The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
The market tends to overreact, and then correct. This is the essence of the “Market Cycle”.
Is international still a good place to be? We believe the answer is yes.
Our clients trust that the professionals at Iron Capital are making the best possible investment decisions, based on investment management knowledge and experience.
I was sitting at home the other night with my wife and we rented a movie I had not seen in a long time. It was the 1997 hit “Men In Black” featuring Tommy Lee Jones and Will Smith as secret agents policing alien activity here on earth. The existence of these aliens here on earth of course had to be kept top secret to avoid a panic. Agent J (Will Smith) thought the MIB should just let everyone know about the aliens – after all, as he said, “People are smart, they can handle it.” Agent K (Tommy Lee Jones), who was older and perhaps wiser, responded, “A person is smart. People are dumb, panicky, dangerous animals, and you know it.” How profound. Agent K could have had a very lucrative career on Wall Street.
When it comes to investing, the individual investor may be intelligent, but the market? The market is a dumb, panicky, dangerous animal, and you should know that. This year has been a classic example. In the first quarter, the market took off like a rocket for no real reason, and to make matters more confusing, it was led by the most overvalued, lowest quality sectors. In the second quarter, the market corrected based on inflation fears. The fear of inflation was treated by the market as a shocking surprise. (Evidently, too many market gurus live in Manhattan and never drive their own cars.) The only surprise about core inflation rising is that it took this long to start happening. Higher energy prices eventually will impact other prices in the market. This should not be a surprise even to Wall Street. So, what is really going on? Unfortunately, the market is just irrational, at least in the short-term. The market tends to overreact, and then correct. This is the essence of the “market cycle”. The irrational behavior of the market is not new. Robert Shiller, the Yale professor and best selling author of “Irrational Exuberance” (a title he stole from former Fed Chairman Alan Greenspan), wrote extensively about how irrational the market can be. The famous economist John Maynard Keynes once warned, “The market can stay irrational much longer than you can stay solvent.”
So what is an investor to do? I believe we should hold on to the knowledge that eventually the market does get it right. In the long-term the market does a good job of valuing assets fairly. In the short-term we should always remember Keynes’ warning. This is why having a well-defined investment discipline is so crucial.
One of the most common mistakes we find when we take over portfolios for our new clients is that often there is no discernable investment strategy in place. We usually find a random hodgepodge of holdings with no evidence that anyone ever thought about overall portfolio construction and/or risk management. Individual investors tend to make investment decisions in a vacuum. For example, when I am at a party and someone starts asking me investment questions, it is usually something along the lines of, “What do you think about Dell?” or “Should I buy GM bonds?” I used to tell them the truth – that it depends on what the rest of your portfolio looks like, and that you have to decide not only whether to buy but also how much to buy, in what account you want to buy and what to sell in order to buy. However, I have found that telling the truth at cocktail parties often means you will be drinking alone, so now I just try to change the subject.
Portfolio management is much more than just making decisions on investing in this asset and/or that asset. Portfolio management involves creating a whole portfolio where every part has its function and making decisions is based on a sound investment philosophy and controlling risk. Controlling risk is arguably the most important element in portfolio management, yet most investors do not really understand what it means. When you talk to most investors about controlling risk, they start talking about buying investments that are conservative when considered on an individual basis, but what we are talking about is much more dynamic than that. Controlling risk entails thinking about each investment in terms of your overall portfolio.
The portfolio management process should begin with a declaration. You should put in writing a carefully considered investment policy statement, which should include your objective. Where are we going? Most of our clients do not invest for the sake of investing. They are investing to fund their retirement or their children’s education, or in some cases just to have more money than their neighbors. Whatever the motivation there is a goal, and that goal greatly impacts how the portfolio should be managed.
Once we know what the goal is, we can determine the return required to achieve that goal and the amount of risk we are both able and willing to take in order to achieve that return. Then, and only then, can we build a strategic asset allocation that gives you the highest likelihood of achieving your return objective based on long-term relationships of various assets. While constructing this long-term strategy you must do something that is incredibly difficult: you must completely ignore what is happening in the market today. Don’t worry, we will eventually get around to today’s environment, but not yet. First we have to look at long-term market relationships and the big picture questions like how much equity exposure should I have long-term, how much international, how much real-estate, and how much in bonds? Only once we have made these decisions can we intelligently look at what is going on today.
Once you know how much equity exposure you want in the long-term, then you can review what is going on today and decide if right now you should be over-weighted, have more exposure than your long-term strategy calls for, or underweighted. If you are not sure, then go back to your long-term strategy. This structure gives us a framework from which to make rational decisions in an irrational market. We can then control the amount of risk you take by asking one simple question: what happens if we are wrong?
