Why smaller can be better for equity investors

When it comes to investing in a managed investment strategy -- a mutual fund, for example -- many investors do not realize that total amount of assets under management (AUM) can be an important differentiating factor in the portfolio's performance.

For example, an equity investment strategy with fewer AUM, say below $2 billion, has far more investment choices than a strategy with AUM in the tens of billions of dollars.

The reason for this situation is fairly straightforward, although it is not widely discussed in popular investment literature. 

Imagine a mutual fund which owns 50 stocks in different promising businesses, allocating 2% of the total portfolio to each company in the portfolio.

If the fund has $100 million in total assets under management, the hypothetical portfolio described above would buy $2 million worth of shares in each of the 50 different stocks. 

However, if the same hypothetical fund had $10 billion in total assets under management, the same 2% per company would now amount to $200 million worth of shares in each of the 50 different stocks.

There is a big difference between buying $2 million worth of shares in a company, and buying $200 million worth of shares in the same company. 

For one thing, placing a trade for $200 million of shares in a company will move the price of that stock much more, even if the company in question is very large with a large volume of shares traded each day.  And it will usually necessitate several days of carefully-considered trades in order to move into (or out of) that complete 2% position during which time its price can fluctuate.

But an even bigger problem for the larger fund is the fact that its sheer size will make placing 2% into many companies an impossibility, without buying the company altogether, or buying such a large share of the company that the portfolio would own 20%, 30%, or even 50% of the company (depending on the total market capitalization of the company).  

A fund with $10 billion in assets under management cannot even invest 1% in the stock of a company with a market capitalization of $100 million without buying that company completely, or in a company with a market capitalization of $200 million without buying half of the entire company. And if the fund goes up to $20 billion, then the fund cannot put 1% into a $200 million company without buying the entire thing, or into a $400 million company without ending up owning half of the entire company. 

Most investors will also understand that putting less than 1% of a portfolio into a company is not really very productive: if that company turns out to be a real winner, it won't really create very much gain if the portfolio only has 1/2 of a percent allocated to that company (hardly worth the time it takes to thoroughly research that company and to monitor its performance over time).

There are literally thousands of innovative companies with market capitalizations below $1 billion which are effectively too small for many large funds. In fact, out of the roughly 4,000 publicly-traded companies in the US listed on the major exchanges, more than 2,000 of them have market capitalizations below $1 billion, and over 2,500 have market capitalizations below $2 billion (as of 12/09/2016). 

This means that over half of the companies trading on the major exchanges will be effectively "off limits" for practical investment for a mutual fund with tens of billions of dollars in assets under management, simply by virtue of the fact that those funds are too large to be able to take a position in those smaller companies. 

To make matters worse, many of the biggest opportunities for growth will be found in companies with smaller market capitalizations. Companies that have only recently gone public, for example, may begin their careers as public companies with market capitalizations in just this capitalization range. For example, the innovative Internet-of-Things company Impinj* (ticker symbol PI) came public in July of 2016, and its current market capitalization is in the neighborhood of $600 million.

A fund with $60 billion in assets simply cannot invest even 1% in this name without buying the entire company (thereby taking them private again), while even a fund with just $15 billion in assets cannot take a 1% position of Impinj in its portfolio without owning 25% of the entire company.

However, a fund with only $1 billion in assets, or even $2 billion in assets, would have no trouble taking a position of 2% in a $600 million company like Impinj.

If you think of the job of running an investment strategy as somewhat analogous to participating in a fantasy football league, the reality described above basically means that portfolio managers of larger funds have more and more potential "players in the league" off-limits to them -- and the number of potential players who become off-limits grows as the investment portfolio gets larger. At around $2 billion and upwards (in terms of AUM), investment portfolios begin to have a harder and harder time investing in small-capitalization companies.

Note, however, that while a portfolio manager with tens of billions of assets under management cannot effectively own smaller capitalization names, a portfolio manager with fewer assets under management can still invest in BOTH larger and smaller capitalization companies without any problem. 

Investment options diminish as an investment strategy gets bigger,as does the speed with which the strategy can buy or sell an investment position. For these reasons, we believe that for some investment goals, investing in funds with fewer assets under management can offer greater opportunity.

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* Disclosure: at the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Impinj (PI).

An Historic Election

The 2016 U.S. presidential election was clearly a watershed in American politics, if for no other reason than because a person who has never held any political office has made it to the highest ranking office in the nation and, once again, America sets the stage for peaceful change.  That said, we will keep it brief and stick to the effects we think the transition will have on the economy and our portfolios.

As many who have followed our writings in the past know well, we have been highly critical of the heavy-handed role of government into the affairs of the private sector in the 21st century.  We believe anything that can stem the tide of government overreach will be a boon to the economy, and ultimately the worth of companies.

As it relates to the economy, Donald Trump's campaign focused on three primary policy objectives: trade, regulation, and taxes.  Specifically, he claimed he would "renegotiate" trade agreements like NAFTA (North American Free Trade Agreement) and TPP (Trans Pacific Partnership) and levy tariffs on goods entering the U.S. that are made in countries like Mexico by U.S. companies manufacturing there.  With respect to regulation, he suggested he would reduce, or even eliminate regulatory regimes like Dodd-Frank and Sarbannes-Oxley, which have served to inhibit business formation and expand the already burdensome size of government bureaucracy.  As for taxes, he supported "across the board" tax cuts on both individuals and businesses, most importantly advocating for a reduction in the U.S. corporate income tax rate (which currently the highest of all developed countries at 35%; he wants it cut to 15%) as well as simplification of the tax code.

