestly during the quarter. They fell 1.8% in October and rose 0.8% in November. Initial Christmas sales reports suggest only marginal gains over last year.

Corporate spending was a primary driver of economic growth last quarter. Fifteen consecutive quarters of double-digit earnings growth has enabled companies to increase capital investment spending at double-digit rates. Large companies have been among the most aggressive spenders, with S&P 500 firms increasing capital spending by 24% during the 3rd quarter, versus year-ago levels. For the economy as a whole, spending on non-defense capital goods grew by 19.6% during the 3rd quarter. The high level of corporate spending is expected to contribute positively to GDP growth.

The underlying economy remains strong. Year-end unemployment stood at 4.9%; 2005 state government revenues were higher than predicted; 3rd quarter productivity growth was 4.7%; interest rates remain low by historical standards; and inflation remained moderate.

Review of Market

To control inflation and manage economic growth, the Federal Reserve hiked the federal funds rate twice during the 4th quarter to 4.25%. The Fed has raised rates at each of its last 13 meetings by 25 basis points. The statement accompanying the most recent rate cut suggests the Fed may only need to raise rates a few more times before ending the interest rate hike cycle. Most market watchers believe the Fed will raise rates at Chairman Alan Greenspan’s final meeting in January and at Ben Bernanke’s first meeting as chairman in early March.

The market’s confidence in the Fed’s ability to control inflation is reflected in the low 10-year Treasury yield of 4.39%, up only slightly from 4.32% at the beginning of the quarter. Despite the continued rate hikes by the Fed, the Lehman Brothers Aggregate Bond index managed to post a small gain of 0.59% for the quarter and 2.43% for the year.

Domestic equity markets ended the quarter on a positive note as investors became more confident in the economy’s ability to continue growing without generating inflation. For the quarter, the S&P 500 gained 2.09%. For the year, large cap stocks outperformed small cap stocks, and value stocks outperformed growth stocks. The S&P 500 index rose 4.91% in 2005, versus 4.55% for the Russell 2000 index. The Russell 1000 Growth index rose 4.15%, versus 4.71% for the Russell 1000 Value index. In the last 6 months of the year, however, growth stocks have outperformed value stocks by 1.91%. It is interesting to note that value stocks have outperformed growth stocks for 6 straight years.

International stocks were the best performers in 2005. The MSCI EAFE index, a proxy for international equity markets gained 4.12% for the quarter and 14.02% for the year. Within the foreign developed market sector, Japanese stocks were up 25.5% for the quarter, European stocks gained 9.4%, and Pacific ex- Japan stocks rose 13.8%. International stocks performed well despite a strengthening dollar.

Market Forecast

Paul Torregrosa, PhD, Chief Investment Officer

The economy has shown surprising strength in the face of significant obstacles, including the disruption to businesses and consumers in the Gulf region caused by Hurricane Katrina, high gasoline and natural gas prices, rising interest rates, large trade and budget deficits, and a strengthening dollar. Economists expect 2006 economic growth to be a very respectable 3.2% to 3.5%. Economists believe unemployment will remain around 5% and inflation will fall to 3.0%. Overall, the economy is positioned for moderate growth.

Consumer spending, which represents two-thirds of the economy, is expected to grow more slowly in 2006. Low savings rates, rising interest rates and a softening of the housing market will likely restrain growth. Refinancing and home-equity loans, which have placed billions of dollars into consumers’ pockets in recent years, are expected to decline. One economist estimates that consumers withdrew $887 billion from residential real estate in 2005. That number is expected to fall to $552 billion in 2006 and $363 billion in 2007. Without the easy ability to tap into home equity appreciation, consumer spending is expected to slow to 3.1% in 2006.

Corporations, thanks to continued profit growth and an underinvestment in plant and equipment over the last several years, are expected to increase spending by 8% in 2006. The majority of this spending is expected to go into machinery and equipment. Investment in nonresidential structures is expected to grow by only 4%.

Government spending is forecasted to increase by 3% in 2006. Expenditures for the war on terror, hurricane relief and entitlement programs, such as the new prescription drug benefit, will likely increase faster. With regards to monetary policy, the Federal Reserve is expected to increase the fed funds rate by 0.50% in the first quarter to 4.75%.

Given the economic forecast, the equity market appears relatively attractive. At the end of the 2005, the S&P 500 index stood at 1248 with a P/E ratio of 16. Analysts believe 2006 S&P earnings will be $85.38. If P/Es remain steady, the S&P would close 2006 at 1390, up 11% for the year. Given that interest rates are rising and economic growth is slowing, the market’s P/E ratio may fall if investors become less optimistic. If P/Es fell to 15, the S&P would end the year at 1280, a gain of just 2.6%. The market’s P/E has already fallen from 18 to 16 in 2005 in response to higher rates and slower expected earnings growth. If the economy slows, a further drop in P/Es could be expected. A likely scenario is that stocks return between 7% and 9% for the year.