RULE THREE: PRUDENT INVESTING IS RISK-AVERSE

Defense wins championships! I don’t care which sport you are playing, the best always understand that defense is what makes the difference when it really counts. Everyone loves the homerun hitters, but come October it is usually the team with the best pitching staff that wins the World Series. Everyone loves scoring touchdowns and watching teams score 50-plus points, but in the BCS National Championship game it is almost always the team with the best defense that wins. Everyone loves the team that can run the fast break and punctuate it with the awe-inspiring slam dunk, but whether it is March Madness or the NBA Finals it is almost always the team that plays the best defense that wins. I could go on and on.

The reason this cliché represents a nearly universal truth is because it is based on the combination of simple math and human psychology. If you hold your opponent to fewer points scored, your offense doesn’t have to score that many to win. It isn’t a difficult concept to understand. In most sports defense is primarily about attitude and effort, which one should be able to manage with a degree of consistency. Offense, on the other hand, usually requires timing and touch, which can from time to time just disappear even in the most gifted of athletes and especially under the pressure of competition. The excitement of the championship usually makes it easier to “get up” for the moment, have the right attitude and give a full effort. That same excitement, however, often wreaks havoc with timing and touch, leading commentators to often use yet another cliché and explain that the offense just needs to “settle down” and get back to playing their game. The greater the pressure moment, the greater the advantage of the defensively minded team or athlete. Hence the reason for the cliché: Defense really does win when one is under the most pressure – during championships.

The same is true in investing. Defense wins in the end, and in the investing world that means being risk-averse. I know what you are thinking: you are thinking this means having to settle for lower returns, but that is not necessarily the case. Defense can often lead to offense, and I will get to that, but first we need to discuss why people think there is such a strong relationship between risk and return.

This confusion stems from modern portfolio theory. This is the theory that dominates academia, most regulators and the mass educational material that is disseminated from Wall Street. Modern portfolio theory defines risk as beta. Beta is a mathematical term that describes the relationship between the overall market and one particular investment. For those who remember introductory algebra, beta is the slope of the line. What that means is that if the market goes up 10 percent and the investment in question also goes up 10 percent then the beta of that investment is 1. If the investment goes up only 8 percent then its beta 0.8, and if it goes up 12 percent then it has a beta of 1.2 percent.

Any investment that outperforms in an up market by definition will have a high beta, which means that if beta is your definition of risk, then any investment that performs well when the market is up is risky. Conversely, should the market go down and the investment goes down less, it is deemed to have a low beta and therefore labeled safe.

The problems with this definition of risk are manyfold. First, beta is not causal. In other words the investment did not have a higher rate of return because it had a high beta; in fact it is just the opposite. It had a high beta because it had a high rate of return. Secondly, beta is not constant. The beta of an investment is calculated by historical returns, and those return patterns can change at any time. It is probable that an investment that outperforms in the future has a low beta today because most investments, particularly stocks, tend to go along with fairly flat returns for long periods of time until some positive developments occur and the market realizes that this investment is worth more, and then the price shoots up rather quickly. The opposite can happen as well. The point is that beta changes over time and always reflects things that have already happened, not what might happen in the future, which is what we care about as investors. Beta simply tells us what an investment looked like relative to the overall market in the past. It tells us nothing about the future riskiness of an investment and is therefore a poor measure of risk.

Another common measure of risk is volatility. Technically we call this standard deviation, but the concept is simple: the more an investment’s price moves from day to day, the higher the risk. If one uses this definition of risk, then there probably is a relationship between risk and return. The most attractive long-term investments are often companies facing short-term distress. Their prices can swing wildly as little tidbits of news flow regarding the stressful issues at hand. The problem with using volatility as a measure of risk is that volatility goes in both directions. In my experience no client is ever upset by upside volatility; the downside is what people care about.

The other problem is that one is once again defining risk by looking backward, and saying that any investment that had a large return – high volatility = large price movement – is risky. Once again we are defining things as risky after the fact. The level of risk did not determine the return; the return determined what we are calling the level of risk. Just like with beta, it is probable that highly volatile investments were not so volatile before the big move in price. For example: Let’s look at bank stocks as an investment. For much of our history bank stocks were considered boring, safe, usually high dividendpaying stocks. This was true right up to the beginning of the financial crisis. These stocks hardly moved unless there was a merger, and many shareholders owned the stocks for years just collecting the steady dividends. In the beginning of 2007 banks stocks had low volatility and low beta; they were labeled safe. Then the financial crisis hit and these stocks took the worst of it right to the bottom in March of 2009. At that point their standard deviations and betas were very high and they were labeled risky. Wachovia’s stock fell to $2 before Wells Fargo bought them for $6. Wells Fargo, which trades for $40 today, went down to $7 per share. In March of 2009 the selloff had been overdone and these stocks came bounding back. Since then the volatility has been on the up side. It seems to me that in reality banks were risky in 2007 and safe in March of 2009, but these traditional measures had it the other way around.

