I owe a great deal to my parents, which I know is not unusual. The lessons of childhood still ring true to me today. Yes, it is a cliché, but I really do sound like my parents when talking to my children – and I’m ok with that. The positive impact they have had on my life is immeasurable. There are the obvious attributes: my bald head, my blue eyes, and my bad habit of not always finishing a sentence when I am talking – all things I got from my father. My mother had a big influence, too. In fact, she contributed greatly to my investment philosophy. My mother can find values like few others.

My mother, like most women of her generation, was a full-time wife and mother, and she was good at it. She married the man who invented copper wire by stretching a penny as far as he could, so she really had no choice but to become a value-hunter herself. In hindsight it is simply amazing how far Mom could stretch a dollar, and she did it without sacrificing quality. If Mom were 40 years younger she would be teaching the Internet coupon gurus a few things about saving money without sacrificing being well-dressed and eating like kings.

My parents are products of the Great Depression; my father was born in 1929 and my mother in 1931. They learned early on not to waste anything, and they learned the importance of quality and how to take care of things. One of my father’s favorite mantras is, “Never buy anything for temporary use.” Growing up I took my lunch to school, and I was excited when Mom finally let me stop using the metal lunchbox and carry it in a brown paper bag like the cool kids. Unfortunately I was told that I had to bring the bag back home so we could use it the next day, and the next, until it actually wore out. I would wait until my friends weren’t looking and quickly, but carefully, fold the bag and put it in my backpack.

With this foundation it is no wonder I grew up to be a value investor. You see, investment success is largely about having an investment philosophy. There is more than one way to gain investment success, but it is important to select a philosophy that fits who you are at the core. In the wise words of John Wesley, founder of the Methodist Church, “An erroneous view of ourselves naturally leads to numberless errors.”

I have spoken a lot about the investment process in the past, and there is no doubt that having a disciplined process is key to success, but philosophy runs deeper than process. A process can and should change, as one always should be trying to improve the process, and there is no such thing as improvement without some element of change. Your philosophy, on the other hand, should be written in stone. It is the core of what you believe about investing.

Our philosophy: We believe in owning companies, not trading stocks. A stock certificate is nothing more or less than a fractional ownership in a company. We believe this for very important reasons. From an investment decision-making perspective we believe companies have intrinsic value and that this value can be calculated, or, at the very least, accurately estimated. This value does not change quickly, as the actual performance of a company does not change quickly. It may change faster today in our interconnected global economy than it would have a generation ago, but we are still talking about weeks and months, not seconds. Stock prices, however, change in a matter of seconds. This dynamic creates disconnects between the actual value of the company and the price of the company’s stock. Taking advantage of those disconnections by buying stocks when they are selling for less than what the company is worth, and selling stocks when they are selling for more than what the company is worth, is the essence of value investing.

This is different than having a value investing process, or being put in the “value” box by organizations like Morningstar. One can use a value process to actively trade stocks. One can also have a value philosophy and be deemed a growth investor. In fact, the most famous value investor in the world, Warren Buffett, most likely would have been in Morningstar’s “growth” box for much of his career. Another famous value investor, Bill Miller of Legg Mason, was criticized for buying Google immediately after it went public. His explanation for why this was not a contradiction was simple: he believed the company was worth a lot more than what it was selling for at the time. His method for valuing the company got complicated, but philosophically it is very simple, Google was worth more than the price of its stock. That is value investing at its core, even if the world decides to call Google a growth company.

Our philosophy goes beyond just seeking undervalued securities. Owning a company is much different than trading a stock. Ownership entails responsibility:We care about the companies we own. We care about compensation to executives; about long-term strategy and competitive advantage; about being run ethically. I would never describe us as “socially responsible” because that is a loaded title that often connotes a political perspective. We have owned many companies that others may not, including tobacco companies, liquor and beer companies, and gaming companies. However, we do care about ethical management. We have never owned – and unless something changes dramatically in their culture, we will never own – Bank of America. We have refused to invest in so-called ‘payday lenders’ who market uncompetitive loans to people who need cash before payday, even though they looked like bargains during the financial crisis. We vote our clients’ proxies and pay attention to what actually is happening at each company. This is one of the largest differences between investors and traders, and in my opinion it is why we have seen an increase in corporate misbehavior parallel to the increase of trading over investing.

We believe in buying quality. Value is not about price alone, but the combination of price and quality. I think this is best described in investing as the combination of price and dynamics. Dynamics can be defined in several ways: it can mean a company with growing earnings, or a positive product launch, or simply positive market momentum. For example, our asset allocation process is based on the concept of relative valuation, aka price, and market momentum, aka dynamics.

Price alone does not work, it is the combination. Price + dynamics = value. Why is it so important to have an investment philosophy? When everything is going well and anyone can make money it isn’t, but when times get hard and markets do crazy things in the short term it is important to know what one believes, and to stick to it. My colleague just finished reading Michael Lewis’s The Big Short about a handful of investors who made a fortune when the real estate bubble burst, and he said it was fascinating to see what these few individuals went through. I jumped to a conclusion I think most people would – that these individuals who were correct about the collapse of the mortgage market must have been jubilant since they made so much money. He said no, it almost ruined them. When we hear these stories of big investors making all this money we tend to only think about the end and overlook the means.

