The Value of Scuttlebutt

One of the most valuable things an investment manager can do, in my opinion, is talk to other investors whose opinion you respect.

You don't always have to agree with their opinions, or even act on them, but sometimes just talking to others, and getting industry scuttlebutt, can be as valuable as reading annual reports.

Take last fall, for example. Steve Jobs had just died, and the investment community was buzzing about what would be the future of Apple, the company he started.

The initial reaction of the stock market was understandably negative to his passing.  Genius the likes of a Steve Jobs is rare, and while his replacement Tim Cook has proven to be a tremendously capable executive, no one expects Mr. Cook to be able to have the creative capacity that his predecessor had.

I must confess that at the time of his passing I was tempted to sell some of the Apple stock that I had bought for my client portfolios.  Fortunately, I had the chance to have a brief discussion with Chuck Clough.

Chuck Clough had been a top-rated investment strategist for Merrill Lynch for many years.  I was an avid follower of his work, and his insights and analysis were very helpful to me in managing client portfolios.

Mr. Clough left Merrill around a decade ago to manage money in a firm he started. Clough Capital today has about $3 billion under supervision.

Last fall, Chuck and I had attended a meeting hosted by Barclays Securities where the topic of Apple stock was discussed.  Ben Reitzes follows Apple for the brokerage company. I remember that while Reitzes urged those in the room to take advantage of the weakness in Apple stock to add positions, few seemed inclined to do so.

So after the meeting Chuck and I were walking back to our offices, and we got to talking about Apple.

"You know," Chuck said, "this reminds me of the late 1960's, when Walt Disney died.  Everyone wanted to sell Disney stock then, but it turned out to a great buying opportunity."

Chuck went on.

"I have been reading the Jobs biography {written by Walter Isaacson} and it seems to me that while Jobs was obviously a creative genius, the real technology development was done by lots of other people in the company."

"Like Jobs, Disney was obviously a creative genius. But the richness of his company extended far beyond Walt Disney."

"So," Chuck concluded, "I am inclined to believe Ben Reitzes, and buy Apple in here."

In the 12 months since the passing of Steve Jobs, Apple has become the most valuable company in the world, as the stock has nearly doubled.

Besides being thankful for the serendipitous discussion I had with Chuck Clough, I am also reminded that sometimes the best ideas is to simply sit tight.

Or, to put it another, sometimes the obvious trades are not the best trades.

Planning for Retirement

This morning's New York Times carried an excellent column on retirement planning.  If you are at all interested in this subject, I would urge you to click on the link below.

One of the most important subjects the column addresses is the appropriate withdrawal rate for retirement accounts.

This is one of the most favorite topics among my clients who are either retired or nearing retirement, particularly in an environment with ultra-low interest rates.

Here's an interesting question/answer excerpt from the column, authored by financial planner Doug Wheat, a CFP associated with a firm named Family Wealth Management:

Q. I have read that the rule of thumb is to withdraw 4 percent or 1/25 of your retirement funds each year. My guess is that this “rule” was developed when interest rates on “safe” investments (CDs, certain bonds, etc.) would support this level of withdrawal. However, with interest rates near zero (at least for now), it seems only equities have the chance to earn a sufficient return to support the 4 percent rule, but equities are risky for retirees. What is your advice on how to invest retirement funds, and is the 4 percent rule still applicable? —HonuCarl, Los Angeles.

 

A. The notion of a 4 percent safe withdrawal rate emanates from a 1998 academic study often referred to as the “Trinity Study.” In the study the authors from Trinity University provide historical evidence that if you begin withdrawing 4 percent of your accumulated savings your first year of retirement and increase that amount each year by the rate of inflation, you have little danger of running out of money over a 30-year period if it is invested in a balanced portfolio of stocks and bonds. For example, if you have $1 million at retirement, you can withdraw $40,000 the first year. Assuming the inflation rate is 3 percent, the second year of retirement you can withdraw $41,200. This strategy is appealing because it provides a steady cash flow while the value of your portfolio may be fluctuating. Updated studies through 2011 indicate that since 1926 there were no 30-year periods where you would have run out of money using this strategy (although if you retired in 1966 you would have come awfully close). 

http://www.nytimes.com/2012/10/03/booming/03expert-booming.html 

I went on the internet to look up the "Trinity Study" that Mr. Wheat refers to in his column.

The authors of the study (Philip Cooley, Carl Hubbard and Daniel Walz) looked at portfolios that contained at least 75% stocks, and as Mr. Wheat indicates, retirees could provide 4% to 5% inflation-adjusted withdrawals without running out of money over any longer time period.

http://www.afcpe.org/assets/pdf/vol1014.pdf

The problem I have these days, however, is that many people are reluctant to have at least 75% of their retirement accounts invested in stocks.  The pain of 2008-09 is still too fresh in investors' minds, and despite bond yields that are below the rate of inflation most still want a significant allocation to bonds.

However, history would suggest that the real risk to retirement planning is becoming too conservative, not too aggressive.

