I promised when we started this electronic newsletter that we would not clog your inbox just because some amount of time had gone by since our last Insight. We write when there is something of meaning that bares commentary. I also promised not to weigh in on newsworthy subjects outside of our expertise, so while this summer has been full of geo-political events, the lack of action in the financial markets has left us, well, speechless. However, at some point the lack of action itself becomes worthy of notice.

Some of the boredom is masked in short-term headlines. The initial estimate for second quarter GDP just came out at 4 percent growth. Isn’t that exciting? Well it is, until you remember that first quarter GDP shrank 2.9 percent, according to what was supposed to be the final number. They revised that number to 2.1 percent in the latest report. So depending on which final number one choses for the first quarter, the first half of 2014 saw growth of somewhere between 1.1 percent and 1.9 percent. In other words, this seemingly never-ending slow-growth slog just keeps going on and the markets seem to have become numb, as if everyone is just stuck in a wait-and-see mode.

Consider the following: First quarter GDP down 2.9 percent; Workforce participation at forty-year lows; Russia trying to take over Ukraine; ISIS on the rise in Syria and Iraq; Rockets hitting Israel from Gaza; Every major investment asset class providing positive returns. Which one of those statements doesn’t seem to fit?

CNBC keeps celebrating new market highs and they keep asking whether this is different from 1999 or if is it another bubble. Well, it is completely different. In 1999 the world, not just the financial markets, seemed a brighter place. The cold war was over. The globe was mostly peaceful. The promise of the Internet was brand new, optimism was everywhere. That is what a bubble looks like. Bubbles are euphoric, this is not. This feels more like a wait-and-see market.

Globally we are swimming in easy money as near-zero interest rates have become the international norm. Most financial historians will tell you that never ends well. They will tell you that easy money is the fuel for most economic destruction. They may be correct, but fuel alone won’t burn; there must be a spark. For inflation as an example, a nation needs a large supply of cash, but it also needs velocity. The money has to move. The fuel needs a spark.

In financial markets that spark is usually what Allen Greenspan called “irrational exuberance.” This market may or may not be irrational, but the one thing it certainly isn’t is exuberant. I’m not even sure it has a pulse.  As we repeatedly said when the market dove during the financial crisis: This too shall pass. The spark will eventually come, and we will all comment about how obvious it is in hindsight. The question remains: Will all this fuel launch us to new heights or consume us?  It is hard to know at this point, and that is why we wait and see.

Chuck Osborne, CFA
Managing Director

~Wake-Up Call?

Not much is happening in the markets worth writing about. No news is good news I suppose, but there is one bit of entertainment happening which may be a learning moment. As the golf world readies itself for the U.S. Open Championship one of the PGA Tour’s biggest stars, Phil Mickelson, is under investigation for insider trading.

The FBI and the SEC are looking into allegations that Mickelson got some hot stock tips from a Las Vegas gambler who had played poker with legendary investor Carl Icahn. Icahn supposedly told this gambler that he was about to invest in Clorox and the gambler passed it on to Mickelson. Who knows how this case will end? I am sure it sounds horrible to the layperson’s ears, and that was probably part of the point of making it public after more than two years of investigation had led nowhere. From my perspective the case sounds very suspect, but for our purposes that really doesn’t matter. As it turned out Icahn never gained control of Clorox, and to my knowledge he walked away.

Insider trading is not always everything it is cracked up to be. There are a lot of people out there who just can’t resist the idea that there is some short cut. There are others who are convinced that “it” (meaning pretty much everything) is all a conspiracy. “The system is rigged.” All you have to do is say it and “60 Minutes” will plug your book for you. Icahn and every other big-time investor just makes big bets based on hearsay and then flies out to Vegas to party like Leonardo DiCaprio’s character in “The Wolf of Wall Street,” giving tips to high-rollers who play golf with guys like Phil Mickelson. There is only one problem with this whole fantasy: it is a fantasy.

