The market has hopefully put in a bottom. One can never know for sure, but the last several days have been encouraging. Still, it has been a very tough year thus far, and that brings up a topic that is worth discussing: How should one judge the quality of an active mutual fund manager?

The obvious answer is to look at the results. How has the fund performed? It seems like a simple question, but unfortunately the answer is not simple. There are countless ways to measure investment results, so this leads to a problem. We have all heard it before:  figures lie and liars figure. A mutual fund’s marketing department can almost always come up with some measurement that will make it look good. What is real and what isn’t?

The usual measure of investment results is the trailing return numbers. We look at a period ending, typically at the end of a calendar quarter or at least a month-end, and look back over time; specifically, we look at the one-, three-, five-, and 10-year periods (if the fund has not existed for 10 years, then we look at since inception). Most have probably not given those time frames much thought, but if one is a geek like me, she may ask, “What is so magic about the one-, three-, five-, and 10-year periods? Why not six-year periods?”

The truth is there is no magic in these time periods, but in 1940 when Congress decided to regulate investment managers, the Securities and Exchange Commission (SEC) had to come up with something. They decided that managers of mutual funds needed to show a consistent measure that could be compared so an investor could make a wise decision. A mutual fund could show more information if they wished to, but they had to show one-, three-, five-, and 10-year results. Further, they had to be calculated using a time-weighted methodology versus a money-weighted methodology, but that may be too much math for one day. Suffice it to say that all the different mutual funds have to do it the same way.

Since that is what the SEC requires, that has become the default method of looking at mutual fund managers and judging their performance. But should it be? There is a problem with using trailing return periods to judge the quality of a manager. Knowing what the return has been for the one-, three-, five-, and 10-year periods that just ended doesn’t tell an investor how the manager got there.

Judging an investment manager is very much like judging a coach. We could use any sport as an example, but the NBA Playoffs are going on so let’s use basketball. An NBA game lasts for 48 minutes. Knowing who won the game doesn’t mean you know how the game went. In these playoffs there have been games where a team got off to an early lead and never looked back, while the losing team was losing for all 48 minutes. There have also been games when one team got off to a hot start and the other team slowly but surely came back, not taking the lead until the very end. The losing team in that game was actually winning for most of the game. The end result is the same, but how they got there was much different.

Why does that difference matter? It matters because there is going to be a next game, and a team that is close to winning but just didn’t finish is a different thing than a team that is being dominated. Trailing results – even the “long-term” 10-year results – are just one time period, like one game. A manager can be winning that game for nine years, have one bad year and lose that particular 10-year game. Conversely, a manager could be losing for nine long years, have one fantastic year, and end up a winner for that one 10-year game. The future prospects of those two managers are very different. When one year sticks out (for the good or the bad), then that year is a fluke. Odds are that both of those managers will go back to being themselves – one who consistently does well and one who consistently doesn’t. However, if all one considers is that one 10-year period, then how would she know which manager is which?

This is why so many people say that it is impossible to select a manager who will outperform in the future: They keep judging them based on just one game. We don’t judge coaches on the basis of one game, and we shouldn’t judge them on the basis of just one season, although fans are guilty of such. Great coaches are identified based on many games, over many seasons in their careers. Likewise, this is how we should judge the mutual fund manager. Iron Capital uses rolling time periods; In other words, we do not look at just one trailing period of time, regardless of how long, but instead look at every trailing period of time. Each month there is a brand new one-, three-, five-, and 10-year period, and it is two months different than the last one. One month has been added and the oldest month has been removed. It can be surprising what a difference two months can make. For those who look quarterly, the difference is six months and that can be meaningful.

Because time periods can be so different, it is important to look at them all. We primarily focus on the manager’s three-year results rolling forward every month; we then average those periods to see how the manager has done on average. It resembles looking at a coach’s career versus focusing on one game, and it is far more valuable. It tells us with a fairly high degree of certainty whether this manager is good, or if has he just been lucky lately.

It is also important to note what it doesn’t tell us: It does not tell us that this manager will outperform in the next game. Nothing can do that, and there are many in our field who mistake that fact with not being able to judge talent. What our process tells us is that this manager is a quality manager and therefore our odds of doing well over time are good. Rolling time periods is only the beginning for us, but it is an important beginning. It identifies consistency. It also helps us know when we should be patient with a manager who just had a bad game. Everyone has those from time to time, it cannot be avoided, but quality managers bounce back.

