Bill Fries is the lead portfolio manager manager for Thornburg's international mutual funds. He recently participated in the International Herald's global investing roundtable.
Many of my client's hold institutional shares of the Thornburg funds that Bill Fries co-manages.
Friday, December 7, 2007
The International Herald Tribune's 11th annual round table on global investing convened at The New York Times on Nov. 29. Participants in the discussion moderated by Judith Rehak were:
George Evans, portfolio manager of the Oppenheimer International Growth Fund; William Fries, portfolio co-manager of the Thornburg International Value Fund, and David Winters, portfolio manager of the Wintergreen Fund.
We are meeting amid fears that more subprime losses and a credit crunch could turn a U.S. economic slowdown into a recession, affecting Europe and Asia and even the robust emerging markets. Add worries about high-priced oil, the battered U.S. housing sector, and inflation in Europe, and it has been a year of turbulent markets. Against this background, what do you see for 2008?
Fries: After a year like we've been through, I think you have to be more cautious, because one of the things we've learned is that we don't know everything we thought we knew in terms of problems that companies might have. As far as the U.S. influence on the global economy, our monetary authorities are walking on a tightrope, because if they are too aggressive in trying to support the U.S. housing market by dropping interest rates, they likely will end up trashing the dollar even more than it has been trashed. It might be good for some U.S. exporters, but generally speaking I think it's maybe a factor of disequilibrium and would possibly lead to more inflationary pressures from industrial and energy commodities.
I think you need to be careful about company business models and the independence of companies' prospects from direct economic consideration. You want to have companies that have pricing power and the opportunity for volume gains because of innovation.
Asia has been one of the strongest markets in the past year. David, what is your view on that part of the world now?
Winters: I believe that in the history of human beings, there has never been so much material
progress by so many in such a short period of time. And it's our impression that it's not only the people who have progressed so far, but waves of other people coming behind them. So we're very enthusiastic about Asia in the long run. It doesn't mean that there are not going to be bumps along the way, but you've got enormous wealth being created, enormous demand for resources, and a wonderful work ethic. So long term, if you're any kind of investor, you've got to pay attention to what's going on in the Asia sphere.
In Europe and the U.S., I think there's lots to worry about and we think there is also quite a bit of inflation. So I think Bill is right on about pricing power and being cautious. That said, there are some gems in the U.S. and Europe, so we're optimistic long term.
Evans: The biggest story for the rest of my life is what's going on in China and India. But there's a lot that makes me more cautious now than I have been in three or four years. My caution is related to the effect that this subprime issue and related issues are going to have on the availability and price of credit, which inevitably has to have some effect on the real economy over the next few quarters. It depends also on what the monetary authorities do, but one of the marvels of the last two years is just how fantastic business has been for just about everyone. There's a lot of pricing power on everything from a diesel engine to a second-hand hull for a tanker.
Given these uncertain times, where are you finding the most interesting opportunities?
Fries: If the standard of living in emerging markets continues to move toward what Western Europe and the U.S. have had, we will probably have considerable progress in a lot of places, including infrastructure and retailing. The economic boom in China has been going on now for more than a decade at a 10 percent rate essentially, and probably has a long way to go, although it may change character. Some of the things we held when we met last year still look interesting. China Mobile, the cellular phone company, and China Merchants Bank are two that have performed very well. I like to look at history and if you accept the idea that China is in a development stage that might have been like the U.S. in the '50s, we have a long way to go in some of these institutions. Growth rates will be above average and I'm content to stay with those.
What about the more developed markets?
Fries: Europe is showing the way to develop an energy policy, and I think the price of a kilowatt of electricity at the margin from gas-fired sources is creating an umbrella that will ultimately bring green utility generating companies to the forefront. A couple of the stocks we like are E.ON, the German utility, and Fortum, a Finnish utility that is 60 percent hydro, with a big piece of nuclear and a very small part of gas.
Winters: In the U.S, the problems are well flagged, but there are opportunities as well. We do have stakes in a number of companies, and a big stake in Berkshire Hathaway, the conglomerate run by Warren Buffett. Berkshire has come back into fashion because having $40 billion in cash is a good thing in this environment.
In Western Europe, we own shares in Swatch, the Swiss company that makes watches from the basic plastic watch to the middle-range Longines to Breguet. As you have increasing wealth around the world, not everybody can have a big car or a big house, but they all can have a watch. Swatch is very conservative; they have had a stock buyback program and we like that. We also own shares in Schindler, a Swiss elevator and escalator company that is debt-free, and with the urbanization and improvements around the world, they're a beneficiary. And they also have the elevator-escalator service business. We're trying to find niches that should do well, almost no matter what happens.
Evans: We're looking for themes defined by an industry or a group of industries that will grow
sustainably faster than global average growth over the long term, and then look for the winning
companies. Obviously, in emerging markets, a theme is mass affluence. Wealth creation is creating a slew of opportunities, and we have long-standing positions in luxury goods companies like LVMH Moët Hennessy Louis Vuitton. We own Swatch as well and also Richemont, which is the parent company of Cartier and Van Cleef & Arpels. Luxury brands are selling hand over fist in emerging markets. These are not lands of modesty and when you make it, you flaunt it. Also, the vast majority of luxury goods opportunities are European companies with bullet-proof barriers to entry, high margins, and high growth. They're fantastic long-term investments.
We have quite a few investments that are benefiting indirectly from the emerging markets boom, such as ABB, a Swiss-Swedish firm in the electricity transmission business, and Alstom, the French train and subway car manufacturer, and Siemens.
Restructuring is another theme, particularly in the context of Eastern Europe. We own Continental, which is half tire business and half automotive electronics. Their tire manufacturing in Western Europe was very expensive, about €30 per tire and labor. They moved it to Romania where labor costs went down to about €3 and revolutionized the profitability of the business. Another theme we have been investing in for a long time is aging. We own the top three hearing aid makers in the world: William Demant of Denmark, Sonova in Switzerland and Siemens.
What else interests you?
Evans: I am looking at a lot of self-financed growth. When the banks are worried about lending to each other or anyone, it's a healthy thing when a company has the wherewithal to generate enough cash on a sustainable basis to finance their own opportunities. Luxury goods companies are cash generative; so are clothing retailers like Inditex, which has the Zara shops, and Hennes & Mauritz.
Winters: We have certain ways of investing in emerging markets that are different from others. Our biggest position is Japan Tobacco. They have extensive emerging markets positions and they recently acquired Gallaher, the U.K. tobacco group. By putting the two companies together they have a wonderful franchise, a play on emerging markets and developed markets as well, in Japan and Western Europe.
We also like hard assets - for example, real estate. We own a Hong Kong company called Shun Tak with significant historical real estate holdings in Macao, which is on its way to becoming the favorite entertainment destination in Asia. Real estate prices have gone up a lot and we think Shun Tak's management is very good.
I note that you own a number of gambling-related stocks. Is this also related to Macao?
Winters: We like the term "repeat human behavior," and people enjoy gaming and entertainment, so we are involved in the sector. We have a stake in Wynn Resorts, a U.S.-listed company, which is extremely well run and very shareholder oriented. It has assets not only in Las Vegas but Macao and we think they have the premiere properties in both.
And what's your take on energy and materials stocks, which have had a terrific run?
Winters: We own shares in Anglo American, the mining company. They have a big position in
platinum, which is used in catalytic converters, and as the world goes green, Anglo American is a
beneficiary. You also have base metals in there, too, and Anglo owns 45 percent of DeBeers, the
diamond company. We think Anglo is kind of a unique asset play.
And there are niches in this commodity boom. Another company we own in the U.S. is Chesapeake Energy, a natural gas enterprise. Natural gas prices haven't gone up a lot, but it has significant assets, it's well run and natural gas burns cleanly. They have a very significant land base which they are continuing to exploit in terms of looking for more assets.
Fries: One of our holdings is Gazprom, the Russian natural gas producer. To me, natural gas is the next commodity that's going to go global. It has been a local commodity and because of that you have pockets of excess supply. But as oil prices move higher I believe that ultimately, natural gas will follow. One of the principal uses of natural gas in a world that is conscious of global warming will be as the marginal source, because you can't put nuclear power plants in place fast enough. Natural gas will provide the power that will be required in Western Europe and emerging markets so that's a good place to be.
Evans: I own a bit of CVRD (Companhia Vale do Rio Doce), the Brazilian iron ore miner, and I own Impala Platinum for the same reasons as David. We're not overweight, though. The thing that has really powered the materials stocks over the past few years has been a stronger commodities market than has existed on a sustainable basis since the 1970s. Prices won't go up as aggressively in the future but arguably they are sustainable, given emerging-market demand.
Fries: We own Freeport McMoRan, but that's about the only mineral exposure in out international portfolio now. We have owned Rio Tinto and BHP Billiton in past years.
What about the beleaguered banking industry? You both own UBS.
Fries: UBS certainly got caught up in the subprime trading, and a lot of that business is just flat out going to go away. I don't think the institutional end markets that you must have in order to have viable trading are going to be buying some sliced and diced mortgages from the U.S. anymore. In the long run that's a good thing if they pay attention to where they are really strong. I think the [UBS] franchise is too powerful to be ignored and you can buy that at less than 10 times earnings.
Evans: I own UBS and some Credit Suisse, both primarily because of the wealth management
business. Credit Suisse has been a little accident-prone over the last 10 years, but I believe that
management is a lot more aware of the risk they're taking. We're typically very underweight in banks and insurance companies. I like being able to analyze things I understand and if managements at some of these institutions can't tell you what is on their balance sheets there is very little probability that I can. But, the world is getting significantly wealthier, and people want professionals to manage that money. Wealth management is a great business with a great long term trend of more and more assets being accumulated. And it's a very resilient business, too.
Another thing we've been hearing about lately is health, or health care stocks as a defensive measure.
Fries: We own Roche, which has a 54 percent interest in Genentech, the U.S. biotech leader in
terms of creating products, especially in oncology. They have over 20 products in their potential pipeline, and they have the first right of refusal for products that Genentech develops outside the U.S. The other franchise we own is Novo Nordisk, which makes diabetes products. They continue to gain share in the U.S. where there is an aging population impact of diabetes and it has a limited number of competitors. These stocks are inexpensive now because people believe that whoever wins the U.S. presidential election is likely to make it more difficult to sustain high profit margins. That's a way off, and there will be an overhang on these stocks, but we think there is good value in these businesses.
Evans: Most of our health care is franchises in medical devices like Smith & Nephew in the U.K.,which does trauma products, and Synthes in Switzerland, which does the same thing, putting bones back together with bolts and plates and helping repair hips. There are patents, and it's a competitive business but the margins do remain pretty robust and there are new products coming out. So clearly, despite uncertain times, you all are still finding opportunities around the globe, and especially directly or indirectly in emerging markets.
Winters: As an investor, it's just a wonderful time. Things have changed so much, and you've also seen now the principles of Anglo-American finance filter all over the world.
Fries: On that point, it's interesting that we haven't been able to necessarily get people converted to the idea of democratic institutions, but we've had no trouble having them embrace the capitalistic market economy.
Monday, December 10, 2007
Friday, December 7, 2007
Understanding the Emotional Side of Investing
“There is a steady flow of wealth from the hopeful gambler to the men who know what the odds really are. Most people ignore probabilities and exaggerate risk.”
Tversky and Kohneman
Behavioral finance has become a very popular subject. Quantifying how people emotionally deal with their money (what mistakes they make over and over again and why) has produced many interesting findings. The late Amos Tversky, a Stanford professor, and Daniel Kohneman, a Princeton professor, did much of this pioneering work. One of their major discoveries is that a dollar of gain is not equal to a dollar lost in most people’s minds, certainly not when the dollar stakes were high. Who would bet his car against a neighbor’s similar car at even odds? Very few people would take this bet, because having no car is more of a bad than having two cars is a good. So, the value function is non-linear, which means most people have more displeasure in losing a large sum than the pleasure associated with winning the same amount. Most individuals want a two-thirds chance of winning to venture a big bet. Interestingly enough, most individuals don’t invest this way.
In addition, Tversky and Kohneman studied how investors used context in their decision-making process. In other words, people made up their minds differently depending on how the problem was presented to them. Perversely, when the potential gain in a transaction is stressed, people get nervous and wary; and when potential losses are played up, they are willing to assume what are in reality greater risks in order to avoid the losses.
For example, suppose a person has spent the day at the race track, and lost $140, and is considering a $10 bet on a fifteen-to-one long shot in the last race. This decision can be framed in two ways, which corresponds to two natural reference points. If the bettor focuses on the cash flow on hand, the outcomes are framed as a gain of $140 or a loss of $10. On the other hand, if the bettor frames his decision in the frame work of the whole days losses, then it’s a chance to get back to even (from a $140 loss) or to increase his loss a mere $10. Individuals do not adjust their reference points as they lose and can be expected to make bets they normally would find outrageous, even on dubious nags at fifteen to one. This is exactly how many investors have handled their investments. In reaction to huge losses in technology stocks, they have continued to not build a conservative balanced portfolio but have instead tried to chase gains. These investors are speculators still hoping that some day they may break even again.
