We live in a celebrity-obsessed culture. In case you didn’t know it, Peyton Manning lost the Super Bowl. I thought that was a forgone conclusion because, based on the media hype beforehand, the game was Peyton Manning against the entire Seattle Seahawks defense. When I turned on the game I discovered that there were in fact ten other offensive guys on the field with Manning, and evidently there is an entire 52-player football team in Denver called the Broncos.

The NBA recently had a big game that matched up Lebron James vs. Kevin Durant, two of the league’s best players. After seeing the pre-game hype for that contest one could understand my shock when I turned to the game and there were ten – not two – grown men on the basketball court. It turned out it was the entire Miami Heat team playing against the entire Oklahoma City Thunder team, James’ and Durant’s teams respectively. But if you only listened to the report of the game afterward, you would have never known anyone else was there.

This obsession with only the few top players is nothing new to professional sports, but it has spread to the college level. If you were so inclined you could have spent your day Wednesday seeing what potential future celebrity football players are coming to your school next year. As silly as that may seem, the phenomenon has also seemingly hit the stock market, which has to be even sillier.

Apple Inc. reported earnings and beat expectations on both revenue and earnings. Their guidance was in line with market expectations, all in all a very good report, except for one thing: They sold fewer iPhones than expected. They still beat expectations on total revenue because they also sold more iPads than expected. Still, the stock dropped in price. Evidently there are investors out there wishing to invest only in iPhones and not in the whole Apple team.

Gilead Sciences, a pharmaceutical company, reported and beat expectations all around and gave future guidance that was better than expected. They were a little vague on the prospects for a new star drug, so their stock dropped in price.

I could go on and on with similar examples thus far in the quarter. This is a very common market fascination. In sports it is a little different. If LeBron James has a bad game and the Miami Heat still win, it is seen as proof that they are a good team. They are not just a one-man show. Shouldn’t it make sense that if a company beats expectations in a quarter when their star product didn’t have its “best game,” then that is proof of the overall strength of the company?

One would think, but right now Wall Street seems to be in a “glass is half-empty” mood. The fact is that earnings season has gone pretty well; revenues are up year-over-year for S&P 500 companies, as are earnings. This quarter has been at least as good if not better than the two previous quarters that were greeted with gleeful appreciation.

Wednesday night I had the pleasure of listening to George Friedman, PhD., the founder and chairman of Strafor Global Intelligence. They research the geopolitical world and give insight into trends that could benefit or threaten investors. He confirmed my view of this recent downturn – that none of the excuses being bantered about make any sense. The truth is that markets sometimes move in inexplicable ways and then we search for some explanation because that makes us feel better. He suspected that the real reason for the weakness in the market thus far this year is nothing more than profit-taking.

In other words, markets do not go up in straight lines. Football and basketball are team sports. Teams win games and teams win championships. Not even the great Michael Jordan could win a championship without teammates who could help him. Seattle won the Super Bowl because, at least on that night, they were the better team. Teams are always bigger than any one player. Apple beat expectations because it is a very good company with a diverse product line. It is bigger than just the iPhone. The same goes for Gilead, and many other companies that have had their reports nit-picked by people who are simply in the mood to sell. Prudent investors understand that in the long term it is the whole that matters, and like any good team, the whole is often greater than the sum of its parts.

Chuck Osborne, CFA
Managing Director

~Star Power

Good morning,

As a result of the winter storm and resulting city/business/school closures in Atlanta, most of the Iron Capital staff is working from home today. Rest assured that the firm is open and the team is able to conduct all essential businesss operations remotely. A skeleton staff will be able to make it into the office today and will do so until conditions improve, but we are otherwise fully operational. We will return calls to the office at our first chance.

Thank you!
Iron Capital Advisors

~Iron Capital Is Open Despite Atlanta Weather Conditions

Never let logic, reason or pesky things like facts get in the way of a compelling headline. That must be the mantra of the financial press these days.

It reminds me of a scene from “Pirates of the Caribbean; The Curse of the Black Pearl.” (As our long-term readers know, there is very little one cannot learn about investing by simply watching this movie.) The scene is when Captain Jack Sparrow is in jail and the Black Pearl attacks. One of the other prisoners says he has heard stories about the Black Pearl and how they never leave any survivors, to which Captain Jack responds, “No survivors? I wonder where all the stories come from then.” The humor comes in the scene’s reality. We hear something that is just too good to not pass along and the next thing you know we are repeating something that makes no sense whatsoever.

