We are thankfully coming to the end of what has been the longest, and in my opinion the least substantive, presidential race in American history. Oh, we all know who the latest internet poll says is winning, but can anyone accurately describe either candidate’s platform? On August 25 of this year the Wall Street Journal reported on a Pew Research poll which recently discovered that, for the first time, more than 50% of Americans knew that the Democrats have been in control of Congress. If our media have failed to relay this basic fact to the American people, how well do you think they have done in educating people on the nuances of the candidates’ economic policies?

Okay, I know what you are thinking, is Chuck actually going to talk about politics? We try to avoid such subjects at Iron Capital, as we advise clients of all political persuasions and of course do not want to offend anyone. However, in the midst of what may be the worst financial crisis in our country’s history, we think we owe it to our clients to weigh in on economic policy. After all, it has a direct impact on your wallet and is our area of expertise. I make you two promises during this foray into politics: I will stick to economics, and to avoid showing favoritism, I will make sure that I offend everybody.

I will begin the offending process by stating a disturbing fact to the most partisan. While there are plenty of subjects for Democrats and Republicans to disagree on, the basic framework of economic policy should not be one of them.

Earlier this year, the University of Chicago launched a $200 million academic enterprise called the Milton Friedman Institute, named after the famous economist and Nobel laureate who spent the bulk of his career on staff at the school. The effort was attacked by many on the faculty in other departments, most notably by Bruce Lincoln, a professor of the history of religion. The reason for the backlash was a statement made by the institute that it would “reflect the traditions of the Chicago School and typify some of Milton Friedman’s most interesting academic work, including his…advocacy for market alternatives to ill-conceived policy initiatives.”

Professor Lincoln is upset that the University of Chicago could make such a statement as if it has been proven that the free market is superior to government intervention. After all, the battle between free market capitalism and socialism / communism constituted much of 20th-century politics. Lincoln seems surprised to learn that this argument is over. Evidently there has been some confusion as to why Friedman won the Nobel Prize.

Milton Friedman won the Nobel Prize in 1976 because he and his esteemed colleagues from the University of Chicago (from which there have been 25 Nobel Prize winners in economics) transformed economics from a soft social science to positive science. They introduced quantitative analysis of their theories. Friedman defined the Chicago School of Economics as “an approach that insists on the empirical testing of theoretical generalizations and that rejects alike facts without theory and theory without facts.” Friedman actually believed in government intervention in the economy, until the empirical evidence from his research proved otherwise.

What Friedman learned, which surprised him, was that the less involved the government was, the freer the market, and the better off the society as a whole. Particularly surprising, and something that still goes against conventional wisdom, was the fact that the middle class in particular was better off in a free market. In fact, the middle class is a free market phenomenon. The more government is involved, the more you have only two classes of people – the ruling elite and everyone else. This is not an opinion, it is empirical truth. Once you have sailed around the world, arguing that it is flat doesn’t make sense.

Now this is when my Democrat friends will tell me that I’m just spewing Republican propaganda and if any of this is true, then how do you explain this crisis?

When Democrats blame “Bush’s failed policies” for the current crisis, they often follow it up by the political stereotype of Republicans. They say Bush was in love with the free market and deregulation. They fail to remember the lesson that can be found in one of my favorite political movies, Charlie Wilson’s War. Joanne Herring, the socialite played by Julia Roberts, asked Charlie why Congress was busy saying one thing while doing nothing, to which Charlie responded, “Well, tradition mostly.” When it comes to politicians, it is a good idea to take the advice often given to young girls about boys: pay attention to what they do, not what they say.

The problem with the argument that deregulation caused this crisis is that there has not been one act of deregulation in the entire eight years Bush has been in office. The fact is that Bill Clinton, whose political stereotype would be of a pro-government regulator, actually reduced the size of government and passed significant deregulation. As a result the economy grew under his watch and most Americans prospered. The only regulatory accomplishment of the Bush administration has been Sarbanes-Oxley, which has no direct relation to our current problems, but was arguably the  single largest increase in regulation since the Great Depression. This crisis has been caused by Bush’s failed policies, but those policies have been to grow government and increase regulation.

