THE COINCIDENCES IN LIFE ARE AMAZING. I was a young economics student when the Soviet Union began to collapse, and it was fascinating. We had a visiting professor from Moscow teach a class on the economics of communism, which was one of the best classes I took in college. I was so fascinated that I accidently ended up with a minor in international studies. During my last semester I did an independent study on how former Soviet states should transition from the command economy to a free economy. I argued that they should follow the Polish model, which, put simply, was the rip-the-Band-Aid-off approach. My professor did not like my conclusion, but history did, and that explains why I pursued a career in investment management over academia. In my world one gets rewarded for being actually correct, versus politically correct.

In my early career this focus was little more than an interesting talking point. It certainly did not help me get my job at Invesco. Then one day, almost a decade after writing that paper, my boss stormed into my office and told me that I was going to Poland. What are the odds?

I arrived in Warsaw in January. (Even people of Polish decent don’t travel to Warsaw in January.) The manager of the Warsaw office took it upon himself to be my tour guide. He took me to the old part of town, which looks like a lot of old European cities, and explained it was actually a source of embarrassment for many Poles because it was a replica. The Nazis had destroyed Warsaw, and what I saw had been rebuilt.

My tour guide had been a young boy during that period, and we discussed what it was like to be under Nazi occupation. He was defensive about the atrocities which took place in Poland in places like Auschwitz. People today think they could have stood up to the Nazis, but that is much easier to do in the safety of history class; it is a little different when you fear for your own life.

He remembered being liberated by the Soviets. Everyone in Warsaw celebrated at first, but then they transitioned to communist rule. I asked him how the Nazis and Soviets differed, and with tears in his eyes he said, “The only difference was who they chose to murder.” Our modern perception is that the extreme right and the extreme left are opposites, but the truth is they are the same; they were then and they remain so today. We then drank a toast to Lech Walesa and the Solidarity movement that allowed him to be showing his city to his new American friend.

It was refreshing working in Poland. No one appreciates economic freedom more than those who know firsthand what it is like not to have it. They knew full well how fragile freedom could be – a lesson we seem to have lost in modern America.

As with so many subjects which should simply be what they are, economics has become politicized in our modern world. The perception is that people on the right are for capitalism, whatever that means, and people on the left are for socialism. It reminds me of a George Will column in which he made the argument that young people claim to like socialism because they like being social, and that is what they think it means.

I have no idea how they teach economics today, but when I was a student we did not use the terms capitalism or socialism, which I believe is for the best if one really wishes to understand the economic spectrum.

On one end of the spectrum we have a free economy, which is an economy with no government interference; on the other end we have a command economy, which is completely controlled by a governmental central power. This is the spectrum.

In the modern world the closest we have probably gotten to a free economy would have been British-controlled Hong Kong. There were very few rules and regulations, and as a result it became the business center for much of Asia. Nobel Prize-winner Milton Friedman discussed Hong Kong’s success in a book co-authored with his wife, Rose, “Free to Choose.” It was his favorite example of the power of freedom in the economy.

The closest we have come to a true command economy was the Soviet Union. Everything in the Soviet Union was controlled by Moscow. However, even in the days of Stalin, it is nearly impossible for the government to control everything as people will find a way. There was a significant black market in the former Soviet Union.

In reality, most economies exist somewhere along the spectrum between free and command. Our system in the United States has always tilted closer to being free. How free our economy should be – or, put another way, how limited the role of government should be – has been hotly debated throughout our history.

That this debate fits neatly along partisan lines is, however, a myth. The political spectrum, unlike the economic spectrum, is a circle, not a line. Understanding why would take far more space than this newsletter avails, but history tells us this is the case. If one starts with a free economy, it matters not which way she turns politically. She can go right or left, and either way, she will eventually end up in a command economy.

For the first half of America’s history we were pretty close to being a totally free economy. The 19th century was a time of great economic growth and expansion, culminating with the “Gilded Age” as enormous fortunes were gained, and lost. The average annual wage of an industrial worker rose 59 percent in the decade from 1880 to 1890. However, there were also significant recessions. The Panic of 1873 and the Panic of 1893 caused great concern. The financial crisis in 1873 was known as the Great Depression until the crash of 1929 and the decade of the 1930s usurped that title.

While great wealth was produced, the era of the so-called robber barons saw industries monopolized. America started taking steps towards a command economy as antitrust laws sought to break up monopolies and create a more even playing field. In Europe, economies moved even further towards command as the philosophy of Karl Marx and Friedrich Engels became widely adopted. Economists like John Maynard Keynes sought ways to preserve the free economy against the Marxist ideology by trying to smooth freedom’s rough edges.

Governments could use government spending to ease the suffering of recessions. Later economists like Milton Friedman argued that interest rate policy was more effective than government spending. In addition, countries adopted social safety nets to help those in poverty. These things were done with good intent to preserve what was so good about a free economy.