With the market down so dramatically, we will see managers who stumbled, and we will see some who did well, at least relatively. It is easy to judge them after just one period, but that is no way to make prudent decisions. At times like this we need to know that the people managing the mutual funds in which we are invested are actually talented, that they are good at what they do. Trailing returns, no matter how long, can’t tell us that; we have to dig deeper.

Figures lie and liars figure. It isn’t enough to consider only a trailing return number and then think we can judge a manager. We need to understand the how and why, and one cannot get that from simple trailing returns. That is an important lesson anytime, but extremely important in this environment.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Figures Lie and Liars Figure: Manager Edition

“It’s a dog-eat-dog world, and I’m wearing milk bone underwear.” – Norm, “Cheers”

It has been one of those years thus far. We are in a dark cloud. Inflation has come back, even though we learned this lesson in the 1970’s. We have an actual war going on, as in one nation invading another. The stock market has gone past correction and into bear market territory. More importantly, the bond market has produced historic losses.

Through Wednesday, May 11, the S&P 500 is down 17.03 percent year to date, with many areas of the stock market doing much worse. Normally in times like these the bond market would be rallying as investors fled stocks and moved into bonds to reduce risk, but not today. I know I sound like a broken record, but stocks actually do act as the best hedge against inflation in the long run. The problem thus far this year is that inflation is accompanied by fear of recession.

Bonds are usually a hedge against recession fears, but the problem this year is that recession fears are accompanied by inflation. Inflation destroys bonds; the reason for this is self-evident if we take the time to remind ourselves that bonds are simply loans. If we borrow money at 3 percent interest, our loan payments would be attractive income for an investor when inflation was nonexistent. With inflation at 8.3 percent, that 3 percent interest payment now represents a 5.3 percent loss of purchasing power. Bondholders are actually losing money when inflation is considered. So, they are selling, and as a result the U.S. aggregate bond index is down 9.5 percent year to date through May 11.

For the stock market to recover from a 17 percent drop, we would need a 20 percent rally. This happens in the stock market frequently and would be easily done. For the bond market to recover, we would need a rally of 10.5 percent. It could happen, but it is not likely. The yield on the 10-year Treasury bill is trading in the neighborhood of 3 percent. That means the most likely return on those bonds is 3 percent. In other words, stock investors are experiencing short-term pain, but will recover and move forward in all likelihood. Bond investors have no such prospects.

To add insult to injury, many bond investors are retirees who are counting on that income to fund their retirement. They have already had to settle for historically low yields, which has reduced the income possible from the traditional bond approach. Now the people who failed to adapt to the low-interest world we were living in are getting punished more than anyone else.

So where is that silver lining I mentioned in the title? Iron Capital did adapt, many years ago. Our approach to producing retirement income is unique, and it has held up well. Year to date, the average of our income portfolios is still down 6.34 percent, but that is much less than traditional income portfolios, and our approach also provides an opportunity for recovery. We build portfolios that produce the income needed, or as close as possible, while taking the least amount of risk possible; over the last several years that means we have been focusing on dividend-paying stocks. These have been in places like energy, utilities, consumer staples. The areas that have done the best in our current environment.

This was not some sort of miracle foresight; no, we just followed our process, and that process led us to portfolios that many would describe as more risky than traditional bond-heavy portfolios. That is because many are stuck defining risk as either legal structure or volatility. Risk is losing money, and our approach to investing during the most risk-sensitive time in one’s life has held up much better. That is a silver lining in this dark time.

I know, some are reading this and saying, “How does that help me, I’m still trying to accumulate for retirement.” I feel that pain, and times like this are always painful, but they will pass, and the stocks will rise again. It always happens faster than one thinks possible. Meanwhile we will do what we can to protect our client portfolios. One day you will be retiring yourself, and it is good to know that it can be done, even in an environment like today’s.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Silver Lining

This has been frustrating. The market has a case of the glass-half-empties. Earnings for the most part have been good, but the market would rather focus on the few negatives. We had a big up day when Meta (formerly known as Facebook) reported much-improved numbers, then Amazon disappointed. The cloud business, which is the primary focus of Wall Street, grew only 37 percent instead of the 40 percent that it had been growing. Amazon’s stock was punished along with the rest of the market because of the slowing growth. Seems a little overly harsh to me.