I believe there is a better definition of risk. Risk in my opinion is the probability of losing money over a reasonable holding period. What constitutes a reasonable holding period can be in the eye of the beholder, but I would say for an investment it should be three to five years. I like this definition because it is real and constant. Losing money is what real people care about; I have never had a client call me to complain about making too much money. Not once have I had someone say, “Man, this upside volatility is driving me crazy!” When the market goes down, on the other hand, risk becomes important. This leads many people to think that they should alter their risk tolerance with the swings in the market. However, if one understands risk as the probability of losing money, then one will never ask for more risk regardless of what the market is doing. That makes it a better definition and one we can use.

That raises an interesting question: What does it mean to lose money? One might think that is an easy concept, but I can promise you that such a person has never managed someone else’s money. Many people think that one has not lost anything until he “realizes” that loss by selling the investment for less than he purchased it. This mentality leads to all sorts of investing mistakes, which could fill an entire newsletter. For now let’s just go with a definition of a loss as meaning the current market price is below what we originally paid.

This is important because even prudent investments with a low probability of losing money over three years are going to face short-term fluctuations, and clients do need to be able to withstand those fluctuations. This is why we ask our clients how much they are willing to lose over a twelve month period of time. We often then get asked what the right answer is. I have always refused to answer in the past but since I’m writing this newsletter on risk, I will tell you: The correct answer is approximately 20 percent. Why 20 percent? This is step one of why defense wins championships.

Math! To keep things as simple as possible we will assume a $100 portfolio. If we lose 10 percent, that is $10 so now we have $90. To get back to $100 we need to gain $10, which is an 11 percent return on $90. The gain needed to get back to even is not much greater than the loss. Let’s say we lose $20 which would be 20 percent of our original $100. That leaves us with $80 and needing a $20 dollar gain, which is a 25% return, to get back to even. This gain is a little higher percentage than the loss but still in the same ballpark. If we lose $30 or 30 percent, we then need to make $30 from the $70 left, a 42 percent return. If we lose $50 or 50 percent, we then need a 100 percent gain on the $50 remaining to get back to even. All that does is get us back, still not progressing to our ultimate goals. This is why defense wins championships.

As I mentioned there is a psychological advantage in many sports to being defensively minded, and the same is true here as well. Investors make their biggest mistakes when they let emotions control their decisions. After the market goes up they get greedy and tell their advisors that they want to take more risk. When the market goes down they get fearful and in a panic sell everything. Defining risk the way we do leads to the opposite behavior. The probability of loss is largely calculated by what Benjamin Graham called the margin of safety. This was also the title of Seth Klarman’s book that inspired this newsletter series. The margin of safety is the difference between what an investment is worth and the price at which it is currently selling. The larger that margin, the less likely one will lose money. Interestingly that is also how one calculates the expected return on an investment. Perhaps the relationship between risk and return is not as simple as we have been led to believe.

At Iron Capital we believe in prudent investing. To be prudent one must select investments from the bottom up, one at a time; one must have an absolute return mentality, largely ignoring the market; and, one must be risk-averse, avoiding meaningful losses of more than 20 percent. Investing prudently takes discipline and patience. Prudence can be out of style for seemingly long periods, but in the end the prudent investors usually win. After all, defense wins championships.

Charles E. Osborne, CFA, Managing Director

~The Three Rules of Prudent Investing

RULE TWO: PRUDENT INVESTING IS ABSOLUTE RETURN ORIENTED.

“No-one will ever have golf under his thumb. No round ever will be so good it could not have been better. Perhaps this is why golf is the greatest of games. You are not playing a human adversary; you are playing a game. You are playing old man par.” ~BOBBY JONES

I LOVE GOLF. Growing up I loved just about any game. I have fond memories of playing gin rummy with my father when I was as young as eight years old. We had a ping pong table and the family tournaments could get intense. I was never a star, but I played “all the sports,” according to my mother, and for her generation that means football, basketball and baseball. I played tennis and golf in addition to “all the sports.” What I lacked in actual athletic ability I usually made up for with heart and competitive fire. I loved being part of a team and I loved competing. A young person learns a lot of life lessons on the athletic field. Sports are great.

I remember my uncle taking me aside when I was still in junior high and telling me that I should spend more effort on golf. His reasoning was that golf, unlike the other sports I participated in, could be played for the rest of my life. At the time I didn’t listen; after all, high school football players were a lot cooler than high school golfers. Now, well into the “rest of my life,” few days go by when I don’t regret ignoring that advice. All sports teach life lessons, but there is something special about golf. One of the unique things is that golfers don’t actually play against each other, at least successful golfers don’t. Their real opponent is the course and, as Bobby Jones famously stated, old man par.

The same is true about investing, which brings us the second of the three rules of prudent investing: Prudent investing is absolute return oriented, not relative return oriented. We live in a relative return world; it is all about beating your market benchmark and/or beating your peers. Prudent investors, however, are interested in returns only insofar as they relate to the achievement of their own investment goals. In other words, beating old man par.

Prudent investors are investing for some higher purpose. They invest to fund retirement, or college for their children. They invest to endow a worthy charity or to provide a legacy for their children and their children’s children. They do not hold assets for the sake of having assets; there is a purpose, even if that purpose is shallow and dare we say greedy. Warren Buffett is known as the greatest investor of our time, at least in part because that was his purpose. By most accounts Buffett wanted to be wealthy and famous, and his achievement of that status is no accident. There are actually a handful of other investors who have achieved long-term track records similar to Buffett’s, but most of them remain completely unknown to the general public, largely because they wanted it that way.

