A few years back I was playing golf with my minister. We teed off on the first hole and his drive went straight down the middle, while mine went to the right in long rough and behind a tree. I chopped my ball out of the rough and short of the green, while he hit a nice second shot just ten to twelve feet to the left of the hole. I chipped up to about eight feet from the hole. He made a good birdie putt that just missed and then tapped in for par. I sank my putt for par. We walked off with the same score, but he had hit three good shots and I had hit only one good shot. He put his arm around me and said, “You know, sinking eight foot putts will forgive a lot of sins.”

The market over the last year or so has reminded me of that moment. If one only follows the headlines and sees the returns of the large market indices, such as the S&P 500, then one thinks the market is doing fine. If on the other hand one looks below the surface, she will find that the market return has been bolstered by a few darling companies. Further, most of these companies are making little or no money, but they are hot growers with popular products. The two that really stand out are Amazon and Netflix.

Before I go further let me first say that as a customer of both I am a big fan. Over the last year I have gotten everything from books to underwear on Amazon. Their distinctive boxes sit in front of our house more days than not. We also have Netflix steaming service, which my children can operate all by themselves. They have discovered that the cartoons that were around when their parents were young were far less educational and far more entertaining. My wife and I also maintain the now-old fashioned DVD service, because Netflix is smart enough not to stream the movies we really want to see.

However, as an investor I am not a big fan of paying $276 for $1 in earnings for Netflix, nor do I wish to pay much more for a company that never seems to have earnings at all, even if it is Amazon. The stock of those two companies are up 90 percent and 69 percent respectively over the last year.

Meanwhile stocks of companies that not only earn money but that also pay a portion of that money back to shareholders in the way of dividends have been getting killed. We recently ran some numbers, and it turns out the top ten dividend-paying stocks in the S&P 500 are down more than 18 percent over the last year. None of those companies has a positive return. The top 50 dividend- paying stocks are down 15 percent, and only 11 of those companies have a positive return on their stock.

Sinking eight foot putts may forgive some sins. A few star performers may create the illusion of positive markets, but ultimately all one is doing is trying to keep up appearances and put off reality. My minister and I had the same score on that hole but eventually the player hitting more solid shots is the one who will prevail, and he beat me by more than 10 strokes. A market can only hide behind a few stars for so long.

It appears we may have finally started to see some cracks in this façade:  We could be due for a correction. Corrections are always painful, but they are necessary. There is a reason they are called corrections. Some stocks have already been overly beaten down, while others overly inflated. That needs to be corrected so that we can then re-start this bull market with most stocks participating. Good putting can hide a lot of flaws, but ultimately if one wants the good scoring to continue then he has to hit fairways and greens. Likewise, for the bull market to continue we have to see more companies participating. Correcting these flaws may be painful in the short run, but it does pay off in the end.

Chuck Osborne, CFA
Managing Director

~Keeping Up Appearances

“Sell in May and go away.” That used to be the motto on Wall Street – just cash in and go on vacation for the summer. Of course that is not the best long-term retirement strategy, and for taxable accounts that could increase the tax bill quite a bit. But there is something strange in the water this summer that is almost making us take that silly advice seriously. My children have a case of the summer sillies, and the market seems to, too.

We had the Greece scare earlier this summer. I’m always fascinated with the news coverage of such events. Every investor, fund manager, Wall Street executive, etc., who could be found to do an interview pretty much said the same thing: Greece isn’t the story, it is China. Yet the media outlets sent their roaming reporters to Athens, not Beijing. It bordered on the surreal – Greece voting “no” to get a better deal, only to learn that no such deal existed.

To the extent that China has been discussed it is described as a market meltdown, yet it is seldom noted that the domestic stock market in China was up more than 160 percent before this “meltdown” occurred. I used to joke about no client ever complaining about upside volatility, but it really is true. People do not seem to understand that rapid movements up are just as abnormal and usually just as temporary as rapid movements down. China’s government has stepped in to stop the carnage; anyone found selling short will be placed in jail. That will put a stop to a free fall.

