• The stock market is filled with individuals who know the price of everything, but the value of nothing.

    Philip Arthur Fisher

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The Quarterly Report

Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.

  • The Quarterly Report
  • First Quarter 2024
  • Iron Capital Advisors

What Did He Just Say?

Diversification in investing is one of the most sacred yet most misunderstood concepts. To some degree this is on purpose. 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. Real diversification, however, is about carefully selecting investments that are truly different and will likely do well under different circumstances.

  • The Quarterly Report
  • Fourth Quarter 2023
  • Iron Capital Advisors

Good Things Come to Those Who Wait

Patience is a virtue: I have been reminded of that lesson over the last 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 Quarterly Report
  • Third Quarter 2023
  • Iron Capital Advisors

Beware of Yeast

Yeast is a very small thing, but the difference it makes in bread is huge. In the institutional retirement plan world, 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.

  • The Quarterly Report
  • Second Quarter 2023
  • Iron Capital Advisors

Artificial Distribution

We have just experienced one of the strangest quarters that I can remember. At the beginning of June, Goldman Sachs research indicated that all of the return for the S&P 500 year-to-date through May was attributed to just seven stocks; the other 493 stocks in the S&P 500 have an average return of zero, nada, zilch. How did that happen?

  • The Quarterly Report
  • First Quarter 2023
  • Iron Capital Advisors

How’s Business?

The economy is hanging in there better than most experts suggest, since rising interest rates are not actually stopping consumers from living their daily lives. We maintain our view that we will either escape a recession all together or have a very mild one. We are not basing that on our business, but on feedback we get from others. Let’s take a look.

  • 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.

    © visualspace

    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.

    © bluebay2014

    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.

    © HandmadePictures

    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

  • We have just experienced one of the strangest quarters that I can remember. At the beginning of June, Goldman Sachs research indicated that all of the return for the S&P 500 year-to- date through May was attributed to just seven stocks; the other 493 stocks in the S&P 500 have an average return of zero, nada, zilch. How did that happen?

    Let’s start with some history. We are going back all the way to 2022…which sounds silly in most conversations, but stock market participants are famous for their extraordinarily short memories. After a decade of technology stocks dominating all the returns in the stock market, the rest of the market finally got some revenge in 2022. Value investors outperformed their growth colleagues for the first time in a long time and the gap was large in the final quarter of 2022. The Russell 1000 Value Index was up 12.42 percent, while the Russell 1000 Growth Index was up only 2.2 percent.

    The new year began with growth stocks making a comeback: In the firstquarter of 2023, the growth index was up
    14.37 percent, with the value index up just 1.01 percent. At first this was just the normal back-and-forth of the markets. We often refer to a phenomenon known as reversion to the mean – meaning that stock investment results tend to move toward the long-term averages. If they get well above the average they tend to drop, and if they get too far below the averages, they tend to rise. That explains one good quarter for the growth stocks, but as we moved into the month of May, something else started to take over – something that is certainly artificial, but is it intelligent?

    Time will tell as far as stock prices go, but there is no doubt that artificial intelligence (AI) has dominated the stock market in 2023. The poster child for this phenomenon has been Nvidia; the stock has risen 189 percent in 2023. Before we get too excited, remember one thing pundits never bring up: Nvidia stock went from $326.76 in November 2021 to $121.39 in September 2022. The stock is up approximately 30 percent from its high in late 2021, which is a solid two-year return, but not as exciting as the “up 200 percent” we hear about.

    The rebound in Nvidia stock has to do with generative AI such as ChatGPT. These are computer algorithms that can create new content. It is a breakthrough in computer technology, and the long- term potential is tremendous. Experts in the field have suggested that AI will be bigger than the internet, and there is already fear of AI coming for all of our jobs. The machines will take over just like they did in “2001: A Space Odyssey,” or “The Terminator,” or “The Matrix,” or “I, Robot” … you understand, it has been a thing for a while now.

    Nvidia is the leader in designing chips used in Graphic Processing Units (GPU), which are key to the computer power necessary for AI. Microsoft has also benefited as they are a leader in the cloud and have announced a partnership with OpenAI, the maker of ChatGPT. Additionally, some well-known tech companies have the potential to benefit: Meta (Facebook’s parent company), Alphabet (Google’s parent company), Amazon, Apple, and Tesla are all believed to be beneficiaries of AI’s potential. Combined with Nvidia, they have been dubbed the “Magnificent Seven.”