We often believe these windfall investors had some kind of magical power, or unethical inside knowledge, to have made their investment at the perfect time. That does not happen. Ralph Wanger, the famous investor who specialized in investing in small companies, once said you must accept that a stock price will go down when you buy it, and that it will go up after you sell it. Therefore don’t beat yourself up about timing, but instead concentrate on what happens over the entire period you own it. That is easier said than done. Steve Eisman, one of the money managers who bet against the real estate market, first turned negative on real estate in 1997 when he was an analyst at Oppenheimer. He had to wait ten years for his conviction to pay off. Some of the characters in the book almost lost everything before the crash, when they were seeing losses on all their positions and clients therefore were demanding their money back. In times like that, having a good process is not enough. You need faith, and faith comes from a deeper place; it comes from a belief system, or your philosophy.

Not all philosophies are created equal. Many amateur investors will say their philosophy is “to never lose money,” or “to make 20 percent per year.” These are not philosophies, they are goals, or in these extreme examples, merely wishes. An investment philosophy can lead to great results, but it is not about the results. A successful investment philosophy must be based on who you are as an investor, because all philosophies will be tested in the market and keeping the faith during such times often is the key to success. They also must be based on sound investment reasoning.

Our philosophy at Iron Capital is greatly influenced by who I am. I am my parents’ son, influenced my entire life by people who believed deeply in wasting nothing, and getting the best price on the highest quality. Value investing – price and dynamics – fits into that belief system nicely. Our philosophy is also based on studying the careers and philosophies of great investors, from Benjamin Graham and Philip Fisher to Warren Buffett, Peter Lynch, Ralph Wanger, Bill Miller, Joel Greenblatt, Sir John Templeton, Jon Ness, and more. Each of these investors has a different way of describing his process and philosophy but, as with any discipline, they share a core set of fundamentals which can be summarized as the combination of price and dynamics. Some may emphasize one over the other, but in the end it takes both.

If what I am suggesting is true, that all successful investors have the same basic philosophy, then why wouldn’t everyone simply copy it, which ultimately would lead to it no longer working? Joel Greenblatt explains it well in his book, The Little Blue Book That Beats the Market, when he says that value investing always works in the long-term precisely because it does not always work in the short-term. There always have been and always will be periods of time when value investing does not work because the market is ignoring valuations. This usually happens in bubbles, but also has occurred over the past year as the geo-political crisis has driven the market more than the underlying value of the companies whose stocks constitute the market.

Times like this make it difficult to be a value investor. However, this too shall pass. Buying things for less than they are really worth is the recipe for longterm success. I remember my father coming home from work on days when my mother had been shopping. She would greet him by saying, “Come see all the money I saved you.” Some days I feel the same way. I wish I could invite every client into our conference room to show them all the money we have saved through the bargains out there today. My parents are comfortably retired in part because of all that money Mom saved, and is still saving. Old habits die hard.

Investment success is not complicated, but simple and easy are not the same thing. It takes discipline, patience, and a well-defined process. All of those things are made easier when you have a carefully developed philosophy, one based on sound investment principles and knowledge of who you are. I am my parents’ son, always searching for quality at the right price.

Charles E. Osborne, CFA, Managing Director

~“The Value of Knowing How to Find a Value”

They just don’t make things the way they used to. A few weeks ago my son, Charlie, came to me with a problem. He wanted to play with a kickball, but the ball had gone flat. I told him not to worry, we could go out to the garage and use the bicycle pump he had gotten for Christmas with his new bicycle (I’m cheap, but I wouldn’t give my kid just a pump for Christmas, don’t worry). So we went to the garage and I got the pump. Bicycle pumps have not changed much since I was a kid. I grew up in the 1970s, and as the youngest of five children I would guess that the pump we used was made in the early 1960s, about the time my eldest siblings would have been getting their first bicycles. All the parts were metal, including the nozzle. The nozzle had only one use and that was to blow up tires, mostly bicycle tires but it would have probably worked on a car tire as well. To blow up other items, like kick balls, you had to have a needle.

Based on my limited experience, in the last 40 years there have been two “improvements” to bicycle pumps: all that sturdy, last-forever metal has been replaced with break-if-you-look-at-it plastic, and the nozzle has a built-in needle, or at least it is built-in until you use it. I inserted the needle into the ball, pumped air into the ball, and pulled the nozzle away from the ball. Unfortunately, the needle stayed in the ball, which of course meant that all the recently pumped air quickly escaped while the pump had been rendered useless after one use.

The moral of this story is that it just isn’t as easy to inflate things today as it was in the ’70s.

Of course you wouldn’t know that if you listen to financial news, or just visit the grocery store or local gas station. Prices of commodities like oil, wheat and cotton have gone through the roof and inflation is on the lips of just about every financial pundit. Conventional wisdom is that inflation is on its way, if it isn’t already here. But is it true?