Now the focus is back home and on earnings. Last week Netflix reported:  huge customer growth, still can’t make money but no one seems to care, stock went up over 16 percent. Google reported the next day: beat expectations on earnings but missed expectations on revenues, stock went up more than 16 percent. Apple reports, beats all the way around; stock goes down. Microsoft reports, beats all the way around; stock goes down. Oil supplies are down by 1.5 million barrels over the last two weeks as gasoline demand is “unusually high,” according to the EIA. So the price of oil is again in free fall.

So let’s sum up:  If you are a company with a really cool product that you have yet to figure out how to make profitable, or if you are a cool Internet name with less-than-expected revenues, your stock is up dramatically. If you’re a commodity whose supply is down and demand is up, your price is down dramatically. If you are a company with real tangible products that are insanely profitable, and you do better financially then anyone thought possible, then your stock price is down dramatically. What is wrong with this picture?

Some might say it is the direction of these movements. Companies who do not make money are not supposed to have stocks that go up in value and vice versa. However, Wall Street has always been a little silly this way in the short term. A company is a darling and no matter the reality traders and analysts find something to like, or a company goes out of favor and they find something to hate. That has always happened and always will. The real, long-term issue with what is happening now is the word dramatically. Individual stocks are moving huge amounts on a daily basis.

Happy Birthday Dodd-Frank. Five years ago the massive regulatory pile-on was passed. Proprietary trading of Wall Street firms was a bee in the bonnet of Paul Volcker so he got a rule named after him. No more trading for Wall Street firms. Forget that this had nothing to do with the financial crisis, or that much of the proprietary trading that happened was to serve clients. If one wishes to buy, someone has to sell, and Wall Street firms often would just do it themselves and look for someone on the other side later. That made implementing the rule a little difficult. But this summer it is finally here and in full effect.

Those proprietary trading desks added a lot of liquidity to the market and smoothed out a few rough days. Yes the big firms often made money off their trading desks, but they also made the markets work more efficiently by adding volume and liquidity. It is very difficult to quantify the exact impact, but my experience over the last few years as firms one by one got out of the trading business is that volatility has increased. It is not necessarily higher in the aggregate, as losers and winners still cancel one another out, but the individual movement is much different.

Summertime has always been slow, which means less liquidity and therefore bigger daily price movements. More volatility. It has gotten worse and will likely continue to do so. All the more reason for a prudent investing approach, patience and the understanding that as with our children, so goes the market – summertime is often silly time.

Chuck Osborne, CFA
Managing Director

~The Summer Sillies

There is nothing more frustrating in our automated world than dealing with a computer system issue. You are working away then all of a sudden, nothing. You reboot because you know that is what the IT people will tell you. Then you get the blue screen of death and call IT. “Have you tried rebooting?” Yes. “Are you sure it is plugged in?” Yes. “Okay I’ll be right there.” He comes, he reboots and it works again. “I swear I did that,” you say. “Sure you did,” he says as he walks away.

It is so frustrating, but it is part of our lives today. At some point we just have to understand that it is largely out of our control. In his book “The 7 Habits of Highly Successful People,” Stephen Covey states habit one as being proactive. Part of living a proactive life is understanding what is in your control and what is not. He referred to items that one can control as one’s circle of influence.

Covey is not alone. In “Golf is not a Game of Perfect,” sports psychologist Bob Rotella implores golfers to focus on process, because once the ball leaves the club face, everything that happens is out of their control. John Wooden, the legendary basketball coach, spoke about this in his books, too. Wooden focused on teaching and on his players’ execution of what they were taught, not on winning and losing, because he understood that the outcome is often impacted by luck, good or bad, and is therefore out of his control. The interesting thing is that Bob Rotella’s clients have won a lot of golf tournaments, and John Wooden’s teams won a lot of championships. That is what happens when one focuses on the things that are within his control.

In the investment world we often refer to the rate of return on an investment as performance. I once had a senior portfolio manager tell me that we should ban such talk. Performance is something that happens on a stage, he would say. We deliver investment results. When I first heard this I didn’t think much about it; I thought it was just an old man splitting hairs. Now, I’m a lot older and have begun to understand what a difference hair splitting can make.

