Don’t confuse a bull market for brains

by Amy Parvaneh, 01/20/2015

“Don’t confuse a bull market for brains.” - Humphrey B. Neill

Because it’s easy to do so—especially when a general lack of transparency in the investment industry renders it difficult for investors to determine exactly from where their returns are coming.

Integrity and trust have always been key principles in the investment industry, but they’ve become even more poignant issues following the financial crisis as investor confidence largely gave way. Along the same line, the need for investment managers to apply consistent return calculations and provide accurate performance information has also become increasingly crucial.

Questions remain regarding the degree to which investment firms are making efforts to calculate their returns and publicly report their numbers. Certain legal regulations exist, but how widely and sincerely is self-reporting practiced and appreciated in the industry today?

Taylor Frigon Capital Management LLC tells of its commitment to being transparent with its investing strategy and performance results. The boutique wealth manager based in San Luis Obispo, Calif. serves private clients and institutions throughout the U.S. It claims compliance with the Global Investment Performance Standards and is independently verified by Ashland Partners & Co. for GIPS compliance reporting.

“We’ve been doing this compliance from the get go,” said President and Chief Investment Officer Gerry Frigon, who founded the firm in 2007 after more than 20 years of investment strategy, planning and management for private and institutional clients.

“GIPS reporting is a lot of extra work, it’s expensive, and we’ve gone back and forth at times about our decision to report and be verified,” he said. “But transparency is the point we want to drive home. We have taken the initiative to show our performance. We’re not going to run from our performance no matter what it is. We’ve been through some periods of really good outperformance and sometimes underperformance. But over time, if you have a disciplined strategy, we know that it will work.”

Frigon spoke of what he has observed during the three decades of his investment management experience.

“I grew up in a world over the last 30 years where, frankly, the typical investment adviser wants to run away from performance, not embrace it,” he said. “I think we knew that was a problem in the industry. But somehow, the industry has succeeded in pulling the wool over the eyes of the investor. You’re fighting a battle of firms that have gotten used to saying, ‘Performance doesn’t matter; all clients care about is service.’”

There is no official set of data to tell exactly how many investment firms pursue transparency at what levels. But the Global Investment Performance Standards, created by CFA Institute, is becoming more and more widely accepted as a universal language for presentation of investment performance.

“The GIPS standards represent an important part of our effort to restore public trust in our industry,” wrote Annie Lo, director of GIPS Asia Pacific at CFA Institute and Trevor Persaud, managing director for ASEAN and Taiwan at Russell Investments, in a 2013 issueof the CFA Institute Magazine.

“By choosing to comply with the Standards, investment management firms assure prospective clients that the historical ‘track record’ they report is both complete and fairly presented,” the article said. “GIPS compliance allows firms to expand their business territories and to participate in competitive bids against other compliant firms globally.”

Institutional investment data research firm eVestment recently published its 2014 study of the value of GIPS compliance. Analysis was based on survey responses of 101 participants and on the firm’s internal database of individual managers. The survey primarily included advisers managing institutional funds and likely does not represent the trend among advisers who oversee portfolios of individual investors.

Data showed that about 74% of the eVestment database population claims compliance with GIPS, and 82% of those that are in compliance receive verification of their reporting.

About 65% of consultants and investors exclude managers from consideration “some or all the time” if they do not claim compliance with GIPS.

Qualitative survey responses about GIPS included thoughts that compliance is “demanded by international markets,” and that the standards serve as “a scorecard” and “a tool” to evaluate managers. Some said that although the standards “aren’t perfect,” they do provide a certain guideline.

Frigon pointed to the general lack of understanding in the investment industry, even among portfolio managers, regarding their performance.

“The typical adviser has no idea why his or her portfolio has been performing OK,” he said. “If the average investor were to ask his or her manager, ‘What are the business reasons that this or that has happened in my portfolio?’ the manager doesn’t know. It’s possible that the manager is in such a broad index strategy that the performance is kind of accidental. Don’t confuse a bull market for brains.”

He added that there’s been a gradual but clear change in the investment industry over the past few decades.

