The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
“We live in a connected world.”
“When it comes to retirement, the old saying is true – there is more to life than money.”
“The investment world has a language all its own, and it gets used and abused..”
“We can’t control the score board; all we can do is keep playing the game…”
“Arrogance and self-awareness seldom go hand in hand.”
We live in a connected world. I’m sure you know what I mean. You may be on a trip somewhere and you run into a neighbor, or you might meet someone for the first time and find out you grew up down the street from one another. This past fall my wife and I enrolled our son in a newly established charter school, and the wife of one of the founding board members was one of my Wake Forest classmates. I once boarded an airplane and sat down next to an old high school friend I had not seen in twenty years. When I was a young single professional I went out with a colleague in my office, and we were going to be joined by an old friend of his named Richard. I commented that I went to high school with a Rich who had the same last name, but my friend told me it couldn’t be the same person because his friend hated it when people called him Rich. A few minutes later Rich and Richard ended up being the same person after all. In the immortal words of come- dian Steven Wright, “It is a small world, but I wouldn’t want to have to paint it.”
I don’t know what is more amazing, how many times the world reminds us how connected everything is, or how many times we seem to forget. We seem to want to silo everything. We do it in our budgeting. I cannot tell you how many times I have spoken to people with spending problems and had a conversation that goes like this:
Me: You are spending more than you make, that must stop if you wish to get ahead.
Client: Well the problem is the price of gas went way up and I drive so far to work every day that it really has caused a big deficit in my budget for commuting.
Me: But what about this big vacation you took?
Client: Oh that is not a problem. I stayed within my vacation budget.
Clients like this fall into the trap of using complicated budgeting software that breaks everything down and completely forget that it is the whole that matters. The various budget categories are all connected. If one’s personal budget has ten categories and he runs a deficit in one of them then he must make up for that somewhere else. Otherwise he ends up spending more than he actually has. If day-to-day expenses increase, then he may not be able to spend as much as he otherwise would on vacation.
This siloed way of thinking impacts people’s investments as well as their budgets. Clients come to us all the time with portfolios that make no sense simply because they are all parts and no whole: They have an account for college funding for each child; his and her 401(k) accounts; old job retirement accounts; and that one stock Aunt Betsy left them. Each account has a different strategy, sometimes even different risk tolerances. Some folks have conservative money and risky money.
There are lots of reasons for this hodge podge approach to financial and investment planning. Some of it is simply the pace at which we live these days – everyone is moving so fast that nothing gets done correctly. We know things are not correct, but we just never seem to get around to fixing them. Some of it is that people really do silo these things in their minds. “The money Aunt Betsy left us is sacred because she was my favorite Aunt, so whatever you do, don’t lose a dime.” “The college fund for Sally? Well let’s face it, she is the youngest so we won’t be contributing a lot. Let’s roll the dice and see if we can’t win the lottery. If that doesn’t work out she can just live with her older brother, we sent him to Harvard.” Of course this is not logical when we stop and think about it, but when do we ever do that?
Most people conduct most of their financial dealings with their emotions, not their logic. They loved Aunt Betsy. They really want to go on that vacation. They love their kids and deep down just know that their kids will all get scholarships. This is where we come in.
I once heard a speech about the Declaration of Independence. How it starts with the line, “We hold these truths to be self-evident.” What does that mean, self-evident? The speaker said it meant that when one thinks about it for just a second she sits back and says, “Well duh.” The trick is that one has to take that second to actually think about it. Many simply never do that. They see a headline in a newspaper and never take a second to say does this actually make sense? In fact, to the extent most people do think, they tend to do it in reverse; they draw their conclusions and then search out evidence for those conclusions, ignoring all other evidence.
A few years ago in the heat of the financial crisis I got into a discussion with a friend about government deficits. I suggested that one should wait until the crisis had passed before worrying too much about the deficit. He sent me a paper written by an economist he had heard speak and highlighted a line about the long-term problems with deficit spending (with which I agreed, by the way). He failed to highlight the very next sentence which said that the middle of a big recession is not the time to deal with deficits. But that sentence did not fit his already drawn conclusion. I’m not even sure it ever registered with him.
That economist understood that the world is connected. Deficit spending is not a good thing, especially when done chronically year after year. There are, however, other issues. Spending more than one makes to take a fancy vaca- tion is one thing, but spending more than one makes because of an illness is an entirely different issue. Nothing can be intelligently analyzed in a silo.
Today there is nothing that fits this description more than the price of oil. Oil has dropped in price by more than fifty percent and the explanations for this are incredible. According to the pundits and Wall Street apologists, this is a logical reaction to the plummeting demand for oil and the oversupply caused by America’s energy boom. This is when one should start to question the headline.
