Classic Advice

What makes a work of literature a classic?

Photo: SV Klimkin. Source: Morguefile

Mark Twain called a classic a book everyone wants to have read, and no one wants to read. We remember them from high-school: big, scary tomes with strange titles our teachers all said were full of wisdom. We really, really tried to get through them. Some of us actually did. But whether it was the 25th character named Ivan in a Tolstoy story, or a sentence in James Joyce’s Ulysses that went on for three pages—I really wanted my 9th-grade English teacher to try diagramming my 12th-grade literature—most of us got lost at some point and gave up.

And yet those works still stick around. Not because English teachers have a mean streak, but because these books offer insight and wisdom into the human condition: understanding that goes beyond the crisis of the moment, wisdom that goes deeper than shallow sound-bites. We share a common humanity. Great literature—books and poems that have endured for centuries—express this in a way that comes alive. That’s why Homer and Dante and Shakespeare stay relevant centuries after they were written.

Portrait of Dante by Botticelli. Source: Wikipedia

It’s no surprise that these wonders of the world of words have insight for investors. Literature is a reflection on human nature; investing is an exercise in understanding human nature, and the results are written in dollars and cents, not grammar and syntax. By re-reading these great works—more than the Cliff’s Notes summaries—we can gain insight into ourselves, and greater understanding of how investing works—or doesn’t work.

Great authors understand more than just money and math and investing. They offer a vision into what makes us tick. If we study these classics, who knows? We may even want to read them.

Douglas R. Tengdin, CFA

Chief Investment Officer

Economic Growth and Investment Returns

Growth and Investments

Where do investment returns come from?

Photo: Thomas Bresson. Source: Wikipedia

For as long as I’ve been investing, people have said to put money into the stock market for growth and to own bonds for stability. That advice has gotten a little jumbled lately, but it still seems to hold true. The US stock market has returned 7.5% per year for the past 10 years, while the bond market has earned 5.25%. The same relationship holds for longer time periods Stocks can be volatile, to be sure, but on the charts the indices seem to move from the lower left to the upper right.

But why? Markets aren’t magic. If you were a Japanese investor, you didn’t earn much of anything from stocks over the last several decades. The 20-year return from their stock market has been -0.5% per year in Yen. Japan isn’t some obscure country no one’s ever heard of. They’re a modern democracy with the world’s third largest economy. What makes them different from the rest of the world?

Nikkei 225 over last 20 years. Source: Bloomberg

Equities are residual claims on corporate cash flow. Equity holders get paid after everyone else—the bondholders, the employees, the vendors. For the past few decades, earnings at Japanese companies haven’t grown at all. In 2006 they earned 750 yen per share, last year they earned 840. And in the ‘90s their earnings were higher than they are right now. For over two decades, Japanese companies haven’t growth their cash flow at all. So their equity investors have suffered. What’s wrong with Japanese companies? It’s actually pretty straightforward: their economy has been stagnant. In 1996, their economy was actually larger than it is now.

In fact, there’s a pretty strong correlation between long-term economic growth and stock market returns.

The more economic growth there is, the more the market advances. This doesn’t work every year—sometimes markets get overvalued and contract despite a decent underlying economy. But over the long haul, markets depend on the economy to generate earnings for shareholders.

The lesson here is clear: if we want the market to generate decent returns, we need to see the economy grow too. But that growth has to be sustainable.

Douglas R. Tengdin, CFA

Chief Investment Officer

[investment returns, Japan, economic growth]

Fashions, Fowls, and Trend-Following

Where do investment fashions come from?

Photo: G Pinant. Source: Morguefile

I used to work near a large park, where I would take my lunch and eat outside. There wasn’t much litter in that park—any leftover food would quickly get devoured by the many pigeons that hung out there. They were always poking about, searching for random scraps that might have been left behind. If anyone began to feed them, a group would quickly assemble. First a few, then dozens of birds would fly over, attracted by the other birds. In fact, you didn’t even need to have food to gather a flock. All you needed to do was move your arm as if you were tossing out bread crumbs.

Investors can act like those pigeons, racing from one fashion to the next, attracted by the presence of other investors. In the past few years we’ve seen them rush from energy stocks—with their promise of seemingly limitless profits due to fracking—to FANG stocks—Facebook, Amazon, Netflix, and Google, the mobile social, retail, and entertainment behemoths that are transforming how we interact, shop, and entertain ourselves. Their stock prices seem to defy gravity, rising to levels seemingly disconnected from their ability to generate profits.