That is the key to controlling risk. It sounds so simple, yet most investors just are not willing to consider the possibility that they could be wrong. It’s too painful. Yet if you invest money long enough, you will eventually be wrong, but that doesn’t have to be a bad thing. If you consider your mortal nature before pulling the trigger, make sure that the odds are in your favor for being correct and that if you do happen to be wrong then it won’t hurt your overall portfolio too badly, than you will be okay in the long-term. This year, the market has been irrational and we, who pride ourselves in making rational decisions, have been wrong about many things, but our performance has still held up. How can that be possible? It is possible because at Iron Capital we heed Mr. Keynes’ warning and do all in our power to keep our clients solvent while the market is irrational.
Have a great summer,
CHUCK OSBORNE, CFA, Managing Director
Investing outside the United States has always been a somewhat scary proposition. I remember my first real exposure to international investing like it was yesterday. One morning when I was a young analyst at INVESCO, my boss stormed into my office and asked if I had a passport. I stammered, “Yes”. He asked, “Is it current” and I sheepishly said, “I think so.” He said – and this I will never forget – “You’re going to Poland!” Then he disappeared out my door as abruptly as he had entered. I sat there for a moment in shock, and then got up went down the hall to his assistant and politely asked her if I was ever coming back.
It was scary. This was a different world, different culture, different political environment and a very different market. However, the fundamentals of investing remained constant, and that young analyst did pretty well.
For most Americans investing overseas is still a mysterious and somewhat scary issue. When we inherit portfolios from our client’s previous advisors, a lack of international exposure is one of the biggest issues we find. People tend to stick to domestic stocks for a couple of reasons. First, they are more comfortable investing at home in their local surroundings and in familiar companies. The same reasoning causes 401(k) participants to invest heavily in their own company’s stock if given the chance. They are familiar with the company and that gives them more confidence.
Secondly, some believe that investing overseas is somehow less than patriotic, and shows a lack of confidence in our country. On the contrary, nothing seems more patriotic to me than owning the rest of the world. If more Americans invest in Toyota, for example, Toyota will eventually become an American owned company. Still, some people remain politically averse to investing overseas and we certainly respect that, but those who feel this way are limiting their opportunities.
More than half of the world’s invested capital resides outside of the United States. We live in a global marketplace. I am not saying it is good, nor am I saying it is bad, I am merely stating that globalization is a fact of life. Investing internationally provides access to those global opportunities.
Investing internationally also provides diversification. Everyone has heard that they should diversify their investment portfolio, but few people really understand what that means. Diversification is achieved by investing in assets that have a low correlation to one another. In other words, their prices do not move in the same direction. International markets have a low correlation to our market and therefore exposure to them can reduce the overall risk of the portfolio. This is even true of emerging market investing, which while very volatile as a stand alone investment, can actually reduce the volatility of a diversified portfolio.
Globalization and diversification are good general reasons for always having some exposure overseas. However, as our clients are aware, we are not just mildly exposed to international markets; we have a large international position in our portfolios. This has been a great boon to our clients as over the last year the international index MSCI EAFE is up 24.94% in dollar terms versus the S&P 500 which is only up 11.73%. Emerging markets have been even better with the MSCI Emerging Markets index being up 47.98% over the last year.
So how did we know? Unfortunately, it isn’t because we have a crystal ball. Investing is all about process, and it is our process that led us to venture beyond our borders. When investing, you want to buy low (when securities are undervalued) and sell high (when securities are overvalued). Value led us overseas.
According to Morningstar, the price to earnings ratio on December 31, 2005 for the MSCI EAFE international index was 16 as compared to 17.3 for the domestic S&P 500. In other words, it cost you $16 for every $1 of earnings overseas and $17.3 for every $1 of earnings here at home. It sounds simple doesn’t it? Well unfortunately it’s not that simple. The international market has been undervalued relative to the United States for a long time, yet it underperformed dramatically in the 1990’s. In the market an undervalued asset can stay undervalued for a long time. Timing matters and in our process we look not only for value but for signs that the market is beginning to recognize that value.
So, we saw an undervalued asset class and took advantage of it with some fortunate timing. But, is international still a good place to be? We believe the answer is yes. The global economy is strong. Japan is doing better than it has in more than a decade. China is growing at over 9% a year and India is right behind. Europe is a laggard, but that is not all bad. Stock market prices reflect the consensus opinion of what is going to happen in the future. If what actually happens matches expectations the markets will not move dramatically. Market prices make large moves due to surprises, down for negative surprises and up for positive surprises. In other words, it is possible that China grows very fast, but not as fast as people thought, and that Europe grows slowly but not as slowly as people thought, and you make money in Europe and lose money in China. Sometimes low expectations can be a wonderful thing.
