The December “Santa Rally” in the market came just in time for Christmas and then faded in the low volumes of the week between the holiday and the New Year. So far 2016 is looking like a dud. Saudi Arabia is not a big fan of Iran and North Korea is testing nuclear weapons. Those events don’t exactly coincide with positive New Year’s resolutions.

For several years now I have questioned the reverence with which we regard the dawning of a New Year. After all, every day is a new day, isn’t it? Every day starts a new twelve-month period. If one is out of shape in March, he really shouldn’t wait until January 1 to make a resolution. Alas, in the case of the changing of the calendar the old axiom holds true – it is what it is.

For better or worse people use January 1 as the time of the year to mark progress and start over. From an investment standpoint, the issue is that 12 months is too short of a time period to be meaningful. Investing is, by nature, a long-term endeavor. Language can be tricky here, because “long term” is in the eye of the beholder. To be clear, we define that term as one full market/economic cycle. A full cycle is one boom and one bust, a period of growth followed by a period of contraction. This is the natural course of things. We never grow forever nor do we shrink forever. There is a cycle which in total usually means growth – you know, three steps forward and two steps back. The problem is that most people constantly believe that what is happening now will just go on forever.

This morning in Atlanta it felt like 24 degrees outside with the wind chill factor, while it was over 70 degrees and humid on Christmas day. Yesterday I spoke with a friend in the clothing business who is overrun with sweaters because no one buys sweaters as gifts when it is 70 degrees outside. I laughed and asked, “They didn’t think it would ever get cold?” Evidently not.

Well, the weather is indeed going to change, count on it. The market environment will as well, and it really has nothing to do with what day it is on a calendar. If the New Year happens to be the time for reviewing your portfolio’s investment results, a prudent person would not look at the calendar year but instead would examine what has happened over the last five years, or since inception if the investment is newer.

This doesn’t mean set it and forget it. As I have said many times, long-term investing is a mindset, not a time frame. New information could come out tomorrow that would change one’s long-term view dramatically. This information just has nothing to do with short-term price movements. The prudent investor diligently follows what is actually happening at the companies in which he has invested. Is their business growing? Is management doing a good job? Are their balance sheets in order? These are the things that matter in the end. It doesn’t always look that way.

Geopolitical events can temporarily rock markets, but ultimately investment returns are a product of the price one paid for the future earnings of the companies in which she invested. Right now prices are good, especially when one looks beyond the top returners from last year that are selling at ridiculous prices. The vast majority of the time that means that over the next three to five years, returns will be good. What happens tomorrow we have no idea, but we aren’t investing for only one day or even one year.

2015 was a frustrating year for prudent investors. (You can read more about that soon in the next issue of The Quarterly Report). 2016 is off to a rough start. It could get rougher, but as sure as it was not going to stay 70 degrees all winter long in Atlanta, Georgia, it won’t stay like this in the market. This too shall pass and 2016 could prove to be a better year. After all, it’s a New Year and tomorrow is a New Day.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Happy New Year? Bah Humbug!

We live in a crazy world. Every time one sees the news he sees a world in turmoil. When we see the events in Paris and manhunts throughout Europe, the natural response is fear. For those of us fortunate enough to grow up in an era when world history was still taught, this is scary stuff.

China: An emerging world power experiencing the first real economic slowdown in a long time, simultaneously trying to flex its muscles at its borders. The U.S. and Russia: Two world powers who don’t really like each other working in close proximity against a mutual enemy, simultaneously fighting over one’s invasion of a neighbor. Radicals wreaking havoc globally. Collectively this has all the elements of potential disaster.

Facing this horrific news day after day can make one start to feel helpless. To add insult to injury, we have admittedly less important but nonetheless real issues in the financial markets. For more than a year now we have seen the underlying market deteriorate while the headline indices mask much of this because of a few large outliers. The ten S&P 500 stocks with the highest returns over the last year are currently selling for an average of $160 for every one dollar of earnings. One would assume such companies must be growing like crazy, but those same companies have earnings growth of negative 1.67 percent. If that sounds crazy to you, that is because it is.

In the meantime, there is a company that we own in many client portfolios which is growing earnings at a rate of 35 percent, and its stock is selling for $2.33 for every dollar of earnings. This company, however, is in the oil industry; no one seems to care for the moment that the company is doing great, because its industry is out of favor.

None of it makes sense. So what is one to do in a world that does not make sense? Fortunately for us it is the beginning of basketball season, which means we can lean on the wisdom of the late great John Wooden. Coach Wooden had many great sayings, but one of my favorites is, “Don’t let what you can’t do get in the way of what you can do.”

We can’t make the market behave rationally, but we can control what we own, knowing that in the long run what we own will matter.

We can’t control the world around us and make evil people disappear, but we can teach our children through our example to love our neighbors.

We can’t make bad things go away, but we can draw inspiration from a band of Pilgrims who gave us the first Thanksgiving.

There were 102 passengers on the Mayflower when it left England in September of 1620. After a 65-day journey across the North Atlantic and a harsh New England winter, only half survived to see the first harvest. Having lost half of their colleagues and endured hardships which we can barely imagine in our modern world, the Pilgrims could have done a number of things. What they chose to do was to give thanks to God.