First, it puts one in the correct mindset for making investment decisions. We can discuss yesterday’s performance, but it seems silly to discuss yesterday’s investment results. The word investment itself connotes a longer, more meaningful time period, while the word results connotes some sense of finality. The investment result cannot truly be known until it has fully run its course. The day we sell a stock is the first day that we truly know the end result. This puts us in a much better mindset for making prudent decisions.

Secondly, day-to-day performance of an investment is not something one can control. We cannot control, or even know in advance, that the New York Stock Exchange (NYSE) will suffer a technical glitch that will halt trading. We cannot control what happens in Greece. We cannot control the short-term volatility of China’s equity markets. The list of things that have short-term influence on performance which we cannot control could go on forever.

So let’s focus on what we can control. We can control what custodians we recommend for use to our clients. We are not short-term traders, so rare temporary technical issues that halt trading are not really of concern. What is of concern is making sure that good records are kept of what our clients’ actually own. We also keep our own redundant system. Prices change, and pricing errors can be fixed – this is the NYSE’s role. Having proper documentation of what one owns is of most importance, and that is the role of the custodian.

We can control what we own. We can know the balance sheet, the income statement. We can have an understanding of the products they make. We can judge the quality of their management. We can have reasonable certainty that cash will be there for dividend payments, and that the company has intrinsic value. We can diversify knowing that we won’t always be right. In other words, we can do the fundamental things that prudent investors do, which we know bring long-term success. That is what we can do, and what we will continue to do every day for our clients.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Control

“Nip it in the bud!” That is what Grandma would have said. If one wishes to put an end to certain behavior, then she had better make that clear as soon as possible. If one allows small transgressions, then slowly over time the transgressions will grow and grow until all authority to stop any transgression is depleted.

This timeless wisdom – the phrase dates back to the 16th century – is easy to understand, but hard to actually implement. Short-term ramifications always get in the way: the fear of being seen as over-reacting; the rationalization that this current transgression is really not that big of a deal; the fear of potentially negative consequences to making an early stand. Doing what is right is always so hard. Every parent understands this.

Now the EU understands it as well. In childrearing we call it spoiling the child; in economic terms it is known as moral hazard. Once one starts forgiving debts it becomes very difficult to convince a debtor that he really does need to live within his means. The ongoing saga of Greece’s indebtedness has finally come to a head. After kicking the can down the road for the last five years the EU has come to the same conclusion of many parents before them: We have let this go as long as we are going to and it is now time to get serious.

Polls in Greece indicate that the people there are reacting much like a child unaccustomed to discipline. They blame the creditors. How dare they expect us to actually pay what we owe? That is somewhat understandable, after all it was the Greek government not the Greek people that got the country into this mess. Many citizens whose taxes must be raised and pensions cut are rightfully upset as the politicians who got them into this mess are in much better condition than the people they claimed to care about. Of course that is often the downside to democracy; people vote for those who promise the most and then don’t really pay attention. That happens in lots of places. Everywhere one looks today one sees governments awash with debt. Are we all on the road to being the next Greece?

Those who profit from others’ fear will likely pronounce such. However, I’m an optimist. In the long run this tough stance by the EU is a good thing. Governments must take their debts seriously, and every now and then it is healthy to have that reminder, especially within the EU. If the folks in Brussels really want Italy, Ireland, Portugal and yes, even France, to get serious about being fiscally sound, then they need to show them that there are ramifications for not doing so. In other words, nip it in the bud. End this while it is still just Greece, which is so far gone.

On our side of the pond Puerto Rico is suddenly in the news as they are about to default. Of course we have seen it happen to cities in California, and the state of Illinois is the leading candidate for our own internal debt crisis. Maybe the U.S. will finally get serious about fiscal responsibility.

In the meantime, how do we invest with all of this happening? We addressed that in our last Insight, and nothing has happened over the last two weeks to alter our comments. We don’t see Greece having a significant impact. Of course there is always the knee-jerk reaction that leads to a couple of down days, but year-to-date – and even last week – international stocks have been the best place to be, so the markets don’t seem too concerned about Greece. But, even if we are wrong about that, we know what we own and we still like it for the long term. We have our risk controls in place for portfolio security and if need be we will take action.

