Tuesday, August 25, 2009

What's important Part II - Dividends, Diversification, and Safety

Jonathan here: One of the two best best ideas we've ever had is having an enduring investment process. The other is focusing more energy and resources on process than on outcome. In What’s Important Part II, we explore three ordinary but frequently underestimated components of an enduring investment process.  

Our part of the world gets, on average, 43 inches of rainfall each year. That’s too much to worry about the price of rain barrels going up, but not enough that your average gardener can really trust Mother Nature for all watering needs. It seems the popular and cost-effective solution of choice is Drip Irrigation. My introduction to it was nine years ago, in Sacramento, California. My son-in-law hooked up miniature hoses and nozzles, which sputtered, stuttered, and sprayed a fine water mist for three whole minutes twice a day, onto ferns, banana trees, morning glory, oleander, hibiscus, and bird of paradise. His “backyard” was literally a beautiful pool and a cement pool deck with huge terra cotta pots containing mammoth plants. I was astonished that the plants flourished in these conditions. Seriously convinced, once home I visited Lowes in search of all things drip irrigation. I threaded rubber hose no thicker than a pencil through a maze of rhododendron, yew, azaleas, hydrangeas, moon vines, morning glories, black eyed Susan, cardinal vines and impatiens. I attached, at various intervals, micro sprinklers and nozzles, balanced the water output with Y-splitters, and screwed into the nerve center of this hydroponic contraption, one battery operated Gilmour automatic water timer.

But not every gardener has it so easy (so to speak). Parts of California, Nevada and New Mexico, for instance, get between 8 and 16 inches of water per year. There’s a saying that farming is just gambling in slow motion – you have to wait nine months to find out if you’ve won. Recently, Morning Edition featured Zach Sheely, a farmer who can’t afford to place a bet on (or wait nine months to find out) whether he waters too much or too little. Sheely uses a system designed by PureSense (pictured right) to help him rebalance the moisture levels on his 10,000 acre, California vegetable farm. “Using probes, sensors, weather instruments and meters, PureSense calculates the moisture and nutrients in the soil; it uses the Internet to send the information to servers, and then uses software to analyze whether or not the crops are getting the right amount of water.” The data is then transmitted wirelessly to Sheely’s iPhone; he can literally make it rain on any section of his crops with the tap of a button.

The principles governing agriculture and investing are much the same. Plant the best seeds at the right time in good soil, then water, fertilize, weed, thin out, protect against threats, harvest, enjoy, repeat as often as necessary. Too much or too little of any of these activities can create undue risk. But, hit the right balance and you stack the odds of reaping a harvest in your favor. In our last commentary, we outlined six “prism tweaks” we’ve put in motion. We discussed, in detail, the importance of Price, Moat, and Uncertainty; this quarter, we’ll cover Dividends, Diversification, and Safety.

Dividends. Sometimes it helps us to think about investing in terms of being a gardener who sells vegetables, whole vegetable plants, and potted flowers at the local farmers’ market. On any given Saturday, she can decide to sell her hand picked vegetables (which, in investing, is similar to collecting dividends), or she can sell a whole plant (selling a dividend paying stock), or she can also sell her potted flowers (selling a non-dividend paying stock). The problem the gardener faces with buying and selling too many potted flowers (buying non-dividend paying stocks) is that the only way to make a profit is if her buyers think the flowers are worth more than she paid for them. That’s all well and good if her time horizon is long enough or the market for plants is stable. But what if (like many investors today) her time horizon is shorter and the market for plant buyers isn’t especially stable? Or what if the price of soil skyrockets or news reports circulate that recreational gardening is a health risk? People won’t want to plant in their gardens and prices of these plants will drop. If our gardener is depending on selling her plants (vegetable or flowering) for her income, she would have to sell them at an inopportune time. As advisors, we aim to set up our clients’ gardens (portfolios) in such a way that their vegetables (dividends) provide for the majority of their income needs and they aren’t dependent on the price of their plants (stocks) on the day they need income. There’s much more to dividends than finding the highest yield (for example, determining a company’s ability to keep paying it, management’s commitment to upholding it, and what we can expect in terms of its growth) but that’s for another commentary.

Diversification. Suppose our gardener needs to choose between planting squash, cucumbers, or both. She figures each will produce approximately the same amount of income for her and will need the same amount of sunlight, water, and care. The only difference: squash are susceptible to squash bugs while cucumbers are vulnerable to cucumber beetles. With an equal chance of either insect showing up hungry and harming a crop; it makes sense to plant both squash and cucumbers while still trying to ward off both insects. This is the case not only for stock diversification (owning more than just a handful of stocks), but even more so for asset class diversification (owning more than just a couple asset classes such as US Stocks, Bonds, Foreign Stocks, Commodities or Real Estate.) While it does get more complex meshing multiple asset classes, the outcome is still the same. An investor can take a number of inherently risky assets and combine them in a portfolio that delivers the highest expected return for a given level of volatility (determined by what the investor can stomach both financially and emotionally.)

Safety. Sometimes, what could seem safe (taking shelter in a storm under a tree or taking money out of stocks last March) can actually be the most dangerous option possible (both “lightning” and “missing a 30% rally” can really knock the wind out of someone). As portfolio managers, we want to make sure we’re always learning from our mistakes . . . but just not learning too much. We’re conscious to look at the important data points, not the prevailing perception that might say seeking sustainable dividends, wide moats, and low uncertainty is being too “safe” to provide any meaningful returns. We might normally agree, however today is far from normal. We’re in a market where companies with the widest moats are selling for the largest discounts (78% of their worth) while the companies without moats, see chart, are trading for no discount (100% of their value).

