Water, water, everywhere

We've written before about the important insights offered by Clayton Christensen, who is rightfully well-known and admired for his penetrating analysis of the crucial phenomenon of business innovation.

Recently, we've been thinking a lot about his article entitled "We are living the capitalist's dilemma," published towards the end of last month.  In it, he discusses the paradox of capital everywhere (corporate balance sheets are flush with cash, for example), while entrepreneurs seeking to create new innovations cannot find financing.  

He compares the situation to the famous line from Samuel Taylor Coleridge's 1798 poem, The Rime of the Ancient Mariner -- 

Water, water, everywhere,

Nor any drop to drink.

Professor Christensen explains what might be the cause of this dilemma, by drawing a very useful distinction between three different types of innovation, which normally operate in a virtuous cycle, and observing that this cycle seems to have become derailed.

We believe that investors should carefully consider the arguments in Professor Christensen's analysis, and become familiar with the three types of innovation that he describes.  Doing so may help to identify investment opportunities, as well as understand more clearly the current economic latitudes through which we are sailing.

We would also add that, in times such as those that Professor Christensen is describing, searching for the right kind of innovative companies becomes more important than ever for investors, as we have discussed in previous posts (such as this one).  Also, it would be advisable to avoid shooting any friendly albatrosses with crossbows.

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Taylor Frigon Core Growth performance through 12/31/2012

We recently published a post discussing the propensity of investors in the aggregate to make wild swings in and out of markets, and the damage that this type of behavior tends to cause to their investment performance. 

We have always believed that following a consistent investment discipline provides much better results over time.  This does not mean that we advocate a "buy-and-hold" approach: we believe in the importance of diligently seeking out businesses which are well-positioned for exceptional performance, and closely monitoring those businesses once we commit capital to them, replacing them when necessary.

Here is a link to a recent article entitled "Investors sour on pro stock pickers," discussing large flows of investment dollars away from "active managers" and towards ETFs, based on dissatisfaction with the performance of active managers and the general belief that ETFs offer a better deal.  While we do believe that there can be problems with the way some "active" funds are managed, we have also written about the concerns we have over the ETF model. 

We would also point out that these kinds of major swings from one management model to another are very similar to the swings from stocks to bonds and back to stocks that we discussed in the previous post.  It is certainly important to make changes when warranted, but it is also clear from history that  going along with the endless stampeding of the "herd of money" from one extreme to the other can be very harmful.

We believe that a consistent process based on time-tested convictions about businesses is a better way.  Above we post our performance history through the most-recent quarter to back up those convictions and the principles that we advocate here on the blog.



For GIPS disclosures and other information, see here.

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Money flows to investment company funds since 2008, and what they tell us

Recently on his Calafia Beach Pundit blog, Scott Grannis pointed out the data that shows what he terms "an impressive exodus of investors from domestic equity funds over the past several years."  As the chart above illustrates, using fund flow data from the venerable Investment Company Institute (ICI), there is no denying the exodus that Mr. Grannis describes.  We believe this is significant and worth some further comment.

The chart above depicts the ICI data of monthly total dollar flows into (or out of) equity mutual funds as a red line, and the monthly total dollar flows into (or out of) bond mutual funds as a blue line.  The scale on the left measures the flows in millions of dollars, with a zero line in bold.  When net flows for a month are positive for equity funds, for instance, the red line will be above the bold zero line.  When net flows for a month are negative for equity funds, the red line will be below the bold zero line (a net "negative inflow").

As Mr. Grannis observes, the equity market recovery that has taken place since the financial market panic and recession of 2008-2009 has occurred in spite of very heavy outflows of investor dollars from equity mutual funds.  A few notable months are marked above, in red letters for equity and blue letters for bonds.  For instance, in September 2008, equity mutual funds experienced net outflows of fifty billion dollars in investor assets.  The following month the stampede out of equity funds was even heavier, with a whopping seventy billion additional dollars leaving equities.  The same month, bond funds were also experiencing heavy redemptions, with over forty-one billion dollars exiting bond funds in October 2008 (not marked on the chart but clearly visible in the lowest point on the blue line above).

Since the end of the 2008-2009 bear market, which turned around on March 9 of 2009, equity mutual funds have experienced less severe outflows of assets, and even a few months of positive inflows, but in general the net flows for equity funds have been almost all negative.  The outflows have not crossed the forty billion line again, but they have often been greater than twenty billion going out per month.  There were a few periods in which investors in the aggregate briefly added to equity funds, only to change their minds shortly thereafter and return to net withdrawals.

As Scott Grannis also points out in his post, inflows into bond funds over the same period since the 2008-2009 recession have been mostly positive, indicating that on the aggregate investors have been generally pulling money out of equity funds and into bond funds since 2008.

Unfortunately for investors, this exodus from "risky" equities into what are perceived as "safer" bonds is not necessarily a wise way to allocate assets.  We have pointed out in the past that historical data from the 2000-2002 bear market indicates that investors in the aggregate were pulling money out of equity funds  (and plowing money into bond funds) at the very bottom of the equity markets, just as they were piling money into equity funds at record rates just prior to the equity market collapse in 2000.

