Today's headlines are rarely the same as what history's judgement is going to be

Photo courtesy FaceBook

Jonathan here: Went to Stamey's for a late lunch, all by myself. I was really looking forward to three four things: a world class hot dog all the way (that's mustard, chili, onions, and Cole slaw for you northerners), an honest-to-goodness chopped BBQ sandwich, and a tall glass of sweet iced tea (otherwise known as the wine of the South).

To tell the truth, I was looking forward to spending some unhurried alone time with my brand new 2010 US Andex chart.

Image copyright Andex/Morningstar

I love charts. I can spend an hour with a good chart and come away with having had as much enjoyment (and learning as much) as reading a well-written book (for my current new favorite, shown right).

The Andex chart shows what would have happened to $1, had it been invested way back in 1926, in a bunch of different indexes representative of tangible investments (US Small Stocks, S&P500 Total Return Index, Balanced Portfolio, World Stock Markets ex US Total Return Index, Long-Term Government Bonds, 5-Year Fixed-Term Investments, 30-Day Treasury Bills, and that darned old dog, Inflation, sorry Enzo).

As if that wasn't enough, the chart also shows: median PE ratio, minimum wage, the price of a first class stamp, gold, the price of oil, prime interest rate, and inflation. That's not all: dotting the nearly 85 years of time were hundreds of events, panics, assassinations, wars, crises, bombings, collapses, deficits, unemployment, Watergate burglars, hostages, bailouts, bankruptcies, market closings. It shows the day the first international mutual fund was introduced in the US and the day John Glenn orbited the earth.

All of the above is not the half of it, you need to get a copy of the chart for yourself or drop by our office and spend an hour or two with it.  In the words of Jack Bauer, I promise you, it will lower your blood pressure and your heartbeat; two numbers that I imagine have been higher than they really ought to be. Why, because it gives you a 30,000 foot view of things and lets you know that today’s headlines are rarely the same as what history’s judgment is going to be.

It was after 2:30 when I gathered up my belongings (today's News-Record, my PDA, and my new friend the Andex Chart, when I noticed several waitresses and busboys and one cashier, who apparently had just spend the last half hour or so gawking at some guy in a Seersucker suit, eating a hot-dog and a BBQ sandwich and pouring over a chart with as many squiggly lines (and as big) as a road map. The cashier became their spokesman, she took a step toward me and peered at the chart: "I saw the market was up 175 points this morning, what it is gonna do?" "By when," I said pleasantly and sincerely, hoping to draw her out. "Oh, I don't know, I guess by when I retire," she admitted, seeing I was for real. "We have a 401(k) plan, you know."

Judging she had at least 15 more good working years on her side, I said, "Keep your head down, your heart up, and take advantage of buying more shares month in and month out." "Thanks, she said, that's just what I thought I'd do." She added, "And that's just what our guy says to do, too. You know he comes to see us when the market us up and he comes to see us when the market is down, and he always tells us the same thing. I don't know how people without an advisor do it."

"I don't either," I replied, "Put an extra scoop of ice-cream on his peach cobbler next time he comes in. And thank him for telling the truth.”

If all this volatility has you down, drop us a line, give us a call, or come by and see us.  We'll talk about risk and return and how we're guiding investors through this mess, how to turn this crisis to your advantage.  It never hurts to have a second set of eyes, especially in this environment. 

And then we can go to Stamey's and enjoy a hot dog and a BBQ sandwich and a sweet iced tea.

Paul Krugman Thoughts

Justin here. I went with a friend last night to see Paul Krugman speak at the Guilford College Bryan Series. I've got a number of things on my plate today so my review/thoughts will be brief.

Best Quote: "We can no longer make money by selling each other houses that we bought with money we borrowed from the Chinese."

Second Best Quote: In talking about the similarity between the US and Japan he said something to the effect of "With the exception of our raw fish consumption, we're pretty similar. Both democracies, both have hard working intelligent citizens, both have politicians who aren't the best but aren't idiots."

Comment That Provoked a Slight Gasp from the Woman Beside Me: when answering a question about the N.C. furniture industry, Krugman said he couldn't imagine an industry that is so labor intensive lasting so long in a high wage country like the US. And he followed that up with something to the effect of "before you get too worked up about that, remember that it's only here because the high wage North East US forced the jobs south to cheaper labor." As if to say, this is only a pit stop on the way further south.

Cold Sweat Inducing Statistic: 55% of commercial loans that are to reset in 2014 are underwater. And that's considering that they started with an extremely low Loan/Value ratio that would certainly need to go up if they get rolled forward. Makes me think of a number of friends in the commercial real estate business as well and the impacts that has on other industries.

My Question That I Didn't Get To Ask: what do you do with your excess income (i.e. how do you invest)?

Overall message:

• He talked about how we got into this mess ('shadow banking', poor regulation, leverage),
• How this was/is a global crisis (Spain, UK, even countries without bubbles felt it because they were connected.)
• What we did right (cut interest rates, stimulus, flexible fed),
• How we get out this crisis quickly (no silver bullet that will save us like railroads, world wars, and IT did for recessions past . . . only remote quick fix could be green technology, but even that has a lot of barriers and lag time, and 10% unemployment is a HUGE number will take a lot of GDP growth to get over),
• How, more likely, to get out of it slowly (possibly unions (which, to my surprise got a round of applause), possible further stimulus, cut interest rates if we could go any lower)
• Final point was that Keynes said "the shortage of capital through use, decay and obsolescence causes a sufficiently obvious scarcity to increase the marginal efficiency" meaning that our ipods will break, our computers will become slow, and our tires will wear out. Although slow, this process will create demand and innovation.

Politics aside, it was a good talk. It reinforced our slow growth thesis and our propensity to seek quality dividend paying companies as well as opportunities outside the US and in fixed income.

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.