By Edward Studzinski

One should forgive one’s enemies, but not before they are hanged.

Heinrich Heine

So, we are one-third through another year, and things still continue to be not as they should be, at least to the prognosticators of the central banks, the Masters of the Universe on Wall Street, and those who make their livings reporting on same, at Bubblevision Cable and elsewhere. I am less convinced than I used to be that, for media commentators, especially on cable, the correct comparison is to The Gong Show. More often than not, I think a more appropriate comparison is to the skit performed by the late, great, and underappreciated Ernie Kovacs, “The Song of the Nairobi Trio.”

And lest I forget, this is the day after another of Uncle Warren’s Circuses, held in Omaha to capacity crowds. An interesting question there is whether, down the road some fifty years, students of financial and investing history discover after doing the appropriate first order original source research, that what Uncle Warren said he did in terms of his investment research methodology and what he in reality did, were perhaps two different things. Of course, if that were the case, one might wonder how all those who have made almost as good a living selling the teaching of the methodology, either through writing or university programs, failed to observe same before that. But what the heck, in a week where the NY Times prints an article entitled “Obama Lobbies for His Legacy” and the irony is not picked up on, it is a statement of the times.

The best performing asset class in this quarter has been – gold. Actually the best performing asset class has been the gold miners, with silver not too far behind. We have had gold with a mid-teen’s total return. And depending on which previous metals vehicle you have invested in, you may have seen as much as a 60%+ total return (looking at the germane Vanguard fund). Probably the second best area generically has been energy, but again, you had to choose your spots, and also distinguish between levered and unlevered investments, as well as proven reserves versus hopes and prayers.

I think gold is worth commenting on, since it is often reviled as a “barbarous relic.” The usual argument against it that it is just a hunk of something, with a value that goes up and down according to market prices, and it throws off no cash flow.

That argument changes of course in a world of negative interest rates, with central banks in Europe and one may expect shortly, parts of Asia, penalizing the holding of cash by putting a surcharge on it (the negative rate).

A second argument against it is that is often subject to governmental intervention and political manipulation. A wonderful book that I still recommend, and the subjects of whom I met when I was involved with The Santa Fe Institute in New Mexico, is The Predictors by Thomas A. Bass. A group of physicists used chaos theory in developing a quantitative approach to investing with extensive modeling. One of the comments from that book that I have long remembered is that, as they were going through various asset and commodity classes, doing their research and modeling, they came to the conclusion that they could not apply their approach to gold. Why? Because looking at its history of price movements, they became convinced that the movements reflected almost always at some point, the hand of government intervention. An exercise of interest would be to ponder how, over the last ten years, at various points it had been in the political interests of the United States and/or its allies, that the price of gold in relation to the price of the dollar, and those commodities pegged to it, such as petroleum, had moved in such a fashion that did not make sense in terms of supply and demand, but made perfect sense in terms of economic power and the stability of the dollar. I would suggest, among other things, one follow the cases in London involving the European banks that were involved in price fixing of the gold price in London. I would also suggest following the timetable involving the mandated exit of banks such as J.P. Morgan from commodity trading and warehousing of various commodities.

Exeunt, stage left. New scenario, enter our heroes, the Chinese. Now you have to give China credit, because they really do think in terms of centuries, as opposed to when the next presidential or other election cycle begins in a country like the U.S. Faced with events around 2011 and 2012 that perhaps may have seemed to be more about keeping the price of gold and other financial metrics in synch to not impact the 2012 elections here, they moved on. We of course see that they moved on in a “fool me once fashion.” We now have a Shanghai metals exchange with, as of this May, a gold price fixing twice a day. In fact, I suspect very quickly we will see whole set of unintended consequences. China is the largest miner of gold in the world, and all of its domestic supply each year, stays there. As I have said previously in these columns, China is thought to have the largest gold reserves in the world, at in excess of 30,000 tons. Russia is thought to be second, not close, but not exactly a slouch either.

So, does the U.S. dollar continue as the single reserve currency (fiat only, tied solely to our promise to pay) in the world? Or, at some point, does the Chinese currency become its equal as a reserve currency? What happens to the U.S. economy should that come to pass? Interesting question, is it not? On the one hand, we have the view in the U.S. financial press of instability in the Chinese stock market (at least on the Shanghai stock exchange), with extreme volatility. And on the other hand, we have Chinese companies, with some degree of state involvement or ownership, with the financial resources to acquire or make bids on large pieces of arable land or natural resources companies, in Africa, Australia, and Canada. How do we reconcile these events? Actually, the better question is, do we even try and reconcile these events? If you watch the nightly network news, we are so self-centered upon what is not important or critical to our national survival, that we miss the big picture.

Which brings me to the question most of you are asking at this point – what does he really think about gold? Some years ago, at a Grant’s Interest Rate Observer conference, Seth Klarman was one of the speakers and was asked about gold. And his answer was that, at the price it was at, they wanted to have some representation, not in the physical metal itself, but in some of the gold miners as a call option. It would not be more than 5% of a portfolio so that in the event it proved a mistake, the portfolio would not be hurt too badly (the opposite of a Valeant position). If the price of gold went up accordingly, the mine stocks would perhaps achieve a 5X or 10X return, which would help the overall returns of the portfolio (given the nature of events that would trigger those kinds of price movements). Remember, Klarman above all is focused on preserving capital.

And that is how I pretty much view gold, as I view flood insurance or earthquake insurance. Which, when you study flood insurance contracts you learn does not just cover flooding but also cases of extreme rain where, the house you built on the hill or mountain goes sliding down the hill in a massive mudslide. So when the catastrophic event can be covered for a reasonable price, you cover it (everyone forgets that in southern Illinois we have the New Madrid fault, which the last time it caused a major quake, made recent California or Japanese events seem like minor things). And when the prices to cover those events become extreme, recognizing the extreme overvaluation of the underlying asset, you should reconsider the ownership (something most people with coastal property should start to think about).

Twenty-odd years ago, when I first joined Harris Associates, I was assigned to cover DeBeers, the diamond company, since we were the largest shareholders in North America. I knew nothing about mining, and I knew nothing about diamonds, but I set out to learn. I soon found myself in London and Antwerp studying the businesses and meeting managements and engineers. And one thing I learned about the extractive industries is you have to differentiate the managements. There are some for whom there is always another project to consume capital. You either must expand a mine or find another vein, regardless of what the price of the underlying commodity may be (we see this same tendency with managements in the petroleum business). And there are other managements who understand that if you know the mineral is there sitting in the ground, and you have a pretty good idea of how much of it is there, you can let it sit, assuming a politically and legally stable environment, until the return on invested capital justifies bringing it out. For those who want to develop this theme more, I suggest subscribing to Grant’s Interest Rate Observer and reading not just its current issues but its library of back issues. Just remember to always apply your own circumstances rather than accept what you read or are told.

“Advertising is the modern substitute for argument; its function is to make the worse appear the better.”

               George Santayana

So we find one chapter at Sequoia Fund coming to a close, and the next one about to begin.  On this subject my colleague David has more to offer. I will limit myself to saying that it was appropriate, and, the right thing to do, for Bob Goldfarb to elect to retire. After all, it happened on his watch. Whether or not he was solely to blame for Valeant, we will leave to the others to sort out in the future. Given the litigation which is sure to follow, there will be more disclosures down the road.

A different question but in line with Mr. Santayana’s observations above, is, do those responsible for portfolio miscues, always do the honorable thing? When one looks at some of the investment debacles in recent years – Fannie and Freddie, Sears, St. Joe, Valeant (and not just at Sequoia), Tyco, and of course, Washington Mutual (a serial mistake by multiple firms)  – have the right people taken responsibility? Or, do the spin doctors and public relations mavens come in to do damage control? Absent litigation and/or whistle blower complaints, one suspects that there are fall guys and girls, and the perpetrators live on for another day. Simply put, it is all about protecting the franchise (or the goose that is laying the golden eggs) on both the sell side and the buy side. Probably the right analogy is the athlete who denies using performance enhancing drugs, protected, until confronted with irrefutable evidence (like pictures and test results).

Lessons Learned

Can the example of the Sequoia Fund be a teaching moment? Yes, painfully. I have long felt that the best way to invest for the long-term was with a concentrated equity portfolio (fewer than twenty securities) and some overweight positions within that concentration. Looking at the impact Sequoia has had on the retirement and pension funds invested in it, I have to revisit that assumption. I still believe that the best way to accumulate personal wealth is to invest for the long-term in a concentrated portfolio. But as one approaches or enters retirement, it would seem the prudent thing to do is to move retirement moneys into a very diverse portfolio or fund.  That way you minimize the damage that a “torpedo” stock such as Valeant can do to one’s retirement investments, and thus to one’s standard of living, while still reaping the greater compounding effects of equities. There will still be of course, market risk. But one wants to lessen the impact of adverse security selection in a limited portfolio. 

Remember, we tend to underestimate our life expectancy in retirement, and thus underweight our equity allocations relative to cash and bonds. And in a period such as we are in, the risk free rate of return from U.S. Treasuries is not 12% or 16% as it was in the early 1980’s (although it is perhaps higher than we think it is). And for that retirement equity position, what are the choices?  Probably the easiest again, is something like the Vanguard Total Stock Market or the Vanguard S&P 500 index funds, with minimal expense ratios. We have been talking about this for some time now, but Sequoia provides a real life example of the adverse possibilities.  And, it is worth noting that almost every concentrated investment fund has underperformed dramatically in recent years (although the reasons may have more to do with too much money chasing too few and the same good ideas). Is it really worth a hundred basis points to pay someone to own Bank of America, Wells Fargo, Microsoft, Johnson & Johnson, Merck, as their top twenty holdings? Take a look sometime at the top twenty holdings of the largest actively managed funds in the respective categories of growth, growth and income, etc., and see what conclusions you draw.

The more difficult issue going forward will be deflation versus inflation. We have been in a deflationary world for some time now. It is increasingly apparent that the global central banks are in the process (desperately one suspects) to reflate their respective economies out of stagnant or no growth. Thus we see a variety of quantitative easing measures which tend to favor investors at the expense of savers. Should they succeed, it is unlikely that the inflation will stop at their targets (2% here), and the next crisis will be one of currency debasement. The more things change.

Gretchen Morgenson, Take Two

As should be obvious by now, I am a fan of Ms. Morgenson’s investigative reporting and her take no prisoners approach. I don’t know her from Adam, and could be standing next to her in the line for a bagel and coffee in New York and would not know it. But, she has a wonderful knack for goring many of the oxen that need to be gored.

In this Sunday’s New York Times Business Section, she raised the question of the effectiveness of share buybacks. Now, the dirty little secret for some time has been that growth of a business is not impacted by share repurchases. Yet, if you listened to many portfolio managers wax poetic about how they only invest with shareholder friendly managements (which in retrospect turn out to have not been not so shareholder friendly after they have been indicted by a grand jury). Share repurchase does increase per share metrics, such as book value and earnings.  While the pie stays the same size, the size of the pieces changes. But often in recent years, one wonders why the number of shares outstanding does not change after a repurchase of what looked to have been 5% or so of shares outstanding during the year. 

Well, that’s because management keeps awarding themselves options, which are approved by the board. And the options have the effect of selling the business incrementally to the managers over time, unless share purchases eliminate the dilution from issuing the options.  Why approve the options packages? Well, the option packages are marketed to the share owners as critical to attracting and retaining good managers, AND, aligning the interests of management with the interests of shareholders. Which is where Mr. Santayana comes in  –  the bad (for shareholders) is made to look good with the right buzzwords.

However, I think there is another reason. Obviously growing a business is one of the most important things a management can do with shareholder capital. But today, every capital allocation move of reinvesting in a business for growth and expansion directly or by acquisition, faces a barrage of criticism. The comparison is always against the choices of dividends or share repurchase. I think the real reason is somewhat more mundane. 

