Can you tell us how you really feel about your former employer, Mr. Smith? For those who may have missed it, Greg Smith was an employee at Goldman Sachs until this past March when he resigned and had his stinging resignation letter published in The New York Times. He claimed that Goldman Sachs has become a toxic environment where the firm thinks only about its own profits and cares little for its clients. He relayed stories in which senior-level executives referred to clients as “muppets” and the most common question asked about an investment is, “How much money did we make off the client?”

His letter quickly went viral, posted and shared throughout the internet and various social media sites. If his fifteen minutes of fame was what Smith had in mind he succeeded, perhaps at the cost of his career. His letter was one-sided and perhaps a bit extreme, but it did sound very familiar to me.

I saw similar things in my previous career, which motivated me to start Iron Capital. Too many people see stories like this and go immediately to the easy conclusion that “those people are just greedy,” or “they are bad people.” That is too simple, and not realistic. The problem is much bigger, and it is about the entire structure of Wall Street. Interestingly, Jamie Dimon of JP Morgan commanded his people not to take advantage of Mr. Smith’s story. Perhaps he was just taking the high road, but it seems more likely to me that he understood that that letter could have easily been written by one of his employees, or by anyone from any other Wall Street firm.

The problem with Wall Street today boils down to the simple truth that one cannot serve two masters. I started my investment career 20 years ago, and back then stock brokers were stock brokers. They were drilled on the fact that they could not and would not provide advice. They could guide their customers, just like any good sales clerk, but they absolutely did not provide advice. Today, just 20 years later, they call themselves financial advisers. Smith is pointing out the problem with this dual identity. He even states in his letter that he had “the privilege of advising two of the largest hedge funds on the planet.” I am sure he really believes this, but that is complete nonsense. The two largest hedge funds on the planet are not seeking the investment advice of a mid-level derivatives broker at Goldman Sachs. They may buy derivatives from him, but they are doing their own research and when they pick up the phone to call a Wall Street firm they are looking for someone to fulfill an order. They want a broker, not an adviser.

This is the conflict that Smith has going through his mind. He is trying to reconcile his job as a seller of a product with his self image of being an adviser, and he can’t do it. He can’t do it at Goldman and he won’t be able to do it anywhere else, because it cannot be done. One simply cannot serve two masters: one cannot ethically be on both sides of the table.

We have been preaching this message since our founding in 2003, but I think it is hard for many people to fully underWe have been preaching this message since our founding in 2003, but I think it is hard for many people to fully understand. In a relatively short period of time Wall Street and its marketing machine have convinced a generation that they are there to give advice, which is a huge conflict of interest and a fundamental flaw in the business model.

In 2004 the SEC and the Department of Labor (DOL) teamed up to investigate the advice given to retirement plans. They came out with a list of ten questions that retirement plan sponsors should ask their advisers to ensure that they were receiving objective advice. We use this list in our institutional business, and in reading Smith’s letter I realized that it would be good to share it with private clients as well. After all, a large retirement plan may be more complicated, but fundamentally it is still just an investor seeking investment advice. If the SEC and DOL guidance is good for retirement plan sponsors, it should be good for individual investors as well. Here are the questions:

1. Are you registered with the SEC or a state securities regulator as an investment adviser? If so, have you provided me with all the disclosures required under those laws (including Part II of Form ADV)?
Note that they do not ask if you are registered or “licensed” with a brokerdealer, which is the bad advice often given to individuals. In the investment world we often use the terms buy-side and sell-side. The sell-side is what most think of as Wall Street – they create and sell products. The buy-side is the investors and fiduciaries acting on behalf of investors. Traditionally, sell-side firms are registered as broker-dealers and their employees as representatives of the broker-dealer. Buy-side firms register with the SEC as investment advisers.

Objective advice is a buy-side function. Unfortunately this line has blurred as many firms have become dually registered. That simply sounds confusing to most people, but if instead of saying dually registered one used plain English and said they represent both the buyer and the seller, the conflict of interest becomes clearer.

2. Do you or a related company have relationships with money managers that you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, describe those relationships?
Immediately they ask about conflicts of interest. One cannot give objective advice while being paid by the product they are selling.

3. Do you or a related company receive any payments from money managers you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, what is the extent of these payments in relation to your other income (revenue)?
Here they basically repeat the last question in a slightly different manner, emphasizing the importance of independence.