Some of you will think I am crazy for even suggesting that inflation may not be the great threat of our society today, and I understand that. After all, few things impact our day-to-day spending more than fuel and food, and those prices have risen a great deal and inflicted real pain on most people’s budgets. However, that is not inflation. A few months ago I had dinner with Dennis Lockhart, the president of the Atlanta branch of the Federal Reserve and one of the men who gets to vote on monetary policy. He used an analogy of tracking inflation being like tracking a swarm of bees: the Fed is trying to track the direction of the whole swarm, not just one or two bees. That is a good analogy. While the price of milk has been going up, the price of your house has been going down. As painful as today’s milk prices are on a daily basis, in the grand scale of life you will spend more on your home.

Homes are not the only area where prices are dropping. The idea for this article actually came to me when the firm upgraded the copier in our work room. One of my colleagues commented about how it seemed funny that we were getting a newer, faster copier for less than we had been spending on the old copier. I informed my colleague that we did this every two to three years and that has always been the case. But you don’t buy a copier every day.

You also don’t buy a TV every day. Last summer my family finally got with it and purchased a modern flat-panel HDTV. We paid approximately $700 for a 47-inch LCD. Not knowing a lot about TVs, my wife asked the installer if he thought we got a good deal. He put it this way, “A few years ago this TV would have cost you more than $4,000.”

I have friends who belong to the Apple cult. They waited in line to pay $599 for the original iPhone in 2007. You can get one today for $49 with a two-year contract from AT&T. Tracking that whole swarm of bees is not as simple as it may seem when you check out of the grocery store.

One of the problems with the inflation argument is that the loudest voices are coming from people who are selling commodity-related investments. They scare people with talk of inflation, tell them that the solution is to pile into commodities, and then when this speculation has caused the prices of commodities to rise, they say, ‘Look, here is our evidence of inflation. Now you should buy more commodities.’ Madoff is probably sitting in jail and wondering why he didn’t think of that. Unfortunately, intelligent conversation of complicated subjects does not fit in with today’s culture of texting and tweeting, and inflation is a complicated subject. As Lockhart was explaining with his swarm analogy, understanding what inflation is and what it is not is the first hurdle to that conversation. I will try to make this simple by using slightly different terminology.

Inflation happens when the general level of prices rise. For that to happen two things must occur. First, prices of a basket of goods must go up, and second, consumers of goods must continue to consume roughly the same basket of goods. If the price of one item, such as gasoline, goes up by itself people will either consume less gasoline, or consume less of other items in order to pay for the higher price of gas. This is what is occurring today. Inflation happens when one can pay the higher price and still consume the same basket of goods, and that can happen only if their supply of money has grown along with the rising price. Their supply of money can rise in only two ways: their income must increase and/or someone must loan them the money.

Inflation is what happens when the supply of money increases. A larger supply of money does not sound all bad, and it is not. Inflation is not like pregnancy – you can be just a little inflated and that is a good thing. Inflation comes from growth, so we want inflation. The alternative to inflation is deflation, which goes along with economic depressions, which we do not want. When people argue that the actions of the Fed are going to lead to inflation, what Ben Bernanke should say, or tweet, is simply, “Duh, that’s the point.” The Fed wants to see inflation at around two percent per year.

Of course when the commodity ETF-selling fear mongers use the word inflation, they never talk about specifics. They just make it sound scary, and make themselves out to be like Paul Revere riding to the rescue. “Inflation is coming! Inflation is coming! Buy my ETF and save yourself!” The fact is the environment we have been in for the last few years is stagnant to slightly deflationary. Have you felt good? If not, then you may welcome two percent inflation, or to put another way, a two percent growth in your money supply.

Inflation is not bad; runaway or hyper-inflation is bad, which is what we had in the ’70s. When inflation gets beyond four percent or so, it starts to get out of control. If inflation gets up to the double digits, watch out. When the money supply grows too quickly, money simply loses its value, and that, of course, is a bad thing. Many believe this is going to happen because of the large deficits and the easy monetary policy, a recipe that has, in part, led to inflation in the past. There is just one problem: today these policies are not leading to growth in anything other than the national debt.

The money supply for the nation is nothing more than your money supply plus mine plus all the other people out there. Has your money supply grown? Has your salary increased, or is it easier for you to get a loan than it was a few years ago? Wages are not growing and banks are not really lending, and until that happens we will not see inflation. This does not mean that speculators, combined with some poor harvests and unrest in the Middle East, can’t cause the price of commodities to rise. However, without growth in the money supply these price increases will simply cause consumers to cut back elsewhere and are more likely to cause a new recession than they are to cause inflation.

The same goes for our runaway deficits. Just ask the Japanese if government spending will bring about growth and inflation. It will not. Government spending tends to crowd out private spending, and empirical evidence suggests that private spending tends to deliver a greater multiplier effect than government spending does. In other words, millions of people making independent judgments with their own money will in aggregate spend more effectively for economic growth than will a small number of policy-makers spending other people’s money.

Even loose monetary policy will not do the trick by itself. Low interest rates make it more affordable to take on debt and increase your supply of money, but it doesn’t necessarily make people want to do it. Japan has had near-zero interest rates for as long as I can remember, but a dysfunctional banking system and a cultural bent towards saving has kept them from experiencing inflation.

