• The difficulty lies not so much in developing new ideas as in escaping from old ones.

    John Maynard Keynes

Iron Capital Insights

Our insights, reflections and musings on the most timely topics relevant to managing your investments.


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  • Iron Capital Insights
  • September 25, 2020
  • Chuck Osborne

Searching for Direction

At this moment we remain in a trading range, which is shop talk for, “We are not going anywhere.” When this happens, it is a sign that the market is searching for its next move. Should the bull run continue, or should the bear raise its ugly head? It depends on what the market decides is important.


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  • Iron Capital Insights
  • September 11, 2020
  • Chuck Osborne

Back to Reality

We went too far too fast, especially with the technology stocks, and they are simply coming back down to earth. This much, frankly, is not all that insightful; it is obvious. What may be less obvious is what is happening underneath the surface.


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  • Iron Capital Insights
  • September 3, 2020
  • Chuck Osborne

Cash Flow is King

Cash flow is the most important thing we look for when investing in a company, but it is also the most important element of financial planning. Many people refer to it as budgeting, but I do not like that term. Budgeting will get a person in financial trouble quickly.


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  • Iron Capital Insights
  • August 14, 2020
  • Chuck Osborne

Gold

“There’s gold in them thar hills!” Gold fever seems to be taking the markets by storm. The question is:  Should one invest in gold? I believe the answer to that question lies in the very definition of investment.


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  • Iron Capital Insights
  • July 30, 2020
  • Chuck Osborne

The Gap Widens

For the last decade growth stocks have outperformed value stocks, large-company stocks have outperformed small-company stocks, and domestic-company stocks have outperformed international-company stocks. This is not sustainable and it will end; the questions are, how and when will it end?

  • “Smooth seas never made a skilled sailor.”  ~  Franklin D. Roosevelt

    It is getting a little choppy out here. After the market rally, which went too far, the technology stocks that led that rally came back to earth a bit. Now the market is searching for direction. Volatility has increased a bit, but as of this moment we remain in a trading range, which is shop talk for, “We are not going anywhere.”

    When this happens, it is a sign that the market is searching for its next move. Should the bull run continue, or should the bear raise its ugly head? It depends on what the market decides is important.

    The bull case is pretty simple:  the economy is far better than feared, and we are recovering from the lockdown-induced stop. While there are certainly industries that have been hurt by the reaction to the pandemic, there have also been many companies that were helped. The latter are largely technology firms whose stocks have flown high, but they have also come back a bit.

    There is a third category:  the companies that have weathered the storm. Banks, for example, have not really been helped, but their businesses are doing fine. They still have not participated in the market rally, and they are priced at ridiculously low valuations. Analysts are beginning to pay attention to this fact, and upgrades are coming. Will stock prices follow? They certainly could.

    The bear case is more mood and politics. Wall Street has seemingly just clued into the fact that it is an election year, and a highly charged one at that. There is a significant probability that with so many people mailing in their ballots, we may not know who the President is on November 3. That is not going to be good in the short haul.

    More important to the market may be the fate of the Senate. If Biden wins and there is a Democratic sweep, the short term may be smooth as this would avoid civil unrest, but then, what matters is – what do they actually do? The party platform does not represent what I believe to be the actual core of the Democratic party, let alone America as a whole. The question is, who would actually be in charge – the Joe Biden we knew from the Senate, or AOC and her socialist “squad”? If the latter, protecting principal will be the best we can hope for, and perhaps the least of our worries.

    If Trump wins, the long term is more certain, but in the short term we will see riots. There is a significant segment of the population that believes their side losing means Democracy is broken. The truth is, of course, the exact opposite; but facts don’t seem to matter to this group. The market will not like that.

    If Biden wins but the Senate remains under Republican control, this could be the best outcome from the market perspective. I’m not saying it is best for our country – that is a political judgment and not my place, but it will mean peace in the short term and moderation in the long term, and Wall Street likes that.