On the other hand, Apple reported a solid quarter and the stock initially rose, but then Tim Cook explained that there are still supply issues coming from China, and the stock went down. Never mind that he said the same thing last quarter, before the company delivered these good results. We are just in a foul mood, and any little excuse leads the market down or thwarts any attempt at a rally.

Underlying all of this is the environment of slowing economic growth and high inflation. The initial reading for Gross Domestic Product (GDP) came out for the 1^st quarter of 2022 and the economy shrunk by 1.4 percent. Meanwhile, we have 8.5 percent inflation. The Fed is making hawkish statements and the market is nervous, but then raised rates by 0.50 percent as expected. The Fed bark remains much fiercer than its bite and one wonders when the market will ever learn that lesson. Many pundits were suggesting that the Fed may raise by 0.75 percent or even higher. Chairman Powell said after their meeting that this was not even discussed. In other words, it was never even on the table.

The economic concerns are real but seem overdone. Unemployment is the key to an actual recession. Unemployment is currently at 3.6 percent and the consumer is relatively healthy. While GDP came in at a negative number, consumption from consumers actually rose approximately 4 percent. The previous read from GDP was 6.9 percent growth, which was driven by inventory-building. This was a makeup from the previous quarter, when we saw significant supply chain issues. It appears to have been an overshoot, which means there was slower inventory-building this quarter, leading to negative growth. Other contributors were slowing of government spending, as we have gotten past the various stimulus measures, and growing imports, which are actually counted as a negative. These are not the makings of a recession.

All of this has combined to take the market roughly back to the lows we had seen earlier this year.  We are now at a turning point. Does the market bounce from here, or does this prolonged correction turn into something worse? We believe the market should bounce. Company earnings have been strong, and that is what should matter. While major indexes still appear expensive, this is driven by a small number of large companies. Take those away and stocks are attractively valued. Now the Fed has moved as most expected, and not more dramatically as some feared. The rational move is for stocks to go higher.

Of course, in the words of John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.” While we believe the market should go up from here, we cannot ignore what the market is actually doing.  We are watching this point closely and will take action to protect portfolios as needed.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Turning Point

“Even a fool, when he keeps silent, is considered wise. When he closes his lips, he is considered prudent.”
– Proverbs 17:28

I have some free advice for Jerome Powell and the rest of the Federal Reserve board members:  Shut up! Perhaps I am guilty of romanticizing my early career, but I really miss the days when the Fed just went about its business in silence. Do we really need to know every thought that crosses the minds of the various Fed members?

The market fixates on every breath as if it means something. The minutes come out and some members wanted to be more aggressive. They got out-voted – so what? The Fed did what it did, and that is really all we need to know. Besides, one cannot tell from minutes alone the seriousness of a conversation. Have market participants ever been in a meeting? In the adult world alternative points of view are often expressed so that we can think through them.

These days, every time a Fed member speaks, the financial press and short-term traders parse every single word. The market knows that inflation is the biggest economic concern; the market knows that this means interest rates will rise until inflation is under control. The market fears that the Fed (who, let’s face it, has messed up to allow inflation to take hold) will now mess up by over-correcting and putting us into a recession.

What does this mean for you? It means the market is trying to rally and come back from the correction of earlier this year, but every time we start to make serious progress, some Fed official insists on stepping in front of a microphone. The market mostly thinks that Fed members are foolish, but when they step up to the microphone and open their mouths, they remove any doubt that remained.

The greatest example of this was the taper tantrum of 2018. Fed Chair Powell gave a speech in October of 2018 suggesting that the Fed would start to taper its asset purchases. The market crashed. In a later speech he backed off on his earlier forecast, and in early 2019 the market took off like a rocket. Intelligent people will, to this day, say that the Fed “quickly changed policy” or “reversed course.”

The Fed did no such thing. Policy never changed during that time period. The only thing that changed was the tenor of Powell’s speeches. When eventually the Fed actually began to taper, it was a non-event from an equity market standpoint. What the Fed needs to do is stop thinking out loud.

But don’t we want transparency? Last night I enjoyed a sausage pizza with my kids. It was delicious. You know why it was delicious? Because we did not see the sausage being made. We need enough transparency to know that nothing unethical is going on, and no more. In other words, justify your actions after the fact, and stop telling us what you might do in the future. Stop thinking out loud.

This is not likely to happen, but perhaps the market could learn a lesson here:  What all of this talk does, other than undermine Fed credibility, is create market expectations. Those expectations get reflected in Fed funds futures (contracts that predict future rates). Those futures are incredibly bad at predicting reality. According to research done by the CME group, they historically have been wrong by 75 – 175 basis points. Considering the current Fed funds rate is 33 basis points, these are huge misses.