In Europe it mattered little if one was occupied by far-right Nazi Germany or far-left Soviet Union; the outcomes were the same. Over 100 million lives were lost to the two great evils of the 20th century, and the one thing they had in common was the command economy. Is that a coincidence? Friedrich Hayek didn’t think so, and he had some knowledge, having a front-row seat to the rise of fascism. His conclusion that concentrating that much power in government will eventually lead to a tyrant taking power fits both logic and history.

The United States of America went down the path of Keynes and then Friedman, maintaining our free economy while using government policy to smooth the rough edges. We also were the hero of that century; we seem to have forgotten that with all of our flaws, we were still the good guys who helped our Allies defeat the extremism of both the right and the left.

Our challenge is one of nuance, and unfortunately we are not very good at nuance anymore. It was good that we broke up monopolies and helped people with a hand up during time of economic distress. But how far down the road towards the command economy becomes too far?

As in Europe, it matters not if we go to the left or to the right. John F. Kennedy was a man of America’s left, but he believed in the power of a free economy. Ronald Reagan was a man of America’s right, but he too believed in the power of a free economy. Lydon Johnson was a man of the left who believed in the command economy, followed by Richard Nixon, a man of the right who believed in the command economy. Jimmy Carter, a man of the left, started our move back towards freedom.

After Reagan, George H.W. Bush held us steady and so did Bill Clinton – a man of the left who said Reagan was right and, “the days of big government are over.” If only George W Bush had listened. W, a man of the right, moved us well down the path towards command. Barack Obama, a man of the left, campaigned on change, yet the only economic change he made was to push down hard on the gas pedal and get us moving even faster in the direction in which W had first turned us.

Donald Trump, in his first administration, moved us back towards a free economy and got the good economic results that Americans my age expect, but younger Americans didn’t know were possible. Joe Biden reversed all of that, and here we are today. What will the next administration do? Their track records suggest that Kamala Harris will move us even further towards government command of the economy and Donald Trump would do the opposite. However, Harris keeps flip-flopping on all of her positions and Trump is talking more like a big-government command guy than he did eight years ago. It is hard to know.

I can tell you this: It is policy that matters. What do they actually do? It matters little what color jersey they wear. Modern politicians don’t lead, they follow. They do what they think the voters want. Did Bill Clinton really believe in deregulating banks? I have no idea, but in the 1990s that was popular and he did it. Did Trump really believe in Paul Ryan’s tax and regulatory reform plan? I don’t know, but it was popular, and he did it. All the economic success of his pre-Covid term was driven by it. We get the government we demand. It is up to us.

At the margins, all of this simply leads to better or worse economic conditions. However, today there is a lot of talk about extremism on both the left and the right. Much of that is hyperbole, but to the extent that it exists, we should all remember what my Polish friend witnessed: the only difference between the extreme left and the extreme right is who they choose to murder. The 20th century was the era of the command economy. It was also the bloodiest century in human history. We would do well to remember that. The free economy is about a lot more than just maximizing growth. So, no matter if you are of the left or the right, we need to all do our part to keep our respective political sides moving up towards freedom.

Warm regards,

Chuck Osborne,
CFA, Managing Director

Authored October 4, 2024

~How Politics Relates to Economics

Like father, Like son. In May, my son Charlie anchored his high school’s 4×800 relay team during the state championship track meet. When the third runner handed him the baton, they were in sixth place. When he completed his two laps, they were in third. They broke a school record and made the medal podium for the first time in the event. His split time would have won the state championship in the individual race by almost two seconds.

Many who know me well are now wondering what I am talking about with the like-father-like-son stuff? When I ran, my coaches would put away their watches and bring out the sundial…speed is not what my son and I have in common. However, after the race there is a picture of Charlie’s teammates on the podium without him, and if you look really hard you can just make out his image behind the podium, vomiting.

That was an annual ritual when I was in high school. Football camp began each and every year with the running of the 800, and every year I would show up out of shape from having fun all summer and would have to push myself to make the required time for my position group, which I always did… then I would go under the bleachers and puke. My brother has similar stories, and we joke about the Osborne Puking Gene.

In these cases it comes from pushing ourselves right to our limits, which in Charlie’s case was to win a medal. For me, it was because I showed up out of shape. I grew up before the days of “wellness.”

Most employers these days have wellness programs. They started largely to give employees an incentive to stop smoking. By quitting smoking, they could save money on health insurance. They quickly expanded to other healthy habits like diet and exercise, again with the incentive to save some money on insurance.

In the last several years this has spread to financial wellness – trying to get employees to improve their financial health along with their physical and mental health. The idea is fantastic, but unfortunately it falls under the category of, “You can lead a horse to water, but you can’t make him drink.”

Cerulli Associates, a Boston-based financial industry research firm, recently conducted a study on financial wellness programs. Cerulli found that 90 percent of retirement plan providers offer financial wellness programs, and 71 percent of plan sponsors have included these programs in their plans. That is where the good news ends. Fewer than 20 percent of the employees have actually used these programs, and those who have used them do not rate them very well. Only 41 percent say they were helpful, which isn’t very good.

