The Dream Factories

Why do people start companies?

At the heart of capitalism is the small start-up—the new project founded on an idea and some hustle that creates something new out of nothing. If the idea catches on, the founders can become quite wealthy. If the idea falters, the founders learn what doesn’t work and move on.

Many entrepreneurs fail in their first few tries. It’s an expensive tuition. That’s because there are far more things that don’t work than do. It’s like science: knowledge grows by proving what doesn’t work. But experimenting with your life can be a volatile experience.

Most startups are founded by technicians—engineers, design professionals, cooks—who understand how to make a product, but not necessarily how to run a business. They pick up the business skills along the way. Sometimes, the idea is so good that they never have to pick up the skills. But they don’t usually do it for the money; they do it for the adventure, or because they have a vision, or because it gives them a sense of control over their own future, instead of wilting inside a corporate bureaucracy.

Start-ups succeed because new ideas often do not scale well. Sometimes there is a payout at the end, more often there is not. But a startup allows its founders to dream. And they believe, as some have said, that if you can dream it, you can do it.

Douglas R. Tengdin, CFA

Chief Investment Officer

Money Market Mischief

Are money funds too big to reform?

At the heart of the Financial Crisis were money market funds. When Lehman filed for bankruptcy in September of 2008, one of its creditors was The Reserve Primary Fund, an independent money fund with $125 billion in assets. Because it held almost $800 million in Lehman debt, it was forced to mark down its stable Net Asset Value, causing investors to take a loss.

Financial chaos ensued. Over $500 billion fled the $13 trillion money market sector. While the Primary Fund was the only one to “break the buck,” at least 62 other money funds had to receive support from their sponsors or parents. Companies that borrow from money funds lost their funding and went into a panic. Millions of workers were laid off. The run on money funds intensified the recession.

The SEC was charged to study the systemic risk and develop policy responses. The core of the problem is money-market funds’ stable Net Asset Value, which incentivizes a rush for redemptions if holders sense trouble. The SEC came up with two proposals (that have elicited thousands of comment letters): one to impose “gates” on redemptions, and the other to force money funds to float their price.

But nothing fundamental has been done. The stakes are huge—for the economy, and money-fund providers—and legislators are being lobbied by voters, advocates, think-tanks, and, of course, the financial industry. Any new rule will gore someone’s ox.

The humble money fund has become a source of financial and economic insecurity. Something has to change.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Dragon and the Bear

Could China reconcile with Russia?

The crisis in Crimea and Ukraine seems to have had little impact on the markets. Germany, the European economy most closely affected by what happens in Russia, has seen its stock market hover near its all-time highs. German newspapers have more coverage of Edward Snowden and the NSA revelations than they do of the military upheaval close to their borders. The markets seem to have concluded that Ukraine is not that important.

But the confrontation may have implications with an economy further afield: China. China has been isolated by suspicious neighbors who are worried that their economies and cultures will be overshadowed by the global giant. Both China and Russia have bristled as America has sought to contain their influence. Could they work together to frustrate American foreign policy goals?

The two powers tried it before, in the ‘50s, when both were pursuing global Communism. That connection ultimately foundered, however, over personality conflicts and the desire each had to lead the communist movement. While past problems may be instructive, they are not necessarily prologue. Global powers have found common cause before. Could the enemy of their enemy be their friend?

America is no longer the unipolar power it was following the Cold War. The world is now multi-polar, and dangerous. Both China and Russia are deeply suspicious of American containment strategies. An alliance between the two could spell trouble for global trade, and make budget-cutting in the US military more difficult.

Christians look for the lion to lie down with the lamb as a sign that peace is breaking out. But right now it looks more likely that the Dragon will lie down with the Bear.

Douglas R. Tengdin, CFA

Chief Investment Officer

Wishing Upon a Star?

Be careful what you wish for.

Years ago the organic food movement was a fringe activity. You could find organic food at a few health-food stores and farmer’s markets, but not very easily. Now almost every supermarket has an organic food section, and entire chains, like Whole Foods, are devoted to the concept. Organic food sales now comprise over 4% of total food sales in the US, doubling every 10 years or so.