My critics will say that we are different than Japan. They are correct, but as Mark Twain said, “History doesn’t repeat itself, but it rhymes.” There are no carbon copies, just common repeated themes. We are closer to looking like Japan of the 1990s than the U.S. of the 1970s. In the ’70s we had wage inflation and quality metal nozzles on bicycle pumps, both of which made it a lot easier for inflation to take hold. Today we have neither – something one should consider when making investment decisions, or buying their child a bike.

Charles E. Osborne, CFA, Managing Director

~Inflation

Alternative (adj). ~ Employing or following nontraditional or unconventional ideas, methods, etc.; existing outside the establishment.

Alternative is a loaded word, and I have to admit that it is not one I particularly like. My history with the term goes back to my high school years. It is always dangerous to date oneself, but I was in high school when “Alternative music” became popular. To be clear, I liked the music. I hated the term. You see, being alternative, a.k.a. unconventional, would mean I was different than the mainstream. Yet, everyone of my generation seemed to listen to so-called alternative music. Isn’t everyone doing it the definition of mainstream a.k.a. conventional?

Of course that was all in the childishness of high school, until it followed me into my profession. Nothing is more mainstream in today’s investment world than “alternative investments.” Just like high school I still hate the term. However, unlike then the word alternative carries different meaning in the investment world. If I get nothing across in this newsletter I hope I can drive this point into my readers: the word ‘alternative’ in the investment world has one meaning – outrageously high fees. This is the only universal truth of all investments under the so-called “alternative” label. If someone approaches you by saying, “I have a great alternative investment opportunity for you,” you must translate that as, “I have a great outrageously high fee investment opportunity that will pay me a lot more than any traditional investment I could sell.”

We will get back to that, but first some history. Where did this idea originate that there is some kind of alternative? It is all Harvard and Yale’s fault. In the late 1990s and early 2000s while the rest of the world was all excited about dot com-this and world wide web-that, the very smart people who ran the endowments for Harvard and Yale were investing in long-short absolute return strategies, private equity, natural resource limited partnerships, and other less obvious investments, moving away from the “traditional” equity market. The tech bubble burst and the stock market experienced a lost decade of huge volatility and no actual returns, and those smart guys at Harvard and Yale were making solid double-digit returns in their “alternative” investments.

The greatest form of flattery is imitation, so advisers and consultants started employing the ‘endowment model’ of investing, which led to a heavy use of so-called alternative investments. However – and this is key – Harvard and Yale endowments have huge asset bases and unparalleled networks for direct access to investment opportunities that smaller institutions and individual investors just cannot copy. So, in comes Wall Street with the solution: instead of investing directly in the private equity and/ or hedge funds that invest in these alternative spaces, smaller investors can use a ‘fund of funds.’ This means you would invest in a fund whose manager does not actually make investments but rather hires other managers who actually invest the money.

This is an extremely expensive way to invest money, because it adds yet another layer of fees. Even the supporters of this strategy will admit that it is less than ideal, but they claim it is worth it because this is the only way to gain access to these alternative assets and imitate the successful endowment funds. What do the guys who are being imitated say? David Swensen runs the Yale endowment and he discussed this phenomenon with The Wall Street Journal in January, 2009. When asked about investors imitating his success at Yale he responded, “…investors think they are emulating Yale, but they are not. Most use fund of funds and consultants, rather than making their own well-informed decisions.” When pressed further about fund of funds, Swensen said, “Fund of funds are a cancer on the institutional – investor world. They facilitate the flow of ignorant capital.” This may seem harsh, but blunt truth often does.

What struck me about Swensen’s comments was not actually the harsh words about fund of funds, since every legitimate investor will share this sentiment. What struck me was him saying people think they are imitating him but really they are not. So I revisited his book, Pioneering Portfolio Management, in which he describes the process he and his team use to invest the Yale endowment fund.

In his book Swensen describes a process that uses a great deal of direct decision-making. He talks about his team of investment professionals using their judgment in accurately valuing assets and determining reasonable future return estimates. He talks about knowing exactly what they own, and he spends a great deal of time discussing the importance of lowering cost. They do use hedge funds, although he never mentions that term; he talks instead about what the managers actually are doing. He also talks about complete transparency, working in partnership and negotiating the fees down. He also uses examples of specific investments Yale made directly.

What does he mean when he says that the emulators are not actually imitating? I believe he means that they simply are imitating the result – a result that is retrospective – and not the process, and especially not the cost discipline that led to the result.

So what was it in which Yale and Harvard were actually investing that has become known as ‘alternative?’ The list can be long and some people include many more investments than others – yet another reason to hate the term – but I will discuss the main three alternative investments: private equity, commodities, and hedge funds.

Private equity is simply ownership in private, or non-publicly traded companies. Historically, investors in this category look for companies that are new and have the potential to one day become publicly traded. The alternative pushers will pretend that there is some kind of magic about private equity. There is a natural mystique to it because you must be an accredited investor to participate. However, the reality is that owning a company is owning a company regardless of whether that company’s stock is traded publicly or privately. There is no reason that private equity would produce better returns than public equity over any meaningful investment horizon, and in fact it hasn’t.