Without survivors there would be no stories. Likewise, a bubble cannot pop if it did not exist. The story for the last few days of this downturn has been that markets – both bond and stock markets – in the emerging countries have been pumped up by the Federal Reserve’s (Fed) policy of quantitative easing (QE). The story goes that investors, who would have preferred to purchase Treasuries but couldn’t do so because the Fed has been buying them all, needed some place to go and they piled into emerging markets. Now that the Fed will be buying fewer bonds – that is what tapering is all about – these investors are going to drop emerging-market securities like a hot potato and run into Treasuries.

This story is almost as good as the crew of the Black Pearl never leaving any survivors. Like that story it has a flaw. Emerging markets were actually the worst place to be last year; in fact they have been the worst place to be for about three years – which is why they now appear cheap. How could emerging markets underperform if all these investors are being forced to invest there? That question is about the same as asking how those dead people spread all the stories about the Black Pearl. If QE did not prop up emerging markets, which is pretty clear, then the mild tapering of QE is not likely to cause any real issues.

I had the pleasure about a week ago of meeting with Dennis Lockhart, the president of the Federal Reserve Bank of Atlanta. He is always very professional and does not reveal anything unofficial, but reading between the lines of that meeting together with the official releases from Fed itself, it seems to me that the Fed is anxious to taper because they have finally realized that QE isn’t working. Some asset prices may have been pumped up, especially bank stocks and domestic small-company stocks, but the real economy has shown little benefit, if any, from QE. If it is not working then it is better to end it as soon as possible before any long-term unintended consequences occur.

So what is really happening in the markets? Markets do not go up in straight lines. After going up 32.39 percent last year and up 10.51 percent just in the last quarter, the S&P 500 is now down 3.06 percent year-to-date. The headlines are talking about markets “tumbling” and that is scary, but that is also the point; they are selling newspapers (or at least the electronic equivalent). Describing the current activity as “stocks in mild correction after a huge run-up” doesn’t compel attention like the word “tumbling.” However, no broad market indexes that we follow, including emerging markets, are even close to the ten percent drop that would constitute a normal correction during a bull market.

Of course, one cannot be complacent. We must always be prudent, and episodes like this are a good reminder of why prudent investing is done from the bottom-up. What is happening at the companies whose stock one owns is far more important than some sensationalistic headline. Prudent investing is absolute return-oriented, avoiding hot assets whose valuations cannot be justified. Prudent investing is also risk-averse, avoiding loss, or more specifically the permanent loss of capital. This does not mean avoiding three percent short-term price volatility; it means that when one is prudently invested, one is less likely to see any significant loss over time.

So what are we going to do in the face of outrageous headlines? We will stay prudent. What we own is sound and should do well in 2014. We have avoided or minimized areas like retail stocks, banks, and small company stocks in general that do appear overvalued and would likely lead the way downward if this proves to be more than a short-term blip. We will take action if this short-term volatility turns into anything more serious, but for now, rest assured: no bubbles have popped, nothing is tumbling, and dead people can’t spread stories.

Chuck Osborne, CFA
Managing Director

~News Flash: Emerging Market Bubble Burst by Fed Tapering!

The other night I had the pleasure of watching my two favorite college basketball teams win. There was a time when that was not unusual, but the last few years have been tough for my Wake Forest Demon Deacons. As a Wake alum, the Deacons are of course my favorite team. My second favorite team is whoever is playing Duke, and this week that was Notre Dame. Wake successfully vanquished the Carolina Tarheels while the Fighting Irish took care of those Blue Devils for us.

At the halftime break a reporter grabbed Wake’s coach, Jeff Bzdelik, to get a few words. Bzdelik said he was happy with Wake’s rebounding. The announcers, and everyone else watching, was left wondering what he was talking about. Carolina was killing Wake on the boards and had a huge lead in rebounds, even though it wasn’t helping them much on the scoreboard. It reminded me that things aren’t always what they seem when you are actually going through them. I’m sure when Bzdelik looked at the actual statistics his opinion changed, but watching it from his perspective in real time things looked different. It happens to all of us. This is one of the reasons keeping statistics can be so helpful.

Take 2013 for example: I think if you asked most people about 2013 they would say it was a wonderful year in the stock market, but a horrible year from a political or public policy stand point. But was it? At the beginning of 2013 we were facing a fiscal cliff, a sequester and the debt ceiling. The consensus among economists was that our debt situation required a combination of tax increases and spending cuts. There was also a consensus that it would never happen because one party refused to cut spending while the other refused to raise taxes. But it did happen. Yes it was ugly – very ugly – and far from perfect. No one is happy because no one got their way. However, we are in better shape fiscally today then we were 365 days ago, and that improvement is progress. Mild perhaps, but progress nonetheless. That progress is not acknowledged, but it is part of why the economy is improving slowly but surely.