It is always better to take your lumps and reset your reference points. Interestingly enough, the same reset is necessary with investment wins as losses. If your portfolio does exceptionally well, don’t start believing you are the new Superman of the investment world. Remember every time you flip a coin, it could come up heads or tails. The next flip of the coin isn’t influenced by results of the last toss.
If you want to minimize your investment risk, then don’t bet all your money on one filly or one spin of the roulette wheel. Instead invest in a balanced diversified portfolio; hold for the long term; and keep systematically investing each month through your 401(k) plan 403(b), IRAs and taxable account. Also, don’t forget to forgive yourself for all the wacky investment decisions you’ve made in the past. Remember to reset your reference points.
What can patience and diversification and rebalancing regularly get you? Well rewarded. The chart below is worth studying. Owning high-quality bonds in a down market can save you from serious losses. The value of being diversified is apparent when you consider the entire period returns (third column). Small cap, mid-cap and bonds all generated positive returns for the.bmp)
entire period while international stocks, Nasdaq composite and large cap stocks were all negative. If you had put everything you owned in the Nasdaq Composite in March 2000 at its peak and then held (not resetting your reference point) hoping to get back to breakeven, you just proved Tversky and Kohneman’s behavioral finance theories. I could update the chart above to include the last few years but it just further proves the point. Stay diversified and rebalance at least once a year.
Happy Holidays!
Tversky and Kohneman
Behavioral finance has become a very popular subject. Quantifying how people emotionally deal with their money (what mistakes they make over and over again and why) has produced many interesting findings. The late Amos Tversky, a Stanford professor, and Daniel Kohneman, a Princeton professor, did much of this pioneering work. One of their major discoveries is that a dollar of gain is not equal to a dollar lost in most people’s minds, certainly not when the dollar stakes were high. Who would bet his car against a neighbor’s similar car at even odds? Very few people would take this bet, because having no car is more of a bad than having two cars is a good. So, the value function is non-linear, which means most people have more displeasure in losing a large sum than the pleasure associated with winning the same amount. Most individuals want a two-thirds chance of winning to venture a big bet. Interestingly enough, most individuals don’t invest this way.
In addition, Tversky and Kohneman studied how investors used context in their decision-making process. In other words, people made up their minds differently depending on how the problem was presented to them. Perversely, when the potential gain in a transaction is stressed, people get nervous and wary; and when potential losses are played up, they are willing to assume what are in reality greater risks in order to avoid the losses.
For example, suppose a person has spent the day at the race track, and lost $140, and is considering a $10 bet on a fifteen-to-one long shot in the last race. This decision can be framed in two ways, which corresponds to two natural reference points. If the bettor focuses on the cash flow on hand, the outcomes are framed as a gain of $140 or a loss of $10. On the other hand, if the bettor frames his decision in the frame work of the whole days losses, then it’s a chance to get back to even (from a $140 loss) or to increase his loss a mere $10. Individuals do not adjust their reference points as they lose and can be expected to make bets they normally would find outrageous, even on dubious nags at fifteen to one. This is exactly how many investors have handled their investments. In reaction to huge losses in technology stocks, they have continued to not build a conservative balanced portfolio but have instead tried to chase gains. These investors are speculators still hoping that some day they may break even again.
It is always better to take your lumps and reset your reference points. Interestingly enough, the same reset is necessary with investment wins as losses. If your portfolio does exceptionally well, don’t start believing you are the new Superman of the investment world. Remember every time you flip a coin, it could come up heads or tails. The next flip of the coin isn’t influenced by results of the last toss.
If you want to minimize your investment risk, then don’t bet all your money on one filly or one spin of the roulette wheel. Instead invest in a balanced diversified portfolio; hold for the long term; and keep systematically investing each month through your 401(k) plan 403(b), IRAs and taxable account. Also, don’t forget to forgive yourself for all the wacky investment decisions you’ve made in the past. Remember to reset your reference points.
What can patience and diversification and rebalancing regularly get you? Well rewarded. The chart below is worth studying. Owning high-quality bonds in a down market can save you from serious losses. The value of being diversified is apparent when you consider the entire period returns (third column). Small cap, mid-cap and bonds all generated positive returns for the
.bmp)
entire period while international stocks, Nasdaq composite and large cap stocks were all negative. If you had put everything you owned in the Nasdaq Composite in March 2000 at its peak and then held (not resetting your reference point) hoping to get back to breakeven, you just proved Tversky and Kohneman’s behavioral finance theories. I could update the chart above to include the last few years but it just further proves the point. Stay diversified and rebalance at least once a year.Happy Holidays!
Tuesday, December 4, 2007
Emerging Markets Appear Vulnerable
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Emerging markets appear vulnerable compared to the developed international markets. For instance, China is currently facing an inflation spike (+6.5%). Inflation is rising at the fastest pace in China in more than 10 years. The culprit is almost entirely food costs, caused by supply constraints. The Chinese government is trying to contain the inflation with price controls.Chinese consumer spending (retail sales +17.1% year over year) remains too hot and is not sustainable. Unless China can begin to rein in its growth and control inflation we could be looking at a major correction. Investing in only one country or region is risky. The investment inflows into Asian and Chinese oriented investment vehicles have been of tsunami proportions.
Is the Chinese market ready for a correction? Given the alarming growth of the iShares FTSE/Xinhua China 25 Index over the last three years, I wouldn't be surprised. It looks surprisingly like many historic investment bubbles such as the Nasdaq high tech/internet bubble and the more recent housing bubble. Will the Chinese stock market suffer the same fate as the NASDAQ or the housing market anytime soon? That is unclear, but a pullback sooner or later is inevitable.
I have not allocated a significant portion of international investments to emerging market mutual funds. Most international funds have over 5% invested in emerging markets. It is dangerous to then allocate another 10% to this sector given its inherent risk. I am firmly committed to increasing the allocation to international stocks and bonds in each client’s portfolio but not to over emphasize the emerging markets.
I have not allocated a significant portion of international investments to emerging market mutual funds. Most international funds have over 5% invested in emerging markets. It is dangerous to then allocate another 10% to this sector given its inherent risk. I am firmly committed to increasing the allocation to international stocks and bonds in each client’s portfolio but not to over emphasize the emerging markets.
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My goal is to structure each portfolio so that the overall equity allocation is equally-weighted between U.S. and international stocks. As we become a global economy this equally-weighted allocation just makes intuitive sense, but in the investment world this is a radical strategy. Most investment strategy is fashioned by looking at history (backwards) and frequently misses indicators that signal major shifts in the economic paradigm. The world is no longer U.S.-centric and this shift in growth is recognized in your portfolio allocation. If you decide to increase your international allocation, just make sure you do not overweight the risky emerging markets sector.
Tuesday, November 27, 2007
What Happens When the Easy Money is Gone? Go Global!
Consumers can no longer tap their homes to support their lifestyle nor can they run up their credit cards forever (credit card debt is reaching a historic high). The subprime mortgage debacle has made it difficult for consumers to withdraw funds from their homes and caused housing prices to fall. Add in a falling stock market to this mix and the American consumer must be feeling less wealthy. Historically, a falling housing market has caused consumers to rein in their spending. As credit continues to dry up, the American consumer will have to begin living within their means. That could make things uncomfortable for a while and leave the U.S. economy in a bind.
In the past when the U.S. economy caught a cold, the contagion spread around the world. The world economy has been too dependent upon the U.S. consumer to buy its good but the world is becoming a different place. Hopefully, the global economy can slowly wean itself from the American consumer and become more dependent upon the emerging middle class in India, China, and South America.
The falling U.S. dollar will help this global shift by making imported goods more expensive. On the plus side, exported U.S. goods will become more affordable to the new world emerging middle class. This new demand for U.S. goods and a falling demand for imported goods to the U.S. could correct the trade imbalance caused by years of over spending by and over dependence upon the U.S. consumer. This scenario would allow the U.S. economy to grow albeit slowly and the world to grow apace.
Credit is drying up for the U.S. consumer making him played out as the engine for global growth. The U.S. consumer won’t be able to borrow and may have to begin to save. The easy money has dried up and we are about to find out what the world will look like without the U.S. consumer in the drivers seat. Hold onto your hat! The ride is going to be bumpy especially in the U.S.
In short, emphasizing global investments will be crucial if your portfolio is going to generate decent returns over the next few years. That means allocating half of your equity investments abroad which is a stark change from the past when the U.S. markets dominated the world.
In the past when the U.S. economy caught a cold, the contagion spread around the world. The world economy has been too dependent upon the U.S. consumer to buy its good but the world is becoming a different place. Hopefully, the global economy can slowly wean itself from the American consumer and become more dependent upon the emerging middle class in India, China, and South America.
The falling U.S. dollar will help this global shift by making imported goods more expensive. On the plus side, exported U.S. goods will become more affordable to the new world emerging middle class. This new demand for U.S. goods and a falling demand for imported goods to the U.S. could correct the trade imbalance caused by years of over spending by and over dependence upon the U.S. consumer. This scenario would allow the U.S. economy to grow albeit slowly and the world to grow apace.
Credit is drying up for the U.S. consumer making him played out as the engine for global growth. The U.S. consumer won’t be able to borrow and may have to begin to save. The easy money has dried up and we are about to find out what the world will look like without the U.S. consumer in the drivers seat. Hold onto your hat! The ride is going to be bumpy especially in the U.S.
In short, emphasizing global investments will be crucial if your portfolio is going to generate decent returns over the next few years. That means allocating half of your equity investments abroad which is a stark change from the past when the U.S. markets dominated the world.
Thursday, November 15, 2007
Market Volatility is Normal
If you listened to the news media this summer you might have thought the sky was falling. The sky is fine and the markets are sound, we are just experiencing the return of normal volatility. Yes, the markets go up then down and up again but this is normal. I love the chart below because it illustrates how volatile the markets usually are in.bmp)
any one year. For instance, in 1998 the S&P500 index (ex-dividends) generated a 27% return but at one point during the year the index was down 19%. The index has generated on average an annual 10% to 11% return despite suffering an average mid-year drop of 12.7%. The moral, stay focused on the long term (at least a three year if not 10 year time horizon) and ignore the day-to-day gyrations of the market.
If the graph is tough to read then click on it. The graph will then appear larger.
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any one year. For instance, in 1998 the S&P500 index (ex-dividends) generated a 27% return but at one point during the year the index was down 19%. The index has generated on average an annual 10% to 11% return despite suffering an average mid-year drop of 12.7%. The moral, stay focused on the long term (at least a three year if not 10 year time horizon) and ignore the day-to-day gyrations of the market.If the graph is tough to read then click on it. The graph will then appear larger.
Thursday, November 8, 2007
How Bad is the Housing Market? Pretty Bad
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The pizza guy delivers a pizza to your door. He wants to be paid in cash right now. He doesn’t care how much equity you have built up in your house. You look in your wallet and it is empty. This scene is playing out for many home owners. They can’t make their mortgage payments and the bank is knocking on their door demanding payment. These resetting mortgages payments have ballooned to a level that borrowers aren’t able to pay. 
Why did the banks and secondary lending institutions make these loans to people they knew would never be able to repay? Greed! Wall Street was clamoring for these riskier mortgages because they were looking for bonds that generated a higher yield (higher interest rates) and to heck with the risk. In particular, hedge funds had an insatiable appetite for these riskier asset-backed consumer loans. Here is the bad news: the worst is yet to come. The most egregious of these risky loans (with high escalating payments at reset) were 2 year Adjustable Rate Mortgages made in 2006 and early 2007. As the above graph shows there is a massive wave of these loans that will reset in 2008. The default rate will be significant. This is like watching a train wreck in slow motion.
Unfortunately, when excesses end, things don’t just return to normal. The pendulum frequently swings far in the other direction. This quick swing sparked a liquidity crisis on Wall Street. The mortgage defaults triggered an extreme lack of interest in holding consumer-backed debt, and an inclination on the
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part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who have played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks during the quarter.With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points, things have settled down, but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This is somewhat good because excess liquidity was leading many investors to make imprudent investment decisions. On the flip side, the seizing up of the credit markets in a credit-dependent economy has a ripple effect which will hurt consumer spending.
With consumers unable to use their homes as an ATM machine (consumers extracting capital from their homes largely shut down and housing prices have fallen) and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending. The primary driver of economic growth is consumer spending,.bmp)
which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth.
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which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth. Sunday, November 4, 2007
Earth quake Insurance
Here is a link to an article in the San Jose Mercury News in which I'm interviewed regarding earth quake insurance.
http://www.mercurynews.com/personalfinance/ci_7366738
Hope you had a beautiful weekend and didn't feel the latest 2 plus tumbler this afternoon!
