The Quarterly Report

  • The Quarterly Report
  • First Quarter 2014
  • Chuck Osborne

Win This Possession

Have you ever noticed how wise coaches seem to be? The good ones, at least. They give us little bits of wisdom that last a lifetime. Even the run-of-the-mill coach will tell you things like: “Practice doesn’t make perfect, it makes permanent; only perfect practice makes perfect.” Or, “There is nothing wrong with getting knocked down as long as you get back up.” Or, “There is no ‘I’ in ‘team’.” The legendary coaches, however, are much more original and impart enough wisdom to fill a book – in some cases, multiple books. Don’t believe me? Go to the self-help and/or business management section of the bookstore and you will find a myriad of books written by coaches.

John Wooden, Dean Smith, Bill Walsh and Vince Lombardi have all written books. One gets the idea that these are truly singular men and special leaders. I know I thought so, and then last fall I agreed to coach my son’s youth basket-ball team. I was born in North Carolina, played high school basketball in Indiana, and went to college on Tobacco Road. In Georgia – where the two most popular sports are football and football tailgating – that makes you a basketball expert. I took the job, and I am not sure how much the kids learned, but their coach learned a great deal.

Mostly I learned that the old cliché about there not being any such thing as great men, only ordinary men who are thrown into great circumstances…it may be true. Within a few weeks of being named head coach of the Sharks (that was the name the kids picked) I started saying all kinds of really deep, life-altering stuff. The most significant moment came in a game when one of our players had scored and the volunteer scorekeeper was not as fast at updating the scoreboard as the guys who work the big television networks. The other team is driving down the court and my star point guard is pointing at the scoreboard instead of playing defense. At that moment in the heat of battle, if you will, I yelled, “Don’t worry about the score, play this possession. Win this possession.”

After the game I had two thoughts. First, there actually is something intrinsic to coaching that brings out the inner philosopher. Secondly, I can write a news- letter on that one. I am certainly not the first person to speak to the importance of always staying in the present. From Buddhism to our Western Judeo-Christian tradition, this is a concept that is universal in major religion and philosophy. You have probably heard the saying, “Yesterday is history, tomorrow is a mystery, but today is a gift. That’s why they call it the present.” Even a long time ago in a galaxy far, far away, this principle held true. Jedi Master Yoda scolds the young Luke Skywalker about his fantasies of the future, saying never was his mind on where he is, what he is doing.

In economics they speak of the concept of sunk cost. An economic decision must be made in the present, with no regard for how we got here. The great example they use is a story about Andrew Carnegie. Carnegie’s steel company was building a new factory. While the factory was under construction, new technology emerged that would make the factory obsolete upon opening. His managers wanted to open it anyway, after all the company had made a large investment in its construction, but Carnegie understood that this past did not matter. That was sunk cost. In other words, it was in the past and there is no way to go get it back. That investment did not matter now, because facts had changed, and Carnegie ordered the factory to be rebuilt with the new technology.

In our world we are not running steel companies and investing in factories and equipment; we are investing our clients’ portfolios in various securities. The concept is still the same. One of our favorite maxims is that long-term investing is a mindset, not a time frame. I think many people struggle with this concept. We hear people all the time who have made investing mistakes and watched the value of their portfolio drop and they say, “Well I’m in it for the long term.” Behavioral finance teaches us that the usual immediate reaction to bad news about an investment is denial. We want to believe we make good decisions and if we have made an investment then it will work out in the end. If the drop is due to nothing but market noise then it will work out, but when facts have changed the rational investor must change with them.

It is really a simple concept. We make a decision today based on what we believe the long-term future holds. Tomorrow we have to do the same thing, and the day after that. The big picture does not change all that quickly, but it does change. There are lots of people who have made good livings on Wall Street by being “consistent.” They are either consistently optimistic, or consistently pessimistic. They are both right about half the time. They come across as brilliant because they will tell you about how they predicted this bull market, or that bear market. What they don’t tell you is that the optimist has predicted twenty of the last twelve bull markets and the pessimist has predicted twenty of the last five major crashes. A broken watch is correct twice every day. A consistent thought process applied to dynamic information will yield dynamic outcomes. Someone who is truly consistent and in the present will accept new information and allow that information to change his mind. One may invest in a company believing that the long-term return will be fifty percent. If the stock of that company then goes up fifty percent over a short period of time, assuming nothing has actually changed at the company, then the long-term investor should sell.

