Thursday morning last week I was greeted by a text message from a friend: David F. Swensen had lost his fight with cancer at age 67.

Swensen was the manager of Yale’s endowment and a legend in our industry. Many people often say that Warren Buffett is the greatest investor of all time, but truth be told, Buffett is simply the greatest at drawing attention to himself. There are lots of great investors, most of whom prefer not to be in the spotlight, and Swensen was certainly one of those.

That isn’t to say that Swensen was some mild-mannered person afraid of making a statement. He once claimed that CNBC personality Jim Cramer was a waste of an Ivy League education, and this wasn’t some off-the-cuff cocktail party comment; he began a chapter in his book, “Pioneering Portfolio Management,” with that zinger. Ouch.

I never met Swensen personally, but he influenced Iron Capital all the same. He believed in an aggressive allocation of capital and continually rebalancing, not towards some arbitrary target allocation, but based on future expected returns. Although he successfully managed Yale’s endowment since 1985, he became well-known in the industry in the aftermath of the tech-bubble bust. His process of rebalancing towards investments with larger future expected returns meant that Yale did not own a lot of technology stocks.

In fact, at the time they had a heavy allocation to so \-called alternative investments:  private equity, market-neutral hedge funds, and real estate – all areas that had underperformed in the 1990s and were therefore due to outperform in the 2000’s. Outperform they did, and as a result lots of people in our industry copied what became known as the “endowment model.” Of course, as is typical with humans, most did not copy the hard work of Swensen’s process, which would lead to putting money where it is likely to do well moving forward, as opposed to putting it in what did well yesterday. That, like so many truths in life, is simple but not easy.

No, most endowment model followers took the easy route and simply copied the resulting portfolio. This led to one of my favorite Wall Street Journal articles of all time, in which Swensen said that not only were these people not emulating him, but they were in fact “a cancer” and they serve to “facilitate the flow of ignorant capital.” I discussed this at the time in our First Quarter 2011 issue of our “Quarterly Report” newsletter, “There Is No Alternative.”

It likely comes as no surprise that I would have huge respect for someone who was that bluntly honest. I also respected what he did. Under his leadership, Yale’s endowment grew from $1 billion to more than $31 billion. They went from supporting a tenth of Yale’s annual budget to more than a third. The fact that an endowment grew by 30 times and the portion of the budget it pays for only grew three times reflects the criminal enterprise of modern “education,” which we recently addressed on our blog, but that wasn’t Swensen’s fault.

At Iron Capital we have implemented many of the strategies he spelled out in his writings. Ironically, since he was so known for alternative investing, he is a large part of the reason that we never invest in alternatives. He influenced our asset allocation process and specifically our views on rebalancing.

This is not to say we agree with everything he did. Late in his career he publicly stated that investors who were not Yale should invest in index funds. I personally credit that with the fact that he was part of academia and therefore bound to political correctness; in finance departments across the nation, that means worshiping the index fund. However, like every serious investor who has ever said anything good about index funds, that isn’t at all what he did. Being independent and therefore able to give more weight to actual correctness, I file that under the category of do what they do, not what they say.

There is an old Cherokee Indian proverb that says, “When you came into this world you cried and the world rejoiced. Live your life so that when you die, the world cries and you rejoice.” David Swensen has left this world and the investment world is weeping.

Warm regards,

Chuck Osborne, CFA
Managing Director

~A Great Loss

Great expectations often lead to disappointment. No, I’m not talking about the Dickens novel, Pip would never disappoint. I’m talking about real life. How many times do we go into a situation, from a movie to a vacation destination, with really high expectations, only to end up disappointed?

It happens all the time and it begs the question, are the Disney “Star Wars” movies really that bad? This may be blasphemy, but I don’t think they are as horrible as most Star Wars fans seem to believe. The issue is when it says, “Star Wars,” our expectations go, well…to the stars. The original faced no such obstacle. No one had any expectations as nothing like it had every really been done.

Back in our universe and in present day, we are in the midst of an economic recovery from the reaction to COVID-19, and expectations are getting great. The Fed has said it foresees 6 percent economic growth. When most people hear that they probably celebrate, but when I hear that I immediately think: We could grow at 5.5 percent and Wall Street will be disappointed.

During the pandemic the U.S. economy continued to do much better than expected. Commerce, which was already moving online, accelerated that trend. The professional class simply worked from home and barely missed a beat. In the meantime, hospitality workers and school children took the brunt of our draconian reaction – which will be looked back upon as a human tragedy, but they don’t move the economic needle. Beating expectations leads to bullish markets.