Not so long ago, index funds were the province of finance professors and pension-fund consultants. The market-matching concept was a minor part of the investment landscape. Then came the evelopment of index-dependent ETFs and the growth of index-oriented mutual fund family Vanguard. Now it seems that everyone offers some kind of index-alternative.

When niche products go mainstream they bring their own sets of problems and policy fights to the table. Regulators get involved. Some consumers and providers long for the “good old days” of obscurity and minor-player status. But you can’t go back. Once a product becomes big business, billions of dollars are at stake. Conflict is inevitable

Years ago Richard Bach wrote, “Be careful what you pray for, because you’re going to get it.” Whether it’s in the grocery aisle or a broker’s office, the world often molds itself to our expectations. We just don’t always like what we get.

Douglas R. Tengdin, CFA

Chief Investment Officer

Being Smart

Is smart beta the future?

Beta is a measure of risk. If a stock has a beta of one, it goes up and down by the same percentage, day-to-day, as the market does. Investment portfolios have a beta component, which corresponds to their general exposure to a broad market average, like the S&P 500. By definition, if you own an index of the entire market, your beta is one.

Smart beta is a rules-based approach that reduces costs by limiting investment discretion. It is attractive because it is inexpensive and has the potential to add value when compared to traditional active management. It’s is a way to have broad market exposure and diversification but not hold the same weightings as the general index. Fundamental indexing, that holds companies in proportion to their earnings, or revenues, or dividends, is one such approach. So are sector allocation limits.

The key is the cost to the investor. If these managers charge just as much as the average mutual fund—1 ½ percent—then the lower costs of these strategies lining the manager’s pocket. But if the fees are lower, then investors benefit.

Smart beta can be a reasonable way to limit expenses and grow returns. But don’t be dumb about reading the fine print!

Douglas R. Tengdin, CFA

Chief Investment Officer

Bubble, Bubble, Toil, and …

Is the stock market becoming bubble-icious?

The S&P 500 is up 50% since the middle of 2012. The price-earnings ratio has risen from 14 to 17 times trailing 12-month earnings, according to Bloomberg. And speculative IPOs for companies like Twitter and Candy Crush seem to be multiplying. Are we headed back to the giddy heights of the 2000 tech-bubble?

Consider some facts: in the first quarter of 2000 there were 123 IPOs. Their average first-day returns were an eye-popping 96 percent. In the first quarter of 2014, there were only 58 offerings, and their first-day returns were only 22 percent. 2000’s IPO lineup included Va Linux,, Foundry Networks and Webmethods all returning over 500% on their first day—all of which are now defunct, by the way. The first quarter of 2014 had such pedestrian offerings as Zoes Kitchen, Akebia, Rubicon, and GrubHub offering 30% returns. And all in different sectors, by the way.

The fear of overpaying should dampen speculative spirits for a while. We’ve been through two 50% declines in the past 15 years—something that hadn’t happened since the Great Depression. It’s unlikely investors will forget those lessons anytime soon. But fears of excessive animal spirits will keep popping up. A new story in the Wall Street Journal notes the return of the miniskirt for this spring’s fashion lineup. The “hemline indicator” has been with us since the ‘20s. Well, it must be the silly season. Skirt-length doesn’t predict financial performance.

The more people worry about a bubble, the less we have to worry about a bubble. The only thing the market has to fear is the lack of fear itself.

Douglas R. Tengdin, CFA

Chief Investment Officer

Managing for Life

We’ve heard about finding quality investments. But what about finding quality in your life?

Investment quality involves a combination of security and growth, of stability and volatility. It means being exposed to various parts of the economy so that a problem in one area doesn’t threaten your financial future, and so can participate when there is growth in another area. We don’t know the future. Diversification is the complement humility pays to uncertainty.

It’s that way in life as well. A balanced life combines work, family, recreation, study, spirituality, giving, and other areas. When you face problems in one sector, the other portions can compensate. Conversely, unexpectedly good news can lift your outlook on the rest of life. Again, we don’t know the future. Balance is key.