Private equity funds do however have meaningfully different fees than public equity funds. It is not unusual for a private equity manager to charge four percent and take a large chunk of the profits. If you access these investments through a fund of funds you add another layer of fees and then pay your adviser, and by the time it is done it is unlikely you will ever see a positive return. We have seen cases where investors had to overcome nine percent in total fees before making a dime. That just about equals your expected return for private equity, which would net you a zero percent expected return.

Commodities are the hot thing today. RS Investments wrote a white paper about this subject, which the CFA Institue published. They even quoted Swensen. “Unlike commodity indices, which give investors simple price exposure, wellchosen and well-structured real assets investments provide price exposure plus an intrinsic rate of return. For example, oil and gas reserve purchases in the past two decades generated low double-digit rates of return above and beyond the return from holding period increases in energy prices. Price exposure plus an intrinsic rate of return trumps price exposure alone…. Pure commodity price exposure holds little interest to sensible investors.” In other words, owning a barrel of oil is never a sensible investment, but owning an oil well and/or an oil company can be. This was the conclusion of RS Investments study. An investor is better off in terms of both return and diversification by owning commodity related stocks than they are owning the commodities themselves, but one does not have to pay for the “alternative” label to own the stock of oil or mining companies.

Finally, in the land of alternatives, one must have hedge funds in his portfolio. As a side note, it pains me to even talk about hedge funds this way, because the words ‘hedge fund’ alone tells you nothing about in what you are actually investing. I don’t recall Swensen ever using the term. He, like any wise investor, is looking beyond legal structures and labels to the actual investment. ’Hedge fund’ is alternative language. There are just about as many hedge fund strategies as there are hedge funds, but the most common is some form of absolute return strategy where the manager is investing both long (traditional equity ownership) and short (selling stock you don’t actually own in the hopes the price goes down before you have to cover i.e. buy the shares you already sold). In other words, they buy and sell stocks and/or bonds. Please, say that again so you get it: ‘Hedge funds buy and sell stocks and/or bonds.’

The idea is that by going both long and short, the hedge fund manager can eliminate the effect of market movements. As long as his long stocks go up more or down less than the market, and his short stocks go up less or down more than the market, he can deliver positive returns. In other words the only return you get is the manager’s value added, instead of the traditional manager where you get the market return plus or minus the manager’s value added.

Here is the rub: the very same people who push hedge funds, and especially hedge fund of funds, are often the people who will tell you that managers can’t add value. There is no intellectually consistent argument for indexing your traditional equity exposure, supposedly because managers cannot overcome their traditional fees of one percent or less, and then allocating heavily in hedge fund of funds paying fees two to three times as high. After all, the only returns from the hedge funds are the managers’ value added, and by indexing the rest of the portfolio you are saying that you believe a manager’s value added is negative, at least on a net of fee basis. If that is your belief then you are investing in an instrument that you must believe represents a negative expected return from day one. This is idiocy dressed up in faux sophistication.

Wise investors avoid labels. Benjamin Graham defined an investment as follows: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.” He didn’t use the word ‘stock’ or the word ‘bond.’ He didn’t say ‘traditional investment’ or ‘alternative.’ These terms are pure garbage spewed by people whose lack of true investing knowledge is only surpassed by their insecure need to be thought of as intelligent. It would be comical if they didn’t do so much harm.

One of the greatest impediments to Graham’s adequate return requisite is the cost of investing that must be overcome. In this regard Swensen is absolutely correct to call fund of funds a cancer. To truly emulate the Ivy league endowments one would invest as directly as possible, eliminating layers of fees. One would invest using a disciplined process that led to selecting investments that promised safety of principal and an adequate return. One would not care how those investments were labeled – traditional, alternative or otherwise. After all, when one looks under the hood, the only alternative thing about alternative investing is the cost. When it comes to investing, there is no alternative. When it comes to cost, alternative simply means outrageous fees.We will not follow the crowd in their folly. Our duty to you our clients is not to follow fads, but rather to seek safety for your principal and an adequate return.

Charles E. Osborne, CFA, Managing Director

~There is no ‘Alternative’

In the spirit of modern day discourse, I wish it to be known that so-called passive investing – the use of index funds and/or ETFs – as a long-term investment strategy is not just less than optimal, it is morally irreprehensible and frankly the root of all evil in the universe.

Okay, maybe that is a little over the top. (I have been told I should jazz up my writing style in order to keep up with the edgy blogosphere.) However, it is my position that “passive index investing” as a long-term strategy is not just a poor way to invest, but is actually wrong. A note of caution: I am not saying ETFs and index funds do not have some uses. We often use them to gain exposure to the markets while looking for better long-term opportunities, but they should not be the core of any long-term strategy.

There are a lot of very smart people who disagree with this position, so I don’t make this argument lightly. They will claim that active investment managers don’t beat the index, and even if a few do, they cannot be identified ahead of time. I will argue that they are wrong about that, but even if they were not, indexing is still wrong. Indexing is wrong because of how it distorts the free flow of capital in the market, and the way the concept is abused in actual practice makes this distortion even worse.