We could not be more emphatic in our support for the latter two objectives of President-Elect Trump.  Anything that can be done to reduce the tax burden on businesses, both large and small, will help the economy and ultimately the employees (and future employees) of those businesses. The same holds true for the reduction of burdensome regulation on businesses.  Sensible regulation is one thing but, today, regulations have become more about promoting political "pet projects" than ensuring safety and adherence to common sense best practices.

As for trade policies, we believe that it would be a mistake to become protectionist in today's global economy.  Like it or not, globalization is here to stay and denying that will only serve to reduce the standards of living for all American's, as well as for consumers in the rest of the world who buy our goods and services.

At the end of the day a tariff is a tax on consumers, and while there is no doubt that other countries (including the United States) try to "protect" certain favored industries and workers, in this case, two wrongs don't make a right and it does no good to exacerbate trade wars.  Mr. Trump is a real estate investor by trade, and, as such, is comfortable negotiating. To the extent he can "negotiate" equitable trade deals, we wish him the best, but it should by no means be at the expense of free trade!

Fortunately, the incentives that would be created by fixing the tax code and reducing regulations may well solve many of the problems of lagging capital investment that has plagued the rust-belt areas who so emphatically supported Mr. Trump and have been understandably frustrated by the lack of new jobs.  Almost $3 trillion dollars in U.S. company cash sits overseas because it would be taxed at 35% if it was repatriated to the U.S. Unlocking that cash would go a very long way in promoting the necessary capital investment that would help propel many of the hardest hit areas in the country.

Regardless, the two points of policy we believe are very favorable, regulatory reform and tax reform, will be much easier to enact and will be well on their way to helping the economy before any poor trade policy could ever be enacted.  In fact, we believe it is unlikely that any seriously damaging trade policies would ever make it to realization.

All in all, we are very encouraged and hopeful by the prospects of the changes we have discussed.  We look forward to seeing these put into practice because if they are given the chance, all Americans  will be better off.

Investment Climate October 2016

The stock market recovered nicely in the third quarter after the “panic” over the Brexit vote subsided and the focus turned to the slow but consistent growth in the economy that has prevailed for a number of years now.  Markets in general, as well as our Core Growth Strategy, ended the third quarter with a year-to-date return in the mid-single digits.  

While some would marvel over the market’s move upward since the 2008-9 debacle, we believe that viewing market performance with a start date of March 9, 2009 (the day the market bottomed in the wake of the crisis) is a big mistake.  While we are pleased, and frankly, not surprised that the market has recovered from the depths of its decline in 2009, we are dismayed at the significantly below- average growth in the economy, and in the price of the average stock over the course of the last 15+ years.  Although during that period we have witnessed outperformance in our Core Growth Strategy versus the market in general, we have not seen the kind of growth we would have expected considering the massive technological advancements that have benefitted the world over that same period of time.

We will begin by emphasizing that we are more confident than ever that the types of companies we focus on in our strategy are poised for significant success which we believe will be reflected in their stock prices in the years to come.  But why has it been such a slow slog forward?  

Simply put, the “investment climate” of the last 15 years has not been ideal, and particularly it has not been well-suited towards entrepreneurial activity and capital investment.  The reasons for this are plentiful, and have been discussed before, but to recap what we believe to be the primary culprits: government intrusion into the affairs of free enterprises has been, at best, meddlesome and, at worst, stultifying.  With all good intentions, and in the wake of scandals like Enron and Worldcom in the late 1990s, and the mortgage/housing/ financial crisis in 2008-9, the politicians “acted” by giving us regulatory regimes like Sarbannes-Oxley and Dodd-Frank (with its offspring, the Consumer Finance Protection Board) that has made it increasingly difficult for businesses (especially smaller ones) to navigate the already complex web of regulations.  If there is need of evidence of this problem, to us -- professional investors who seek out growing businesses for a living -- one need look no further than the dearth of initial public offerings (IPOs) of common stock in the last 15 years.

This drought has become an epidemic, in our view.  While there have been fits and starts in the IPO market over the last few years, the general trend has been abysmal for so long that it has considerably limited our ability to find new growing companies in the public markets.  This is, in our view, the single most important issue facing the investor today!

Fortunately, we believe we have such a formidable group of opportunities in our strategies for growth investing in both public and private companies that we don’t fear this situation, yet.  As previously mentioned, we have never been more confident in the positions we have taken in both public and private holdings.  However, it does concern us for the future, and particularly future generations of investors, that this drought in new business formation has run for so long.  As we have said for years, echoing our mentor Richard C. Taylor: “we get by in spite”.  When Dick spoke those words he meant to describe the errors of the ways of those who have over-intruded into the private affairs of businesses, just as we have witnessed in the last 15 years.  

While we acknowledge the challenges that such intrusions place on businesses, we are optimistic that the remarkable business men and women who run the companies we own will shine regardless of what unintended hurdles are foisted upon them.  Doug Waggoner from Echo Global Logistics, Eyal Waldman from Mellanox Technologies, Colin Reed from Ryman Hospitality Properties, Arkadiy Dobkin from EPAM Systems, Anat Cohen-Dayag from Compugen, Jules Urbach and Alissa Grainger from OTOY, just to name a few, are examples of the brilliant and committed stewards of our companies who, with their entrepreneurial spirit and innovative products and services, are impacting our world.  Fortunately, we can benefit as we standby and watch them do their work!