    It is these seven stocks that have dominated the returns this year. They completely skew the valuation of the market and the market’s return, and it is these that pundits are really talking about when they ask if the market can continue to rally. Let’s address them specifically.

    I am no technology expert, but I do know a little about how the market reacts to technological breakthroughs. The market response is a phenomenon called the Gartner Hype Cycle: It begins with a technological trigger – the breakthrough itself kicks things off. We then move to the peak of inflated expectations, and early publicity leads to grossly exaggerated claims of potential. Then, we enter the trough of disillusionment – technology has never adapted as quickly as the zealots believe it will, and when the fantastic predictions fail to immediately materialize, then bubbles burst and stocks plummet.

    That leads to the slope of enlightenment: Technology has never adapted as quickly as zealots believe, but it has adapted faster than naysayers would suggest. People start to see realistic applications. These realistic applications eventually lead to the plateau of productivity, in which the new technology is being used to make our lives easier – not as first imagined, but in real ways nonetheless.

    AI is currently in the peak of inflated expectations. Nvidia’s stock is selling at a price-to-earnings (P/E) ratio of 215, so a speculator in Nvidia’s stock is paying $215 for every $1 in earnings. That is not sustainable, but does that mean the market will come crashing down?

    No, it does not. There are 493 stocks in the S&P 500 alone that have been neglected thus far in 2023. The excitement over AI is understandable, but it is only part of the market story thus far in 2023. The other part remains the insistence by many pundits that the recession they said would be here by now is just delayed, as opposed to them just being wrong. The theory goes that the never-arriving recession is right around the corner and therefore stocks will get beat up, so let’s get ahead of it and beat them up now…except for the Magnificent Seven, because with the power of AI these companies will be able to grow regardless of what is happening in the economy. That is true and was certainly the case in the aftermath of the Great Recession. Then it was the FANG stocks (Facebook, Amazon, Netflix, and Google) that held up the market. However, the idea that we are heading into a recession today has thus far been wrong. At some point, reasonable people must admit their mistake.

    Let’s play devil’s advocate just for a second: Let us pretend that the people who have been saying we are heading into a recession for the last year and a half are actually correct, so the recession arrives and the AI companies are the only ones growing. So far so good, but what about the stocks that usually hold up in recessions? Defensive stocks like utilities? Duke Energy’s stock is down 13 percent year to date. This makes no sense for two reasons: First, utilities should hold up well in a recession, and secondly and perhaps more importantly, what do GPUs (graphic processing units), cloud computing, and electric cars all have in common, besides AI? They all use enormous amounts of electricity. What does Duke Energy sell? Oh yeah, electricity. In what world can Tesla and Nvidia thrive but utilities suffer? That world does not exist.

    Maybe utilities shouldn’t have been beaten up like they have been this year, but when that recession we keep hearing about finally comes, stock valuations must come down. Fair enough, but the index valuations are now completely skewed by the Magnificent Seven. One of the ways Iron Capital looks at valuations is to compare the valuations of different asset classes, and then comparing them. The valuation spread, or difference, between domestic stocks and international stocks is currently at a two standard deviation level. In plain English – the difference between international stocks and domestic stocks is larger than it normally is by an unusual amount … so unusual that this happens less than 5 percent of the time. Nvidia may be selling at 215 times, but the French energy company Total Energies is selling at only 6 times. This is unbelievably inexpensive.

    So, what does all this mean? It means the headline story of the first six months of 2023 is misleading. When pundits say the market is up, they are really only talking about seven stocks in the S&P 500. When they say it is expensive, they are really only talking about seven stocks. When they say it can’t continue, they are right – if they mean those seven stocks. The other 493, on the other hand, are poised to catch up.

    We are optimistic about the rest of 2023, but it can’t look like the first half. First, the doomsayers need to admit they are wrong: We are not heading into a recession because interest rates are returning to normal levels. Second, AI may indeed be bigger than the internet one day, but that day is a lot farther away than the zealots believe…it is also closer than the naysayers might think, but it isn’t here yet.

    Before this little detour into insanity, we saw the markets rotating to value, small and international. That remains the long-term trend, and one six-month tease doesn’t change it. That rotation has legs, and the power of both momentum and valuation. We just need patience. Prudent investing pays off in the long run, but it does require patience.

