• Financial & Investment Management Group
  • Monday, December 01, 2008

Hope, Faith and the Rational

by Paul Sutherland
Posted November 14, 2008
Paul Sutherland, President

Current Observations

November Edition
PDF Version

I have hope and faith that the financial markets will once again return to rationalism. I think it is both rational and empirically logical that the markets will once again reflect the world's future. I also believe that your faith and trust in FIM Group as your portfolio's stewards and investment managers are well–placed and logical.

These beliefs are based on faith. While I have had friends and family say I am the most "faithful" person they know, I don't base my beliefs in luck or that we are the chosen ones so all will be okay. Rather, my "faith," is based on human nature, cause and effect, and Einstein's theory of relativity. It is a simple faith that even an agnostic or non–theist has – that the sun will rise in the east, parents will love their children, and people will eat, communicate, seek happiness and avoid suffering. Simply put … life will go on. It is a faith that comes from education, knowledge, study and experience.

This is, I think, the most important newsletter I will ever write. It is written for our clients, not to market FIM Group. It is written because I believe in honest, straightforward transparency. I believe we are your employees, hired and kept because we perform a valuable service and have performed well over the past 24 years. Were we lucky? Occasionally. But for the most part, our success thus far can be attributed to our flexible, well–educated and disciplined approach to investment management.

This October and the preceding months have certainly tested our faith in the U.S. government, democracy, capitalism, the goodness of people and institutions, and the rationality of optimism, hope and faith.

Years ago I wrote the words "faith" and "thank God" in a client newsletter and promptly received a call from a client who was terminating his account because he wanted his money managed by someone more "empirical" and "rational," not based on some "faith thing." Whether your "faith thing" is in God or empirical rationalism, the natural consequence of reflecting on the current state of your portfolio will be to stay the course. So, in the spirit of empirical rationalism, we will make this case.

In addition to our normal business conversations the investment management team and I have been discussing the current state of affairs in the world. We are asking one another, "Is this time different? Why? Why not?" We want to make sure we are asking the right questions, like, "Will democracy continue to exist?" "Will capitalism be the way of the world?" or, "Will the U.S. and other governments nationalize everything?" Of course those are important questions, but the real question is, "What are we doing at FIM Group?" And our answer is quite simple: Our focus is centered on making our clients feel confident despite the losses. We want our clients to sleep well knowing their portfolios are constructed to give them absolute, long–term performance, to sustain their retirement, to educate their children and to give them financial peace of mind.

At our Michigan office, we recently held four client roundtables – 1) Standing in the Economic and Financial Future, 2) Investing Basics, 3) Retirement Income Investing, and 4) Connectedness, Complexity and Culture. These were held originally on a trial basis, but they have been so spectacularly received that we ended up conducting three separate sessions on Retirement Income Investing alone due to popular demand. We will be holding similar discussions in the future, so if you interested in attending, please e–mail or call Sara Harding, FIM Group's communications director, at sharding@fimg.net or 1.800.632.5528.

Many clients who attended these sessions found relief through understanding the composition of their portfolios, how dividends work, and why stocks and bonds are wonderful liquid investments. However, we also explained the downside of a "liquidity crisis," which affects the price but not value of the security. We also chatted about the fact that despite the significant decrease in portfolio values, P/E ratios, dividends and security prices are already reflecting a depressed economy, a very long, deep recession or, as some are calling it, a "contained depression." We are often afraid of things we don't understand. Those investors who panic into cash or CDs at times like these simply do not understand. The goal of our seminars, letters and newsletter in particular is to give our clients understanding and knowledge, so they can have rational "faith" in their portfolios, investments and in the team that stewards them.

