Up 43 percent! If only that were our investment results, but it is not. That would have been the increase in Iron Capital’s health insurance premiums if we had renewed our policy on schedule in January. Fortunately we have a good agent who advised us to renew early, giving us almost one more year before we have to be fully compliant with the Affordable Care Act. People across the country are getting such notices if not having their policies cancelled. In the meantime I have noticed that the service I get from my doctors has gotten worse; I seem to be waiting longer and being treated more rudely, if that is possible.

Please do not misunderstand my perspective; I personally believe we need health care reform. The problem, as I see it, is that every attempt to reform health care, from both sides of the political aisle, is focused on the symptoms of our problems and not the cause. Granted this is a complicated issue, but most of what is wrong with health care today can be summed up in one sentence: The patient is not the doctor’s customer. Doctors work for the insurance company, not for their patients. That is obvious when you walk in their office. They have a team of people coordinating with insurance companies, while you get a clipboard and a sign that reads, “Please sign in.” Most of the things we complain about are caused by that one fact.

To truly fix our health care system we need to be asking how we make the patient the customer. But that is not the question that most ask when trying to come up with reform ideas. They may very well come up with great answers to the questions they do ask – how can we get more people insurance, for example – but the correct answer to the wrong question is still not a workable solution. Getting more people insured is a worthy goal, but if, as I believe, the uninsured are a symptom of our problem and not the problem itself, then we are not correcting the actual problem, and that will be the ultimate downfall of any such reforms.

One has to be sure that they are asking the correct questions. This is just as crucial to investing success as it is to public policy. The other day a well-meaning and very nice acquaintance asked me, “What are you telling your clients for 2014?” I am sure that many traditional advisers love these kinds of questions because it is an opportunity for a sales pitch. However, the fact that the calendar moves one more day and we call it another year means very little to the true long-term investor. Questions like this are encouraged by Wall Street firms because they are good for business. If one believes he must do something differently in 2014 than he did in 2013 that means transactions, and transactions are what Wall Street is all about. One should ask about process and fundamentals, and those things don’t change with the flip of a calendar.

Focusing on what is really important is not always that easy. We have to know the right questions. Do we care that everyone has insurance, or is it more important that everyone has good care for their health? Do we want to know what someone is saying about 2014, or do we need a long-term, goal-oriented path to investing success?

If there is ever a time when we should be mindful of what really matters it should be now as we celebrate our national day of thanks. We all have much for which to be thankful, and as is our tradition here is my list.

1. I am thankful for a good health insurance and an agent who helped us keep it.

2. I am thankful for the opportunity to coach my son and his teammates (the Sharks) in basketball, a sport I actually played and understand.

3. I am thankful that I can pull for the Sharks while my beloved Wake Forest Demon Deacons go through yet another year of a seemingly never-ending “rebuilding project.”

4. I am thankful for my family, immediate and extended.

5. I am thankful for loved ones lost and the time we did have together.

6. I am still grateful for Mama’s pumpkin cheese cake and my loose-fitting pants that make the enjoyment of said cheese cake possible.

7. Last but certainly not least, I am thankful for you, our clients and friends of the firm. Your trust in Iron Capital is our greatest asset and we value you every day of the year.

Happy Thanksgiving!

Chuck Osborne, CFA
Managing Director

~Health Insurance and Other Things for Which We Should Be Thankful

Several years ago I sat down with the team here at Iron Capital and together we defined our guiding principles. We have used these as entirely internal guidelines for our behavior at work and how we approach serving our clients. One of our principles is that everyone here at Iron Capital will strive for wisdom. I can still remember the conversation around this one: The initial reaction was that wisdom is hokey and old-fashioned. I persisted because I felt then, and still feel, that wisdom is what our clients expect from us. After all, information is now at your fingertips. Knowledge isn’t all that rare or even helpful in many cases. What clients are looking for is wisdom – the combination of knowledge and experience that produces insight for the actual actions that need to take place for clients to reach their goals.