In fact, the market is far less interested in absolute growth than it is in growth relative to expectations. We are setting up for potential disappointment, while the Fed has kept the gas pedal to the floor, saying it no longer cares about short-term inflation but will keep the money loose until people get back to work.

At the same time, the administration and Congress are passing relief packages seemingly designed to stop people from going back to work. As I write, the CEO of Red Lobster is on TV saying they can’t find workers. This is a theme. People will not go back to work because they do not want to give up their enhanced unemployment benefits. In the words of Ronald Reagan, the safety net needs to be a hand up, not a handout. It was Bill Clinton who signed the reform to end the harmful policies left over from the Great Society to encourage people back to work.

Those reforms have now been completely undermined. That is a political issue, but it spills over because the Fed now says it won’t fight inflation until unemployment is where they want it. So these sets of policies have the potential to lead to permanent higher unemployment and easy money, which could lead to inflation. The Producer Price Index, which tracks wholesale prices, is up more than 4 percent over the last year, and the recent reading for the Consumer Price Index was 2.6 percent – more than half a percent higher than the Fed’s long-term target.

For years economists have believed that inflation was a monetary policy issue; loose policy (i.e. low interest rates) caused inflation. However, when we actually fought inflation in the 1970s, we had a combination of loose monetary policy and runaway government spending from the Johnson, Nixon/Ford, and Carter administrations. Paul Volcker, Fed Chair at the time, famously raised rates to stop inflation, but Ronald Reagan also slowed the growth of government spending.

Reagan was right, and one does not have to be an economist to understand that. His re-election strategy was simple: Are you better off? He won 49 of the 50 states, narrowly losing in his opponent’s home state. Eight years later, Bill Clinton won largely by admitting that Reagan was right, explaining that being socially liberal shouldn’t have to mean being anti-economic freedom.

For 20 years government spending was largely kept under control, and despite easy monetary policy which led to the dot-com and later the housing bubble, inflation as a whole has been kept at bay. Starting in 2000 and accelerating until this past year of explosive fiscal spending, those controls were loosened to point where they are now completely off.

Is inflation a solely monetary issue, or is it the combination of loose monetary policy plus big government spending? I don’t know the answer to that question, but I do know that too few policy makers are asking it.

Our great expectations could lead to disappointment coupled with inflation. That will not be fun. It might not; it might all work out, but this is the risk we face today. Be cautious when others are greedy – that is investment wisdom to live by and something to keep in mind. It is time for caution.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Great Expectations

The Federal Open Market Committee of the Federal Reserve (Fed) met last week and while they did nothing, they said plenty. Fed Chairman Jerome Powell told us that the Fed now expects economic growth in 2021 of 6.5 percent, and that the Fed will still not raise rates even if inflation creeps up beyond their 2 percent target.

This rosy outlook on growth is partly due to the fact that Congress just promised to spend another $1.9 trillion dollars on top of what was already a rapidly recovering economy. The market has sold off; how could that be?

In a word, inflation. Right now there is a tug of war going on between people who believe that all this stimulus and the Fed keeping rates low will lead to wonderful economic growth, and those who believe that all this spending on top of easy money will lead to simultaneous high unemployment, high interest rates, and high inflation. Grow out your sideburns, flare out those pant legs and someone find us a disco ball, 1970’s here we come! Would “Billy Beer” be considered a micro-brew? (Now I’ve dated myself.)

Thus far the inflation worriers are winning. The short-term data is certainly helping them. The last reading for the Consumer Price Index came in at 1.7 percent, and the last reading for the Producer Price Index (or wholesale prices) came in at 2.8 percent. In the meantime, the Fed can keep the overnight borrowing rate low, but markets control other rates and the 10-year Treasury is yielding 1.74 percent as I write this article. That is up from 1.44 percent at the beginning of this month, or 0.93 percent at the beginning of this year. This does not bode well for the economy, and it comes as expectations are extremely high.

What does this mean for the market? That is a good question. It is times like this when prudent selection of individual investments really matters. When things get uncertain and the market is not sure where to go, bottom-up investors tend to do best. This flies in the face of the modern groupthink that index investing is the way to go.

Recently we took a look at our own institutional business, where we help retirement plan sponsors decide which money managers (through mutual funds or other institutional products) to include in their plans. Over the decade that ended December 31, 2020, we have 28 managers that we have held in client plans for that entire decade. Of these 28, 23 are outperforming their market benchmarks and five are not. That equates to 82.1 percent outperforming. The average amount of outperformance is 1.90 percent annualized over that decade, and the average amount of underperformance is 0.38 percent.

