Taking stock of 2008

Well, 2008 is finally coming to a close, and there were definitely some fireworks this year, although not the kind that most businesses were happy to see.

One year ago, we noted several financial commentators who were predicting a recession in 2008, and why we felt their assumptions were incorrect. We agreed with the obvious assessment of the state of the housing market, but did not believe it would spill over into the broader economy, and ended with the conclusion that "The prospects for a happy 2008 are not as bleak as the news is making them out to be!"

While we were wrong about that, it has always been our assertion that investors should not attempt to time cycles and that we do not base our portfolio management process on an ability to make short-term calls about the direction of the economy, interest rates, or market movements. We have repeated that assertion many times on this blog, including in first sentence of our second post ever, and more recently in posts such as "Stock Market Guessing."

Furthermore, we believe there is ample evidence that the problems in the housing market and financial companies that unwisely overindulged in housing-related financial products would not have spilled over into the broader economy if it had not been for a stubborn adherence by regulators to two very damaging "good ideas": mark-to-market accounting and the removal of the uptick rule for short-sellers in July 2007.

We wrote of the dangers of over-reliance on mark-to-market accounting as early as Friday, March 14, prior to the stunning disappearance of Bear Stearns over the weekend. There were others who had been sounding the alarms on mark-to-market before that, and yet the nation's leaders have continued to ignore the problem. Had this accounting problem been corrected back then, and had the time-tested uptick rule been reinstated, it is very possible that the spectacular implosion of Wall Street in September and October could have been avoided.

We maintain that it was the violent downdraft of all asset values this past fall that finally shocked the rest of the business world to such a degree that they basically came to a stand-still; we called it a case of "jaw-dropping, screen-staring amazement." In the aftermath, corporate budgets were hastily rewritten, and plans for business activity were drastically cut back.

It is important to have the correct perspective on the events of 2008, because -- as we predicted back on October 6 -- many will want to interpret them as a failure of the entire idea of free market enterprise.

In fact, today there is an article in the Wall Street Journal from the consistently anti-business Frank Thomas entitled "The 'Market' isn't so Wise After All" in which the author happily concludes that the carnage of 2008 should show everyone except for the most dogmatic ideologues that the idea of "the market and its fantastic self-regulating powers" is a dangerous illusion.

But while that article is full of snide jabs, it has little substance. Pointing to the recent meltdown and saying "I told you free markets don't work" should not convince anyone. While painful, the recent events do not prove that free-market capitalism is a system that fails. In fact, the past hundred years have decisively proven the opposite.

Elsewhere in 2008, our business-focused perspective enabled us to warn readers about the significant bubbles in oil and commodities before they deflated with a collapse that was bigger than the collapse in stock prices.

For instance, on March 31 we wrote a post entitled "What about commodities???" in which we warned against the chorus of voices which had been advocating commodities since they began their most recent upward journey in February 2007. Since that post was published, the commodities index has dropped about 47% in nine months.

On June 4, we published a post entitled "A hard look at the current price of oil and gasoline," in which we noted that crude oil futures were at $135 and rising, and that many pundits were talking as though oil prices had become "the one investment that will 'always go up and never go down.'"

We warned that "the real culprit in the current price of oil has been excessive Fed easing" and advised investors that "trying to 'play' the run-up in oil, which is caused by political and monetary factors that have little to do with the long-term fundamentals of business and which can reverse rapidly, is a shaky foundation for building long-term wealth and one we would strongly caution against."

Since then, the price of oil futures has dropped more than 70% in less than seven months.

It must be repeated that we did not make these timely observations because we have some kind of extraordinary ability to tell you what direction markets will move next. That goes against everything we believe in. On the contrary, we were able to sound a note of caution about those former "flavors of the month" because we believe in building the foundation of wealth on the long-term performance of well-run businesses operating in fertile fields of growth, rather than on an ability to "play" the current hot ticket.

As we have said many times before, most of the big fortunes in this country were made by men who retained shares of exceptional businesses through market cycles -- even through market cycles that were as dramatic as those we experienced in 2008. Bill Gates, for instance, didn't become one of the world's wealthiest men by selling his position in Microsoft every time he thought the market was going to have a bad year, and then buying it all back again.*

At the end of 2008, our most important piece of advice to investors is exactly the same as it was at the beginning of 2008: entrust your long-term financial well-being to the ownership of well-run businesses that are positioned in front of substantial opportunities for future growth.

We look forward to discussing some of those opportunities with you in 2009. Happy New Year!

* The principals of Taylor Frigon Capital Management do not own securities issued by Microsoft (MSFT).