Passive Investment and Marxism!

We were very pleased to see someone else pointing out the potential negative societal aspects of passive investment, even going so far as to compare the phenomenon to something worse than Marxism!

This Bloomberg article highlighting commentary from investment firm Sanford C. Bernstein Co., LLC, hits the nail on the head.

Hooray! we say.  We just wish more financial industry folks would speak up on the subject.

We've been writing about it for a long time:

December 2015: "Get Out of the Market"

August 2015: "Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets"

July 2014: "The 'passive' investing myth"

August 2012: "Who's right Bill Gross, Jeremy Siegel?  Answer: George Gilder"

December 2011: "The fantasy world of modern portfolio theory"

June 2011: "New investment idea: invest in good businesses"

July 2010: "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital"

October 2009: "S&P takes aim at active management"

May 2008: "The active vs. passive debate"

November 2007: "Would you prefer options linked to your company or the S&P 500?"

Stay tuned as we will keep on the topic!

"Boring Markets"...Really?

We came in to work this morning and the first thing we looked at was a daily market commentary from a major Wall Street firm whose first words were "Market Update - another boring and quiet day in US equities...."  Mind you, we are in no way trashing this Wall Street firm, although they will remain unnamed (they, and anyone who reads their work know who they are).  We would add that this is one of the few Wall Street firms we respect for doing some very good research on publicly trading companies.  But the comment just underscores an underlying problem in the way the world views the role of the market.

We are fully prepared to accept that we just may be ornery as we enter our sixth decade of managing money professionally for ourselves and our clients, but it occurs to us that the mentality that views the market as "boring and quiet" has grown to put too much emphasis on the "market" than is healthy.

Clearly, we are picking on this one commentary, and we admit that it's not fair to that firm, for they are by no means alone.  We would posit that most of the "investment firms" (we use that term skeptically) on the street, are anything but and have become gigantic trading houses, or as some may better describe them, giant gambling casinos!

Our patriarch and mentor, Richard C. Taylor used to reference the concept that one could put capital at risk in three possible ways: by gambling (relying on pure chance), speculating (relying on an educated guess), and investing (relying on thorough research and business-related knowledge over long periods of time).  He was certainly not the first one to put these three terms together in an effort to differentiate them, but it was definitely at the heart of his investment process and we carry on that idea today as we deploy capital.

The problem, in our assessment, is that far too much of the focus with respect to capital deployment is dedicated to the first two types of risk.  In fact, we would argue that much of what is considered "investment" nowadays is, at best, speculation and more likely simply gambling.  We believe this is having negative ramifications for true investment, as we define it above.

Why is this important?  Because the economy depends on capital investment.  Without it, the system we adhere to, entrepreneurial capitalism, simply is not allowed to operate at full potential.  As the investment world moves towards schemes that are more aligned with speculation, and even gambling, it loses perspective on investment and thus distorts the allocation of capital, creating dislocation that affects the economy, and ultimately all of us.

Perhaps an example will best illustrate the predicament.  Our good friend and venture capital partner, George Gilder, in his recent book, The Scandal of Money: Why Wall Street Recovers But The Economy Never Does, points out that each day over $5.3 trillion dollars (with a T) trade in the world foreign currency markets.  This is astounding!  This is capital that is essentially trading on a guess (at best) and can most appropriately be categorized as gambling.  We have long said we have no problem with traders.  They are very necessary to provide liquidity to the market.  But this is an example of the tail wagging the dog!  We can assure you that not even close to $5.3 trillion dollars is being invested in innovative, entrepreneurial companies in a year.

In  February 2009, our Chief Investment Officer, Gerry Frigon, gave a speech before a business symposium on the Central Coast of California.  This was in the midst of the mayhem caused by the mortgage and credit crisis.  In it, he described the need to get back to investment for investment's sake.  In other words, stop trying to game the system, and look at businesses as the investment, not the "market".  

Some people may think that investing in innovation that may take a few years to really make a difference is "boring," but we don't think so at all -- and we believe it is much more beneficial and necessary for economies, and ultimately much more beneficial for investors (as opposed to "gambling," which may be exciting but is often quite bad for investors). 

It would appear that we still need to be giving that speech.

Investment Climate: The Importance of Brexit

What a crazy few weeks in world markets!  The second quarter was shaping up to be a decent rebound from the sloppy start in January,  but the markets made an abrupt about-face and sold off dramatically in the wake of the vote in Great Britain to leave the European Union. The “Brexit” vote was a surprise to most speculators/traders who had taken the consensus bet that it would never actually prevail.  The consternation and teeth gnashing emanating from the “elites” in both Europe and the U.S. was so pervasive and fierce you would think the world as we know it was truly ending!  In our view, it was another case of “here we go again.”  

How many more tales of impending doom, which simply don’t come about, do we need to hear before the sober world of investors takes hold?  Somewhat surprisingly, the market may finally be tiring of these pundits of pessimism since, as of this writing, barely three weeks after the June 23^rd Brexit vote, the stock market averages have powered to new highs, ignoring the sirens of the elite class.  

On the day of the Brexit vote results, we posted on our blog (entitled “Don’t Fear Brexit”) that we believed the vote was a significant positive step toward rebuking the decades-long degradation of Western Europe at the hands of “democratic Socialism.”  A system that has resulted in perpetual sub-par growth throughout the European continent.  