In real life the most successful investors are more like college professors than Vegas high-rollers. Most do not consider losing money a thrill, and they wouldn’t tell their own mother what their next trade is going to be. Also ironic is that the most successful investors are in no way “insiders.” Most notably Warren Buffett made his fortune in Omaha. Sure, everyone knows him now, but that was not the case when he was picking stocks out of the S&P register while sitting in his living room wearing pajamas. Sir John Templeton said his results improved when he left New York for Bermuda because he was less connected to the noise. Templeton wrote extensively about investing of course, but his favorite subject was actually theology – which is not all bad if your goal is to build a firm as successful as Franklin/Templeton, but probably a little too boring for Hollywood. In his book “More Than You Know,” Michael Mauboussin points out that most mutual fund managers who beat the market over time are not located in large financial cities, i.e. New York and Boston. In fact distance from those cities has a positive correlation with better investment results. One doesn’t need insider information to make good investment decisions, but if you really want some insider knowledge, don’t ask Carl Icahn, or anyone for that matter, what he is investing in next. Ask him how he thinks.

A few days before the Mickelson insider trading story broke I was playing golf with a friend who commented on Icahn’s very public investment in Apple. My friend knew that we had invested in Apple and knew that I had written an Insight about what Apple should do to boost the share price: Return more cash to shareholders and split the stock. He was evidently impressed that people like Icahn had made the same realization. I told him that it happens fairly often – we make an investment for our clients and a little while later it comes out that some big name hedge fund manager made a similar move at a similar time.

My favorite story happened in 2008 when we increased our allocation to U.S. stocks days before Warren Buffett published an op-ed in the New York Times telling people that he had done the same. That same year we invested in Goldman Sachs and a few days later Buffett made his large investment in Goldman. Later we were about to pull the trigger on a railroad when Buffett beat us to it. We joked that we should search our offices for bugs. It shouldn’t be that surprising. We have all read the same books and taken the same math, economics and finance classes. Investing really is not as mysterious as many wish to believe. Understanding value is simply a mindset, which can be trained. When one does so, he is then able to make his own decisions and draw his own conclusions, and he too will find that more famous investors will often be in agreement.

If you really want to get the inside scoop I guess you could fly to Vegas and play golf until someone hands you a hot tip from some famous investor. Or, you could just start thinking like a famous investor yourself. It takes a little more work and may not be as glamorous, but I believe you’ll find it is more rewarding in the long run.

Chuck Osborne, CFA
Managing Director

~Insider Trading

I know that everyone does not think like I do, but somehow I am always surprised by how so many people just do not get math.

For thirteen years I drove the same car. It was a great car and I loved it. Nothing lasts forever though, and I finally had to replace the vehicle. I had been thinking about what car I would buy so it did not take long. I called the dealer, they told me about the current deal option and it sounded good, so I went to test drive the car. The car drove beautifully and I told them I would take it. The salesperson came back with the numbers and just as I had feared they held little resemblance to what I had been told over the phone. In a strange way it was reassuring to know that nothing had changed in the car buying process over the last thirteen years. I informed him that this was not what I had been told and he explained that the difference was taxes and fees, which had not been included (in fairness to the auto industry the representative on the phone had indeed said, “plus tax and fees”). So I did the math. The extra amount they were going to charge me was twice the disclosed amount for taxes and fees. My poor salesperson was dumbfounded. It took me almost twenty minutes to explain the math to him. Of course he had to speak to his manager, as they always do. They corrected their “mistake” and I got the deal they had advertised, plus the actual taxes and fees.

My wife was with me, and she went from being embarrassed (it is no longer customary to negotiate with car dealers) to shocked once she understood that I wasn’t really even negotiating, just correcting their bad math. She then was mad. These people are crooks! Well, the nice gentleman who helped me get my first new car in thirteen years was not a crook; he was just bad at math and very trusting of his mysterious manager.