Libby Mihalka, CFA
The Financial Pragmatist
http://www.mercurynews.com/personalfinance/ci_7366738
Hope you had a beautiful weekend and didn't feel the latest 2 plus tumbler this afternoon!
Libby Mihalka, CFA
The Financial Pragmatist
Friday, November 2, 2007
Third Quarter 2007 Performance
The Third Quarter was another roller coaster ride that almost defied gravity on the downside and upside. The average general domestic stock fund was up 1.2 percent, according to.bmp)
Morningstar. The S&P 500 (a proxy for large stock performance in the U.S.) was up a respectable 2.1% (the ETF proxy used in the adjacent chart outperformed the index, generating a 3.1% return). The small and mid cap sectors of the U.S. markets did not fare as well.
International stocks in developed countries persevered and performed well. Interestingly, many specific country markets were down for the quarter which validates keeping your international portfolio diversified across countries and regions. A substantially weaker dollar bolstered returns from international investments this quarter so their returns were as good as or better than that of the S&P. The average foreign stock mutual fund gained 5 percent for the quarter.
International emerging-market funds continued on a tear, up 17%. Emerging markets refers to countries that are under developed and rural in nature. China and India are countries commonly referred to as having emerging economies. Growth in these regions has been astronomic (up 35% year-to-date).
Size mattered this quarter. The more super-sized your portfolio was (weighted toward the biggest large cap equities), the more bang you got for your investments. The strongest growth has occurred abroad this year and the US mega caps that have the largest international component to their earnings. The S&P500 ishares generated 3.1% third quarter while the S&P400 MidCaps and the S&P600 SmallCap ishares fell. International large caps also outperformed international small caps this quarter for the first time in years.
Growth also stole the spotlight, outperforming value despite capitalization (cap size) and country. S&P500 Growth ishares were up 5% for the quarter while the S&P500 Value ishares gained only 1.7%. This pattern was true for the smaller cap indices such as the S&P400 and S&P600 ishares, with the value shares falling and growth shares.bmp)
holding their value.
.bmp)
Emerging-market short-term bonds (PIMCO Developing Local Markets) continue to perform well despite volatility in the fixed income arena. Year-to-date the fund is up 4.5% primarily due to declining value of the dollar against other currencies.
Libby Mihalka, CFA
.bmp)
Morningstar. The S&P 500 (a proxy for large stock performance in the U.S.) was up a respectable 2.1% (the ETF proxy used in the adjacent chart outperformed the index, generating a 3.1% return). The small and mid cap sectors of the U.S. markets did not fare as well.International stocks in developed countries persevered and performed well. Interestingly, many specific country markets were down for the quarter which validates keeping your international portfolio diversified across countries and regions. A substantially weaker dollar bolstered returns from international investments this quarter so their returns were as good as or better than that of the S&P. The average foreign stock mutual fund gained 5 percent for the quarter.
International emerging-market funds continued on a tear, up 17%. Emerging markets refers to countries that are under developed and rural in nature. China and India are countries commonly referred to as having emerging economies. Growth in these regions has been astronomic (up 35% year-to-date).
Size mattered this quarter. The more super-sized your portfolio was (weighted toward the biggest large cap equities), the more bang you got for your investments. The strongest growth has occurred abroad this year and the US mega caps that have the largest international component to their earnings. The S&P500 ishares generated 3.1% third quarter while the S&P400 MidCaps and the S&P600 SmallCap ishares fell. International large caps also outperformed international small caps this quarter for the first time in years.
Growth also stole the spotlight, outperforming value despite capitalization (cap size) and country. S&P500 Growth ishares were up 5% for the quarter while the S&P500 Value ishares gained only 1.7%. This pattern was true for the smaller cap indices such as the S&P400 and S&P600 ishares, with the value shares falling and growth shares
.bmp)
holding their value.The reintroduction of risk was very apparent in the bond market, with high quality bonds rising in value and low quality falling. Scared by the upheaval in the credit markets, investors began piling into high-quality bonds, drove the Lehman Brothers Aggregate Bond Index up 2.8%, and caused yields to fall. For example, the yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries (flight to quality) also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated (junk) corporate bonds, to post a modest 0.12% loss for the quarter.
Other parts of the fixed income markets have not fared as well. The subprime mortgage-backed market is nonexistent, making it impossible to gauge the value of many existing securities. Many banks are writing them off as worthless. Despite this nuclear melt down, the Eaton Vance Institutional Floating Rate has performed well: although it fell 1.8% for the quarter, it is still up 2% for the year.
Commodity futures performed well this quarter due to the surge in oil prices, which breached the $80 a barrel level. The PIMCO Commodity Real Return Institutional Fund rose 10% in the third quarter generating a year-to-date return of 13%. The iPath Dow Jones-AIG Commodity Index rose a more modest 6% during the quarter and 10% for the year.
Other parts of the fixed income markets have not fared as well. The subprime mortgage-backed market is nonexistent, making it impossible to gauge the value of many existing securities. Many banks are writing them off as worthless. Despite this nuclear melt down, the Eaton Vance Institutional Floating Rate has performed well: although it fell 1.8% for the quarter, it is still up 2% for the year.
Commodity futures performed well this quarter due to the surge in oil prices, which breached the $80 a barrel level. The PIMCO Commodity Real Return Institutional Fund rose 10% in the third quarter generating a year-to-date return of 13%. The iPath Dow Jones-AIG Commodity Index rose a more modest 6% during the quarter and 10% for the year.
Emerging-market short-term bonds (PIMCO Developing Local Markets) continue to perform well despite volatility in the fixed income arena. Year-to-date the fund is up 4.5% primarily due to declining value of the dollar against other currencies.Libby Mihalka, CFA
Thursday, June 14, 2007
Financial Literacy
Here is a great new website by Schwab designed to teach financial literacy to kids and young adults. It is well designed and has great content.
http://www.schwabmoneywise.com/index.htm
Teaching your children to be financially savvy is essential.
Libby Mihalka
http://www.schwabmoneywise.com/index.htm
Teaching your children to be financially savvy is essential.
Libby Mihalka
Monday, May 21, 2007
Protecting the Elderly from Telemarketing Scams
The Elderly are frequent targets of fraud. Here is a very scary article from the New York Times. I recommend sending or reading this article to all your elderly relatives.
I also suggest you check the credit of all your elderly relatives if they will let you help them. See the blog article regarding Identity Theft.
I would also place all my elderly relatives on the Do Not Call List which should eliminate most solicitation calls. Telemarketing calls are a way many scammers bilk the elderly.
Since mail can easily be stolen, a secured (locking) mailbox is a great idea. I would also register all of my elderly relatives on the no credit card solicitation list. This list is legitamite and is endorsed by the Federal Trade Commission.
In fact, it would be smart to implement many of these ideas for yourself. A little time now could save you from becoming an identity theft victim
I also suggest you check the credit of all your elderly relatives if they will let you help them. See the blog article regarding Identity Theft.
I would also place all my elderly relatives on the Do Not Call List which should eliminate most solicitation calls. Telemarketing calls are a way many scammers bilk the elderly.
Since mail can easily be stolen, a secured (locking) mailbox is a great idea. I would also register all of my elderly relatives on the no credit card solicitation list. This list is legitamite and is endorsed by the Federal Trade Commission.
In fact, it would be smart to implement many of these ideas for yourself. A little time now could save you from becoming an identity theft victim
Five Common Investment Missteps That Could Derail Your Retirement
Here is my column in today's Contra Costa and Valley Times. They shortened the article considerably so I thought you all might enjoy reading the unedited longer piece.
Five Common Investment Missteps That Could Derail Your Retirement
As an investment manager and financial planner, I don’t know how many investment portfolios I’ve reviewed over the past 20 years. I consistently see the same missteps made by investors over and over again. These slip-ups can be avoided. Some of these are easy to fix and others may take time, effort and due diligence to resolve. Now that tax season is over, this is good time to turn over a new leaf and get your finances organized and well deployed. Here are some of the main missteps that I see frequently.
Misstep #1, A Trail of Accounts: When I meet with a clients to review their portfolio for the first time, I can expect to be handed a plethora of statements from different brokerage firms and 401(k)s from previous employers. There is no reason to have 10 different investment accounts. By having your assets strewn around so many places you’ve just made it impossible to monitor the performance of your investments and periodically rebalance. Get organized! Simplify your life by rolling your old 401(k) s and 403(b) s directly into an IRA at one brokerage firm. Open one brokerage account for your non-qualified (non-IRA) assets and consolidate. Two to three accounts are easier to follow than 8 or 10. In addition, there are definite advantages to having all of your accounts at one brokerage firm. Frequently, brokerage firms give investors a break in fees, higher money market rates and better service if all your accounts (IRAs, taxable brokerage accounts, etc.) are consolidated at one place.
Misstep #2, Track the Performance of Your Portfolio: Most investors do not know how their investments are performing. They do not know what their annualized rate of return is for each account much less the consolidated portfolio. Most people just glance at their monthly statements to see if their accounts are up or down but, they really do not know how they are doing. It is important to know your portfolio’s performance and how it compares to the major indices. Monitoring your portfolio’s performance is equivalent to knowing your batting average and how it compares to everyone else’s in your league. To be informed you need to know your stats and how they compare. If you don’t monitor your performance you won’t know what grade you received (an A or an F) and if you are on course to achieve your financial goals.
You can download this information into Microsoft Money or Quicken, and this software will calculate your return. After you have your total portfolio’s return, the next step is to compare it to the index returns. It is easy to find information on the major indices in your newspaper or on the internet. Websites like Yahoo Finance (finance.yahoo.com) and Google Finance (finance.google.com) can be very helpful in monitoring index and investment performance. Once you have the software downloads working, it will be easy to monitor your portfolio’s performance compared to the major indices.
Misstep # 3, Create an Asset Allocation: Even if they have only a few accounts, most people do not know how their assets are allocated, and approach each investment account separately. This piecemeal approach results in a mishmash of investments that does not reflect their goals, retirement plans or risk tolerance. It is important to construct an asset allocation for your entire portfolio instead of just looking at your IRA and then three months later your 401(k). The first step is to develop a coherent asset allocation plan for your entire portfolio and then decide how to implement the plan among your different accounts. A great place to start is the SEC (Securities and Exchange Commission) website (www.sec.gov/investor/pubs/assetallocation.htm). It explains the basics of asset allocation and has some good links to other resources.
Misstep #4, : Most investors don’t know anything about the investments they hold. For instance most investors are clueless when it comes to the credit quality of their corporate bonds, the fees charged on their mutual funds, the outlook on a particular stock, or other important details about their holdings. By not understanding their holdings, investors are frequently invested in very risky ventures and paying exorbitant fees.
If you do not have time everyday to devote to your portfolio, then do not invest in individual stocks or bonds. Be honest with yourself and admit that once you are invested you are never going to look at your investments again. In this situation, I would recommend you research some of the new lifecycle funds. These funds rebalance to a more conservative asset allocation as the targeted portfolio date (specified in the fund name) approaches. Unfortunately, most of these funds are too conservative (too heavily weighted toward cash and bonds) so don’t select a fund with the same target date as your retirement. Instead consider selecting a fund with a targeted date that is at least 10 years further off than your impending retirement. This will help you avoid asset allocations that are too conservative.
It is worth the time and effort to research your investments and not just opt out by using lifestyle funds. You lose control of your asset allocation and the fees are higher for lifestyle funds. I recommend using a combination of mutual funds and index funds to execute your asset allocation plan. This is a great way to diversify and manage risk. It won’t require you to daily manage your investments; bi-monthly to monthly monitoring should be enough once your portfolio is all invested.
It is important to research the cost of these investment vehicles before investing. Many investors are surprised to find out that they are paying a load or 12b-1 fee on their mutual fund investments. It is important to know the up front, annual or back end fees you will be paying before investing. Fees are usually buried in the back or middle of a Prospectus which is a legal document published by the fund company. You can also find information regarding fees and more on the internet at the Morningstar website (http://www.morningstar.com/#A1) and FundAlarm (http://www.fundalarm.com/) before investing.
In addition, it is very important to understand what the fund is purported to be invested in and what it is really holding. Janus Overseas is labeled by Morningstar as a Foreign Large Growth fund. Except Janus Overseas has a great deal more risk than any fund in this category because it is 27% invested in Foreign Emerging Markets (China, India, Thailand). This is a great deal riskier than being invested in Large Companies in Developed Foreign markets (Germany, United Kingdom, and Japan). In fact, most Large Cap Foreign funds typically have a 3% to 5% exposure to Emerging Markets. So if you had allocated part of your portfolio to Foreign Emerging Markets and then bought Janus Overseas, you would be over-weighted in Emerging Markets and have a riskier portfolio than you intended. Make sure you read the fund’s prospectus and research the funds using the two websites listed above.
Misstep #5: Not doing anything because you are too busy or are intimidated is the biggest misstep of all. It is your money and it may very well be your sole support in retirement. Take control or get help by hiring a professional financial planner. Get organized and design an investment plan that will help you meet your life goals and retirement plans. Good luck!