It may be helpful to explain what experts mean by financial wellness. In the same way that physical wellness begins with diet, financial wellness begins with budget. No one likes to talk about these things; it is our nature to just want a pill that allows us to eat whatever we want and still be thin. Likewise, we would like to spend on whatever we want and still be financially sound. Unfortunately, that isn’t how life works. Being physically healthy starts with a good diet and being financially healthy starts with a budget.

When one is young there is often the idea that if I exercise enough I can eat whatever I like, but as we age, we learn the hard way that one cannot out exercise a bad diet. Similarly, we often think we just need to make more money, but many people learn the hard way that one cannot out earn bad spending habits. Just look at professional athletes. These individuals make millions of dollars while playing their sport, and yet there is nothing more common than the broke former athlete.

If one wants to lose weight, then he must burn more calories than he consumes. Similarly, if one wants to gain financial wellbeing, then he must spend less than he makes. There are no short cuts and no magic pills, and unlike dieting there is no magic shot either. That is the bad news.

The good news is that what is needed is a good diet, but not necessarily a perfect diet. Similarly, we need a good budget, but this doesn’t mean the budget has to be perfect. In fact, for the vast majority of us, “perfect” is unattainable and the idea that one must be perfect is what keeps a lot of people from ever trying to be better to begin with. How do we put ourselves on a good budget?

The first step is knowing where the money is going in the first place. I served on a board a few years back with a gentleman who would often say, “If you want to improve something, you must measure it.” There is a great deal of truth in that. The first step is simply figuring out where the money is going in the first place. This can be done, and has been done for centuries, with pencil and paper. It does not have to be fancy; it just has to work for you. Today we have lots of resources at our fingertips, and there are many budgeting apps that can be put right on your phone. However one does it, this step is necessary. For some this needs to be done only for a few months. Once they see the real picture, they can go from there without tracking every dollar. Others need to continue this indefinitely, it just depends on the personality.

Once the spending has been recorded, then we can make a realistic budget. One should be able to see where overspending is occurring and simply correct by becoming more intentional. The goal of a budget is to calculate how much money one can set aside for her future. Depending on where she is beginning, that could mean debt reduction or it could mean savings and investment. Either way, the point is to determine that number, and once she has it, the next step is to pay herself first. That amount should go towards her future before any other expense is paid. This is step one on the road to financial wellness.

Step two is to build an emergency fund. Why? Because stuff happens. Life rarely goes as planned. There is a horrible statistic from Bankrate which says that 56 percent of Americans lack the ability to pay for a $1,000 emergency. It does not take a lot to have an $1,000 emergency, especially if one owns a house or even a car. How much should one have in savings? We would suggest anywhere from three to 12 months of expenses, and the difference would be based on risk tolerance. If one is on the lower end of this scale, then he may have to tap into longer term investments if a serious emergency were to take place, which is why we consider this part of risk tolerance. I would say that less than three months is probably not enough, and when one gets over 12 months, then she is not allocating her funds wisely. In between those numbers there is no one right answer, it will just depend on the individual.

What if there is a lot of debt? Debt is to the budget what sugar is to the diet. It needs to be kept under control. There are those who claim that no one should ever have any debt, but I do not find that very realistic. Mortgage debt is perfectly reasonable as long as one keeps it well within their budget. Using debt to purchase a car is more debatable; some say never do it, and I certainly understand that. However, it may be necessary or a more efficient use of assets depending on interest rates. There are few things that help a budget as much as not having a car payment.

Today we have to discuss education debt. The cost of education today is criminal. I have written about this before, but if the education industry were any other industry, they would be accused of price gouging, but for some reason we as a society have put up with it because it is education. The truth is there are very few academic degrees worth going into debt to earn.

The biggest debt issue is the credit card. It is often the frequent snacking that ruins a diet, it is almost always the credit card spending that ruins a budget. Credit cards should be paid off in their entirety every month. If one lacks the discipline to do this, then he needs to cut those cards up and close those accounts.

Regardless of the form of debt, one has to balance paying off the debt while building savings. There are pundits out there who preach total sacrifice until the debt is paid off. The problem I see with this approach is that there is a risk of the whole endeavor being broken by an emergency. If one has neglected savings entirely in an attempt to get out of debt quickly, then she risks an emergency which she can only handle by using debt, which is a very discouraging setback. I believe one needs to balance the two and focus on making consistent progress as opposed to obsessing on getting completely out of debt as soon as possible. Don’t misunderstand, that is the ultimate goal; However, one did not get into trouble with debt overnight, and one is not going to get out of it overnight.

The next step is to start investing. For most that begins with contributing to their retirement plan at work. If one’s employer matches contributions, then she should contribute at least up to that match. The most common example would be an employer who matches 50 percent up to 6 percent of income. Many get confused by percentages, so I prefer to talk in dollars and cents. This means that for every dollar one contributes into the retirement plan, his employer will give him 50 cents. If he does not contribute the full 6 percent, then he is leaving money on the table.