In another scenario, a long-term investor invests in the stock of a company that she believes has solid management whose interests are in line with shareholders’ as they hold large quantities of the stock themselves. If that management resigns, gets caught in a scandal or simply sells all their shares, then the facts have changed. She may have just made the investment a week ago, but it doesn’t matter. The long-term view is now different and action is required.

It really is simple. However, many people confuse simple with easy. If staying in the present were so easy there wouldn’t be so much written about it. It is really a very hard thing to do. The past clouds our judgment, and the future can cause problems as well. In sports it is very easy for teams to get ahead of themselves. I can recall clearly one of my most embarrassing moments from my college days. I was in the Dean Dome in Chapel Hill, NC, sitting with several Tar Heel friends while my Wake Forest Demon Deacons built a twenty point half time lead. I could see the future of a wonderful upset victory only made better by the fact that we were in Chapel Hill. The Wake team must have had the same vision because they came out in the second half prepared to ease into the victory. Unfortunately for them, and for me, Dean Smith’s Tar Heels did not stop playing just because they were down big. Slowly but surely they marched back and as they got closer the future began to dim, panic set in, and the thought of “we could blow this” could practically be seen on the Deacons’ faces. Carolina took their first lead of the entire game with seconds remain- ing. It was the largest comeback of Dean Smith’s coaching career to that point – thankfully for our pride the Georgia Tech Yellow Jackets gave up an even bigger lead a few years later.

How does a team get that far ahead and then end up losing? They get out of the moment and are living in the future. It can happen the other way as well – a team gets down and then just gives up. It happens in investing, too. Just like in sports, people think whatever is happening right now is always going to continue. Why did people pile into technology stocks in 1999? Because they saw this fantastic future where everything tied to the Internet turns to gold. Why did they pile into housing in 2006? Because they saw a future just like the past, where no one ever loses money on houses.

It is hard to not allow the past to cloud our decision- making, and it is equally as hard to humble ourselves to realize that we really do not know what the future holds. All we have is today, right now. This is why prudent investing is so important. Who knows what the whole world will look like years from now, but we can know if a company’s stock looks undervalued today. Who knows how long markets will boost up the returns of overvalued assets, but chasing those returns usually ends poorly. What risk will actually raise its head tomorrow, we do not know, but we know the risk is there today and the prudent course is to avoid it. We can’t control the score board; all we can do is keep playing the game one possession at a time.

Play this possession. Win this possession. Go Sharks!

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Charles E. Osborne, CFA, Managing Director

Review of Economy

Slow and steady wins the race. The economy grew at 2.6% in the 4th quarter of 2013, slower than first reported but far closer to our estimate. Many believe this is the year the U.S. breaks out of this 2% growth new normal, but we don’t see it. We think we are still in the new normal of slow but steady growth. The official unemployment rate remains 6.7% and all the other employment data looks pretty poor. The private sector is picking up which is good, but we still have a long way to go. Workforce participation remains at the lowest level since 1978. The Federal Reserve Bank (Fed) has begun to taper but they will maintain very loose monetary policy until the unemployment situation sees more than headline improvement.

 

Review of Market

Volatility anyone? After the 32.4% ride in 2013 we started 2014 with a mild correction and a bounce back. The S&P 500 ended up 1.8%, but compared to the last few quarters that more normal quarterly return seems like a loss. Bonds rallied as they still provide a diversification benefit when stocks start to correct. The Barclays Capital U.S. Aggregate Bond Index ended the quarter up 1.84%. With 10 year treasury yields at 2.73%, it is still hard to be excited about bonds long term. Hello political risk. The year started with concerns over Chinese growth or lack thereof, but the big story turned out to be Russia’s ambition. Russia takes over Crimea and threatens larger Ukraine. The financial markets largely shrugged the events off, for now, with the MSCI EAFE up 0.8% for the quarter, but the broader index masks losses in much of Europe, China, Japan and Russia. Political risk is alive and well.

Market Forecast

We remain cautiously optimistic about the equity markets. For the most part valuations on equities are reasonable, and that cannot be said of almost any other asset at the moment. The short-term correction after such a lofty 2013, did not surprise us, neither did the bounce back.U.S. large-cap stocks still look attractive. International stocks would be looking better except for Russia poised to expand its borders. Emerging markets are perhaps the most attractive on a valuation basis but risks remain and momentum has remained negative. Small company stocks are the only area that appears overvalued. Bonds remain our biggest concern over the long term. Yields remain very low. Stocks may actually be safer.