The quality of analysts on both the buy and sell side has been dumbed down to the point that they no longer know how to go out and evaluate the impact of an acquisition or other growth strategy. They are limited to running their spread sheet models against industry statistics that they pull off of their Bloomberg terminals. I remember the horror with which I was greeted when I suggested to an analyst that perhaps his understanding of a company and its business would improve if he would find out what bars near a company’s plants and headquarters were favorites of the company’s employees on a Friday after work and go sit there. Now actually I wasn’t serious about that (most of the analysts I knew lacked the social graces and skills to pull it off). I was serious about getting tickets to industry tradeshows and talking to the competitor salespeople at their booths.  You would be amazed about how much you can learn about a company and its products that way. And people love to talk about what they do and how it stands up against their competition. That was a stratagem that fell on deaf ears because you actually had to spend real dollars (rather than commission dollars), and you had to spend time out of the office. Horrors!  You might have to miss a few softball games.

The other part of this is managements and the boards, which also have become deficient at understanding the paths of growing and reinvesting in a business that was entrusted to them.

Sadly, what we have today is a mercenary class of professional managers who can and will flit from opportunity to opportunity, never really understanding (or loving) the business. And we also have a mercenary class of professional board members, who spend their post-management days running their own little business – a board portfolio. And if you doubt all of this, take a look again at Valeant and the people on the board and running the business. It was and is a world of consultants and financial engineers, reapplying the same case study or stratagem they had used many times before. The end result is often a hollowed-out shell of a company, looking good to appearances but rotting away on the inside.

By Edward Studzinski 

“When we unleash the dogs of war, we must go where they take us.”

Dowager Countess of Grantham

Starting off one of these monthly discussions with a title about the weather should be indicative that this piece will perhaps be more disjointed than usual, but that is how the world and markets look to me at present. And there is very little in the way of rational explanation for why the things that are happening are happening. My friend Larry Jeddeloh, of The Institutional Strategist, would argue that this country has been on a credit cycle rather than a business cycle for more than fifteen years now. Growth in the economy is tied to the price and availability of credit. But the cost of high yield debt is rising as spreads blow out, so having lots of cheap credit available is not doing much to grow the economy. Put another way, those who need to be able to borrow to either sustain or grow their business, can’t. A friend in the investment banking business told me yesterday about a charter school that has been trying to refinance a debt package for several years now, and has not been able to (thank you, Dodd-Frank). So once again we find ourselves in a situation where those who don’t need the money can easily borrow, and those who need it, are having difficulty obtaining it. We see this in another area, where consumers, rather than spend and take on more debt, have pulled back.

Why? We truly are in a moment of deflation on the one hand (think fuel and energy costs) and the hints of inflation on the other (think food, property taxes, and prescription drug costs on the other). And the debt overload, especially public debt, has reached a point where something has to be done other than kicking the can down the road, or other major crisis. I would argue we are on the cusp of that crisis now, where illiquidity and an inability to refinance, is increasingly a problem in the capital markets. And we see that, where the business models of businesses such as energy-related master limited partnerships, premised on always being able to refinance or raise more equity, face issues.

I was reading through some old articles recently, and came across the transcript in Hermes, the Columbia Business School publication, of a seminar held in May 1985 there. The speakers were Warren Buffett, James Rogers, Jr., and Donald Kurtz. As is often the case, sifting through the older Buffett can be rewarding albeit frustrating when you realize he saw something way before its time. One of the things Buffett said then was that, based on his observations of our political system, “ … there is a small but not insignificant probability that we will lose fiscal control at some point.” His point was that given a choice, politicians will always opt for an implicit tax rather than an explicit tax. If expenditures should determine the level of explicit taxes, than taxes should cover expenditures. Instead, we have built in implicit taxation, expecting inflation to cover things without the citizens realizing it (just as you are not supposed to notice how much smaller the contents are with the packaging changes in food products – dramatically increasing your food budget).

The easier way to think of this is that politicians will always do what allows them to keep doing what they like, which is to stay in office. Hence, the bias ends up being to debase the currency through the printing presses. So you say, what’s the problem? We have more deflation than inflation at this point?

And the problem is, if you look at history, especially Weimar Germany, you see that you had bouts of severe inflation and sharp deflationary periods – things did not move in a straight line.

Now we have had many years of a bull market in stocks and other assets, which was supposed to create wealth, which would than drive increases in consumption. The wealth aspect happened, especially for the top 5%, but the consumption did not necessarily follow, especially for those lower on the economic ladder. So now we see stock and asset prices not rising, and the unspoken fear is – is recession coming?

My take on it, is that we have been in a huge jobless recovery for most of the country, that the energy patch and those industries related to it (and the banks that lent money) are now beyond entering recession, and that those effects will continue to ripple through the rest of the economy. Already we see that, with earnings estimates for the S&P 500 continuing to drift lower. So for most of you, again, my suggestion is to pay attention to what your investment time horizons and risk tolerances are.

Moving totally down a different path, I would like to suggest that an article in the February 28, 2016 New York Sunday Times Magazine entitled “Stocks & Bots” is well worth a read. The focus of the article is about the extent to which automation will eliminate jobs in the financial services industry going forward. We are not talking about clerks and order entry positions. That revolution has already taken place, with computerized trading over the last twenty years cutting by way of example, the number of employees buying and selling stock over the phone from 600 to 4 at one of the major investment banking firms. No, we are talking about the next level of change, where the analysts start getting replaced by search programs and algorithms. And it then moves on from there to the people who provide financial advice. Will the Millennials seek financial advice from programs rather than stock brokers? Will the demand grow exponentially for cheaper investment products?

I think the answer to these questions is yes, the Millennials will do things very differently in terms of utilizing financial services, and the profit margins of many of today’s investment products, such as mutual funds, will be driven much lower in the not too distant future. Anecdotally, when one has a year in the markets like 2015 and the beginning of 2016, many investment firms would push down the bonus levels and payments from the highest paid to take care of the lower ranks of employees. I was not surprised however to hear that one of the largest asset managers in the world, based in Boston, had its senior employees elect to keep the bonuses high at the “partner” levels and not take care of the next levels down this past year. They could see the handwriting on the wall.

All of which brings me back to the weather. Probably suggesting that one should read a politically incorrect writer like Mark Twain is anathema to many today, but I do so love his speech on the New England weather. For a preview for those so inclined, “The lightning there is peculiar; it is so convincing that, when it strikes a thing it doesn’t leave enough of that thing behind for you tell whether – Well, you’d think it was something valuable, and a Congressman had been there.”

At a future point I will come back for a discussion of Mr. Twain’s essay “On the Decay of the Art of Lying” which might be essential reading as this year’s elections take shape.

Edward A. Studzinski

“Every revolution evaporates and leaves behind only the slime of a new bureaucracy.”

 Kafka

So, time now for something of a follow-up to my suggestion of a year ago that a family unit should own no more than ten mutual funds. As some will recall, I was instructed by “She Who Must Be Obeyed” to follow my own advice and get our own number of fund investments down from the more than twenty-five where it had been. We are now down to sixteen, which includes money market funds. My first observation would be that this is not as easy to do as I thought it would be, especially when you are starting from something of an ark approach (one of these, two of those). It is far easier to do when you start to build your portfolio from scratch, when you can be ruthless about diversification. That is, you don’t really need two large cap growth or four value funds. You may only add a new fund if you get rid of an old fund. You are quite specific about setting out the reasons for investing in a fund, and you are equally disciplined about getting rid of it when the reasons for owning it change, e.g. asset bloat, change in managers, style drift, no fund managers who are in Boston, etc., etc.

Which brings me to a point that I think will be controversial – for most families, mutual fund ownership should be concentrated in tax-exempt (retirement accounts) if taxes matter. And mutual fund ownership in retirement accounts should emphasize passive investments to maximize the effects of lower fees on compounding. It also lessens the likelihood of an active manager shooting himself or herself in the foot by selling the wrong thing at the wrong time because of a need to meet redemptions, or dare I suggest it, panic or depression overwhelm the manager’s common sense in maintaining an investment position (which often hits short seller specialists more than long only investors, but that is another story for another day).

The reasons for this will become clearer as holdings come out for 12/31 and 3/31, as well as asset levels (which will let you know what redemptions are – the rumor is that they are large). It will also become pretty clear as you look at your tax forms from your taxable fund accounts and are wondering where the money will come from to pay the capital gains that were triggered by the manager’s need to raise funds (actually they probably didn’t need to sell to meet redemptions as they all have bank lines of credit in place to cover those periods when redemptions exceed cash on hand, but …..).

The other thing to keep in mind about index funds that are widely diversified (a total market fund for instance) – yes, it will lag on the upside against a concentrated fund that does well. But it will also do better on the downside than a concentrated fund that does not do well. Look at it this way – a fifty stock portfolio that has a number of three and four per cent positions, especially in the energy or energy services sector this past year, that has seen those decline by 50% or more, has a lot of ground to make up. A total stock market portfolio that has a thousand or more positions – one or two or twenty or thirty bad stocks, do not cripple it. And in retirement accounts, it is the compounding effect that you want. The other issue of course is that the index funds will stay fully invested in the indices, rather than be caught out underinvested because they were trying to balance out exiting positions with adding positions with meeting redemptions. The one exception here would be for funds where the inefficiencies of an asset class can lead to a positive sustainable alpha by a good active manager – look for that manager as one to invest with in either taxable or tax-exempt accounts.

China, China, China, All the Time

In both the financial print press and the financial media on television and cable, much of the “blame” for market volatility is attributed to nervousness about the Chinese economy, the Chinese stock market, in fact everything to do with China. There generally appear to be two sorts of stories about China these days. One recurring theme is that they are novices at capital markets, currencies, as well as dealing with volatility and transparency in their markets, and that this has exacerbated trends in the swings in the Shanghai market, which has spread to other emerging markets. Another element of this particular them is that China’s economy is slowing and was not transparent to begin with, and that lack of growth will flow through and send the rest of the world into recession. Now, mind you, we are talking about economic growth that by most accounts, has slowed from high single digits recently (above 7%) to what will be a range going forward of low to still mid-single digits (4 – 7%).

I think a couple of comments are in order about this first theme. One, the Shanghai market has very much been intended as a punter’s market, where not necessarily the best companies are listed (somewhat like Vancouver in Canada twenty-odd years ago). The best companies in China are listed on the Hong Kong market – always have been, and will continue to be for the foreseeable future. The second thing to be said is that if you think things happen in China by accident or because they have lost control, you don’t understand very much about China and its thousands of years of history. Let’s be realistic here – the currency is controlled, interest rates are controlled, the companies are controlled, the economy is controlled – so while there may be random events and undercurrents going on, they are probably not the ones we are seeing or are worried about.

This brings me to the second different theme you hear about China these days, which is that China and the Chinese economy have carried the global economy for the last several years, and that even last year, their contribution to the world economy was quite substantial. I realize this runs counter to stories that you hear emanating from Washington, DC these days, but much that you hear emanating from Washington now is quite surreal. But let’s look at a few things. China still has $3 trillion dollars of foreign exchange reserves. China does not look to be a debtor nation. China has really not a lot of places left to spend money domestically since they have a modern transportation infrastructure and, they have built lots of ghost cities that could be occupied by a still growing population. And while China has goods that are manufactured that they would like to export, the rest of the world is not in a buying mood. A rumor which I keep hearing, is that they have more than 30,000 metric tons of gold reserves with which to back their currency, should they so choose (by comparison, the US as of October 2014 was thought to have about 4,200 metric tons in Fort Knox).

For those familiar with magic shows and sleight of hand tricks, I think this is what we are seeing now. Those who watch the cable financial news shows come away with the impression that the world is ending in the Chinese equity markets, and that will cause the rest of the world to end as well. So while you are watching that, let’s see what you are missing. We have a currency that has become a second reserve currency to the world, supplanting the exclusive role of the U.S. dollar as countries that are commodity economies now price their commodities and do trade deals in Chinese currency. And, notwithstanding that, the prices of commodities have fallen considerably, we continue to see acquisition and investment in the securing of commodities (at fire sale prices) by China. And finally, we have a major expansion by China in Africa, where it is securing arable land to provide another bread basket for itself for the future, as well as an area to send parts of it population.