Buffett is a great example of the focus on absolute returns. We have short memories in our society today, but almost twenty years ago the conventional wisdom was that Warren Buffett was washed up, a dinosaur out of touch with our modern world. We were in the midst of what we now know as the dot-com bubble, but at the time no one was calling it that. Buffett, who had done so well on a relative basis for most of his career, was underperforming the market and other money managers by dramatic amounts. He didn’t care. He was still growing his nest egg year in and year out, and he knew what a bubble looks like. Today he is once again considered a genius.

Buffett had stated his goal early in his career before Berkshire when he was still managing what today we would call a hedge fund. His stated goal was a nine percent return. Similarly, all prudent investors should have a stated goal – after all, we have to know what old man par is. This gets investors focused on what’s important: achieving your actual purpose. So if retirement income is one’s goal, then we need to calculate what return must be achieved, based on the size of one’s portfolio, saving rate, and time to and/or in retirement,in order to reach that goal. This is the financial planning process and it is the same process for the average worker saving for retirement as it is for the wealthy family or college endowment or large corporate pension plan. There may be more moving parts for some investors and less for others, but ultimately it boils down to a number. In order to achieve one’s goal one must get a six percent return, or maybe it is eight, or only four. Whatever it is, that is your personal par. It is the return you need to get for all of your goals to be achieved, and that is the only return that matters. Not what the market does; not what your neighbor says he did (he’s lying by the way – not just to you but to himself – but that is a whole other article); but your old man par.

If your number is six percent, then the prudent action would be to build a portfolio that maximizes the probability of achieving that return and minimizes risk. (In practice it is wise to give some room for error so one may actually aim slightly above what is actually needed). This means if you can get the desired return from Treasuries, then you should have most if not all your assets in Treasuries. If you can’t, which is likely the case, then you should make prudent investments that will hit that mark with a reasonable amount of certainty over a reasonable holding period. This brings us to another big advantage of an absolute return focus: Investors who are thusly focused tend to be very patient. They care about achieving their return over their time frame and because, as we discussed last quarter, they have selected investments prudently from the bottom-up and know what they own, they have great confidence that everything will work out over time.

Relative result focused investors, on the other hand, are constantly comparing their results to the market, to other investment managers and to the inflated bragging of their neighbors. They are like the person stuck in traffic constantly changing lanes just to see the lane they had been in start to move. We all know that this is not the right thing to do, but it is a very hard habit to break. The financial world reinforces this view in almost every way. Wall Street firms are in the business of making transactions, and in order to get investors to transact, one must convince them that they could do better elsewhere. So Wall Street has created an atmosphere of what I call competitive investing: They have convinced people that the right thing to do is to constantly compare your return to what else is out there, and why not – after all, there will always be something that did better; which means investors must constantly transact; and that is how Wall Street makes money.

It isn’t just Wall Street though. CNBC and similar channels always celebrate whoever is doing well at the time, which is always fleeting – even for the best in the business. So-called consumer experts often tout indexing, and indexing may very well be the ultimate form of relative investing. If you are constantly comparing yourself to the market and other investors, ultimately you are just going to look like the market. The problem is that this focus on return and ultimately short-term return is that it ignores risk. It ignores prudence. Markets outperform prudent investors usually during times of bubble creation, and bubbles eventually pop. Warren Buffett once again looks like a genius, and those who wrote him off are forgotten.

Ultimately the relative return culture is about coveting what we perceive others to have. Wall Street is in the business of selling things, and coveting is a powerful force in making people purchase whatever it is one is selling. However, there is a reason coveting made it on God’s top-ten list, right up there with murder and adultery. Coveting will ruin one’s life. Nowhere is that more obvious than in investing. Studies show that investors buy high and sell low. To be more accurate investors tend to buy high, then ride the investment all the way down until they finally capitulate, and this isn’t just unsophisticated retail investors.

When one is constantly worried about being compared, one does imprudent things. Earlier this year we received a paper written by one of the largest and most respected fixed income managers in the industry. The paper was on what to do when interest rates begin to go higher, and they listed different options and their potential risks. There was one strategy that they deemed to be the most effective should rates rise, but the risk of that strategy was tracking error. They went on and on about not looking like everyone else and the problem that would cause should it take longer than expected for rates to begin to rise. Today investors in these funds have done worse than need be because the managers were more worried about being different than about getting the best absolute return.

For much of my career I was part of this problem. I was trained in the institutional mindset of beating the benchmark and peer group. Early in 2009 I had lunch with my former boss from Invesco. He was retired and enjoying it, and I looked forward to updating him on our success. I knew he would ask how we did during the downturn and I couldn’t wait to tell him: our core equity strategy had outperformed its benchmark, the S&P 500, by ten percent. No one does that in the relative performance world. If one compared our strategy to the entire Morningstar domestic equity universe regardless of specific style, we were in the top ten percent; better then ninety percent of our peers. I told him all of this and he just looked at me and said, “So you were down thirty percent or so? That isn’t very good is it?” No, it wasn’t.