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

    July 2023

    ~Artificial Distribution

  • “Are we heading into a recession?”

    This is the number-one question I have been getting from clients recently. I answer with a question: How is your business? The answers vary, even inside the same company.

    One of our long-term clients is primarily in the transportation business. They have other businesses as well, including a few very good restaurants, but their main business is helping goods get into our harbors, off of ships, and up rivers. They have several locations around the country, and we get to go to all of them. I shouldn’t say this on the record because now they will be on to me, but casual conversations with this client have an impact on our view of the economy. They are on the front line. I almost laugh when they ask for my view – I sit in an office reading reports. These folks are moving a significant portion of everything you buy. They will know long before I do whether the economy is slowing down.

    Just a few weeks ago I was visiting their Norfolk, VA, location. Someone there asked me about the economy, and I replied by asking about their business. “We are busy,” was the response. Last year was a record year and they are expecting it to be just a little higher this year. That is an encouraging sign, but is it universal?

    A few weeks before that visit I was talking to the same company’s CFO. When I asked him how business was going, his response was a little different. He said that when viewing potential mergers or acquisitions, they now had to factor in the cost of capital. In other words, higher interest rates mean that it will cost them more if they decide to purchase another company. That may mean fewer business deals this year. That isn’t encouraging.

    Meanwhile, one of my colleagues visited the same client’s New Orleans location. When he asked how their business was going, they said it was good, but some of their clients are seeing a slowdown because they used to bring grain from Russia, which now isn’t happening because of the war in Ukraine. That is interesting.

    The same client, yet three different takes on the economy. I have also gone on record saying that I believe the power of the Fed over the real economy is hugely overrated. I still believe that, and I still believe that Wall Street and economists in general remain overly pessimistic. How do we make sense of these mixed messages?

    Albert Einstein famously said, “If you can’t explain it simply, you don’t understand it well enough.” I believe he is correct, but it goes further. Most experts can’t explain things clearly because they are more concerned with being considered an expert than communicating clearly to the everyday person. In other words, their egos get in the way. They insist on peppering their speech with jargon, or worse yet, acronyms. As a result, in my opinion, they often lose sight of the most basic fundamental understanding of what is actually happening.

    The experts cite past data showing that when the Fed raises interest rates, the economy goes into a recession. They get so focused on analyzing data that they forget to ask the most fundamental questions: Why? What is really happening?

    Raising interest rates impacts just one thing: the cost of borrowing money. That is what interest rates are – they are the cost of borrowing money. When one purchases a house, she usually borrows the money in the form of a mortgage. That mortgage, like all loans, has an interest rate tied to it, and the interest must be paid. The higher the interest rate, the higher the monthly payment.

    However, that same consumer, if she is being responsible, doesn’t borrow money to buy groceries, clothes, or any other day-to-day item. Most of the goods we buy do not require loans, so interest rates don’t have an impact. Likewise, a company will usually borrow money to buy another company, to build a factory, or for any other major business investment. That same company hopefully does not borrow money to hire a new employee, pay their office lease, or any other routine business expense.

    Those day-to-day items, which are paid for out of pocket, make up the bulk of economic activity. Roughly 70 percent of our gross domestic product (GDP) is made up of consumer spending. For consumers to spend, all they need is an income source, preferably a job. Companies mostly hire without borrowing and most consumer spending is done without borrowing, so the majority of the economy is not actually impacted by the Fed raising interest rates.

    However, there are items that typically require borrowing, and these items will be impacted by higher interest rates. For the consumer, those are primarily automobiles and houses. For companies, the biggest items that require borrowing in our current economy would be other companies – mergers and acquisitions. One of the primary drivers of an individual company’s growth is its ability to purchase competitors and/or suppliers. Occasionally they will even purchase a completely unrelated business.

    © tumsasedgars

    Mergers and acquisitions also fuel much of the financial universe. Investment bankers are the financial professionals who help negotiate and fund mergers and acquisitions. This is a large part of Wall Street’s business, and that is important to understand. Higher interest rates will make it more expensive to buy businesses, just like they make it more expensive to buy houses. That will result in fewer mergers and acquisitions.

