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

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