However, that amount is probably not enough to fully realize one’s retirement goals. Many experts will say that one has to contribute 15 percent of their income in order to fund retirement; I disagree. I would suggest contributing 10 percent of your income. Of course, there is no such thing as too much money to retire, but I have never had a client who saved 10 percent fall short of retirement. I have had many clients have a non-retirement related goal which they cannot fund because they put all of their investments into retirement. Life happens and to be honest, many people find that retirement is not all it is built up to be.

The key in my opinion is balance. If one can save more than 10 percent, then the excess should probably go into a brokerage account. This may not be as tax advantaged as a retirement account, but it provides the one thing that is often missing in financial plans: flexibility. The future is always uncertain, and it is hard to overstate the value of flexibility.

These are the steps to financial wellness. Like physical wellness, they are more of a journey than a destination. In both cases it is an ongoing process, and there will be setbacks. I no longer get sick every time I run. In fact, this Fourth of July I ran in the world’s largest 10K, the Peachtree Road Race. This was my 17th time running. I will freely admit that I was in worse shape this year than I was last year; in fact, I am in the worst shape I have been in years. This past year has been challenging, but that is life. I could beat myself up and just give up, but that is not the best response. Wellness, in all of its forms, is a journey. There will be ups and downs, forward progress and setbacks. When the setbacks happen, we must brush ourselves off and get back on course. I will run the Peachtree for the 18th time next year and I will be better than I was this year. That is what wellness is all about.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Are You Well?

Have you ever finished someone else’s sentence in your head…and then been totally surprised by what the person actually said? So, there I was in Opelika, AL. If you are not familiar with Opelika, it is a town in Alabama just north of Auburn. There isn’t a lot there, but I was young in my career and was sent there to conduct a 401(k) education session.

The uniqueness of this trip started when I first met the broker who had sold the plan to the employer. He grilled me about being from Atlanta and then dug down into my family history; he seemed to like the fact that I was born in Greensboro, NC.

When we got to the meeting and he introduced me, he said, “This is Chuck Osborne. He came down here from Atlanta, but don’t worry, he is actually from the South.” With this amusing introduction I began my presentation. It went smoothly until the broker interrupted me when the subject of diversification came up. He said, “What Chuck is saying is that you don’t want to put all your eggs…”

You know what comes next – everyone knows this one: You don’t want to put all your eggs in one basket. Except, that isn’t what he said. He said, “…under the same layin’ hen.” It was all I could do to keep from bursting into laughter. Ever since that day, any time I hear that cliché I now finish it, “…under the same layin’ hen.” I suppose the difference would depend on whether your ultimate goal was an omelet or more chickens. Either way, the change made an impact.

Diversification in investing is one of the most sacred yet most misunderstood concepts. To some degree this is on purpose. In our podcast series we have been discussing how Wall Street promotes what is good for business, and diversification is probably the best example. One should never forget that Wall Street is in the transaction business: The more transactions an investor makes, the better, and no concept has led to more transactions than diversification.

This does not mean that diversifying the portfolio is not the right thing to do; However, it is often misunderstood, even by people within the industry. I recall another story a little later in my career, when a speaker at a conference said something you have probably heard before: “Diversification, as we all know, leads to reduced risk and better returns.” That is not true, and I called her out on it.

In her own example she used theoretical expected returns and expected volatility, or risk. The investment with the highest expected return in her example had an expected return of 12 percent. I explained to her that there was no combination of investments in her example that would achieve a return of 12 percent, let alone exceed it. If maximizing the expected return regardless of risk was the goal, then the investor would put 100 percent of her money in the 12 percent investment.

This is all theoretical, since the actual returns and expected returns don’t often match in the real world, but the issue to understand here is that diversification is about defense, not offense. If wanting to become filthy rich is one’s goal, then taking a gamble on one investment is the way to do it. Don’t believe me? Look at all the billionaires. Almost every single one of them is there because they put all, or at least most, of their eggs under the same layin’ hen. In most cases it was a company that they founded and/or managed, but it is almost always just one company: Jeff Bezos and Amazon, Bill Gates and Microsoft. The notable exception would be Warren Buffett, who made his money through investing, but Warren Buffett’s investment portfolio is notably concentrated. At one point during his rise, American Express was almost a third of his entire portfolio. In fact, if one were to take that out, then there is a good chance you would have never heard about Warren Buffett.

However, for the vast majority of us, getting filthy rich is not, in fact, the point of investing. Most of us are searching for financial independence, the ability to retire. Far more of our clients view their portfolio as a means for safety and stability than as a means for riches. This is where diversification comes to play.

Diversification is about defense. Prudent investing is risk-averse, and risk is largely controlled by not putting all your eggs under the same layin’ hen. This leads to the next fallacy about diversification: that it is just about spreading out, and the more the better. If only it were that simple. Just buying a lot of investments will not necessarily diversify an investor; In the 401(k) world, we learned this the hard way during the dot-com bust in 2000.