The drop in the price of oil has been taking place since June, and there have been no significant changes in supply or demand for oil since June. That does not stop those who have already drawn a conclusion from seeking out data to support that conclusion. Speculators are lining up to be quoted about the plummeting demand for oil. The only problem is that out in the real world, according to government organizations that track such things, there is no drop in demand.
The U.S. Energy Information Agency (EIA) projects global demand for oil growing in 2015 by nine hundred thousand barrels a day…yes, growing. This number corresponds to the estimate given by the International Energy Agency (IEA). It is true that their projections for next year were higher a few months ago, so if one assumes these organizations are actually correct in their forecasts – granted that is a huge leap of faith – then one could say the growth in demand is slowing, but demand is not shrinking in the least and it certainly isn’t plummeting.
Much has also been written about the “glut” in oil supplies. Currently the world is producing more oil every day than we consume, but that is not unusual. According to the EIA the world produced 91.96 million barrels a day in 2014 while we consumed 91.44 million barrels a day – a difference of 520,000 barrels a day. In 2012 the world produced 89.76 million barrels a day and we consumed 89.14 million barrels a day – a difference of 620,000 barrels a day. Of course 620,000 is more than 520,000 and there was no crash in the oil price in 2012. In 2013 the world consumed more than it produced as demand increased more than supply, and my bet is that happens once more.
People who live in New York and never drive anywhere may not under- stand this, but everyone else will use more oil if the price is cheaper. Consumer Reports recently named the new car models with the lowest consumer satisfaction. Guess what, they were all tiny, super fuel-efficient cars. Gas is a lot cheaper than it was when those disgruntled consumers settled for those models. The toe bone is connected the foot bone and the foot bone is connected to the heel bone. Don’t be surprised if consumers start going back to larger, less efficient cars.
Many of the pundits who go on and on about the plummeting demand for oil claim that it is because the global economy is evidently collapsing. A day later the very same pundits will talk about third quarter GDP for the U.S. coming in at 5 percent growth. The U.S. is the largest economy on the planet. We are the largest consumer of oil. We love our big cars and hate the tiny things high-priced oil made us buy. Yes, Europe has issues and China is growing up and no longer having pubescent growth spurts, but the heel bone is connected to the ankle bone and the ankle bone is connected to the shin bone. The U.S. economy has positive momentum and now the U.S. consumer has just been given a huge budget saving price cut at the pump.
Here is one of those self-evident moments: The economy of the United States cannot grow at five percent, or anywhere close to that, and the demand for oil drop. One of those big market- moving stories must be incorrect. After all the shin bone is connected to the knee bone. Everything we consume in the U.S. requires energy in order to be produced and transported. GDP (gross domestic product) is a measure of everything we produce and consume. The knee bone is connected to the thigh bone and the thigh bone is connected to the hip bone.
So what is really causing the price of oil to drop? In my opinion that is the wrong question. The question should be the same question we started asking in 2008: Why in the world did oil’s price go so high in the first place? In 2008 I wrote about the roaring price of oil. Once again, back then supply and demand were blamed. Of course it was true that demand from emerging markets had an impact, just as greater production from the U.S. is having one now, but then as now, the price jump happened rapidly while the supposed excuse had been around for years. The best research we could find in 2008 suggested that the supply and demand alone would justify a price in the $60 to $70 range. Nothing has happened since then which would substantially change that estimate. EIA data suggest that global supply and demand have grown slowly and largely together since 2008.
What has changed is institutional investors. I mentioned in 2008 that pension plans, endowments and other institutions were piling into oil. Stocks looked bad in their rearview mirror and commodities had been rising so they started selling stocks and adding commodities to their portfolios. Oil was trading at $140 per barrel when I wrote that. Those investors were a large part of the reason, because if everyone buys the same investment at the same time the price goes way up. You see, the hip bone connected to the back bone and the back bone is connected to the shoulder bone.
Fast forward six years and those stocks all those institutional investors got out of have come all the way back and then some. But those institutional investors and their retail financial adviser copy cats have been going into commodities. Oil was already down almost $40 per barrel over that time period. Once again with eyes glued to the rearview mirror these same institutions are now questioning their collective wisdom. Many have begun to exit such “alternative” strategies. The shoulder bone is connected to the neck bone and the neck bone is connected to the head bone. This ride in oil is far more about Wall Street than it is about Main Street’s demand for oil.
The problem with investing in commodities such as oil is that they are not really investments. As Benjamin Graham taught us, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” A commodity is simply worth what someone is willing to pay and that is a speculative operation. When one takes a moment to think it becomes self-evident: speculation is driving the price of oil.
The pundits don’t want you to see the connections. Wall Street makes money from trading – to them it makes no difference in which direction the price is going. Emotions drive trading, and in the case of oil, the emotion is fear. Those emotions are more easily manipulated when issues can be siloed. But, Dem Bones are connected. Whether it is budgeting or managing one’s investments or anything else, the more one understands that Dem Bones are connected, the more self-evident the prudent path becomes.
