The Competitive Edge (Part 5)

So how do you acquire a competitive edge?

The answer is simple: you already have one. As in sports, all people have something that they’re good at. Whether it’s understanding how a store’s layout might be confusing or knowing what kind of computer games kids are playing, everyone has some kind of expertise.

As we go about our daily lives, we all have favorite activities, favorite stores, favorite brands that we use. We become experts on motorcycles, camping gear, or farm equipment. Suppose you work in a hospital; you likely have a better understanding of which medical devices are popular right now than most financial professions, because you see the these products in action every day.

Insight you achieve from your everyday interactions is often more valuable than Wall Street’s research. People know when an activity is increasingly popular, or when a company seems to be offering good value to its consumers. When Apple was able to offer the iPod at a lower price than any of the MP3 players already out there, many investing pros were skeptical—but consumers lapped it up. Offering a cheap, convenient way to listen to 99-cent songs was a winning formula.

When people focus on what they already understand, they are more likely to be able to hold on through the many ups and downs of the market. In the short run stock prices seem disconnected from a company’s success. But in the long run there is a 100 percent correlation.

Investing is a competitive activity where everyone wants to be above average. But if you use the expertise you already have, you’ll be more likely to achieve your financial goals—and have some fun along the way!

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Competitive Edge (Part 4)

Everyone’s looking for an edge. How can you be sure that you have one?

There are three roads to outperformance: working harder, working smarter, and working calmer. Working harder is a simple notion: do more research about stocks, bonds, and commodities than others, and apply this knowledge to your portfolio. It’s simple, but it’s not easy. It requires more reading, more phone calls, more meetings, and more effort. It can be physically challenging.

Working smarter requires a deeper understanding of the way the world works. Competing this way requires you to reflect deeply on how and why people behave the way they do. These investors are sometimes called financial philosophers, and philosophical concepts tend to dominate their thinking. They can often see a social trend before it emerges. It’s intellectually hard.

Working calmer requires you to keep your head when everyone around you is losing theirs. It sometimes means that you have to get away from the financial centers like New York or Chicago—or sometimes just not answer the phone. It means that you often have to do the opposite of everyone else, selling when markets are exuberant and buying when they seem depressed. It’s emotionally difficult.

Hard work, smart insight, and a wise temperament aren’t easy. But they’re the only way I know to maintain a competitive edge.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Competitive Edge (Part 3)

It’s not so easy.

Picking growth companies that can benefit from social or technological trends isn’t like going to the grocery store and buying a gallon of milk.

A case in point is Amazon. That company would seem to epitomize a growth stock. They’ve expanded from selling books online to selling pretty much everything; they’ve designed and delivered a powerful e-reader that’s re-making the publishing industry; and their web-site hosts hundreds of other companies that want to pursue e-commerce. Their sales have increased from $7 billion to $40 billion per year over the last 5 years.

And their price has grown, too, increasing an average of 35% per year when the general market has been flat. But there’s the problem. High prices mean high risk—so when they announced yesterday that they didn’t meet analysts’ expectations last quarter, the stock took a serious tumble, falling over 20% in after-hours trading. Yikes!

It’s easy to be wrong in this business. Folks who thought Amazon was an expensive stock five years ago missed out on the way up—and if you capitulated and bought in recently, you may be riding the roller coaster down right now. That’s why diversification is so important. There are a lot of e-commerce companies—Amazon, eBay, Netflix, Apple—and each offers a bumpy ride. But together they’re less volatile than any one of them might be.

We don’t know the future. But through hard work and insight we can see some of the major trends. The problem is, millions of other investors are trying to do the same thing, and prices get expensive. By diversifying, we may not see our portfolio quadruple in five years, but we can smooth out some the bumps along the way.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Competitive Edge (Part 2)

How do you pick winning stocks?

That’s the question that many people ask. Security selection is a key way to add value to a portfolio, one of the three approaches I mentioned yesterday. Critical to finding winning securities is having a way to identify them.

