The Portfolio

We have had a good start to the year.  The truth is there is probably not much significance in performance figures spanning only one quarter.  As the market so often reminds us, anything can happen in the short run.  However, this is one more in a long series of time periods where we do not look like the S&P 500.  For better or worse, you can be sure we are not closet indexing. 

We sold the last of the Champion (CHB – Manufactured Homes) stock during the quarter.  While the worst of the troubles in this industry may be past, we are not convinced that it is clear sailing.  We fear that the large run up in the share price is mostly a result of the market’s currently large appetite for risk and therefore the shares could fall just as quickly as they have risen.  We felt that the opportunity to exit the stock at just a bit below break-even was enough for us to close the books on this poor choice of an investment.  Now that we have sold, there should be nothing to keep the shares from doubling! 

We trimmed our position in Safeco (SAFC - Insurance) during the quarter.  This is simply a valuation issue.  The stock has done well over the last couple years as the company’s restructuring efforts have dramatically improved profitability.  Safeco, along with St. Paul Insurance, now account for about 5.5% of portfolios.  This comprises our total exposure to the financial sector.  This is far below the 21.3% weighting in the S&P 500.  This low exposure has hurt us lately as financial stocks have done quite well.  However, we think this is one of the riskiest sectors in the market.  This may be comparable to ’99 when the best performing stocks (tech) were setting up for the most dramatic fall.  Even though the strong price momentum may seem attractive, it may prove to be a dangerous illusion. 

We believe that credit cycle is turning.  Generically, the financial sector companies, especially lenders, make money by creating and extending credit to borrowers.  They benefit from a credit expansion cycle.  This characterizes the environment for most of the last 2 decades.  Expansionary credit cycles, with falling interest rates are the best time to own these stocks.  They have grown to such prominence that they are now the largest sector in the S&P 500.  In the future, they are likely to comprise a much smaller part of the market and economy.  

As noted, we believe the credit cycle is turning from expansion to contraction.  There is plenty of evidence to suggest that the tremendous rise in debt of all types may not have much room to grow further.  Additionally, the fuel of the financial sector, falling interest rates, may have run their course.  The bond market appears to have growing concerns about the prospect for Federal Reserve rate hikes in the near future as well as the possibility of reduced foreign demand for US Treasuries.  Rising interest rates could make things difficult for the companies in this sector.  For these reasons, including high valuations, we are comfortable with our very limited exposure here.    

We still have a large exposure to the energy sector.  Lately the performance of our energy investments has been mixed.  Even as the price of oil has risen as high as $38/bbl, most of the oil service stocks have moved relatively little.  Apparently the market believes that either the price will soon collapse, or that the market will not be spurred into new exploration activity by the high prices.  We believe neither.  It appears that there is little ability to deliver large amounts of oil and/or natural gas into the market anytime soon.  Therefore, prices seem likely to remain on the high side for a while.  However, we are not convinced that $100/bbl oil is just around the corner or that the world is running out of oil.  We simply believe that the lack of exploration activity over the last 10-15 years has reduced the deliverable supply, and that high prices will encourage exploration activity which will eventually deliver new supplies to market.  This is a typical cycle and most of the energy stocks should have more room to run.  We have about 13% of the portfolio invested in this sector versus a much smaller 5.9% weighting in the S&P 500 index. 

 The changing structure of the investment industry and how it affects you

The money management industry is likely to see great changes in the next 10-20 years.  Tom Brown has written an excellent, brief article identifying some of the weaknesses in the current structure of the industry. http://www.bankstocks.com/article.asp?id=865&type=0   In his view, “too often the investment game is tilted in favor of the professional, and against the investor.”  This is partly because “they (fund managers) play not to lose, by broadly diversifying (or “de-worse-ifying”) and trading aggressively to try to outperform quarter in and quarter out.  That approach may improve job security—but it almost guarantees long-term underperformance.”  Good for the manager’s job security but bad for the investor’s performance – a classic case of conflict of interest. 

For those of us in the business, such conflicts of interest are well known.  It is all too easy to sacrifice the interest of the client for the sake of the manager’s interest.  A recent survey has some interesting findings.  A study by Washington University, reported in the Wall Street Journal, found that portfolio managers “say their bonuses are often determined more by their firms’ profitability and the amount of money they gather for the firms rather than how skillfully they oversee assets for investors”.  The biggest determinants of a manager’s annual bonus, which averages about 45% of total pay, are : 1- profitability or stock price performance of the firm, 2- generating new business, 3- current investment returns compared with a benchmark, 4- flows of new money into existing portfolios.  The least important factors in the bonus calculation are “tax efficiency and risk control in managing client assets”.  This means that the manager often has more incentive to grow the business than to deliver the best results to the client.  The only factor in the top 4 that even concerns the client is number 3, and we argue that this factor does a poor job of aligning the manager’s interests with those of the investor.  A bear market quickly shows up the weakness of this ‘relative value’ approach.  Focusing on returns against a benchmark is fine if you can outperform in a rising market.  However, it loses some appeal when you ‘outperform’ by losing less than some index in a falling market.  The investor loses money and the manager gets a bonus.  Hmmm.  That doesn’t sound right.  Risk control, by which we mean the risk of losing money, should be a key part of the manager’s focus.  Too often it is not.   