But a funny thing happens in markets. Whenever an industry becomes popular, entrepreneurs take note. They move into that sector or business and increase the level of competition. What seemed a sure way to print money becomes a struggle that favors the most innovative producer. It seems like the law of gravity, but it’s actually the law of competition: excess profits invite new entrants that drive down prices. And the profits—well, they don’t disappear, but they aren’t so excess any more.

Gravity illustration. Source: NASA

With information travelling so quickly, these themes get started, grow, become over-inflated, and collapse in record time. Mutual funds used to have holding periods measured in years; this is now months or even weeks. Many quantitative investors who front-run order flow (to make a penny or two each trade) may own shares for only a fraction of a second. This trend—towards ever-higher turnover—doesn’t seem sustainable. But it’s hard to see a bubble from inside.

Thankfully, long-term investors don’t need to play this game. We can look for quality businesses with a history of profitably serving customers with good products at fair prices and stick with those. We don’t need to fly off to the next new thing. Just because the pigeons are gathering doesn’t mean there’s any food there. It may just be someone waving his arms.

Douglas R. Tengdin, CFA

Chief Investment Officer

On Tips and Tipping (Part 4)

When do tips work?

Photo: S Klimkin. Source: Morguefile

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 investments—like bonds—come with contractual payments and a final date. Others—like new companies—come with a vague promise to begin returning cash to shareholders when the business matures. All of them depend on how the economy does.

If you were running a restaurant, you wouldn’t tune in to Duck Dynasty for advice. There might be some general ideas, like marketing or planning, that are universal enough where you might gain some insight. But you want advice designed for you, that helps you with your specific issues. The same holds true for investment advice. It should be tailored to fit your particular situation.

Photo: M Connors. Source: Morguefile

Be aware of the prior assumptions of anyone who gives you advice—their incentives, background, temperament, and experience. Everyone has assumptions built into their outlook. I started working as an institutional investor in the late ‘80s and early ‘90s, when stock and bond prices were volatile and unpredictable, but generally trended higher. So I tend to emphasize risk management and diversification. But any advice can be dangerous, and sometimes there are no good options. Someone who freely offers an 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

On Tips and Tipping (Part 3)

On Tips and Tipping (Part 3)

What’s wrong with investment tips?

A “Rubbish Tip” in the UK. Photo: Bob Embleton. Source: Wikipedia

Investment recommendations rarely work out. Part of the reason is because they need to fit into an overall plan. But people who give advice rarely give the nuance and conditions that might make the advice less applicable. Think of all the times you’ve seen the headline: “5 Stocks that could Double in the Next Year!” But what are the risk factors? How will the advice get updated? What’s 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—especially—how things turn out after they make a recommendation.

What’s even worse is when the recommender has the opposite motivation as you. That’s the premise behind “pump-and-dump” stock schemes. In these situations a small firm will gradually acquire a large position in a little-known penny-stock—one that sells for less than a $1. Then they send out recommendations via email, post notes on social media, and write up official-looking research reports. That’s the pump. Once folks get interested and the price begins to move, they unload their shares. That’s the dump. In reality, there’s nothing special going on at the firm, and the price eventually collapses—leaving a lot of small investors with big losses.

Photo: Stuart Whitmore. Source: Morguefile

So when you think about a stock recommendation, the only reasonable way to use the advice is to re-create the analyst’s work yourself, to see if it’s legitimate. Even a good investment might not be appropriate for your portfolio. Looking for factors the opinionator might have left out—like how volatile might a company’s earnings be, or how much debt they have—and whether the debt is investment grade, or how fast the company is growing. These are all factors that can make a stock more risky—and perhaps too risky for you.

But most folks can’t or won’t do that work. They just want to sprinkle some magic pixie dust over their investments, hoping to get big gains in a period of short time. But “hope” is not a plan.

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

Douglas R. Tengdin, CFA

Chief Investment Officer

On Tips and Tipping (Part 2)

On Tips and Tipping (Part 2)

Everyone wants a tip. What’s the best way to make money?

Photo: Nick Stanley. Source: Life of Pix

Profitable investing starts with a plan. It starts with investors reviewing their goals, their fears, how much time they have, how much access to their money they need, and other circumstances. No one plans to fail, but many people fail to plan. And if you don’t know where you’re going, any road will do.

But once you have a plan, what do you do? Investing is a prospective activity. The results depend on things that we don’t know. What will the economy do? What will the Fed do? How will company managers respond? What conditions will change—politically, technologically, socially, geopolitically? We don’t know the future. The best we can do is make educated estimates.