One commonly cited approach is the value method. This practice looks at a company’s financial statements and compares them with its market value. If the company is cheap enough, it’s a buy. An example is the A&P chain store. After going public in 1929, it declined during the depression to a value below the level of its working capital. Canny investors who purchased it there saw the price triple the next year.

Value investors tend to look at a company’s balance sheet to find opportunities. By contrast, growth investors look how a company is run—whether it is positioned to capitalize on demographic trends or new technology to expand exponentially into the future. Global growth investing might involve understanding how different cultures develop, and how a firm might capitalize on these dynamics.

A growth investor might have seen database design as a critical future industry in 1990, and have invested in several competing database startups—Sybase, Progress, and Oracle. Over the next 20 years, these three firms returned an average of 15% per year, while the broad market advanced at half that rate. But it was a bumpy road!

Growth and value investing are different ways to deliver the same result: superior returns. Both require insight, intelligence, and patience. The key is knowing whether either approach fits you.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Competitive Edge (Part 1)

Investment is like sports. Performance can be measured, and compared with others. It’s important. One percentage point of excess return over 20 years can add 25% or more to a portfolio.

The market’s return is just an average of every investor, weighted by size. For someone to beat the market, someone else has to get less than the market. It’s like a running race: each competitor has his or her individual time, but each contributes to the course average. How you do relative to the course average is your relative performance.

In investing, there are really only three sources of excess relative performance: market timing, security selection, and execution efficiency. Market timing is easy to understand but hard to do: be in stocks when the market is going up, and in cash when it is falling. The problem comes in picking which days. It’s possible, but it requires a lot of focus.

Execution efficiency has to do with trading. It’s what trading firms with microsecond algorithmic computers are trying to do. It’s interesting, but most people don’t have access to the necessary data.

The most common source of excess return is security selection: finding the right stocks or bonds or funds, and holding on. There are a lot of ways to do this: value investing, growth investing, global investing, and others.

It makes sense to pursue every way to get an edge. Because when the returns are in, that market may weigh the dollars, but what determines your results will be how much sense that you show.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Rating the Raters

What do credit ratings mean?

Once again the credit rating agencies are in the news. In the aftermath of S&P’s announcement that if Europe falls into another recession they will likely downgrade France, Spain, Italy Ireland and Portugal, an EU commissioner has suggested that sovereign ratings be banned for countries in bailout talks.

Of course it is fundamentally foolish to outlawing a messenger when the news is bad; kind of like banning weather reports when we don’t like the weather. But we can also ask what a sovereign credit rating accomplishes.

Ostensibly, it measures the probability of default—of investors not receiving principal or interest as scheduled. For bonds, that is perhaps the most important issue to an investor, and significantly affects how much an issuer will have to pay. A bond issued by Exxon-Mobil is significantly less risky than one issued by Denny’s restaurants.

But it’s a lot trickier when you evaluate the debt of sovereign nations. When a country runs a chronic deficit that is greater than its potential for economic growth, that debt will eventually overwhelm the nation’s finances. If it’s due to temporary factors, those can be adjusted for and the debt paid off—as happened in England in the 19th century and the US in the 20th. But if the borrower can’t grow fast enough, it has to reduce its expenses, or default.

There are well-tested metrics of default-risk: liquidity, solvency, efficiency, and so on. We use them ourselves. And liquid markets make credit decisions every time a bond changes hands. So in many ways ratings agencies are irrelevant. But summarizing credit risk in a simple serves a useful function.

Just remember that ratings agencies are subject to herd behavior like every other market player. And no matter what the rating, Moody’s doesn’t pay the coupon.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Outward, Ho!

There’s another place to invest: the frontier.

Frontier markets are emerging markets that are “out there.” They’re developing markets that are smaller, less liquid, less regulated, and more volatile than the BRICS. They include places like Bangladesh, Kenya, and Romania.

Emerging markets like Brazil or China were once considered exotic, but now they’re home to some of the largest companies in the world. Their economies are large and diverse, and their politics have matured. Twenty years ago they were exotic. Now they are an increasingly mainstream investment.