Libby Mihalka
The Financial Pragmatist
Five Common Investment Missteps That Could Derail Your Retirement
As an investment manager and financial planner, I don’t know how many investment portfolios I’ve reviewed over the past 20 years. I consistently see the same missteps made by investors over and over again. These slip-ups can be avoided. Some of these are easy to fix and others may take time, effort and due diligence to resolve. Now that tax season is over, this is good time to turn over a new leaf and get your finances organized and well deployed. Here are some of the main missteps that I see frequently.
Misstep #1, A Trail of Accounts: When I meet with a clients to review their portfolio for the first time, I can expect to be handed a plethora of statements from different brokerage firms and 401(k)s from previous employers. There is no reason to have 10 different investment accounts. By having your assets strewn around so many places you’ve just made it impossible to monitor the performance of your investments and periodically rebalance. Get organized! Simplify your life by rolling your old 401(k) s and 403(b) s directly into an IRA at one brokerage firm. Open one brokerage account for your non-qualified (non-IRA) assets and consolidate. Two to three accounts are easier to follow than 8 or 10. In addition, there are definite advantages to having all of your accounts at one brokerage firm. Frequently, brokerage firms give investors a break in fees, higher money market rates and better service if all your accounts (IRAs, taxable brokerage accounts, etc.) are consolidated at one place.
Misstep #2, Track the Performance of Your Portfolio: Most investors do not know how their investments are performing. They do not know what their annualized rate of return is for each account much less the consolidated portfolio. Most people just glance at their monthly statements to see if their accounts are up or down but, they really do not know how they are doing. It is important to know your portfolio’s performance and how it compares to the major indices. Monitoring your portfolio’s performance is equivalent to knowing your batting average and how it compares to everyone else’s in your league. To be informed you need to know your stats and how they compare. If you don’t monitor your performance you won’t know what grade you received (an A or an F) and if you are on course to achieve your financial goals.
You can download this information into Microsoft Money or Quicken, and this software will calculate your return. After you have your total portfolio’s return, the next step is to compare it to the index returns. It is easy to find information on the major indices in your newspaper or on the internet. Websites like Yahoo Finance (finance.yahoo.com) and Google Finance (finance.google.com) can be very helpful in monitoring index and investment performance. Once you have the software downloads working, it will be easy to monitor your portfolio’s performance compared to the major indices.
Misstep # 3, Create an Asset Allocation: Even if they have only a few accounts, most people do not know how their assets are allocated, and approach each investment account separately. This piecemeal approach results in a mishmash of investments that does not reflect their goals, retirement plans or risk tolerance. It is important to construct an asset allocation for your entire portfolio instead of just looking at your IRA and then three months later your 401(k). The first step is to develop a coherent asset allocation plan for your entire portfolio and then decide how to implement the plan among your different accounts. A great place to start is the SEC (Securities and Exchange Commission) website (www.sec.gov/investor/pubs/assetallocation.htm). It explains the basics of asset allocation and has some good links to other resources.
Misstep #4, : Most investors don’t know anything about the investments they hold. For instance most investors are clueless when it comes to the credit quality of their corporate bonds, the fees charged on their mutual funds, the outlook on a particular stock, or other important details about their holdings. By not understanding their holdings, investors are frequently invested in very risky ventures and paying exorbitant fees.
If you do not have time everyday to devote to your portfolio, then do not invest in individual stocks or bonds. Be honest with yourself and admit that once you are invested you are never going to look at your investments again. In this situation, I would recommend you research some of the new lifecycle funds. These funds rebalance to a more conservative asset allocation as the targeted portfolio date (specified in the fund name) approaches. Unfortunately, most of these funds are too conservative (too heavily weighted toward cash and bonds) so don’t select a fund with the same target date as your retirement. Instead consider selecting a fund with a targeted date that is at least 10 years further off than your impending retirement. This will help you avoid asset allocations that are too conservative.
It is worth the time and effort to research your investments and not just opt out by using lifestyle funds. You lose control of your asset allocation and the fees are higher for lifestyle funds. I recommend using a combination of mutual funds and index funds to execute your asset allocation plan. This is a great way to diversify and manage risk. It won’t require you to daily manage your investments; bi-monthly to monthly monitoring should be enough once your portfolio is all invested.
It is important to research the cost of these investment vehicles before investing. Many investors are surprised to find out that they are paying a load or 12b-1 fee on their mutual fund investments. It is important to know the up front, annual or back end fees you will be paying before investing. Fees are usually buried in the back or middle of a Prospectus which is a legal document published by the fund company. You can also find information regarding fees and more on the internet at the Morningstar website (http://www.morningstar.com/#A1) and FundAlarm (http://www.fundalarm.com/) before investing.
In addition, it is very important to understand what the fund is purported to be invested in and what it is really holding. Janus Overseas is labeled by Morningstar as a Foreign Large Growth fund. Except Janus Overseas has a great deal more risk than any fund in this category because it is 27% invested in Foreign Emerging Markets (China, India, Thailand). This is a great deal riskier than being invested in Large Companies in Developed Foreign markets (Germany, United Kingdom, and Japan). In fact, most Large Cap Foreign funds typically have a 3% to 5% exposure to Emerging Markets. So if you had allocated part of your portfolio to Foreign Emerging Markets and then bought Janus Overseas, you would be over-weighted in Emerging Markets and have a riskier portfolio than you intended. Make sure you read the fund’s prospectus and research the funds using the two websites listed above.
Misstep #5: Not doing anything because you are too busy or are intimidated is the biggest misstep of all. It is your money and it may very well be your sole support in retirement. Take control or get help by hiring a professional financial planner. Get organized and design an investment plan that will help you meet your life goals and retirement plans. Good luck!
Libby Mihalka
The Financial Pragmatist
Thursday, May 17, 2007
How to Navigate Refinancing Your Mortgage: Beware of Scams
Refinancing or financing your home can be stressful. Let’s face it, the biggest transaction you will probably ever make is purchasing and financing a home. I hear a good number of horror stories about refinancing. I’ve even had some of these tricks played on me. Fortunately I knew what to do. Here is what you should know about financing your home.
Do not accept a lender solicitation you got in the mail just because it looks good. Always do your due diligence and get competing quotes from reputable lenders. Usually a lender that woes you is not offering the most competitive terms. In addition, don't pursue the lender offering the lowest rate on sites such as bankrate especially if you've never heard of them before. These are the firms that are most apt to bait and switch the loan terms at the last moment or pad the closing costs. So watch out and do your home work.
Always watch out for the old bait and switch scam. Typically this is what happens. You complete the loan application and a few days later the loan officer confirms your application has been accepted. However, the loan is not at the initial rate and terms discussed, a fact the broker conveniently forgets to mention. Many people don’t realize that the terms have been changed until they are signing documents at closing. It is important to receive a copy of the terms and rates of your loan after your application has been accepted.
Make sure you have locked down your rate and make sure you understand what you need to do in order to keep it. I recommend call the lending officer regularly through the process to ensure that your loan is moving along and the rates and terms have not changed. Frequently, you can lose your loan terms if you do not submit all your forms and documentation required by a specific date. Keep copies of all the information you have given the lender and send the information by fax or certified mail. Call to make sure it has been received. If at closing the terms of the loan aren’t what you agreed to, don’t sign the documents.
Many borrowers don’t know the terms of their loans. Many of these terms, especially in combination, could spell financial disaster. So watch out for prepayment penalties, balloon payments, and an adjustable rate. These three items together should be a huge red flag. If these are the terms your lender is offering then you should go and talk to other reputable lenders and make sure you are making the right decision.
One of the biggest scams is padding the closing costs. Most borrowers don’t know that the lender is required to give you a good faith estimate of your closing costs (GFE) within three working days of accepting the loan application. The list is itemized and contains costs that are non-negotiable such as property taxes. One scam is to low ball the GFE and then pump them up on the closing statement. It is important to get another copy of the GFE a few days before closing. If the fees are more than 5% higher then the original estimate then demand that the fees be lowered or you’ll walk.
Many of the closing costs are negotiable. Below is a mortgage broker’s website that shows a sample GFE and explains some of the fees. (Website to Sample GFE). Focus on the fees in section 800 and try to eliminate unnecessary fees and lower the lender fees. Section 1100 outlines the title company fees. This is the title company that your mortgage broker wants you to use. You can use a different title company but expect a fight from your broker. They have established relationships with title companies that frequently provide services that support their business. Frequently you can save money by employing the title company yourself but it may not be worth the hassle.
Make sure you get as complete a GFE as possible and let the lender know that you will walk away if the final closing statement is significantly different from the GFE. Incomplete GFEs are the most frequent cause of an under estimated closing costs.
Finally, look out for mortgage brokers that try to cross sell you additional services such as home owners insurance. Always get multiple bids on these services. You can almost always find better coverage at a more reasonable price if you bid out these services separately.
The Financial Pragmatist
Libby Mihalka
Do not accept a lender solicitation you got in the mail just because it looks good. Always do your due diligence and get competing quotes from reputable lenders. Usually a lender that woes you is not offering the most competitive terms. In addition, don't pursue the lender offering the lowest rate on sites such as bankrate especially if you've never heard of them before. These are the firms that are most apt to bait and switch the loan terms at the last moment or pad the closing costs. So watch out and do your home work.
Always watch out for the old bait and switch scam. Typically this is what happens. You complete the loan application and a few days later the loan officer confirms your application has been accepted. However, the loan is not at the initial rate and terms discussed, a fact the broker conveniently forgets to mention. Many people don’t realize that the terms have been changed until they are signing documents at closing. It is important to receive a copy of the terms and rates of your loan after your application has been accepted.
Make sure you have locked down your rate and make sure you understand what you need to do in order to keep it. I recommend call the lending officer regularly through the process to ensure that your loan is moving along and the rates and terms have not changed. Frequently, you can lose your loan terms if you do not submit all your forms and documentation required by a specific date. Keep copies of all the information you have given the lender and send the information by fax or certified mail. Call to make sure it has been received. If at closing the terms of the loan aren’t what you agreed to, don’t sign the documents.
Many borrowers don’t know the terms of their loans. Many of these terms, especially in combination, could spell financial disaster. So watch out for prepayment penalties, balloon payments, and an adjustable rate. These three items together should be a huge red flag. If these are the terms your lender is offering then you should go and talk to other reputable lenders and make sure you are making the right decision.
One of the biggest scams is padding the closing costs. Most borrowers don’t know that the lender is required to give you a good faith estimate of your closing costs (GFE) within three working days of accepting the loan application. The list is itemized and contains costs that are non-negotiable such as property taxes. One scam is to low ball the GFE and then pump them up on the closing statement. It is important to get another copy of the GFE a few days before closing. If the fees are more than 5% higher then the original estimate then demand that the fees be lowered or you’ll walk.
Many of the closing costs are negotiable. Below is a mortgage broker’s website that shows a sample GFE and explains some of the fees. (Website to Sample GFE). Focus on the fees in section 800 and try to eliminate unnecessary fees and lower the lender fees. Section 1100 outlines the title company fees. This is the title company that your mortgage broker wants you to use. You can use a different title company but expect a fight from your broker. They have established relationships with title companies that frequently provide services that support their business. Frequently you can save money by employing the title company yourself but it may not be worth the hassle.
Make sure you get as complete a GFE as possible and let the lender know that you will walk away if the final closing statement is significantly different from the GFE. Incomplete GFEs are the most frequent cause of an under estimated closing costs.
Finally, look out for mortgage brokers that try to cross sell you additional services such as home owners insurance. Always get multiple bids on these services. You can almost always find better coverage at a more reasonable price if you bid out these services separately.
The Financial Pragmatist
Libby Mihalka
Wednesday, May 9, 2007
It is Time to Rebalance
At the end of last week, the indices were all moving towards new highs. Despite slowing earnings growth the market just keeps heading up. While the long term trend is healthy, I think we are in for some turbulence. Usually when the market moves aggressively ahead, pushing toward new highs, after a while it takes very little news to derail the train. It seems inevitable as we head into the summer that the market will consolidate its gains by pulling back a little. The market will then take the summer off to digest the latest gains. .bmp)
While the majority of the economic news remains positive there are negatives looming out there. For instance, there is slower U.S. employment growth, tightening credit, higher gas prices, slowing corporate earnings growth, and falling housing prices). Despite the negatives, the current situation does not warrant selling and walking away. Corporate earnings are still strong and P/E ratios are still reasonable (see chart). The current market conditions do warrant implementing a strategy of rebalancing and trimming. Increasing cash holdings over the next few weeks will enable an investor to take advantage of any pull backs. The catalyst(s) that could spark a correction is (are) unknown, but it could finally be the U.S. consumer cutting back or disappointing economic data.
It is likely that turbulence will be minor should it happen at all. The new global economy will continue to perform well pulling the U.S. market along with it. The story here is really the global economy and not just us anymore.
