It's all about the thought process

Michael Mauboussin recently published a detailed discussion of investment performance entitled "Untangling Skill and Luck: How to think about outcomes -- past, present, and future." Many of his conclusions agree with convictions we have held for many years and which we have discussed in this blog before, and we feel that the basic lesson at the heart of the essay is one that is extremely important for all investors.

After pointing out that luck and skill interact in the world of investment management, just as they do in many sports and other human endeavors, and offering some tools for evaluating and observing the interaction of luck and skill and measuring performance, he concludes with a discussion of the crucial importance of a sound investment process, what Warren Buffett describes in the essay's concluding quotation as the "framework for investment decision making." We would argue that this idea is crucial to investing, and would add that what really matters is:

a) the soundness of this basic thought process

and

b) the consistency with which this basic thought process is applied over time.

We believe that there are many fundamentally sound thought processes from which to choose, much as there are many fundamentally sound martial arts from which to choose, as we discussed in a post at the beginning of 2009. As touched on in the article referenced above, many investors focus too much on investment "style" when they should be focused on the quality and consistency of the process (while there are investment styles with which we have fundamental disagreements, we believe that many "growth" and "value" styles, if applied properly, can be fundamentally sound).

The problem is that most investors (and their professional advisors or investment management consultants) switch from one to another, depending upon which one is most popular or which investment style appears to be doing the best in the short term, and end up getting seriously hurt (much the way someone who dabbles in one martial art after another without much consistency can also end up getting seriously hurt in a real situation).

We believe that overwhelming evidence suggests that this lack of a consistent thought process is at the heart of the long-term failure of many investors to make money, or even stay ahead of inflation. Investors tend to switch money managers frequently (every two to three years), making it impossible to have a consistent thought process governing their investment selection for decades.

We have presented this evidence in several previous posts, including here and here. Back in early 2008, we also noted evidence that, by switching from one manager to another in a similar fashion, institutional investment management consultants appeared to be causing the same self-inflicted wounds that retail investors routinely suffer. Mr. Mauboussin's piece cites a more recent study published in the Financial Analysts Journal November/December 2009 issue which found that such switching cost institutional investors over $170 billion from 1985 to 2006, which could have been prevented "if they had simply stayed the course."

We believe that the importance of having a sound thought process and of consistently sticking to that thought process simply cannot be overstated. We have discussed this before in "The same thought process for 30+ years."

Unfortunately, with the current structure of the financial industry, it is difficult for many investors to get a consistent process for decades. Investors either have to develop their own process (preferably while they are still young) and then stick to it for their entire investing lifetime, or find a money manager whose thought process they believe is fundamentally sound and with whom they can invest for decades.

We commend Mr. Mauboussin for his valuable contribution to this important issue.

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For other previous posts in which we discuss this important subject, see also:

• "So when do you fire a manager?" 02/01/2008.

• "Managers who hate their own cooking" 06/19/2008.

• "If portfolios were parachutes" 03/09/2009.
  

• "Melanie Oudin, Billy Beane, and the portfolio management process" 09/09/2009.
  

• "What a farmers' market can teach us about money management" 01/18/2010.
  

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Lower tax rates stimulate growth

This past Friday, the opinion page of the Wall Street Journal published an article entitled "Liberal Tax Revolt," citing several Democrat Congressmen who are arguing that allowing the tax rate cuts of 2003 to expire would be harmful. Among those cited are Senators Evan Bayh (D-Indiana), Ben Nelson (D-Nebraska), and Kent Conrad (D-South Dakota), as well as Democrat members of the House of Representatives Bobby Bright (of Alabama) and Jerrold Nadler (of New York).

As reported last week in the Evansville Courier-Press, Bayh spoke in favor of keeping the tax rate cuts of 2003 alive by saying: "This is not the right time to raise taxes. First, we need robust economic growth. Second, we need to address our country's long-term fiscal challenges and take a hard look at restraining government spending. The economy is not as strong as it should be in Indiana and around the country. Raising taxes would hurt the recovery and increase uncertainty for Hoosier businesses that compete in the global marketplace."