Charles E. Osborne, CFA, Managing Director
In 1913 a great flood hit the state of Indiana. It started on March 21, which happened to be Good Friday. A windstorm hit the state followed two days later, on Easter morning, by rain. It rained for three days, causing the Wabash River to rise and flood by Tuesday morning March 25. The water continued to rise for two more days, completely flooding the town of Logansport and leaving many of the town’s residents stranded and fearing for their lives.
At approximately midnight on March 25 the mayor of Logansport sent out a distress call to General Leigh R. Gignilliat at nearby Culver Military Academy boarding school. Culver, which is located on a large lake, had just a few years earlier launched a summer Naval School where summer campers could learn to operate cutter boats. Culver’s boats were in dry dock for the winter. Each boat was twenty-eight feet long and eight feet wide and weighed approximately 3,000 pounds.
Gignilliat woke the corps of cadets and they started loading the cutters onto rail cars. By 3:00 a.m. on March 26 the boats were loaded and the cadets jumped on the train and headed to Logansport. They went as far as the train could go, unloaded the boats and began their rescue mission. Over the next two days those cadets saved the lives of more than 1,500 residents stranded by the floodwaters. The following year, in 1914, the town of Logansport commissioned and donated a bronze and brick memorial gate in appreciation for what
those cadets had done. Logansport Gate, as it is known today, now forms the back gate to Culver’s campus.
Seventy years later a young man named Chuck Osborne matriculated at Culver and was required to memorize that story, among others. It is a great story, and I still get emotional when I retell it. One can only imagine what it was like for those teenage boys to come to the rescue of so many. For Culver students then and now the story becomes ours, as it was a seminal event that helped shape the institution and its mission to create leaders who learn to lead by doing, or should I say lead from in front. That story helps to bring purpose and meaning to being part of the Culver institution.
We all have those kinds of stories. They may not involve saving lives (trust me I have never done anything that heroic), but they define our life stories. The groups we belong to, the people with whom we have shared fellowship, the places we have lived and things we have witnessed: These things bring meaning to our existence and most of the time they happen when we are doing something as part of a defined group. It could be our high school, like the story I shared, or it could be family, church, etc. However, for most of us we spend the majority of our lives, and therefore our stories, doing something we usually think of as work.
From the time we are in our early twenties until today, we have spent most of our time working. We are often defined by our work. “This is Chuck he manages money,” or “This is Susan, she is a lawyer,” or “This is Bob, he is the captain of a tug boat,” or maybe, “This is Dawn she is a stay-at-home mom.” Certainly there is more to each one of us than just our jobs, but our jobs are a significant part of our lives.
So what happens when it is time to retire?
Retirement is the number one goal that we hear from our clients. The vast majority of the money we manage is being accumulated for the purpose of providing retire- ment income. The two most frequent questions we are asked from our clients are, “Do I have enough for retirement?” and “How do I transition from accumulating a retirement portfolio to living off a retirement portfolio?”
In our experience most fear the first question more than they should. They hear claims like the one recently made by Senator Maria Cantwell who stated that “…92 percent of Americans are unprepared [financially] for retirement.” Of course the senator was quoting a study, and there are lots of them. Most claim that anywhere from 53 percent to 84 percent of Americans will have inadequate income in old age. Andrew Biggs and Sylvester Schieber recently co-authored an article in The Wall Street Journal claiming that “…these statistics are vast over- statements, generated by methods that range from flawed to bogus.” Biggs is a former principal deputy commissioner of the Social Security Administration and Schieber is a former chairman of the Social Security Advisory Board. They know a little bit about the subject of American retirement readiness.
Their claim matches what we have seen in our own client base. We help many of our clients with retirement and other forms of financial planning. There are certainly times when in doing so we must bring our clients bad news, but the majority of the time we deliver to our clients the news that they are better prepared then they originally thought. We can see the stress disappear from their faces as we go through the results.
The second question is easily answered. Several years ago now we created our income strategy. It is based on our belief that a prudent investor is absolute return-oriented and not concerned with the investment results of others. If a retiree needs to take income from her portfolio that equals 5 percent of the total, then we should invest that portfolio to achieve 5 percent income while taking as little risk as possible. In today’s market that means owning the stock of companies like AT&T that makes dividend payments equal to 5.19 percent of the current price of the stock, or in industry terms yields 5.19 percent. Should rates rise and the United States Treasury offer to pay 5 percent interest on its debt, then she would own Treasuries. The point is to get the retirement income in the safest way possible. It also has the side effect of leaning more to stocks when interest rates are low and toward bonds when interest rates are high, which just happens to be a logical way to maximize returns over time.