    In the meantime, prudence is necessary. In sailing, when the wind picks up and the waves get a little higher, a sailor reefs the sails, which means she reduces the size of the sail to slow the boat and get it under control. The saying goes, “The time to reef is when it first crosses your mind.” We are entering a time where it may pay to be defensive.

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

    ~Searching for Direction

  • The market over the last several days has me thinking about Soul II Soul, and their 1989 hit, “Back to Life.”  For those who don’t remember, or who wisely blocked it out, I apologize in advance because it is one of those songs that gets into your head and you want to get it out, but can’t. It goes, “Back to life, back to reality…” I’m pretty sure those were the only lyrics but you can fact check me on that. (Again, sorry.)

    Anyway, this is exactly what is happening in the market today. We went too far too fast, especially with the technology stocks, and they are simply coming back down to earth. This much, frankly, is not all that insightful; it is obvious. What may be less obvious is what is happening underneath the surface.

    We have written about this before, but it bears repeating:  This market rally has not been a tide that has lifted all ships; it has been decidedly unbalanced in favor of the technology firms that have benefitted from the Covid-19 world of virtual work, school, and social life. To put it in perspective, one can look at the Morningstar style boxes.

    As a reminder, Morningstar breaks the world up into a grid consisting of large companies, small companies, and those in between. They also break the universe up into stock of companies that would be attractive to the average-growth investor, value investor, and in-between or blend investor. The index for the large-company growth box is the Russell 1000 Growth index, and it returned a positive 23.2 percent over the 12 months that ended June 30, 2020. Over that same period, the small-company value box represented by the Russell 2000 Value index returned a negative 17.4 percent. Yes, you read that correctly – there is a 40 percent difference over the last year between one category of stocks and another. No, that is not normal.

    Not only is it not normal, it is historic. It is also completely unsustainable. The last time anything came close to this in the market was the dot-com bubble. The similarities between now and then are striking. Then, large-growth (aka technology) stocks had dominated the returns in the market for a decade. Today, large-growth (aka technology) stocks have dominated the returns for a decade. Twenty years ago that dominance accelerated toward the crash. Today, the dominance has certainly accelerated.

    Here the stories differ a little bit. Twenty years ago there were many tech companies, lots of whom did not have a sensible business plan let alone things like revenue, and almost none of them had any profits. Today, that is not the case. These firms represent the core of our economy. They are the big blue chip companies. Coming back to reality twenty years ago meant industry consolidation and years of building actual businesses. Amazon was an online bookstore when the dot-com bubble burst. Today it is everywhere.

    I’m not sure whether Mark Twain actually said it, however, “history does not repeat itself, but it often rhymes.” There is no force in investing stronger than what we call the reversion to the mean. That is a fancy way of saying stocks seem to find a way to do what they have always done on average. There should not be a 40 percent gap between one segment of the market and another, and that gap will disappear. It appears to have begun that process a few days ago, as technology stocks have been the biggest losers in this short selloff.

    This doesn’t mean we have to go through a bear market as we did when the tech bubble burst twenty years ago. It does mean that there are many areas of the market that have been neglected over the last decade, and they will catch up. Diversification is likely to be much more important in the decade ahead of us then it has been.

    One last thought. Nineteen years ago, terrorists from the other side of the world flew planes into the World Trade Center and the Pentagon. Heroes on another plane fought back against a fourth attempt, crashing into a field in western Pennsylvania. That day is burned into my memory like few other days. However, what I want to focus on right now is the days that followed. For a brief time, we came together as a nation, and it was the most beautiful thing. The goal of the terrorists was to split us apart, but the opposite happened.

    Unfortunately that unity did not last long, but those of us who lived it can still remember that togetherness is possible. Hopefully my children will get to experience such a time, and hopefully it won’t take an enormous tragedy to make it happen.

    Too many people died on that day. Don’t ever forget that with all of our flaws and how far we fall short from the scale of perfection, when graded on the curve of human history, the United States is the shining city on the hill. We are the light in the darkness. That is why we were a target then, and it is why we remain a target today for those who, at their core, are the enemies of freedom.