For right now, the market is still hot because of accelerating merger-and-acquisition activity. As of the end of last week the mid cap market has been blazing hot since the start of the year. In the last few weeks large cap domestic stocks have picked up the pace. It is very unclear whether large caps will finally outperform small and mid caps this year. It is inevitable that large caps will at some point outperform its small cap brethren in the future due to valuation metrics (see past blog postings for more information). International stocks are still chugging along with the MSCI EAFE up approximately 8% for the year. Bonds are showing some life with the Lehman Bros Aggregate index up almost 2% year-to-date.
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While the majority of the economic news remains positive there are negatives looming out there. For instance, there is slower U.S. employment growth, tightening credit, higher gas prices, slowing corporate earnings growth, and falling housing prices). Despite the negatives, the current situation does not warrant selling and walking away. Corporate earnings are still strong and P/E ratios are still reasonable (see chart). The current market conditions do warrant implementing a strategy of rebalancing and trimming. Increasing cash holdings over the next few weeks will enable an investor to take advantage of any pull backs. The catalyst(s) that could spark a correction is (are) unknown, but it could finally be the U.S. consumer cutting back or disappointing economic data.
It is likely that turbulence will be minor should it happen at all. The new global economy will continue to perform well pulling the U.S. market along with it. The story here is really the global economy and not just us anymore.
For right now, the market is still hot because of accelerating merger-and-acquisition activity. As of the end of last week the mid cap market has been blazing hot since the start of the year. In the last few weeks large cap domestic stocks have picked up the pace. It is very unclear whether large caps will finally outperform small and mid caps this year. It is inevitable that large caps will at some point outperform its small cap brethren in the future due to valuation metrics (see past blog postings for more information). International stocks are still chugging along with the MSCI EAFE up approximately 8% for the year. Bonds are showing some life with the Lehman Bros Aggregate index up almost 2% year-to-date.
Tuesday, May 1, 2007
Subprime Mortgage Debacle: What is the Impact?
Last year, the market overcame a wrenching period of soul-searching in May and June (2006). Back then, the Federal Reserve was at the end of a two-year campaign to raise interest rates, and the housing boom had started to fade. The concerns that dominated the minds of investors, however, did not linger, and the market had a solid second half.
Many market specialists assert that the current concerns will play out similarly. Weaknesses like those in the market for subprime mortgages issued to borrowers with weak credit will not threaten the broader financial markets, these experts say, because the world economy is growing, corporate profits are rising, and consumers with good credit are not defaulting at high rates.
Most of us (especially those living in areas with very high housing costs) are aware that lenders have pushed the envelope in recent years and granted loans to enable people to buy homes they would other
wise be unable to afford. In so doing, many of these buyers have stretched themselves financially and have little margin for error. Low starter rates and temporary interest-only terms are winding down or expiring. The rates on these loans are resetting at a much higher level because interest rates are rising. As a result, defaults among subprime mortgages have climbed sharply. How widespread is the problem? Well loans in this segment ac-counted for 24% of loan originations in 2006, and late payments in Alternative-A mortgages are esca-lating (the default rate in this sector is in the 13% to 14% range). The result: people are losing their homes and some subprime lenders have either experienced big financial losses or gone out of business.
Research analysts at PIMCO have suggested that this is a meaningful source of risk to the housing market, since these defaulting buyers have starter homes (less expensive homes) which are the first rung on the housing-market food chain. So on its face, rising delinquencies in a high-growth part of the market could be a serious concern.
Defaults and tighter lending standards will mean that growth in the subprime arena will stall, causing demand to sag even further in the housing market. PIMCO’s analysts believe that we’re in the middle of the housing downturn, and that this will ultimately cut roughly another 1% from GDP growth over the next few quarters (and that there is at least some risk that it could be worse). Clearly that’s not good, but it is also not as bad an outcome as many others seem to expect given the extensive media play that this problem has received.
The reason the spill over effects on the economy and corporate earnings aren’t more severe becomes clear when you break the U.S. consumer into quintiles. The bottom 20 percent of U.S. consumers generate only 8 percent of consumer spending. These are the very consumers that are caught in the sub-prime lending squeeze and could lose their homes. Conversely, the top 10% represents about 40% of consumer spending and these consumers are unaffected. The subprime debacle will effect will cause dislocations in the housing market but won’t deliver a crippling blow to the economy. It is just another road hazard that the economy and financial markets will need to navigate around.
Many market specialists assert that the current concerns will play out similarly. Weaknesses like those in the market for subprime mortgages issued to borrowers with weak credit will not threaten the broader financial markets, these experts say, because the world economy is growing, corporate profits are rising, and consumers with good credit are not defaulting at high rates.
Most of us (especially those living in areas with very high housing costs) are aware that lenders have pushed the envelope in recent years and granted loans to enable people to buy homes they would other
wise be unable to afford. In so doing, many of these buyers have stretched themselves financially and have little margin for error. Low starter rates and temporary interest-only terms are winding down or expiring. The rates on these loans are resetting at a much higher level because interest rates are rising. As a result, defaults among subprime mortgages have climbed sharply. How widespread is the problem? Well loans in this segment ac-counted for 24% of loan originations in 2006, and late payments in Alternative-A mortgages are esca-lating (the default rate in this sector is in the 13% to 14% range). The result: people are losing their homes and some subprime lenders have either experienced big financial losses or gone out of business.Research analysts at PIMCO have suggested that this is a meaningful source of risk to the housing market, since these defaulting buyers have starter homes (less expensive homes) which are the first rung on the housing-market food chain. So on its face, rising delinquencies in a high-growth part of the market could be a serious concern.
Defaults and tighter lending standards will mean that growth in the subprime arena will stall, causing demand to sag even further in the housing market. PIMCO’s analysts believe that we’re in the middle of the housing downturn, and that this will ultimately cut roughly another 1% from GDP growth over the next few quarters (and that there is at least some risk that it could be worse). Clearly that’s not good, but it is also not as bad an outcome as many others seem to expect given the extensive media play that this problem has received.
The reason the spill over effects on the economy and corporate earnings aren’t more severe becomes clear when you break the U.S. consumer into quintiles. The bottom 20 percent of U.S. consumers generate only 8 percent of consumer spending. These are the very consumers that are caught in the sub-prime lending squeeze and could lose their homes. Conversely, the top 10% represents about 40% of consumer spending and these consumers are unaffected. The subprime debacle will effect will cause dislocations in the housing market but won’t deliver a crippling blow to the economy. It is just another road hazard that the economy and financial markets will need to navigate around.
HOW TO PROTECT YOURSELF FROM IDENTITY THEFT
Identity theft has become a very common crime. Law enforcement agencies are reporting that identity theft criminals have become increasingly organized and sophisticated. Simply stated, a thief or organized group of thieves acquire your personal information and use it to access your accounts or set up new ones in your name.
Much of this information is readily available in the public domain. Other information may be simply stolen from an unsecure mailbox, or obtained through fraudulent means such as “phishing” on the internet. Phishers attempt to fraudulently acquire sensitive information, such as usernames, passwords and credit cards details, by masquerading as a trustworthy entity in an electronic communication. eBay and PayPal are two of the most targeted companies, and online banks are also a common targets. Phishing is typically carried out using email or an instant message, and often directs users to give details at a website, although phone contact has been used as well. Once a person logs in to the phony site, the log-in information is captured and used by the thieves to access the real account on the real site.
Much of this information is readily available in the public domain. Other information may be simply stolen from an unsecure mailbox, or obtained through fraudulent means such as “phishing” on the internet. Phishers attempt to fraudulently acquire sensitive information, such as usernames, passwords and credit cards details, by masquerading as a trustworthy entity in an electronic communication. eBay and PayPal are two of the most targeted companies, and online banks are also a common targets. Phishing is typically carried out using email or an instant message, and often directs users to give details at a website, although phone contact has been used as well. Once a person logs in to the phony site, the log-in information is captured and used by the thieves to access the real account on the real site.
Still other thefts involve tricking computer users to unwittingly download viruses or spyware by pretending to offer (ironically enough) free software that will improve their computer’s security. Once installed, these programs secretly transmit data (such as usernames and passwords) to the thieves, who are often overseas. These are just a few examples of how identify theft can take place, but approaches are always evolving so it pays to be skeptical and vigilant before providing any information to an unknown source, whether by phone, internet or in person.
The ease and speed with which identify theft can be accomplished, the losses that result, and the complexity and time required to stop the activity, are costly and nerve-wracking. Actual losses are seldom recoverable; furthermore, they are greatly exacerbated by the huge ongoing stress and hassle.
What should you do?
At a minimum, please consider the following that have been recommended by the U.S. Postal Inspection Service:
- Secure your mail by either obtaining and installing a secure mailbox (if you do not currently have a slot in your door or garage door) or re-routing your mail to a P.O. Box.
- Use a paper shredder to shred all personal documents before throwing them away, including the pre-approved junk mail you receive.
- Remove yourself from marketing lists by contacting the Mail Preference Section, Direct Marketing Association, P.O. Box 9008, Farmingdale, N.Y. 11735, (212) 768-7277, (www.dmaconsumers.org/offmailinglist.html).
- Regularly check your credit report at one of the three major credit agencies:
1. TransUnion, 800-888-4213 (www.tuc.com); or
2. Experian, 888-EXPERIAN (www.experian.com); or
3. Equifax, 800-685-1111 (www.equifax.com). - Use extreme caution about providing personal information when using the Internet. Do not download unknown programs or respond to unsolicited email notices. Links provided in email notices can be made to appear legitimate, such that the web address that is displayed in the link is not the one to which the link is connected. Scammers have been known to create elaborate duplicates of legitimate sites just for the purpose of collecting account information. If you aren’t sure about an emailed account notice, just ignore the link in the email and go directly to site on your own.
I am not suggesting that you become obsessive or paranoid, but a few relatively simple steps will go a long way towards protecting yourself. For further information, check out the U. S. Postal Inspection Service brochure and website.
Brochure (www.usps.com/cpim/ftp/pubs/pub280.pdf )
Website (www.usps.com/postalinspectors/)
The Financial Pragmatist
Libby Mihalka
Thursday, April 26, 2007
Earnings Are the Key
The main story is the st.bmp)
rength of corporate earnings. The adjacent graph shows that the growth rate of corporate profits over the last five years has been incredible. In fact, the growth rate has been double digit for the last seven quarters. Even more interesting is that these record profits are not fully reflected in stock prices.
The next graph below shows the performance of the S&P 500 from 1996 through First Quarter 2007. It shows the ride up to the top of the dot-com bubble; the subsequent bust and the climb back up. Although close, the S&P 500 has still not exceeded its previous high (as of quarter end) even though the index is up 83% from its low. Stocks are significantly cheaper than on March 24, 2000 based on P/E ratios (for explanation of P/E ratio see below). In fact, stocks are 43% cheaper than from previous high.
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Why isn’t the current high earnings growth rate fully reflected in current P/E ratios? Because built into P/E ratios are future earning expectations. Current stock valuations anticipate the slowing of earnings growth rate to rates closer to the historic norm from the current extraordinary levels. The market does not believe this elevated rate of earnings is sustainable in the long run. In addition, the market is building a margin of safety lest inflation doesn’t moderate and the Federal Reserve has to raise interest rates again. It is factoring in all potential risks and discounting stock prices to reflect this increasing volatility. Usually big market declines are generally preceded by stretched valuations. It is comforting to know that even though the markets were more volatile this quarter, valuations are re.bmp)
asonable.
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rength of corporate earnings. The adjacent graph shows that the growth rate of corporate profits over the last five years has been incredible. In fact, the growth rate has been double digit for the last seven quarters. Even more interesting is that these record profits are not fully reflected in stock prices.The next graph below shows the performance of the S&P 500 from 1996 through First Quarter 2007. It shows the ride up to the top of the dot-com bubble; the subsequent bust and the climb back up. Although close, the S&P 500 has still not exceeded its previous high (as of quarter end) even though the index is up 83% from its low. Stocks are significantly cheaper than on March 24, 2000 based on P/E ratios (for explanation of P/E ratio see below). In fact, stocks are 43% cheaper than from previous high.
The P/E Ratio
P/E is the ratio of Price to Earnings. The price of a stock is a function of the underlying earnings and the P/E multiple captures that relationship. The ratio shows the embedded cost for every dollar of earnings the stock is generating. In other words, if the P/E ratio is 30 then you are paying $30 dollars for every dollar of earnings.
P/E is the ratio of Price to Earnings. The price of a stock is a function of the underlying earnings and the P/E multiple captures that relationship. The ratio shows the embedded cost for every dollar of earnings the stock is generating. In other words, if the P/E ratio is 30 then you are paying $30 dollars for every dollar of earnings.