Once the ability is calculated and the strategy understood, the conversation usually ends. But, it should not. There are two other questions that few ask, but everyone should. The first deals with health. Remember the story of Tithonus in Greek mythology: Tithonus was kidnapped by Eos, Titan of the dawn, to be her lover. Eos asked Zeus to grant Tithonus immortality, but she forgot to ask for eternal youth. Tithonus indeed lived forever but became old and frail and eventually was too weak to move his limbs. He begged for death but it would not come. The moral of the story is be careful for what you wish.
Retirement may seem great but one needs to plan for keeping in shape. For many Americans what little exercise they get comes from work. When they stop working they stop moving, and when that happens they start falling apart like Tithonus. In their book, “Younger Next Year,” authors Chris Crowley and Henry Lodge do a great job of discussing the importance of staying active as we age. Lodge is a doctor in New York and Crowley is one of his patients. They discuss the importance of exercise in retirement.
Our joints need to be moved and our muscles used or they lock up and deteriorate. The older we get, the faster that starts happening.
The second unasked question is perhaps even more important: What am I going to do to bring meaning to my life? Work provides purpose. We get up in the morning because we have to get to work. I am reminded of the simple prayer written by John Wesley, founder of the Methodist church. “God, grant that I may never live to be useless.” People need to be useful, helpful, needed. If you don’t believe me, watch the crowd on the plane the next time you fly. It starts in the security line as the person in front of you is unprepared to take his shoes and belt off and get out his laptop and quart-sized bag of allowed liquids, because he just had to check all of his messages instead of getting prepared while he meandered through the line for the last twenty minutes. I have often thought that airports should have signs that read, “If your email is so important that it can’t wait 20 minutes then you would be flying private. Put the iPhone away!”
Of course it doesn’t stop there. The minute the plane lands everyone has their phones back out, off of “airplane mode” and seeing what they missed over the last hour in flight. It makes them feel needed. It makes them feel important. While we may not need as much of that as we get with our electronically connected society, we do need some of it and for most of us it comes primarily from work.
Being prepared for retirement is not just about having the money. One needs a plan to stay active, to be involved and to create that sense of purpose. What am I going to do to keep my body active and healthy? What am I going to do for social interaction, fellowship and purpose? When faced with these questions many may come to the conclusion that the supposed bliss of retirement is nothing but a myth. When forced to fill their days, some will choose to play golf and other stereotypical retirement activities, but most will decide that work isn’t all that bad. They may want different work – fewer hours or more flexibility. They may want something more dear to their hearts, like volunteering at a charity, their church, the hospital or some other worthy institution. A person turning sixty-five years old today has a life expectancy of more than twenty years. We all love vacations, but a twenty- year vacation is a bit much.
I can only imagine the sense of purpose and fulfillment that those young Culver cadets felt with every life they saved. They were just boys. The gate that was given to Culver in recognition of their efforts is now more than 100 years old. For those unaware of its history and meaning, today the gate is the place where hungry students go to pick up the pizza they just ordered from local favorite Papa’s Pizza. Even in old age we all need a purpose.
It is our job to help our clients meet their financial goals, the most important of which is usually retirement. This may seem strange coming from someone who manages money for a living, but when it comes to retirement the old saying is true: There is more to life than money. We would be remiss in our duty if we didn’t remind you of that from time to time.
Charles E. Osborne, CFA, Managing Director
~The Retirement Myth
Do you really write “The Quarterly Report”? I get that question a lot. The answer is yes. Most people who know me well think my wife actually writes the report. Her career has been in corporate communications and she is a good writer, but she simply edits. (She will actually tell you she only proof reads my writing, but that is just because she is too modest.) In my opinion it takes two skills to be able to write well: First, you have to be able to tell a story; I learned that from my father. Second, one needs knowledge of language and something we are increasingly destroying in our 140-character culture: grammar.
I learned most of what I know about grammar in the eighth grade. My eighth grade English teacher was a volunteer; her husband was a successful doctor and she didn’t need to work. She volunteered her time at my church-run school because she felt it was her calling to teach middle schoolers how to speak and write in proper English. My hands are beginning to shake just thinking about it now – she was the toughest teacher I ever had, and my first report card that year had on it something that my mother had never seen: a letter other than A – and it wasn’t B either. Mom threatened to not let me play basketball. My father interceded on my behalf and made a deal – I could play my favorite team sport as long as I got that grade back up where they expected it.
So I did just that. I worked harder in that class than I probably did in any other class until I got into my major in college. Along the way something happened that I really didn’t appreciate until many years later: I learned the English language. While that skill can be very helpful in one’s career it does have one very negative side effect: I get chills up and down my spine when people abuse our language, which they increasingly do on a daily basis.
Some things one just has to learn to live with, such as the misuse of good and well, especially in sports. Golfers, for example, will start their post-round interview saying, “I hit the ball really good today,” and I want to stand up and scream at the TV, “No you didn’t! You hit it WELL!!” But, I resist that urge because the proper use of well and good is a battle that cannot be won. Please don’t misunderstand, I am not judging; it is just a knee-jerk reaction ingrained in me by teachers who would respond to the question, “Can I go to the restroom?” with, “I don’t know. Can you?” Then one would sit there holding it in until the correct, “May I…” was presented. I suppose those teachers would be brought up on child abuse charges in today’s schools.