    The markets get carried away as does society at large sometimes, but ultimately we have to come “back to life, back to reality.” (Sorry, I know it is a horrible song.)

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

     

    ~Back to Reality

  • When I was a young analyst at Invesco I worked with a lot of other young singles. Like most generations of young professionals, we often socialized with one another. One of those friends introduced me to my wife. She also offered to set up another colleague with a date, and asked him what he was looking for in a potential mate. I’ll never forget what he said, “The most attractive quality in any potential partner would be positive net cash flow.”

    Not exactly romantic, even if it was extremely practical. His argument was sound. He was not looking for someone to financially support him, and he did not care how much money she made. This was not about marrying for money. He was looking for someone who had the discipline to live within her means; and reasoned that if she could do that, then they would be able to live comfortably within their means. Positive net cash flow.

    Cash flow is the most important thing we look for when investing in a company, but it is also the most important element of financial planning. Many people refer to it as budgeting, but I do not like that term. Budgeting will get a person in financial trouble quickly. Here is the problem with budgeting.

    An individual sits down at the beginning of the new year – this was a resolution after all – and puts together a budget. He budgets among everything else, $5,000 for home maintenance, and $5,000 for a vacation. In May, his HVAC goes caput and he has to replace the entire system. It costs $10,000. He is $5,000 over budget on home maintenance.

    In June it is time for his vacation. He knows he just spent $5,000 more than he meant to on home maintenance, but his vacation budget has not even been touched. He goes on his vacation. He also continues to spend on all his other budgeted items. After all, only the home maintenance budget was affected by the unbudgeted item so why would that impact anything else? That is how budgets work in the business world.

    Budgeting leads to siloing of expenses – this item comes from this bucket and that item comes out of that bucket. That leads to overspending, which is an obvious problem; however, it is not the only problem.

    Here is an interesting fact:  most small businesses that go out of business actually show a profit on their last set of financials. How could that be? They spend relative to a budget versus spending relative to cash flow. In other words, the timing of expenses and revenue matter. Using our example again, let’s say our friend budgets $5,000 for vacation, but he doesn’t actually have the money in the bank yet. He based the $5,000 on his expected annual income. He then takes that vacation in February before he has actually made the money. No problem, he thinks; he has credit cards.

    Now he has debt and then the HVAC goes. The hole gets bigger, but he is only overbudget on home maintenance, right?

    This is how people get in debt. Budgeting is a bad word. What is needed is cash flow management. One way to do this, and the way most credit counseling services will recommend for anyone who is over their head in debt, is to use only cash. In our world today that would mean debit cards. The first thing to do in order to get out of credit card debt is to tear up the credit cards. That is good advice for a lot of people.

    However, for those who do not carry credit card debt, focusing on cash flow is still just as crucial in the planning process. The proper use of credit cards can be very helpful. It can make it far easier to see where one’s money is going and to allow one to hold onto her cash a little longer. That is not as much of a benefit today with our extraordinarily low interest rates, but it is still a useful habit. To do that, the rule still needs to be that she does not buy anything with a credit card unless the cash is already in the bank to pay for it.

    The appropriate way to plan for that vacation is to set the money aside before the event. That can be done by a process we refer to as cash flow management. While in our working years we should strive to live within our means. It is helpful to know what our major expenses are and to plan for what we need, so that we know what we can afford to save. My first boss referred to this as “paying yourself first.” Put that money in savings before you spend a dime.

    My wife and I have tried to start this process early with our children. They each get an allowance, and with every allowance, they must set aside 10 percent to give and 10 percent to save. The giving comes from our family’s faith, but I would think it is a good exercise for anyone. The saving is for the unforeseen or bigger purchases. This is what my colleague was looking for: positive net cash flow. If every young person would start their career with this practice, they would end up in a good place.