Once government interference starts, it is like being on a drug. It makes you feel good at first, but then the crash occurs. A rational mind would say, “I must get off this drug because it makes me feel so bad,” but that isn’t what the drug addict thinks. He thinks he needs even more, and the destructive cycle begins. You regulate an industry, so they become incented to get friendly politicians elected. The industry contributes large sums to campaigns, and politicians rig regulation to help their financial backers. While some regulation is obviously needed, we must remain mindful that regulation often leads to corruption.

This same cycle is evident in what has really happened in our current crisis. The federal government many years ago made encouragement of home ownership national policy. They created Freddie Mac and Fannie Mae to back mortgages made to lower-and middle-class Americans. This worked great at first, as more and more Americans were able to buy homes. Then these government agencies started donating hundreds of thousands of dollars to the very politicians who were supposed to be policing them. In return for their generous gifts, there was more and more encouragement of creating mortgages for anyone who wanted one, whether they could qualify or not.

This created a distortion in the free market. The perceived risk of lending to so-called subprime home buyers was reduced because of the inherent government backing – banks knew they would be bailed out if it went wrong, so why not do it. This was only compounded by the evolution of securitization, which allowed banks to sell their mortgages in bundles to further reduce the risk.

Bubbles occur when markets get distorted, and when a bubble explodes, we have a crisis. This crisis was caused primarily by the drug of government interference in the marketplace, which led to corruption. The rational solution would be less government involvement in the mortgage market, and better, not more, regulatory oversight. However, the knee-jerk reaction is simply more regulation, which will once again make us feel better in the short-term, but will lead only to misery down the road.

We have a very important choice to make when we go to the polls in November. It will determine in a large part whether we do the wise thing in response to this crisis, or do the emotional thing and make things worse. Milton Friedman and his fellow economists have proved that the empirical evidence for free market capitalism is overwhelming. Like Democracy, capitalism is not perfect, but it is the best system we have. Crises like the one we are in now are almost always caused not by truly free markets but by market distortions caused by government involvement.

So which candidate understands this, and would be better economically? The only advice we can give is to vote how your heart leads you, but do so not based on what politicians say in their speeches, but based on what they have actually done in their careers. Remember the “Liberal Democrat” Bill Clinton reduced government, balanced the budget and gave us eight years of economic growth, while the “Conservative Republican” George W. Bush has grown government, increased regulation, and given us the worst economic crisis in generations. If the economy is your issue, vote for the candidate who has a track record of actually trying to reduce government and create better, not more, regulation. Remember Charlie Wilson’s warning. Saying one thing and doing another is a tradition in Washington. Don’t pay attention to speeches, pay attention to what candidates have actually done.

CHUCK OSBORNE, CFA, Managing Director

~The Politics of Economics

“Come and listen to a story ’bout a man named Jed, poor mountaineer barely kept his family fed. Then one day he was shootin’ at some food, and up from the ground come a bubbling crude. Oil that is. Black gold, Texas tea.”
~ The Ballad of Jed Clampett ~

If they were ever going to bring back “The Beverly Hillbillies,” now would be the time. Not only is that Texas tea in Jed’s backyard worth approximately five times what it was worth in 2002, but that mansion in Beverly (Hills, that is) can be purchased for a good 20% discount off the housing boom highs. Jethro could have the biggest cement pond you have ever seen, and Granny could have a proper distillery added to the house. Mr. Drysdale would be ecstatic, as Jed’s business alone might be enough to save his bank from the woes of sub-prime. Can you imagine a more timely show?

Unfortunately, this is not a television situation comedy. The housing slide continues and the credit crisis just seems to linger. However, the big star of this past quarter has been oil, so that will be our focus for this article.

Americans love nothing more than to play the blame game. Whose fault is it that oil is selling at over $140 per barrel? We want a simple solution, like the oil companies are just gouging us, or speculators are manipulating the market. The truth is not that simple, and unfortunately for those who would like to see “justice” done, there really aren’t any bad people pumping up the price of oil just to make our lives miserable, and no matter what your favorite politician promises, there are no quick fixes.