The Crisis Is a Lot of Things – But for Our Portfolios it Is (Mostly) About Liquidity

Stocks and bonds are great! You can always buy and sell them, and they most always have a price every hour of the business day. They are regarded as a liquid investment. Suppose, however, that for some reason their values only go down, making their liquidity a non–benefit to an investor. Imagine that a few years ago you inherited a building appraised at $2 million that's in a prime location and 100% leased to the U.S. government under a 35–year "hell or high–water" non–cancelable lease that guarantees you a $10,000 monthly income. Now imagine you've consistently declined $1.5 million and $2 million offers from realtors to sell your building, opting to keep $10,000 monthly income, but all the while giving you a sense of safety and security. Then a crisis happens, the government bails out banks, basically nationalizes the two largest home lenders, which cancels the income promise on their preferred and common shares, and even government guaranteed treasury securities (TIPS) plummet. You suddenly realize you are no longer receiving any offers on your building. On a whim you call on a previous bidder asking, "What would you pay me for my building today?" And the reply is, "Well, if we close on your building today, I can pay you $100,000. If I can get financing, I can pay you more." You remind them it is a prime location with a guaranteed tenant. They say, "Take it or leave it," to which you reply, "I will leave it!" This example reflects the current liquidity of the stock and bond markets.

Stocks and bonds represent things ranging from a secure government guarantee of principal and interest to a potential to profit from a "what if " scenario. Most companies chug along in the middle of those extremes. Not to pick on Berkshire Hathaway, Warren Buffett's famous diversified company, but its "B" shares, which hit a high of $5,059 per share last December, also hit its low of $3,000 in October. Was it really worth 40% less? Were the billions of dollars of income received annually from all of Berkshire's business holdings worth that much less?

Let's say that you inherited Berkshire stock along with the $2 million building. Your brother, who runs the family business, calls and says, "Sis, I can't make payroll this week, because one of my customers can't pay me. And my bank isn't lending until they sort out this "crisis thing." Is there any way you can help me?" To which you reply, "Can't you sell the Berkshire stock you inherited?" And he says, "I did that to make last week's payroll."

You don't want to sell, but the Berkshire stock is the only liquid thing you have, so you sell it. That is an example of a liquidity crisis, and similar situations are happening all over. Normal business practices are anything but normal. Rock solid customers are delaying payments and causing others to delay, while banks are unable to increase lines of credits. Customers have quit buying and there is limited cash flow. This is when fear sets in and exacerbates the situation.

Banks can soon expect to receive, if they have not gotten them already, the first installment of the $700 billion federal bailout. This action should add liquidity to the markets, so people don't have to sell their long–term liquid–oriented assets in order to make payroll, pay their suppliers, or make rent or mortgage payments. As banks receive the government money, the selling pressure on liquid assets should decrease significantly. And once this happens, watch out, because history shows that markets may come back quite dramatically. The Be Early chart that appeared in a previous newsletter is reprinted below to illustrate this phenomenon. In summary, the devastating downward price movement of stocks – especially banks, insurance companies, brokers, home builders and real estate firms – was justified. Many of these companies were leveraged to the hilt on a Goldilocks belief that home prices wound grow at unsustainable levels. They were wrong. The interesting thing is that the energy, health care, pharmaceutical and communications companies were dragged down along with those (banks, brokers, financial companies, etc.) that were on the speculation side of the equation. Keep this in mind as we look in to some of the positions we have been buying in the portfolios.

Shareholders, Dividends Diversification and Economics

Figure 1

Click to Enlarge

Many companies are proud of how well their stocks have performed for their shareholders. Most measure the success of their stocks in terms of their appreciation and cash dividends paid, combining the two to reflect total returns. Historically, dividends have given around half of total stock returns to their investors. Of course, this is an average. Companies like Berkshire Hathaway do not pay dividends and choose to reinvest all profits to grow the asset value of the company. Some companies pay out most of their dividends because they are in mature industries that need little capital for growth. Of course, all companies fall somewhere between those extremes.

Our economic base case is that we could have a long recession, which lasts many years, takes interest rates to near 1% on CD and money market instruments, and is deflationary or inflationary as a consequence. Either way, unemployment will rise, the economy will be slow and, in our opinion, cash flow, current interest income, current dividends and good solid balance sheets in good industries will survive.