That day and over the days that followed my eyes began to open and I began to realize that our industry has it all wrong. We need to be focused on achieving clients’ goals and not beating one another. Or perhaps this realization just comes once one has enough experience. Arnold Palmer has said he didn’t get good at golf until he finally realized that you play the course not the man. There is a great story about Jack Nicklaus in the first round of the 1967 U.S. Open. He was partnered with a rookie and they were both right around even par on their first nine holes. As they made the turn they looked at the leader board and the leader was in the clubhouse at five under par. The rookie turned to Nicklaus and said we better get going the leaders are already five strokes ahead. Nicklaus responded by saying this is the U.S. Open and four under will win, we are doing just fine. He finished that day at one over par, six strokes behind the leader. Three days later Jack Nicklaus won the U.S. Open with a total score of five under par; four under would have been good enough indeed.

It is easy to be absolute return focused when you are steady and the market is going down, but when the leaders seem like they are so far ahead it becomes difficult to just stay the course. That is human nature. That is when one must channel their inner Jack Nicklaus and remember that this is equity investing, and ten percent is what the market does over the long-term. Eventually everyone comes back to old man par. Prudent investors choose to get there taking the least amount of risk, and that is next quarter’s lesson.

Charles E. Osborne, CFA, Managing Director

~The Three Rules of Prudent Investing

RULE ONE: PRUDENT INVESTING IS DONE FROM THE BOTTOM UP.

My brother-in-law loves to ski. He and my sister had a winter wedding and honeymooned at a ski resort. Both were inexperienced skiers at the time but they thought it would be good fun to learn together. My brother-in-law took to skiing like a duck to water; my sister, not so much. My sister loves to tease about their “romantic honeymoon” with her groom skiing by every once in a while to see how she was doing on the bunny slopes. In my brotherin- law’s defense they have been happily married for 27 years so it couldn’t have been that bad. Their kids fell in love with skiing too, and later snowboarding as they grew up. Year after year they went on family ski trips where everyone had fun except for my sister, who just couldn’t get it. She tried, and would take lessons, but somehow it just didn’t click. Then about five years ago my whole family went on a ski trip together and my wife convinced my sister to take one more ski lesson together with her.

That evening when we all circled back together my sister was overjoyed. This instructor, for whatever reason, was able to communicate the art of skiing to my sister in a way that finally clicked (to this day neither my sister nor my wife has revealed his “secret”). She got it, and she finally had a great time skiing. I can only guess what the secret is – seriously, they won’t tell – but I suspect he didn’t say anything that the dozen or so other instructors hadn’t said. He just had a way of saying it that resonated with my sister at that moment.

It is funny how those things happen in life: Someone says something in a different way and it unlocks your understanding of a subject with which you had struggled. Or, sometimes you may be the teacher and you hear or read someone else’s description and you say, “Yes! That is exactly what I have been trying to say.” I had one of those moments earlier this year.

A friend loaned me the book, “Margin of Safety,” by Seth Klarman. Klarman is as famous as most investors ever get – with Warren Buffett being the glaring exception. He has an extraordinary track record of success with his firm, The Baupost Group, and he wrote this book about his investment philosophy in 1991. The book is famous not only because of Klarman’s reputation but also because he has refused to approve any more printing runs after the first, so it is hard to get and can sell for as much as $2,500. (Yes, I returned it.)

Klarman, like Buffett and many other very successful investors, is hugely influenced by Benjamin Graham and David Dodd; in fact the name of the book is directly borrowed from Graham, who coined the phrase “margin of safety.” As I suspected there was nothing in Klarman’s book that was actually new to me. However, just like my sister’s ski instructor, Klarman had a slightly different way of saying the same thing, and in one of his chapters in particular I heard something I have always known in a way I had never heard it.

Chapter seven: “At the Root of a Value-Investment Philosophy.” In an attempt to clear up some investment speak I am going to refer to it simply as prudent investing. There is a bit of editorial in that description but beyond that I think it is important to distinguish the difference between a value philosophy and “value style” which is often discussed. I have written about this in past newsletters, but for our purpose here let’s just say Klarman is describing what he and I would both agree is the prudent way to invest, which could accommodate various “styles.”

Klarman defined three central elements to this philosophy. First, prudent investing is a bottom-up strategy entailing the identification of specific investment opportunities. Second, prudent investing is absolute return, not relative return oriented. Finally, prudent investing is a risk-adverse approach where, as Klarman says, “attention is paid as much to what can go wrong (risk) as to what can go right (return).” Over the next three quarters I am going to discuss Klarman’s three rules, starting here with prudent investing always being done from the bottom-up.