The first eight years of this new century have seen explosive growth in emerging countries, primarily in China and India. Along with that growth has come new-found wealth, and with this wealth, a good percentage of the approximately 2.5 billion people in China and India started trading in their bicycles for automobiles. The demand for oil consequently rose sharply, and as any first-year economics student can tell you, if the demand rises and supply stays the same, the price will go up. Economic theory would suggest that the higher price would cause people to cut  back on consumption and would provide an incentive for suppliers to increase output, thereby causing demand to shrink, supply to grow, and the prices to fall back to norms.

Why hasn’t that happened? Let’s take supply first. There was an initial supply response, but supply seemed to peak in 2005 with total production of approximately 85 million barrels a day. There are a couple of reasons why supply has not grown faster. In our fast paced world we forget that getting oil out of the ground takes time, and six years is not a long time in the context of developing an oil field. The largest part of the price increase has been over the last nine to twelve months, and it simply isn’t reasonable to expect results that quickly. Based on capital expenditures of the large oil companies, they are working hard to find and get us more oil, but it doesn’t happen overnight.

In addition, oil is a non-renewable energy source. The world’s existing oil fields are in different stages of their production life, but as a whole, the existing sources are experiencing declines of approximately four percent per year. This means that the first 3.4 million barrels of new daily production simply replaces the depletion from existing wells.

These factors have played a role in the lack of response in the supply of oil, but what has kept demand so high? The reality is that cutting back on oil is not that easy. Sure there are things we can do. Couples with two cars can use the more efficient car as much as possible. We can all plan more carefully to consolidate our car trips and avoid wasted mileage. We can use public transportation and, of course, take better care of your car and check the tire pressure. All these tips can help your pocketbook and the environment, but not driving is not an option for most of us, nor is not heating your home.

The biggest reason there has not been a reduction in the demand side of the equation is because of government subsidies for oil. Fuel subsidies are widespread in emerging-market nations. Morgan Stanley estimates that half the world’s population enjoys fuel subsidies, and a quarter of the gasoline consumed worldwide is bought at less than market prices. Gas is five cents per liter in Venezuela, which is the cheapest price in the world. The Chinese pay $0.79 per liter, compared to Americans at $1.04 per liter and Germans at $2.35 per liter. Consumer demand in the emerging economies will not slow down unless the consumer is impacted by the higher prices.

This combination of increased demand and tight supply started the run-up in oil prices, but does it really explain $140 per barrel? Not by a long shot, according to Chicago-based market research firm Probability Analytics Research. They say that supply and demand account for a price of oil in the $60 to $75 range. The Saudi Arabian oil minister, Ali Al-Naimi, agrees with them and has suggested that the range should be $60 to $70. These estimates are considerably higher than what oil prices were in the last decade, but half the current price. So what is causing the  difference?

Some have blamed the value of the dollar. Oil, like most global commodities, is priced in dollars and the value of the dollar has been falling. If the dollar is less valuable, then it will buy less oil, or so the argument goes. This is true to a point, but the dollar has not fallen nearly far enough to account for oil at $140 a barrel. So there must be something else.

Investors make up the difference, according to Mike Masters of Masters Capital Management, who notes that trading volume in oil futures markets has gone through the roof. For example, open interest in the West Texas Intermediate crude oil contract traded on the NYMEX (just one example on just one of several exchanges) has risen from less than 500,000 contracts in 2004 to more than 1.5 million contracts currently. Each contract represents 1,000 barrels of oil. Masters, in his testimony before a Senate sub-committee on May 20, 2008, estimated that the rise in investment interest has added an equivalent of 848 million barrels of oil to demand, roughly the same impact as increased demand from China.

To be fair, Masters’ view is controversial. There are many people who have come out and tried to dispute the idea that futures trading could have this impact. They argue that investors are buying futures contracts (which give the purchaser the right, but not the obligation, to buy oil at a given price some time in the future), not actual oil. This argument does not hold water, however, because the futures price and the actual price must converge as the contracts near expiration. Otherwise there would be an arbitrage opportunity, and the markets are far too efficient for that to happen. Others argue that for every speculator that is betting on oil going up there is another speculator betting on it going down, and they counteract each other. That would be true if this was about speculation, but it isn’t.