And let me suggest in passing that the one place China could elect to spend massively in their domestic economy is to build up their defense establishment far beyond what they have done to date. After all, President Reagan launched a massive arms build-up by the US during his terms in office, which in effect bankrupted the Soviets as they tried to keep up. One wonders whether we would or could try to keep up should China elect to do the same to us at this point.

So, dear readers, I will leave it to you to figure out which theme you prefer, although I suspect it depends on your time horizon. But let me emphasize again – looking at the equity markets in China means looking at the wrong things. By the end of this year, we should have a better sense of whether the industrial economy is China has undergone a rather strong recovery, driven by the wealth of a growing middle class (which is really quite entrepreneurial, and which to put it into context, should be approaching by the end of this year, 400M in size). And it will really also become clear that much of the capital that has been rumored to be “fleeing” China has to be split out to account for that which is investment in other parts of the world. Paying attention to those investment outflows will give you some insight as to why China still thinks of and refers to itself as, “The Middle Kingdom.”

Edward A. Studzinski

“In present-day America it’s very difficult, when commenting on events of the day, to invent something so bizarre that it might not actually come to pass while your piece is still on the presses.”

Calvin Trillin, remarking on the problems in writing satire today.

So, the year has ended and again there is no joy in Mudville. The investors have no yachts or NetJet cards but on a trailing fee basis, fund managers still got rich. The S&P 500, which by the way has 30-35% of the earnings of its component companies coming from overseas so it is internationally diversified, trounced most active managers again. We continued to see the acceleration of the generational shift at investment management companies, not necessarily having anything to do with the older generation becoming unfit or incompetent. After all, Warren Buffett is in his 80’s, Charlie Munger is even older, and Roy Neuberger kept working, I believe, well into his 90’s. No, most such changes have to do with appearances and marketing. The buzzword of the day is “succession planning.” In the investment management business, old is generally defined as 55 (at least in Boston at the two largest fund management firms in that town). But at least it is not Hollywood.

One manager I know who cut his teeth as a media analyst allegedly tried to secure a place as a contestant on “The Bachelor” through his industry contacts. Alas, he was told that at age 40 he was too old. Probably the best advice I had in this regard was a discussion with a senior infantry commander, who explained to me that at 22, a man (or woman) was probably too old to be in the front lines in battle. They no longer believed they couldn’t be killed. The same applies to investment management, where the younger folks, especially when dealing with other people’s money, think that this time the “new, new thing” really is new and this time it really is different. That is a little bit of what we have seen in the energy and commodity sectors this year, as people kept doubling down and buying on the dips. This is not to say that I am without sin in this regard myself, but at a certain point, experience does cause one to stand back and reassess. Those looking for further insight, I would advise doing a search on the word “Passchendaele.” Continuing to double down on investments especially where the profit of the underlying business is tied to the price of a commodity has often proved to be a fool’s errand.

The period between Christmas and New Year’s Day is when I usually try to catch up on seeing movies. If you go to the first showing in the morning, you get both the discounted price and, a theater that is usually pretty empty. This year, we saw two movies. I highly recommend both of them. One of them was “The Big Short” based on the book by Michael Lewis. The other was “Spotlight” which was about The Boston Globe’s breaking of the scandal involving abusive priests in the Archdiocese of Boston.

Now, I suspect many of you will see “The Big Short” and think it is hyped-up entertainment. That of course, the real estate bubble with massive fraud taking place in the underwriting and placement of mortgages happened in 2006-2008 but ….. Yes, it happened. And a very small group of people, as you will see in the story, saw it, thought something did not make sense, asked questions, researched, and made a great deal of money going against the conventional wisdom. They did not just avoid the area (don’t invest in thrifts or banks, don’t invest in home building stocks, don’t invest in mortgage guaranty insurers) but found vehicles to invest in that would go up as the housing market bubble burst and the mortgages became worthless. I wish I could tell you I was likewise as smart to have made those contrary investments. I wasn’t. However, I did know something was wrong, based on my days at a bank and on its asset-liability committee. When mortgages stopped being retained on the books by the institutions that had made them and were packaged to be sold into the secondary market (and then securitized), it was clear that, without ongoing accountability, underwriting standards were being stretched. Why? With gain-on-sale accounting, profits and bonuses were increased and stock options went into the money. That was one of the reasons I refused to drink the thrift/bank Kool-Aid (not the only time I did not go along to get along, but we really don’t change after the age of 8). One food for thought question – are we seeing a replay event in China, tied as their boom was to residential construction and real estate?

One of the great scenes in the “Big Short” is when two individuals from New York fly down to Florida to check on the housing market and find unfinished construction, mortgages on homes being occupied by renters, people owning four or five homes trying to flip them, and totally bogus underwriting on mortgage lending. The point here is that they did the research – they went and looked. Often in fund management, a lot of people did not do that. After all, fill-in-the blank sell-side firm would not be recommending purchase of equities in home builders or mortgage lenders, without actually doing the real due diligence. Leaving aside the question of conflicts of interest, it was not that difficult to go look at the underlying properties and check valuations out against the deeds in the Recorder’s Office (there is a reason why there are tax stamps on deeds). So you might miss a few of your kid’s Little League games. But what resonates most with me is that no senior executive that I can remember from any of the big investment banks, the big thrifts, the big commercial banks was criminally charged and went to jail. Instead, what seems to have worked is what I will call the “good German defense.” And another aside, in China, there is still capital punishment and what are capital crimes is defined differently than here.

This brings me to “Spotlight” where one of the great lines is, “We all knew something was going on and we didn’t do anything about it.” And the reason it resonates with me is that you see a similar conspiracy of silence in the financial services industry. Does the investor come first or the consultant? Is it most important that the assets grow so the parent company gets a bigger return on its investment, or is investment performance most important? John Bogle, when he has spoken about conflicts of interest, is right when he talks about the many conflicts that came about when investment firms were allowed to sell themselves and basically eliminate personal responsibility.

This year, we have seen the poster child for what is wrong with this business with the ongoing mess at The Third Avenue Funds. There is a lot that has been written so far. I expect more will be written (and maybe even some litigation to boot). I commend all of you to the extensive pieces that have appeared in the Wall Street Journal. But what they highlight that I don’t think has been paid enough attention to is the problem of a roll-up investment (one company buying up and owning multiple investment management firms) with absentee masters. In the case of Third Avenue, we have Affiliated Managers Group owning, as reported by the WSJ, 60% of Third Avenue, and those at Third Avenue keeping a 40% stake (to incentivize them). With other companies from Europe, such as Allianz, the percentages may change but the ownership is always majority. So, 60% of the revenues come off the top, and the locals are left to grow the business, reinvest in it by hiring and retaining talent, focus on investment performance, etc., with their percentage Unfortunately, when the Emperor is several states, or an ocean away, one often does not know what is really going on. You get to see numbers, you get told what you want to hear (ISIS has been contained, Bill Gross is a distraction to the other people), and you accept it until something stops working.

So I leave you with my question for you all to ponder for 2016. Is the 1940 Act mutual fund industry, the next big short? Investors, compliments of Third Avenue, have now been reminded that daily liquidity and redemption is that until it is not. As I have mentioned before, this is an investment class with an unlimited duration and a mismatch of assets and liabilities. This is perhaps an unusual concern for a publication named “Mutual Fund Observer.” But I figure if nothing else, we can always start a separate publication called “Mutual Fund Managers Address Book” so you can go look at the mansions and townhouses in person.

Edward A. Studzinski

“What is youth except a man or a woman before it is ready or fit to be seen.”

Evelyn Waugh

We are now in that time of the year, December, which I will categorize as the silly season for investors, both institutional and individual. Generally things should be settling down into the holiday whirl of Christmas parties and distribution of bonus checks, at least in the world of money management. Unfortunately, things have not gone according to plan. Once again that pesky passive index, the S&P 500, is outperforming many active managers. And in some instances, it is not just outperforming, but in positive total-return territory while many active managers are in negative territory. So for the month of December, there is an unusual degree of pressure to catch-up the underperformance by year-end.

We have seen this play out in the commodities, especially the energy sector. As the price of oil has drifted downwards, bouncing but now hovering around $40 a barrel, it has been dangerous to assume that all energy stocks were alike, that leverage did not matter, and that lifting costs and the ability to get product to market did not matter. It did, which is why we see some companies on the verge of being acquired at a very low price relative to barrels of energy in the ground and others faced with potential bankruptcy. It did matter whether your reserves were shale, tar sands, deep water, or something else.

Some of you wonder why, with a career of approaching thirty years as an active value investor, I am so apparently negative on active management. I’m not – I still firmly believe that over time, value outperforms, and active management should add positive alpha. But as I have also said in past commentaries, we are in the midst of a generational shift of analysts and money managers. And it is often a shift where there is not a mentoring overlap or transition (hard to have an overlap when someone is spending much of his or her time a thousand miles away). Most of them have never seen, let alone been through, a protracted bear market. So I don’t really know how they will react. Will they panic or will they freeze? It is very hard to predict, especially from the outside looking in. But in a world of email, social media, and other forms of instantaneous communication, it is also very hard to shut out the outside noise and intrusions. I have talked to and seen managers and analysts who retreated into their offices, shut the door, and melted under the pressure.

For many of you, I think the safer and better course of action is to allocate certain assets, particularly retirement, to passively-managed products which will track the long-term returns of the asset classes in which they are invested. They too will have maximum draw-down and other bear market issues, but you will eliminate a human element that may negatively impact you at the wrong time.

The other issue of course is benchmarking and time horizons, which is difficult for non-value investors to appreciate. Value can be out of favor for a long, long period of time. Indeed it can be out of favor so long that you throw in the towel. And then, you wish you had not. The tendency towards short-termism in money management is the enemy of value investing. And many in money management who call themselves value managers view the financial consultant or intermediary as the client rather than Mr. and Mrs. Six-Pack whose money it is in the fund. They play the game of relative value, by using strategies such as regression to the mean. “See, we really are value investors. We lost less money than the other guys.”

The Real Thing

One of the high points for me over the last month was the opportunity to attend a dinner hosted by David Marcus, of Evermore Global Value, in Boston, at the time of the Schwab Conference. I would like to say that David Snowball and I attended the Schwab Conference, but Schwab does not consider MFO to be a real financial publication. They did not consider David Snowball to be a financial journalist.

I have known of David Marcus for some years, as one of the original apostles under Max Heine and Michael Price at Mutual Shares. I am unfortunately old enough to remember that the old Mutual Shares organization was something special, perhaps akin to the Brooklyn Dodgers team of 1955 that beat the Yankees in the World Series (yes, children, the Dodgers were once in Brooklyn). Mutual Shares nurtured a lot of value investing talent, many of whom you know and others, like Seth Klarman of Baupost and my friend Bruce Crystal, whom you may not.

David Snowball and I subsequently interviewed David Marcus for a profile of his fund. I remember being struck by his advice to managers thinking of starting another 1940 Act mutual fund – “Don’t start another large cap value fund just like every other large cap value fund.” And Evermore Global is not like any other fund out there that I can see. How do I know? Well, I have now listened to David Marcus at length in person, explaining what he and his analysts do in his special situation fund. And I have done what I always do to see whether what I am hearing is a marketing spiel or not. I have looked at the portfolio. And it is unlike any other fund out there that I can see in terms of holdings. Its composition tells me that they are doing what they say they are doing. And, David can articulate clearly, at length, about why he owns each holding.