Another common practice with which we disagree is the compulsion to remain fully invested.  Most investment managers will tell you that they are paid to buy stocks. They have learned during the great bull market that even 3 or 4% cash works against you when stocks are rising.  They may have been chastised by client comments like ‘I am not paying you to hold cash’.  Whatever the reason, today it is quite rare to find a manager who doesn’t feel compelled to remain fully invested at all times.  We see things differently.  We think it is our responsibility to try to deliver attractive positive returns with a reasonable amount of risk.  If many appealing investments are available we will take full advantage of the opportunity and be fully invested.  However, each investment must implicitly be more attractive than cash or it makes a poor choice.  If cash is taken out of consideration then a manager can easily find himself sliding down a slippery slope.  We feel it is much more prudent to only invest in a security when there is an attractive risk vs. reward tradeoff, not simply to get rid of cash. 

As an aside, we have often remarked in the past, that we try to learn from those investors who have, over many decades, proven to be exceptional practitioners of the craft.  Here are a couple of recent quotes from such investors loosely related to the compulsion to be fully invested.  The cash level has been rising at Berkshire Hathaway.  Warren Buffett says that with interest rates on cash at such low levels, “It’s a painful condition to be in – but not as painful as doing something stupid.”  And the 91 year old investment legend Sir John Templeton recently said “This is a dangerous time to own stocks.”  And, “I don’t think anybody should have over half their assets in common stock.”  These are dramatic statements from men who have made their careers by buying stocks.  Sometimes the best investment is the one you don’t make. 

Returning to our discussion…The practice of limiting a manager to investing only in some arbitrary range of market capitalization seems equally odd.  Is a manager who has been successful investing in large cap stocks likely to prove incompetent when considering mid cap or small cap stocks?  Of course not.  In ’98 and ’99 when small caps were cheap and large caps were very expensive, a value manager would have done his clients a disservice by only considering the overvalued stocks simply because he was arbitrarily limited to the large cap universe.  We think investors are beginning to realize that they are best served by finding a manager with a demonstrated expertise and then allowing the manager maximum flexibility to apply his craft. 

These are some of the flaws that we see in the conventional way of investing money for others.  These are but a few of the common practices with which we disagree.  As a result of the deficiencies we see in the industry, we have tried to structure our business to offer the investor a better option.  Simply put, we are trying to invest for our clients the same way that we invest for ourselves.  We believe that, gradually, investors will come to demand this of all managers. 

One final note, Tom Brown relates the findings of Michael Mauboussin regarding the common traits of successful funds:  1-lower than average turnover; 2-above average portfolio concentration; 3-a value bias; 4-located geographically outside of New York and Boston.  There is food for thought.  We suspect there may also be a high correlation between the long term performance of managers and the percentage of their own net worth in their funds. 

A note on Real Estate

While we proclaim no expertise in real estate, it is a subject on everyone’s mind.  Is there a bubble?  Opinions are all over the map here.  Whatever you want to call it, bubble, top of cycle, over heated, etc. we believe there is at least some excess in real estate generally.  Contrary to popular opinion, real estate can and does occasionally fall in value, especially if the market is a bit frothy.  Consider a recent news release by the National Association of Securities Dealers (NASD) titled “Betting the Ranch: Risking Your Home to Buy Securities”.  They state, “With a rising stock market, record low interest rates, and large gains in home value, some investors have taken out new mortgages, refinanced, or obtained line-of-credits secured by their homes for the specific purpose of investing in securities.”  Clearly, some home owners have unrealistic expectations for real estate.  And we will leave you with this comment from Templeton: “I think 20 percent of people who have mortgages on their homes are likely to lose them in foreclosures.”  We believe it is prudent to at least consider how much risk you have in real estate. 

 We want to thank you for your business and assure you that we will continue to watch over your money as carefully as we watch our own.

 Sincerely,

Clayton Bryan, CFA                                        Doug Manz, CFA

Principal                                                                      Principal

*This letter is for informational purposes only.  Nothing contained herein shall be construed as an offer or recommendation to buy or sell individual securities.  Data has been obtained from sources believed to be reliable but there can be no guarantees concerning errors or omissions.