Leading up to the bust, the trend for retirement plan sponsors was to give participants as many options as possible. Knowing they needed to diversify, participants would tend to own four or five different funds within the plan. Most often they picked funds based solely on how they were performing. At any given time in the market, the funds that are performing the best are all investing in the same things; In the late 1990s this meant they were investing in internet companies. When that bubble burst, the 401(k) participants who thought they were diversified because they owned several different funds found out the hard way that every fund they owned was investing in the same things. In other words, all their eggs had been under the same layin’ hen.

This happened again in the financial crisis of 2008, this time with mortgage-based investments. The pros on Wall Street figured that it was safer to invest in hundreds of mortgages that one had no way of actually analyzing than it was to invest in, say, 20 very carefully underwritten mortgages. When fear gripped the mortgage market, the investors realized they had no way of knowing how many bad mortgages were in those securities; the diversification of hundreds of mortgages in one package became a liability as people feared they could all be bad. Panic ensued, and a full-blown crisis was at hand.

Wall Street loves the more-is-better diversification fallacy, because the more transactions an investor makes, the more money Wall Street makes, regardless of whether it actually benefits the investor. So, this more-is- better diversification fallacy continues to get pushed.

Real diversification is about carefully selecting investments that are truly different and will likely do well under different circumstances. One of the pioneers in this idea was the economist John Maynard Keynes. While he is mostly known for his economic theories, his greatest actual success was his ability to invest. Keynes ran what today would be considered very concentrated portfolios. He believed it was better to own a few companies with which he was very familiar than to own many companies of which he knew little.

However, Keynes would purposely select companies whose businesses would thrive in different circumstances. One example he used to illustrate this idea was a battery company. If he owned a battery company, he would then ask himself, “What is the greatest risk to their business?” His answer was the rising cost of raw materials, so his solution was to also invest in a raw material company. If the cost of raw materials dropped then the material company would suffer, but the battery company would benefit. If raw materials increased in price, then the opposite would happen. Either way at least one of his stocks would do well. This is diversification.

Today we use this same idea in our portfolios. Our core equity portfolio only has 20 to 30 stocks at any given time, but it is diversified. We own technology companies that do well when growth dominates the market’s mindset, but we also own energy companies and banks, which do well when value leads the way.

In our model portfolios within retirement plans we invest in large companies, small companies, and international companies. They tend to do better at different times and we will tilt one way or the other depending on what is happening, but we never go all in on one type of investment. We don’t have to own hundreds of funds to do this; in fact, owning that many would add nothing in terms of diversification and would likely detract from the return. We carefully select high- quality funds that are all truly different from one another. That is how diversification is supposed to work.

Prudent investing is done from the bottom-up. This means that one knows what he owns and why he owns it, and that can be done only when one diversifies appropriately. If he simply buys hundreds of stocks, then he can’t really know what he owns, and this ultimately leads to financial ruin.

Prudent investing is absolute return-oriented. At any given time in the market there will be one area, or even one stock, that is driving everything. If one gets sucked into competitive investing, always comparing her returns to someone else or some market index, then she will give up on diversification and go all in on what is working today. What works today is seldom what works tomorrow, and this approach leads to chasing returns yet never achieving returns. Diversification means we will own investments that are not doing great right now, yet these are often the investments that do the best in the next cycle.

This leads us to the third step in prudent investing. Prudent investing is risk-averse. This means not going all-in on what is hot at the moment, because we can’t know when, but we do know that the moment will pass and when it does, it is the other investments that often save the day.

Diversification is not as simple as it may seem. If one invests in the S&P 500, then she owns 500 stocks, but the makeup of the index means that only 10 or so stocks drive the whole return, and they are all large technology companies whose fates are closely aligned, so she is not diversified. Another investor may own as few as 20 individual stocks, but if they are carefully selected, he could be well diversified. It is not about the number of investments, but about their relationship to one another.

It has been nearly 30 years since my trip to Opelika. I will admit that I made fun of it when I first heard it, but that gentleman’s country twist on an old cliché made an impact. I now understand his wisdom, and I will never forget that one does not put all their eggs under the same layin’ hen.

Warm regards,

Chuck Osborne, CFA
Managing Director

~What Did He Just Say?

Patience is a virtue.(Not one that I possess, but it is a virtue nonetheless.) It is one that I continually work on, and I am getting better. My hobbies have helped with that.

Growing up I had an uncle who lived in Maryland and owned a small sailboat, which he kept on Chesapeake Bay. I have very fond memories of overnight trips with my uncle and my father. We would sail during the day, then find a place to anchor for the night. My uncle would grill something on the small charcoal grill, which somehow tasted better than the same thing on land. When bedtime came, he would tell me that there is no better sleep than sleeping on a boat at anchor. The gentle movement would rock you to sleep like a baby being rocked in a cradle. In the morning my uncle made pancakes, which he referred to as sinkers.

Fast forward thirty plus years and I am at the beach with my family. We went to dinner at a restaurant in a marina and afterward walked down the dock to see the boats. I was reminiscing about those childhood trips and looked at my wife and said, “I am going to learn how to sail.” She thought I was joking. I found a sailing school on Lake Lanier, just north of Atlanta. I had no idea how challenging it would be to learn to sail on a lake surrounded by heavily treed hills.