What really bothers me is when people use words that are not really words, especially in an effort to seem more intelligent. Irregardless is a classic example. The fact that it isn’t a word does not seem to discourage those who either do not know what regardless means or just feel that it is not sophisticated enough. Resiliency is another good example. A few months ago I was watching a sports event and the announcer kept saying it: resiliency. It was like fingernails on a chalk board. As it turns out, resiliency is a word. It means resilience, but people stopped using it a few hundred years ago because why in the world would one use a four-syllable word when three syllables do the job. It has unfortunately returned to some popularity thanks to the pseudosophistication movement. Resiliency, it seems, has a great deal of resilience due to its more sophisticated sound.
This poor use of language is not just a problem for those of us who enjoy watching sports. It is rampant in corporate America, where it is seemingly more important to be able to construct sentences with nonsensical industry speak than it is to actually know anything. Branding was the first example I experienced at my first annual conference with Aetna Retirement. Until that time I thought branding was something a cowboy did to a cow in an old western, but there I was listening to some guy high-up in the marketing department who talked for 40 minutes, used the word brand or branding 250 times and somehow said nothing. I felt like Tom Hanks in the movie “Big.” He was a young boy who woke up in the body of a grown man after wishing to be big. In his first business meeting he simply raised his hand and said, “I don’t get it.”
In no industry is this truer than in ours. The investment world has a language all its own, and it gets used and abused. The degrees of abuse range from simple confusion to practical dishonesty. It starts with how we refer
to ourselves: In the good old days when people spoke plain English the investment world was made up of bankers, brokers and investment advisers. Bankers helped companies raise capital to get started or more often to expand operations. Brokers brought buyers and sellers of investments together. Investment advisers managed other people’s investments. It was fairly simple.
Then technology brought buyers and sellers together without the middle man, and the broker, instead of going away, became the financial adviser. They used that term because they were prohibited from calling themselves investment advisers. Investment advisers really didn’t mind however, because they had long been known as money managers. So financial advisers became wealth managers. Every time I have heard someone use the term “wealth management” I have asked what it means. No one has yet given me an intelligent answer.
This is not all harmless marketing spin. Most of our individual clients come to us with accounts from the big brokerage firms, Merrill Lynch, Morgan Stanley etc. Clients over a certain age will say, “I manage my money, and Bob at Merrill Lynch is my broker.” Younger clients will say, “Morgan Stanley manages my money.” They say that because they don’t understand the difference between wealth management and money management. Well, it is the same as the difference between irregardless and regardless. One is a real word, the other isn’t.
Understanding how our industry works is confusing enough. Understanding who is in the business of giving advice versus the business of selling products is a huge step. However the language barrier doesn’t stop there. Regardless (notice: no ir needed) of whether an investor wishes to DIY – that is the contemporary non-English way of saying do it yourself – with the help of a broker or to use an adviser, she must navigate a labyrinth of industry speak in order to build a simple portfolio. Concepts such as risk are described as “beta” and “standard deviation.” Philosophy and process are described as “value, growth, or GARP” – growth at a reasonable price. Portfolio construction is described as “diversification” and investments that cost more are called “alternative.”One is then told that the alternatives he invested in are losing money because they have a low “correlation,” and that is evidently something he should want. Following an index that constantly changes is described as “passive” while owning the same core companies for several years is “active.” The newest thing is “smart beta.” I’m not sure if that means regular old beta is dumb, but I saw an article just last week saying that “smart beta” is here to stay, so we better get some.
All of this is designed, whether purposefully or just by the subconscious habit of human nature, to make those of us in the industry look smart and you, the clients, feel dumb. But don’t! Albert Einstein once said, “If you can’t explain it to a 6-year-old, you don’t understand it yourself.” As I understand it Einstein was a pretty smart guy.
This has long been an issue with fast-talkers who are really more interested in making a sale and gaining a commission then they are in understanding what they are selling, or more importantly in understanding their client’s actual needs. Increasingly, however, it seems to be an issue with actual investors. We often meet people who are just dying to use the five industry terms they picked up to impress us, and I can almost feel their disappointment when we ask them to describe their objectives in plain language.
In plain language people don’t want exposure to beta, smart or otherwise; they want to stay in their home during retirement. They don’t want an uncorrelated alternative portfolio; they want to provide their children with an education. They don’t want market neutral alpha; they want a reasonable certainty that they will not outlive their assets. A 6-year-old can understand that.