True wisdom can only be gained in one way: experience. Some dictionaries define wisdom as good judgment, which reminds me of my honeymoon. My wife and I honeymooned in Scotland, and in the town of Edinburgh we found a great, old hole-in-the-wall Scottish pub where we could relax. On the wall hung a sign that read, “Good judgment comes from experience. Experience comes from poor judgment.” It is true that experience is based on mileage and not years, but there is no denying that it takes time to accumulate experience, and therefore wisdom.

Why has wisdom been on my mind? While it has been quiet in the capital markets and there has frankly been little to write about, the political world has been what has captivated us. First the government was shut down by a young senator and his followers who wished to defund the Affordable Care Act, aka “Obamacare.” Then after that battle and the other side’s refusal to avoid shutdown by postponing the Obamacare launch, the new national healthcare system opened on schedule, and I think we can all agree that at best it was not quite ready for prime time. I am not here to discuss politics except to say that I think most will again agree that we seem to be lacking anything resembling wisdom in Washington today.

But we are here to manage money, not to fix our national woes, and in doing so something worth mentioning happen here not long ago. Every quarter we have an investment committee meeting during which the analysts and I sit down and review the results for every outside mutual fund manager we use with our clients. This list includes all the mutual funds we have chosen for our private client accounts and the ones we have recommended for our institutional clients. It also includes some we may not have chosen but rather inherited, or some that may not have been our first choice but were what we considered the best from which we had to choose. Usually in these meetings we focus on what happened in the quarter and the rolling three-year return rankings (and to a lesser extent five-year return rankings). However, this summer we celebrated Iron Capital’s 10th anniversary as a firm, and I started looking at those ten-year return numbers. Something amazing emerged: In every asset class except two, every manager we cover (approximately 90 managers) had delivered better investment results than their market benchmark. The two exceptions were the domestic large blend category, where we never recommend active management but have inherited a few; and high-yield bonds, where no manger we would consider would have been as risky as the benchmark over that time period, which included the financial crisis (although our favorite manager is outperforming). Other than those two, every manager we have in every major asset class was doing what many in academia say is impossible: beating “the market.”

One of the most famous voices in this academia chorus, Professor Eugene Fama, just won the Nobel Prize for his work proving that firms like Iron Capital can’t possibly exist…which reminds me of something a hedge fund manager once told me. This manager had a Ph.D. in mathematics and I was talking to him about considering going back to school and getting a Ph.D. in finance or economics. He looked at me like I had two heads and asked, “Why?” (He actually said more than that, but this is a family newsletter.) His point was that finance is a practical field; one can practice it in real life. It isn’t like Russian literature, or ancient dead languages. One does not have to hide in the ivory tower to study finance since he can practice it in real life. This brings us back to the difference between knowledge and wisdom.

There are lots of knowledgeable people who will tell you to put your money in an index fund and invest passively. Yet, all of my experience tells me that they are wrong. I know that I have a great team here at Iron Capital and we are very good at what we do. I believe we are better than most, but we are not miracle workers. I do not believe we have done something that no other firm could do; I do not even believe that we are that unusual if really compared to only our true peers. Many firms like ours across the country probably have similar results. The point is that active management does add value over time. More importantly, in my opinion, it adds value usually at the most important time, when markets are down or moving sideways. Active management also promotes caring about what one owns and how the management of these companies behave.

There is a trend in our industry to go more and more toward passive index products, funds or ETFs, and I personally believe this is dangerous. It is a fact that our clients would have been worse off if we had done that ten years ago, and my experience tells me that going in that direction is unwise. Experience also tells me that the more passive investors get, the more reckless management becomes. We saw that in the accounting scandals of the early 2000’s and again in the financial crisis. But wisdom comes with age and we live in a youth-obsessed society. So I will likely remain in a small minority who believe the words “young” and “senator” should never be used in the same sentence, and that being active is the best way to invest.

Then again, I didn’t care that my own staff called me “hokey” for telling them they must strive for wisdom. I hope you are pleased about that.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Wisdom

I remember the late winter storm in 1994 that hit the entire East Coast from Florida to Maine. It dumped more snow on Atlanta than we have seen since and was deemed the “Storm of The Century.” In the next six years I believe there were three or four more “storms of the century” or other similarly exaggerated names. Let’s face it, our popular culture has a narcissistic streak to it. Our storms are bigger, our athletes more dominant and our political crises are more critical.