What makes me comfortable? Because I don’t think David is going to morph into something different than what he is and has been. Apparently Michael Price, not known for suffering fools gladly, said that if the rationale for making an investment changed or was not what you thought it was, get rid of the investment. Don’t try and come up with a new rationale. I will not ruin your day by telling you that in many firms today the analysts and portfolio managers regularly reinvent a new rational, especially when compensation is tied to invested assets under management. I also believe Marcus when he says the number of stocks will stay at a certain level, to make sure they are the best ideas. You will not have to look back at prior semi-annual reports to wonder why the relatively concentrated fund of forty stocks became the concentrated fund of eighty stocks (well it’s active share because there are not as many as Fidelity has in their similar fund). So, I think this is a fund worth looking at, for those who have long time horizons. By way of disclosure, I am an investor in the fund.

Final Thoughts

For those of you who like history, and who want to understand what I am talking about in terms of the need for appreciating generational shifts in management when they happen, I commend to you Rick Atkinson’s first book in his WWII trilogy, An Army at Dawn.

My friend Robin Angus, at the very long-term driven UK Investment Trust Personal Assets, in his November 2015 Quarterly Report quoted Brian Spector of Baupost Partners in Boston, whose words I think are worth quoting again. “One of the most common misconceptions regarding Baupost is that most outsiders think we have generated good risk-adjusted returns despite holding cash. Most insiders, on the other hand, believe we have generated those returns BECAUSE of that cash. Without that cash, it would be impossible to deploy capital when … great opportunities became widespread.”

Finally, to put you in the holiday mood, another friend, Larry Jeddeloh of The Institutional Strategist, recently came back from a European trip visiting clients there. A client in Geneva said to Larry, “If you forget for a moment analysis, logic, reasoning and just sniff the air, one smells gunpowder.”

Not my hope for the New Year, but ….

Edward A. Studzinski

“The pure and simple truth is rarely pure and never simple.”

                             Oscar Wilde

There are a number of things that I was thinking about writing, but given what has transpired recently at Sequoia Fund as a result of its investment in and concentration in Valeant Pharmaceuticals, I should offer some comments and thoughts to complement David’s. Mine are from the perspective of an investor (I have owned shares in Sequoia for more than thirty years), and also as a former competitor.

Sequoia Fund was started back in 1970. It came into its own when Warren Buffett, upon winding up his first investment partnership, was asked by a number of his investors, what they should do with their money since he was leaving the business for the time being. Buffett advised them to invest with the Sequoia Fund. The other part of this story of course is that Buffett had asked his friend Bill Ruane to start the Sequoia Fund so that there would be a place he could refer his investors to and have confidence in how they would be treated.

Bill Ruane was a successful value investor in his own right. He believed in concentrated portfolios, generally fewer than twenty stock positions. He also believed that you should watch those stock investments very carefully, so that the amount of due diligence and research that went into making an investment decision and then monitoring it, was considerable. The usual course of business was for Ruane, Dick Cunniff and almost the entire team of analysts to descend upon a company for a full day or more of meetings with management. And these were not the kind of meetings you find being conducted today, as a result of regulation FD, with company managements giving canned presentations and canned answers. These, according to my friend Tom Russo who started his career at Ruane, were truly get down into the weeds efforts, in terms of unit costs of raw materials, costs of manufacturing, and other variables, that could tell them the quality of a business. In terms of something like a cigarette, they understood what all the components and production costs were, and knew what that individual cigarette or pack of cigarettes, meant to a Philip Morris. And they went into plants to understand the manufacturing process where appropriate.

Fast forward to the year 2000, and yes, there is a succession plan in place at Ruane, with Bob Goldfarb and Carly Cunniff (daughter of Dick, but again, a formidable talent in her own right who would have been a super investor talent if her name had been Smith) in place as President and Executive Vice President of the firm respectively. The two of them represented a nice intellectual and personality balance, complementing or mellowing each other where appropriate, and at an equal level regardless of title.

Unfortunately, fate intervened as Ms. Cunniff was diagnosed with cancer in 2001, and passed away far too early in life, in 2005. Fate also intervened again that year, and Bill Ruane also passed away in 2005.

At that point, it became Bob Goldfarb’s firm effectively, and certainly Bob Goldfarb’s fund. At the end of 2000, according to the 12/31/2000 annual report, Sequoia had 11 individual stock positions, with Berkshire representing 35.6% and Progressive Insurance representing 6.4%. At the end of 2004, according to the 12/31/2004 annual report, Sequoia had 21 individual stock positions, with Berkshire representing 35.3% and Progressive Insurance representing 12.6% (notice a theme here). By the end of 2008, according to the 12/31/2008, Berkshire represented 22.8% of the fund, Progressive was gone totally from the portfolio, and there were 26 individual stock positions in the fund. By the end of 2014, according to the 12/31/2014 report, Sequoia had 41 individual stock positions, with Berkshire representing 12.9% and healthcare representing 21.4%.

So, clearly at this point, it is a different fund than it used to be, in terms of concentration as well as the types of businesses that it would invest in. In 2000 for instance, there was no healthcare and in 2004 it was de minimis. Which begs the question, has the number of high quality businesses expanded in recent years? The answer is probably not. Has the number of outstanding managements increased in recent years, in terms of the intelligence and integrity of those management teams? Again, that would not seem to be the case. What we can say however, is that this is a Goldfarb portfolio, or more aptly, a Goldfarb/Poppe portfolio, distinct from that of the founders.

An interesting question is, given the fund’s present composition, would Buffett, if asked today for a recommendation as to where his investors should go down the road, still suggest Sequoia? My suspicion is he would not with how the fund is presently managed and, given his public comments advocating that his wife’s money after his demise should go to an S&P 500 index fund.

A fairer question is – why have I held on to my investment at Sequoia? Well, first of all, Bob Goldfarb is 70 and one would think by this point in time he has proved whatever it was that he felt he needed to prove (and perhaps a number of things he didn’t). But secondly, there is another great investor at Ruane, and that is Greg Alexander. Those who attend the Sequoia annual meetings see Greg, because he is regularly introduced, even though he is a separate profit center at Ruane and he and his team have nothing to do with Sequoia Fund. However, Bruce Greenwald of Columbia, in a Value Walk interview in June of 2010 said Buffett had indicated there were three people he would like to have manage his money after he died (this was before the index fund comment). One of them was Seth Klarman at Baupost. Li Lu who manages Charlie Munger’s money was a second, and Greg Alexander at Ruane was the third. Greg has been at Ruane since 1985 and his partnerships have been unique. In fact, Roger Lowenstein, a Sequoia director, is quoted as saying that he knows Greg and thinks Warren is right, but that was all he would say. So my hope is that the management of Ruane as well as the outside directors remaining at Sequoia, wake up and refocus the fund to return to its historic roots.

Why is the truth never pure and simple in and of itself. We have said that you need to watch the changes taking place at firms like Third Avenue and FPA. I must emphasize that one can never truly appreciate the dynamics inside an active management firm. Has a co-manager been named to serve as a Sancho Panza or alternatively to truly manage the portfolio while the lead manager is out of the picture for non-disclosed reasons? The index investor doesn’t have to worry about these things. He or she also doesn’t have to worry about whether an investment is being made or sold to prove a point. Is it being made because it is truly a top ten investment opportunity? But the real question you need to think about is, “Can an active manager be fired, and if so, by whom?” The index investor need not worry about such things, only whether he or she is investing in the right index. But the active investor – and that is why I will discuss this subject at length down the road.

“Cynicism is an unpleasant way of saying the truth.”

Lillian Hellman

Current Events:

While we may be where we are, it is worth a few moments to talk about how we got here. In recent months the dichotomy between the news agendas of the U.S. financial press and the international press has become increasingly obvious. At the beginning of August, a headline on the front page of the Financial Times read, “One Trillion Dollars in Capital Flees Emerging Markets.” I looked in vain for a similar story in The Wall Street Journal or The New York Times. There were many stories about the next Federal Reserve meeting and whether they would raise rates, stories about Hillary Clinton’s email server, and stories about Apple’s new products to come, but nothing about that capital flight from the emerging markets.

We then had the Chinese currency devaluation with varying interpretations on the motivation. Let me run a theme by you that was making the rounds of institutional investors outside of the U.S. and was reported at that time. In July there was a meeting of the International Monetary Fund in Europe. One of the issues to be considered was whether or not China’s currency, the renminbi, would be included in the basket of currencies against which countries could have special drawing (borrowing) rights. This would effectively have given the Chinese currency the status of a reserve currency by the IMF. The IMF’s staff, whose response sounded like it could have been drafted by the U.S. Treasury, argued against including the renminbi. While the issue is not yet settled, the Executive Directors accepted the staff report and will recommend extending the lifespan of the current basket, now set to expire December 31, until at least September 2016. At the least, that would lock out the renminbi for another year. The story I heard about what happened next is curious but telling. The Chinese representative at the meeting is alleged to have said something like, “You won’t like what we are going to do next as a result of this.” Two weeks after the conclusion of the IMF meeting, we then had the devaluation of China’s currency, which in the minds of some triggered the increased volatility and market sell-offs that we have seen since then.

I know many of you are saying, “Pshaw, the Chinese would never do anything as irrational as that for such silly reasons.” And if you think that dear reader, you have yet to understand the concept of “Face” and the importance that it plays in the Asian world. You also do not understand the Chinese view of self – that they are a Great People and a Great Nation. And, that we disrespect them at our own peril. If you factor in a definition of long-term, measured in centuries, events become much more understandable.

One must read the world financial press regularly to truly get a picture of global events. I suggest the Financial Times as one easily accessible source. What is reported and considered front page news overseas is very different from what is reported here. It seems on occasion that the bobble-heads who used to write for Pravda have gotten jobs in public relations and journalism in Washington and Wall Street.

One example – this week the Financial Times reported the story that many of the sovereign wealth funds (those funds established by countries such as Kuwait, Norway, and Singapore to invest in stocks, bonds, and other assets, for pension, infrastructure or healthcare, among other things), have been liquidating investments. And in particular, they have been liquidating stocks, not bonds. Another story making the rounds in Europe is that the various “Quantitative Easing” programs that we have seen in the U.S., Europe, and Japan, are, surprise, having the effect of being deflationary. And in the United States, we have recently seen the three month U.S. Treasury Bill trading at negative yields, the ultimate deflationary sign. Another story that is making the rounds – the Chinese have been selling their U.S. Treasury holdings and at a fairly rapid clip. This may cause an unscripted rate rise not intended or dictated by the Federal Reserve, but rather caused by market forces as the U.S. Treasury continues to come to market with refinancing issues.

The collapse in commodity prices, especially oil, will sooner or later cause corporate bodies to float to the surface, especially in the energy sector. Counter-party (the other side of a trade) risk in hedging and lending will be a factor again, as banks start shrinking or pulling lines of credit. Liquidity, which was an issue long before this in the stock and bond markets (especially high yield), will be an even greater problem now.

The SEC, in response to warnings from the IMF and the Federal Reserve, has unanimously (which does not often happen) called for rules to prevent investors’ demands for redemptions in a market crisis from causing mutual funds to be driven out of business. Translation: don’t expect to get your money as quickly as you thought. I refer you to the SEC’s Proposal on Liquidity Risk Management Programs.

I mention that for the better of those who think that my repeated discussions of liquidity risk is “crying wolf.”

“It’s a Fine Kettle of Fish You’ve Gotten Us in, Ollie.”