Plain, correct language that any 6-year-old would understand is always the best way. An investor always plays one of two roles: she either owns something that she believes will increase in value over time, or she loans money to someone else who promises to pay it back plus interest. We call those roles equity and debt, respectively. Risk to an investor is losing money, not some mathematical formula. This is what we do at Iron Capital. We are investment advisers, or money managers if you will. We represent our clients, not any financial institution. We invest our clients’ money in things we understand. We know what we own and to whom we have loaned. We make prudent investments and structure portfolios to meet real needs while avoiding any permanent losses. It may be considered old-fashioned or boring, but it works. It is a lot like grammar.
Of course there will always be those who are too hip to speak properly and too self-important to speak simply. Irregardless of the truth, the folks who come up with smart beta and reverse CDOs and alternative strategies of every sort have a great deal of resiliency in their ability to produce marketing spin. Why wouldn’t they? After all, they do it so good.
Charles E. Osborne, CFA, Managing Director
~The Things People Say
Have you ever noticed how wise coaches seem to be? The good ones, at least. They give us little bits of wisdom that last a lifetime. Even the run-of-the-mill coach will tell you things like: “Practice doesn’t make perfect, it makes permanent; only perfect practice makes perfect.” Or, “There is nothing wrong with getting knocked down as long as you get back up.” Or, “There is no ‘I’ in ‘team’.” The legendary coaches, however, are much more original and impart enough wisdom to fill a book – in some cases, multiple books. Don’t believe me? Go to the self-help and/or business management section of the bookstore and you will find a myriad of books written by coaches.
John Wooden, Dean Smith, Bill Walsh and Vince Lombardi have all written books. One gets the idea that these are truly singular men and special leaders. I know I thought so, and then last fall I agreed to coach my son’s youth basket-ball team. I was born in North Carolina, played high school basketball in Indiana, and went to college on Tobacco Road. In Georgia – where the two most popular sports are football and football tailgating – that makes you a basketball expert. I took the job, and I am not sure how much the kids learned, but their coach learned a great deal.
Mostly I learned that the old cliché about there not being any such thing as great men, only ordinary men who are thrown into great circumstances…it may be true. Within a few weeks of being named head coach of the Sharks (that was the name the kids picked) I started saying all kinds of really deep, life-altering stuff. The most significant moment came in a game when one of our players had scored and the volunteer scorekeeper was not as fast at updating the scoreboard as the guys who work the big television networks. The other team is driving down the court and my star point guard is pointing at the scoreboard instead of playing defense. At that moment in the heat of battle, if you will, I yelled, “Don’t worry about the score, play this possession. Win this possession.”
After the game I had two thoughts. First, there actually is something intrinsic to coaching that brings out the inner philosopher. Secondly, I can write a news- letter on that one. I am certainly not the first person to speak to the importance of always staying in the present. From Buddhism to our Western Judeo-Christian tradition, this is a concept that is universal in major religion and philosophy. You have probably heard the saying, “Yesterday is history, tomorrow is a mystery, but today is a gift. That’s why they call it the present.” Even a long time ago in a galaxy far, far away, this principle held true. Jedi Master Yoda scolds the young Luke Skywalker about his fantasies of the future, saying never was his mind on where he is, what he is doing.
In economics they speak of the concept of sunk cost. An economic decision must be made in the present, with no regard for how we got here. The great example they use is a story about Andrew Carnegie. Carnegie’s steel company was building a new factory. While the factory was under construction, new technology emerged that would make the factory obsolete upon opening. His managers wanted to open it anyway, after all the company had made a large investment in its construction, but Carnegie understood that this past did not matter. That was sunk cost. In other words, it was in the past and there is no way to go get it back. That investment did not matter now, because facts had changed, and Carnegie ordered the factory to be rebuilt with the new technology.
In our world we are not running steel companies and investing in factories and equipment; we are investing our clients’ portfolios in various securities. The concept is still the same. One of our favorite maxims is that long-term investing is a mindset, not a time frame. I think many people struggle with this concept. We hear people all the time who have made investing mistakes and watched the value of their portfolio drop and they say, “Well I’m in it for the long term.” Behavioral finance teaches us that the usual immediate reaction to bad news about an investment is denial. We want to believe we make good decisions and if we have made an investment then it will work out in the end. If the drop is due to nothing but market noise then it will work out, but when facts have changed the rational investor must change with them.
It is really a simple concept. We make a decision today based on what we believe the long-term future holds. Tomorrow we have to do the same thing, and the day after that. The big picture does not change all that quickly, but it does change. There are lots of people who have made good livings on Wall Street by being “consistent.” They are either consistently optimistic, or consistently pessimistic. They are both right about half the time. They come across as brilliant because they will tell you about how they predicted this bull market, or that bear market. What they don’t tell you is that the optimist has predicted twenty of the last twelve bull markets and the pessimist has predicted twenty of the last five major crashes. A broken watch is correct twice every day. A consistent thought process applied to dynamic information will yield dynamic outcomes. Someone who is truly consistent and in the present will accept new information and allow that information to change his mind. One may invest in a company believing that the long-term return will be fifty percent. If the stock of that company then goes up fifty percent over a short period of time, assuming nothing has actually changed at the company, then the long-term investor should sell.