That post was published in September of 2008, as investors in the aggregate were selling equities at very bad prices.  We continued to advise against panicked selling right up through the March 2009 market bottom (at a point when many who had hung on at the end of 2008 were losing their resolve and selling their shares).  In fact, we were making portfolio acquisitions of well-run growth companies at that time, which would perform very well during the ensuing months and years.

More recently, we pointed out the exact same phenomenon discussed by Scott Grannis above in a post dated October 2010.  At that time, we remarked that:

This kind of behavior is exactly what leads to the dismal long-term returns highlighted by numerous Dalbar studies year after year, which we have discussed in several previous posts. While many articles (such as the Times article) focus on this as the behavior of the "small investor," it is important to note that many of these small investors [individuals, regardless of wealth, as opposed to institutions] are in fact advised by professionals who bear much of the blame.

The most recently-published 2012 Dalbar study confirms the same general pattern discussed in the link from that 2010 post, and seen in previous Dalbar studies stretching back to 1994.   In that 2012 study, Dalbar found that the average equity mutual fund investor achieved a return of negative 5.73% in 2011, in spite of the fact that the overall equity markets as measured by the S&P 500 grew by a positive 2.12% that year.  The same study found that the long-term results were equally dismal: for the twenty-year period ending in 2011, the average equity investor achieved an average annual return of 3.49%, while the markets as measured by the S&P 500 grew at an annualized rate of 7.81%.

As usual, the authors of the Dalbar study conclude that the kind of stock-market guessing indicated by the stock and bond inflow/outflow data we have been discussing above is a major factor contributing to the self-inflicted damage investors experience.

We have consistently declared that we cannot predict markets, neither the stock market nor the bond market, but that we believe that careful analysis and a disciplined process can uncover exceptional companies whose performance over long periods of time can be predicted to some degree.  We advise our readers to focus on owning the securities issued by such businesses*, and to avoid the dangerous practice of trying to jump in and out of the stock market and/or the bond market.



*  As an aside, we have written elsewhere about our belief that investors should focus on individual businesses and the individual stocks or bonds issued by those individual companies, rather than investing in mutual funds (whether equity mutual funds or bond funds).

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Another bag of birdshot, and Happy New Year!

Well, it's a new year and the markets around the world today have been exuberant in their response to the application of the brakes at the last possible moment before hurtling over the so-called "fiscal cliff."  

Some analysts have suggested that policymakers "played chicken" for so long before slamming on the brakes that the Senate, at least, could not possibly have even read the final agreement before they voted to approve it.  But, no matter -- what the markets are happy about today is the fact that things probably could have been a whole lot worse, in that taxes will go up (more on that in a moment) but not by as much as they might have.

As many have also pointed out, and as we would like to point out as well, the last-minute "compromise" that moved through Congress was by no means a "budget."  What the politicians in Washington hammered out was a tax package, and one that does not even pretend to address the elephant in the room, which is the need for spending cuts on the entitlements (Medicare and Social Security in particular) that in some future budget will have to be addressed (but just not yet).  In the meantime, instead of dealing with that thorny issue, we have a bit of tinkering around the edges of the tax levels, and harmful tinkering at that.

The percentage of an employee's income taxed by the federal government for Social Security now reverts to 6.2% (from a temporarily-reduced level of 4.2%), which will immediately impact everyone drawing a paycheck in 2013.  Individuals filing annual returns for 2013 showing an adjusted gross income (AGI) of $250,000 or more -- and couples filing jointly with an AGI of $300,000 or more -- will see many of their deductions reduced or eliminated, including the "personal exemption" as well as the elimination of the majority of itemized deductions available to such filers, including charitable contributions and mortgage interest.

Most significantly, the new cliff deal raises income and capital gains / dividend tax rates on individuals with a 2013 AGI of $400,000 or more, and on couples filing jointly with an AGI of $450,000 or more.  Those taxpayers will see their marginal income tax rates rise to 39.6% from 35%, and their tax on any capital gains and dividends rise to 20% from the previous 15%.  We have written before that these types of increased tax rates on investment, even if they are only enacted on "the wealthiest 2%" -- as the president described them in his press briefing minutes after the deal was reached -- can be very significant to the decision of whether to expand a business, fund a young entrepreneur with a promising innovation or new idea, or take a pass on risky investments because any increase will be taxed more heavily.  In other words, the tax rates on "the wealthiest" matter to everyone, as we explained in that previous post.

On the other hand, the increases agreed upon in this last-minute deal are not likely to be devastating, and they certainly could have been worse in many ways (the levels of AGI at which the increased taxes on investment gains might have been set even lower, for instance).  They will handicap the economy some more, to be sure, but they do not represent a reason for investors to panic or flee in terror.  They are simply another canvas bag filled with birdshot that will now be padlocked to the necks of the citizenry and hence the economy as a whole, to use the vivid metaphor created by author Kurt Vonnegut in his 1961 short story, "Harrison Bergeron."