If only any of that were true. Today we are surrounded with talk about this “unprecedented political standoff.” It has been said that it would be unprecedented for the debt ceiling increase to be used as political leverage, even though that is exactly what has happened since the 1970’s with even our own President voting against an increase when he was in the Senate. I have read that it is unprecedented for one party to shut down the government when they only control one house of Congress. The list goes on and on.

The old saying goes that one can pick one’s point of view, but one cannot pick his own facts. Standard and Poor’s (S&P) sent us some interesting data on government shutdowns last week that I think is worth sharing: Since 1976 the government has been shut down 18 times; several times for just one day, but the longest was for 21 days during the Clinton administration. Seven times, all during the Reagan administration, the government was shut down when the opposition party controlled only the House of Representatives, as is the case today. Interestingly the government was shut down five times during the single four-year term of the Carter administration when one party controlled all of Washington. Not only was it shut down under one-party control, but the shutdowns lasted longer. Carter owns the second longest shutdown of 18 days, the third longest at 12 days and the fourth longest at 11 days. The S&P data went back to only 1976, but I would assume the longest absence of our federal government, as we now know it, would be the eight years between the final victory at Yorktown in 1781 and the final ratification of the Constitution in 1789. Those were political disagreements of an actual historic nature. To my knowledge no one has yet threatened a duel on the Common as a possible solution to our current stalemate.

Why has the market largely ignored this Washington side show? I like to think it is because a lot of us understand that there is nothing historical or even unique about the current level of political tension. Whether the shutdown continues or not, the probability of a debt ceiling extension not happening seems slim. So, not much has really changed.

In other news and random thoughts, the Nobel Prize in economics was split between three U.S. economists: Eugene Fama, Lars Peter Hansen and Robert Shiller. Fama is famous for espousing the so-called efficient market hypothesis, which is the backbone of Modern Portfolio Theory. Hanson works with Fama. Shiller, using some of Hansen’s work, is famous for proving Fama wrong. This has nothing to do with your portfolio, but it is good news for us because it shows that not even the Nobel Prize committee understands what economists are saying. Now that is what I call job security.

Chuck Osborne, CFA
Managing Director

~We Are Never The First

Sometimes we forget how much wisdom there is in the classic children’s stories. Consider Aesop’s Fable “The Boy Who Cried Wolf.” The first time he cries wolf everyone comes running, worried about the wolf attacking the sheep. The second time much the same and so on, until people finally get tired of all the false alarms. When the wolf actually comes, no one believes it.

We are having a governing crisis! Yep, it works in real life too. The government has shut down and we, like the villagers in Aesop’s fable, seem to be letting out a collective, “whatever.” To be clear, the government is not actually shutting down. Services deemed essential will remain in operation. That means the vast majority of us will not notice; which leads one to wonder why the government has “non-essential” departments in the first place?

While that is an interesting question our concern here is investing not politics, so the more important question is: What impact, if any, will this shutdown have on your portfolio? Most likely the impact will be in line with that of the Bush tax cut expiration, the sequester, the Cyprus banking crisis, etc. I think we have all had our fill of the government-created crisis. It just doesn’t scare us anymore.

In the meantime, the world outside of the Washington beltway is looking pretty stable. The economy continues to just slug along, which isn’t great but isn’t horrible either. Valuations on the equity market as a whole are reasonable, and international markets are becoming more attractive. Interest rates seemed to have peaked at 3 percent on the ten-year Treasury and are now slowly and quietly working their way back down towards 2.5 percent, maybe even lower. All of that bodes well for equity investors.

So, it is pretty quiet out here in the real world, which brings us back to our fable. Eventually the wolf actually did attack the sheep, and that is the real danger we face today. Having become numb to the drummed-up crisis of the day, will we actually underestimate a real crisis when it comes? That keeps us ever mindful that these political games, as painful as they are to watch, cannot be ignored. So we at Iron Capital will continue to watch and guard against the numbness.