The easiest way to understand what it means to invest from the bottom up may be to first understand the opposite approach, investing from the top down. Top-down investors start with economic analysis. They project what the big picture is going to look like; how the environment will affect specific industries; and then how an industry’s environment will impact the company in which one might invest. Today many of these types of investors don’t even invest in companies; instead they choose exchange-traded funds (ETFs), which represent industries or sectors of the economy. These investors must be correct about their economic forecast, which is nearly impossible; then they must correctly assess how that forecasted environment will actually impact any particular sector of the economy. Then they have to pick which specific industries will be the real winners, and if they still own stocks they have to pick which companies within the industry are best positioned. Not only do they have to do all of that without having any errors along the way, but they must do it faster than anyone else, otherwise the whole opportunity will be lost. Sound impossible?

Well there is a better and much easier way. The investor can look for quality companies one at a time, from the bottom up. We have often referred to this strategy as being owners of companies instead of traders of stocks. The common sense of this approach is pretty clear: It is much easier to understand a single company, its track record of results, the products it sells or services it provides, the strength of its balance sheet etc, then it is to know how much the entire global economy will grow. Once a company is understood it may be difficult to pin down an exact value for that company, but certainly one could come up with a range of what that company is actually worth. Then all one has to do is have the patience and discipline to buy the stock of that company when the stock is selling for less than the actual value of the company, and the further patience to wait for the market to realize that value. As Klarman puts it, “The entire strategy can be concisely described as buy a bargain and wait.”

This bottom-up philosophy is almost universal among successful investors. In fact, John Maynard Keynes, the famous and still controversial economist, was a fantastic investor and he paid no attention to his own economic forecast when managing the endowment of King’s College, Cambridge. Peter Lynch, the famous manager of the Fidelity Magellan Fund, is quoted as saying that “if one spends thirteen minutes reading a market forecast than he has wasted ten minutes.” True investing success is about making prudent investments from the bottom up.

Doing so, however, is far more difficult than one might imagine. All of Wall Street is geared towards a top-down approach, and for good reason: top-down economic forecasts change almost constantly, meaning those who use these forecasts as reasons to invest must trade constantly. Wall Street is in a transaction-oriented business; constant trading pays their bills, so they are more than happy to provide everyone with top-down oriented research. Bottom-up investing, on the other hand, involves patience. The market could recognize value shortly after one makes an investment (remember being a long-term investor is a mindset, not a timeframe), but usually one must wait for the value of a company to be recognized. While the prudent investor is waiting, Wall Street is not making a dime.

Bottom-up investors have little use for CNBC or any of the other 24 hours-a-day investing channels; what they say is of little value unless they happen to be talking about the specific company you have invested in, and the odds of that are fairly slim. Moreover, the fundamentals of a company really do not change very quickly, and things that do not change quickly make for bad television. Economic data, on the other hand, can bring excitement, and the more they can convince you that every piece of data is vital, the longer you will watch and boost their ratings. Yet most of what comes from these sources in really noise, not news.

This is not to say that economic data has no value; even Peter Lynch thinks that forecasts are worth three minutes of your time. Knowing what is happening in the economy gives one a better frame of reference when judging how well an individual company is performing. For example, Apple has grown at a rate of nearly sixty percent a year over the last five years; knowing that the last five years have been marked by anemic overall economic growth makes that accomplishment stand out all the more. Many technology companies saw that kind of growth in the roaring 1990s, but for a company to do that during the Great Recession is far more impressive.

At Iron Capital, we take it a step further. Our top-down forecast is actually built from the bottom up. While we track the macro economic data, what we pay the closest attention to is the fundamental valuation of various assets and the current dynamics being reported by individual companies within the various sectors. Are the mutual fund managers we like finding opportunities in their space or are we finding bottom-up opportunities? We have found this ground level data, so to speak, to be far more valuable in making asset allocation decisions than any economic or market forecast. We try to be prudent in everything we do, and the first rule of prudent investing is that it is built from the bottom up.

Charles E. Osborne, CFA, Managing Director

~The Three Rules of Prudent Investing

You have heard me say it before, but I really do believe that I could write a complete investment textbook solely on the basis of quotes from the 2003 Disney classic, “Pirates of the Caribbean: The Curse of the Black Pearl.” (If you have not yet seen the movie, it really is worth the watch. This article will be impactful all the same, please read on.) We have already written about market uncertainty, “Reason’s got nothing to do with it,” Mr. Gibbs. We could discuss risk management, “There’s just one question, how far are you willing to go?” Captain Jack Sparrow. We could talk about contrarian strategies, “This is either brilliance or madness,” Will Turner. We could discuss the deadly sin of over confidence, “There is only one rule – what a man can do and what a man can’t do,” Captain Jack Sparrow. But, without doubt, there is one quote that is the number one core lesson of all investing.

The scene takes place as Captain Jack Sparrow enters the secret cave on the Isla de Muerta for the second time. Captain Barbossa sees him and, after just stranding him on a deserted island for the second time, exclaims, “Impossible!” To which Sparrow simply waives his finger like Barbossa’s eighth grade grammar teacher and corrects him with one word, “Improbable.” I will admit that my own wife does not understand why this is my favorite scene from the movie, but investment geeks, like all different variation of geeks, have a humor that is ours alone, and ours primarily deals with the general public’s misunderstanding of probabilities. Barbossa thought Sparrow’s escape was impossible, but any wise investor would have told him that it was simply improbable.