I myself got caught by that argument, but in reading the research it dawned on me that these new entrants into the oil futures market are not speculators at all – they are pension funds, who are buying and holding. This is all part of the “alternative investment” craze, which is a subject for a future newsletter. The bottom line is that pension funds in recent years have made commodities a permanent part of their portfolios. Masters may overestimate the impact, but his arguments are sound, and it defies logic to think that billions of dollars can be poured into commodity futures without having any impact on the market prices of those commodities.

So who is to blame for $140 oil? There is no one culprit, but rather a result of the confluence and culmination of several new realities of our global economy. Oil started to rise in price because of real fundamental economic principles of supply and demand, and it has kept going up because of investor interest. However, there is good news. Oil prices will fall. When? I can’t tell you, but it will happen. Demand is cracking. Airlines are cutting back, people are buying smaller, more efficient cars, and those emerging countries are beginning to lift those subsidies. Finally, supply eventually will increase as new exploration begins to pay off and alternative energy sources become more competitive.

We survived the 1970’s, and we will make it through these times as well. So as Jed and all his kin folk would say, “Y’all come back now, ya hear?”

CHUCK OSBORNE, CFA, Managing Director

~Texas Tea

Those who know me well know that I love dogs, and especially my dogs. For years most people in my neighborhood knew me as The Guy With The Two Old English Sheepdogs, Mookie and Sydney. I rescued them from a shelter when they were puppies and never had their tails cropped, as is the custom for sheepdogs with better pedigrees, and I wouldn’t change that for the world. Every day when I got home from work, I was greeted by these two huge, hairy dogs who would practically fall down the steps into our garage, furry tails going 100 miles per hour all the way. No matter how hard my day had been, that sight always put a smile on my face. I swear there were times when I thought that if I could just grab that tail and hold it, the dog would certainly start to wag. So I tried. It became one of my favorite games, but no matter how excited I got them, I could not get the tail to wag the dog. It just won’t happen.

If only humans could actually learn from their pets. However, we seem constantly to let our tails wag our dogs. You can see the phenomenon everywhere in our society. Look at the current election cycle. You can watch election news coverage for hours and hear about this poll and that poll. You will learn that young people and Blacks are voting for Obama, that older people and women support Hillary, and that although the Republican Party has a very low approval rating, people still like McCain as a candidate. You will hear about inconsistent speeches, and this flub and that mistake.

However, you won’t hear a thing about what any of these people actually propose to do if they get elected President of the United States. You won’t hear about education, health care, economics or national security. In other words, you will see, in living color, the tail wagging the dog.

While this is a poor commentary on our political system, it is not the only place you will see this phenomenon, and actually in my opinion, not even the worst example. The place where you will see this most is in the financial markets. Everywhere you look these days, you see tails wagging dogs.

Earlier this quarter I met with an attorney who specializes in helping people with trusts and wills and other estate planning matters. We often refer clients to such attorneys and they often refer their clients to us as well. I was explaining to this attorney our investment process, and we showed him our track record of success. His response was that our process seemed very impressive, and moreover the returns which we have generated extremely impressive. Then he said something that almost dropped me on the floor. He said, “But none of that really matters.” What did matter to him was whether or not the little old lady he might introduce us to would like us.

I understand his point; it is important to like your advisers, to trust them and feel comfortable with them. (And for the record, I’d like to think the little old lady would like us.) However, let’s say we are talking about brain surgery and not investment management. Is it more important to like your surgeon, or is it more important that she is the best neurosurgeon you can find? Ideally, of course, we all want both. You want the best surgeon who also has a great bedside manner,but if that were not possible and your life were on the line, I think most would agree that they want the most skilled surgeon.