The rational response to in the face of such uncertainty is to spread the assets around: different asset classes, different industries, different capital structures, different places in the economy. At a minimum, a portfolio should have securities that do well if the economy accelerates, if it keeps going the way has it has, and if it slows, or even contracts. There should always some assets that perform well under widely different scenarios.

In this way, diversification reduces risk. If different parts of the portfolio go in different directions, they cancel each other out and the volatility of the entire portfolio is reduced. It’s not a free lunch, but diversification is a cheap snack.

Planning comes first. But the second tip? Diversify.

Douglas R. Tengdin, CFA

Chief Investment Officer

On Tipping (Part 1)

Psst: want a quick stock tip?

Photo: Stuart J. Whitmore. Source: Morguefile

Lots of folks ask me for a quick tip. It’s natural when they hear that I help people manage their money. After all, if you can find the next 10-bagger before it goes parabolic, you could spin the straw of your savings account into retirement gold. Or we think.

But investing isn’t like that. It’s not about getting lucky. When we invest, we put our money to work among economic enterprises where we don’t know the future. That’s an inherently risky undertaking. So many things can go wrong: the economy could fall into recession, gridlock might shut the government down, fickle consumer tastes can change.

But competent business managers can cope with change and even thrive. And contrary to Dilbert’s vision of the pointy-haired boss, most managers are competent. That’s why IBM has been able to reinvent itself four times during the last four decades. That’s why Apple could create the whole notion of mobile computing. A growing economy means more good things happen than bad things. We just don’t know what we don’t know.

Photo: Laura Musikanski. Source: Morguefile

But what we do know is our own plans and aspirations. If we understand ourselves—what we need, how much risk we can handle, how soon we need the money—that knowledge implies certain things about how to invest and what to buy and sell. That’s why investment advice should be tailored to the person receiving it. Not everyone can handle investing in tech stocks. Not everyone should. Sound investment decisions grow out of a deep understanding of our present and future financial assets, liabilities, income, and expenses. It’s more like accounting than gambling.

So, want a quick investment tip? Make a plan.

Douglas R. Tengdin, CFA

Chief Investment Officer

Mr. Market and You

Mr. Market and You

Who is Mr. Market?

Drama masks. Source: Musei Capitolini

Investing is a partnership between the investor and Mr. Market. Mr. Market is a moody fellow. Some days he’s gloomy and unhappy. He wants you to buy something—anything—from him at the cheapest prices. The world looks uncertain, the economy looks lousy, profits are miserable, and nothing seems to be getting better. So the prices he asks for his goods are cheap.

Other days he’s happier than a lamb skipping across the fields. The sun is shining, business is booming, and all seems right with the world. Life’s a peach. So he doesn’t want to sell you anything. In fact, he’s buying everything he can lay his hands on with abandon. It seems that no price is too dear for him. He’s upbeat and glad, and wants share some of his cheer with anyone around him.

Photo: Dave Meier. Source: Picography

They key is to understand the nature of your partnership. You don’t have to do business with Mr. Market. You don’t have to do anything at all. He’s happy to do his thing, and let you do yours. But you can’t change your partner, you have to wait for him to change. And he will. He always does.

These days, Mr. Market is double-minded. He’s quite depressed about some businesses—banking, farming, mining. These old-line activities seem pointless. There’s nothing new, nothing to get excited about. On the other hand, anything having to do with consumers is great. Consumers keep spending on cigarettes, snack foods, and cleaning supplies, so any company that makes these things is golden, in his thinking. And online consumer activity has that “wow” factor. Those companies don’t need profits. He’s willing to let them make up their own pro-forma financials—like a newspaper reporting on fantasy sports league scores instead of the real games.

In the past, your partner was willing to do a lot of heavy lifting as far as helping you achieve your financial goals. In the ‘80s and ‘90s, double-digit returns were common. But now, you need to step up and provide a bit more capital for your partner to work with. Mr. Market can seem to work wonders, but he doesn’t do magic tricks. He can’t pull a silver dollar out from behind your ear, or spin straw into gold. He’s all business, all the time.

Investing has always been a partnership between the markets and the investor. In order to invest successfully, we need to accept the markets as they are, not as we’d like them to be. If you want to have more savings, you’ll need to save more money.

Douglas R. Tengdin, CFA

Chief Investment Officer

Getting Going

How do you get started investing?

Photo: Adam Raoof. Source: Animal Photos

Investing can be daunting. Stocks, bonds, real estate, commodities—they all seem to hitting record highs. And there’s all the specialized jargon: cash settlement, maturities, dividends, not to mention taxes. Sometimes it seems like the industry deliberately makes things unclear so you’ll have to go to them for advice. And nothing comes for free, does it? We’ve all read stories of Ponzi schemes and other predatory financial products.