Figure 2

Click to Enlarge

The bottom line is that our world needs energy. And renewable energy sources – wind, solar, hydro and geothermal – will be growth industries as will clean coal, gas and other hydrocarbon–based energy sources. As such, we hold many investments in the energy industry. The chart on this page illustrates some of the representative investments for FIM Group portfolios. While there are only a few energy companies highlighted, it is one of our largest areas of investment on behalf of our clients. We will all heat our houses, factories and offices, drive ourselves around, move products and create products with energy, regardless of our country's economic climate. Dividends should chug along for energy company shareholders. If you are a growth or retired long–term investor, what would you rather own during a recession? A diversified portfolio of well–managed companies in good industries paying over 5%, or a 1% CD? If you have short–term needs, money markets and CDs make sense. If you want long–term security, then a diversified portfolio chock–full of nice–yielding dividend–paying stocks is the right prescription. Merck and Eli Lilly are both paying good dividends and have good prospects. It is interesting how many of the great companies listed on the Dividends Chart have a price that has been as low as half of its former one–year high. The dividends keep paying, while income investors keep getting their income to pay the bills, even though the price of the investment has gone down.

The price of good long–term performance is volatility, and all long–term investments tend to have fluctuating prices based on the mania of the market. The Dividend Yield chart to the right illustrates that when dividends have gotten to generous levels (today, for example) the future returns have been quite good.

During the Retirement Income Investing roundtable, I pointed out six things that make for a successful portfolio:

  • Diversification.
  • A global portfolio of carefully selected long–term current income–producing assets, stocks, bonds and government inflation securities.
  • A portfolio that is professionally managed with a tax–sensitive, disciplined and forward–looking approach.
  • Realistic expectations.
  • Patience
  • Avoidance of budget busters or situations – such as loaning money to family members who can't pay back, permanent capital loss due to living off principal or sellng assets from fear.

 

Naturally, the success aspects translate into nearly any portfolio, not just retired client portfolios.

Even Bonds and Other Fixed–Income Investments Have Gotten to Bargain Prices

Figure 3

Click to Enlarge

Bonds, of course, are boring. Like stocks they, too, fluctuate, especially during a liquidity crisis. But what's interesting is that during the recent market crisis, even bonds went down dramatically. Bonds offer two things: 1) Principal back at a certain time in the future; and 2) Interest, of course, subject to the entity issuing the fixed–income security being around when the bond matures.

When confidence is shaken, people sell everything: AAA bonds, fixed–income securities and even TIPS, which are guaranteed by the U.S. government. (The iShares exchange–traded fund (ETF) that just owns U.S. government TIPS, for example, was down by 9.67% in October, while the iShares long–term 20–plus–year Treasury ETF was down 4.25% for the month.)

So even good ol' government TIPS and long–term bonds had a rough go in October. I am oversimplifying, but the base understanding about the "why" of all this comes from understanding two things: 1) Human nature and our ability to panic; and 2) The consequences of a liquidity crisis.

It is rational to assume that things will improve because liquidity will improve. People will realize that although their long–term assets are priced at much less than they were, they still have a value that is much higher than the current price reflects. It is rational to assume that banks will survive and provide loans and liquidity to good businesses. It takes little hope or faith for even the most fearful investor to realize it is just "ignorant" to sell into this panic.

I love history and am filled with pride and joy when Thanksgiving is near. It's a uniquely American holiday where we simply express love and gratitude while reflecting on all our blessings. I am grateful to have all of our colleagues here at FIM Group to help navigate into the future. I am most grateful to our clients who have stuck through this market with us and have shown us incredible support.

We are coming upon our 25th anniversary at FIM Group, and we are looking forward to another 25 years. I know that each Thanksgiving we will hold hands around the dinner table and express gratitude – a gratitude based on hope, faith and a rational understanding of how lucky we are.

 
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