The same should be true with managing your money. Of course servicing is important. Service is one of Iron Capital’s core values, but then tails are important too. You can’t win a dog show if you don’t have a proper tail. They just are not as important as the dog itself. Likewise, what really matters in money management is the skill of your adviser. Because skill combined with a disciplined investment process it what produces long-term outperformance. For example our flagship growth strategy, which is 100% equities, has outperformed the S&P 500 by 3.2% annually net of our highest fee, since inception through March 31, 2008. Now that might not sound like a lot to a lay person, but if you invested $100,000 and got the S&P return for the next 30 years you would have $395,508.70 in your account. On the other hand if you got the Iron Capital return, you would have $975,968.50 in your account.

That 3.2% is the difference between retiring and having to keep working. That is the difference between touring Europe and moving in with your kids. That is the difference between fishing and playing golf everyday and greeting people as they enter Wal-Mart. 3.2% is the difference between living your dream, and just getting by. However, long-term outperformance is still not the dog.

Skill combined with a disciplined investment process is the dog. Long-term outperformance is what happens when you let the dog wag the tail. Unfortunately, this is increasingly rare on Wall Street today. There is no greater example of the tail wagging the dog than the current credit crisis, and more specifically the response to the current credit crisis. I recently had breakfast with Andrew Phillips, the co-head of US fixed income at Blackrock. Andrew, like most, was blaming the mortgage banks for the crisis. The mortgage banks were providing mortgages to people with less than perfect credit so they could buy a house. Instead of keeping these mortgages on their books, the banks were packaging them together with several other mortgages and selling them as securities to mostly institutional, sophisticated investors – hedge funds, pension plans, etc. Because they were selling these mortgages and not keeping them, the banks did not care about underwriting standards, and continued to loan money to people who traditionally could have never qualified to get a mortgage. Now some of these people are unable to pay their mortgage and the financial market is in crisis, and everyone thinks it is the banks’ fault for not doing their job to underwrite these securities properly.

I told Andrew that this sounded a lot like people blaming McDonalds for the fact that their pants don’t fit. After all, these are sophisticated investors with Ivy League educations, CFA designations and seven- to eight-figure salaries. When these investors were buying these mortgages, where was the buy side research, the responsibility to know what you own? Where was the responsibility of managers and advisers to understand the risk they were taking? Where was the credit analysis that you were taught at business school and tested on by the CFA institute?

It was not there, Andrew explained, and it still isn’t. The fact that no real research was done by so many is what caused the problem, and it has also made the problem much worse. The mortgage products that these banks created are, for the most part, doing exactly what they are supposed to do. Most mortgage securities are performing, or as the fixed income managers say, they are “money good.” In other words, these fixed income securities, which promise certain income payments, are making those payments as promised. The issue is that the market for the securities has completely gone away. It went away because all the people who were buying these securities without doing any research can’t tell which of these securities is a worthy investment and which is one of the few bad investments, so they just are not going to buy anything. When no one will buy anything, you have a crisis. And here we are.

The magnitude of this crisis has shed some light on how few people in the financial world actually do the required research that we are all taught to do. I asked Andrew if he thought we would ever learn. He laughed, and said, “We never do.”

That may be true of the market as a whole, but it is not true at Iron Capital. We do learn, and we pay very close attention to our process, to assure that the dog is indeed waging the tail and not the other way around.

CHUCK OSBORNE, CFA, Managing Director

~Is That Tail Wagging That Dog?

“Can’t you see what is happening? Potter isn’t selling, Potter is buying and all because we are panicking and he isn’t.” – George Bailey (Jimmy Stewart), It’s a Wonderful Life.

This is one of my favorite quotes from one of my favorite Christmas movies. George Bailey and his new bride are on the way out of town for their honeymoon when they see a run on the bank. They give up their honeymoon budget to save the Bailey Building and Loan during the depression.