It was our stated belief in 1989, when the talk of a “United States of Europe” was taking hold and the stage was being set for the European Union’s formation, that it would be extraordinarily difficult to achieve monetary and economic union without political union.  Essentially, without a U.S.-style constitution the project was destined to have major problems.  While we certainly argued for the benefits of a common currency amongst nations so closely tied geographically and economically, it was that stubborn political and even cultural difference amongst these same countries that we thought would be at least problematic and potentially fatal to the union.  If those political issues were not eventually dealt with (sooner rather than later) at some point a break would ensue.  The beginnings of that break appear to be underway.  

The lack of a truly “democratic” political structure, and, in fact, what turned into the equivalent of “taxation without representation” via the bureaucratic, unelected European Parliament in Brussels finally reached a breaking point as the British people decided they were tiring of having mandates forced upon them by people they had no say in putting into power.  Worse, these same bureaucrats advocated a level of socialistic control over the Europe that has resulted in the weak economic growth, to which we previously described, and a series of financial train wrecks such as the Greece mess, which we have discussed at length in past commentaries.

To reiterate, it is our view that the events in Europe are a very positive step in beginning the healing process from decades of mismanagement in Europe.  However, we would strongly emphasize that this in no way means that we are taking an “anti-globalist” view in our positive reaction to these events.  It does not mean we favor trade protectionism in any form.  We thoroughly endorse the free flow of trade amongst nations and would agree that a positive byproduct of the European Union has been the role it has played in keeping peace on the European continent for the longest time in world history.  So it is imperative that one not misread our support of Brexit and a retooling of the order in Europe as support for those forces that would throw up tariffs and other protectionist obstacles in the way of economic progress, or use misplaced nationalism to allow for the rise of bad actors the likes of which caused two world wars in Europe. 

However, as was our view in 1989, a U.S. of Europe, along with a constitution and bill of rights, is not going to happen across the European continent any time soon.  Probably never.  That being the case, in order for truly free enterprise to flourish, it is crucial that those forces propagating the exercise of freedom, in all forms, be allowed to flourish.  If those forces emanate from places like a sovereign Great Britain, a country with a recent history of promoting free enterprise, then that is a step in the right direction.  Perhaps it is enough to stem the tide and swing the pendulum back towards policies that are less intrusive on businesses and citizens alike, and promote economic growth through low taxes and easy access to capital markets across the globe.  Maybe it will encourage a similar movement in the U.S of America, which is growing like Europe of the last five decades (weakly) under the weight of ever more regulation and taxation; a topic we have harped on in these commentaries for years.  For while great companies can still succeed in spite of these intrusions, they would flourish all the more in an environment more favorable to business formation.

Don't Fear Brexit

In 1989, as we were hearing about the benefits of the "United States of Europe", we can clearly recall our skepticism over the noble idea of creating a common currency throughout Europe without a clear political union to go along with it.  Was it reasonable in an area so geographically tied together to have a common currency to allow business to transact their trade across the many borders in a more effective way?  Absolutely!  Yet it seemed impossible to us to think that the myriad cultural differences throughout that same geographic region would allow for that necessary political cohesiveness.  Essentially, our thoughts were that without a U.S.-style constitution, it seemed improbable, at best, that the experiment would succeed.

Yesterday, voters in the United Kingdom dealt a devastating blow to the experiment of a "United States of Europe" with their vote to leave the European Union.  The "elite" of Europe, and throughout the world, including America, warned of cataclysmic ramifications if the vote to leave were to win.  We believed all along that was ridiculous and continue to believe so in the wake of the approval by the British people to leave the Union.  Not only do we think that it is ridiculous to think that Brexit would be cataclysmic, we believe the historic vote is a step in the right direction towards exposing the failure of socialism in Europe and throughout the world!

Whatever negative reaction happens in the markets today or over the course of coming weeks and month, related to fear over this movement, we believe it will be short-lived.  We stand ready to take advantage of any weaknesses to add to our holdings in great, innovative companies run by the solid entrepreneuers who make our capitalist system so vibrant.

Stay tuned for more updates on this amazing turn of events.

Higher Interest Rates....Please!

We have written about this issue for so long now it is hard for us to imagine it is still necessary to do so; however, we feel compelled to reiterate how important we think it is for the US Federal Reserve to continue the nascent increase in interest rates it began late in 2015.  Obviously, the era of "Zero Interest Rates" (ZIRP) has ended, but the ramifications still endure as long as the Fed continues to hesitate in getting on with pushing their target for the Federal Funds Rate up.

We now live in a world where Central Banks in Europe and Japan actually think a "Negative Interest Rate Policy" (NIRP) is a good thing, so in "relative" terms, the US Fed is thought of as "tight"!  This is all crazy!!  These extended years of ZIRP and now NIRP are causes of slower economic growth, not "stimulative" policies that are helping the world economy.

Last week we had the pleasure of meeting with our distinguished Board of Advisors member, VC partner and best-selling author George Gilder in the Silicon Valley and this topic was at the forefront. George's view (which is well spelled out in his latest book, The Scandal of Money) is that these policies fail because they are actually valuing time far too low, thereby creating a lack of urgency or incentive to innovate.  The old adage "time is money" really gets turned on its head in a world which values time as worth zero -- or less than zero, in the case of NIRP!

This is not going unnoticed any longer as both German and Japanese bankers are realizing that the NIRP world is creating uncertainty for their their customers and, as a result, hurting them.  The following excerpt from a Wall St. Journal article regarding Japanese banks underscores the problem:

MUFG President Nobuyuki Hirano in April became the first top Japanese banking executive to publicly criticize the BOJ's negative-rate policy, saying it had actually caused households and businesses to rein in spending by creating a sense of uncertainty about the future. "For the banking industry, the consequences, at least in the short term, are clearly negative," Mr. Hirano said in a speech in Tokyo.