As the authors of the Journal article point out, it's not likely that Senators Bayh, Nelson, and Conrad, or Representatives Bright and Nadler have suddenly undergone "supply-side conversions." They do not necessarily make the important distinction between "raising taxes" and raising "tax rates" -- meaning, as Art Laffer has famously pointed out, that raising tax rates can and actually does cause changes in behavior, especially at the highest income bracket, resulting in less "taxes" being collected (those who fail to make this distinction talk as though lower tax rates result in lower tax revenues, when in fact lowering tax rates can actually increase tax revenues). Even if all the Congressmen mentioned above don't make this distinction, as the Journal authors say: "it's a start."

Another way of making this important distinction is by focusing on the critical but often-ignored element of growth. Lower tax rates encourage growth, but higher rates discourage it by decreasing the potential reward for the investment of capital, especially among those who have the most capital to invest and the most choices as to where they should invest it, or whether they should invest it at all.

We believe that the recent statements from Senator Bayh and other Congressional leaders are further evidence that growth should be an issue on which everyone can agree. In fact, we have written extensively on this very subject, including a post from February entitled "Why can't we all just get along (on economic policy)?" in which we demonstrate that there really should be no argument that growth is good and that low tax rates stimulate growth. If good people want to disagree with what to do with all the positive byproducts of growth, so be it, but why would anyone argue against growth itself?

Unfortunately, there are still plenty who do not believe that there is much connection between tax rates and growth. In this video clip, for example, economist Larry Kudlow interviews Christian Weller of the Center for American Progress (and associate professor at UMass Boston).

Dr. Weller encapsulates the raise-rates argument in his opening remarks, when he says: "I can't think of any policy that would have less effect on growth than extending the tax cuts for the wealthiest two to three percent of Americans -- even the CBO ranks it as the least-stimulative policy -- and it would blow an over-$800 billion hole in the deficit, and thereby permanently increase interest rates and make business costs even higher in this world. So, if we're really concerned about deficits -- the majority of even Republicans are concerned about deficits -- I think we need to let those tax cuts expire. It's the right economic policy; it's sensible economic policy; and it will have very little -- no impact on economic growth" (beginning at about 3:15 in the video).

Dr. Weller echoes the remarks aired earlier in the clip by Speaker of the House Nancy Pelosi, who said the Bush tax rate cuts "contributed to the deficit, did not create any jobs, and should be repealed."

We recommend that readers interested in the economic arguments against the fantasy promoted by Dr. Weller and Speaker Pelosi that tax rate hikes have no impact on economic growth* go back and revisit some of the posts we have published over the past two and a half years, including:

• "Say 'tax rate cuts,' not tax cuts" 01/25/2008.

• "Say 'tax rate cuts,' not tax cuts (part II)" 03/20/2008.

• "The consumption / production distinction with regard to stimulus plans" 01/15/2009.

• "First, do no harm" 02/02/2009.

• "Growth is the answer: the primacy of human creativity" 05/18/2010.

The last post mentioned is perhaps the most important, containing powerful quotations from finance professor John Cochrane of the Chicago Business School and others who flatly declare the primacy of growth (as well as the importance of low tax rates in unleashing that growth).

While those in favor of raising taxe rates often point to "reducing deficits" as their rationale (as do both Speaker Pelosi and Christian Weller in the video clip referenced above), history and common sense demonstrate clearly that economic growth is the true means of paying for deficits or anything else.

We commend politicians who have recently made a stand for the connection between lower tax rates and economic growth. What surprises us is the fact that this is still an argument at all.

* To the list of those who do not make the distinction between tax rates and tax revenues we would also have to add the Congressional Budget Office (CBO) mentioned by Weller as a supporting authority; they are perennially guilty of acting as though changes in tax rates have no impact on the behavior of those being taxed, which is why they always score tax rate cuts as decreasing tax revenue and tax rate increases as increasing tax revenue, in complete disregard for reality.

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Does a rising tide really lift all boats?

If you've been around the investment world for very long, you will no doubt have heard the old adage, "A rising tide lifts all boats."

We've pointed out before that investors should exercise caution when choosing whether or not to accept old investment bromides as being beyond question, such as in our examination of the advice to "Sell in May, then go away."

The expression "A rising tide lifts all boats" is meant to emphasize the primacy of the overall economic environment over the importance of the individual businesses negotiating that environment like so many boats upon the sea. When the tide is rising, according to this axiom, everyone benefits.