I have a friend who is a retired partner from Wellington in Boston (actually I have a number of friends who are retired partners from there). Wellington is not unique in that, like Fidelity, it is very unusual for an analyst or money manager to

stay much beyond the age of fifty-five. So I asked him one day how he had his retirement investments structured, hoping I might get some perspective into thinking on the East Coast, as well as perhaps some insights into Vanguard’s products, given the close relationship between Vanguard and Wellington. His answer surprised me – “I have it all in index funds.” I asked if there were any particular index funds. Again the answer surprised me. “No bond funds, and actually only one index fund – the Vanguard S&P 500 Index Fund.” And when I asked for further color on that, the answer I got was that he was not in the business full time anymore, looking at markets and security valuations every day, so this was the best way to manage his retirement portfolio for the long-term at the lowest cost. Did he know that there were managers, that 10% or so, who consistently (or at least for a while, consistently) outperform the index? Yes, he was aware that such managers were out there. But at this juncture in his life he did not think that he either (a) had the time, interest, and energy to devote to researching and in effect “trading managers” by trading funds and (b) did not think he had any special skill set or insights that would add value in that process that would justify the time, the one resource he could not replace. Rather, he knew what equity exposure he wanted over the next twenty or thirty years (and he recognized that life expectancies keep lengthening). The index fund over that period of time would probably compound at 8% a year as it had historically with minimal transaction costs and minimal tax consequences. He could meet his needs for a diversified portfolio of equities at an expense ratio of five basis points. The rest of his assets would be in cash or cash equivalents (again, not bonds but rather insured certificates of deposit).

I have talked in the past about the need to focus on asset allocation as one gets older, and how index funds are the low cost way to achieve asset diversification. I have also talked about how your significant other may not have the same interest or ability in managing investments (trading funds) after you go on to your just reward. But I have not talked about the intangible benefits from investing in an index fund. They lessen or eliminate the danger of portfolio manager or analyst hubris blowing up a fund portfolio with a torpedo stock. They also eliminate the divergence of interests between the investment firm and investors that arises when the primary focus is running the investment business (gathering assets).

What goes into the index is determined not by the entity running the fund (although they can choose to create their own index, as some of the European banks have done, and charge fees close to 2.00%). There is no line drawn in the sand because a portfolio manager has staked his public reputation on his or her genius in investing in a particular entity. There is also no danger in an analyst recommending sale of an issue to lock in a bonus. There is no danger of an analyst recommending an investment to please someone in management with a different agenda. There is no danger of having a truncated universe of opportunities to invest in because the portfolio manager has a bias against investing in companies that have women chief executive officers. There is no danger of stock selection being tainted because a firm has changed its process by adding an undisclosed subjective screening mechanism before new ideas may be even considered. While firm insiders may know these things, it is a very difficult thing to learn them from the outside.

Is there a real life example here? I go back to the lunch I had at the time of the Morningstar Conference in June with the father-son team running a value fund out of Seattle. As is often the case, a subject that came up (not raised by me) was Washington Mutual (WaMu, a bank holding company that collapsed in 2008, trashing a bunch of mutual funds when it did). They opined how, by being in Seattle (a big small town), they had been able to observe up close and personally how the roll-up (which was what Washington Mutual was) had worked until it didn’t. Their observation was that the Old Guard, who had been at the firm from the beginning with the chair of the board/CEO had been able to remind him that he put his pants on one leg at a time. When that Old Guard retired over time, there was no one left who had the guts to perform that function, and ultimately the firm got too big relative to what had driven past success. Their assumption was that their Seattle presence gave them an edge in seeing that. Sadly, that was not necessarily the case. In the case of many an investment firm, Washington Mutual became their Stalingrad. Generally, less is more in investing. If it takes more than a few simple declarative sentences to explain why you are investing in a business, you probably should not be doing it. And when the rationale for investing changes and lengthens over time, it should serve as a warning.

I suspect many of you feel that the investment world is not this way in reality. For those who are willing to consider whether they should rein in their animal spirits, I commend to you an article entitled “Journey into the Whirlwind: Graham-and-Doddsville Revisited” by Louis Lowenstein (2006) and published by The Center for Law and Economic Studies at Columbia Law School. (Lowenstein, father of Roger Lowenstein, looks at the antics of large growth managers and conclude, “Having attracted, not investors, but speculators trying to catch the next new thing, management got the shareholders they deserved.” Snowball). When I look at the investment management profession today, as well as its lobbying efforts to prevent the imposition of stricter fiduciary standards, I question whether what they really feel in their hearts is that the sin of Madoff was getting caught.

The End

Is there anything I am going to say this month that may be useful to the long-term investor? There is at present much fear abroad in the land about investing in emerging and frontier markets today, driven by what has happened in China

and the attendant ripple effect. The question I will pose for your consideration is this. What if five years from now it becomes compellingly obvious that China has become the dominant economic force in the world? Since economic power ultimately leads to political and military power, China wins. How should one be investing a slice of one’s assets (actively-managed of course) today if one even thinks that this is a remotely possible outcome? Should you be looking for a long-term oriented, China-centric fund?

There is one other investment suggestion I will make that may be useful to the long-term investor. David has raised it once already, and that is dedicating some assets into the micro-cap stock area. Focus on those investments that are in effect too small and extraordinarily illiquid in market capitalization for the big firms (or sovereign wealth funds) to invest in and distort the prices, both coming and going. Micro-cap investing is an area where it is possible to add value by active management, especially where the manager is prepared to cap the assets that it will take under management. Look for managers or funds where the strategy cannot be replicated or imitated by an exchange traded fund. Always remember, when the elephants start to dance, it is generally not pleasant for those who are not elephants.

Edward A. Studzinski

P.S. – Where Eagles Dare

The fearless financial writer for the New York Times, Gretchen Morgenson, wrote a piece in the Sunday Times (9/27/2015) about the asset management company First Eagle Investment Management. The article covered an action brought by the SEC for allegedly questionable marketing practices under the firm’s mutual funds’ 12b-1 Plan. Without confirming or denying the allegations, First Eagle settled the matter by paying $27M in disgorgement and interest, and $12.5M in fines. With approximately $100B in assets generating an estimated $900+M in revenues annually, one does not need to hold a Tag Day for the family-controlled firm. Others have written and will write more about this event than I will.

Of more interest is the fact that Blackstone Management Partners is reportedly purchasing a 25% stake in First Eagle that is being sold by T/A Associates of Boston, another private equity firm. As we have seen with Matthews in San Francisco, investments in investment management firms by private equity firms have generally not inured to the benefit of individual investors. It remains to be seen what the purpose is of this investment for Blackstone. Blackstone had had a right-time, right-strategy investment operation with its two previously-owned closed-end funds, The Asia Tigers Fund and The India Fund, both run by experienced teams. The funds were sold to Aberdeen Asset Management, ostensibly so Blackstone could concentrate on asset management in alternatives and private equity. With this action, they appear to be rethinking that.

Other private equity firms, like Oaktree, have recently launched their own specialist mutual funds. I would note however that while the First Eagle Funds have distinguished long-term records, they were generated by individuals now absent from the firm. There is also the question of asset bloat. One has to wonder if the investment strategy and methodology could not be replicated by a much lower cost (to investors) vehicle as the funds become more commodity-like.

Which leaves us with the issue of distribution – is a load-based product, going through a network of financial intermediaries, viable, especially given how the Millennials appear to make their financial decisions? It remains to be seen. I suggest an analogy worth considering is the problem of agency-driven insurance firms like Allstate. Allstate would clearly like to not have an agency distribution system, and would make the switch overnight if it could without losing business. It can’t, because too much of the book of business would leave. And yet, when one looks at the success of GEICO and Progressive in going the on-line or 1-800 route, one can see the competitive disadvantage, especially in automobile insurance, which is the far more profitable business to capture. It remains to be seen how distribution will evolve in the investment management world, especially as pertains to funds. As fiduciary requirements change, there is the danger of the entire industry model also changing.

“I prefer the company of peasants because they have not been educated sufficiently to reason incorrectly.”

               Michel de Montaigne

At this point in time, rather than focus on the “if only” questions that tend to freeze people in their tracks in these periods of market volatility, I think we should consider what is important. For most of us, indeed, the vast majority of us, the world did not end in August and it is unlikely to end in September.  Indeed, for most Americans and therefore by definition most of us, the vagaries of the stock market are not that important.

What then is important? A Chicago Tribune columnist, Mary Schmich, recently interviewed Edward Stuart, an economics professor at Northeastern Illinois University as a follow-up to his appearance on a panel on Chicago Public Television’s “Chicago Tonight” show. Stuart had pointed out that the ownership of stock (and by implication, mutual funds) in the United States is quite unequal. He noted that while the stock market has done very well in recent years, the standard of living of the average American citizen has not done as well. Stuart thinks that the real median income for a household size of four is about $40,000 …. and that number has not changed since the late 70’s. My spin on this is rather simple – the move up the economic ladder that we used to see for various demographic groups – has stopped.

If you think about it, the evidence is before us. How many of us have friends whose children went to college, got their degrees, and returned home to live with their parents while they hunted for a job in their chosen field, which they often could not find? When one drives around city and suburban streets, how many vacancies do we see in commercial properties?  How many middle class families that used to bootstrap themselves up by investing in and owning apartment buildings or strip malls don’t now?  What is needed is a growing economy that offers real job prospects that pay real wages. Stuart also pointed out that student debt is one of the few kinds of debt that one cannot expunge with bankruptcy.

As I read that piece of Ms. Schmick’s and reflected on it, I was reminded of another column I had read a few months back that talked about where we had gone off the rails collectively. The piece was entitled “Battle for the Boardroom” by Joe Nocera and was in the NY Times on May 9, 2015. Nocera was discussing the concept of “activist investors” and “shareholder value” specifically as it pertained to Nelson Peltz, Trian Investments, and a proxy fight with the management and board of DuPont.  And Nocera pointed out that Trian, by all accounts, had a good record and was often a constructive force once it got a board seat or two.

Nocera’s concern, which he raised in a fashion that went straight for the jugular, was simple. Have we really reached the point where the activist investor gets to call the tune, no matter how well run the company? What is shareholder value, especially in a company like DuPont? Trian’s argument was that DuPont was not getting a return on its spending on research and development? Yet R&D spending is what made DuPont, given the years it takes to often produce from scientific research a commercial product. Take away the R&D spending argued Nocera, and you have not just a poorer DuPont, but also a poorer United States. He closed by talking with and quoting Martin Lipton, a corporate attorney who has made a career out of disparaging corporate activists. Lipton said, “Activism has caused companies to cut R&D, capital investment, and, most significantly, employment,” he said. “It forces companies to lay off employees to meet quarterly earnings.”

“It is,” he concluded, “a disaster for the country.”

This brings me to my final set of ruminations. Some years ago, my wife and I were guests at a small dinner party at the home of a former ambassador (and patriot) living in Santa Fe.  There were a total of six of us at that dinner. One of the other guests raised the question as to whether any of us ever thought about what things would have been like for the country if Al Gore, rather than George W. Bush, had won the presidential election. My immediate response was that I didn’t think about such things as it was just far too painful to contemplate.

In like vein, having recently read Ron Suskind’s book Confidence Men, I have been forced to contemplate what it would have meant for the country if President-elect Barack Obama had actually followed through with the recommendations of his transition advisors and appointed his “A” Economic Team. Think about it – Paul Volcker as Secretary of the Treasury, the resurrection of Glass-Steagall, the break-up of the big investment banks – it too is just too painful to contemplate.  Or as the line from T.H. White’s Once and Future King goes, “I dream things that never were, and ask why not?”

Now, a few thoughts about the carnage and how to deal with it.  Have a plan and stick to it. Do not panic, for inevitably all panic does is lead to self-inflicted wounds. Think about fees, but from the perspective of correlated investments. That is, if five large (over $10B in assets) balanced funds are all positively correlated in terms of their portfolios, does it really make sense not to own the one with the lowest expense ratio (and depending on where it is held, taxes may come into play)? Think about doing things where other people’s panic does not impact you, e.g., is there a place for closed end funds in a long-term investment portfolio? And avoid investments where the bugs have not been worked out, as the glitches in pricing and execution of trades for ETF’s have shown us over the last few weeks.

There is a wonderful Dilbert cartoon where the CEO says “Asok, you can beat market averages by doing your own stock research. Asok then says, “So … You believe every investor can beat the average by reading the same information? “Yes” says the CEO. Asok then says, “Makes you wonder why more people don’t do it.” The CEO closes saying, “Just lazy, I guess.”

Edward A. Studzinski

Some men are born mediocre, some men achieve mediocrity, and some men have mediocrity thrust upon them.