Investing LIke Warren

Probably no investor in the history of Wall Street has been more widely followed and analyzed than Warren Buffett.

If you go to Amazon, for example, and type in "Warren Buffett" in a book search, you will find 1,117 paperback books, and 832 hardcover books, that have sufficient reference to Mr. Buffett that they are included in the search results.

Buffett's influence has been pervasive. News that Buffett might be buying a stock is usually cause for that stock to soar.

Buffett's views have been cited in dividend payouts (Berkshire Hathaway does not pay a dividend); tax policy (President Obama calls his proposal to increase tax rates on annual earnings of more than $1 million "the Buffett rule"); and philanthropy (Buffett famously is giving away most of his money, as is his good friend Bill Gates of Microsoft).

I think that one of the reasons that Buffett is so widely followed is that his investment style seems to be so easily duplicated.  Buying shares in companies like Coca-Cola; American Express; and Wells Fargo is not an actively limited to billionaires - anyone with capital and access to a brokerage account could buy the same stock.

Buffett is also famously very open about how he invests.  The letters in his annual reports are very readable, and he often appears in the business media.

Yet few, if any, have the investment track record over the past 50 years that Warren Buffett has been able to compile.

The Economist's Buttonwood column recently covered the latest research reports trying to figure out why Buffett is so good.

You can read the whole piece by following the link, but basically researchers at New York University and AQR Capital Management believe that Buffett's success boils down to two factors:  investing in low beta stocks, and an aggressive use of financial leverage.

Low beta stocks typically offer superior risk-adjusted returns to higher beta stocks, but market investors often will gravitate to higher beta stocks in an effort to produce superior returns. This means that "boring"stocks are often mispriced relative to their more volatile brethren.

According to the researchers, Buffett has combined leverage with low beta stocks with leverage (derived from the float in Berkshire's reinsurance business) to give him the best of both worlds, and deliver spectacular returns.

Here's an excerpt from the piece:

Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Better still, the firm has been able to borrow at a low cost; its debt was AAA-rated from 1989 to 2009....

These two factors—the low-beta nature of the portfolio and leverage—pretty much explain all of Mr Buffett’s superior returns, the authors find. Of course, that is quite a different thing from saying that such a long-term performance could be easily replicated. As the authors admit, Mr Buffett recognised these principles, and started applying them, half a century before they wrote their paper.

http://www.economist.com/node/21563735?fsrc=scn/tw/te/pe/secretofbuffettssuccess

I am not sure I totally buy into this latest research. I think there are other factors included in Buffett's DNA that has allowed him to invest in the way that he has.

For example, one big factor, it seems to me, is his incredibly long time frame in managing his investment portfolio.  This is a concept he took from growth stock giant Phillip Fisher, who used to say that his optimal holding period for a stock is "forever".

Buffett's partner Charlie Munger was interviewed recently by the BBC.  Munger was asked whether he and Buffett were concerned about the recent share price drop of Berkshire Stock.

Not only did Munger immediately dismiss any concerns about the share price drop, he went on to say that Berkshire has experienced price declines of up to -50% over the course of their management, and it was never a cause for concern.

Moreover, Munger says, anyone who invests in stocks should be prepared for large price declines. If they can't handle a decline, they should be prepared for the "mediocre results that they will almost certainly earn".

Here's the interview in total.  The most important comments occur at the start:

Stocks Continue To Climb The Wall of Worry

The S&P 500 posted a solid +6.4% total return in the third quarter, and is now up more than +16% for the year.

For the last 12 months, the broader market is up more than +30%.

But this has been truly The Rally That Wall Street hates.

Focused mostly on what can go wrong - and not on the huge relative attraction of stocks relative to bonds - strategists have consistently called for caution over the past year, and have thus missed one of the strongest 12 month rallies in the past decade.

And Wall Street still remains bearish, as Merrill Lynch's global strategist Savita Subramanian wrote yesterday:

Equity sentiment remains unchanged near all-time lows 

Despite the Federal Reserve's announcement of another round of quantitative easing on September 13th, the Sell Side Indicator was unchanged during the month. At 44.4, our measure of Wall Street bullishness on stocks remains just slightly above the all-time low of 43.9 set last July. This suggests that sell side strategists' bearishness on equities remains near 27-year extremes. 

http://rcr.ml.com/Archive/11207916.pdf?w=dglen%40bpbtc.com&q=vvLKv532TueBzvmV!cAugA&__gda__=1349185384_bb996c9b864636019d46b0be4bcf2677 

Although we are probably due for some sort of correction, I continue to believe that we could rally into the end of the year. 

To be sure, recent economic data has not been especially encouraging, and comments coming from corporate America have been cautious. But with so much money on the sidelines earnings essentially nothing, investors are being forced to gradually deploy at least a portion of their reserves into riskier assets.

A good example of this can be found in the private equity community.