For later posts dealing with this same topic, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.

• "Guide the market's invisible hand with a higher principle?" 02/26/2009.

• "Dangerous media distractions" 07/07/2009.

• "If Rip Van Winkle took a one-year nap before September 15, 2008" 09/14/2009.

• "The best defense is a good offense!" 12/03/2009.

• "The end of 2009" 12/30/2009.

• "How your view of 2008-2009 impacts your understanding of today's big events" 02/03/2010.

• "March 9 anniversary" 03/09/2010.

• "Great minds think alike!" 03/19/2010.

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Lessons from the Madoff Scandal, part two

The discussion of the Ponzi scheme perpetrated by Bernard Madoff is likely to continue for a long time, and it raises several issues that are worth discussing, including many important issues concerning regulation and the SEC.

However, there are at least two issues that the Madoff scandal exposes that are absolutely vital for all investors to understand, whether you are investing millions (or even billions) of dollars, or whether you are investing sums less than those lost by Madoff.

1. The intermediary trap.

It has been noted that most of those who lost money with Bernard Madoff did not invest directly with him, but did so through an intermediary. Some of those that he robbed of their savings were his personal friends, including people he had known for decades, but even more were robbed because they gave their money to "middlemen" who charged a fee themselves, and then farmed the management out to other managers -- in this case, to Bernard Madoff.

Over the weekend, the Wall Street Journal published the story "Madoff Feeders under Focus," (follow the link and then click the title of the story at the Digg website) which shows that some of these "middlemen" charged significant fees, even though they were not actually managing the money themselves but were only funneling the money to other managers. One apparently charged a "1 and 20," meaning 1% per year and 20% of any upside, while another charged an exorbitant 4.5% per year. These fees were for the middlemen; Madoff himself apparently made money by brokerage commissions on the trades he made (as well as by siphoning money from clients, which will now apparently result in a cost of 100% to most or all of them).

This arrangement, of paying a middleman who does not actually manage the money but rather farms it out to someone else, is actually a very common arrangement in the financial services industry -- in fact, it is the arrangement that the entire industry is built on. We have explained extensively why we believe it is a bad arrangement in previous posts, including "The Intermediary Trap" back in February of 2008. The diagram above, from that post, shows the "middlemen" in circle "B" -- they are often called "financial advisors" or "wealth managers."

To be sure, most middlemen do not farm the money out to managers who turn out to be fraudulent criminals. The reason this setup usually leads to substandard returns -- and extensive data over many years supports this assertion -- is not that the manager (or the middleman) are in any way nefarious, but rather that the manager's long-term returns ("point C") end up being better than what the original investor ("point A") experiences, because along the way the middleman ("point B") decides to do "something better" and short-circuits the manager.

However, the reason that the middleman tends to short-circuit the process is that the middleman is very focused on one-year performance numbers. When he sits down with his clients, he is very aware of "how manager X did in 2008, how manager Y did in 2008," and so on. This short-term focus (short-term compared to the business prospects of a well-run growing company, which can take a few years or more to realize its full business potential) is what leads investors -- and their advisors -- astray, according to studies on the matter.

This focus on the one-year performance numbers is a common trait of middlemen, and it certainly was a factor in the Bernard Madoff scandal, in which middlemen and their investors were clearly attracted by what they thought were consistently good one-year performance numbers.

The fact that the middlemen in the Madoff scandal did not believe he was actually stealing investors' money is fairly clear from the fact that many of them invested their own funds in his program as well. This is related to the discussion of "eating one's own cooking" which we have examined previously.

In this context, however, it highlights the extent to which these middlemen were unable to actually understand the investment management they were putting their clients into, which is another problem with the intermediary trap even when fraud is not involved.

The entire premise of the intermediary structure is that the intermediary doesn't get "bogged down" in the demanding job of actually making calls on individual securities in the portfolio -- let the manager do that. This supposedly frees up the middleman to be better at "wealth management" and the evaluation of managers.

We have always questioned that premise, and wondered why anyone would want to have someone giving them advice about investment management who is not actually in the trenches themselves and does not know how to be. We discussed this issue over a year ago in a post entitled "Don't hire a journalist to coach your team." The Madoff scandal demonstrates very clearly that even the most apparently successful and sophisticated middlemen in the world are still just middlemen. Better to have your investment manager be the one who actually understands the strategy on which your life savings depends.

This lack of transparency brings us to the second critical lesson that the Madoff scandal illustrates:

2. The zero-sum connection.

Madoff's apparently world-class returns were billed as the product of a sophisticated trading strategy, one that could exploit market inefficiencies. The Wall Street Journal story cited above contains an investor presentation claiming that the strategy involved something called an "approximate notional put hedge," among other things (just how "notional" it would turn out to be no doubt came as a surprise to everybody).