4. Do you have any policies or procedures to address conflicts of interest or to prevent these payments or relationships from being considered when you provide advice to your clients?
We do not believe conflicts can be overcome, but because the vast majority of firms do have serious conflicts woven into their very business models, this question has to be asked.

5. If you allow plans to pay your consulting fees using the plan’s brokerage commissions, do you monitor the amount of commissions paid and alert plans when consulting fees have been paid in full? If not, how can a plan make sure it does not over-pay its consulting fees?
This question may not sound relevant to individuals, however: If you are paying your adviser through commissions, how do you know how much you have paid?

6. If you allow plans to pay your consulting fees using the plan’s brokerage commissions, what steps do you take to ensure that the plan receives best execution for its securities trades?
If you are getting advice from a traditional broker, the expenses you pay are actually revenue to them and to their firm. There is no way you are getting best execution.

7. Do you have any arrangements with broker-dealers under which you or a related company will benefit if money managers place trades for their clients with such broker-dealers?
This is huge for individual investors. A critical point: The SEC and DOL are suggesting that investors should be leery of anyone that has any “arrangement” with a broker-dealer. Again, a broker-dealer is the sell-side, or what one might think of as a Wall Street firm; Goldman Sachs, Merrill Lynch, Morgan Stanley, Charles Schwab, and E-trade are all brokerdealers. They are the firms that custody assets, sell products and execute trades on behalf of their customers. This is exactly where the vast majority of individual investors get their “advice,” and the SEC and DOL are telling institutional investors that they should be concerned if there is any business connection, let alone the adviser being an actual employee of the broker-dealer.

I have been preaching this message for years. I think some of our clients and readers get it, but others probably just hear this as me promoting our business model. This is not coming from me; it comes from two government agencies tasked with protecting retirement plan investors, and the implication is clear: Do not take advice from an employee of a broker-dealer.

8. If you are hired, will you acknowledge in writing that you have a fiduciary obligation as an investment adviser to the plan while providing the consulting services we are seeking?
Broker-dealers and their employees do not have a fiduciary responsibility to their customers. This does not mean that they have no responsibility. Like any merchant selling a product, they should stand by their product and they should not sell anything that is not suitable. But, being a fiduciary is a much higher standard.

9. Do you consider yourself a fiduciary under ERISA with respect to the recommendations you provide the plan?
The highest standard for fiduciaries is provided by the Employee Retirement Income Security Act (ERISA). Under ERISA a fiduciary must act solely in the interest of the plan and plan participants. When we started Iron Capital we were among a very small group that accepted this level of responsibility; today I am glad to say that we have many more competitors. Some have been dragged kicking and screaming by client demands, but several firms share our belief that this is the way an advisory firm should operate.

10. What percentage of your plan clients utilize money managers, investment funds, brokerage services or other service providers from whom you receive fees?
I can’t say it enough: One cannot serve two masters. When you are getting paid to sell a product you are not able to also provide objective advice, period.

That does not mean that salespeople are bad people. They are by nature competitive people. They want to win, and winning means selling the customer their product. When the customer does not cooperate they may get frustrated and say things in the privacy of their offices out of emotion, such as calling a customer a “muppet.” They are and always have been rewarded by their employer by bringing in revenue. They legitimately want to know how much money the firm made from their sales efforts. There is nothing wrong with this. We expect this from a salesperson. I’m sure the clerk at Brooks Brothers thinks I am crazy for not liking the ties he suggests. We all laugh when Julia Roberts, in the famous scene from “Pretty Woman,” goes into the store that had refused to help her the day before with her arms full of packages and asks if the clerk works on commission. Holding out her packages she says, “Big mistake. Big. Huge!”

There is nothing wrong with being a salesperson, as long as one is honest about it. The problem with Wall Street today is that its salespeople have been convinced through training and marketing spin that they are, in fact, advisers. Smith’s letter is the result of this identity conflict. He believes that he was supposed to be a trusted adviser, but he lived in a sales culture.

Many investors today believe they are working with a trusted adviser, but in reality are simply buying products from a nice salesperson. This may be what one wants. Brokers did very well before the culture of Wall Street started to deceive people about their role. However, if advice is what you seek, then take some from the SEC and DOL and ask your adviser the ten questions. You may be surprised about what you learn.