But the frontier subset is still on the fringe. They’re subject to military coups and regional wars; corruption and insider dealing can be an issue; and their markets are extremely small: often only a handful of companies are available in any one country.

So why invest there? Because they offer significant growth, an expanding middle class, and extremely low valuations. They’re also less correlated with the US. So a small slice can improve a portfolio’s return without significantly increasing its risk.

But they’re not for everyone. Wars, trade wars, and contagion are not uncommon. For long-term, growth-oriented investors with steely nerves, however, these high-risk markets could be highly rewarding.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Developing Middle

So where do you invest now?

One approach is to look for emerging social trends and climb aboard. By investing in companies that cater to a growing market, you can start small and watch your investment grow over time. T. Rowe Price developed the discipline of “growth investing” some decades ago, and it is still a valid approach.

What’s growing today? One such trend is the expansion of the global middle class. As China, India, Africa, and Brazil develop, billions of people are moving from living hand-to-mouth to having aspirations and plans. When people move from a subsistence lifestyle to working in a factory, unquestionably their income and wealth rises.

This will bring with it all kinds of new needs—needs for improved communications, benefiting cell-phone providers, needs for improved diets, benefitting food-processors, needs for improved transportation, benefitting auto and airplane manufacturers. Investing in companies that provide these kinds of goods and services in the developing world could add real return to a portfolio.

But be careful! Today’s hot topic can quickly become last week’s lunch. Diversification is important. Riding a global trend is exciting, but you have to be able to stay on board when the going gets rough.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Germans and Euros and Bears

Oh my.

It looks like the bears have gotten loose again. Just when we thought it was safe to go back into the market, along come the Germans to shoot down any dreams of a comprehensive fix to the euro-area debt crisis. Angela Merkel has said that dreams of a solution as early as this weekend are likely to be disappointed, and in Greece Finance Ministry workers began a ten-day strike. Hey, if the IRS doesn’t collect taxes, will people file?

The Germans are pressuring peripheral countries and private investors in order to increase the odds that their taxpayers will be paid back. It also doesn’t hurt that every time they threaten to pull their support from the rescue fund the Euro falls, making German industry more competitive.

Still, what the Germans want is budget discipline, and budget discipline is important. Cutting expenditures enough so that they fit within the revenues the government can reasonably collect is, well, reasonable. It can lead to a stronger financial sector, better allocation of capital, and improved consumer confidence. In the short-run, austerity hurts. Unemployment rises and consumers pull in their horns. But in the long run, living within your means means more sustainable living. It’s worked in Canada, Mexico, Sweden, and it looks like it’s working in Ireland.

The Germans will talk down their currency right until the crisis point. By then, the bears will be out. Let’s hope they don’t end up in a bear trap.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Back to the War

Don’t look now, but there is a labor shortage looming.

I’m talking about the global war for talent. From cloud computing hackers to system administrators to marketing specialists with developing economy experience, skilled personnel are in short supply. Newly minted college graduates with almost no experience are being snapped up by start-ups and mid-sized firms with salaries in the middle five-figures. Top recruits going to Apple or Google can get offers in the high five-figures. And don’t even ask what experienced programming team-leaders are getting. Those seven-figure eye-poppers are related to options, restricted stock, and IPO-minted instant wealth.

Not since the initial days of the internet boom have we seen such demand for nerds. Like every talent boom, this one will have excesses. I remember during the heyday of the “Japan Investment Miracle” of the late ‘80s, all you needed was a –okosan at the end of your name and you could write your own ticket. Now, with shifting buzz-words, “peer-networking engineers” or “cloud hackers” with any initiative can probably talk their way into innovation labs at Apple or Amazon.

It has always been this way. New technology creates demand for design and development which in turn creates its own sub-industry. And before a new crop of recruits can be trained, companies vie with one another to nab the next new thing.

It seems bizarre to talk about a talent-shortage when there is a labor-surplus. The key for many will be transforming their labor into talent. That’s the way to win this global war.

Douglas R. Tengdin, CFA
Chief Investment Officer
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