It seems safer to leave your money in the bank, rather than succumb to a hot sales pitch from some financial snake oil salesman. But we also know that the steady drip, drip, drip of 2% inflation means that $1,000 today will only buy $670 worth of goods and services in a couple of decades. So where do we start?

The first place to start is between your two ears. Figure out what you want to use your money for, then decide how to invest it. If you need an emergency fund—usually a couple months’ expenses—the best place for that is probably in the bank. When you use cash for something unexpected—a car or home repair, or transitioning between jobs—you don’t want to have to wait for a check from a mutual fund company. And you don’t want to have to sell something at a bad time.

But if you have longer-term goals, banks don’t pay very much. They never have. Their business is to borrow money—your money—cheap, and lend it out dear. It makes sense to keep some liquid funds there. But not all your savings. For your long-term objectives, you should take some time to educate yourself.

Whenever I visit a foreign country, I try to learn some rudimentary phrases—at least enough to get by. The same holds true with professional services. Each has its own specialized lingo. Whether it’s health care, or construction, or the military, we don’t know what’s going on if we can’t understand the language. So since we have to spend time in the Republic of Finance—if only as tourists—we should learn the language and what some of the main attractions are: landmarks, monuments, prisons, and especially, how to get to the airport. Unless you plan to move there, you want to be able to leave.

Photo: Clara Natoli. Source: Morguefile

Leaning about investing can feel overwhelming, but it doesn’t have to be. Treat it as a game—as a trivia game, or an animal-vegetable-mineral 20-questions game, or monopoly—with real money. Do something that allows you to have some fun while you learn the basics. Because just as war is too important to be left to the generals, finance is too serious to leave to financial professionals.

Douglas R. Tengdin, CFA

Chief Investment Officer

Humpty-Dumpty Investing

Investing has gotten really weird.

Illustration from “Through the Looking Glass.” Source: Ebbemunk

In today’s world the best performing assets are bonds. Bonds that have historically low interest rates continue to defy expectations. Ten years ago, bond guru Bill Gross famously declared that the great, multi-decade bond bull market was over. Since that prediction, long-term US Treasuries have returned 9% per year, while a cap-weighted index of global equities has returned about half that. And so far this year, bonds have zoomed up over 30%, while stocks have languished.

10-year returns. Source: Bloomberg

With coupons so low, people can’t buy bonds for income. What’s the point? A long-term US Treasury pays less than 2.5%. Over 90% of government bonds around the world pay less than 1%; more than a third have negative yields. The reason to hold bonds in the past was for diversification, and for the income they produce. That diversification has been quite profitable, up to now, as bonds have provided significant capital appreciation.

But where can investors go for income? Increasingly, they have been going to stocks. Triple-A rated Johnson & Johnson shares yield 2.6%. Exxon pays more than 3%. And telephone companies AT&T and Verizon pay more than 4%. The S&P 500 yields more than the 10-year US Treasury—and has done so for the past five years. Increasingly, investors own bonds for capital gains and stocks for income.

This is backwards. Companies pay dividends when they generate more cash from their operations than they can deploy profitably within their business. By definition, the dividend payers’ prospects for growth are limited. Bonds appreciate in price when interest rates fall. But rates are now so low that a buy-and-hold investor in many markets is guaranteed to lose money. And stocks can cut their dividends, as the S&P 500 did from 2008 to 2010, and as energy companies have for the past year.

Negative 5-year government bond yields. Source: Bloomberg

In “Through the Looking Glass,” Lewis Carroll has his main character, Alice, talk with Humpty-Dumpty sitting on a wall. Humpty-Dumpty loves to play word games. In the midst of a discussion about the meaning of a word, Humpty says, “When I use a word, it means just what I choose it to mean—neither more nor less. The question is, which is to be master?” Today he might say that when he chooses an investment, it functions just the way he wants it to. If equities are to provide income and bonds capital gains, who’s to argue? It’s worked for him so far.

But markets have a way of reasserting themselves. Never forget that bonds and stocks are financial instruments, and represent senior and junior claims on the cash flow of the global economy. Eventually, markets will adjust. When they do, Humpty-Dumpty—and unbalanced investors—will likely fall off the wall. We need to be prepared—through careful portfolio construction and proper diversification—to pick up the pieces.

Douglas R. Tengdin, CFA

Chief Investment Officer