Right now, the fear of the market is that the Fed is going to create a recession. That fear is overblown. Unemployment is currently at 3.6 percent. We are not going into a recession when 96.4 percent of workers are employed. Employment is the key statistic; as long as it holds up, we will avoid a recession, and there are currently no signs of the job market weakening. Of course anything is possible, but the probability of a recession when we have less than 4 percent unemployed is extremely low.

Currently we are at worst stuck in a market range, bouncing back and forth but going nowhere, and at best beginning to climb the wall of worry. The most recent market lows have been higher than previous lows, which is a good sign we may be moving ever so slowly up. The market is taking care of raising rates on its own, as the 10-year Treasury is approaching 3 percent. The Fed is still behind, if anything.

They could regain some credibility, perhaps even seem wise, if the Fed members would just keep quiet and do their collective job.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The Wisdom of Silence

The war in Ukraine has put a fog on the market. The rising cost of oil will exacerbate the already-high inflation. There is significant risk of a recession in Europe. Russia is un-investable and, in our view, will remain so, at least as long as Putin is in power. China was already having issues with its economy, as its regime continues to reverse the liberating reforms that had made China the economic power it is today.

There is lots to worry about as an investor, which is why we have seen a market correction. Corrections are not fun; in fact they are scary, as it always seems this could turn into more than just a correction. There are always arguments for why this time it is really the end of days and the market will go to zero…which causes stress, and stress literally causes tunnel vision, and all we can focus on are the negative news items, of which there are plenty. It is like being in a fog: one cannot see anything around them, only what is right in front of them, which today is the conflict in Ukraine.

Eventually the fog lifts and the world reappears. When it does – and it may already be happening – there are opportunities for investors. It may not seem like it, but then it never does. Prudent investing is really simple but extremely difficult, because the best time to buy is when everyone else wants to sell, and the best time to sell is when everyone else wants to buy. That takes discipline.

We find that discipline by focusing our investments from the bottom-up. We analyze individual investments on their own merit, instead of guessing where the market is headed or what the outcome of this crisis will be, or when the next crisis will come. That does not mean one can ignore totally what is happening around them, but the environment needs to be considered from the point of view of each single investment.

I was an economics student when the Soviet Union was collapsing. I found it fascinating, and I took every course I could that touched on it… unintentionally I ended up with a minor in international studies. One of my professors had Russian stock certificates framed and hanging on the walls of his office. They had been issued during the period known as the New Economic Policy (NEP). Lenin had tried to go straight for socialism, but that made people’s lives worse (as it always does, but that is a subject for a different day). So, he relented to some market-oriented reforms, and some companies were able to raise capital through the issue of stock.

Stalin could care less if people’s lives were miserable, so he reversed NEP, and in one day, those stock certificates became worthless as those companies were now property of the Soviet Union. Putin resembles Stalin more so than Lenin; therefore, even after this crisis goes away and markets reopen for Russian companies, one has to know that any company in Russia could simply be taken over by Putin, making your investment worthless. In our view that makes Russian stocks un-investable.

However, most companies aren’t located in Russia or Ukraine, and will continue to do business regardless of the outcome of this conflict. When we look at these companies, we put an estimated value on their business, then we compare that value to the actual price of their stock. The difference between those two is our expected return, should we invest. Those expected returns are the highest they have been in several years. To be honest, I’m not sure how long it has been since we have seen the expected returns this high.

What does that mean? It means companies are doing much better than their stocks. We have been saying it for a while, but inflation boosts companies’ reported earnings, and valuations are based on earnings, or more sophisticatedly cash flow. Higher inflation leads us to higher cash flows, higher earnings and higher company valuations. Eventually the fog will lift, and this is what investors will see.

We already see signs of it any time there is good news on the war front. We could see further setbacks. It could take months before we are completely out of this fog, or it could happen between the time I write this and when it published. That is the hard thing about investing. It is impossible to time the market. However, the fog will rise, and when it does, the future will look bright.

Meanwhile, our job is to manage your investments, so that is our focus. Simultaneously, our thoughts and prayers are with those in Ukraine. We also pray for our leaders, may they rise to the occasion.

Warm regards,

Chuck Osborne, CFA
Managing Director

~When the Fog Lifts