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Why isn’t the current high earnings growth rate fully reflected in current P/E ratios? Because built into P/E ratios are future earning expectations. Current stock valuations anticipate the slowing of earnings growth rate to rates closer to the historic norm from the current extraordinary levels. The market does not believe this elevated rate of earnings is sustainable in the long run. In addition, the market is building a margin of safety lest inflation doesn’t moderate and the Federal Reserve has to raise interest rates again. It is factoring in all potential risks and discounting stock prices to reflect this increasing volatility. Usually big market declines are generally preceded by stretched valuations. It is comforting to know that even though the markets were more volatile this quarter, valuations are re.bmp)
asonable.However, valuations are stretched in some segments of the market, like mid and small caps (Russell 2000 index). These smaller caps have outperformed large caps for years but as a result valuations are pushed. Russell 2000 index has a high P/E ratio of 38.7 which implies a 63% earnings growth rate. It is doubtful that small caps will be able to de-liver such a strong performance forever. Conversely, the Nasdaq has a negative implied earnings growth rate. The market expects the earnings of Nasdaq-high tech stocks to contract. Growth stocks have underperformed value stocks since the dot-com bust but it is unlikely that this underperformance will last forever.
Sunday, April 22, 2007
The Economic News
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I regularly attempt to explain the current state of the economy, the Federal Reserve’s policy stance, and other news items that could impact the markets. It is difficult to present the general state of the economy in just a few paragraphs, so I was thrilled when I discovered this scorecard designed by JPMorgan. I’ll try to regularly include it in my future newsletters. If the chart seems unclear just click on it to get a larger clearer view. Many economists believe that we are close to full employment (5% or less unemployment is considered full employment by economists and the Fed). These gurus fear that full employment could lead to rising wages which could then cause inflation. The Federal Reserve is focused on the core rate of inflation (inflation less the volatile food and energy segments). Inflation is currently at the high end of the Fed’s defined range of acceptable. So the Fed’s board members want the core inflation rate to fall but don’t want to raise interest rates again to achieve it. The Fed wants the market to adjust itself.
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When Bernanke became Federal Reserve Chairman he stated that he wanted to communicate the Fed’s intentions more clearly to investors. The unintentional result has been the inversion of the yield curve (short term interest rates are higher than long term rates). In order to get long term interest rates up, the Fed has begun to abandon its policy of clear communication and transparency. It is instead refusing to send a clear message. The Fed recently changed its stance to neutral (instead of signaling its intention by stating a bias towards raising or lowering rates) but it is all posturing. The most recent Fed minutes from its last meeting are meandering and unclear. Consider, for instance, this excerpt from the minutes:
…the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee’s predominant concern.
The Fed's mixed reactions regarding inflation are unsettling to many analysts and economists. It is all part of an elaborate game of chicken as the Fed desperately tries to balance the need to moderate inflation with keeping the economy growing. If the Fed has to raise short term rates to check inflation it might also destabilize the financial markets. If the Fed states a bias towards lowering short term rates, it could cause the markets to grow too quickly the old boom followed by bust pattern). The Fed hopes to avoid these scenarios by convincing the market to raise long term rates which should help moderate full employment and wages and hence cool the core inflation rate. It will be interesting to see who blinks first, the markets or the Fed.
The Financial Pragmatist
Libby Mihalka
Wednesday, April 18, 2007
The Return of Volatility
With the recent choppiness in the markets, investors have become aware that stocks don’t always just trend nicely straight up.
Marc D. Stern, the chief investment officer at Bessemer Trust said in a recent interview, “We are in for some meaningful volatility for the next several years, and none of us should be surprised by that. There are lots of uncertainties to ponder.”
Investors have gotten used to extremely low levels of volatility and they may find these normal price swings disconcerting. To put this in perspective, I’ve included the adjacent chart of the Chicago Board of Trade’s VIX index. This index measures volatility based on investors’ use of options on the S&P 500-stock index. .bmp)
It spiked in early March from historically low levels (see the far left portion of the top chart). As the graph shows, equity volatility is near the historical average but far from the high levels (peaks on the graph) experienced during the dot-com bust in the early 2000’s. Bounces in the market are normal. A 3.5% one-day loss in the U.S. markets like the one experienced at the end of February is not unprecedented after seven straight months of gains totaling over 14%.
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It spiked in early March from historically low levels (see the far left portion of the top chart). As the graph shows, equity volatility is near the historical average but far from the high levels (peaks on the graph) experienced during the dot-com bust in the early 2000’s. Bounces in the market are normal. A 3.5% one-day loss in the U.S. markets like the one experienced at the end of February is not unprecedented after seven straight months of gains totaling over 14%.What is interesting is how little investors are being paid for taking greater risk especially in the bond market. The bottom graph illustrates this point. It shows the difference in return earned (spread) in a risky investment (in this case High Yield Bonds and Foreign Emerging Country Debt) compared to what is considered a risk less investment in ten year U.S. Treasuries. High Yield bonds are loans made to corporations that have compromised credit. These bonds are risky because they could default (not pay). So to compensate investors for this risk they pay a higher interest rate. The amount of additional interest compared to U.S. Treasuries varies over time. Currently these High Yield bonds are paying a historically low premium compared to the risk free Treasuries (free of credit risk).
Investors are earning less of a premium despite the increasing volatility (another measure of risk) shown in the top chart. In other words, investors are not being paid enough of a premium for the risk they are taking. Investors have become complacent about risk. They have been so focused on chasing higher yields that they have forgotten that they could easily lose money in these riskier investments.
Investors beware. Risk is back and she can be a cruel mistress!
The Financial Pragmatist
Libby Mihalka
Monday, April 16, 2007
Week in Review
Let's look at the numbers..bmp)
In the last week the S&P 500 gained as much as it did in the whole First Quarter (0.6%). The stock market has bounced back and year-to-date has generated a 3% return (S&P 500). Mid Caps are still outperforming Large Caps domestic stocks. Large Caps are now keeping up with Small Cap stocks after lagging for years. Growth is beginning to outperform value stocks reversing a long standing trend. The market volatility of late February and early March does not seem to be having a lasting impact on the market.
Despite this performance, the market is facing uncharted waters. Here are
Bob Doll's opinion of the state of the economy and particularly corporate earnings growth. He is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock.
Last week was a good one for stocks, with the Dow Jones Industrial Average posting a 0.4% gain to close at 12,612, while the S&P 500® Index climbed 0.6% to 1,452 and the Nasdaq® Composite rose 0.8% to 2,491. Currently, the S&P 500 Index is on pace to end the year with a 8.5% gain, which would be broadly in line with our view that stocks should experience a reasonably constructive year.
Expectations for U.S. economic growth have continued to fade over recent weeks. At present, the consensus view is that gross domestic product (GDP) growth will come in at a 2.0% rate for the first quarter and around 2.4% for the second quarter. Expectations for the second half of the year currently peg economic growth at around the 2.5% to 3% level, but those numbers have been trending downward as well..bmp)
There are some negatives in the global economic picture right now, but they are primarily concentrated in the United States (with the most notable being the housing slump). Weaker U.S. economic growth, combined with slowing corporate profit growth, has caused some to worry about the possibility of a recession. In our opinion, however, these fears are unfounded. Resilient income growth, jobs growth and employment levels are helping to keep the U.S. economy from slowing too much, and growth outside the United States continues to be strong. These factors should be enough to prevent the U.S. economy from sliding into a recession.
It is a tricky time for investors right now given all of the crosscurrents in the economy, so we thought it would be useful to take a look at some of the most important trends. First, we believe the U.S. economy will continue to grow at a below-trend level for at least another two or three quarters before returning to a somewhat higher rate of growth. Second, we think it is important to recognize that the world has shifted from a time when the U.S. consumer was the key engine of growth to a more broad-based set of stimuli — an environment that is more constructive for global financial markets. Third, we believe inflation will remain at reasonably low levels, but we recognize that inflation worries will persistently flare up given the backdrop of strong world growth and ongoing high energy prices. Fourth, we believe the U.S. dollar will remain somewhat weak given diverging economic growth prospects around the world. Finally, we expect global interest rates to remain relatively low.
So what does all of this mean for equities? The combination of slower economic growth and weaker corporate profits tells us that we are likely to see continued choppiness in trading levels, and additional corrective action is not out of the question. However, we continue to believe that attractive valuations should help stock prices to move higher over the course of the year. Additionally, although the Federal Reserve does not appear inclined to make any interest rate changes at present, we do believe that as evidence of slowing economic growth continues to mount, the central bank will begin cutting rates in the second half of the year, which would be a further benefit to stocks.
.bmp)
In the last week the S&P 500 gained as much as it did in the whole First Quarter (0.6%). The stock market has bounced back and year-to-date has generated a 3% return (S&P 500). Mid Caps are still outperforming Large Caps domestic stocks. Large Caps are now keeping up with Small Cap stocks after lagging for years. Growth is beginning to outperform value stocks reversing a long standing trend. The market volatility of late February and early March does not seem to be having a lasting impact on the market.
Despite this performance, the market is facing uncharted waters. Here are
Bob Doll's opinion of the state of the economy and particularly corporate earnings growth. He is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock.
Last week was a good one for stocks, with the Dow Jones Industrial Average posting a 0.4% gain to close at 12,612, while the S&P 500® Index climbed 0.6% to 1,452 and the Nasdaq® Composite rose 0.8% to 2,491. Currently, the S&P 500 Index is on pace to end the year with a 8.5% gain, which would be broadly in line with our view that stocks should experience a reasonably constructive year.
Expectations for U.S. economic growth have continued to fade over recent weeks. At present, the consensus view is that gross domestic product (GDP) growth will come in at a 2.0% rate for the first quarter and around 2.4% for the second quarter. Expectations for the second half of the year currently peg economic growth at around the 2.5% to 3% level, but those numbers have been trending downward as well.
.bmp)
There are some negatives in the global economic picture right now, but they are primarily concentrated in the United States (with the most notable being the housing slump). Weaker U.S. economic growth, combined with slowing corporate profit growth, has caused some to worry about the possibility of a recession. In our opinion, however, these fears are unfounded. Resilient income growth, jobs growth and employment levels are helping to keep the U.S. economy from slowing too much, and growth outside the United States continues to be strong. These factors should be enough to prevent the U.S. economy from sliding into a recession.It is a tricky time for investors right now given all of the crosscurrents in the economy, so we thought it would be useful to take a look at some of the most important trends. First, we believe the U.S. economy will continue to grow at a below-trend level for at least another two or three quarters before returning to a somewhat higher rate of growth. Second, we think it is important to recognize that the world has shifted from a time when the U.S. consumer was the key engine of growth to a more broad-based set of stimuli — an environment that is more constructive for global financial markets. Third, we believe inflation will remain at reasonably low levels, but we recognize that inflation worries will persistently flare up given the backdrop of strong world growth and ongoing high energy prices. Fourth, we believe the U.S. dollar will remain somewhat weak given diverging economic growth prospects around the world. Finally, we expect global interest rates to remain relatively low.
So what does all of this mean for equities? The combination of slower economic growth and weaker corporate profits tells us that we are likely to see continued choppiness in trading levels, and additional corrective action is not out of the question. However, we continue to believe that attractive valuations should help stock prices to move higher over the course of the year. Additionally, although the Federal Reserve does not appear inclined to make any interest rate changes at present, we do believe that as evidence of slowing economic growth continues to mount, the central bank will begin cutting rates in the second half of the year, which would be a further benefit to stocks.
First Quarter 2007 Performance Report
After enjoying a seven-month run of smoothly climbing stock prices, investors hit a nasty road bump in February. Despite the choppiness, the U.S stock market ended the quarter approximately where it started with the S&P 500 up just 0.6%. .bmp)
Once again the small (S&P 600) and the mid cap (S&P400) U.S. equity market outperformed their large cap brethren (S&P 500). Mid Caps ruled the roost, gaining 5.8% for the quarter. Small Caps turned in a more than a respectable 3.1%.
Value barely continued its run of outperforming growth in the large cap arena. The S&P 500 Growth ishares fell slightly while the Value ishares rose slightly during the quarter. The reverse was true in the small and mid cap stocks as growth edged out value.
The major indexes for most Asian markets were breakeven or down slightly for the quarter. The Shanghai exchange was the one exception. It led the February global sell-off and was down significantly. European stocks fared much better but returns were less than earned in the back half of last year. Overall, over-weighting in international stocks continued to payoff during the First Quarter as the international markets continued to outperform..bmp)
The market choppiness in stocks was caused by a familiar group of concerns: a slowing American economy, rising problems with risky mortgages and signs that fast-growing emerging markets like China and India might be due for a correction.
The turmoil was triggered in late February by the Chinese government stating that it wanted to cool down its market’s extraordinary growth. This caused a big drop in the Chinese (Shanghai) market, and a subsequent dip in stock prices worldwide.
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Once again the small (S&P 600) and the mid cap (S&P400) U.S. equity market outperformed their large cap brethren (S&P 500). Mid Caps ruled the roost, gaining 5.8% for the quarter. Small Caps turned in a more than a respectable 3.1%.