There is a degree of truth in this expression, and we do believe that the overall "ocean conditions" are important to the performance of the businesses which must sail through them on a daily basis. We have written about some of the important barometers for measuring the existing conditions many times before, particularly taxes, interest rates, inflation, and global freedom, discussed in last September's post entitled "The Four Pillars."

However, we have also made the observation that -- while "rising tides may lift all boats" during periods of expanding economic freedom (lower taxes, lower inflation, etc.) -- history seems to demonstrate that when the overall situation is less inviting, some boats do much better than others, even during the relative upswings.

For example, we have presented data which illustrates that during the 1970s, the rebound from the crushing bear market of 1973-1974 was extremely lopsided, in which there was a huge performance gap between smaller and more innovative companies and larger and more mature companies. During the "rising tides" of 1975 and 1976, for example, some "boats" did a lot better than others.

In fact, as we pointed out, it was not until the mid-1980s and the decade of the1990s, when conditions improved dramatically in the categories of tax rates, inflation, interest rates, and economic freedom, that large-cap names began to take the lead again. During those years, the rising tides really did lift all boats, to such an extent that many investors came to believe that they should just "own the entire market" (via an index fund or similar investment) rather than trying to search out superior individual businesses for their investment dollars. We pointed out that a similar fallacy had taken hold in the 1960s, in a strategy known as the "Nifty Fifty," but that the 1970s put an end to that strategy, which was also based on a belief in the "rising tide" theory.

Today, many investors and their advisors remain enamored with the idea of "indexing" or owning the entire market. We have expressed many times the reasons why we believe investors are better served by allocating investment capital to growing, well-managed businesses as opposed to focusing on "the market" (or various sectors of "the market"). Beyond that, it is very possible that the conditions that allowed the index theory to arise in previous decades may well be history for the next several years.

While the idea that "we could be entering a period similar to the 1970s" is not a new one, we would actually argue that we may have entered such a period three or more years ago, and that it is hard to say when conditions will get back to the "rising tide" business-friendly scenarios of the 1960s, 1990s, or the second half of the 1980s. During such periods the importance of selecting more innovative companies becomes far more important.

While there is often a substantial grain of truth behind well-worn "market sayings," investors should realize that these adages by their very nature and origin usually focus more on "the market" than on the importance of individual businesses and their specific strengths and weaknesses. We would argue that now is a very good time to be wary of market-focused platitudes and concentrate on finding businesses that are well situated to navigate some potentially stormy conditions.

Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.

For later posts on this same subject, see also:

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "Have you heard of this company? EZCH" 12/09/2010.

• "The question of our time, continued" 03/14/2011.

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Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital

Every now and then, the argument surfaces that "passive management" represents the investment method that best reflects the principles espoused by champions of economic liberty such as Friedrich Hayek and Adam Smith, and that "only the North Koreans, the Cubans, and active investment managers" have yet to come around to the position that "markets work." This particular usage of the insights of Hayek and Smith was first articulated in 1995 by Rex Sinquefield in a debate and has been recycled endlessly in the fifteen years since. In fact, we received a mailing earlier this year from a group whose opinions we generally respect, reproducing the transcript of Sinquefield's 1995 remarks and using them to promote their brand of "passive investing."

We presented a detailed rebuttal to Sinquefield's points two years ago, in a post published in May 2008, but we believe that there are several reasons why the topic is worth revisiting.

Perhaps most important is to dispel the attempt to co-opt the brilliant work of Friedrich Hayek into an argument for indexing, and the attempt to argue that anyone who doesn't acquiesce that indexing is the only way to invest capital has gone over "to the dark side of the force" (Sinquefield's phrase) and aligned themselves with brutal communist dictatorships such as those still oppressing North Korea and Cuba.

Well, we are active managers, and have made it quite clear in numerous previous posts (such as this one and this one) that we disagree with the tenets of "passive investing" or "indexing" or even the "efficient market hypothesis" that Sinquefield says is "simply an extension of Hayek's fundamental assertion: markets work," and yet we yield to no one in our admiration of and agreement with Friedrich Hayek and his arguments.

The egregious mistake that over-eager proponents of "passive investing" make when they claim that indexing is the logical extension of the insights of Friedrich Hayek or Adam Smith is their failure to make the crucial distinction between what we call "free markets" and "free enterprise."

Free markets are a necessary precondition for free enterprise, but they are not the same thing.