That improvement has in part spurred the bull market. The year in stocks, however, is more complicated than it might seem on the surface. I say it all the time, but what is happening beneath the surface of the broad indices is much more meaningful than just the return of the index. What looked like a straight line bull market all year was really two very different halves. The first half of 2013 was all about junk; half way through the year the best place to have been within the S&P 500 was the 50 companies with the worst analyst ratings. That was unsustainable. We had a mini-correction in August and then began a rotation. The second half of the year quality once again mattered, and that is an encouraging sign in our opinion.

For two and a half years or so fundamentals and valuation seemed to not matter as the market was so focused on one political crisis after another – domestically and in Europe – instead of what was really happening at the company level. A recent article on Bloomberg.com noted that Warren Buffett has underperformed over this period. That isn’t surprising because almost everyone who pays attention and tries to act rationally has been in the same boat. But these periods never last. Eventually reality wins out and fundamentals are recognized. It appears that transition began in the second half of 2013.

That makes us optimistic about the beginning of 2014. Markets don’t go up in straight lines, and after a 10 percent quarter we wouldn’t be surprised by some consolidation. There is certainly some over-priced junk left from the bull run in 2013, but there are also some quality companies out there with decent valuations. 2014 could be a good year, particularly for the prudent investor.

Happy New Year, and Go Deacs!

Chuck Osborne, CFA
Managing Director

~It Really Wasn’t That Bad

I used to work with a guy who was fond of saying that clichés exist for a reason. “Perception is greater than reality” is certainly one of those clichés. Coming to the end of this year I keep hearing the same thing, both from clients and some pundits: When is the market going to crash?

It is understandable. After all, most of us have witnessed first-hand two bubbles that burst. We have become programmed to believe that every time the market is up this much, it must be another bubble. However that is perception, not reality. This not to say that there will not be volatility or that we may not be due for a correction; markets certainly don’t continue to go up six or seven percent a month indefinitely as they have done in the fourth quarter. However, not every bull market is a bubble.

Bubbles occur when valuations get stretched beyond anything reasonable, or put more simply, when people pay far more for something than it could possibly be worth. I know what you are thinking: All the people on TV keep saying the market is at record highs. Doesn’t that mean it is expensive? No, it does not. The level of any market index, whether it is the Dow Jones or the S&P 500, is really just an arbitrary accounting measure based on the price for the stock. Inflation alone would cause this value to rise and making new highs is really the norm, it just hasn’t seemed like it for thirteen years as we have recovered from the technology bubble – a true bubble. What matters in determining the price of the stock market is the price relative to the earnings of the companies in the market, or what we refer to as the price-to-earnings (P/E) ratio.

Crashes occur when the price for dollar of earnings gets way too high. In the tech bubble that is exactly what happened, and why true investment professionals, like us, looked like complete geniuses when that bubble burst. It is easy to look at a high P/E and know that eventually it means trouble. The 2008 situation was a little more difficult to foresee. In 2008 the stated P/E didn’t look all that bad, but we were about to enter a massive recession and the E (earnings) part of the equation was about to drop dramatically.

Neither of those cases seems to be the situation today. U.S. stocks are valued in line with historic norms, neither cheap nor expensive, based on earnings. The economic data seems to be improving, not deteriorating. International valuations are reasonable and their situation, while not all that good, seems to be stable to improving slightly. Emerging market stocks are cheap; there are risks of course, but in the long run cheap is usually a good thing. Bonds and so-called alternatives continue to be the areas that look most expensive, although less so than a few months ago.

Of course things can always change quickly, but I was reminded the other day that part of our job is to give our clients peace of mind. In 2000, before I started Iron Capital, I went to my then-boss and told him that a fund our firm was running was about to blow up. Two months later the bubble burst. In January of 2008 I stated in our Quarterly Report that we were heading for recession and a bear market. As many of you know, the reason I am in this business is because as a student in the fall of 1987 I had the foresight – or sheer dumb luck – to short the market in my student mock portfolio.

Of course I also predicted a downturn in 2012, and that didn’t happen. The point is that I, and we for that matter, have been very good at seeing downturns, and we don’t see one right now. We are not perfect; I should have made the 2008 prediction in the fall of 2007. I could be making the same mistake today, but the data isn’t there. Perception rules in the short term, but eventually reality wins out. The reality today looks pretty good for equity investors.

There may be areas of concern – small-cap stocks, social media stocks, and banks come to mind. But, this is why prudent investors always start from the bottom-up. Prudent investors are absolute return-focused and do not invest in hot areas to try in compete with the market or our neighbors. Prudent investors are risk-averse, and if we are anything at Iron Capital, we are prudent.

I hope that helps provide some peace of mind. All of us at Iron Capital wish you have a very Merry Christmas and a Happy New Year.

Chuck Osborne, CFA
Managing Director

~Perception vs. Reality