Value barely continued its run of outperforming growth in the large cap arena. The S&P 500 Growth ishares fell slightly while the Value ishares rose slightly during the quarter. The reverse was true in the small and mid cap stocks as growth edged out value.
The major indexes for most Asian markets were breakeven or down slightly for the quarter. The Shanghai exchange was the one exception. It led the February global sell-off and was down significantly. European stocks fared much better but returns were less than earned in the back half of last year. Overall, over-weighting in international stocks continued to payoff during the First Quarter as the international markets continued to outperform.
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The market choppiness in stocks was caused by a familiar group of concerns: a slowing American economy, rising problems with risky mortgages and signs that fast-growing emerging markets like China and India might be due for a correction.
The turmoil was triggered in late February by the Chinese government stating that it wanted to cool down its market’s extraordinary growth. This caused a big drop in the Chinese (Shanghai) market, and a subsequent dip in stock prices worldwide.
The 3.5% one-day loss experienced in the U.S. markets (in late February) is not unusual after the gains of the last seven months but it shook many investors which had become complacent. This left many investors wondering whether this was the beginning of the end of the four-year bull market that started in October 2002, or simply a pause.
Tuesday, April 10, 2007
Where are the markets going?
The current market turmoil shouldn't spoke investors but caution is still warrented. I enjoyed reading Bob Doll's weekly commentary which captures the spirit of current market activity. So here is his Monday commentary in full. Read and enjoy!
The Financial Pragmatist
Libby Mihalka
Weekly Investment Commentary
By Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock
April 9, 2007
The U.S. stock market seems to be following a pattern of one week being up and the next being down; and last week was one of the "up" ones, despite some mixed economic reports (the Institute for Supply Management's manufacturing index declined, while Friday's payrolls report was better than expected). Market sentiment was helped by the resolution over the issue of British sailors and marines being held by Iran as well as by continued high levels of merger-and-acquisition activity. For the week, the Dow Jones Industrial Average gained 1.7% to 12,560, the S&P 500® Index climbed 1.6% to 1,443 and the Nasdaq® Composite rose 2.1% to 2,471.
In our opinion, last week was fairly typical of the type of economic environment we expect going forward—that is, one in which economic growth slows, but not so quickly as to spark a recession. Additionally, we believe that lingering signs of economic strength will disappoint those who are hoping that the Federal Reserve will soon enact rate cuts. We do believe, however, that as economic growth continues to weaken, inflation pressures will recede, which should set the stage for the Fed to begin cutting rates in the second half of this year.
Over the next couple of weeks, investors will shift gears to focus on first-quarter corporate earnings. At present, consensus expectations are for first-quarter earnings growth to be around 3% to 4%, with overall 2007 growth levels to come in slightly below the 7% mark. For our part, we continue to believe that 2007 growth levels will be a bit below that—likely around the 5% area.
One factor that has been helping to push equity markets higher despite evidence of slowing economic and earnings growth has been ongoing corporate deal activity, which has been driven by a combination of high levels of cash available to companies and attractive equity valuation levels. We have been seeing high levels of stock buybacks, mergers and both public and private buyouts. In the first quarter, like the fourth quarter of last year, there was more than $1 trillion of reported deal activity, marking the first back-to-back quarters at that level since 2000. In our opinion, this environment is likely to persist until either the availability of capital dries up or until equity valuations rise considerably.
Looking ahead, we believe that the global economic backdrop remains healthy and conducive to continued good equity market performance. The potential danger of a hard economic landing in the United States remains, although we believe such an event has a low probability of occurring. Over the next few months, we expect markets to remain bumpy as investors digest ongoing news of slowing economic growth and weakening corporate profits growth, but do not believe these events will mark the end of the current bull market.
The Financial Pragmatist
Libby Mihalka
Weekly Investment Commentary
By Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock
April 9, 2007
The U.S. stock market seems to be following a pattern of one week being up and the next being down; and last week was one of the "up" ones, despite some mixed economic reports (the Institute for Supply Management's manufacturing index declined, while Friday's payrolls report was better than expected). Market sentiment was helped by the resolution over the issue of British sailors and marines being held by Iran as well as by continued high levels of merger-and-acquisition activity. For the week, the Dow Jones Industrial Average gained 1.7% to 12,560, the S&P 500® Index climbed 1.6% to 1,443 and the Nasdaq® Composite rose 2.1% to 2,471.
In our opinion, last week was fairly typical of the type of economic environment we expect going forward—that is, one in which economic growth slows, but not so quickly as to spark a recession. Additionally, we believe that lingering signs of economic strength will disappoint those who are hoping that the Federal Reserve will soon enact rate cuts. We do believe, however, that as economic growth continues to weaken, inflation pressures will recede, which should set the stage for the Fed to begin cutting rates in the second half of this year.
Over the next couple of weeks, investors will shift gears to focus on first-quarter corporate earnings. At present, consensus expectations are for first-quarter earnings growth to be around 3% to 4%, with overall 2007 growth levels to come in slightly below the 7% mark. For our part, we continue to believe that 2007 growth levels will be a bit below that—likely around the 5% area.
One factor that has been helping to push equity markets higher despite evidence of slowing economic and earnings growth has been ongoing corporate deal activity, which has been driven by a combination of high levels of cash available to companies and attractive equity valuation levels. We have been seeing high levels of stock buybacks, mergers and both public and private buyouts. In the first quarter, like the fourth quarter of last year, there was more than $1 trillion of reported deal activity, marking the first back-to-back quarters at that level since 2000. In our opinion, this environment is likely to persist until either the availability of capital dries up or until equity valuations rise considerably.
Looking ahead, we believe that the global economic backdrop remains healthy and conducive to continued good equity market performance. The potential danger of a hard economic landing in the United States remains, although we believe such an event has a low probability of occurring. Over the next few months, we expect markets to remain bumpy as investors digest ongoing news of slowing economic growth and weakening corporate profits growth, but do not believe these events will mark the end of the current bull market.
Tuesday, April 3, 2007
Small Cap GARP Fund
A good small cap fund is tough to find. A successful fund can find itself swamped with incoming new assets. It becomes difficult to stay in the small caps when assets under management reach over $500 million.
Summary of Investment Process:
When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies (i.e., a more-mature business that they can look at and learn from in order to assess trends in revenues, margins, etc.). A general rule with respect to the growth rates they are willing to use in the DCF models is that a company can only grow as fast as it can reinvest its cash flows. For example, if a company has a 10% return on investment, and is retaining 80% of earnings, by definition its cash flows can only finance 8% growth assuming the balance sheet items stay static, i.e., the company is not issuing stock or borrowing money. If a company says it’s growing much faster, the team is very skeptical and they would have to clearly understand where the capital will come from to fund the growth. Brayman is biased against companies that constantly dilute shareholders with equity or debt, leveraging up the balance sheet to sustain a higher growth rate. Generally speaking the “steady-state” growth rates used for the DCF are 5% to 6%, although some may be slightly higher at 7% to 8%. The rationale here is that Brayman also believes growth expectations are generally hyped and peak-to-peak earnings growth is about 6% over time, “yet every company is touted as a 15% to 20% grower in small-caps.” He says the reality is that the Russell 2000 growth rate is about half of the forecasted growth rate over time.
Sell Discipline:
Litman/Gregory Opinion
Here is a small cap fund that has only $115 million under management. Its track re.bmp)
cord is less than 2 years so it does not have a Morningstar rating. But its performance as a Small cap GARP (growth-at-a-reasonable-price) fund has been more than respectable. Morningstar catagorizes the fund as a growth fund but its style is more a blend. This is not an aggressive growth fund so its style will hoover between blend and growth (see the style performance chart).
.bmp)
cord is less than 2 years so it does not have a Morningstar rating. But its performance as a Small cap GARP (growth-at-a-reasonable-price) fund has been more than respectable. Morningstar catagorizes the fund as a growth fund but its style is more a blend. This is not an aggressive growth fund so its style will hoover between blend and growth (see the style performance chart).My only crticism is the fund is expensive because it charges a 12b-1 fee. I try to avoid funds that charge 12b-1 fees. But if you are looking for a good Small Cap GARP style fund the Champlain fund has alot to offer.
Below is some additional information on the fund from Litman Gregory.
Also here is the link to the firm's website.
The Financial Pragmatist
Libby Mihalka
February 2007
DUE DILIGENCE REPORT: Champlain Small Company Fund (CIPSX)
Manager: Scott BraymanCategory: Smaller-Cap Growth at a Reasonable Price
Manager: Scott BraymanCategory: Smaller-Cap Growth at a Reasonable Price
Over the past few months we completed due diligence on Champlain Small Company Fund. Our history with portfolio manager Scott Brayman dates back to late 2004, shortly after he left NL Capital Management (where he managed Sentinel Small Cap Fund) to start Champlain Investment Partners. After following the firm for almost two years, we resumed coverage and have since had several phone calls with Brayman and the three analysts, a face-to-face meeting with Brayman at an investment conference, and a visit to their Vermont offices. As a result of our research, we are adding the fund to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category, reflecting our confidence in the fund’s ability to perform at least as well as the benchmark over time. Approved is a designation that reflects a high level of selectivity, and few funds we research manage to clear this bar. Below is a summary of Champlain’s investment process, the firm/team’s background, and the basis for our favorable opinion.
Summary of Investment Process:
The investment focus is on buying small-cap companies with superior business models at a good price. Brayman defines a superior business model as one where a company earns a profit that exceeds its cost of capital. He believes investing in these good businesses at a good price is a high-probability path to wealth creation. Brayman thinks about capital preservation and strongly emphasizes managing business risk. He focuses on companies with more-predictable operating results, while trying to avoid companies with less reliable business patterns that can lead to big losses. Managing valuation risk is also important. The team looks to capitalize on Wall Street’s shortsightedness or overreaction to a company’s short-term problems, thereby limiting downside potential. In managing portfolio risk, Brayman builds a diversified portfolio of 75 to 100 names. His goal is to “build a portfolio that outperforms notably in three years, and compellingly in five years.”
Idea Generation/Fundamental Research:
The team starts with the S&P 600 as its investment universe, as they believe this benchmark offers a higher-quality group of stocks than the broader Russell 2000 Index. However, they look at numerous companies outside of the S&P index as well. The process for winnowing down the universe is based on a qualitative assessment of a company’s business models to determine if it’s the type of company they want to own. This qualitative assessment is based on a number of “sector factors” that are designed to highlight predictable (i.e., consistent operating results) and defensible business models, while minimizing exposure to factors that can create high variability in cash flow, and ultimately stock prices. Brayman emphasizes the word “minimize” because in some cases it’s difficult to completely steer clear of the risks that the sector factors are designed to avoid.
Brayman applies these sector factors to five major sectors: technology, health care, financials, industrials, and consumer. In technology, the sector factor is low obsolescence risk. Brayman thinks trying to correctly time the buying and selling of the latest hot tech product is a loser’s game. Owning these companies/products would force him to make too many decisions around the success of the product, determining the appropriate valuation, as well as the timing of trades, all of which he says increases the odds of a mistake and potentially a big loss. Instead, he looks to own tech companies with recurring revenue or those that sell a unique product. In the consumer sector, he looks for brand loyalty and tries to avoid brands going out of style. In health care, he wants to minimize exposure to government payors because changes in government reimbursement are too tough to call and can lead to big stock-price declines. In industrials, Brayman wants to avoid decisions centered on the timing of economic cycles, so he looks for problem solvers and innovators in the industry. In financials, he looks for companies that have a very strong niche because he believes large-cap financials have an advantage over small-caps due to their scale and therefore a comparatively lower cost of funds.
Brayman estimates that the sector factors eliminate about 60% of the universe. For the companies that pass the sector factors, Brayman looks for superior relative growth, low debt, quality earnings (i.e., positive cash flow), proven management, and strong company fundamentals. Touching on each of the components, Brayman is looking for the best growth opportunities within each of the five major sectors. He is constantly ranking companies in each industry (based largely on feedback from the firm’s three sector analysts) to see what stocks are the cheapest and why. As for the low-debt criterion, Brayman prefers companies that are able to grow their business organically, i.e., they don’t have to go to the credit markets to fund growth. Related to debt is the “quality earnings” attribute, which Brayman defines as strong cash flow from operations. When assessing management, Brayman looks to see how they manage the balance sheet, how it deploys capital, the deals management has done, how they have followed through on what they said they do, and how they manage inventories. Brayman also wants to see managements’ interests aligned with shareholders, who they have on the company’s board, the compensation structure, and how much “skin they have in the game.” As for company fundamentals, the team evaluates factors such as the competitive environment, barriers to entry, end-market opportunity, financing, and long-term growth expectations.