Before we get to that, let’s address the usual arguments for indexing. Argument 1: The average active investment manager never beats the market. This is absolutely true; you get no argument from me. It is also true that the average college basketball coach never gets to coach in a Final Four game, let alone win a championship. I have not seen a study, but I would wager a guess that the average college basketball coach will end his career with a losing record. It doesn’t have to stop there. The average touring golf pro never wins a tournament, let alone a major. I could fill a book of examples where average isn’t very good.

Fortunately for basketball fans, John Wooden wasn’t average, neither were Adolph Rupp, Dean Smith or (as much as it pains me to admit) Mike Krzyzewski. Arnold Palmer, Jack Nicklaus, Phil Mickelson and yes, the philandering Tiger Woods, aren’t exactly average either. Talent exists. It exists in every human endeavor, so why in the world would anyone believe that the management of investment portfolios is any different.

Of course this leads us to the next big argument. Argument 2: You cannot pick a winning manager by using past performance. Again, true, you get no argument from me. However, contrary to what most believe, this is not the same as saying you can’t pick a winning manager. John Wooden defined success as “peace of mind which is a direct result of self-satisfaction in knowing you made the effort to become the best which you are capable.” John Wooden led the UCLA Bruins to ten NCAA championships, seven in a row. But winning championships was not his definition of success; it was a byproduct of his definition of success. In my experience this is true for just about every truly successful person I have ever known or known about, including consistently successful investment managers.

In the investment world it is about process, process, process. Investment managers form a process that is intellectually sound and consistent, and they are always trying to improve upon it. Results are a byproduct; it is the process they want to talk about. By focusing on the process ourselves, we have consistently been able to identify superior managers, as well as beat the market. (For more on process leading to long term out-performance I recommend reading “The Superinvestors of Graham and Doddsville,” an essay by Warren Buffett, which can be found on-line at no cost.)

So the two big arguments for passive index investing do not hold up. However, even if they did, indexing is still wrong because of what it does to the market. This goes to the very purpose of capitalism and free financial markets. The free market exists for the purpose of allocating capital throughout society. The marketplace allows investors to sell stock in a company whose future no longer seems bright – at least to that investor – and to purchase stock in another company that has a brighter future. In other words, the market allocates capital to its best possible use, maximizing the growth of the whole economy. The market’s ability to do this has been questioned over the last few years, largely because of the misunderstanding of risk that led to distortions, but also because too many investors are no longer actively seeking to allocate their money across what they really believe are the best companies. Too many are passively investing in index products that place the most capital where the most capital already exists, instead of where it needs to be going. In other words, companies are rewarded with fresh capital not because they are deserving but because they are big and already in the index.

To use the language of the anti-market people, the rich get richer. This is the byproduct of widespread use of passive index investment instruments. This is how we get Enron, WorldCom, Tyco, Lehman Brothers, etc. Sure, I know active managers that may have been fooled by one or two of these bad stories, but the only fund I know that had them all is the index fund. Passive investing is also a mindset that impacts things like how proxies are voted. If one is passively investing in an index, then he probably does not care what the CEO of one of the 500 companies whose stock he indirectly owns is getting paid. The passive attitude of too many shareholders has allowed many of the scandals of the last decade to occur, and I personally believe the concept of passive index investing has played a big part in that.

There is another major flaw in the index investing theory: it cannot actually be done. The index is not real. Read the index disclaimer sometime, it often says so right there. One cannot invest in the index. The index itself is a collection of securities, usually chosen by a committee or a formula, whose prices are tracked and combined to produce a proxy for the market’s return. There are no transaction costs in the actual index, and the real world does not work that way. Index products have relatively low price tags, but there is no such thing as free investing.

Index funds have costs, and those costs are higher than most people realize. If you purchase an index mutual fund you will pay a management fee. Your returns also will be net of internal transaction costs. The index fund seeks to mimic the returns of the actual index, usually by purchasing all the securities in the index. Let’s use the most popular S&P 500 as our example. The fund goes out and purchases the stocks of the 500 companies in the S&P 500 index in proper proportion. Index funds use sophisticated trading strategies to minimize this cost, but it is still there.

If, instead of a mutual fund you decide to purchase an ETF, the ride gets even better. ETFs have commissions and dealer spreads associated with them, so they are more expensive to purchase and they compensate with lower management fees. Because they can be traded during the day, they also have the disadvantage of not always selling at NAV (the market value of the actual stocks owned by the ETF). In a rising market the typical S&P 500 ETF will sell at a premium, because there are more buyers than sellers. When the market heads south, it sells at a discount, and this time there are more sellers than buyers. Investors lose in both directions.

A few years ago one of our newer analysts suggested we should place all the index options in our institutional clients’ plans on the watch list. Her reason was that they all had a reverse upside, downside capture. Yet index funds and ETFs will always underperform their index. They will go up less in up markets, and they will go down more in down markets. We typically do not like managers with that kind of record, but our analyst did not realize that all index funds will always do this.

Let me say this again, because it is worth repeating: the next time some index-hugger tells you whatever percentage of active managers don’t beat the index (over the last ten years, it is about 40%, but the index believer is likely to exaggerate), remind him that 100% of all index funds and ETFs never beat their indexes. The index investor is settling for known failure.