Charles E. Osborne, CFA, Managing Director

~Mr. Smith Goes to Wall Street.

WHEN I WAS A KID, my family took a lot of road trips. We went to the beach, to Disney World, to visit relatives …always in the car. Most of the time my mother, my siblings and I would fall asleep while Dad motored down the road. When we woke up, we always asked the same question, “Where are we?” My father would always respond, “I don’t know, but we are making good time.” Well, I have good news and bad news. The bad news is that most people believe America is headed in the wrong direction. The good news is that we are making good time. I have seen these polls for years: Anywhere between 70 to 80% of us think our country is headed in the wrong direction. But, has anyone asked in what direction we are heading?

I came up with the idea for this newsletter while waiting inline to go through security at the airport shortly after the 10th anniversary of 9/11. I was thinking about how our country had changed since 2001, and I had been reading an article inThe Economist about Russia. According to the article more Russians want to leave Russia now than at any time since the collapse of the Soviet Union. Standing in the winding line preparing to partially disrobe for security I couldn’t help thinking, “Was traveling the Soviet Union any more difficult than this?” Intellectually I know the answer is yes; we may feel harassed by the new security measures, but we can still go wherever we wish in this country.However, standing in that crowded line being herded like cattle, it hit me: we are less free today than we were 10 years ago, and we are heading in the direction of increasingly less freedom.

When I began research for this article I thought I would talk about how increased regulation has slowed economic growth and created uncertainty, and therefore decreased investment returns while increasing volatility.However, in doing the research and paying attention to every mention of new rules, I began to realize this issue is much bigger. Every day I was printing off two or three articles about some crazy regulation or law. The examples are too plentiful to list, but my favorite was a family in San Juan Capistrano, Ca. that was fined for having a Bible study in their home because a local ordinance prohibits groups of three or more from gathering without a permit. I think that bears repeating: There is a city in the United States of America where it is against the law for three or more people to gather.

In 2000, the United States ranked third in the world in terms of economic freedom, behind Hong Kong and Singapore,according to the Index of Economic Freedom published by the Heritage Foundation and The Wall Street Journal. We have dropped to tenth and our momentum continues in the wrong direction.

According to a recent article in The Wall Street Journal there are 4,500 federal criminal statutes. This does not include the300,000+ regulations that are not in the federal code but that can carry criminal penalties including prison. I want to make it clear that I do not believe any rational person would want to live in a society with no rules or laws. But, how many laws do we really need? Moses came down from Mt. Sinai with ten, and Jesus said the ten really can be summed up in two, the second of which is known as the Golden Rule: Do unto others as you would have them do unto you. It is universal, and some variation exists in all mainstream religions and/or philosophies.Going to one law may be a little too simplistic, but somewhere between one and 4500 there has to be a happy medium, and my guess is that it is closer to one than to 4500.There is substantial evidence that more laws and more regulations can be counterproductive. Hans Monderman may not be familiar toyou, but he is as famous as a traffic engineer ever gets. He was a Dutch engineer who realized that most modern safety infrastructure –warning signs, traffic lights, guard rails, curbs, painted lines,speed bumps and so on – is not only often unnecessary, but can actually endanger those it is meant to protect. His favorite maxim was, “When you treat people like idiots, they’ll behave like idiots.”

Monderman made his name in the provincial city of Drachten. In the center of town was a congested four-way intersection that was dangerous and constantly overcrowded.He removed all the lights and every other traffic sign he could without violating Dutch law, and replaced them all with a radical type of roundabout,which he called a square about, marked only by a raised circle of grass in the middle and several fountains. After his transformation,congestion decreased and, more remarkably, the number of accidents per year was cut in half. By doing away with the signs and lights he actuallym ade drivers think, and by forcing people to think, he made the intersection safer while improving traffic. Interestingly, surveys found that locals perceive the intersection to be more dangerous after the changes,even though the evidence clearly shows the opposite. That was music to Monderman’s ears. In an article for The Wilson Quarterly, he said that if they had not felt less secure he would have changed it immediately.

Regulations are usually brought forth in an effort to protect people.The great example of our time is the duo of Fannie Mae and Freddie Mac,whose entire purpose was to grow housing by bringing a quasi-government guarantee of mortgages, which made investors feel like mortgage securities were “almost as safe as treasuries.” That false sense of security was a major contributor to the housing bubble and ensuing crash. If investors knew how risky mortgages could be, their behavior may have been different.