Chuck Osborne, CFA
Managing Director

~Crying Wolf

The stock market has been down four whole days in a row and media is all abuzz. Interest rates are on the rise as market participants continue to worry about the Fed’s tapering off of quantitative easing. The rate on the ten-year Treasury has now gone from 1.5 percent to 2.8 percent. That is a big rise, and of course as rates rise, the value falls. This brings us to the concept of risk in investing and how it can be managed.

The first step in managing risk is defining it. There are four primary definitions in the financial world and which one you use will have a big influence in how you manage your investments. I will call the first definition the legal claim definition. Different investment vehicles provide different claims on assets. Bonds, for example, are simply loans, and loans are generally backed by some form of collateral. The bondholders of a corporation have a claim on the company’s assets should the company fail and go into bankruptcy. Stock is ownership in a company and should a company fail, the owners will get only what is left after all the bondholders’ claims have been settled. In this view bonds are always safer than stocks.

The problem with this definition is that legal rights do not trump the laws of physics. It reminds me of a former colleague, an attorney who served as in-house counsel at Invesco. He and I would often go to lunch together and in doing so we would have to cross a few streets. He had a habit of walking right out in front of oncoming traffic. I would tell him not to do it and he would respond, “I’m in the crosswalk and have the right of way.” I would often tease that I would be sure to tell everyone that when I was speaking at his funeral. The legal rights to assets mean little if there are no assets to be had, and perhaps less obviously they also mean little if there are more than enough assets to cover all claims and leave the owners with a windfall. This is a poor definition of risk in the real world, even though it dominates popular investor education materials.

The second definition is that risk equals volatility. This is the dominant view of the investment world. Risk is defined as standard deviation and/or Beta, both mathematical terms which measure respectively the absolute and relative price movement of financial assets. Under most circumstances stock prices move more than bond prices, so this view also leads to the conclusion that bonds are always safer than stocks. The problem here though is that volatility goes in both directions. Do we care equally about upside volatility and downside volatility? Most investors I know do not. This leads to the phenomenon of investors saying that they want to take on more risk when the market is going up, then less when it starts going down. I would argue that any useful definition of risk would not change with the direction of the market.

The third definition is relatively new and it is exclusively used within the investment world. This is the risk known as tracking error. It is the measure by which a fund manager’s return differs from the market benchmark by which he is judged. This measure is completely useless to the client as what it really measures is career risk for the professional. The idea is that as long as one looks like the benchmark, the client won’t fire them. It is one of the most damaging results of relative return-focused investing.
Finally there is what we believe to be the real definition of risk. Risk is the probability of losing money (or not making enough) over a given investment horizon. In this definition there are no absolute relationships because the safety of an asset is not primarily determined by legal structure or price volatility and it certainly has nothing to do with the relationship between it and some arbitrary definition of “the market.” The risk of losing money is determined by the price an investor pays. If one pays more than what an asset is worth, then that investor is likely to lose money. If one pays less, then that investor is likely to do well. By this definition bonds can be riskier than stocks.

Third quarter to-date through this past Friday the S&P 500 is up 3.4 percent and the Barclays Aggregate Bond index is down -0.90 percent. Which looks more attractive to you? When bond yields are as low as 1.5 percent for a ten-year obligation then the risk of owning them is high, if you consider risk losing money or at best not making enough. With rates at that level the best case scenario is that one gets the 1.5 percent gain. That won’t pay for much of a retirement.

We have been saying this in our forecasts for some time, and of course earlier this year we moved to an under-weight to bonds and diversified our bond exposure to try to mitigate the risk of rising rates. We didn’t do that because we are clairvoyant; we did it because we understand that risk is price. When bonds are that expensive, it is best to sell them and own something more reasonably valued; in this case, stocks.

Seth Klarman, the famous hedge fund manager, is fond of saying that Wall Street has the habit of taking the safe label and putting it on risky assets and taking the risky label and putting it on safe assets. This is because too many have the overly simplistic view that risk is somehow predetermined by legal structure or volatility. Prudent investors understand that risk is price. Any asset can be safe if the price is right, and likewise any asset can be risky if the price is wrong. Recognizing the difference is the essence of prudent investing.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~What Is Risk?