    Cash flow is not just for those of us still working. In retirement, cash flow is just as important. One of our primary roles as an advisor is to help our clients understand where their cash is going and how much they really need. This may seem odd, but the more successful the client in their working years, the more likely they need help with cash flow management in retirement. While it is certainly possible to outspend any level of income, higher incomes do make cash flow management easier. As a result, many hyper-focused businesspeople really do not know where their cash is going and how much they really need from their investments.

    We spend most of our time at Iron Capital talking about the act of investing. We do this because if one does not invest properly, then it does not matter how well he plans. However, planning is an important part of the investment process. We invest for a reason, and those reasons are significantly deeper than just making money. The cornerstone of planning is learning to manage one’s cash flow. It will help your financial future, and if you are single and looking, it may even help you get a date.

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

    ~Cash Flow is King

  • “There’s gold in them thar hills!” Gold fever seems to be taking the markets by storm. I knew it was both time to write about it and that it has gone way too far when I heard an ad on the radio for buying gold coins. (By the way, these gold sellers must not have to register with the SEC, because if we said the stuff they say, we would end up in jail. Frankly they should, but that isn’t likely to happen.)

    I digress. The question is:  Should one invest in gold? I believe the answer to that question lies in the very definition of investment. Benjamin Graham, the father of security analysis and Warren Buffett’s mentor, defined an investment as follows:  “An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return.” Does gold promise safety of principal and a satisfactory return?

    Safety of principal is provided by what Graham referred to as the “margin of safety.” The margin of safety is calculated by subtracting the current market price of an item from the actual intrinsic value of that item. This is the principle on which pawn shops operate. Sure, they will give you money for that watch, but they are not going to give you what it is actually worth. They can safely loan you money because if you fail to repay them, then they can sell the watch for far more than they gave you. They have a large margin of safety.

    A pawnbroker may know the actual value of a watch, but how are we supposed to know the actual value of an investment? The intrinsic value of an investment is the present value of all future cash flows. One must project what those cash flows will be, but the math itself is pretty simple. If your investment is an office building, one just projects the lease payments from the tenants out into the future and does the math for what that cash flow is worth today; that is the actual value of the building. If the market price for the building is less than that amount, a margin of safety exists. On the other hand, if the market value is higher, then there is no margin of safety, and purchasing the building would be very risky speculation.

    Stock in companies works the same way; one projects the cash flow of the business and does the math to determine the actual value. If the market price is below that value, then a margin of safety exists. So this is how one determines the safety of principal; what about the adequate return?

    The return of an investment can only truly be known after the fact. The investor subtracts the original value she paid from the current market value and divides that number by the original investment amount. So if our investor paid $5 for a stock which is now worth $10, then 10 – 5 = 5  and 5/5 = 1 or 100%. She experienced a return of 100 percent, or in other words, doubled her money. The problem is, we don’t have a time machine and there is really no way of knowing what the future price will be. So when the investment is made, one must project an expected return. The expected return is based on the price we think the investment will sell for in the future, and the best guess for that price is the calculated intrinsic value.

    For something to qualify as an investment, there must be a calculable intrinsic value. Gold has no intrinsic value. Gold is gold. It was gold when Solomon used it in the Temple and it was gold when James Bond saved the world from Auric Goldfinger, and it will be gold forever. Nothing more and nothing less. There is no intrinsic growth, no cash flow, nothing that gives it intrinsic value. It has value to the extent that other people want it because it is pretty.

    If that is true, how do I explain the huge success of gold investors as described by the charlatans who peddle the stuff in advertisements? By telling the truth. In January of 1980, gold sold for $2,257.64 an ounce. This morning it sold for $1,934.00 per ounce. Losing $300 over 40 years does not seem like a great deal to me, especially when compared to the growth of almost any investment. Should we “invest” in gold?

    James Bond:  “What do you know about gold, Moneypenny?”
    Miss Moneypenny:  “The only gold I know is the kind you wear. You know, on the third finger of your left hand.”

    I think Miss Moneypenny had it right. The only gold one should buy is the kind he wears.

    James Bond:  “One day we will have to look into that.”
    Miss Moneypenny:  “Oh James….”