Author Annie Dillard says “Danger is the safest thing in the world if you go about it right.” While investing is and will continue to be “dangerous” in terms of uncertainty and volatility, we’re confident that we’re “going about it right.” As we said last quarter, we’re doing that by: concentrating on buying undervalued assets (Price), owning businesses with sustainable competitive advantages (Moat), and investing in areas where we have a narrower range of outcomes (Uncertainty). By adding to those the areas we’ve covered this quarter, we’re able to take calculated risks that line up with our clients’ ability and willingness to take those risks.

Monday, August 17, 2009

Justin W. Smith, CFA, Earns Prestigious Chartered Financial Analyst Designation

Greensboro, NC, August 14, 2009 − Justin W. Smith, CFA, a Financial Advisor at Jonathan Smith & Co., Investment Counsel in Greensboro, NC has earned the prestigious Chartered Financial Analyst® (CFA®) designation.

The CFA charter is a globally recognized credential for investment analysis and management. The CFA Program sets a globally recognized standard for measuring the competence and integrity of financial analysts, portfolio managers, and investment advisers. Currently, more than 82,800 investment professionals in 128 countries and territories hold the CFA charter.

Recipients of the CFA charter have successfully completed a graduate-level, self-study curriculum and series of three intensive examinations taken sequentially over at least two years. It is recommended that candidates prepare a minimum of 250 hours per exam, with substantially more recommended for individual circumstances.

Since the inception of the CFA Program 45 years ago, pass rates at each of the three exam levels have averaged about 50 percent. Because of the rigor of the program, only about one in five candidates who enter the program pass all three exams and successfully complete all the requirements to earn the charter.

Administered exclusively in English, the international language of business, the three six-hour exams cover ethical and professional standards, securities analysis and valuation, financial statement analysis, quantitative methods, economics, corporate finance, portfolio management, and performance measurement.

“This isn’t about adding three letters to the end of my name,” Smith pointed out. “At a time in the market where there is so much uncertainty, I’m happy to be able to do something that not only makes me a better advisor, but also gives our clients some added confidence in who they are trusting to get them safely home.”

“Five months ago, you could have picked a portfolio by throwing darts at the Wall Street Journal and had a great return,” Smith said. “But today, we think we’re looking at just the opposite. That’s an almost inconceivable shift in such a short amount of time. The CFA program has given me the knowledge, insight, and persistence to tackle this ever-changing investment landscape.”

And if his day job weren’t enough, he’s got a full load on his hands at home. “I’ve got a 115 year-old house, one toddler and another due soon, and a honey-do list that, due to the CFA exams, has been three years in the making,” Smith noted. “All that CFA work is going to seem like a breeze compared with what I have in store for me at home.”

Robert R. Johnson, Ph.D., CFA, deputy CEO, explained what motivates candidates to make such a significant investment of their time and energy to seek to earn the CFA designation.

“For more than 40 years, candidates have sought to earn the CFA charter for two chief reasons,” Johnson said, “one, to expand and test their knowledge of current practice across a broad range of investment topics, and two, to demonstrate to clients, employers, and peers their mastery of a demanding body of knowledge."

CFA Institute
CFA Institute is the global association for investment professionals. It administers the CFA and CIPM curriculum and exam programs worldwide; publishes research; conducts professional development programs; and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute has more than 96,000 members, who include the world’s 82,800 CFA charterholders, in 133 countries and territories, as well as 136 affiliated professional societies in 57 countries and territories. More information may be found at http://www.cfainstitute.org/.

Jonathan Smith & Co., Investment Counsel
Jonathan Smith & Co. is a Registered Investment Advisor providing investment counsel and financial planning for individuals, trusts, estates, corporations, investment trusts, employee benefit trusts, and institutions. Aware that each engagement’s wealth management needs are unique and often complex, they craft individualized solutions and simplify life's financial aspects for their clients. Their mission is to build, protect and manage each client's wealth through every stage of life. More information may be found at http://www.jonathansmith.com/.

Monday, August 03, 2009

I Probably Won't Be Dessert . . .

Justin here. Professor Jeremy Seigel recently pointed out the difference between the fear of unemployment vs the reality of unemployment here:

"The June unemployment rate touched 9.5%, and it is quite possible that that rate will eventually exceed the 10.8% rate reached in November 1982. But even if it does, unemployment will rise, at most, 2 percentage points, far less than the reported 30% to 40% of workers who fear they will be laid off. And as the economy mends, the fear of being unemployed will subside, and consumption will rise."

Professor Seigel has forgotten more than I'll ever know about economics, but I have to (very respectfully) disagree. I think it’s unrealistic to think that Joe Consumer could have 10-20% more friends, family, and co-workers lose their jobs and then somehow he'll then breathe a sign of relief and start spending because some economists think that unemployment is already far above normal. I think Joe is going to pretty scared for a pretty good while.

It’s like being in a pit of lions that, on average, will eat no more than one human in a sitting. I don’t know about you, but if I’m stuck in there and two of my buddies were just eaten (mind you that's 100% above the average), mean reversion and bell curves won’t make me any less likely to need a clean pair of underwear.