~Have Passport, Will Travel
Welcome to The Quarterly Report from Iron Capital. This is the first issue of what I hope you will find to be an interesting and informative investment newsletter. I must admit to being nervous as I began to write this first article for our first newsletter – strange, since I used to have my own column in an industry trade journal, and have written countless market commentaries. I now realize that writing on behalf of your own firm is different, because it’s personal. In future issues we will use this space to share our views on investing your assets in the current market environment, but I want to take this first opportunity to tell you the Iron Capital story.
We formed Iron Capital Advisors in 2003 when I left INVESCO Retirement and partnered with Larry Gray, founder of Gray & Company, to start a firm that conducts business in what I believe is the “right” way. Iron Capital is more than a firm to me; it’s my dream. Throughout my career, as I worked my way up through the investment industry, I was constantly disturbed by two major flaws:
1) the industry is ripe with conflicts of interest, and
2) the end investor often has no access to expert advice or guidance. The final straw occurred when we all witnessed too many people lose half or more of their assets in the bear market of 2000– 2002. I felt I had to do something to help, and from that desire, Iron Capital was born.
Our mission at Iron Capital is to provide truly independent, customized investment counsel and portfolio management to retirement plan sponsors, participants, and individual investors. We accomplish this by adhering to certain principles that I believe are largely missing in the financial industry.
First, we believe in independence. One cannot serve two masters; you cannot have the client’s interest at heart if you are getting paid by a third party. This may sound obvious, and you would think that no-one would take advice from someone who is getting paid by someone else. However, people seeking financial and investment advice do it all the time. Most investors get advice from someone who is paid by the institution whose products or services they are selling. Their titles are usually Financial Planners, Financial Advisors, Financial Consultants, Wealth Managers, or if they are old-fashioned they will still call themselves Stock Brokers. Regardless of title, the reality is that they are all salespeople.
There is nothing wrong with salespeople, as long as they are honest about what they do and where their financial interests lie. Historically the stock broker’s job was not that of an advisor, but rather to bring buyers and sellers together to execute trades for a commission. Over time, as technology has made trading easier and more efficient, brokers have started offering advice. Today, the stock broker or “financial advisor” role is like that of a pharmaceutical sales representative. Pharmaceutical sales reps, like financial advisors, are professional, generally well-educated and trained by their home office to understand the products they represent. They know how the drugs work and benefit patients, and if a doctor asks an unusual or difficult question, they call the home office and consult the scientist who created the drug to answer the doctor’s question. Pharmaceutical sales reps are good people who believe in the products they sell, but you don’t go to one of them when you are sick.
Financial advisors are good people who believe in the products they sell, but going to a financial advisor to help you build an investment portfolio would be like going to a pharmaceutical sales rep when you are sick. Financial advisors work for the brokerage firm and cannot recommend any product that is not on their firm’s platform. In addition they aren’t investment management professionals. Very few have either the education or investment management experience that would qualify them to create and manage a portfolio.
The second principle we live by at Iron Capital is trust. Trust denotes honesty and integrity, but it also goes one step farther for us. Our clients trust that the professionals at Iron Capital are making the best possible investment decisions, based on investment management knowledge and experience. Every investment decision is made with only the client’s interest at heart by professionals who have extensive investment industry experience – each of us has been that “scientist” in the home office who actually created the product.
Due to that experience, we understand that the key to investment success is following a disciplined process. We work with our clients to create custom investment policy statements, identify the appropriate asset classes to be represented within the portfolio and select the right investments to represent each asset class. We allocate their assets across those investments and monitor the portfolio for adherence to the strategy spelled out in their investment policy. We can do this because, at Iron Capital, you are dealing not with a salesperson but rather directly with an investment professional.
My desire in creating this firm was to provide conflict-free, professional investment counsel. I felt the time was right, and that there were enough people out there who realized that the old way of doing business was broken. Two and a half short years later, Iron Capital now advises more than four billion in assets. There must be something to our approach.
So that is our story. I hope I have communicated who we are and why we created this firm. If you are tired of the old way of doing business, please give us a call. We are your gateway to independent investment advice.
We will be in touch next quarter with some true investment insight. In the meantime, buy low, sell high, and if you take investment advice, make sure it is coming from someone with real investment management experience who has only your interest at heart.
CHUCK OSBORNE, CFA, Managing Director
~The Iron Capital Story