The Germans are protesting these policies as well, as this Reuters article on the topic points out:

. . . some banks complain that a dim global economic outlook means there is weak demand for loans on the terms they require, and they have little option but to hoard cash.

The "hoarding" of cash is not a good thing! This is all part of the argument that Gilder is making when he says:

Since time is the scarcest of all scarce resources, the fact that the market values it at zero creates an environment where there is no sense of urgency to create or innovate.

Our last two posts have emphasized the fact that we are suffering from a lack of IPOs coming to market.  This all fits together in the sense that the ZIRP and NIRP world has at least served to exacerbate that phenomenon if not been a primary culprit in this predicament.

Follow-up on the IPO conveyor belt disconnect

We certainly don't agree with Mark Cuban on everything, but we give him credit for continuing to hammer on a subject of great importance to the economy at large: the lack of IPOs.

We wrote a post last week entitled "Disconnect in the IPO conveyor belt" discussing some of the ramifications of this problem, ramifications which extend far beyond the somewhat rarified and (to many investors) unfamiliar world of start-ups and venture funding -- ramifications which impact employment, prices, innovation, and the quality of all kinds of goods and services used in business and in daily life.

This morning, Mark Cuban was on CNBC again talking about this subject, and made the point that the dysfunctional IPO landscape also has a negative impact on equity markets in general.

Specifically, he said (beginning at about 00:45 seconds in the above-linked clip):

If we have a problem, it's not that there's frothy valuations for tech companies in the public markets: it's that there's no tech companies that have high growth rates, that are in a position to get frothy valuations -- that's the problem. I mean, if you look at, you know . . . tell me who the high-growth-rate companies are today that have under a hundred billion dollar market caps -- Netflix? You know, how many of them are  there? And that's the real problem in this market. And what's happening is, you've got -- because companies are refusing to go public -- it's just, you know, if you want to talk about the Valley, the whole ethos is now: "Don't go public." It's crushing our stock market.

This is a huge issue, for all of the reasons we discussed in the earlier post (here's that link again) and in our post from 2013 on this same subject, as well as the reasons discussed in Mark Cuban's blog post from February on this topic, and the even more in-depth discussion in the excellent article from Julie Segal from 2010 which we linked in the previous post as well.

Despite what Mark Cuban appears to be saying at the very beginning of the clip above, we don't actually agree that the solution is to "write down to zero" any investment in a private company that is not yet profitable -- one reason start-up companies raise venture capital is because they are not yet profitable, despite having a new or innovative idea which could be profitable in the future.

For that matter, many innovative public companies may not yet be profitable, but this does not mean that investors should "write their stock down to zero." We actually do believe that there are innovative and worthwhile companies for investors to analyze whose market capitalizations are well below $100 billion (some of which may not yet be profitable), but we definitely agree with Mark Cuban that there are a lot fewer of them than there might be if the funding and IPO landscape were not as dysfunctional as it has been for the past fifteen years.

Of course, there are many other contributing factors to this present environment, including the increasingly convoluted regulatory landscape and the additional costs which have been added to the burden of being public in the past fifteen years (or more -- the process has been going on for quite some time).

We commend Mark Cuban for his efforts to bring this situation to the attention of a wider audience.



At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Netflix (NFLX). For the record, the market cap of Netflix at time of publication was approximately $38 billion.

Disconnect in the IPO conveyor belt

image: Wikimedia commons (link).

Entrepreneur and investor Mark Cuban was on CNBC's "Squawk on the Street" this morning discussing what he sees as a "disconnect" in the progression from company formation ("start-ups") to growth and access to the capital markets through public listing. In a response to a question about the lackluster economic growth in recent years, he replied:

There's a disconnect right now because so few companies are going public. That gives an incentive for any S&P company, any major public corporation, to just wait and see rather than investing -- making capital investment in their own company, the things that make them competitively strong -- just waiting to make an acquisition. 

And so if you are not investing in yourself -- look, there's hundreds of billions of dollars being invested in start-ups of all kinds, whether it's retail start-ups, technology start-ups, biotech start-ups -- and so, rather than big companies having to invest in their own R&D, they just sit back and wait because now the culture of start-ups is you don't go public: you look for an exit. [based on the unofficial transcript posted by CNBC here].

In other words, he notes that very few start-ups are trying to make it all the way to public viability as a new competitor on the scene, and instead their founders and investors are just looking for "an exit" by selling to a large company. One effect of this situation, he points out, is that the big companies can outsource the research and development that they would normally undertake, and just watch for interesting or innovative start-up companies, and buy the ones that look promising -- absorbing their technology.

Mark Cuban casts this situation as a negative development -- and we agree with him.

We would argue that the reason so many entrepreneurs have a culture of (in Mark Cuban's words) "You don't go public: you look for an exit" is not that they wouldn't want to go public and compete as an independent entity, but because the path to doing so has become much more constricted over the past twenty years, for a variety of reasons, leading to an unhealthy situation which has ramifications far beyond the world of venture investing and which ties in to the health of the economy at large. 

The "conveyor belt" connecting innovative ideas with access to capital that entrepreneurs require in order to grow and compete on their own in the economy is broken, to the point that many companies which could become viable players never even get funded, and those who do end up getting bought by big, existing companies. It is a problem that signals unhealthy developments involving the capital market landscape, although it may manifest itself more noticeably in the world of start-ups.