There is no great cause for concern for your portfolio. The concern should be for the people of Greece, and over the hope that the political leaders in other countries are watching this and beginning to understand that fiscal irresponsibility needs to be nipped in the bud.

Chuck Osborne, CFA
Managing Director

~“Nip It in the Bud!”

The only constant in life is change. Then again, the more things change, the more they stay the same. But wait, sometimes what is old is new again? These cliché’s can be so confusing.

If you don’t believe me then consider the NBA championship series between Golden State and Cleveland. It could be called the new versus the old. Cleveland represents the old NBA – rough and tough defense sometimes boarding on dirty play, and offense best described as “give the ball to LeBron James.” (In fairness, Cleveland has been forced to play this way due to injuries.) Golden State represents the new-style NBA – they do this crazy new thing called passing the ball. All five players seem to move at once and while Steph Curry is certainly their star, they all seem to have permission to score when open. The millennial-aged writers at places like ESPN are beside themselves with this new type of game they are calling “motion offense.” To them it is something completely new. Of course those basketball fans who are a little older can remember when motion offense was the norm, not some new thing. To us it is basketball and it is about time they have started playing it again at the professional level.

Real life is no different. I recall a conversation I overheard in the spring of 2009 as I was walking to lunch and overheard two men behind me discussing what came to be known as the Great Recession. One said, “I hope I never have to live through another recession.” I looked back – I couldn’t help myself – and the man appeared to be in his late thirties. I did not know him so I did not say anything, but my thought was, “He must not have a long life expectancy, I hope I see a lots of recessions.” Not that I enjoy them but I know that recessions happen to occur approximately every five years; it is what we call the business cycle. I hope to see lots of them before I’m done.

This brings me to today. I have been looking for something to write about as the market seems stuck and the oil story has gotten old, and then someone asked me what is going to happen if Greece actually does default. As I was pondering that question I looked at this week’s Economist magazine. On the cover they make a bold statement, “The world is not ready for the next recession.”

Before I go further let me reassure you that we do not see any signs of recession at the moment, but the headline does make one think. After all it has been seven years since that dreadful summer and fall of 2008. While this is the first year since then that the IMF is estimating that every economy in the developed world will indeed grow, the U.S. has been growing since 2009. That growth has been painfully slow, but it has been growth none the less. We have also been in a bull market for stocks since the bottom in the spring of 2009. That is a long time, and eventually a recession will happen.

During the financial crisis I began writing these newsletters in an effort to calm nerves. The theme of almost every one of them was, “this too shall pass.” Now we have been at or around new market highs for almost two years and the economy has kept moving forward. I hate to say it, but eventually this too shall pass.

Will Greece be the trigger that kills our tranquility and takes us back into a downturn? I doubt it, I really do. Greece is a lot smaller, and with all due respect to the salad and the gyro (both of which are delicious), less important than Lehman Brothers. This also has been coming for five years now, not a shock over a weekend. Having said that, the truth is that I don’t know, and by the way neither does anyone else.

This is why prudent investing is always done from the bottom-up. Will Europe go back into crisis and U.S. into recession? I don’t know, but I know you can follow it on your iPhone. Apple will likely survive, as will every other company in which our clients are invested. Might stock prices drop a bit? If so, there are lots of companies we would like to invest in at better prices. Will interest rates spike? I don’t know, but it is unlikely to hurt our fixed income portfolio.

Will it be another 2008? That I can comfortably say is extremely unlikely. Life is a cycle. Summer leads to fall, which leads to winter, which brings us spring. But no two years are exactly the same. Today’s NBA motion offense is not an exact copy of the motion offenses of the 1970’s. The next recession will not look like the last one. The cycle will continue and this too shall pass, but prudence never goes out of style. The more things change the more they stay the same, and we will continue to invest from the bottom-up for absolute returns in all environments while always being risk-averse.

Chuck Osborne, CFA
Managing Director

~Change