Indexing also impacts many “active” managers. I once had a portfolio manager in my conference room talk for twenty minutes about all the reasons he did not like Exxon as an investment. It’s not relevant to the story whether he was correct; what does matter is that Exxon was in his top five holdings. I asked him about that, and his response was that it was the largest holding in the index to which he was benchmarked. To him this was a significant underweight. This manager was not trying to deliver adequate returns to his clients, he was trying to protect his job by never being too far off from the index.

In the institutional world many managers talk about risk as being tracking error, or the amount their portfolios differ from the index. To me this is one of the more hideous evils of indexing, and consequently why so many “active” managers fail to beat their indexes. One cannot beat the index by looking like the index. If one’s goal is to not stray too far from their benchmark, instead of being the best he can be, then one shouldn’t be surprised when they fail both to beat the index and to be the best they could be.

The last major problem with index investing in practice is that there is no such thing as an intellectually consistent methodology for passive investing. Almost all passive index investors have been sold by someone who claims to be a superior asset allocator. In other words, they use passive index instruments as tools to make active asset allocation decisions. According to the “Crosscurrents” newsletter, the average holding period for U.S. stocks has gone from two years in the 1980s to just 2.8 months today. There are several reasons for this but among the top three is the explosion of ETFs. A large contingent of so-called passive investors are using these instruments to be more active than anyone would have even dreamed possible 20 years ago, and they are contributing to the massive volatility of the market in the process.

Worse yet, many have been convinced that passive is the way to go for “traditional” investments, but “alternative” investments are different, warranting huge hedge fund fund-of-fund management fees. Stay tuned until next quarter’s newsletter for that discussion.

In the meantime, know what you own and own it deliberately. Life is too important and too short to go through passively. We need the free flow of capital in our society to bring back growth and prosperity. We need capital to go to those who are deserving, not to those who just happen to be in an index. We need shareholders once again to act like owners.

Charles E. Osborne, CFA, Managing Director

~Indexing is Evil!

“Let me tell you how it will be; there’s one for you, nineteen for me – ’cause I’m the taxman, yeah the taxman. …If you drive a car, I’ll tax the street; if you sit I’ll tax the seat; if you get cold, I’ll tax the heat; if you walk, I’ll tax your feet… ’Cause I’m the taxman, yeah I’m the taxman.” ~The Beatles

In this issue, we wrap up our series on politics and economics with discussion of an issue on everyone’s mind right now: Should we raise taxes? Those on the right argue this would be harmful to the economy at a time when the economy is already weak. Those on the left say we need to raise taxes to fight the deficit. Who is correct?

Last quarter, I talked about how economic advisers to administrations tend to be economists first and political advisers second. I do not believe that it is a coincidence that while President Obama has drawn a line in the sand saying that the Bush tax cuts must go away for top income earners, two of his top economic   advisers have done just that – gone away. First, Christina Romer resigned her post as Chairman of the Council of Economic Advisors. Her resignation was coincidently well-timed with the publication of a research paper she co-authored with her husband in which Romer stated there is empirical evidence that “tax increases appear to have a very large, sustained, and highly significant negative impact on output.” Not exactly what her then-boss wanted to hear as he campaigns to raise taxes. Romer is now home once again, teaching at the University of California at Berkeley.

After Romer’s departure, White House National Economic Council Director Larry Summers announced he would leave the administration to rejoin the faculty at Harvard where his colleagues, Alberto Alesina and Silvia Ardagna, recently published another paper stating that the empirical evidence suggests “… that tax cuts are more expansionary than spending increases in the cases of a fiscal stimulus. Based upon these correlations we would argue that the current stimulus package in the U.S. is too much tilted in the direction of spending rather than tax cuts. For fiscal adjustments, we show that spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions.”

Seeing reports like these published by  faculty at traditionally liberal institutions such as Harvard and Berkeley brings hope that we may be getting back to a day of higher political discourse. In my youth today’s debate over taxes would have been carried forth by people like Daniel Patrick Moynihan on the left and William F. Buckley on the right, while today we get Michael Moore and Glen Beck. We might all agree this is an astonishing decline in the level of national discourse.

“Everyone,” Moynihan liked to say, “is entitled to his own opinion, but not to his own facts.” The fact is raising taxes will be harmful to the economy and will be less effective in lowering the deficit than spending cuts. To raise the level of discourse on this issue, we might try to understand why tax rate increases are harmful to the economy, and in fact do not always produce more tax revenue, and why tax rate decreases are helpful to the economy and often actually increase tax revenues.

Taxes represent a cost to consumers and businesses alike, and revenue to the government. In my opinion, one of the best ways to think of taxes is to think of them as the price of a product or service. Let’s say that we are a retailer like Wal-Mart, we’ll call ourselves IC-Mart. The prices we put on our products are costs to our customers and revenue to us, just like taxes for the government. If we are going to open our store we have to decide what price to put on our various products. Our goal of course is the same goal of any store, to maximize our long-term profits, so how do we set the prices?