Several news articles since the scandal surfaced, such as this one, note that many sources report that "if current clients asked Madoff too many questions about how he invested, he kicked them out."

"Secret" trading strategies that must remain secret in order to work should raise a red flag.

Many in the general public have been led to believe that investing is all about finding out some secret information before everyone else and then profiting from it. However, that is only one type of investment strategy, and one that is antithetical to the investment philosophy practiced at Taylor Frigon Capital Management.

It is true that arbitrage strategies and many of the strategies followed by hedge funds are based on secret (or, more commonly, "proprietary") methods of exploiting inefficiencies, such an approach is necessarily a zero-sum game. One side of the trade benefits at the expense of the other side in such a strategy.

On the contrary, we advocate a strategy that is based upon the ownership of well-run businesses that are positioned in front of major growth opportunities. Such a strategy is not dependent upon keeping a secret or moving at lightning speeds -- instead, it is dependent upon having the discipline to do the homework to identify those companies, and then having the discipline to stay with them through the various cycles that come along on their way to realizing their business potential.

This is almost the exact opposite of secret or proprietary trading strategies -- an investor in such a strategy may even find himself in the position of telling others how good a company's prospects are, but people will not want to listen because the cycles are against that company at that particular time. In other words, he doesn't need to keep it a secret the way someone running a zero-sum strategy does.

That's because the classic growth strategy is a positive-sum game -- it is based upon the principle that enterprising companies can and do actually add new value that was not there before. Such a strategy aims to allow investors to participate in such new value creation, and thus it is the opposite of the zero-sum approach which many mistakenly believe is the heart of what it means to be an investor.

We have discussed the difference between zero-sum trading strategies and the classic growth investment philosophy in the past as well, such as in this post from June of 2008.

The Bernard Madoff scandal is a despicable episode and one that has apparently resulted in the robbery of billions of dollars of wealth from hundreds of families, foundations, and institutions. Investors should carefully consider the two important issues that it exposes in a dramatic object lesson.


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For later posts on this same subject, see also:

• "The same thought process for 30+ years" 03/31/2009.

• "The best defense is a good offense!" 12/03/2009.

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

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Seasons Greetings -- including to Mr. Grinch

Here for your holiday listening pleasure is the delightful 1966 song "Mr. Grinch," sung by Thurl Ravenscroft (also the original voice of Tony the Tiger until his death in 2005). Due to its creative metaphors, the song never seems to get old (who can resist "You're a three-decker sauerkraut-and-toadstool sandwich, with arsenic sauce"?).

Lest anyone object that such fare is too light for the season, it should be pointed out that Dr. Seuss's 1957 classic, How the Grinch Stole Christmas, is a sort of modern Christmas Carol, in which the main character experiences a radical change in heart.

Furthermore, with the 3rd quarter GDP down 0.5%, and with the fourth quarter likely to be down 6% or more due to the "grinding halt in the economy that took place in September through November" that we described in the previous post, the grinning Grinch seems an appropriate image this year.

On the financial news stations and in the wider media, pundits are regularly raising the specter of "deflation," while others warn of Argentina-like "hyperinflation" (see the link to the video in the previous post referenced above). It seems that the Grinch is going to be busy this year!

However, as economist Brian Wesbury explains in the "Wesbury 101" video below, entitled "No Deflation, No Hyperinflation," the monetary supply situation may not currently be either deflationary or hyperinflationary:























We believe Mr. Wesbury provides significant evidence to cry "humbug" at the current deflationary chatter in the media. Perhaps there will be an opportunity for a Grinch-like change of heart for some of the pessimists in the future.

In any event, we wish all our readers a very joyous holiday and seasons greetings from all of us at Taylor Frigon Capital Management.



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The best perspective comes from a business focus

Many pundits are arguing over how far in to the economic crisis we are and what is the correct direction for investors to take. Many are predicting far worse catastrophes yet to come, while others believe a bottom has been put in and things are beginning to turn.

If there is a central point to all the posts we make on the Taylor Frigon Advisor, it is that investors must remain focused on the foundation of investing, which is businesses.

We continually try to draw people's attention back to the fact that investing is about providing capital to businesses, whether you are investing in common stock or whether you are searching for yield through ownership of bonds, preferreds, or other income securities.

The reason that a large percentage of investors lose sight of this fact is that it is quite the opposite of what Wall Street has been selling them, which is that there is some kind of magic to investing, and that there is a caste of those on the inside who can "read the tea leaves" and on whom you must rely to tell you what is going to happen next.