It is a topic that many experienced investors in the venture capital landscape have been writing about for the past few years. Mark Cuban published a more detailed discussion of some of the issues he expressed in today's interview in a blog post he wrote this past February, entitled "The Pre-cognitive Anti-trust Violation: How the decimation of the IPO market has hurt the economy and worse." 

The title may at first seem a little whimsical, but it actually conveys an extremely important idea, albeit in a somewhat obscure metaphor that takes a little thinking in order to unpack. 

It appears to be a reference to the "pre-cogs" in the famous movie Minority Report, which depicts a dystopian future in which three psychic beings known as "pre-cogs" are able to see crimes before they happen, and then law enforcement officers can go take down the criminals before they even carry out the future crime (a situation which is obviously ripe for horrific abuse, as the movie dramatizes quite effectively, and as the brilliant author Philip K. Dick was trying to warn society when he wrote the story upon which the movie was later based).

Mark Cuban implies that unhealthy constriction in the pathway to public viability is enabling established competitors to do a kind of "pre-crime" take-down of their future competitors, before the competitor even has an opportunity to get out into the world and become a competitor. Thus, it is a situation in which competition is killed off in much the same way that the anti-trust advocates of a hundred years ago were worried about, but in an even more sinister way -- before the competition even happens (hence the reference to the "pre-cogs" of Minority Report fame).

The negative effects of such a situation are obvious: less opportunity and incentive for companies to innovate;  less opportunity for investors to invest in small public companies before their real growth kicks in; less capital available for entrepreneurs to create a viable business; less ability for employees to benefit financially from the added work and risk they take by working at a startup; and ultimately fewer jobs, fewer opportunities, and less innovation for the economy at large.

And those are just the more obvious negative effects of the problem that Mark Cuban is describing!

We ourselves also wrote about this phenomenon back in May of 2013, in a post entitled "Crossing the chasm to IPO becomes even more difficult."

Perhaps the deepest and most thorough analysis of the historical causes of this phenomenon could be an article written by veteran investment journalist Julie Segal, published in 2010 in Institutional Investor entitled "Death of the IPO." Even more wide-ranging consequences that she traces back to this problem include a reduction in the volume, availability, and ultimately quality of equity research. 

The most telling of the ramifications she points to is the widening divide between "Main Street" and "Wall Street," as the connecting link between the two is narrowed, constricted, or obstructed completely.

This is a very serious subject, and one we commend Mark Cuban and others for discussing candidly. The solutions to the problem are not easy or obvious -- as Julie Segal points out in her article, some of the contributing factors go back to decisions made decades earlier. But it is one that we believe investors should think about and understand.

Pfizer CEO Speaks Out Against the Insanity

image: Charles Pfizer (1824 - 1906), entrepreneur, chemist, co-founder of Pfizer.

We have been long-term owners of the shares of Pfizer, Inc., the major drug company, in our TFCM Income Strategy.  Its more than 3.5% dividend yield, which has grown over 8% per year in the last five years, and its slow but steady growing business has made it a fine investment for that strategy and for our clients who own it.

Given that we make a point to own companies run by people who are very capable and smart, we are particularly proud of the opinion piece written by Ian Read, Chairman & CEO of Pfizer, that was published in the Wall Street Journal.

In it, Ian highlights the folly of the recent ruling by the U.S. Treasury Department, run by Jack Lew (and ultimately Barack Obama), which undermines the very core of the rule of law and further puts American companies and the American economy at risk of further weakness.

At some point we believe Americans will have to take a stand against this type of behavior.  Unfortunately, what most may come to realize is that more and more American companies will simply choose to leave altogether, likely led by the smaller businesses who will choose to start somewhere else (maybe Ireland?) rather than put up with the type of anti-business rhetoric and actions that seem to have become commonplace in America these days.

Enough said, since Ian does a better job of describing the predicament than we can!

Extraordinary Happenings In Brazil

image: Brazil protests (link).

It has not been highly publicized in our media but the events in Brazil in the last few weeks are nothing short of extraordinary and underscore how socialist, crony policies and actions are always doomed to fail.  What is most notable is that Mises is being preferred to Marx by the young people in the streets; 4 million of them!  This is worth noting as we have watched the "Latin Miracle" go up in flames in recent years.  In the 1990s, led largely by movements in Chile and Argentina, it looked like the decades of "Banana Republics" were finally over and free enterprise was taking hold.

Many businesses were being privatized, most notable Telebras, the Brazilian telecom monopoly that was broken up in favor of regional "baby bras's".  Over the course of the next several years however, many of the nations that were leading the charge seemed to give up on the experiment and allowed characters like Lula in Brazil, Kirchner in Argentina, Morales in Bolivia and of course, Hugo Chavez in Venezuela, in one form or another to set back or completely reverse the reforms that had made it look in the 1990s as though Latin America was going to join the ranks of the "free enterprise" nations.

Maybe they will someday get it right?

Mobile World Congress 2016

We just returned from the Mobile World Congress 2016 (MWC 2016) in beautiful Barcelona, Spain.  With over 2,000 companies presenting their products and services, and 100,000-plus people in attendance, MWC 2016 lived up to expectations as the premiere trade show/conference for "everything mobile" again this year.