The wind tended to be light, which is a challenge in and of itself, but it also tended to swirl among the trees and hills. We would be cruising along nicely one minute and then the wind would just stop. The first few times this happened I went into “do something” mode. I would mess with the sails trying to get us going again, or God forbid, turn on the engine. As soon as I did all that work the wind would return, and we would have to undo all I just did and get things back the way they were. Finally, I learned to just wait. The wind always comes back, I just needed some patience.

I have been reminded of that lesson over the last year. Patience is a key ingredient to long-term investing success. This past year we have been recovering from the 2022 bear market, and it has been a frustratingly slow process. Things started off looking better, yet it was only seven stocks that were going up while everything else went nowhere or even down. Then finally the wind came back around and we ended 2023 with a strong rally. I am happy to say that we were well-positioned for that rally and delivered very good results for our clients, but that is not the point of this lesson.

The point is that in our fast-paced world in which we are constantly on and constantly connected, we need to constantly remind ourselves to be patient. To put it in market terms: there are trends, and there is a lot of noise. The art of investing, and frankly life in general, is to be able to filter out the noise.

This is easier said than done as sometimes the wind does actually shift. One cannot just go out in a boat point it in the direction you want to go, raise the sails, and wait. That isn’t how it works. We cannot control the wind; one must work with the wind as it is. If we simply do nothing we could get blown onto the rocks. So, we need to know the difference between a momentary change that we just wait out, or a permanent shift, which must be addressed.

So how do we know? Experience certainly helps, but there are fundamentals that can help too. Investments of all kinds spend most of their time actually going nowhere; they will trade in a range. Oil is a perfect example. For some time now, oil has been valued at $70 to $90. It just keeps going back and forth. Sometimes it may drop to the high-$60 range and it may break $90 for some short period, but in reality, it is stuck in this range.

As I write this oil is priced at $71, which puts it on the low end of its range. There are no guarantees in life, but the odds are strong that oil will go back up to $90 before coming back down. At some point in time there will be an event that will break this cycle, but until that happens we are in this range, and that matters if one is invested in energy companies.

When the price of oil goes down, the stock price of energy companies will usually go down with it. Then when the price of oil goes up, the stock price of energy companies tends to rise. Every time we approach the bottom of oil’s range, the media starts talking about oil prices “collapsing,” and when we approach the oil highs, there is talk of spiking and inflation. If one panics when oil is on the lower end of its range and/or gets greedy when it is on the high end, then he will end up selling low and buying high – the opposite of what an investor wants.

We own Marathon Petroleum Corporation in portfolios where we believe it is appropriate. (Please note: I use this as an example for educational purposes only, this is not a recommendation as this may not be an appropriate investment for you.) Marathons stock was up 30.61 percent in 2023. That is a very good return and better than the S&P 500. However, the stock ranges in price from $104 to $162, and as I write this it is $153. That is a range of 55 percent. There were a lot of ups and downs in what ended up being a 30 percent return for the year.

It is tempting to believe one can trade into and out of a stock that moved up and down in a 55 percent range, but that is a fool’s errand. History has taught us that timing does not work. If one is going to get a good long-term return, then patience is a requirement. Good things come to those who wait. Of course, doing the same thing over and over again while expecting a different result is the definition of insanity, according to Einstein. Cliches can only take us so far.

There is a difference between patience and stubbornness; being patient is not the same thing as sticking one’s head in the sand and ignoring what is happening. As with sailing, how do we know when we just need to wait, versus when we need to make a change? I can certainly tell you that I am much better at this today then I was 30 years ago when I was still young in my career. Part of this is the art of investing, but our investment philosophy helps.

Prudent investing is done from the bottom-up. This means we make investment decisions based on each individual investment. It is much easier to analyze a particular company and assess its future than it is to guess where the entire market is going. This is obvious to anyone who thinks about it for a second, yet the standard question we get is, “Where is the market going?” That is what the media focuses on, so that is what people think about.

Back to our example of Marathon Petroleum. It is relatively easy to understand that this is one of the best-run refiners in the world and the stock is selling for less than six times earnings, which means we are investing in a solid business at a very attractive price. It is much harder to guess where the price of oil is going; those prices will move a lot, while the dynamics of Marathon’s business do not change nearly as rapidly. As long as the business is solid and the price of the stock is cheap relative to the company’s earnings, then Marathon remains a good investment.

Does this mean we just ignore the short-term movements of the market? Not exactly. One of the biggest differences between the professional investor and the lay investor is that the professional thinks in terms of weightings while the lay investor thinks in terms of absolutes. In other words, the lay investor will think in terms of either buying Marathon’s stock or selling it, while the professional thinks in terms of how much we want to own.

For example, in our core equity strategy we tend to own stocks in a range from 2 percent of the total portfolio to 7 percent of the total portfolio. We don’t buy stock above 5 percent, but we will allow winners to run as high as 7 percent. This is just an example. A more aggressive investor may be more concentrated and therefore have larger position sizes, and a more conservative investor may want more diversification which would mean smaller sizes.