Fear and Greed: these are the emotions of the marketplace. Fear gripped the nation during the Great Depression and the runs on the bank that were illustrated in the classic film were commonplace. Franklin D. Roosevelt, in his first inaugural address on March 4, 1933, uttered these famous words, “So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning unjustified terror which paralyzes needed efforts to convert retreat into advance.” I would guess that most of you recognize that quote. I would also guess that most of you did not know that this was given in a speech in 1933, long before the onset of World War II, and FDR was not talking about facing Nazis or the Japanese. Later in the same speech he goes on to say, “In such a spirit on my part and on yours, we face our common difficulties. They concern, thank God, only material things.”

FDR was talking about economic fear. He was talking about the kind of fear we see today on Wall Street. Irrational, short-sighted fear. There is of course a difference between now and then. Now, we are just a few short months from all-time record highs on Wall Street, then we were suffering through the worst bear market of all time. Now we have 5% unemployment which is incredibly low on historic basis, then unemployment was rampant. Now we have had just a few mortgage companies go out of business, then more than 4000 banks went under in the first two months of 1933 alone. In other words, they actually had cause for fear; we do not.

The problem with fear and its evil twin greed for that matter is that it is almost always short-sighted. Wall Street has always suffered from this disease, but in recent years it has gotten much worse. The CFA Institute has even given it a name, Short-Termism. Short-termism results in the permanent destruction of wealth, or at least the permanent transfer of wealth. This was the conclusion drawn by Jack Gray, investment strategist at the firm of Grantham, Mayo, Van Otterloo and Company in Sydney, Australia. Gray presented his findings at the CFA Institute’s 2006 annual conference.

Gray points out that from 1945 to 2005 the average turnover of US equity mutual funds has gone from just over 20% to over 100%. In 2005 the average mutual fund held a stock for no more than 9 months. The results speak for themselves. Jack Bogle, founder of Vanguard, points out in his research that from 1983 to 2003 the average mutual fund had an average annual return of 10%, while the S&P 500 had an average annual return of 13%. The actual investor did even worse, with a 6% return according to Bogle. Not only are the mutual fund managers short-term focused with 9 month holding periods, but the mutual fund investor was also short-term focused holding their investment for only 2 years. Let me put this in perspective for you. If you invested $100,000 in a tax free account in 1983 and got the 13% return from the S&P 500, in 2003 you would have accumulated $1,152,309. If you got the 10% return from an average mutual fund you would have accumulated $672,750, and the 6% return of the average investor would net only $320,714. Those differences in percentage returns may not seem that great, but the difference in resulting wealth is huge.

Much of that wealth destruction can be blamed on shorttermism. Gray conducted a poll to determine who was responsible for short-termism and 89% of respondents selected the media. Mutual fund managers know they can get on the cover of Money magazine, or one of the other financial tabloids, only if they post huge short-term returns. You as an investor may have a time horizon of 10, 20 or even 30 years but no one in the financial system shares that view. Starting with government regulators, who are either political appointees whose time may be short, or are young attorneys padding the resume to make the big move to a Wall Street firm. Their time horizon may be 3 years if you are lucky. Investment managers are judged monthly by their institutional clients. The media may have a time horizon as short as hourly. The good people at CNBC want to know what is going to happen in the next 15 minutes. Finally, traders and hedge fund managers have the shortest time horizons of all. The system is heavily biased towards the short-term which causes what Gray refers to as a substantial principal-agency horizon misfit.

This leads us to the newly popular momentum investing fad, which is the quintessential form of short-termism. Momentum investors buy what has gone up and sell what has gone down. Momentum investing can be a self-fulfilling process as prices go up or down not because they should but because momentum carries them in that direction. This private gain comes at a public loss as the market ceases to be a mechanism to allocate capital efficiently in order to maximize total economic output, and becomes instead a ponzi scheme leading to bubble after bubble.