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

    ~Gold

  • For the last decade growth stocks have outperformed value stocks, large-company stocks have outperformed small-company stocks, and domestic-company stocks have outperformed international-company stocks. This is not sustainable and it will end; the questions are, how and when will it end?

    First, some background. As a reminder, growth and value are terms thrown around by people in the investing world to describe the two great philosophies of investing. The growth school suggests that an investor should favor companies that are growing their business more rapidly than the general economy. The value school suggests that all companies have intrinsic value that can be estimated, and if the stock is selling for less than that amount, it is a good investment. We often use the example of shoppers: Growth investors want the latest and greatest fashion and are willing to pay in order to get it, while value investors want bargains.

    In reality, all great investors, like good shoppers, are a bit of both. One may lean more towards value or more towards growth, but no one wants to overpay or buy the stock of a company that cannot grow its business.

    One will often hear the terms growth stock or value stock, but these are simply descriptions of the typical stocks favored by growth and value investors, respectively. Trust me, no board of directors has ever met and said, “This company should be priced as a value stock.”

    Large versus small is clearer, although keep in mind this is all relative. These are all publicly traded companies, so none of them are that small. Likewise, international versus domestic is clear, but it is important to remember we are talking about where a company is headquartered and not where it does business. Most large companies today are global in their business efforts, but everyone has a home somewhere.

    This tilt towards U.S.-based growth companies, most of which are technology companies, began in the aftermath of the financial crisis. The decade of the aughts was led by small value stocks and international stocks. It seems so long ago now, but this was the so-called lost decade where the S&P 500 went nowhere. While the media obsessed over “stocks” going nowhere, small company stocks and the stocks of companies headquartered overseas did very well. Then the crisis hit.

    During the crisis, panic ruled and all stocks were thrown out like babies with bathwater. Then we had the knee-jerk rebound, and once that was over a new bull market took hold. However, when the global economy should have been rebounding dramatically, we instead went on a horrible detour of economic stupidity. Governments seemingly did everything in their power to keep us in the “new normal;” that was artificially low economic growth. During a period of low economic growth, investors will generally favor the stocks of companies that can grow faster than the economy.

    The financial crisis started in the U.S. and thus we were the first to emerge out of the crisis. This, and our advantage in technology, gave us a head start on the rest of the world. The combination of these two factors led to the outperformance of U.S.-based technology (growth) stocks. This is how usual market cycles go. These cycles usually last five years, and this is the unusual part: We have been in this cycle for a decade.

    Let me put some numbers to it. As of June 30, 2020, the Russell 1000 Growth index, which represents large U.S.-based growth stocks, is up 17.2 percent annualized. The Russell 2000 Value index, representing small value stocks, is up 7.8 percent. Companies headquartered in emerging markets, represented by the MSCI Emerging Markets index, saw their stocks go nowhere at 0.8 percent annualized. Developed international markets as represented by the MSCI EAFE index were up only 6.2 percent.

    Not only has this been going on for a decade, but it has gotten worse lately. The last 12 months ending June 30 saw the Russell 1000 Growth go up 23.2 percent while the Russell 2000 Value is down 17.4 percent. This is the largest gap since the Tech bubble. That ended and this will too.

    This leads us to our questions, how and when? No one knows when, but with things this extreme it would seemingly have to be soon. How is more interesting. The tech bubble burst with a long bear market. However, history doesn’t always repeat itself exactly. These companies are a lot more mature than they were 20 years ago. They may not collapse so much as go nowhere. As I write this, their CEOs are testifying to legislators who can agree on little other than the dislike of large tech.

    There is really a lost decade in stocks not included in the U.S. large-growth bucket. I believe we will see a long period of reverting to the mean, and these companies will once again get to lead the way. Markets can go up being led by companies other than U.S. tech firms; it is about time for that to happen. Diversification has not really helped investors over the last decade, which leads me to believe it will be more important than ever over the next decade.

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

    ~The Gap Widens