Valuation:
For companies that pass the sector factors and look appealing based on the company attributes listed above, the team then turns to valuation. They look at valuation from a few perspectives because Brayman believes valuation is an art and every valuation approach has its strengths and weaknesses. Their valuation methodologies include: an internally generated discounted cashflow (DCF) model, a DCF using HOLT (a third-party valuation tool), transaction-based analyses (if applicable), and historical valuations relative to a company’s history and its peers (although this last approach gets little weight). As part of their valuation analysis the team runs through scenario analysis (particularly with the DCFs) to get an understanding of what the big swing factors are in order to get a sense for the range of outcomes. Because each valuation approach can result in a different price target, the team uses a weighted-average of the different results, where they give the most weight to their highest-conviction valuation.
When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies (i.e., a more-mature business that they can look at and learn from in order to assess trends in revenues, margins, etc.). A general rule with respect to the growth rates they are willing to use in the DCF models is that a company can only grow as fast as it can reinvest its cash flows. For example, if a company has a 10% return on investment, and is retaining 80% of earnings, by definition its cash flows can only finance 8% growth assuming the balance sheet items stay static, i.e., the company is not issuing stock or borrowing money. If a company says it’s growing much faster, the team is very skeptical and they would have to clearly understand where the capital will come from to fund the growth. Brayman is biased against companies that constantly dilute shareholders with equity or debt, leveraging up the balance sheet to sustain a higher growth rate. Generally speaking the “steady-state” growth rates used for the DCF are 5% to 6%, although some may be slightly higher at 7% to 8%. The rationale here is that Brayman also believes growth expectations are generally hyped and peak-to-peak earnings growth is about 6% over time, “yet every company is touted as a 15% to 20% grower in small-caps.” He says the reality is that the Russell 2000 growth rate is about half of the forecasted growth rate over time.
As part of the team’s valuation work, they also look at what they call “strategic value.” The team evaluates if each company has “something really special” that a larger company might be interested in acquiring. For example, if a small company has a great product but no distribution, a large company might easily fold it into its business. For these types of companies, they will selectively increase the target price by a “nominal” amount, generally no more than 10%. The team also adjusts for the dilution of options.
As for the degree of the discount at the time of purchase, the team tries to buy at a 20% to 25% discount. They will accept a somewhat lower upside for a “rock-solid company.”
Portfolio Construction: The portfolio consists of approximately 75 to 100 stocks of small companies, and to a lesser extent medium-sized companies. Position size is a function of business risk, liquidity, and valuation discount. More-predictable business models with a longer operating history will typically be larger holdings, not necessarily the cheapest stocks. Smaller positions generally have less operating history or higher levels of perceived risk. Brayman has loose sector-weighting guidelines (no more than 25% of the fund’s assets will be invested in any one industry), and overall sector weighting are a byproduct of bottom-up stock selection, not a sector call. The fund is managed close to fully invested.
Portfolio Construction: The portfolio consists of approximately 75 to 100 stocks of small companies, and to a lesser extent medium-sized companies. Position size is a function of business risk, liquidity, and valuation discount. More-predictable business models with a longer operating history will typically be larger holdings, not necessarily the cheapest stocks. Smaller positions generally have less operating history or higher levels of perceived risk. Brayman has loose sector-weighting guidelines (no more than 25% of the fund’s assets will be invested in any one industry), and overall sector weighting are a byproduct of bottom-up stock selection, not a sector call. The fund is managed close to fully invested.
Sell Discipline:
The team generally begins to trim a holding when it is within 5% to 10% of its estimate of fair value, and in most cases will sell completely when a stock hits fair value. But if a stock has a lot of price momentum (and fundamentals remain strong) the team may not sell completely in an attempt to take advantage of Wall Street’s optimism. Explaining this, Brayman says, “Historically we know that markets and stocks tend to overshoot. If they want to overshoot, we’ll let them, but we begin a program of systematically cutting back on a stock.” The team also has a “down 25% rule,” where they have to take a fresh look at the stock if it is down by 25% from the time of purchase, but in practice the team is taking a close look when the stock is down 10%.
Firm/Team Background
Champlain Investment Partners was founded in 2004. All key professionals at Champlain (both investment-team members and business operations) formerly worked together at National Life Group’s investment-management subsidiary, NL Capital Management. The four-member investment team is led by Brayman, and the fund is run using an investment process that has been in place since 1996.
While Brayman is responsible for making the final investment-management decisions, the three analysts play an integral part in generating investment ideas. The three analysts are divided by sector: health care, technology, and consumer. Brayman covers financials, industrials, and energy. Each member of the team applies the investment process to the names in their sector, determines fair value for each stock, and then recommends buy and sells.
The analyst team is made up of Van Harissis, who covers consumer stocks. Harissis has more than 20 years of investment-management experience, and prior to joining Champlain his most-recent role was lead portfolio manager for Sentinel Common Stock Fund and co-manager of Sentinel Balanced Fund. David O’Neal covers health care. Prior to joining Champlain, he was a health care equity analyst for the small-cap and mid-cap equity products at NL Capital Management. Daniel Butler follows technology. His most recent experience was as a technology analyst for Sentinel’s small-cap product.Champlain offers a small- and a mid-cap product, and the investment team is responsible for both strategies. The mid-cap product (which is currently only available via separate accounts) is often made up of companies that the team owned in its small-cap strategy, and with which they are very familiar, that migrated up in market cap as a result of their success. The only difference between the small- and mid-cap products is market capitalization. The mid-cap product can only buy stocks with a market capitalization above $1.5 billion. Brayman targets a median market capitalization of $1 billion for the small-cap product versus $4 billion to $6 billion for the mid-cap product.
As of year-end, Champlain manages approximately $585 million in domestic equity assets (including mutual fund and separate-account assets). The vast majority of assets are in small-cap.
Performance
When assessing Brayman’s performance, we take his record from Sentinel Small Company Fund into consideration, which he ran from late 1995 until he introduced Champlain Small Company Fund in November 2004. One important consideration in evaluating Brayman’s record is that there was a meaningful change in the number of portfolio holdings. Brayman started running this strategy at NL Capital in 1996, and for the first two years, Brayman was basically a one-man shop and held an average of 50 holdings. As he grew the investment team, the number of names increased. Since 1999, the portfolio has held between 75 and 100 names. Brayman contends that the higher number of names does not dilute the portfolio’s upside potential. A larger team means they can cover more ground, and Brayman’s experience is that a lot of the upside comes from interesting emerging-growth ideas, which are names that he’s confident in but doesn’t want an above-average position size for liquidity or increased risk reasons. As Brayman puts it, “Large positions are positions I’m more comfortable with. If I’m comfortable with them, a whole lot of other portfolio managers are also comfortable with them. Big gains come from names that others are uncomfortable with. But as management proves itself and peoples’ confidence goes up, there’s tremendous price upside.” Despite the increase in names, we think Brayman’s entire track record is applicable. He is still the lead portfolio manager and he is still using the same investment philosophy and process.
Since the beginning of his record, Brayman’s annualized return (through December) is 14.7% compared to 9.8% for the Russell 2000 Index iShares. (Note: Prior to the iShares’ inception, we use the Vanguard Small Cap.) A big component of Brayman’s strong outperformance is due to very good absolute and relative performance in 2000, when the fund was up 38.9% compared to a 3.8% loss for the benchmark. Outperforming in a down market is consistent with our expectations for the fund, although the extent of the outperformance in 2000 is not something we’d bank on in the future. Qualitatively, we expect the fund to lag its benchmark during strong small-cap markets, and outperform in average or weak environments, particularly when there is a flight to quality such as in calendar year 2000. Our view is based on the team’s clear focus on buying companies with consistent earnings and attractive valuations.
The fund’s historical record highlights the success of the downside risk control. Since 1996, the Russell 2000 iShares benchmark had 35 periods where rolling 12-month returns were negative. The average loss during these negative periods is 11.3%. During those same 35 periods, Champlain Small Company Fund suffered a loss in only 16 periods, and the fund’s average return was a 0.2% gain. The fund’s worst 12-month performance is a 19.9% loss, compared to a 27% loss for the benchmark. The fund has also beaten the benchmark in up markets. Since 1996, there are 86 rolling 12-month periods where the Russell 2000 iShares was positive.
During those periods, the fund’s average gain is 21.7% versus 20% for the benchmark. The fund’s best 12-month gain was 47.8% compared to 64% for the benchmark. Looking at the fund’s consistency over rolling three-year time frames, the fund has beaten the benchmark in 81% of the periods. The 10-year-plus track record provides evidence that this disciplined investment process has led to a high degree of consistency.
Litman/Gregory Opinion
As a result of our research, we feel there are a sufficient number of positives to warrant adding Champlain Small Company Fund to our Approved list in the Smaller-Cap GARP category. Below are the key positives that underlie our opinion.Champlain employs a thoughtful and well-laid-out investment process that’s designed to stack the odds of success in their favor over time. The team uses an uncommon process for generating ideas via the sector-factor criteria, which not only creates clear-cut parameters for what qualifies as a buy (or a sell in the case of a changing business plan), but aids in minimizing the likelihood of an unexpected negative surprise. In our conversations with the team, the decision-making process was clearly articulated and conversations with each of the team members made it extremely clear that the process is applied consistently. The team sticks to its circle of competence.
There is a focus on capital preservation and elements of conservatism are apparent throughout the process. The team looks for investments with a clear eye towards preserving capital (such as consistent earnings, attractive valuations, sound financials, and proven management) in order to increase the probability of a favorable outcome. By lining up these attributes, the team believes it has gone a long way to make sure the portfolio is set up for long-term outperformance. There is a definite focus on avoiding a big downside move, and the team consistently demonstrated that they are willing to be patient (and even miss out on some of a stock’s upside) to ensure that operating fundamentals are intact and they won’t have a big negative surprise on the downside.
The team does thoughtful quantiative analysis. We find their analysis to use realistic, conservative assumptions that are based on an understanding of the company, its history, and the industry, as opposed to unique insights, superior number crunching, or better information gathering. Although we don’t think the team wins by gaining an information edge, there’s a clear focus on gaining a solid understanding of the issues that could negatively impact the business, and making sure a sufficient margin of safety puts the probability of being right in their favor.
Their qualitative thinking comes out in the team’s valuation analysis where they take a well-rounded view and look at a number of methodologies and scenarios. Their goal is to be aware of their assumptions and what the sensitivities are to those assumptions. In Brayman’s words, “The more scenario analysis you do, the more probability-weighted thinking you do, which helps you to understand the potential risks.” They also have an interesting way of thinking about valuation with their “strategic value” component. Our discussions about companies where the team applied a strategic value component to its valuation assessment served to emphasize the team’s knowledge of companies and the industries.
Another positive is the team’s stability. We recognize that Champlain is only two years old, but the team has worked together previously and in our conversations with Brayman, he clearly wants to build a team that stays together. All but one of the team members has equity and Brayman is planning to give the remaining member equity in the near future. The ownership in the firm makes investment-team departures less likely.
Brayman is also shareholder-oriented. He strikes us as someone who wants to win for shareholders. He conveys a sense of high integrity, and there are clear signs of intellectual honesty as well as a willingness to admit mistakes and cull losses; there are no signs of hubris. Brayman is very mindful of assets and plans to close the fund at $1.5 billion, a level we find reasonable. Expenses are reasonable at 1.4% given the relatively small asset base.
Our decision to add the fund to our Approved list reflects our confidence in the fund’s ability to perform at least as well as a benchmark, if not better over time. As such, we would be comfortable using this fund as an alternative to an index fund. We reiterate that Approved is a high hurdle for us, and as always, we will continue to stay in touch with the team and provide ongoing updates.
While there are enough things to like about Champlain Small Company Fund to give us the confidence to add it to our short list of Approved funds in the Smaller-Cap Growth-at-a-Reasonable-Price category, we are not able to gain a high enough degree of confidence to get to Recommended. We reserve Recommended for funds that have a clearly identifiable investment edge, giving us a high degree of confidence that the fund will beat the benchmark over the long term. In the case of Champlain, we feel that they do several things well, all of which stem from a well-thought-out and consistently applied investment approach. But in the end, we couldn’t identify a specific, clear cut edge. For example, we thought both their qualitative and qualitative analysis was good in that it was thoughtful and well-reasoned, but we did not identify an edge or something that they clearly do better than the competition. When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are often based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies, as opposed to unique insights gained by digging deeper than the competition. At the same time, there’s an element of conservatism that’s used in their models, where the team doesn’t need to make aggressive assumptions in order to be right on the stock.
We think this is a positive, but again, by itself it’s not a clear edge. In the end, determining an edge is somewhat subjective, and we recognize that Champlain’s process itself may provide them with an edge. However, we don’t feel strongly enough that this is the case to recommend the fund outright.
As for concerns, we don’t have any major issues. One area we will continue to monitor is the growth of the team’s mid-cap product. Currently the mid-cap separate account is only $1 million, but the team is considering the introduction of a mid-cap mutual fund. To the extent that this product grows and detracts from the amount of time the team is spending on small-cap (either through following more names or additional marketing efforts) we would view it as a negative. All else equal, we favor teams that focus on a specific strategy.
—Jack Chee
_________________________________________________________________________________Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.
—Jack Chee
_________________________________________________________________________________Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.
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