I have often been asked how it is that Warren Buffett is able to do what he does, and my answer is simple. He never has to answer to clients or the media. He has the benefit of being able to think long-term. Long-termism has three distinct advantages to short-termism. First, there is better predictability. It is nearly impossible to accurately predict what the market will do next week or next month. However, in the long-run the market tends to get valuations right, therefore assets that are over-valued currently will tend to go down while assets that are under-valued currently will tend to go up. In fact Bill Miller of Legg Mason has suggested that the current short-termism epidemic has actually caused what he referred to as a “long-term arbitrage opportunity.” For investors who are brave enough to move against the grain, great long-term gains can be earned. However, the pull of short-termism is great. In late October, I was asked by a friend what we thought of the current market conditions and where we saw opportunities. I told him that we saw great opportunities in banks that have been overly beaten down by Wall Street short-termers. I saw my friend again over Christmas, and he told me that our bank idea had not turned out that well. I had to laugh. It had been less than two months, we won’t know how it “turns out” for several years. We are investing here, not speculating.

Long-termism also leads to lower cost because of lower turnover, and lower risk of real investment losses. As we discussed last quarter, long-term investors are owners who are less concerned about price fluctuations than they are about the fundamental health of the companies they own.

There is a scene later on in It’s a Wonderful Life when Potter offers George Bailey a job. Potter, singing George’s praises, remembers the depression and says that George and he were the only two who didn’t panic. “You saved the Building and Loan, and I saved the rest.” George responds, “…most say you stole the rest.” Potter retorts, “The jealous ones say that…” In our current environment gripped with fear of the short-term most will panic but we will not. A few years from now when we look at the gains we have achieved from this point, some may suggest that we stole them, but those will be the jealous people who didn’t have the courage it takes to think past this current crisis.

CHUCK OSBORNE, CFA, Managing Director

~Short-Termism

WHERE HAVE ALL THE OWNERS GONE? Do you miss the days when you went to the hardware store and the owner was standing behind the counter? Or what about going out to eat? Certainly there are some good chain restaurants, but my favorites are still places where the owner is on site and comes by your table to see how everything is going. Owners make a big difference.

If you don’t believe me look at any franchised business. Let’s take Holiday Inn for example. I travel a lot and have stayed in all sorts of hotels, and I can tell you that some Holiday Inn’s are fantastic, and others are a little scary. It all depends on the individual owner. Holiday Inn’s corporate office knows this. They have found that one of the main reasons their market share of hotel nights has fallen is because the frequent traveler never knows what they are going to get from one Holiday Inn to the next. As a result, Holiday Inn is weeding out bad owners from their system. OWNERS MATTER. So who owns corporate America?

Do you know? Do you care? I argue that you should. Being in this business I always hear about how mad people are about CEO compensation, ethical breaches and yes, even six years later, I still get an earful about Enron. I usually just listen politely and agree with most of what people are saying. Then I might ask how they invest their money, and I hear things like, ‘I have it all in index funds.’ More and more, they tell me about this great hedge fund, or about the virtues of commodities and of course the new ETF they just bought. What I never hear anymore is something like, “I own Coke.” Somewhere along the line, Wall Street seems to have convinced people that they should stop investing in companies and start investing in markets. John Boggle is probably as responsible for this as anyone else. If you don’t recognize the name, Mr. Boggle is the founder of Vanguard, the indexing king of the mutual fund world. He popularized the notion that most active money managers don’t beat the market and therefore one should simply invest in the market and not try to pick companies. In the boom years of the 1990s, this notion became conventional wisdom.

Of course, like most conventional wisdom, there is some truth to what Mr. Boggle suggests. Especially in very efficient markets and in markets that are being driven by irrational forces. For example, in the late 1990s when most active managers were avoiding technology stocks due to their valuations, the S&P 500 looked unbeatable. In July of 1997 less than 6% of active managers benchmarked to the S&P 500 were outperforming the index for the three year period that had just ended. Contrast that to January of 1982, when 81% of active managers outperformed the “market.” Thirty-five percent of managers beat the S&P 500 over three year periods on average. So, like most conventional wisdom, it isn’t completely true.