The understanding of probabilities is taught in statistics. If one wants to have a future in the money management industry, he or she had better like statistics. Statistics is to our world what English is to the practice of law, what physics is to architecture, or what biology is to the practice of medicine. Investment professionals must make decisions today about a tomorrow which is, by definition, unknowable. We don’t have crystal balls; we simply have the knowledge of today, what is happening, our current trajectory, and a long list of probable futures. Our job is to understand those probabilities and position our clients’ portfolios in order to manage risk and put the odds in their favor.

This may sound complicated and the work involved is much more intense than most think, but at its essence it is really simple. The best analogy of what investment professionals do is found in the world of sports. Football coaches have to make decisions without the benefit of knowing the outcome. A few years ago my Wake Forest Demon Deacons had the local Georgia Tech Yellow Jackets on the ropes. Tech came back and tied the game to send it to overtime. Wake went first and had to settle for a field goal; Tech was then stopped and their new coach Paul Johnson decided to go for it on fourth down. They made it, scored a touch down and won the game.

Later I was talking to a Tech fan about the game. He was exuberant about their new coach and his bold decision-making. This is the classic response to judging decision making: the layperson waits until the outcome is known and then weighs in on the quality of the decision. The problem with that approach is that it does not separate luck from skill. After all, the best in every field will sometimes be wrong and even a broken clock is right twice a day. One of life’s difficulties is that when making decisions about an unknowable future, good decisions can turn out poorly and bad ones can turn out well. I informed my friend that I thought Johnson had made a poor decision. Sure it worked out, but the odds were against him and if one consistently goes against the odds, one will lose more than one wins. Most of the Tech fans I know are now ready for Mr. Johnson to practice his poor decision making elsewhere.

Another football coach who is famous for going for it is LSU’s Les Miles. He is known by the LSU faithful as the Mad Hatter because he says things that are crazy and he entirely disregards probabilities. In 2007 Miles led his LSU Tigers to the national championship largely by “going for it” seemingly all the time. He completely disregards the odds, and in many ways he is loved by the LSU faithful because of this trait. For some reason we love the risk-takers. However, that risk-taking just cost LSU a loss in the Chick-fil-A Bowl where all they had to do is run out the clock; instead of playing the odds, they came out throwing the ball, stopping the clock and having to punt to Clemson, who then drove for a winning score.

Contrast that model of decision making with the man Miles replaced at LSU, Nick Saban. Saban’s teams are not exactly known for taking big risks. They play text book, hard-nosed football and they obsess over process. I’m sure Saban has probably “gone for it” at some point in his career but you wouldn’t know it watching his current team, The University of Alabama. Miles has had success, but Saban just won his third National Championship in the last four years, fourth overall. Playing the odds is not endearing – people love to hate Saban – but it works.

This is also true in other endeavors. Take golf for example: crowds adore Phil Mickelson largely because he ignores the odds. We all applaud his boldness when he hits it on the 15th green at Augusta National off the pine straw and behind some trees, but when he fails to pull off a similar shot at Winged Foot causing him to lose the U.S. Open, we call him an idiot. (Actually, he called himself an idiot.) The truth is they were both questionable decisions. In an earlier era Arnold Palmer had a similar outlook and was similarly loved by the crowds. Similarly his go-for-broke, ignore-the-odds style cost him as many heartbreaks as it won him championships.

Contrast these two with their main rivals, Tiger Woods and Jack Nicklaus. They plod around the course, always playing the high percentage shot. They are almost robotic, and while they endeared huge amounts of respect for their talent they have never felt the love like Phil and Arnold. They have, however, won more majors than anyone else and gone down in history as the two greatest of all time. This does not mean that they never lost; they have both felt the pain of defeat, but by keeping the odds in their favor they have won more often than anyone else.

Of course no discussion of probabilities would be complete without discussing gambling. One hears it all the time: investing is really just gambling, Wall Street is just Las Vegas East. There are in fact huge differences between investing and gambling, but they do have one thing in common: probabilities. Like most investors I know, I am not much of a gambler, but I knew a portfolio manager from Boston who liked to play Blackjack. He was what we call a quant, meaning his methodology for investing was based largely on mathematical formulas (mostly statistics). He told me that without counting cards, which Vegas deems as cheating, if one plays Blackjack “perfectly,” that player has a 49 percent chance of winning. Those are the best odds one can get at a Casino unless he heads to the poker tables where he plays against other guests instead of the house. His point was that the casino always has the odds in its favor. This does not ensure always winning – players do win, which of course is what brings them back. However, those big hotels and all those bright lights were not paid for by people winning. The casinos know that as long as the odds stay in their favor they may not win every time, but they will win over time.

As investors, we often get to choose: do we want to act like the players, betting on a hot tip based on price movement, or on a hundred other forms of speculation? Or do we want to act like the casino, always insisting that the odds be in our favor? At its essence this is the difference between speculating and investing. Investors get the odds in their favor by investing in companies that are either a) growing rapidly – the odds are that a fastgrowing company will be worth more tomorrow than it is today; or b) in companies whose stock is selling for less than the company is actually worth – odds are that this disconnect will correct itself over time. This is where we get the growth and value schools of investing. Most legendary investors have had the discipline to demand both, which, is the closest thing one can get to a sure thing.