In that disturbing tale, set in a dark dystopian future in the year 2081, the "United States Handicapper General" mandates "handicap bags" to be worn at all times by anyone who is stronger than average,  as well as a variety of other impediments to compensate for any above-average traits, including masks for those with beautiful faces, and ear implants that blast mentally-disruptive bursts of noise for anyone of above-average thinking ability.  The story can be found in Vonnegut's collection of stories entitled Welcome to the Monkey House as well as in a variety of places on the internet (here is one website where you can read it; it is broken into two pages and the second page is here). 

The fiscal cliff deal, in other words, only adds another "handicap" to the economy, along with all the others that the politicians (of both parties) have been mandating for decades, with greater or lesser degrees of negative impact (see our previous post entitled "We get by in spite" for more on that subject).  As we have written before, during times (such as this one) in which the economy and climate for growth is more dystopian than normal, investors cannot rely on the idea that "a rising tide lifts all boats," and must become even more selective in the companies in which they invest their capital.  Investors have to seek out truly exceptional destinations for their investment capital, in other words -- exceptional in the way that young Harrison Bergeron or the ballerina are exceptional, so to speak.

We wish all our readers a very Happy New Year, and welcome to 2081 2013!

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The "Budget Uncertainty Tax"

As the play-acting drama of the "fiscal cliff" negotiations continue -- a drama that would be ridiculous and laughable were it not so detrimental to the ability of individuals and businesses to plan for their immediate future -- we would like to offer several related observations.

First, we point out that the entire "fiscal cliff" scenario is itself the product of the inability of the elected representatives in Washington DC to agree upon a budget.  This inability is not new -- it has become a regular feature of political life over the past decade.  In fact, although the Congress did pass what is often called a "budget" in 2009 (and has not passed one since), the 2009 measure was only a temporary "omnibus spending bill" and to find the actual date of the most-recent budget passed into law in the US, one needs to go back to 1997 (now over fifteen years ago).

This inability of Republicans and Democrats to reach an agreement is compounded by the fact that the two sides cannot even agree upon what the problem is, let alone which measures should be taken to solve the problem.  In this case, some believe that government spending is the problem, while others believe that government spending is the solution, and some believe that low tax rates are the problem, while others believe that low tax rates are the solution.

But the problem is much deeper than that, as it is clear that even within the major political parties there are deep divisions over how to define the real problem.  Within Republican ranks, for example, it has recently become clear that there are deep divisions between those who are arguing that the main focus should be on the "debt ceiling" while others argue that the debt ceiling is a red herring and that the real focus should be on pro-growth tax reforms and regulation reform (see for example this article). 

The situation has become so divisive that an increased level of cynicism and pessimism among those who have to try to do business in a world that is impacted by the decisions of these "leaders" is entirely understandable.  We believe that it is reasonable to conclude that an era of budget uncertainty is here to stay for the foreseeable future, and that the real questions investors should ask are how it will impact them, and what they should do about it?

We believe that this government-induced "budget uncertainty" acts as a drag on business, because it creates additional uncertainty about where tax rates will be from one month to the next, causes business leaders to be more cautious than they would otherwise need to be, and generally saps economic growth and productivity as energies and attention is diverted away from primary business concerns and into all sorts of political analysis and tax-planning activities.  This drag on business activity caused by budgetary uncertainty is very similar to the drag on business activity that comes from misguided monetary policy that makes it  more difficult for businesses to predict the future price of raw materials or the future strength of  different currencies, and more difficult for lenders to provide capital to businesses that need it to expand (see here and here).

We might call the drag on business imposed by the budget follies of the past fifteen years a sort of a tax: the "Budget Uncertainty Tax."  It is not an actual tax in that it doesn't represent business activity that is taxed after revenues are made and employees are paid -- instead, it is a tax that is taken in the form of revenues that are never made in the first place.  In that sense, it is a "stealth tax" in much the same way that inflation can be a stealth tax.

So what should investors do when they perceive that businesses are likely to be facing a "Budget Uncertainty Tax" for the next several years?  Well, we don't believe that the answer is to run and hide, trying to escape the problem by not investing in businesses at all.  We believe that almost all investors need the potential growth that comes from participating in the success of well-run businesses over the course of many years, and that investment in growing companies has historically been one of the very best defenses against the loss of purchasing power caused by inflation and other destroyers of wealth (see here and here for example).

However, during times when the obstacles to business success multiply -- obstacles such as the ones described above -- the need to become more discriminating in the businesses to which one commits capital increases dramatically.  History appears to illustrate that during better business climates, the "rising tide lifts all boats" and investors can do fairly well by owning just about any group of well-run companies.  During such periods, the advice to "just invest in an index" becomes popular (during the 1960s, an early version of large-cap "indexing" called the Nifty Fifty strategy was popular).

During uglier periods, however, investors need to be more like the prospector panning for gold, keeping only what are true nuggets and discarding companies that might be worth considering in better times (companies that might turn into diamonds if given the chance, but may never get that chance in the more uncertain climate). 

We will continue to discuss this subject in future posts.

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