There is of course one investor who is known for his ability to beat the market. Warren Buffett is not only the second wealthiest man in America, but also the most famous of all investors. The annual report of his company, Berkshire Hathaway, is a must-read for anyone interested in investing. Buffett made his name by investing in the stocks of publicly traded companies, and his firm has grown to the point where he now mainly buys companies in their entirety. However, he still runs the stock portfolio, and this is where I think the greatest lessons lie for average investors who don’t have a few billion dollars at hand. I was reading the 2006 Berkshire Hathaway Annual Report earlier this year, and something jumped out at me: Buffett went through the entire discussion of the stock portfolio without once mentioning what had happened to the price of any of the individual stocks he owns. He talked about the various companies’ earnings and cash flow, and he spent the greatest amount of time talking about the CEOs and how talented they were. Not once did he mention whether the price of the stocks had gone up or down, or by how much.

I don’t know why this jumped out at me this year, because it is nothing new for Buffett. He has many famous quotes about how important it is to ignore the market, but for some reason this year it really struck a chord with me. This man does not invest in the market, he owns companies. This is at least part of what has made him so successful.

Contrary to his legend, he is not alone either. There are actually several legendary investors who can rival Buffett; they just don’t have his fame or his personal wealth because unlike Buffett, they mainly invested other people’s money – people like Buffett’s mentor, Benjamin Graham; Philip Fisher; Peter Lynch; Bill Miller; Ralph Wanger; and more. There is actually a long list. Each of these investors is unique. Graham is the father of security analysis and of what we today call value investing. Fisher is the father of what we now call growth investing. Peter Lynch ran portfolios with hundreds of stocks, while Bill Miller has never owned more than 40 or 50 stocks. Ralph Wanger was a small stock specialist.

Very different men with very different approaches, yet they all have two things in common. First, they were/are owners of companies. Good companies with solid fundamentals and good managers. Second, they bought these companies at good prices, then held on to those companies for a long time. It is that simple. You are probably thinking, “It can’t be that simple.” Well in the words of Buffett himself, “There seems to be some perverse human characteristic that likes to make easy things difficult. It’s likely to continue that way. Ships sail around the world, but the Flat Earth Society will flourish.”

Michael Mauboussin in his book, More Than You Know, looked at the characteristics of mutual funds that had beaten the market over the decade that ended in 2004. Those funds had an average portfolio turnover of 27% versus the average equity mutual fund, which had a turnover rate of 112%. That means the average mutual fund manager owned the stocks in his portfolio for less than a year, while the average manager who actually outperformed owned his stocks for an average of four years. Most money managers did not own companies, and instead were simply “renting” the stock. The successful money managers were owners.

There are other benefits to owning companies as well. When you own stock in a company, you have a vote – a voice in what direction the company decides to go. Granted, for the average investor your voice may be one of the quieter voices in the room, but it still exists. If you don’t like how the current management is running the company you can voice that opposition, and if there are enough other investors out there who share your concerns, you can effect change. If that change doesn’t occur you can sell your shares before the consequences of management’s actions come to roost. For example, many investors get upset when companies fire their CEO and pay them millions in severance. However, the owner who is actively paying attention knows that the real mistakes happen when that severance is promised upon hiring the CEO, not when it is paid out.

Ownership also tends to settle the nerves in the face of market turmoil. When stock prices drop, traders tend to panic, while owners ask themselves, “Has something really changed with this business, or is this just short-term market silliness?” Most of the time it is just silliness. To a large extent, this explains why owners do better in the long run.

I hear lots of stories about exciting investment products like hedge funds that promise huge returns with little risk. However, I have never met anyone who has gotten rich by investing in a hedge fund. If you have, please ask them to give me a call – I would like to meet that person, but I won’t be holding my breath. On the other hand, I have met lots of people who have come to me for advice in how to manage the large sums of money they have made from companies they invested in 20, 30 or even 50 years ago. Ownership works.

At Iron Capital, we believe in ownership. We agree with Peter Lynch when he said, “You should know what you own and know why you own it.” We use that philosophy not only in the equities our clients own directly, but also when picking mutual fund managers. We like managers who own companies, who understand the long-term strategy of a business, and who are not just guessing about what the stock will do over the next few months. This strategy doesn’t always outperform in every short-term interval, but it does in the long run, and in the end that is the only run that really matters.

CHUCK OSBORNE, CFA, Managing Director

~Stop Investing in The Market. Own Companies Instead.