       Joseph Heller

We are now at the seven month mark. All would not appear to be well in the investing world. But before I head off on that tangent, there are some housekeeping matters to address.

First, at the beginning of the year I suggested that the average family unit should own no more than ten mutual funds, which would cover both individual and retirement assets. When my long-suffering spouse read that, the question she asked was how many we had. I stopped counting when I got to twenty-five, and told her the results of my search. I was then told that if I was going to tell others they should have ten or less per family unit, we should follow suit. I am happy to report that the number is now down to seventeen (exclusive of money market funds), and I am aiming to hit that ten number by year-end.

Obviously, tax consequences play a big role in this process of consolidation. One, there are tax consequences you can control, in terms of whether your ownership is long-term or short-term, and when to sell. Two, there are tax consequences you can’t control, which are tied in an actively-managed fund, to the decision by the portfolio manager to take some gains and losses in an effort to manage the fund in a tax-efficient manner. At least that is what I hope they are doing. There are other tax consequences you cannot control when the fund in question’s performance is bad, leading to a wave of redemptions. The wave of redemptions then leads to forced selling of equity positions, either en masse or on a pro rata basis, which then triggers tax issues (hopefully gains but sometimes not). The problem with these unintended or unplanned for tax consequences, is that in non-retirement accounts, you are often faced with a tax bill that you have not planned for at filing time, and need to come up with a check to pay the taxes due. A very different way to control the tax consequences, especially if you are of a certain age, is to own passive index funds, whose portfolios won’t change except for those issues going into or leaving the index. Turnover and hence capital gains distributions, tend to be minimized. And since they do tend to own everything as it were, you will pick up some of the benefit of merger and acquisition activity. However, index funds are not immune to an investor panic, which leads to forced selling which again triggers tax consequences.

In this consolidation process, one of the issues I am wrestling with is what to do with money market funds, given that later this year unless something changes again, they will be allowed to “break the buck” or no longer have a constant $1 share price. My inclination is to say that cash reserves for individuals should go back into bank certificates of deposit, up to the maximum amounts of the FDIC insurance. That will work until or unless, like Europe, the government through the banks decides to start charging a negative interest rate on bank deposits. The other issue I am wrestling with is the category of balanced funds, where I am increasingly concerned that the three usual asset classes of equities, fixed income, and cash, will not necessarily work in a complementary manner to reduce risk. The counter argument to that of course, is that most people investing in a balanced (or equity fund for that matter) investment, do not have a sufficiently long time horizon, ten years perhaps being the minimum commitment. If you look at recent history, it is extraordinary how many ten year returns both for equity funds and balanced funds, tend to cluster around the 8% annualized mark.

Morningstar, revisited:

One of the more interesting lunch meetings I had around the Morningstar conference that I did not attend, was with a Seattle-based father-son team with an outstanding record to date in their fund. One of the major research tools used was, shock of shock, the Value Line. But that should not surprise people. Many of Buffet’s own personal investments were, as he relates it, arrived at by thumbing through things like a handbook of Korean stocks. I have used a similar handbook to look at Japanese stocks. One needs to understand that in many respects, the purpose of hordes of analysts, producing detailed models and exhaustive reports is to provide the cover of the appearance of adequate due diligence. Years ago, when I was back in the trust investment world, I used to have various services for sale by the big trust banks (think New York and Philadelphia) presented to me as necessary. Not necessary to arrive at good investment decisions, but necessary to have as file drawer stuffers when the regulators came to examine why a particular equity issue had been added to the approved list. Now of course with Regulation FD, rather than individual access to managements and the danger of selective disclosure of material information, we have big and medium sized companies putting on analyst days, where all investors – buy side, sell side, and retail, get access to the same information at the same time, and what they make of it is up to them.

So how does one improve the decision making process, or rather, get an investment edge? The answer is, it depends on the industry and what you are defining as your circle of competency. Let’s assume for the moment it is property and casualty reinsurance. I would submit that one would want to make a point of attending the industry meetings, held annually, in Monte Carlo and Baden-Baden. If you have even the most rudimentary of social skills, you will come away from those events with a good idea as to how pricing (rate on line) is going to be set for categories of business and renewals. You will get an idea as to whose underwriting is conservative and whose is not. And you will get an idea as to who is under-reserved for prior events and who is not. You will also get a sense as to how a particular executive is perceived.

Is this the basis for an investment decision alone? No, but in the insurance business, which is a business of estimates to begin with, the two most critical variables are the intelligence and integrity of management (which comes down from the top). What about those wonderfully complex models, forecasting interest rates, pricing, catastrophic events leading to loss ratios and the like? It strikes me that fewer and fewer people have taken sciences in high school or college, where they have learned about the Law of Significant Numbers. Or put another way, perhaps appropriately cynical, garbage in/garbage out.

Now, many of you are sitting there thinking that it really cannot be this simple. And I will tell you that the finest investment analyst I have ever met, a contemporary of mine, when he was acting as an analyst, used to do up his research ideas by hand, on one or one and a half sheets of 8 ½ by 11 paper.

There would be a one or two sentence description of the company and lines of business, a simple income statement going out maybe two years beyond this year, several bullet points as to what the investment case was, with what could go right (and sometimes what could go wrong), and that was generally it, except for perhaps a concluding “Reasons to Own. AND HIS RETURNS WERE SPECTACULAR FOR HIS IDEAS! People often disbelieve me when I tell them that, so luckily I have saved one of those write-ups. My point is this – the best ideas are often the simplest ideas, capable of being presented and explained in one or two declarative sentences.

What’s coming?

And finally, for a drop of my usual enthusiasm for the glass half empty. There is a lot of strange stuff going on in the world at the moment, much of it not going according to plan, for governments, central banks, and corporations as one expected in January. Commodity prices are collapsing. Interest rates look to go up in this country, perhaps sooner rather than later. China may or may not have lost control of its markets, which would not augur well for the rest of us. I will leave you with something else to ponder. The “dot.com” crash in 2000 and the financial crisis of 2007-2008-2009 were water-torture events. Most of the people running money now were around for them, and it represents their experiential reference point. The October 1987 crash was a very different animal – you came in one day, and things just headed down and did not stop. Derivatives did not work, portfolio insurance did not work, and there was no liquidity as everyone panicked and tried to go through the door at once. Very few people who went through that experience are still actively running money. I bring this up, because I worry that the next event (and there will be one), will not necessarily be like the last two, where one had time to get out in orderly fashion. That is why I keep emphasizing – do not put at risk more than you can afford to lose without impacting your standard of living. Investors, whether professional or individual, need to guard mentally against always being prepared to fight the last war.

Edward A. Studzinski

By Edward Studzinski

“A sign of celebrity is that his name is often worth more than his services.”

Daniel J. Boorstin

So the annual Morningstar Conference has come and gone again, with fifteen thousand attendees in town hoping to receive the benefit of some bit of investment or business wisdom. The theme of this year’s conference appears to have been that the world of investors now increasingly is populated by and belongs to “Gen X’ers” and “Millennials.” Baby Boomers such as yours truly, are a thing of the past in terms of influence as well as a group from whom assets are to be gathered. Indeed, according to my colleagues, advisors should be focused not on the current decision maker in a client family but rather the spouse (who statistically should outlive) or the children. And their process of decision making will most likely be very different than that of the patriarch. We can see that now, in terms of how they desire to communicate, which is increasingly less by the written word or in face to face meetings.

In year’s past, the conference had the flavor of being an investment conference. Now it has taken on the appearance of a marketing and asset allocation advice event. Many a person told me that they do not come to attend the conference and hear the speakers. Rather, they come because they have conveniently assembled in one place a large number of individuals that they have been interested either in meeting or catching up with. My friend Charles’ observation was that it was a conference of “suits” and “skirts” in the Exhibitors’ Hall. Unfortunately I have the benefit of these observations only second and third hand, as for the first part of the week I was in Massachusetts and did not get back to Chicago until late Wednesday evening. And while I could have made my way to events on Thursday afternoon and Friday morning, I have found it increasingly difficult to take the whole thing seriously as an investment information event (although it is obviously a tremendous cash cow for Morningstar). Given the tremendous success of the conference year in and year out, one increasingly wonders what the correct valuation metric is to be applied to Morningstar equity. Is it the Google of the investment and financial services world? Nonetheless, given the focus of many of the attendees on the highest margin opportunities in the investment business and the way to sustain an investment management franchise, I wonder if, notwithstanding how she said it, whether Senator Elizabeth Warren is correct when she says that “the game is rigged.”

Friday apparently saw two value-oriented investors in a small panel presenting and taking Q&A. One of those manages a fund with $20 Billion in assets, which is a larger amount of money than he historically has managed. Charging a 1% fee on that $20B, his firm is picking up $200 Million in revenue from that one fund alone, notwithstanding that they have other funds. Historically he has been more of a small-midcap manager, with a lot of special situations but not to worry, he’s finding lots of things to invest in, albeit with 40% or so in cash or cash equivalents. The other domestic manager runs two domestic funds as the lead manager, with slightly more than $24 Billion in assets, and for simplicity’s sake, let’s call it a blended rate of 90 basis points in fees. His firm is seeing than somewhat in excess of $216 Million in revenue from the two funds. Now let me point out that unless the assets collapse, these fees are recurring, so in five years, there has been a billion dollars in revenue generated at each firm, more than enough to purchase several yachts. The problem I have with this is it is not a serious discussion of the world we are in at present. Valuation metrics for stocks and bonds are at levels approaching if not beyond the two standard deviation warning bells. I suppose some of this is to be expected, as if is a rare manager who is going to tell you to keep your money. However, I would be hard pressed at this time if running a fund, to have it open. I am actually reminded of the situation where a friend sent me to her family’s restaurant in suburban Chicago, and her mother rattled off the specials of the evening, one of which was Bohemian style duck. I asked her to go ask the chef how the duck looked that night, and after a minute she came back and said, “Chef says the duck looks real good tonight.” At that point, one of the regulars at the bar started laughing and said, “What do you think? The chef’s going to say, oh, the duck looks like crap tonight?”

Now, if I could make a suggestion in Senator Warren’s ear, it would be that hearings should be held about what kind of compensation in the investment management field is excessive. When the dispersion between the lowest paid employee and the highest results in the highest compensated being paid two hundred times more than the lowest, it seems extreme. I suppose we will hear that not all of the compensation is compensation, but rather some reflects ownership and management responsibilities. The rub is that many times the so-called ownership interests are artificial or phantom.

It just strikes that this is an area ripe for reform, for something in the nature of an excess profits tax to be proposed. After all, nothing is really being created here that redounds to the benefit of the U.S. economy, or is creating jobs (and yes Virginia, carried interest for hedge funds as a tax advantage should also be eliminated).

We now face a world where the can increasingly looks like it cannot be kicked down the road financially for either Greece or Puerto Rico. And that doesn’t even consider the states like Illinois and Rhode Island that have serious underfunded pension issues, as well as crumbling infrastructures. So, I say again, there is a great deal of risk in the global financial system at present. One should focus, as an investor, in not putting any more at risk than one could afford to write off without compromising one’s standard of living. Low interest rates have done more harm than good, for both the U.S. economy and the global economy. And liquidity is increasingly a problem, especially in the fixed income markets but also in stocks. Be warned! Don’t be one of the investors who has caught the disease known as FOMO or “Fear of Missing Out.”

“Moon in a barrel: you never know just when the bottom will fall out.”