Even with all the bad things that happen in our world we still have much for which we are thankful. In keeping with our tradition, here is my list:

1. I’m thankful for long-term investment opportunities provided by short-term traders.

2. I’m thankful that the United States of America is a place where people are still free to disagree without threat of violence.

3. I’m thankful for the opportunity to once again coach my son’s basketball team.

4. I’m thankful that my Wake Forest Demon Deacons are finally headed in the right direction under second-year coach Danny Manning.

5. I’m thankful for my family – immediate and extended.

6. I’m thankful for a good friend lost this year and the time we had together.

7. Of course, I’m always thankful for Mama’s pumpkin cheesecake and my loose-fitting pants that make enjoyment of said cheesecake possible.

8. Finally, I am thankful for you, our clients and friends. Your trust in Iron Capital is our greatest asset and we value it every day of the year.

Happy Thanksgiving!

Chuck Osborne, CFA
Managing Director

~What Can You Do?

“I will not lie, cheat or steal and I will discourage others from such actions.” That is the honor code at my alma mater Culver Military Academy. There are similar codes at other schools, and while the language varies slightly, the message is the same:  I not only will act with honor myself but also will insist that those around me do the same. These codes are usually enforced by student-run honor councils that have the ability to punish severely, including dismissal. One can be punished not only for lying, cheating or stealing, but also for not sufficiently discouraging such action, i.e. witnessing an honor violation and not reporting it.

It is interesting that these codes almost always trace back to the military. The Latin word “integritas” is what Roman legionnaries would shout while being inspected. It means wholeness, completeness and entirety. The legionnaire was signaling to his commander that he was whole and ready for battle. It is from this word that we get “integrity.”

I don’t know if they have an honor code at Volkswagen, but if they do, some heads are going to roll. For those who missed it, Volkswagen somehow rigged the software in some of their diesel vehicles to pass U.S. emissions inspections. How does this happen? I have no insider knowledge of this situation; in fact Iron Capital owned Volkswagen in some client portfolios until this came to light. I drive one of their products as do several friends and relatives. However, having spent my career working in and researching large corporations I can submit a very likely hypothesis: This revelation most likely came as a complete shock to senior management. That does not make them innocent, but the conspiracy theorists who are undoubtedly out there are as usual dead wrong. The CEO and board of directors likely did not meet in secret and decide to break the law because they were so greedy that they really want the stock price to completely collapse. What likely happened was some middle-level engineer was told, “Fix this,” and since he couldn’t figure out how to build an affordable vehicle that complies with EPA standards, he cheated. His bosses are likely more guilty of not being curious enough about how things actually get done. They all are likely guilty of caring more about pleasing the boss than living with integrity.

Of course lost in this story will be any question of why U.S. emission standards for diesel engines are so much more restrictive than the restrictions in Europe? Could that have anything to do with the lack of diesels made by the U.S. auto industry? Why was this not discovered by EPA inspectors? We will likely never know. One of the great tragedies of the aftermath of the financial crisis is that there is no accountability given to regulators and policy makers. Greed was and is a convenient and believable villain, which has the benefit of also being factual – there are greedy people in the world – but it is not complete, and therefore lacks integritas.

Just about every asset pricing bubble that has ever popped has taken place after a prolonged period of time with lower than normal interest rates. Yet rates sit at zero seven years after the crisis is over. I have not been critical of the Federal Reserve in the past, but last Thursday’s decision was a poor one. Of course the biggest benefactors of low interest rates are the world’s largest debtors – governments. Could it be that the Fed has the same lack of courage as the engineer at Volkswagen? Could it be that they are just too scared to tell the truth? Sorry, we cannot profitably make a diesel engine that meets EPA standards at the price point demanded for such small cars in America. Sorry, we cannot keep borrowing money for free. Integrity is tougher than it looks.

Towards the end of the Roman Empire the tradition of pounding the chest and shouting integritas was replaced. They changed integritas to, “Hail Caesar!” Seemed like a small thing. That is the trouble with honor codes; it is the second part that gives them strength – using the power of peer pressure for good. It is much easier to just try and please one’s boss.

Alas, we cannot control what goes on around us, we can only react. While integrity may seem like a quaint notion in our modern world, it is this love of truth – the whole truth – which drives prudent investment decisions: the desire to not be satisfied with surface answers, for investment opportunities exist precisely where actual truth differs from perceived truth. That is what we strive to find every day.

Chuck Osborne, CFA
Managing Director

~Integritas!

They say that the road to hell is paved with good intentions – good things that we will get to tomorrow. Take the Federal Reserve for instance:  They are going to raise rates – when your target is set at zero, it is tough to do anything else – but when? It could be on Thursday or they could do it later. The market is currently obsessed with this question. Frankly I think we worry far too much about the Fed, but this current episode does shed light on an all too human tendency.

How did we get here? It has been nine years since the Fed last raised rates. In June of 2006 they increased the Fed Funds rate by 0.25 percent to 5.25 percent. It is now at zero, and if one likes to wallow in hyperbole, then this potential 0.25 percent increase is earth shattering. The rate was lowered, bit by bit, during the financial crisis until it hit zero in December of 2008. It has been at zero ever since.

