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

The Quality is Right

Which is more important: price, or quality?

There’s an old saying in business: quality is remembered long after price is forgotten. This quote is frequently attributed to Aldo Gucci, the founder of the Italian fashion company, but it had been a business maxim long before he was around. It presents an aspect of marketplace wisdom that still rings true: people will often forget how much they paid, the how a product performs is in their face all the time.

The same can be said of stocks. How much you pay for a stock matters. It matters a lot. Getting in at the top of a market, during the enthusiasm and mania can depress your returns for years to come. But the quality of the stocks you buy matters more. If a company is on its way to liquidation, no entry price is low enough.

Conversely, high quality can overcome a bad entry point. A lot of great companies have stumbled over the years: Coca-Cola, Johnson & Johnson, IBM. In these cases, the strength of the firm’s management team and the resources it can draw upon allowed these firms to put their troubles behind them and resume growing.

But how do you measure quality without begging the question—assuming the answer as you formulate the problem? I look at three elements: management, financial, and marketplace quality. These factors aren’t foolproof, but they can give you a sense of how resilient a firm will be when it faces challenges.

Because adversity reveals character. And character is destiny.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Tragedy of Expertise

What is Vail doing?

Vail Resorts is a diversified ski-resort operator. They own four ski resorts in Colorado, three in the Lake Tahoe area, and one in Utah. They also own luxury resort hotels. Vail was opened in 1962 by a former 10th Mountain Division ski trooper, who saw what European skiing was like and thought the sport could be popular over here if developed properly.

Vail was successful and skiing took off in the US. But the ski business is difficult. Several operating companies have gone in and out of bankruptcy over the year, including Vail. The sport has high operating costs and a fickle customer base, and is notoriously weather-dependent.

The normal approach to uncertainty is diversification, at least in portfolio management. So Vail has started to purchase some ski areas in Minnesota and Michigan. But other than the fact that they both use snow, the ski business in the Midwest is very different than that it is in the Mountains: the hills are about one-tenth the size, sometimes built from landfill and construction debris.

We’ve seen this movie before: an operator succeeds in one area, so tries to parlay than expertise somewhere else. Vail’s top executives are former private equity guys. Just because you can run a high-end restaurant doesn’t mean you should buy the local bistro. Skiing may be a lot of fun, but it’s a tough business.

Douglas R. Tengdin, CFA

Chief Investment Officer

Advising Ourselves (Part 4)

When do stock tips work?

Investment advice works best when people treat their investments like a business. If you are investing, you’re really acquiring future sources of cash. Some—like most bonds—come with contractual payments and a final date. Others—like tech stocks—come with a vague promise to begin returning cash to shareholders when the business matures. All of them, even government bonds, depend on the economy.

If you were running a business, you wouldn’t tune in to a general business show for specific advice. There might be some general principles, like human resource management or accounting, that are universal enough where general advice could help. But if you want advice tailored to help you, you want someone that will take the time to understand your specific situation.

Be aware of the biases of those who would advise you—their incentives, background, temperament, and experience. Advice is a dangerous gift, and there may be no good options. Someone who freely offers his opinion about fire may not have been burned yet. Be careful.

Above all, don’t be afraid to ask hard questions. Good opinions take a long time to form. They should be grounded in economic and financial reality, and, once implemented, be fairly boring. Good investing is like good gardening—it takes time to bear fruit. But it’s worth the wait.

Douglas R. Tengdin, CFA

Chief Investment Officer

Advising Ourselves (Part 3)

What’s wrong with stock tips?

Stock recommendations rarely work out. Part of the reason is because they need to fit into an overall plan. But people who give investment advice (“5 stocks that could double!”) rarely give the nuance and conditions that might make the advice less applicable. What are the risk factors? What is the time horizon? How will the advice get updated? What is the benchmark?

Gurus and pundits usually don’t have much skin in the game. The rules of journalism require that a writer either have no position at stake, or follow significant disclosure documentation. It’s easier for them to write and talk about something they don’t own. But that makes them less interested in what might go wrong, and how things turn out after they make a recommendation.

So when you think about a stock recommendation, the only reasonable way to use the advice is to re-create the analyst’s work, looking for factors the opinionator might have left out—questions that are crucial to how applicable the idea is to your portfolio. But most folks can’t or won’t do that work. They just want to sprinkle some magic pixie dust over their investments.

So, want a tip? Eat your own cooking: study.

Douglas R. Tengdin, CFA

Chief Investment Officer