• Financial & Investment Management Group
  • Tuesday, January 06, 2009

Money Doesn't Manage Itself

by Paul Sutherland
Posted December 12, 2008
Paul Sutherland, President

Current Observations

December Edition
PDF Version

Hindsight tells us we should have been 100% in cash all this year and now investing in long–term investments. Today we can lock in great yields on U.S.– backed TIPS (Treasury Inflation–Protected Securities), common stocks and bonds that, in some cases, pay more than twice what we could have gotten even a few months ago.

What is amazing is that many of today's long–term investors are selling off their investments and going to cash. Money market funds have never had a greater percentage of an investor's nest egg than today. DALBAR, Inc., a client service rating organization, examined the flows in and out of common stock investment funds over a 20– year period. Their findings (below) were quite remarkable, and until this year, I doubted their results. But after the year we've had, I am a believer. I do, however, think the study overstates the fickleness of the average investor, who jumps from cash to stocks and back again based on emotion, fear and greed. But their findings illustrate a cognitive bias known as the recency effect, in which people tend to be more influenced by the most recent events or experiences rather than considering their overall "history" in the decision–making process.

Figure 1

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In other words, as Daisy Maxey pointed out in her article, "Protecting the Investments of Bad Investors," "[Investors] pour in cash as markets rise and start a selling frenzy after a decline" (The Wall Street Journal, online edition, July 19, 2007). Conclusion: Investors make these mistakes because they are "driven by fear that the markets will not recover." Conclusion! Investors left to their own devices tend to sell low and buy high, chase yesterday's instead of tomorrow's results, and let emotions drive their investing.

Even with today's market, every investor who has read The Intelligent Investor, by Benjamin Graham and David Dodd, should be completely optimistic that going forward investment returns will trounce cash, CDs, government bonds and fixed annuities. Today, cash is trash for long–term investors. Naturally, shortterm investments are good for those who need cash during the next six to 12 months, but why would investors feel good about getting a few percent on cash when they can get more than 5% or 6% in cash dividends on many great wellmanaged companies, in good solid industries, with quality finances that pay dividend yields rarely seen and have the potential for growth in both price and dividends. Of course the securities could go down more – and some companies will fail – that is why you analyze and diversify.

Let's also assume that we have a long, drawn–out recession, investors get tired of the low return rates on their "safe" money market investments, and they decide to venture back into stocks that offer at least 4% cash dividend yield. Today investors are demanding higher (potential) future returns. As illustrated in the Stock Market Math in Action chart below investors can drive a $10 stock to $16 or decrease the price per share to earn a higher dividend yield.

Figure 2

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Markets Are Like the Weaeher

Like the weather, we have no control over the markets. Stocks, bonds, real estate, CDs and all financial markets are influenced by earnings, growth, dividends, management, interest rates, liquidity, investors' expectations, government policies, inflation expectations and thousands of other trends and counter–trends.

We can, however, control our actions in response to the markets. There's no excuse to go into a personal financial fetal position, call on our government to compromise capitalism or overreact on the regulation or deregulation front. Historically, governments have always been both part of the problem and part of the solution. Investors, likewise, have been … well … as fickle as the weather. They say with patriotism and pride that they believe in the free market system, then as soon as their portfolios drop, fear consumes them and they set aside their beliefs.

"Financial" markets have existed since the 11th century and some form of cooperative capitalism has always been the model. Today's markets are much more complicated and sophisticated, but they exist simply because people exist. All countries, business, non–profits, people and governments cooperate, negotiate, seek and compete for resources. As long as this economic activity continues, financial markets will continue. Economic activity will exist as long as people wish, work and seek happiness.

Success

If you look at successful institutional investors, you will find that they have both a strategy and a plan. I have not heard of one endowment, large pension plan, insurance company, foundation or long–term, professionally managed investment pool going to "cash" or even raising "cash" in an unstable economy. They use history as their guide, not fear, because they realize that successful long–term performance will be subjected to some volatility. Most have a disciplined range of parameters that dictate how much is allocated to stocks, real estate, bonds, metals, international investments, special situations/opportunities and cash. And as we do internally at FIM Group, many plans have allocation parameters that might look like, for example, 25% to 50% in stocks for a conservative account – more when stock expected future yields are high (like today) and less when not.