Writing in this morning's New York Times, columnist Andrew Ross Sorkin observes that many private equity funds are under pressure to invest some of their cash reserves or face the unappealing prospect of being forced to return funds to their investors and lose out on their lucrative fees.

Sorkin notes that private equity funds currently control nearly $1 trillion.  Nearly $200 billion from funds raised in 2007 and 2008 have be spent in the next 12 months, or else returned to investors.

Here's what he writes:


If the private equity firms don’t spend the money that they have already raised, it is unlikely they will be able to raise even more in coming years. And increasingly, the private equity firms have become dependent on the management fees not just to keep the lights on but to expand their businesses into other areas, in part to diversify, which has been part of the pitch to public investors. The biggest firms have become asset gatherers.

“In a nutshell, 95 percent of funds would be affected and see a big drop in fee income based on not investing all of the committed capital,” according to Tim Friedman, director of North America for Preqin, which tracks private equity fund-raising and deals. He said that he did not expect firms to do deals simply “for the sake of it,” but he also cautioned that the firms were “under a lot of pressure.”

http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-to-do-with/ 
 

Feeling the Pain in Spain

My wife and I just returned from a week in Madrid.  We had a marvelous time - Spain's capital city is beautiful.  We loved walking around the city, and seeing the wide variety of neighborhoods and cultural sights.

Our trip was not without drama, however.

In response to conditions imposed by the European Central Bank, Prime Minister Rajoy's government has proposed a very austere fiscal program. 

These cutbacks will impact nearly every segment of Spanish society, as the New York Times explained this morning:

And then there was Spain, where last Thursday the government of Prime Minister Mariano Rajoy introduced one of the most draconian budgets in the country’s history. It was intended to reassure international investors and demonstrate the fiscal discipline that the euro zone was demanding of Madrid. 

The markets need reassuring: Spain has a stubbornly high budget deficit, its banks require tens of billions of euros in rescue loans and the government may soon have little choice but to request European aid. 

http://www.nytimes.com/2012/10/01/business/global/pension-dilemma-in-europes-debt-crisis.html 

Demonstrations were held protesting Rajoy's proposals throughout Spain last week, including several in Madrid and Barcelona. 

Since our hotel was only a block from the Spain's Parliament building, we experienced first hand the frustration and unhappiness of Madrid's citizens.

The larger demonstration was held on last Tuesday night, when several thousand people gathered in the park located down the street from the government offices.  Another similar demonstration was held on Wednesday night, although the crowd was noticeably smaller.

The demonstrations were largely peaceful, and had the feel more like a sports rally than an angry mob.   However, once the police moved in to try to break up the crowd, the atmosphere became a little more tense, as protestors battled with police dressed in riot gear.

We watched the protests from the vantage point right outside our hotel, joined by several other curious visitors and hotel employees. 

It was somewhat uncomfortable, to be honest, to be standing outside of our luxury hotel watching the chants of protest being raised by passionate citizens.

While we were watching, I had the chance to have a long conversation with one of the hotel employees, whose English was nearly flawless. 

He told me that his girlfriend - who works for the national health service - just had her pay significantly cut as a result of the government's austerity program.  In other words, in his world, Spain's economic woes are very real.

At one point he turned to me and asked:

"What do Americans do when the government cuts their benefits? Do they have similar protests as these?"

For a moment I thought, and then had to answer him truthfully.

"Well," I said, "in America, our government does not ask our citizens to take cuts. Since we have the ability to print money, and the world apparently has an insatiable appetite for dollars, our debates are largely about cutting taxes and raising benefits."

He looked at me incredulously, then shook his head. 

Spain's economic woes are not the result of fiscal probity, but rather an overextended banking system.Yet the Spanish citizens are paying the price.

I thought about this conversation on the plane ride home, and wondered how our country would react to seeing benefits cut and taxes raised.  

Fiscal austerity has not been proposed in the United States for decades, despite our $16 trillion cumulative budget deficit. President Jimmy Carter, for example, was widely mocked in the late 1970's for suggesting that Americans turn down their thermostats and reduce their dependence on debt.

Since then, politicians on both sides of the aisle have steered clear of any suggestions that American lifestyles might eventually have to changed.

Columnist Frank Bruni had a good piece on this same subject in the op-ed section of the New York Times yesterday.  Here's an excerpt:

The size of the federal debt and the pace of its growth can’t be ignored. 

Economists disagree on how soon and aggressively to tackle them, but not about the eventual need to. 

Yet we have tax rates that, by some measures, are near the lowest in the postwar era. We also have polls that show that a clear majority of Americans don’t think our country is positioned to afford its children as good a life as its adults have enjoyed. 

Conditions, all in all, are ripe for a serious conversation about sacrifice. But this presidential campaign has been noteworthy for its nonsensical insinuations or assurances that although we’re in a jam, we can emerge from it with discrete, minimal inconvenience. 

http://www.nytimes.com/2012/09/30/opinion/sunday/bruni-sacrifice-three-muffled-syllables.html?pagewanted=1