Even with the odds in one’s favor no one wins all the time. Investors, though, can choose how they lose: they can risk losing more in a down market or making less in the up market. Most prudent investors choose the latter. It isn’t as sexy as going for it all the time like Les Miles, Phil Mickelson or Arnold Palmer, which may bring glory and the adoration of others. It is, however, the way to win most of the time, over time, like Nick Saban, Tiger Woods and Jack Nicklaus.

The tension comes from our human tendency to see not the odds but only the outcome. When a football coach goes for it on fourth and long and makes it, people say he is brilliant. When he goes for it and fails, people say he is an idiot. The truth is that the quality of the decision is not dependent on the outcome; it is dependent on the process by which the decision was made. There have been countless studies saying that investment managers who outperform cannot be identified by their past performance, yet for ten years now Iron Capital has selected winning managers with a more than 76 percent success rate. How is that possible? Looking solely at performance is judging the outcome, but future success is based on making quality decisions that put the odds in your favor. The key to success is having the discipline to judge the quality of the decision-making process divorced from outcomes, especially short-term outcomes.

This will be especially true for investors in the beginning of 2013. 2012 was one of those years that defied the odds. The market was up 16 percent while the average hedge fund according to Bloomberg was up only 2 percent. These are the “smartest guys in the room,” and that amount of divergence seems impossible, but actually it is just improbable. Being prudent, managing risk, and keeping the odds on your side does not guarantee success every time, but it is what it takes to be successful over time.

Charles E. Osborne, CFA, Managing Director

~MISSION: IMPROBABLE

WE’VE ALL HEARD THE WORDS.
At some point in our youth we all have been in the familiar scenario, trying to convince our parents that letting us do something stupid – go to a party or on a trip, get a tattoo, etc. – would actually be a good idea. Our logic was likely that “everyone” (translation: one friend whose parents were “cool”) – was doing it. Then we would get the timeless retort to which there is no response, “If your friends were jumping off of a cliff, would you follow them?”

Now we are the adults. Our friends in Greece, Spain, Italy, and France – you know, all those cool countries that “really know how to live” – have already jumped off of cliffs or will do so soon, and evidently the answer to that age-old question is actually, “Yes.” Yes, Mom and Dad, if all of our friends jump off the cliff, then we will, too.

On January 1, 2013, the United States of America, the great world power with the largest and most sophisticated economy on the planet, is going to be driven over the aptly named fiscal cliff. We have suffered through the worst economic recovery in our history, we are now in a new downturn and we will be facing the largest tax increase in American history with a simultaneous slashing of the federal government’s budget. Even the hyperoptimistic Congressional Budget Office (CBO) says that if something is not done to fix it, the U.S. will experience a recession in 2013. Yet this looming cliff barely garners a mention on the campaign trail.

One of the reasons it is hardly mentioned is that few really believe that our politicians are so reckless that they would actually let us fall off the cliff. The conventional wisdom is that after the election the two parties will sit down and fix this before year-end. I hope that is correct and it probably is, but that still leaves us sitting here in October 2012 with no real clue about what our tax code or government programs will look like in 2013. This isn’t supposed to happen in America, or in any developed country for that matter. This is the kind of thing that happens in “Banana Republics,” smaller former Soviet republics, and Middle Eastern dictatorships. This should be the great scandal of our time.

This whole situation was set up when the administration and Congress could not agree on a lasting fix to the debt ceiling debate in the summer of 2011. That embarrassing episode led to Standard and Poor’s downgrading our credit rating and forced our politicians in Washington to punt the decision until after the election. It is dangerous to bring up economic subjects like this, because it ultimately gets political. To avoid that trap let’s pay attention to the old adage, “Great minds discuss ideas, average minds discuss events, and small minds discuss people.” The famous investigative reporter and author Bob Woodward has published a book about the events and the cable news networks have already villainized all the people involved, so we will take the high road and discuss the ideas of what this means to us as investors and how we as a country might get out of it.

To some degree the fiscal cliff is the perfect representation of what has gone wrong in this anemic economic recovery. It represents uncertainty. The numberone concern of business leaders today is a lack of confidence and uncertainty about the future. This argument has been made many times. Some refute it, arguing that life is always uncertain. Business, economics, and investing are by their nature uncertain. Investors and business leaders always make decisions today not really knowing what will happen tomorrow. This is true, but it misses the point.

Let me use a recent analogy. Football is an uncertain game, as are all games. There is always a favorite going into a game. We know the coaches and the players, we know their tendencies. We may think we know what will happen, but as the old football saying goes, “There is a reason they play the game.” You see, upsets happen. Underdogs surprise us and stars disappoint, that is what makes us watch. We enjoy that uncertainty. It is exciting, in the same way business leaders enjoy the marketing game and professional investors enjoy the action of the market. This is the normal uncertainty in which business gets done and economies grow.