We attended MWC 2016 in order to get firsthand experience viewing the latest and most innovative offerings from many of the companies in our portfolios, as well as to gain exposure to new ideas and companies from around the world, upon some of which we will certainly be doing due diligence with respect to new investment opportunities.

As the MWC 2016 tag line was "everything mobile" and "mobile is everything," we couldn't agree more as there is no doubt that some of the most exciting ideas in the investment world relate but their  to mobile/wireless technology.  Full disclosure: we are invested in private Israeli company ASOCS, Ltd through  Taylor Frigon Capital Partners LP (TFCP LP), but their launch of the generation 3 virtual base station (vBS) was simply mind-boggling!  

ASOCSs software defined radio (SDR) is going to make it possible for carriers such as Deutsche Telekom, Telefonica, Verizon and AT&T to reduce the cost of deploying base station for cell towers by roughly 90% by some estimates.  This is huge for purposes of increasing cell coverage and the bandwidth capability for mobile networks around the world.  The most significant take away from our discussions with CEO, Gilad Garon, was his statement: "5G is just a software upgrade with our system."

Additionally, the Internet of Things (IoT) was a major focus at MWC 2016.  Here, TFCM Core Growth Strategy holding Qualcomm (QCOM) was clearly making major noise with its Snapdragon processors.  Snapdragon can be found in devices that enable everything to be "connected" -- from your car to your clothes!

TFCM Income Strategy holding, Intel (INTC), is also a big player in the IoT.  Its "Smart Home Gateways" are set to connect just about everything in your home.  It's great to see a company that pays significant cash dividends is still investing in the future so as to ensure they will be able to grow those dividend over the coming years!

Another big hit at the show was the Samsung "Gear VR" (powered by Oculus, a Facebook company) virtual reality device which enables you to connect your Samsung Galaxy phone to the Gear VR headset and become immersed in "virtual worlds."  Another TFCP LP company, OTOY, Inc., is very closely working with Oculus on the delivery of VR/AR content through the cloud.

The description of innovative and fascinating technologies can go on and on but the most important revelation we take away from the 2016 MWC is that many of the trends and paradigm shifts that we have been following for the last fifteen to twenty years seem very much intact and perhaps even accelerating.

At the time of publication, the principals of Taylor Frigon owned securities issued by Qualcomm (QCOM), Verizon (VZ), Telefonica (TEF),  and Intel (INTC). At the time of publication, the principals of Taylor Frigon did not own securities issued by Facebook (FB), AT&T (T), Samsung Electronics (SSUN), or Deutsche Telekom (DTE).

So When Do You Change Your Financial Advisor?

We recently spoke at a prospective client event in Santa Barbara, California and we were asked the question "how do you know when you should change financial advisors?"  Before answering that question, however, one must understand that the term "financial advisor" can take on many different definitions.  Most "retail" (individual) investors, who use a financial advisor in helping them with their planning and investments, do not deal directly with those who make actual day to day investment decisions.  By our definition, a "financial advisor" is generally NOT an "investment manager".  In todays financial services world, financial advisors usually invest primarily in mutual funds or pick a 3rd party "investment manager" (sometimes also referred to as an "asset manager"). An investment manager will make actual "investment decisions" which we define as picking individual companies to be put into the client portfolio (whether bonds, stocks or preferred stock, etc.).  By that definition, an investment manager is NOT someone who chooses third party asset managers (who DO make investment decisions) or picks mutual funds (also managed by a third party).  This distinction is important because investment managers will often also act as financial advisors to their clients (as does Taylor Frigon) by helping them with important planning decisions and so forth.

Those who have been long time readers of this blog, or are familiar with our philosophy, know that we believe it is preferable that investors get as close to those that are making actual investment decisions as possible.  This blog is full of other posts explaining why we believe that, but here are just a few examples:

Novemeber 15, 2007 "Don't hire a journalist to coach your team." :

"...would you want Vince Lombardi running your team or the guy who is up in the booth doing commentary? A reporter may know a lot about the game, but the experience of voicing opinions is vastly different than the experience of making the tough calls day-in and day-out."

January 23, 2008 : "A twenty-year perspective for the recent market turbulence":

"The lesson of the terrible long-term performance shown in the graph above is that the average investor (and the average advisor, according to our understanding of the data) is fairly capable at picking short-term performers, but does not have the consistency required to achieve long-term success."

January 28, 2008: "Can your advisor answer this question?"

"Can an advisor even tell you what the long-term rate of return experienced by his clients has been? He should be able to, but can he?

It is very easy to pull out a track record of a fund or a manager that his clients own right now, and show the twenty-year record ... of that particular fund or manager, but as we have pointed out before, the advisor's clients may very well have just entered that fund or portfolio and thus the history before that time does not reflect returns that the clients themselves experienced."

February 1, 2008  "When do you fire your investment manager?":

"We have long advocated finding a money manager who has a consistent investment process and has been using that investment process for a period of many years, and has an infrastructure around him, but who isn't too big. We believe that a manager's level of investment in his own portfolios is also an important indicator (he should "eat his own cooking")."

Investment Climate Jan 2016 "The Sky is Falling," Again!

The year 2015 went out with a whimper as major market indices in the U.S. ended relatively flat to down. This is not surprising given that the Federal Reserve finally raised the target for the interest rate on Federal Funds at the December 2015 meeting of the Federal Open Market Committee (FOMC), and that the market averages had been dancing around ‘break even” for most of the year. As we have discussed in previous Investment Climate pieces, investors (or more specifically “traders”) have become far too focused on the actions of the Fed and a “hissy fit” driving the value of stocks down was to be expected.