In another scenario, a long-term investor invests in the stock of a company that she believes has solid management whose interests are in line with shareholders’ as they hold large quantities of the stock themselves. If that management resigns, gets caught in a scandal or simply sells all their shares, then the facts have changed. She may have just made the investment a week ago, but it doesn’t matter. The long-term view is now different and action is required.
It really is simple. However, many people confuse simple with easy. If staying in the present were so easy there wouldn’t be so much written about it. It is really a very hard thing to do. The past clouds our judgment, and the future can cause problems as well. In sports it is very easy for teams to get ahead of themselves. I can recall clearly one of my most embarrassing moments from my college days. I was in the Dean Dome in Chapel Hill, NC, sitting with several Tar Heel friends while my Wake Forest Demon Deacons built a twenty point half time lead. I could see the future of a wonderful upset victory only made better by the fact that we were in Chapel Hill. The Wake team must have had the same vision because they came out in the second half prepared to ease into the victory. Unfortunately for them, and for me, Dean Smith’s Tar Heels did not stop playing just because they were down big. Slowly but surely they marched back and as they got closer the future began to dim, panic set in, and the thought of “we could blow this” could practically be seen on the Deacons’ faces. Carolina took their first lead of the entire game with seconds remain- ing. It was the largest comeback of Dean Smith’s coaching career to that point – thankfully for our pride the Georgia Tech Yellow Jackets gave up an even bigger lead a few years later.
How does a team get that far ahead and then end up losing? They get out of the moment and are living in the future. It can happen the other way as well – a team gets down and then just gives up. It happens in investing, too. Just like in sports, people think whatever is happening right now is always going to continue. Why did people pile into technology stocks in 1999? Because they saw this fantastic future where everything tied to the Internet turns to gold. Why did they pile into housing in 2006? Because they saw a future just like the past, where no one ever loses money on houses.
It is hard to not allow the past to cloud our decision- making, and it is equally as hard to humble ourselves to realize that we really do not know what the future holds. All we have is today, right now. This is why prudent investing is so important. Who knows what the whole world will look like years from now, but we can know if a company’s stock looks undervalued today. Who knows how long markets will boost up the returns of overvalued assets, but chasing those returns usually ends poorly. What risk will actually raise its head tomorrow, we do not know, but we know the risk is there today and the prudent course is to avoid it. We can’t control the score board; all we can do is keep playing the game one possession at a time.
Play this possession. Win this possession. Go Sharks!
Charles E. Osborne, CFA, Managing Director
~Win This Possession
We live in the world of Facebook and Twitter. My generation grew up with the advent of fast food and McEverything. It is no surprise that today’s technology generation grew up with iEverything, starting with the iPod, iTunes, iPhone, iPad, iMac, etc. “Look at me” is the universal cry, so much so that I constantly see people so busy taking pictures of themselves and their friends in what look like fun places that I wonder if they might be forgetting to actually have fun.
Of course this is nothing new, it is the human condition. Our ancient myths are full of stories of prideful heroes being cut down to size and learning that a little humility is a good thing. Recall the story of Daedalus and Icarus from Greek mythology. Locked in a tower by King Minos, the great inventor, Daedalus fashioned wings for himself and his son Icarus so they could escape their prison. The wings were made of feathers held together with wax. Before taking flight Daedalus told his son, “Icarus, my son, I charge you to keep at a moderate height, for if you fly too low the damp will clog your wings, and if too high the heat will melt them. Keep near me and you will be safe.” Of course we all know how it ended: Icarus, so full of himself and the thrill of flying like a god, went higher and higher as if to reach heaven and his wings melted away. Daedalus, in grief over the loss of his son, made it onto Sicily, where he built a temple to the sun god Apollo and hung up his wings as an offering. The great concession: he was only human after all.
Even today in our often narcissistic culture we can see references to the wisdom of humility. In the 2006 hit James Bond movie “Casino Royale” Dame Judith Dench, playing the role of M, delivers what I think is one of the greatest lines in the whole James Bond series while speaking to Bond: “This may be too much for a blunt instrument like yourself to understand, but arrogance and self-awareness seldom go hand in hand.” C.S. Lewis, in “Mere Christianity,” was a little more blunt than M. He refers to pride as the “anti-God state of mind”. He believed it was the route of all evil. Whether that may be a little over-the-top is a discussion for another time, but he makes one of the most insightful comments I have ever read on the subject. “There is no fault which makes a man more unpopular, and no fault which we are more unconscious of in ourselves,” Lewis writes of pride. There is a reason the word arrogant is frequently followed by another word starting with a, which we won’t publish in our family newsletter, almost as often as the word fool.