It is not all that surprising that a car salesperson might struggle with math, but when the chairwoman of the Federal Reserve does much the same, it is a little curious. In her testimony to Congress Janet Yellen said that the economic experts at the Fed have been surprised that the housing recovery has slowed. I am sure that part of the surprise may be that rising interest rates make homes more expensive and therefore reduces demand. I say surprise, because the Fed has to maintain institutional surprise about there being a relationship between interest rates and housing, otherwise they would have to take partial blame for the housing bubble and financial crisis, and that will never happen.

However, that is not even the biggest mathematical error. There are half as many people in Generation X as there are Baby Boomers; half the people, but just as many houses. Math. Housing is not coming back to 2005-2006 levels for a generation – not until the Baby Booms kids finally move out of their parents’ houses and have jobs that pay enough to support mortgages of their own. This brings us to another seemingly simple piece of math that eludes so many.

This week Wall Street seemed surprised that Walmart isn’t doing all that well. They are even more shocked that industrial production is not growing faster. After all, unemployment is down to 6.3 percent. Once again, it is math: the rate has dropped primarily because there are fewer people in the workforce today. More people are either retiring or giving up on work than are finding new jobs. If fewer people are working, Walmart will sell less, industrial production will be down and housing is going nowhere fast. It is just math.
We keep repeating the same pattern: the economy is slugging along at 2 to 2.5 percent growth while expectations keep going back and forth from boom to bust. Most recently expectations were for boom and now everyone is disappointed. Before you know it they will be calling for a recession. The reality is we are still stuck in the same old “new normal” – and there are too many factors keeping us there for that to change anytime soon.

That isn’t all bad for investors. Bond rates are fluctuating in a range between 2.5 and 3 percent; equity valuations are still reasonable; and the most attractive places to be, large dividend-paying companies, do not require huge economic growth to be profitable. One can choose whether to see the glass as half-empty or half-full. I have a car payment for the first time in many years, but my kids are no longer embarrassed to be seen in my car. That’s math I can live with.

Chuck Osborne, CFA
Managing Director

~It’s Just Math!

It has been a while since we sent out our last Insight, because there really has not been much of note in the investing world. That is not true of world events lately but we are not here to pontificate on everything, only those things that impact your investment portfolios.

Sometimes, however, something happens that may not impact your portfolio but does illustrate a learning moment. The end of the college basketball season can be such a time. For the winning programs this marks the spring ritual of the NCAA Tournament, also known as March Madness. Even people who never watch basketball through the year get excited about filling out their brackets. Our president filled his out on national television. It’s a big deal.

For the other basketball programs it can mark the time of another kind of madness: the search for a new coach, namely one who might get them into the aforementioned tournament. Unfortunately for my fellow Wake Forest Demon Deacons we are in the second type of madness. The search for a new coach has begun and the online commentary from the fan base has begun right along with it. It has struck me that hiring a new coach is much like making an investment. The processes share more than a few similarities: The success or failure of a new coach will be completely determined in the future, yet all one can possibly know about the individual is in the past. One must look at past data and project what the future may hold. The psychological mistakes can largely be the same as well.

Online the avid fans are all demanding a coach who has seen recent success. Winning two games in the NCAA tournament can turn a coach from someone no one has ever heard of into a celebrity and a must-hire. There are currently two coaches being rumored to be front-runners for the job at Wake Forest. One has the kind of background a reasonable person might expect: He played college basketball under a Hall of Fame coach and even won an NCAA championship as a player. He had a successful career in the NBA as a player. He has been an assistant coach at a major college basketball program working under another Hall of Fame coach. He has won an NCAA championship as an assistant coach. He has worked as a head coach in a smaller program and had early success.

The other candidate has little pedigree but did get a job as a head coach at a smaller program. He inherited a very good team from the previous coach who left for a bigger job. That team went to the NCAA tournament and made it all the way to the Final Four. Since then he has not accomplished much; in fact his winning percentage is not as good as the coach from whom he inherited that Final Four team. But, his name is always mentioned when major programs are looking for a coach.