 Mabutsu

So as David Snowball mentioned in his May commentary, I have been thinking about the potential consequences of illiquidity in the fixed income market. Obviously, if you have a portfolio in U.S. Treasury issues, you assume you can turn it into cash overnight. If you can’t, that’s a potential problem. That appears to be a problem now – selling $10 or $20 million in Treasuries without moving the market is difficult. Part of the problem is there are not a lot of natural buyers, especially at these rates and prices. QE has given the Federal Reserve their fill of them. Banks have to hold them as part of the Dodd-Frank capital requirements, but are adding to their holdings only when growing their assets. And those people who always act in the best interests of the United States, namely the Chinese, have been liquidating their U.S. Treasury portfolio. Why? As they cut rates to stimulate their economy, they are trying to sterilize their currency from the effects of those rate cuts by selling our bonds, part of their foreign reserve holdings. Remember, the goal of China is to supplant, with their own currency, the dollar as a reserve currency, especially in Asia and the developing world. And our Russian friends have similarly been selling their Treasury holdings, but in that instance using the proceeds to purchase gold bullion to add to their reserves.

Who is there to buy bonds today? Bond funds? Not likely. If you are a fund manager and thought a Treasury bond was a cash equivalent, it is not. But if there are redemptions from your fund, there is a line of credit to use until you can sell securities to cover the redemptions, right? And it is a committed line of credit, so the bank has to lend on it, no worries! In the face of a full blown market panic, with the same half dozen banks in the business of providing lines of credit to the fund industry, where will your fund firm fall in the pecking order of mutual fund holding companies, all of whom have committed lines of credit? It now becomes more understandable why the mutual fund firms with a number of grey hairs still around, have been raising cash in their funds, not just because they are running out of things to invest in that meet their parameters. It also gives you a sense as to who understands their obligations to their shareholder investors.

We also saw this week, through an article in The Wall Street Journal, that there is a liquidity problem in the equity markets as well. There are trading volumes at the open. There are trading volumes, usually quite heavy, at the end of the day. The rest of the time – there is no volume and no liquidity. So if you thought you had protected yourself from another tsunami by having no position in your fund composed of more than three days average volume of a large or mega cap stock, surprise – you have again fought the last war. And heaven help you if you decide to still sell a position when the liquidity is limited and you trigger one or more parameters for the program and quant traders.

As Lenin asked, “What is to be done?” Jason Zweig, whom I regard as the Zen Philosopher King of financial columnists, wrote a piece in the WSJ on May 23, 2015 entitled “Lessons From A Buffett Believer.” It is a discussion about the annual meeting of Markel Corporation and the presentation given by its Chief Investment Officer, Tom Gayner. Gayner, an active manager, has compiled a wonderful long-term investment record. However, he also has a huge competitive advantage. Markel is a property and casualty company that consistently underwrites at a profitable combined ratio. Gayner is always (monthly) receiving additional capital to invest. He does not appear to trade his portfolio. So the investors in Markel have gotten a double compounding effect both at the level of the investment portfolio and at the corporation (book value growth). And it has happened in a tax-efficient manner and with an expense ratio in investing that Vanguard would be proud of in its index funds.

I recently was speaking with a friend in Japan, Alex Kinmont, who has compiled a very strong record as a deep value investor in the Japanese market, in particular the small cap end of the market. We were discussing the viability of a global value fund and whether it could successfully exist with an open-ended mutual fund as its vehicle. Alex reminded me of something that I know but have on occasion forgotten in semi-retirement, which is that our style of value can be out of favor for years. Given the increased fickleness today of mutual fund investors, the style may not fit the vehicle. Robert Sanborn used to say the same thing about those occasions when value was out of favor (think dot.com insanity). But Robert was an investment manager who was always willing to put the interests of his investors above the interests of the business.

Alex made another point which is more telling, which is that Warren Buffett has been able to do what is sensible in investing successfully because he has permanent capital. Not for him the fear of redemptions. Not for him the need to appear at noon on the Gong Show on cable to flog his investment in Bank America as a stroke of genius. Not for him the need to pander to colleagues or holding company managers more worried about their bonuses than their fiduciary obligations. Gayner at Markel has the same huge competitive advantage. Both of them can focus on the underlying business value of their investments over the long term without having to worry about short-term market pricing volatility.

What does this mean for the average fund investor? You have to be very careful, because what you think you are investing in is not always what you are getting. You can see the whole transformation of a fund organization if you look carefully at what Third Avenue was and how it invested ten years ago. And now look at what its portfolios are invested in with the departure of most of the old hands.

The annual Morningstar Conference happens in a few weeks here in Chicago. Steve Romick of FPA Advisors and the manager of FPA Crescent will be a speaker, both at Morningstar and at an Investment Analysts Society of Chicago event. Steve now has more than $20B in assets in Crescent. If I were in a position to ask questions, one of them would be to inquire about the consequences of style drift given the size of the fund. Another would be about fees, where the fee breakpoints are, and will they be adjusted as assets continue to be sought after.

 I believe in 2010, Steve’s colleague Bob Rodriguez did a well-deserved victory lap as a keynote speaker at Morningstar and also as well at another Investment Analysts Society of Chicago meeting. And what I heard then, both in the presentation and in the q&a by myself and others then has made me wonder, “What’s changed?” Of course, this was just before Bob was going on a year’s sabbatical, leaving the business in the hands of others. But, he said we should not expect to see FPA doing conference calls, or having a large marketing effort. And since all of their funds at that time, with the exception of Crescent, were load funds I asked him why they kept them as load funds? Bob said that that distribution channel had been loyal to them and they needed to be loyal to it, especially since it encouraged the investors to be long term. Now all the FPA Funds are no load, and they have marketing events and conference calls up the wazoo. What I suspect you are seeing is the kind of generational shift that occurs at organizations when the founders die or leave, and the children or adopted children want to make it seem like the success of the organization and the investment brilliance is solely due to them. For those of us familiar with the history of Source Capital and FPA, and the involvement of Charlie Munger, Jim Gipson, and George Michaelis, this is to say the least, disappointing.

“Life is an unbroken succession of false situations.”

                                     Thornton Wilder

Given my predilection to make reference to scenes from various movies, some of you may conclude I am a frustrated film critic. Since much that is being produced these days appears to be of questionable artistic merit, all I would say is that there would be lifetime employment (or the standards that exist for commercial success have declined). That said, an unusual Clint Eastwood movie came out in 1970. One of the more notable characters in the movie was Sergeant “Oddball” the tanker, played by Canadian actor Donald Sutherland. And one of the more memorable scenes and lines from that movie has the “Oddball” character saying  “Always with the negative waves Moriarty, always with the negative waves.”

Over the last several months, my comments could probably be viewed as taking a pessimistic view of the world and markets. Those who are familiar with my writings and thoughts over the years would not have been surprised by this, as I have always tended to be a “glass half-empty” person. As my former colleague Clyde McGregor once said of me, the glass was not only half-empty but broken and on the floor in little pieces. Some of this is a reflection of innate conservatism. Some of it is driven by having seen too many things “behind the curtain” over the years. In the world of the Mutual Fund Observer, there is a different set of rules by which we have to play, when comments are made “off the record” or a story cannot be verified from more than one source. So what may be seen as negativism or an excess of caution is driven by a journalistic inability to allow those of you would so desire, to paraphrase the New Testament, to “put your hands into the wounds.”  Underlying it all of course, as someone who finds himself firmly rooted in the camp of “value investor” is the need for a “margin of safety” in investments and adherence to Warren Buffett’s Rules Numbers One and Two for Investing. Rule Number One of course is “Don’t lose money.” Rule Number Two is “Don’t forget Rule Number One.”

So where does this leave us now? It is safe to say that it is not easy to find investments with a margin of safety currently, at least in the U.S. domestic markets. Stocks on various metrics do not seem especially undervalued. A number of commentators would argue that as a whole the U.S. market ranges from fully valued to over-valued. The domestic bond market, on historic measures does not look cheap either. Only when one looks at fixed income on a global basis does U.S. fixed income stand out when one has negative yields throughout much of Europe and parts of Asia starting to move in that direction. All of course is driven by central banks’ increasing fear of deflation. 

Thus, global capital is flowing into U.S. fixed income markets as they seem relatively attractive, assuming the strengthening U.S. currency is not an issue.  Overhanging that is the fear that later this year the Federal Reserve will begin raising rates, causing bond prices to tumble.  Unfortunately, the message from the Fed seems to be clearly mixed.  Will it be a while before rates really are increased in the U.S. , or,  will they start to raise rates in the second half of this year?  No one knows, nor should they.

As one who built portfolios on a stock by stock basis, rather than paying attention to index weightings, does this mean I could not put together a portfolio of undervalued stocks today?   I probably could but it would be a portfolio that would have a lot of energy-related and commodity-like issues in it.  And I would be looking for long-term investors who really meant it (were willing to lock up their money) for at least a five-year time horizon.  Since mutual funds can’t do that, it explains why many of the value-oriented investors are carrying a far greater amount of cash than they would like or is usual.  As an aside, let me say that in the last month, I have had more than one investment manager tell me that for the first time in their investing careers, they really were unsure as to how to deal with the current environment.

What I will leave you with are questions to ponder.  Over the years, Mr. Buffett and Mr. Munger have indicated that they would prefer to buy very good businesses at fair prices. And those businesses have traditionally been tilted towards those that did not require a lot of capital expenditures but rather threw off lots of cash with minimal capital investment requirements, and provided very high returns on invested capital. Or they had a built-in margin of safety, such as property and casualty insurance businesses where you were in effect buying a bond portfolio at a discount to book, had the benefit of investing the premium float, had a necessary product (automobile insurance) and again did not need a lot of capital investment. But now we see, with the Burlington Northern and utility company investments a different kettle of fish. These are businesses that will require continued capital investment going forward, albeit in oligopoly-like businesses with returns that may be fairly certain (in an uncertain world). Those investments will however not leave as much excess capital to be diverted into new portfolio investments as has historically been the case. There will be in effect required capital calls to sustain the returns from the current portfolio of businesses.  And, we see investments being made as joint ventures (Kraft, Heinz) with private equity managers (3G) with a very different mindset than U.S. private equity or investment banking firms. That is, 3G acquires companies to fix, improve, and run for the long term. This is not like your typical private equity firm here, which buys a company to put into a limited life fund which they will sell or take public again later.

So here are your questions to ponder?  Does this mean that the expectation for equity returns in the U.S. for the foreseeable future is at best in the low single digit range?  Are the days of the high single digit domestic long-term equity returns a thing of the past?   And, given how Buffett and Munger have positioned Berkshire now, what does this say about the investing environment?  And in a world of increased volatility (which value investors like as it presents opportunities) what does it say about the mutual fund model, with the requirement for daily pricing and liquidity?

By Edward Studzinski

“We do not have to visit a madhouse to find disordered minds; our planet is the mental institution of the universe.”          Goethe

For students of the stock market, one of the better reads is John Brooks’, The Go-Go Years.   It did a wonderful job of describing the rather manic era of the 60’s and 70’s (pre-1973). One of the arguments made then was that the older generation of money managers was out of touch with both technology and new investment ideas. This resulted in a youth movement on Wall Street, especially in the investment management firms. You needed to have a “kid” as a portfolio manager, which was taken to its logical conclusion in a cartoon which showed an approximately ten-year old sitting behind a desk, looking at a Quotron machine. Around 2000, a similar youth movement came along during the dot.com craze, where once again investment managers, especially value managers, were told that their era was over, that they didn’t understand the new way and new wave of investing. Each of those two eras ended badly for those who had entrusted their assets to what was in vogue at the time.

In 2008, we had a period of over-valuation in the markets that was pretty clear in terms of equities. We also had what appears in retrospect to have been the deliberate misrepresentation and marketing of certain categories of fixed income investments to those who should have known better and did not. This resulted in a market meltdown that caused substantial drawdowns in value for many equity mutual funds, in a range of forty to sixty per cent, causing many small investors to panic and suffer a permanent loss of capital which many of them could not afford nor replace. The argument of many fund managers who had invested in their own funds (and as David has often written about, many do not), was that they too had skin in the game, and suffered the losses alongside of their investors.