In this example we may buy a stock at a 4 percent position. To make this easy let’s just assume a portfolio of $1M. We do the math and 4 percent of $1M is $40k, so we would buy $40k worth of that stock. For our example we will say the stock price is $100, so that would be 400 shares of this hypothetical stock. If the price of that stock goes up $50 to $150 and to keep it simple the portfolio as a whole has not changed, the total investment would be worth $60k or 6 percent.

At this point the lay investor is thinking, “Should I sell it all and take the profit?” On the other hand, the professional thinks, “This company should still be a 4 percent holding.” We don’t sell it all, we trim 133 shares or $20 thousand worth of the stock to get back to the 4 percent. If the opposite were to happen and the stock price goes down, but nothing has changed at the actual company, then we would add and get it back to 4 percent. In other words, we rebalance. Lay investors are familiar with that concept because they may do this in their 401(k) with their asset allocation among the various funds, but I believe the reason behind this becomes clearer when looking at individual stocks.

We purchased our hypothetical stock for $100. If the price goes up to $150, then we sell some of it at a high price. If it goes down to $80, we buy more at a low price. This discipline forces us to buy low and sell high, which is exactly what investors want. It also helps us to focus on the actual company, and by doing that helps us to be patient.

The market will do silly things, but as long as we focus on the fundamentals of the actual investments we own, then we can be patient and even allow the market silliness to create opportunities. If we focus from the bottom-up and pay attention to only what matters, we can position our portfolio prudently. Then good things will come to those who wait. Patience is a virtue.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Good Things Come to Those Who Wait

“‘Be careful,’ Jesus said to them.‘Be on your guard against the yeast of the Pharisees and Sadducees.’”
~ Matthew 16:6

This is one of my favorite Bible verses. (That may seem strange as I am not sure how many top-10 lists this makes.) For those who have not studied the Bible, one is often shocked by how much of our language and culture come from that one book.

How many Matthews, Marks, Lukes, and Johns do you know? You can’t be Better than Ezra if you don’t know Ezra. How can you Turn! Turn! Turn! with The Byrds if you have never read Ecclesiastes? We know a young family who recently named their baby boy Jude, and a friend speculated they named him after Jude Law. Perhaps, but my guess is it comes from “Jude, a servant of Jesus Christ and a brother of James”, as the author of the book of Jude described himself. If it was Jude Law, I’d wager that his mother probably knew the origin, and I am almost certain the Beatles did too.

Stepping outside of the Bible for the spirit of that verse, how about the famous basketball coach John Wooden? “It’s the little details that are vital. Little things make big things happen.” Yeast is a very small thing, but the difference it makes in bread is huge.

Earlier this year, a prospective institutional client asked me what Iron Capital does to protect retirement plan sponsors from liability. This is a reasonable concern, as many employers have been sued over their retirement plans. First: everything Iron Capital does for plan sponsors helps protect them from any possible liability. However, the way the question was asked sparked something in me; for the lack of a better term, it was a yeast moment here in Iron Capital’s 20th year.

Years ago, I was at a basketball game with a close acquaintance who was on the investment committee for a local employer I was interested in pursuing as a client. While we watched the game, I let him know how Iron Capital was different than other firms. We discussed our investment process and the success we had building retirement plans. He told me something I’ll never forget. “Chuck, I’m impressed with what you all have done, and I would be all for hiring you, but my company isn’t interested in having the best retirement plan around. We just want someone big whom we can sue if things go wrong.” In other words, what are you going to do to protect us from our liability?

That time I just thanked him for his warning and moved on, but earlier this year something struck me: There is very little difference between doing the right thing for plan participants and covering one’s behind – DTRT or CYA? The difference in action is no bigger than a single grain of yeast, but oh my what a difference it makes in outcomes.

We pride ourselves on our ability to select investment managers for retirement plans. We track our results, and although it is hard to compare to others as there are no databases, I would wager we are among the best. Over the 10-year period that ended June 30, 2023 (September 30 data not yet available), the funds we have had in our client plans for 10 years or longer have delivered an excess return of 0.82 percent per year; 64.3 percent of these funds outperformed their benchmark by an average of 1.56 percent per year. The funds that underperformed (which includes all index funds, as they underperform by design) did so by an average of 0.51 percent. When blended, we get an average of 0.82 percent excess return. Let’s put that in perspective: T. Rowe Price recently published research showing that a 0.50 percent excess return over the life of a 401(k) participant equates to an additional five years of retirement income.

We are proud of that achievement, but how did we do it? There are many factors, but one of the most important is that we are patient with good managers when they go through bad periods. We don’t track the data this way, but I would wager that every one of the managers who outperformed over that 10-year period has underperformed during some shorter-term period along the way. That puts tension on DTRT vs. CYA.