    How do fewer mergers and acquisitions impact the economy? Buying another company can be of significant benefit to the owners of both companies. The owners of the company being purchased get a big payday, and the owners of the purchaser now own a much larger company. What benefit is this to the economy as a whole? Very little, if any. Economic activity is measured by GDP, which is the gross domestic product – or in plain English, everything that is made and consumed in the country. The two companies produced a certain amount of goods. When they become one company, they still produce roughly the same amount of goods. There may be some efficiencies gained that boost production on the margin, but that also comes with the fact that two companies becoming one usually involves some people losing their jobs. This activity is great for owners and for Wall Street, but it doesn’t really help the economy.

    Today we seem to be in the mirror image of what occurred in The Great Recession following the 2008 financial crisis. For nearly 8 years after that crisis, we kept hearing from Wall Street and economists that growth was right around the corner. Yet years after the crisis ended surveys suggested that most people still thought we were in a recession. Why? At that time the Fed aggressively reduced interest rates, eventually all the way to zero. Money was practically free to borrow.

    This spurred a boom in housing and in mergers and acquisitions – big purchases that require borrowing. Housing will stimulate the economy, but as we discussed, mergers and acquisitions don’t really add to the economy as a whole. So, while business owners and financial professionals benefited from free borrowing, the bulk of the economy just didn’t grow. This led to an environment where economic growth kept disappointing the financial experts.

    Today interest rates are rising, and the same financial experts who kept predicting growth that didn’t come a decade ago are predicting a recession that has yet to show up now. We can see why Fed policy impacts the owner class and financial professionals much more than it impacts the economy as a whole, but why can’t the economists see it? My theory is that it is human nature to see the world through one’s own view. In my experience, this happens regardless of one’s level of sophistication. We all tend to believe that people think the way we do, and that what we are experiencing is what everyone else is experiencing.

    When interest rates are very low, things like mergers and acquisitions happen easily, benefitting business owners and financial firms who are the primary employers of economists outside universities. Their economic lives are good, so their view of the economy is positive. When interest rates are higher, things like mergers and acquisitions become harder, and that hurts business owners and financial firms. Their economic lives are in recession, so their view of the economy is negative.

    Meanwhile, the vast majority of consumers are just going on with their lives. When there are a lot of mergers and acquisitions happening, rank-and-file employees are under stress. Things at work are changing and some are likely to lose their jobs. They may even curtail their spending. When interest rates are high, there is less change at work. The consumer hangs in there.

    This explains a great deal about why, in the last 20 years or so of record-low interest rates, the gains in our economy have skewed to the owner class and financial professionals. There has been disappointing overall growth and an increase in inequality. It also explains our current situation, and the different stories from our client in the field and the chief financial officer.

    But what about the slowdown driven by government sanctions on Russia? Economists love to analyze interest rates and tax rates because these are numbers and can be quantified. Government regulation, on the other hand, cannot be quantified easily, if at all. Sanctions against Russia are a great example: As long as our government says no to Russian grain, it will not come here. It doesn’t matter how much demand there is for grain, or what interest rates are. This is a structural barrier that cannot be overcome. Only the government can remove that barrier if they so choose.

    I do want to be clear: Sanctioning Russia may very well be the right thing to do, but that is a political judgment and not an economic judgment. These sanctions, like all government regulations, create structural barriers to economic activity that cannot be overcome by attempting to stimulate the economy. This is important to understand, because over the last 23 years, there has been only one period of time when economic benefits were flowing to rank-and-file workers faster than to owners: that was in 2017-2020, when we saw the first decline in regulation since the 1990s.

    When structural barriers are removed, then we can get real economic growth, which benefits everyone, instead of financial engineering, which only benefits the few. Today we are going in the opposite direction, which does not bode well for the longer term.

    In the meantime, the economy is hanging in there better than most experts suggest. This is because rising interest rates are not actually stopping consumers from living their daily lives; they are, however, making it harder for mergers and acquisitions. They triggered a bear market last year.

    This all means that those experts who are predicting doom and gloom are themselves experiencing a personal economic recession, coloring the lens through which they make their projections. What they are really saying is that they are being hurt by this environment and therefore they assume everyone else will be hurt as well. It is understandable, but it may not work out that way. We maintain our view that we will either escape a recession all together or have a very mild one. We are not basing that on our business, but on feedback we get from others.

    So, how is your business?

    Warm regards,

    Chuck Osborne, CFA
    Managing Director

    ~How’s Business?