We categorize this approach as snake oil, and we have written about it recently in "Beware of the witch doctors of modern finance" and in "Stock market guessing."

Investors who have been taken in by this concept, as well as those who haven't, should look to the foundation concept of "investing in businesses" as they try to determine what they should do at this juncture.

We argue that it is critical to place your financial foundation firmly upon the ownership of shares in well-run, growing businesses. If you own income-producing securities, such as bonds or preferreds, you should be equally critical in your analysis of the business fundamentals of the issuer -- its cash flow, its balance sheet, its leadership, and its future business prospects.

If the market price of the securities of a good business go down during hard times, it is important to remember that wealth is not made by bailing on your business in hard times. Those who have built a successful small business can attest to the truth of that fact. It is probably safe to say that there is not a successful small business owner who has not faced hard times and resisted the temptation to give up.

However, it is also true that many of those successful business owners did something more than just hold on through the hard times: often they succeeded because they positioned themselves during the bad times to be successful on the other side, and to take advantage of the opportunities presented by the exit of some of their competition or other new circumstances.

Likewise, investors should now be positioning their investments during the bad times to be ready when there is a turnaround.

Although this current crisis is a dire set of circumstances, it is by no means unprecedented. In fact, it is no more dire than situations the economy has faced in the past. We have had equally dire threats in the past and survived them.

Some pessimists are claiming that America is economically on its way to becoming a "banana republic," heading for economic disaster because it has thrown away its industrial base and is just a "phony service-sector economy."

Many are listening to such rubbish because those who are pushing such views "predicted" the financial panic of the past months. This is just another example of the "snake oil" discussed earlier, and those who feel tempted to follow this or that new witch doctor should go back and revisit the two articles linked above.

In fact, America's industrial base produces significantly more manufacturing output than at any time in previous history. Look at the chart of manufacturing industrial production above, which shows that even with the downturn of the past few months, current manufacturing output is far above that of ten years ago and dwarfs the output of previous decades.

Over the next few months, economic data will continue to come out that will look bleak, reflecting the grinding halt in the economy that took place in September through November. But economic data is backwards-looking.

We would urge investors to force their focus onto business fundamentals, to not bail on those businesses that are actually well-run companies positioned in front of promising opportunities for growth, and to make necessary changes wherever they have allocated capital without a good look at the businesses underneath. By doing so, they can avoid the siren call of the snake oil salesmen at the same time.


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For later posts on this same topic, see also:

• "New Year's Resolution: swear off snake oil" 01/05/2009.

• "Solid convictions versus snake oil" 01/08/2010.

• "Another black swan?" 05/13/2010.

• "The dance of the hippos" 08/10/2010.

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Lessons from Madoff and his Ponzi scheme

With last week's announcement of the largest Ponzi scheme of all time it is important for investors to understand that for a Ponzi scheme to work, the operator has to take the money from one investor and give it out to another.

In order to do that, the first investor must lose visibility of his money. In other words, he must be unable to see what is actually happening in his account, either because he does not get regular account statements every month, or because he gets false account statements every month.

In the case of the Madoff fraud, the investors were receiving false account statements every month. For this to happen, the custodian of the assets (where the accounts are held) must be part of the scheme. In the Madoff fraud, Madoff's own broker/dealer firm was acting as the custodian for his clients.

The Wall Street Journal today published an article explaining ways investors can avoid falling into such a situation. Most important of the recommendations is the sentence "If your adviser manages your investments, but the funds are actually held at, say, Charles Schwab or Fidelity, it's almost impossible for him or her to run a Ponzi scheme." That is because it is extremely unlikely that a separate custodian firm, especially a large and well-known firm, would enter into an agreement to commit fraud, or that such a firm would be able to hide such a fraud.

Ultimately, we believe that it is wise for clients to get their investment advice from a source that is separate from the custodian who holds their assets and trades their accounts.

In fact, the larger general lesson that investors may draw from this scandal is that the advisory business, including asset management, should be separate from the brokerage/custodial business -- and the investment banking business as well. We have made a similar point in the past, such as in this post.

Investors whose assets are currently held with a large reputable custodian who is separate from their investment advisor are much less vulnerable to the kind of fraud perpetrated by Bernie Madoff.

For later blog posts dealing with this same subject, see also:

• "Lessons from the Madoff Scandal, part two" 12/29/2008.

• "The same thought process for 30+ years" 03/31/2009.

• "The best defense is a good offense!" 12/03/2009.

Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.

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