I have no idea which coach would do better, or if the rumors are even true that these are the two finalists for the job. However, the Internet crowd is almost unanimous in their desire for the second option, and I find that both interesting and educational. Making sound investment decisions is about understanding probabilities. No one knows what the future holds; all we can do is use our logic and reason to judge whether success is more probable than failure. However, the madness of crowds gets in our way. What is probable and what is popular are often at odds.

Take the Wake Forest coaching dilemma as an example. The future success of the first candidate – the one who has been there himself as a player, has tutored under two Hall of Fame coaches and has had early success building a program from nothing – is highly probable. I would go so far as to suggest reasonable success is practically guaranteed.

The second candidate – who happened to win four games in a row at the right time once – could possibly be better. Anything is possible. However, I believe most reasonable minds would agree that the likelihood is far less certain. Yet the online crowd says he would be a “home run” and the other guy would be a disappointment.

Benjamin Graham, the father of security analysis, once said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.” Evidently that is true for basketball fans as well.

Warm Regards,

Chuck Osborne, CFA
Managing Director

~March Madness

We start this week with the realization that we now live in what George Friedman, PhD., founder and chairman of Strafor Global Intelligence, calls the “Post-Post-Cold War World.” He freely admits it is a poor name, but it is the only one he has at the moment.

The “Post-Cold War World” was a world dominated by America. We had won and the Soviet Union had lost. More than that, capitalism had triumphed over the command economy, freedom and democracy had triumphed over communism and its weaker cousin socialism, and the United States of America was the sole world power. Our way of life was looked upon as being the correct model.

For much of the next twenty years the rest of the world not only relied on us to keep the peace, they copied us. Economic freedom grew globally. Democracy, at least in name, grew globally. Prosperity grew with it, as it always does. Then two events happened in the summer of 2008 that, according to Friedman, marked the end of that era and the beginning of the new era with the really bad name: Lehman Brothers collapsed, creating a financial crisis that eventually spread throughout the Western world. Then, Russia invaded the small country of Georgia.

We have obviously given much thought and written a great deal on the financial crisis, but until I heard Friedman speak a month ago I had not given much thought to the invasion of Georgia since it ended almost as quickly as it began. Friedman, however, makes a solid argument for how the two events are linked. The first showed that even our mighty economy can be vulnerable, while the second showed that we no longer possess the strength to deter all the potential bullies in the world. In his view after the summer of 2008 the United States became just a world power, instead of being the world power.

Perhaps Friedman is correct. It certainly appears that this was the lesson Vladimir Putin learned. Russia threatens Ukraine, the Western world threatens consequences, and the Wall Street Journal reports Monday that Oleg Panteleyev, a member of Russia’s upper house of parliament, said Saturday, “They talk and talk, and then they’ll stop,” noting that the West made threats but did little in 2008.

The geo-political and humanitarian consequences of these events in Ukraine could be huge. While that concerns us, as it should everyone, we are at work today and our job at Iron Capital is not to pontificate on global events, but to understand how they may impact our clients’ investment portfolios. So that is where I will focus.

The immediate reaction is likely to be negative. Markets were down yesterday, as the knee-jerk reaction to any global unrest is always to sell. Soon, however, investors will realize that these events, as important and tragic as they are, do not really impact the amount of iPhones that Apple will sell, or the Xboxes that Microsoft sells, or even the number of trucks Ford may sell. Ukraine – and even Russia, for that matter,  – are not really important business partners to most companies, and ultimately investing is about what happens at the company in whose stock one is invested.

In the long term the post-post-Cold War world may be re-introducing us to something we had forgotten about over the last twenty to thirty years: the concept of political risk in international investing. The world is no longer marching in unison toward more economic freedom and opportunity. Whether it is Russia or Brazil or Argentina, we are surrounded with examples of government corruption, incompetence and bullying. This environment requires a prudent approach to investing, and that is what we strive for at Iron Capital every day.

Chuck Osborne, CFA
Managing Director

~The New World