The “hissy fit” has continued into the first part of the new year. As of this writing, the major market indices in the U.S., and the world, have gotten off to the worst start ever. This is giving fodder to all those pundits of perpetual pessimism in the media who are clamoring to pronounce that the “sky is falling”. We would emphasize that this is not the first time we have witnessed reactions like this from both the mainstream financial media and the “experts” they traipse onto their stage 24/7 offering suggestions for the “trade of the day.”

While market drops are never comforting, these periods serve to reinforce the mantra we have preached for years that one must be an investor, in the truest sense of the word — not a trader, speculator or gambler, with respect to the way money management is viewed– if one is to maintain their sanity when facing the inevitable gyrations that the market and, for that matter, the economy will bring. Unfortunately, today the markets are more and more driven by phenomena that have little or nothing to do with the conducting of business and more to do with schemes that attempt to “game” the market. Contrived mechanisms that attempt to steer one away from the natural ups and downs that occur in something as dynamic as business activity and ensure long term success at the same time are nonsense! Thinking in terms of “macro trends”, arbitrage, liquid alternatives, synthetic instruments, hedging risk, high frequency trading, and on and on… just misses the point of real investment.

Investors (those who provide capital to an enterprise in expectation of a future return) are best served to be thinking solely about the enterprise in which they are investing, and its prospects for success. At its core, this is not complicated. However, in recent years (and maybe decades), we believe too many investors have been focused on almost everything except the enterprise to which they have entrusted their capital. They have become further and further removed from the enterprise that is actually benefitting from the use of their capital and in many cases are not even invested directly in a business enterprise. This has transpired through the use of intermediaries, at best, and downright instruments of financial engineering that don’t even ultimately result in the financing of a business entity but are truly schemes “betting” on the outcome of a particular event, at worst. If you are an investor reading this piece, ask yourself, “what enterprise has ultimately received my capital investment and how are they using that capital to ensure I receive a future financial gain?”

Some would argue investing in public companies does not provide capital to the enterprise itself as it is a “secondary” market for shares in that enterprise. That is not accurate because the capital that was originally invested in the enterprise is simply now yours, as transferred to you by the original investor. It is still capital used in the function of the enterprise. When you have no idea if you have invested in an enterprise or enterprises (hopefully you are diversified), or realize you have bought into the hype that there is a way to “game the system” and come out on top, then we suggest you change your approach immediately.

As the cries of doom ring ever louder, those who have our suggested approach will be able to look past the noise and know that what China, Greece, The Fed, Dubai (remember that one?), emerging markets, the Yen, the Dollar, the Euro, the Eurozone, the price of oil, Ireland, Iceland, liquid alt funds, ETFs, Italy, Brazil CDOs, CMOs, CLOs, CDSs and all the rest of the buzz-terms that are used as the “debacle of the day”, will not derail their solid long term plan. Why is that? Because businesses such as Stericycle keep picking up medical waste, Ecolab keeps on cleaning the toilets in restaurants, Nvidia keeps powering the graphics on your computer screens, Amazon keeps being Amazon, Apple keeps you using your thumbs, Verizon makes sure you connect your iPhone, Echo Global Logistics makes sure your packages arrive intact, Edwards Life Sciences makes sure your heart keeps ticking, and Middleby ensures your pizza gets cooked right!

A Rough Start to the Year - Stay Calm!

(image link)

The markets have ushered in 2016 with what is the worst start EVER in a new year for the stock markets around the world.  We are told this is due to turmoil in China, which the conventional wisdom is suggesting is sure to take the U.S. economy into recession.  We don't agree.

While there is a lot to be unhappy about in regards to the way policy has shaped up in recent years here in the U.S. and globally, what we are witnessing is yet more of the "Hissy Fit" we have spoken of coming about as the Fed ends its policy of 0% interest rates.  The problems in China have now been added to the list of reasons why we should all panic.

China is a centrally planned economy.  While they have definitely made great strides in moving towards capitalism, they are still guided by their government.  As such, problems such as those they are experiencing are going to continue until they come to grips and embrace a truly free, entrepreneurial capitalist system.  By the way, this is true everywhere, including in the United States. To the extent that government is allowed to get ever bigger and more intrusive, inefficiencies step in and things don't function as well as they could in a more free enterprise-oriented system.  This is not to suggest we favor a "free for all" system.  Quite the contrary, we suggest a strong rule of law is crucial.  However, "rules of the road" are different then requiring one to take a certain route, and therein lies the problem with centrally controlled systems.  Fortunately in the United States, and much of the Western World, the degree of government control and mandate is less than in places like China.

Still, the markets will have their moments of panic and as we have said many times before, "this too shall pass".  And even if we were to go into another 2008-type downswing, we would simply ride through it (as we did then) and look for where we could take advantage of opportunities that inevitably present themselves in such environments.  We really don't think anything as systemically troubling as 2008-9 is happening now, and today's issues are being overblown, and we suggest that trying to time when to buy and sell (trading) is an exercise in futility.

It is far better for investors to stick with their plan, assuming it is sound.  For us, that involves staying with ownership of business that are well managed and have promising outlooks for the future.  We  think this is one of the best times since 2008-9 to buy great growth companies, but also to buy positions in many income-generating investments and dividend-paying common stocks.  Of particular note are opportunities in many higher-yielding securities issued by well-run companies but suffering in this panic-ridden environment.  We plan on continuing these endeavors on behalf of our clients and recommend others do so as well.