I cannot count how many difficult conversations I have had with clients over the years about this. When a manager in a plan underperforms, the easiest thing for a consultant like me to do is to go to the meeting, point to the underperformance, and announce that we are replacing the manager. No one would ever argue; the manager is underperforming, and we are “doing something,” and doing something makes clients happy. What we are doing is CYA. Clients don’t like underperforming investment managers, and firing them as soon as possible leads to happy meetings.

However, it doesn’t lead to good results for participants. If the manager in question was good to begin with, then she will likely rebound and do well coming out of the short period of underperformance. Meanwhile, the managers that look good right now probably look good because they manage money in a different way.

Take Iron Capital as an example. In 2022, we experienced a bear market in stocks and a historic bond selloff simultaneously, and the more growth- oriented stocks dropped the most. Our aggressive growth stock strategy underperformed, our core stock strategy outperformed, and our income strategy outperformed dramatically. In 2023, the market has rebounded somewhat, but almost all of those returns have come from a small number of very aggressive growth stocks. This year our aggressive growth strategy is doing well, our core stock strategy is underperforming, and our income strategy is suffering.

We are the same team managing these same strategies. These short-term results are not due to us being really bad at growth investing and really great at income investing in 2022 and then flipping a switch and becoming really bad at income investing and awesome at growth investing in 2023. We are just in a different market environment. An investor can be successful over the long term with either strategy if she sticks to her strategy; the investors who lose are the ones who keep switching strategies. The industry term for this is whipsawing. If an investor switches from growth to income at the end of 2022 just to be in the popular place, he now has been in the worst place twice in a row. Some may believe that they could do the opposite, but history tells us that is a fool’s errand.

The phenomenon of whipsawing means that a retirement plan adviser who is in CYA mode and goes into the meeting with the client promising to switch out managers almost always whipsaws the participants. At the end of ten years, they can’t show the results we have, because they have never given a manager 10 years. They have, however, had peaceful meetings with retirement plan committees and always been able to point to high performance on performance reports; but the performance on the reports is all from before the manager was in the plan, so no participant experienced those good results. However, to my knowledge to-date, no employer has ever been sued for switching out managers too frequently. From a CYA perspective, success has been achieved.

How is it different when the motivation is DTRT? The DTRT adviser gets to take it on the chin. He gets yelled at, a lot (trust me on this). How could you keep this manager in the plan? It would be so much easier to say, “Sir, yes Sir, we will replace him right away. Would you like to come to our annual boondoggle, I mean plan sponsor conference?” But the DTRT adviser understands that the client isn’t always right. If she were, then she wouldn’t need an adviser. The DTRT adviser is willing to have difficult conversations because what motivates her is delivering results for participants.

This doesn’t mean there will never be any turnover in managers. Sometimes replacement is the only option. However, replacement should be done when and only when there is a reasonably high probability that the new manger will do better going forward. It is easy to find someone who did better in the past, but picking someone who will do better going forward is far more challenging. The CYA adviser doesn’t really care about that, because he will just replace the new guy as soon as he stumbles.

The CYA adviser is also going to be laser focused on fees…all the fees except his of course. CYA is expensive. This is not to say the DTRT adviser won’t focus on fees; after all, fees are a hurdle that must be overcome. If the T. Rowe Price research is correct and an additional 0.50 percent means an additional five years in retirement income, then every fraction of a percent matters. Here is another grain of yeast: fees matter, but to the DTRT adviser, value matters more. Fees are easy to poke at, but understanding what value is being driven by those fees is much harder. When the CYA adviser continually whipsaws participants then the value add is negative, so any fee at all just adds insult to injury. However, when a DTRT adviser adds 0.82 percent of value a year for ten years net of fees, then the value proposition matters more than just the fee level.

Of course, past performance is no guarantee for future results; just because we have done it in the past doesn’t mean we can keep doing it. That is true, and I would be less than honest if I ever guaranteed otherwise. What I can tell you is that the 10-year period I discuss here is the worst we have done since we have been tracking this statistic. I can promise that we are our own worst critics, and I am more than willing to get yelled at in client meetings because the client is only expressing emotions that we have already dealt with internally. I can also promise that we will continue to always strive to do the right thing, which is what has driven our success in the past.

Does DTRT provide as much protection as CYA? I don’t know, but I do know that in Iron Capital’s 20-year history, none of our clients has ever been sued for mismanagement of the retirement plan. Maybe that is because of our success at selecting good managers and building good plans, but I suspect there is more to it: DTRT advisers usually end up working with employers who themselves are not trying to just CYA, but who actually care about their employees. That also might be hard to differentiate as salaries and benefits are largely driven by market forces and regulation, so CYA and DTRT might not look that different on the surface. It shows in the culture.

Years ago, I pointed out that a large portion of Warren Buffett’s success was because he essentially fired his clients by shutting down the fund he originally ran and using Berkshire Hathaway as his vehicle for investing. The alternative to that is to have really good clients. Iron Capital owes much of its success to the quality of its clients – all of our clients, but especially the plan sponsor clients. We are fortunate to work with companies that truly care about their people. It shows in all the little things, which is why we must beware of the yeast. It is the little things that make the big things happen.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Beware of Yeast