When fans pile into stadiums or turn on their televisions they may not know who will win the game, but they do know the rules. The rules are not uncertain. They are known ahead of time and there is an expectation that the rules will be enforced evenly and fairly by professional referees. When the National Football League (NFL) recently fielded replacement referees, it was a disaster. All of a sudden it was not just the game that became uncertain, but the enforcement of the rules. Ultimately it cost at least one team a game, and one game in the NFL can make the difference between making the playoffs and potentially winning the Super Bowl and not making the playoffs and watching the Super Bowl at home with the rest of America.

Similarly, the uncertainty businesses and investors face today is not regarding the usual uncertainty about the outcome of certain decisions; the uncertainty is about the rules themselves. Embarrassingly bad calls are not supposed to happen in the world’s premier football league, just as not knowing what government will do two months from now is not supposed to happen in the world’s premier democracy. It is an embarrassment, and the result is that economic activity has seemingly ground to a halt.

Of the approximately 30 companies in the S&P that have changed their earnings guidance before the release of third quarter results, 28 have lowered their estimates. A few have lowered guidance more than once. Our fear is that the third quarter results will be very ugly and we are remaining defensively positioned because of this.

We will get beyond this, and just like the NFL finally had to deal with their referees, the U.S. will have to deal with the fiscal cliff. One of our political parties suggests that we can get there by raising taxes on the wealthy. That would be laughable if they were not so serious. It won’t work for multiple reasons but mainly it won’t work because it ignores the problem. Think about your own experiences: we all know someone, a child, sibling, friend or spouse, who simply can’t seem to control their spending. We know it doesn’t matter how much money they are given, they will always find ways to spend more than they have. More income may ultimately be needed, but you must first get spending under control. You can start with small items, cut out the lunches and the Starbucks, but when the situation is severe you then must address the big items. A smaller house, a less expensive car, fewer trips, etc. Likewise, our government is no different than our friends; it has a spending problem, and it must deal with it. Its problem is severe and we are going to have to look at the big items. Social Security and Medicare must be reformed or they will drive us over the cliff just as they have our friends in Greece, Spain, Italy, and soon France.

We have another political party that refuses to raise revenues at all. This is also unrealistic. While spending does need to be controlled that cannot solve the entire problem. Just as we would advise an individual with a budgeting problem, you get spending under control first and then look for ways to increase income. The second part cannot be avoided. There are smart ways to increase revenue to government and not-so-smart ways. The not-so-smart way would be to raise income tax rates on a few rich guys.

Let me explain why this is not smart. It is just math: there isn’t enough money there. We could raise marginal rates to 100 percent on incomes over $1 million and, assuming no one changed their behavior, the money still would not make a significant dent in our debt. People talk about the evil one percent, but to be in that notorious group takes a combined household income of approximately $400,000. Those making more than $1 million are a fraction of a percent of all Americans. The idea that there are millions of billionaires out there that can pay for government for the rest of us is a fantasy. On top of that, in the real world taxes do cause changes in behavior. France just raised its top tax rate to 75 percent. Practically the next day, Bernard Arnault, the wealthiest man in France, applied for Belgian citizenship. Another example closer to home: I live 0.5 miles from my office. Over the last several months my commute has doubled as I have had to detour around multiple movie sets to get home. Why are they filming movies in Atlanta and not Hollywood? Rich people and rich industries have choices, and if one location offers a better tax environment than another they will exercise those choices.

Even if that were not the case and a government could get all it needed from the very rich, there is a danger in having a tax code that is too progressive. It does become an inhibiter of growth, but not for the reasons usually mentioned. Economic growth does not trickle down from the rich. Economic growth happens when a man like Steve Jobs starts a business in a garage. He starts it in a garage because he can’t afford to start it anywhere else. You see, Steve Jobs was not rich when he started Apple, but Apple made him rich, and that is economic growth. Growth occurs when people who are not rich today build something real that makes them rich tomorrow, along with their partners and the hundreds and eventually thousands who get jobs, hopefully with stock options, in the companies they create. When tax rates rise with incomes it does not hurt those who are already on top – they can afford it; it hurts those who are not on top today but wish to be there tomorrow. It puts a barrier in their way, and those are the people who make our economy work.

The smart way to raise revenue is to reform the tax code. Lower rates and eliminate tax breaks that are overwhelmingly skewed to the wealthy. The lower rates create less friction for the entrepreneurs who actually create economic growth, while the closing of loopholes means higher actual taxes for those who are already rich. This is how Ronald Reagan and Tip O’Neal did it in 1986, it is the basic framework of the bi-partisan Simpson Boyles plan, and it is the basic framework that just about every expert who isn’t running for office supports. Reform, however, must be designed to raise revenue if we are going to be serious about fixing our fiscal mess.

Are we going to go over the cliff? Everyone else is doing it, but we have never been everyone else. From our birth as a nation we have been a leader; a trend setter; as Reagan put it, “a shining city upon the hill.” The single biggest obstacle to American growth and future investing success is that fiscal cliff and the continued uncertainty that it represents. We need a president who is prepared to make the tough decisions to get spending under control, reform our social safety net and give us a fair tax system that reasonable people can support. As with most things in life knowing what needs to be done is rather simple, but doing it will be hard. But then, that is why they call it the highest office in the land.

Charles E. Osborne, CFA, Managing Director

~Everyone’s Doing It!