Keep in mind that one cannot actually invest in an index; one can only invest in a product that seeks to mimic the index, and by definition all of these products will underperform the index due to the real-world fees and expenses. These investors insist that outperforming is impossible. They proudly save a few basis point in fees and end up sacrificing, in this specific case, almost 2 percent in net return per year.

In fairness, there is the possibility of survivor bias, meaning we would have fired underperforming managers. There were four managers fired and replaced 9 years ago, all of the four new managers are outperforming, but we did not include them because we did not own them 10 years ago. The last replacement we made was three years ago, and we replaced two managers six years ago. The fact is, we have consistently done what the popular press says cannot be done: picked managers who outperform over the long haul after we pick them.

This is not an advertisement in any way. Perhaps it would be if I believed that what we do is unique, but I do not. I truly believe that there are many firms that can do what we have done. This is strictly for educational purposes. Intelligent managers who make prudent bottom-up investment decisions add significant value over time.

This is very important information when we are collectively heading for a very uncertain future. We will continue to discuss specific economic policies and their real-world results on our Perspective blog, but the big picture is that we seem to be heading for what Jimmy Carter called a malaise. We shall see, but if Jerome Powell’s 6.5 percent is an over/under bet, I will take the under, and still sleep well knowing that my investments have been selected prudently.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Tug of War

In our last Insight I made a prediction about this new day-trading phenomenon: “Trust me, there is nothing new, and nothing good, in this GameStop story. This will not end well for any who get involved.” This brings to light a question: Is there a place for the individual lay investor, or should investing be done only by trained professionals?

I want to be clear: I am a huge fan of the individual lay investor and believe strongly we should have more of them. Does that seem strange coming from someone who makes a living professionally managing other people’s money? Many of my clients have heard me use this analogy before, but I (and any service professional, for that matter) am no different than a plumber. If one has a leaky faucet and is handy with a wrench, then he can save himself some money and fix it himself. On the other hand, if he isn’t that handy, he would be better off in the long run calling in the professional.

Investing is no different. If one has the passion for research and the right temperament, then she can easily do what we would do for her and save some money along the way. Of course, real life isn’t black and white, not one way or the other.

Just this past weekend we had two plumbing issues in my house. The first was the sink in our guest bathroom, which was draining slowly. A clogged drain is pretty simple, so we had no issue tackling this ourselves. It became a little more complicated when the original (we think) 1940 pipe broke. Still, replacing a pipe for a bathroom sink is not hard. The hardest part is the tight working area, so I practiced my Yoga poses and grabbed a wrench. It probably took me longer than it would have a professional, but it cost a grand total of $30 at our local Ace Hardware store. It was also a cold, rainy day, so nothing lost there.

Two days later we had a major backup. This was a little more serious as one side of the house, including our clothes and dish washers, kitchen sink, half bath and two full baths were out of commission. The other side of the house with two full baths was still good, so we were able to isolate the problem. I do own a small household plumbing snake, so we gave it a go. We removed some gunk (I’m pretty sure that is a technical plumbing term) and got a little relief, but it wasn’t completely fixed. For our house, it was time to call in the professionals.

Some of our readers would have called long before then, and some would probably be in their basement replacing pipes as I write this. We all have a different moment when we say, “Call the plumber.” It depends on many factors. What is true in plumbing is true in investing.

The lay investor can do very well for herself if she sticks to investing – researching companies she is familiar with, buying their stock at a good price and holding it for the long term. I know Apple lovers who have owned Apple stock since the early days of the Mac. They have done very well.

Several years ago it would be common for us to meet a client who was retired and was holding onto some shares of Coca-Cola that their father had bought or had been given when he worked there. It had made their families rich. That generation has passed, unfortunately in my opinion. We have never, and I’ll bet my retirement that we won’t ever, have anyone come to us with an index fund that they inherited from their father that made their family rich. This, also unfortunately in my opinion, is what people think of in terms of investing today.

This is what lay investors used to do: buy the stock of really good companies and hold on to it. That is investing. GameStop is not such a company, and the people buying its stock have no intention of holding it and gifting it to their kids. This isn’t investing, it is trading, and there is a huge difference. Trading is a game and a form of gambling. Please do not read into that any kind of judgement; games can be fun, as can gambling, if done responsibly.

The problem is when lay investors fail to recognize the difference between investing and trading. The lay investor can do very well, if he has a good disciplined strategy and is truly investing. However, there is a saying in poker that if you have been in a game for 30 minutes and you cannot figure out who the sucker at the table is, then you’re the sucker. The lay trader is the sucker at the table. He is going to get cleaned out, it is only a matter of time.