Let’s run some simple math. Assume a fund management firm that at 2/27/2015 has $100 billion in assets under management. Assets are equities, a mix of international and domestic, the international with fees and expenses of 1.30% and the domestic with fees and expenses of 0.90%. Let’s assume a 50/50 international/domestic split of assets, so $50 billion at 0.90% and $50 billion at 1.30%. This results in $1.1billion in fees and expenses to the management company. Assuming $300 million goes in expenses to non-investment personnel, overhead, and the other expenses that you read about in the prospectus, you could have $800 million to be divided amongst the equity owners of the management firm. In a world of Marxian simplicity, each partner is getting $40 million dollars a year. But, things are often not simple if we take the PIMCO example. Allianz as owners of the firm, having funded through their acquisitions the buy-out of the founders, may take 50% of profits or revenues off the top. So, each equal-weighted equity owner may only be getting paid $20 million a year. Assets under management may go down with the market sell-off so that fees going forward go down. But it should be obvious that average mutual fund investors are not at parity with the fund managers in risk exposure or tolerance.

Why am I beating this horse into the ground again? U.S. economic growth for the final quarter was revised down from the first reported estimate of 2.6% to 2.2%. More than 440 of the companies in the S&P 500 index had reported Q4 numbers by the end of last week showed revenue growth of 1.5% versus 4.1% in the previous quarter. Earnings increased at an annual rate that had slowed to 5.9% from 10.4% in the previous quarter. Earnings downgrades have become more frequent. 

Why then has the market been rising – faith in the Federal Reserve’s QE policy of bond repurchases (now ended) and their policy of keeping rates low. Things on the economic front are not as good as we are being told. But my real concern is that we have become detached from thinking about the value of individual investments, the margin of safety or lack thereof, and our respective time horizons and risk tolerances. And I will not go into at this time, how much deflation and slowing economies are of concern in the rest of the world.

Look at the energy sector, where the price of oil has come down more than 50% since the 2014 high. Each time we see a movement in the price of oil, as well as in the futures, we see swings in the equity prices of energy companies. Should the valuations of those companies be moving in sync with energy prices, and are the balance sheets of each of those companies equal? No, what you are seeing is the algorithmic trading programs kicking in, with large institutional investors and hedge funds trying to grind out profits from the increased volatility. Most of the readers of this publication are not playing the same game. Indeed they are unable to play that game. 

So I say again, focus upon your time horizons and risk tolerance. If your investment pool represents the accumulation of your life’s work and retirement savings, your focus should be not on how much you can make but rather how much you can afford to lose. As the U.S. equity market has continued to hit one record high after another,  recognize that it is getting close to trading at nearly thirty times long-term, inflation-adjusted earnings. In 2014, the S&P 500 did not fall for more than three consecutive days.

We are in la-la land, and there is little margin for error in most investment opportunities. On January 15, 2015, when the Swiss National Bank eliminated its currency’s Euro-peg, the value of that currency moved 30% in minutes, wiping out many currency traders in what were thought to be low-risk arbitrage-like investments. 

What should this mean for readers of this publication? We at MFO have been looking for absolute value investors. I can tell you that they are in short supply. Charlie Munger had some good advice recently, which others have quoted and I will paraphrase. Focus on doing the easy things. Investment decisions or choices that are complex, and by that I mean things that include shorting stocks, futures, and the like – leave that to others. One of the more brilliant value investors and a contemporary of Benjamin Graham, Irving Kahn, passed away last week. He did very well with 50% of his assets in cash and 50% of his assets in equities. For most of us, the cash serves as a buffer and as a reserve for when the real, once in a lifetime, opportunities arise. I will close now, as is my wont, with a quote from a book, The Last Supper, by one of the great, under-appreciated American authors, Charles McCarry. “Do you know what makes a man a genius? The ability to see the obvious. Practically nobody can do that.”

Imagine the Creator as a low comedian, and at once the world becomes explicable.     H.L. Mencken

January 2015 has perhaps not begun in the fashion for which most investors would have hoped. Instead of continuing on from last year where things seemed to be in their proper order, we have started with recurrent volatility, political incompetence, an increase in terrorist incidents around the world, currency instability in both the developed and developing markets, and more than a faint scent of deflation creeping into the nostrils and minds of central bankers. Through the end of January, the Dow, the S&P 500, and the NASDAQ are all in negative territory. Consumers, rather than following the lead of the mass market media who were telling them that the fall in energy prices presented a tax cut for them to spend, have elected to save for a rainy day. Perhaps the most unappreciated or underappreciated set of changed circumstances for most investors to deal with is the rising specter of currency wars.

So, what is a currency war? With thanks to author Adam Chan, who has written thoughtfully on this subject in the January 29, 2015 issue of The Institutional Strategist, a currency war is usually thought of as an effort by a country’s central bank to deliberately devalue their currency in an effort to stimulate exports. The most recent example of this is the announcement a few weeks ago by the European Central Bank that they would be undertaking another quantitative easing or QE in shorthand. More than a trillion Euros will be spent over the next eighteen months repurchasing government bonds. This has had the immediate effect of producing negative yields on the market prices of most European government bonds in the stronger economies there such as Germany. Add to this the compound effect of another sixty billion Yen a month of QE by the Bank of Japan going forward. Against the U.S. dollar, those two currencies have depreciated respectively 20% and 15% over the last year.

We have started to see the effects of this in earnings season this quarter, where multinational U.S. companies that report in dollars but earn various streams of revenues overseas, have started to miss estimates and guide towards lower numbers going forward. The strong dollar makes their goods and services less competitive around the world. But it ignores another dynamic going on, seen in the collapse of energy and other commodity prices, as well as loss of competitiveness in manufacturing.

Countries such as the BRIC emerging market countries (Brazil, Russia, India, China) but especially China and Russia, resent a situation where the developed countries of the world print money to sustain their economies (and keep the politicians in office) by purchasing hard assets such as oil, minerals, and manufactured goods for essentially nothing. For them, it makes no sense to allow this to continue.

The end result is the presence in the room of another six hundred pound gorilla, gold. I am not talking about gold as a commodity, but rather gold as a currency. Note that over the last year, the price of gold has stayed fairly flat while a well-known commodity index, the CRB, is down more than 25% in value. Reportedly, former Federal Reserve Chairman Alan Greenspan supported this view last November when he said, “Gold is still a currency. “ He went on to refer to it as the “premier currency.” In that vein, for a multitude of reasons, we are seeing some rather interesting actions taking place around the world recently by central banks, most of which have not attracted a great deal of notice in this country.

In January of this year, the Bundesbank announced that in 2014 it repatriated 120 tons of its gold reserves back to Germany, 85 tons from New York and the balance from Paris. Of more interest, IN TOTAL SECRECY, the central bank of the Netherlands repatriated 122 tons of its gold from the New York Federal Reserve, which it announced in November of 2014. The Dutch rationale was explained as part of a currency “Plan B” in the event the Netherlands left the Euro. But it still begs the question as to why two of the strongest economies in Europe would no longer want to leave some of their gold reserves on deposit/storage in New York. And why are Austria and Belgium now considering a similar repatriation of their gold assets from New York?

At the same time, we have seen Russia, with its currency under attack and not by its own doing or desire as a result of economic sanctions. Putin apparently believes this is a deliberate effort to stimulate unrest in Russia and force him from power (just because you are paranoid, it doesn’t mean you are wrong). As a counter to that, you see the Russian central bank being the largest central bank purchaser of gold, 55 tons, in Q314. Why? He is interested in breaking the petrodollar standard in which the U.S. currency is used as the currency to denominate energy purchases and trade. Russia converts its proceeds from the sale of oil into gold. They end up holding gold rather than U.S. Treasuries. If he is successful, there will be considerably less incentive for countries to own U.S. government securities and for the dollar to be the currency of global trade. Note that Russia has a positive balance of trade with most of its neighbors and trading partners.

Now, my point in writing about this is not to engender a discussion about the wisdom or lack thereof in investing in gold, in one fashion or another. The students of history among you will remember that at various points in time it has been illegal for U.S. citizens to own gold, and that on occasion a fixed price has been set when the U.S. government has called it in. My purpose is to point out that there have been some very strange doings in asset class prices this year and last. For most readers of this publication, since their liabilities are denominated in U.S. dollars, they should focus on trying to pay those liabilities without exposing themselves to the vagaries of currency fluctuations, which even professionals have trouble getting right. This is the announced reason, and a good one, as to why the Tweedy, Browne Value Fund and Global Value Fund hedge their investments in foreign securities back into U.S. dollars. It is also why the Wisdom Tree ETF’s which are hedged products have been so successful in attracting assets. What it means is you are going to have to pay considerably more attention this year to a fund’s prospectus and its discussion of hedging policies, especially if you invest in international and/or emerging market mutual funds, both equity and fixed income.

My final thoughts have to do with unintended consequences, diversification, and investment goals and objectives. The last one is most important, but especially this year. Know yourself as an investor! Look at the maximum drawdown numbers my colleague Charles puts out in his quantitative work on fund performance. Know what you can tolerate emotionally in terms of seeing a market value decline in the value of your investment, and what your time horizon is for needing to sell those assets. Warren Buffett used to speak about evaluating investments with the thought as to whether you would still be comfortable with the investment, reflecting ownership in a business, if the stock market were to close for a couple of years. I would argue that fund investments should be evaluated in similar fashion. Christopher Browne of Tweedy, Browne suggested that you should pay attention to the portfolio manager’s investment style and his or her record in the context of that style. Focus on whose record it is that you are looking at in a fund. Looking at Fidelity Magellan’s record after Peter Lynch left the fund was irrelevant, as the successor manager (or managers as is often the case) had a different investment management style. THERE IS A REASON WHY MORNINGSTAR HAS CHANGED THEIR METHODOLOGY FROM FOLLOWING AND EVALUATING FUNDS TO FOLLOWING AND EVALUATING MANAGERS.

Diversification is another key issue to consider. Outstanding Investor Digest, in Volume XV, Number 7, published a lecture and Q&A with Philip Fisher that he gave at Stanford Business School. If you don’t know who Philip Fisher was, you owe it to yourself to read some of his work. Fisher believed strongly that you had achieved most of the benefits of risk reduction from diversification with a portfolio of from seven to ten stocks. After that, the benefits became marginal. The quote worth remembering, “The last thing I want is a lot of good stocks. I want a very few outstanding ones.” I think the same discipline should apply to mutual fund portfolios. You are not building an investment ark, where you need two of everything.

Finally, I do expect this to be a year of unintended consequences, both for institutional and individual investors. It is a year (but the same applies every year) when predominant in your mind should not be, “How much money can I make with this investment?” which is often tied to bragging rights at having done better than your brother-in-law. The focus should be, “How much money could I lose?” And my friend Bruce would ask if you could stand the real loss, and what impact it might have on your standard of living? In 2007 and 2008, many people found that they had to change their standard of living and not for the better because their investments were too “risky” for them and they had inadequate cash reserves to carry them through several years rather than liquidate things in a depressed market.

Finally, I make two suggestions. One, the 2010 documentary on the financial crisis by Charles Ferguson entitled “Inside Job” is worth seeing and if you can’t find it, the interview of Mr. Ferguson by Charlie Rose, which is to be found on line, is quite good. As an aside, there are those who think many of the most important and least watched interviews in our society today are conducted by Mr. Rose, which I agree with and think says something about the state of our society. And for those who think history does not repeat itself, I would suggest reading volume I, With Fire and Sword of the great trilogy of Henryk Sienkiewicz about the Cossack wars of the Sixteenth Century set in present day Ukraine. I think of Sienkiewicz as the Walter Scott of Poland, and you have it all in these novels – revolution and uprising in Ukraine, conflict between the Polish-Lithuanian Commonwealth and Moscow – it’s all there, but many, many years ago. And much of what is happening today, has happened before.

I will leave you with a few sentences from the beginning pages of that novel.

It took an experienced ear to tell the difference between the ordinary baying of the wolves and the howl of vampires. Sometimes entire regiments of tormented souls were seen to drift across the moonlit Steppe so that sentries sounded the alarm and garrisons stood to arms. But such ghostly armies were seen only before a great war.