Effective institutional investors are not reactive and emotional in their response to the current financial malaise (although I'll bet they have some long trustee meetings). Rather, they focus on the things they can control. And, of course, successful institutions and people do accept responsibility for things within their control. They recheck their policies, learn from them and rationally make necessary incremental changes.

Lastly, successful organizations (and people, of course) need to function with sincerity, objectivity and humility and say to themselves, "What could we have done differently? How can we learn from this? Are we asking the right questions? Are our assumptions good and solid?" So naturally we say we should have gone 100% to cash in January and reinvested it today – because, thankfully, we have 20/20 hindsight.

Scenario Planning

Retirees need to stay retired with good income security. People wishing to retire or build wealth for a future event need to grow their capital. In scenario planning, any way you construct it, a strategy of strictly money markets and CDs today would be a way to guarantee failure. Most every scenario, except a short–term one, indicates that now is the time to add stocks, income, real estate, corporate bonds and other long–term assets to a portfolio, not cut back on them. When you have TIPS with principal and income returns guaranteed by the U.S. government, you can lock in returns of over 3% more than inflation, you know that opportunities have been created by the fear and reactive investors running for cover and selling without forethought or any scenario analysis.

Opportunities, Taxes and December 31

Dynamic management is the key to our year–end strategy: When markets recover, there will be winners and losers. And though we will use indexes to tell us the "investment weather," so to speak, they will obscure what is really happening. Studies show that coming out of bear markets, stocks with great dividend yields do better in price appreciation and total return. So even for our growth accounts we will continue to purchase dividend–paying securities, which means selling other investments to buy the investments that we feel will do well in the market recovery.

We are also making several assumptions that will influence our investment strategy:

  • Markets will recover
  • Investors will be attracted once again to well–known investments – so–called blue–chip investments
  • The real action from a performance point of view will be in emerging economies. This means that we will either invest directly in overseas companies or in domestic companies with significant overseas operations
  • The economy in the U.S. and most of the world will be slow with little, none or negative growth. We feel the price of many securities are already reflecting a contained depression, so if economic life goes on even slightly better than comatose, many investments should do well
  • There will be winners and losers. Many banks and financial institutions made bad loans, threw out the risk management rule book, and will have continued trouble earning money. Many retailers are just plain "faddish" and will have trouble competing with the Wal–Marts, Carrefours, Costcos and other discounters. We also think that poorly managed companies and companies with poor–quality balance sheets will have trouble attracting capital, and thus our objective is to avoid those types of companies. We strongly believe that we are in a global energy mega trend that will benefit forward–thinking, "greener" companies that promote renewable energy, gas conservation, fuel efficiency, batteries, electricity, wind power and solar power. We also see huge opportunities in emerging economies with billions of people who not only desire, but will work for a better life. Also as the population ages in the developing world they should benefit from advances in health care, travel, healthy lifestyle products, telecommunications, etc.
  • Governments will become more involved in the economy and businesses with new regulations and ultimately contribute to the "winners and losers".
  • Investors will continue to be manic and cause volatility, which creates opportunities for profit
  • All this money being pumped into the economy should (in the long–term) lead to inflation and U.S. dollar weakness – for now we have deflation
  • Wealth will be transferred from short–sighted short–term investors to long–term investors with foresight to buy securities and investments at bargain prices. We will see an increase in strong companies buying or merging with weak ones
  • We will see weakness in the stock and bond markets through December 2008, for three main reasons: a) Taxes – investors selling to lock in tax losses on investments that have gone down. Therefore selling pressure will be around for a few more weeks; b) Hedge funds unwinding; and c) People will just sit on the sidelines until 2009.

All this plays well into a strategy of being thoughtfully invested going into 2009 and at FIM Group, we are making sure our allocations to stocks in our portfolios have significant cash dividends, complete, solid balance sheets and good future prospects. We are continually researching industries such as health care, pharmaceuticals, telecommunications and energy, in which companies serve emerging economies and benefit from our aging society.

Happy Holidays!

 
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