If someone wants to take a few dollars that don’t really matter and play that game for entertainment’s sake, then more power to you. However, never mistake that for investing or one will end up gambling away far more then she can afford.

If one wants to invest on their own, follow our three rules: Invest from the bottom-up, be absolute return-oriented, and be risk-averse. If that seems like too much work, well that is why we are here. Know when it is time to call the plumber, and you can live comfortably in a nice dry house with working toilets.

Warm regards,

Chuck Osborne, CFA

~When Do You Call The Plumber?

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.”
~ John Maynard Keynes, “The General Theory of Employment, Interest and Money”

I have to tell the truth: I wish I were writing about almost anything else. I find last week’s big story regarding Gamestop and the battle between young, inexperienced hedge fund traders and young, inexperienced day traders a boring distraction from real investing. I share this quote from Keynes as a testament to the fact that if one believes that this is somehow new or unprecedented, then he is gravely mistaken. In fact, I am going to go out on a limb here and say that regardless the subject, if one believes something is truly new, she is wrong. There have been approximately 4,000 years of human history. Whatever it is, it’s been done before. The only thing unprecedented about our era is that we now have too much free time to obsess on the trivial. But I digress.

The story of Gamestop is not complicated. Gamestop sells video games and gaming merchandise much the way Blockbuster used to rent movies. Its future, unless it can completely reinvent itself, is to follow the path of so many companies before into oblivion; to become an answer to trivia questions, and one day be highlighted in a movie where some kid goes back in time.

With this in mind it is certainly a company whose stock should be sold – and sold it was, by not only those who owned it, but also those who did not own it, the short sellers. Here is where a major regulatory disfunction becomes highlighted, once again I might add. To sell short (which is the term used to describe selling a stock one does not own), investors used to have to wait until some other investor bought the stock and caused the price to move higher. This was called the uptick rule, and was the way short selling worked from 1938 until 2007 when the SEC, in their infinite wisdom, removed the rule, and … well, do you remember 2008?

In 2010 the SEC wrote a new, watered down, far-too-complicated (which is another way of saying it’s easy to get around) version. Since then, short sellers have given us the flash bear market in 2018 and last year’s road to misery. The problem, in terms of fixing this, is that the impacts are short-lived and they actually create opportunities for longer term investors. We bounced back very well in both of those cases.

What is less noticeable to lay investors are the micro-disconnections that occur on individual stocks often. We see this almost all the time; there is a compounding effect whereby most hedge fund trading today is run by computer models and all the models are the same, so every professional trader is on the same side of all of these trades, and the daily volatility on individual stocks is hugely amplified.

Some day traders (that’s what we called them when I was their age, so that is what I’m going to call them) figured this out and saw an opportunity. The rest of the story is just color; this is the essence of what has happened. Is it a problem? Not really, but to the extent it is a problem, it is all due to the fact that the SEC has allowed short sellers to run amuck for more than a decade now. Bring back the uptick rule and this story goes away.

For the rest of us, times like this are a good reminder of why we invest prudently. We are owners of companies, not traders of stocks. These things do not happen to quality companies with solid futures. We are bottom-up investors; we invest in companies, not the “stock market.” The market is exactly what its name says, a market. I don’t care if they are price gouging on Captain Crunch, I’m buying eggs and bacon because we eat a real breakfast and the prices for eggs and bacon are fair.

We are absolute return-oriented. In other words, we do not participate in competitive investing. If some day trader made a lot of money on Gamestop, then good for her. That does not hurt me in the least. If some hedge fund rookie trader loses his boss a lot of money, well, welcome to Wall Street. These things do not impact us in the least, except that the time I spend thinking about this is time I can’t use finding actual investments.

We are risk-averse. While I put all the blame, if that is even the right word, for this fiasco on the short selling culture, this day trading trend will not end well. Those who make a lot fast, lose a lot fast. Las Vegas wasn’t built because gamblers are successful. There is a brass card holder and clock on my desk which I refer to as my “Purple Heart.” The last time we had a day trading craze, the technology required serious traders to come to offices where they could access trading terminals. One such place was down the hall from my office when I was a young team leader at what was then Aetna Retirement and is now part of Voya. One of those traders lost everything. In his desperation he took a gun, killed his wife and children, then came to our building. He killed several people that day, and my team members saved the life of one of his victims who was shot in the back. He eventually committed what they call suicide by cop, forcing the police to shoot him. Our bosses at Aetna Retirement came to Atlanta, took us to an expensive lunch, and gave us those card holders – our “Purple Hearts.”

Those who do not learn their history are doomed to repeat it. Trust me, there is nothing new, and nothing good, in this Gamestop story. This will not end well for any who get involved.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The Games Children Play