By free markets, we mean the conditions of predictability brought about when the rule of law is enforced, the medium of exchange is reasonably stable and predictable, and citizens are free to manage their property (including businesses which they form with other individuals) in ways that they see fit, without undue interference from the government, as long as they do no violence in the process.

In fact, these conditions are remarkably like what Thomas Jefferson articulated in his formula "the equal right of every citizen in his person and property and in their management."

While both Hayek and Adam Smith wrote about the critical importance of establishing these conditions, it does not follow that investing should be the process of trusting these conditions to the extent of allocating your capital equally to every company operating in an economy marked by those conditions. Nor does it stand to reason that Hayek would advocate such a course of action.

When we say that the distinction between "free markets" and "free enterprise" is important for investors to understand, we mean that free markets are important, but that they are only a means to an end. What we mean to indicate with the expression "free enterprise" are those innovative businesses which, in the course of trying to add value to their customers, advance the conditions of human existence, by creating new technologies, new products, new services, new and more efficient ways of growing crops or manufacturing goods, and all the other countless innovations that have enhanced human living standards over the past centuries in almost unbelievable ways.

In fact, the Austrian economists -- including the big three of Hayek, Mises, and Schumpeter -- were the most articulate champions of the centrality of entrepreneurial innovation, and if anyone had to hazard a guess as to what their position on the "active vs. passive debate" would be, a very strong case could be made that they would advocate allocation of investment capital towards the most innovative and well-run businesses, rather than the mindless allocation of capital equally towards any business that lists itself on an exchange, regardless of whether it is operating in a dying industry or whether its management has shown itself to be incompetent.

In fact, in an enlightening 1960 essay entitled "Why I am not a conservative," Friedrich Hayek touches on the subject, in the course of making a much larger argument about the distinction between the position of the classical liberal and the continuum between the radical and the conservative.

In that essay, Hayek says, "It would seem to the liberal, indeed, that what is most urgently needed in most parts of the world is a thorough sweeping away of the obstacles to free growth. [. . .] But the admiration of the conservatives for free growth generally applies only to the past. They typically lack the courage to welcome the same undesigned change from which new tools of human endeavors will emerge."

Here, Hayek seems to be reinforcing this important distinction between free markets and free enterprise, because he sees the goal of "the thorough sweeping away of the obstacles" as being the promotion of conditions which enable "free growth."

We would argue that the position of the advocate of "passive investing" or "indexing" is more akin to the position Hayek describes as that of "the conservatives" -- trusting in the growth of the past, lacking the courage to seek out and welcome those disruptive innovators, which Hayek calls the agents of "undesigned change."

We believe this is a timely moment to discuss this supremely important subject, because so many investors have given up on "active management" and stopped looking for innovative companies, in a sort of mass despair and doubt that such things even matter anymore.

It is our conviction that looking for innovation has never mattered more, and we point out that this conviction has served us and our investors well, including during the turbulent past three years (as our investment performance records demonstrate).

We recommend that all investors take the time to consider these important subjects, and to get to know the arguments of Friedrich Hayek for themselves.

Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.

For later posts on this same subject, see also:

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "The political winds are swirling" 09/15/2010.

• "'There are some things that are just too important to be left to the free market'?" 01/07/2011.

• "The ideology of modern finance" 01/12/2011.

• "The growth theory of investment works" 01/14/2011.

• "Don't confuse free enterprise with a questionable theory about securities markets" 01/19/2011.

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Have you heard of this company? HITT

While the financial media and various pundits and intellectuals remain focused on visions of impending economic armageddon, we recommend investors stick to their investment discipline -- and we have written many times that we believe the best foundation for a solid investment discipline is allocating investment capital to well-run, growing businesses.

Over the weekend, the UK's Telegraph ran an article entitled "With the US trapped in depression, this is really starting to feel like 1932." The story opened with a quotation from academic and neo-Keynesian Robert Reich who opines: "The economy is still in the gravitational pull of the Great Recession. All the booster rockets for getting us beyond it are failing."

Meanwhile, the New York Times ran an article on July 2 which remains their most-emailed story of the week, about "A Market Forecast that says 'Take Cover'" -- featuring a technical analyst who believes the Dow will drop well below 1,000 (the Dow is currently at 9,743).