If we set the prices very high, we will make a lot of money on each item and have a very high profit margin. However, if they are too high, no one will be willing to buy from us and although we have a high profit margin, we will have low volume and not make much money, or potentially lose money. We could set our prices very low, in which case we could attract a lot of customers and have a really high volume of sales, but we would have a very low profit margin on each sale, and potentially lose money once again. The trick is finding the right price where you maximize the combination of profit margin with volume. If our prices are too high, then lowering them will actually increase our revenues and total profits. On the other hand, if our prices are too low, then increasing them may make sense.

These same forces impact tax rates and revenues. The idea that simply raising the tax rate will increase revenues, or that lowering the rate decreases revenues, is just plain wrong. However, it is also oversimplified to think that you can just lower taxes and always get more revenue. Taxes work like prices and the effect of raising or lowering them will depend largely on what the current level of taxes are and what the current economic environment is like.

One of the common arguments on the left today is that Clinton raised taxes and the 1990s were a great economic success. Therefore raising taxes this time won’t hurt the economy. This would be funny if it were not so dangerous. In fairness this argument ranks up there with some in the Bush administration who argued that deficits didn’t matter because Reagan had big deficits and the economy did great in the 1980s. Both arguments are evidence of the lessthoughtful Moore-Beck era of political discourse and would have been immediately dismissed by the more thoughtful Moynihan-Buckley era.

The fact is that looking at total economic activity during a short period of time does not show the exact impact Clinton’s tax increases had, or for that matter the impact of Reagan’s tax cuts. In order to know for certain, one would need to have the ability to go back in time and create an alternative reality where opposite policies were enacted, and see the difference. The 1980s saw not only a decrease in tax rates but also a reduction in regulation and the collapse of the Soviet Union, all of which contributed to economic prosperity in the U.S. The 1990s were defined economically by a period of unprecedented world peace and the dawning of the internet age, and these factors alone were going to raise the economy regardless of tax policy. Reagan lowered taxes from a rate as high as 70%, while Clinton raised taxes modestly from relatively low rates. All of these factors must be considered. Economic theory, reason, and common sense tell us that taxes should be thought of as a necessary evil. As such they should be kept as low as possible. Do tax rates need to go up today? Will raising  taxes in these uncertain economic times be catastrophic?

The answers to those questions are not nearly as clear as our political pundits wish to make you think. There is no doubt the government is going to need more revenue in order to dig out of the hole it has dug, but higher tax rates don’t always equal more revenue. Remember, taxes work like prices. You are probably thinking, ‘but Chuck, I don’t have to buy things in your store, but I do have to pay taxes.’ That is true for most of us, but the wealthier you are, the less true it becomes. The “rich” have a great deal of control over how much money they make. The majority of the rich are business owners, and they can decide how much they want to work to grow their business. If growing their business means paying more in taxes but not really taking more money home, then they are likely to spend more time on the golf course and less in the office. In addition, not all taxes are created equal. The capital gains tax, for example, is a largely voluntary tax which one can avoid paying by simply refusing to sell the asset that has appreciated in value. The rich get much of their money from investment income, including capital gains.

Don’t just take my word for it, look at the facts. The Bush tax cuts have been criticized for helping only the rich and in part, if not single-handedly, causing the much-discussed income gap. However, two years after the Bush tax cuts, tax revenues from people making more than $1 million a year were up 80%, from $132 billion to $236 billion. The Treasury Department estimates that without the Bush tax cuts, the top 1% of income earners would pay 31% of all  taxes and the top 10% would be paying 63%. With the tax cuts, the top 1% actually pay 37% of all tax revenue and the top 10% pay 68%.

There is indeed a concerning income gap: the top 1% makes 19% of the income in America and the top 10% make 44%. I would contend that this is a symptom and not a cause of the growing cultural gap in our country, but that is a subject for another day. The fact is the Bush tax cuts actually caused tax receipts to be more progressive than they were before. This is true because unlike the rich, those who live paycheckto-paycheck don’t have any control over how much tax they actually pay. It is this reason that increasing the tax burden on the rich ultimately ends up being a tax increase to the middle class, because it is only the middle class that has the combination of enough money to tax but not enough to play the game and avoid taxation. When taxes go up, the rich avoid them and the middle class ends up carrying more of the burden.

This is the theory of why raising taxes is not a good solution for narrowing the deficit, and the research of Alesina and Ardagna shows that this holds true in the real world. However it does not leave us with the answer to our second question, Will the tax increases be catastrophic? I don’t think so. They will be harmful, but probably not to the extent of being catastrophic, at least not from an equity investment point of view. I say this because I believe the tax increases are currently priced in the market. The looming tax increases are a big reason economic activity is so slow right now. If the Bush cuts are made permanent or at least extended for five years or more, I think you will see a big up tick in the market and the economy. It would surprise me if there was a big negative reaction to the cuts lapsing.

In the long run, I would side with Winston Churchill who once said, “We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” Raising taxes will not get us out of the mess we have created. The only way out is to grow our way out, but that requires growth friendly policies from our government. That will require a massive change in direction.

Charles E. Osborne, CFA, Managing Director

~A Taxing Debate!