But how do you measure success? That depends on what you want. An investment portfolio isn’t successful if its return is so volatile that it gives you a heart-attack. In the same way, money and power aren’t the only ways to measure success. The key is having a plan. An investment policy helps you measure progress against financial goals; a life-plan will guide you towards your life-goals.

What makes for a good life? It depends on what you want. But whatever your plans may be, expect the unexpected!

Douglas R. Tengdin, CFA

Chief Investment Officer

The Quality is Right (Part 4)

What is marketplace quality?

Marketplace quality is related to market share. It’s how much people want to use your product. Your market share may be small because you’re just starting out, or you have limited supplies, or you’re pursuing a limited niche. But market quality measures how much your position in the marketplace is dictated by something other than a low price.

Among food stores, Whole Foods is trying to have a quality image that allows it to charge a higher price. In electronics, Apple has deliberately focused on high-end smartphones, preferring to keep its brand associated with innovation and quality.

The consumer is the great evaluator: if a product doesn’t offer a unique value proposition—either low prices or a specialized function or elegant design, it doesn’t survive very long. Marketplace quality is hard to measure, but if a firm has a recognizable brand that they willing to defend against cheap knock-offs, that indicates that they have something worthwhile.

Gucci’s saying—“Quality is remembered long after the price is forgotten”—holds true in the marketplace of goods, services, ideas, and stocks. And a company that devotes its resources to continually improving the quality of its offerings will do better—even if those investments are never explicitly recognized.

Because when you’re out of quality, you’re out of business.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Quality is Right (Part 3)

Where does financial value come from?

Answering this question is kind of like answering your kids when they ask where babies come from. Most people think that the market performs some kind of magic, taking competition, innovation, and resources and shaking them together, laying the results out under the sunshine of disclosure, and slowly, gradually, value emerges.

But it doesn’t work that way.

Skilled managers run a business for profit. They look minimize their costs, try to hire talented staff, and look for ways to expand without betting the ranch. Sometimes they pick up undervalued assets along the way—real estate or other businesses that have more potential than they’re selling for. Because accounting counts what it can measure, these assets stay on the balance sheet at cost, and can become precious gems hidden in a financial statement filled with slag.

Finding hidden assets—and avoiding financial icebergs that can sink an otherwise sound enterprise—is my main goal in dissecting a company’s annual report. Study is important. If you buy stocks without doing research, you’ll have the same success investing as you do in a poker game if you bet without looking at your cards.

Financial value isn’t magic. It’s something managers build over time. Financial quality can help a company weather rough economic seas without running onto the shoals. And it can keep your portfolio afloat.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Quality is Right (Part 2)

Would you rather bet on a horse, or a jockey?

A smart race-track operator would say, “both.” The horse’s name is the main event, but who the jockey is matters. A good rider can get a lot more out of a horse than people expect.

It’s that way with a company’s management. Good managers can inspire their staff, transform their marketplace, and get more value of corporate assets than anyone thought possible. Bad managers act like poison in the well: anyone who comes near gets sick.

So how do you tell if a company is managed well? I look for three things: first, is their compensation reasonable? Is it in-line with their peers and the size and nature of their business. Bosses who treat their firm like a piggy bank are more likely to break it when they need more change for their toys. Second, is the firm still managed by its original team, or has it gotten over “founder’s fever” and brought in professional management? Large, global companies need immensely talented leaders. It’s unlikely that the requisite skills will be confined to one family, however passionate they may be about the product. Finally, what is their background? Did they rise up through the ranks, mentored along the way? Executives who have been part of a coaching culture that develops leaders tend to keep up the process and develop new leaders to fill their shoes.

Of course, it’s great to meet the folks who run these firms and talk with them about what they see as their greatest challenges and opportunities. Sometimes listening to conference calls and speeches can give you a sense of their capabilities and character. But those can be misleading well. Personal charm is no substitute for effective leadership.

Great business leaders create value. Investors will profit as management implements practical processes that build their business over time.

Douglas R. Tengdin, CFA

Chief Investment Officer