So, what is all this about? The Fed Funds rate is the overnight interest rate that banks must pay other banks to borrow reserves. Banks are required to hold reserves at the Fed based on their deposits. As deposits fluctuate daily, so do reserve requirements. Some banks will have excess reserves and other will need more, so those with excess lend to those that need to borrow. The lower the rate, the more incentive banks with excess reserves have to take those reserves back and do something more constructive, like loan money to you. The Fed raises and lowers this rate in an attempt to discourage or encourage more lending and therefore more economic activity.

During the financial crisis the Fed, rightly in my opinion, needed to act decisively to encourage economic activity. That is always the easy part. There are basically two economic theories as to how the government can help stimulate the economy: Followers of Keynesbelieve in what we call fiscal policy, which is stimulation by running deficits, either through increased spending, lowered taxes or both. The other school is monetarism, most notably represented by Milton Friedman. Monetarists believe in the power of the Fed.

The problem with both academic theories is that they rely on something called normalization:  After the crisis du jour has passed, policy makers are supposed to go back to “normal.” In fact, if things start going too well then they are supposed to go beyond normal and run surpluses in fiscal policy and raise interest rates in the case of monetary policy. This is where they both fail.

These institutions are made up of people after all, and most of us suffer from this same ailment. We like to put off unpleasant tasks and indulge in instant gratification. We slowly lose control of our waist line as we convince ourselves that we will start working out tomorrow, and that bowl of ice cream tonight will be easy to burn off. We make a budget, then fudge this month saying that we will just cut our budget next month so we can do whatever fun thing presented itself today. Of course the same thing happens next month and before one knows it he is neck-deep in debt.

Policy makers find it easy to come to the rescue – it’s like spending money while eating ice cream. But, the morning comes and we are supposed to get out of bed and go for a run, and pack our lunch to pinch some pennies. It’s tough. The Fed is supposed to raise rates. We do these things because we know we will crave ice cream again; we will want to take that quick trip. The Fed knows that another recession will happen. If it begins with interest rates already at zero then how can they help? It has to act now.

The move will likely be small and likely a non-event. The question is, have they waited too long? Only time will tell…but I really need to get back in the gym.

Chuck Osborne, CFA
Managing Director

~Good Intentions

Making money in a bull market is not a difficult thing. Knowing what to do when the direction turns is what separates the wheat from the chaff. Markets have indeed turned over and the long-awaited correction seems to be in place. So what should one do? What are we doing?

First things first:  never panic. The end of the world has a funny way of never turning out that way. There is indeed life after Lehmann Brothers; Enron and WorldCom did not forecast that all corporations were really frauds; and the stock market has survived recessions, depressions, world wars and terrorist attacks. Not once was panicking a wise decision.

This is much easier said than done, so there are some things that we can do to help – the most important of which is knowing what we own. There are two basic world views on stocks: Some people see them as pieces of paper which are traded the way children trade baseball cards. We see them as what they are, partial ownership in companies. I have no idea how scared people in the first camp must be when the Dow Jones opens for trading down more than 1,000 points. That must be terrifying.

We, however, know what we own. Apple’s business did not collapse Monday morning at 9:30 am Eastern Daylight Time. We realize that this is just a big mistake on the part of irrational traders, many of whom are no longer human beings but computer programs, and this overreaction will be corrected shortly. Having this faith is much easier done when one knows what she owns.

It also helps to have a plan – knowing that there are risk controls in place in your portfolio and professionals ready to act when necessary. This is why we discuss with our clients how much pain they can tolerate. It is much better to focus on risk when things are going well and we are not caught up in the emotion of the moment.

Not panicking is of utmost importance, but it is not the only important issue. Secondly, one must understand that not all losses are created equal. There are short-term trading losses, in which the market moves down because the mood has turned negative. Nothing has changed in the underlying businesses of companies whose stocks are being beaten up; it is just the mood of the market. This is the classic opportunity for long-term investors. The prudent thing to do is wait for some sign of a bottom, then add to the position.

Then there are mistakes. Of course mistakes can happen in any market environment, but they are often easier to see in a downturn. Here one must again fight irrational thought. Tax law in our country says that one cannot write off an investment loss on his taxes unless he has realized the loss: in other words, sold the investment. Many people, including several financial advisers, believe this means that one has not lost anything unless he sells. That is simply not true.

A loss is a loss. If the investment in question is sound, then one can expect to gain it back, and usually much faster than people appreciate. However, as Warren Buffett learned early in his investing career, one does not have to make it back in the same way he lost it. Many times investors are better off realizing the loss so that they can rebalance and better take advantage of the next leg up.

In summary, the steps of navigating a downturn are: Don’t panic. Know what you own and have a risk control plan. Then, be honest about the loss. Where your investments remain strong, use it as an opportunity; where there is weakness, cut losses and look for new opportunities made possible by lower prices. Remember the words of Benjamin Graham, and be greedy when others are fearful.

Chuck Osborne, CFA
Managing Director

~Navigating a Correction