We don't claim to be able to predict the economy's next move (although we think economist Brian Wesbury does an excellent job dismantling the 1932 argument here), and we never claim to be able to predict where the Dow is going to go next (we categorize systems that purport to tell you what the market is about to do as "snake oil," and we discuss the problems with predictions of extreme market collapse in this March 2009 post about a similar prediction from Harry Dent). We believe investors should devote their energies to searching out something that they actually can identify with a reasonable degree of effort: well-run businesses in fields of future growth.

To that end, we have highlighted various characteristics of a "Taylor Frigon growth company" and provided readers with examples of actual companies we own in our investment strategy that we believe fit that description -- see previous posts describing Dolby, Tractor Supply, and ResMed.*

Another company we own in our Core Growth Strategy is Hittite Microwave.* Hittite designs and develops high-performance integrated circuits, modules, subsystems, and instrumentation for technically-demanding applications operating in very high frequency ranges.

They are a leader in chips used for applications in the microwave band (generally from six to twenty gigahertz) and the even higher-frequency millimeterwave band (from twenty gigahertz to one hundred ten gigahertz). These wavelengths are used primarily for military and commercial radar systems, satellite uplink and downlink stations, military electronic countermeasures, vehicle anti-collision systems, and for the point-to-point microwave radio receivers that can be used for wireless traffic "backhaul."

In the world of wireless data (including all the data you send and receive on your cellphone/smartphone/netbook/laptop/tablet device operating on a cellular network), "backhaul" refers to the transport of the data from the cell tower back (after your mobile device sends the data to the cell tower). Increased traffic demands -- especially the increased demands from video, as discussed in this recent article -- make backhaul capacity extremely important for wireless providers.

While backhaul can be accomplished with copper cable or with fiber optic cable, it can also be done via point-to-point microwave, which does not require digging trenches and laying cable and which thus enjoys some cost and flexibility advantages, especially wherever laying cable may not be practical, as well as wherever ease and speed of deployment are a factor.

Hittite's return on equity is over 17%, its long-term debt is zero, and its most-recent quarter saw year-over-year growth in operating earnings of 58.8%. We believe it is a good example of the kind of companies investors should be searching for, even in the face of what we have previously called "unfriendly business climates."

We would argue that this type of focus is the best antidote to some of the nonsense being pumped out of the financial media right now.

* The principals of Taylor Frigon Capital Management own securities issued by Dolby (DLB), Tractor Supply Company (TSCO), ResMed (RMD), and Hittite Microwave (HITT).

For later posts on this same subject, see also:

• "Have you heard of this company? IIVI" 08/05/2010.

• "Have you heard of this company? CHRW" 09/20/2010.
  

• "Have you heard of this company? NAT" 11/22/2010.

• "Have you heard of this company? EZCH" 12/09/2010.

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Jefferson on economic freedom

"The true foundation of republican government is the equal right of every citizen in his person and property and in their management."

-- Thomas Jefferson (letter to Samuel Kercheval, June 12, 1816).

On July 4, 1776, the Declaration of Independence changed the course of human history. In the quotation above, its author, Thomas Jefferson, locates the "true foundation" of free government in the equality of every citizen "in his person and property and in their management."

Notice that Jefferson does not focus on "voting" as the true foundation, but rather on the right to be secure in your person, your property, and in your management of those two areas. This is very interesting and noteworthy.

George Gilder also illuminates the essential economic (rather than political) foundation of freedom in his most recent book when he writes: "Elections -- counting heads rather than breaking them -- are a prime tool of democracy, but hardly its essence. [. . .] Elections every day would not make a democracy of a society in which the decisive political forces are teenage gangs with guns and terrorist courtiers doling out foreign aid to an intimidated populace. No tenable theory of democracy allows the majority to destroy or expropriate the minority. Without a functioning and legally protected capitalist system, democracies swiftly sink into ochlocracies. Without the independent private sources of power imparted by free businesses, unbiased courts, and other institutions of economic order, any democracy becomes a despotism ruled by any tribe of thug politicians that manages to gain control" (the Israel Test, 224-5).

There are numerous examples of nations in this world that have "elections" but do not recognize the inalienable right of every citizen in his person, his property, and their management.

On this Independence Day 2010, we are grateful to men such as Jefferson and all those after him who have seen this truth and have been willing to stand up for it and at times to fight and to die for it. This truth is equally important and at risk today as ever, and all who value freedom should understand it and explain it to their friends and families.

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