This is not the only problem that regulation brings forth. As Milton Freidman points out in his 1962 classic, Capitalism and Freedom, regulation goes hand in hand with inequality. Regulation by definition directly impacts a targeted group; however, the costs are spread through the masses.This creates a dynamic where you have a highly motivated, organized and usually well-funded minority that wishes to bend regulation to their favor versus the majority, which is largely disinterested in any one particular regulation. Increasingly regulation is drafted to favor the politically connected and motivated, often at the expense of the majority. There has been a lot of talk about the growing inequality in the United States,but little intelligent discussion of its actual cause. I contend that it is not a coincidence that inequality in our society has grown hand-in-hand with regulation.

The great equalizer in America’s past has always been social mobility –the American dream of rags to riches in a generation. Historically we have not held a poor opinion of the wealthy because most of us believe they must have done something to deserve their wealth, and we hold the belief that we can one day join them if that is an aspiration. The more regulated our society becomes, the less possible this becomes. Regulation first and foremost protects the status quo.
Eric Schmidt, executive chairman of Google, summed it up when he told theWashington Post, “…[R]egulation prohibits real innovation, because the regulation essentially defines a path to follow – which by definition has a bias to the current outcome, because it’s a path for the current outcome.”The explosion of innovation in the internet happened because the internet was new and therefore largely un-regulated. If it had not been for the deregulation of the phone system it is very probable that there would be no internet today. No Google, no Amazon, no Facebook, and certainly no iPhone to access all the aforementioned.

Regulation inhibits competition, especially competition from a completely new innovation. Take my industry as an example:The more regulated the financial industry becomes, the more difficult it becomes for the Iron Capital’s of the world to compete with the JP Morgan’s of the world. There is no amount of regulation with which JP Morgan, Goldman Sachs,etc., cannot afford to comply. There will be a point when independent boutiques like Iron Capital will no longer be able to stay in business as stand-alone entities. This protects the status quo and prohibits real reform, which would come from more customer-friendly competitors.

This is why we see industries and specific companies spend a fortune in lobbying politicians; they do it to shape regulation to give themselves an advantage. This is the cronyism that has so many people upset today. Look at the banks: The crisis of 2008 was supposedly caused because some financial firms had become “too big to fail.” The story goes that they were un-regulated and out of control, So Dodd-Frank passes with the mother load of new rules, many of which have not yet taken effect. Today there are already fewer national banks and the ones remaining are significantly larger than they were in 2007. If they were “too big to fail” then, they must be “too bigger to fail” now.

Regulation also leads to deterioration in ethics. In 2011, we saw the collapse of financial derivatives broker MF Global,which evidently stole up to $1.2 billion from their clients. Ina heavily regulated environment the mindset often becomes,“What can we get away with?” As opposed to, “What is the right thing to do?” Jon Corzine, the former governor of New Jersey and CEO of MF Global, testified before Congress thatall of his actions were legal. He was assured of this by his operations staff. If Jon Corzine simply had to ask himself,“How would I feel if someone stole my money out of my brokerage account?” as opposed to “Is there a way we cando this and have it be legal?” then MF Global clients would be $1.2 billion richer today. The very fact that he felt the need to verify what he was about to do was legal shows how compliance with a web of regulation ends up substituting for simple ethical judgment.

If the growth in regulation goes far enough, we end up in a situation where regulatory compliance is a matter of figuring out which rules the regulators are actually going to en forceand which they are not. It is a short step from there to bribery being the only way anything can get done. Regulation is the yeast of corruption.

This is the direction the United States is going. We are becoming more regulated and less free. We show all the known symptoms: Social mobility has been decreased;inequality has risen; cronyism is the way to success. These are the attributes of a regulated society. The question is, willwe realize this and actually change direction, or will we just continue down the same path, knowing something is wrong but simply blaming “government” or “Wall Street” instead of seriously asking what is it that is wrong and what can be done to fix it? Will we see the wisdom of Monderman, that sometimes less is more? With freedom comes responsibility and personal accountability. If we once again embrace it, we may well find that life is actually safer and more fair without all that safety apparatus.

Charles E. Osborne, CFA, Managing Director

~We’re Making Good Time

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’