I do not know if C.S. Lewis is correct about pride, arrogance, hubris or whatever you wish to call it, being the greatest sin overall, but I can guarantee you that it is the greatest sin in investing. It is incredibly dangerous, largely because it is so hard to see in ourselves. As a result it is the number one mistake made by professional investors. Amateurs make all kinds of mistakes; pros usually make only one, but it is a big one. The most notorious example was of course Long-term Capital Management, otherwise known as the hedge fund that almost destroyed the world. If you are interested you can read the book “When Genius Failed” by Roger Lowenstein. The short version is: Two Nobel laureates run a hedge fund that did great until it blew up and required a $3.6 billion bailout to keep the entire financial world from collapsing. It happened in the late 1990s, so much of the world was too wrapped up in the internet bubble to care, but those of us in the industry will never forget.
Not forgetting and learning are too often two different things. In the Spring of 2007, I attended a lunch presentation delivered by a money manager from Chapel Hill, NC. He was a great presenter. He said several things that were just plain wrong, but he said them with such confidence it was amazing. He was running a strategy that was popular at the time: purchasing mortgagebacked securities, which he promised were completely safe, and he was using leverage – which is industry speak for borrowing money for the purpose of investing it – to raise the rate of return to whatever percentage you wanted. To understand how this works let’s assume you had $100,000 to invest. You want to get a 10 percent return which would be $10,000 on a $100,000 investment. Mortgage-backed securities were paying approximately 5 percent. He then suggested you could just borrow another $100,000, invest the $200,000 in 5 percent mortgage bonds (5 percent of $200,000 would be $10,000) to make your $10,000 “without risk.” Of course you would also have to factor in the cost of borrowing the money etc., but this is the basic idea behind leverage.
There was just one problem: Mortgage bonds were not risk-free. Some went down in value well over 50 percent, and in this scenario that means your $200,000 investment would be worth less than $100,000, which is the amount you borrowed. You end up losing more than you ever had. I was in shock hearing this presentation, and then the person next to me looks over and says “Isn’t this guy great?” I told my fellow audience member as politely as I could – which in all honesty was probably less polite than I should – that our speaker was an arrogant fool. I don’t know if the gentleman next to me invested or not, but he was sold.
I have often wondered what ever happened to the speaker from that day in the aftermath of the financial crisis. I don’t wonder about his clients, because I know what happened to them. I do wonder about the arrogant fool. My guess is he is back at it. In my experience the problem with arrogant fools is that they never admit to themselves that they are arrogant or fools, and therefore no matter how many times it comes back to haunt them, they never cease to be either.
The other problem, especially in my business, is that arrogance can often be convincing. As Mohammed Ali once said, “It ain’t bragging if you can back it up.” He did back it up, and many people loved him for it. This is what happens on Wall Street. There has been a loud theme over the last several years that what caused the financial crisis was greed. I have worked in the investment world my entire adult life, and frankly I have not seen much greed. Sure I have seen some, but not like most claim and certainly nowhere near as much as I have seen pride. I could be accused of splitting hairs here, but even the seemingly never-ending appetite to make more money isn’t always rooted in greed. So many of them never spend the money, because that is not what it is about. It’s about pride – being able to claim that you are the best in a game where money is not something you make to enrich yourself but simply a way of keeping score. You are, as Ali was also fond of saying, the “Champ of the world!”
Some may not see the difference between pride and greed, but I think it is an important point. There are not nearly as many greedy crooks in my business as there are prideful fools who really begin to believe that they can do no wrong, and then all of a sudden they meet Joe Frazier. They get stunned in the 11th round by a left hook and then in the 15th another left and “Down goes Ali, down goes Ali!” They don’t intend to hurt anyone; they truly believe their own propaganda. They are blind to their hubris right up to the point when Frazier hits them with that left hook, or until the sun melts the wax on their wings, or until it turns out that even virtual companies have to make actual money, or when people who can’t afford the house they bought stop paying their mortgages.
One of the best salesmen I have ever known used to tell me all the time that he was often wrong but never in doubt. I would laugh and respond that I try to be seldom wrong, but always in doubt. That is the way one must be if they are going to be making decisions about money, especially other people’s money.
Western culture used to value age. Youth was associated with arrogance, and “coming of age” often meant being humbled. With age comes humility and wisdom, and that is what we strive for everyday at Iron Capital. We will never be perfect but we keep striving, keep making progress. One might wonder why we would choose to write such a newsletter now. Certainly this message would be better suited for the end of 2008 than the end of 2013? Well, pride comes before a fall, and that is when one must be on guard. 2013 was a great year, but as Han Solo told the young Luke Skywalker after Luke shot down an imperial fighter, “Way to go kid. Now don’t get cocky.”
Charles E. Osborne, CFA, Managing Director
~Pride Comes Before a Fall