“It used to be that a stock broker would actually get to know the companies first, and then they would go out to sell the stock to their clients,” he said. “That’s the traditional stockbroker. Some of the best money managers ever were the ‘old’ kind of stockbrokers. They understood how to analyze the company. But we’ve gotten so far from that. That art has been completely thrown out the window for the most part. The money manager types now are in mutual funds, and it’s become a quarter-to-quarter numbers game instead of understanding the companies within them.”

Frigon said Taylor Frigon as a firm hopes to see a shift in the lack of adviser knowledge and value.

“Our clients know that we are ridiculously transparent and that we adhere to a strict set of standards,” he said. “And we tell our clients that there may be periods where the performance might not make sense immediately. That’s because we’re not making our investment decisions based on the whims of the market. We’re doing so based on the businesses we’re buying and based on the things happening inside the businesses. Those things don’t necessarily happen in line with the market.”

“Overall, the issue becomes one of investor trust and manager integrity, and GIPS could be a useful tool to bring about a restoration of those principles in the investment industry,” Frigon said.

“I think being GIPS-compliant is like the cherry on top at this point,” he said. “Most advisers are not even reporting any kind of performance. They are dancing around it, and that’s what I think is shocking. That’s what I think needs to be exposed. Our clients are used to getting those performance reports. It’s standard for them.”

Jonathan Boersma, head of professional standards at CFA Institute, said that he thinks the “biggest challenge [that asset managers face today] is the lack of integrity in the industry that has led to investors’ lack of trust and a collapse in investor confidence.”

Even as the details of the GIPS standards have and will continue to evolve to fit the complex needs of the financial industry, the core objectives of the GIPS standards “remain unchanged [which is] to support fair competition and to promote comparability through consistent calculation and presentation of investment performance information,” he said. “The GIPS standards address some of [today’s challenges] because they are ethical standards that focus on fairness and improving transparency, which can help restore trust.”

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Investment Climate, January 2015

Here is our latest quarterly investment climate report: "An Energized West." Follow the link to access the full commentary, as well as links to previous investment climate commentaries.

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The gut check

image: Wikimedia commons.

The term "gut check" usually refers to the idea of testing resolve, assessing the level of conviction to press on to the goal even in the face of increasingly difficult conditions. 

Militaries around the world have devised various ways of creating "gut check" scenarios: one such "gut check" that we remember hearing about, which was used in the training of candidates for a certain special operations unit, involved a long and difficult road march carrying heavy gear towards a designated point, where participants were told that trucks would be waiting to take them to the next objective. 

When the hopeful candidates, after several hours of walking, arrived at the designated location, the trucks that they found there suddenly started up their engines and drove away, just before anyone could climb on board. The instructor then informed the candidates that they had to move on foot several more miles to meet up with the trucks. 

Many of them threw their rucksacks on the ground and declared that they were quitting right there. What they did not know was that the trucks had only driven a few hundred yards over a ridge and around a bend, and that if they had just pressed on for a little ways their long march would have been finished successfully.

There is an old saying in the investment world that "guts" are in some ways more important than "brains." Certainly, analysis and research are vitally important in finding good investment candidates, and in evaluating those investments and deciding whether or not to commit capital to those investments. But those who have been at this business for any significant length of time will know that the markets have a way of delivering "gut checks" that are every bit as mentally challenging as the truck scenario described above -- and if an investor does not have the "guts" to persevere through those periods of testing, no amount of "brains" will matter.

Investors in the systems which enable the interconnected, mobile networks of the modern world are presently experiencing a real gut check right now -- some might argue that they have been experiencing a gut check for the past few years.

Yesterday, for example, network processor company EZchip, which we have written about in the past, announced that their revenues for the current quarter would be about 10% lower than they had predicted -- an announcement which contributed to the overall negative sentiment in the sector of companies offering solutions to the carriers whose data centers and towers and nodes move the data and enable the mobile networked activity that consumers and businesses use every minute of the day.*

The selloff in EZchip was immediate and significant, with the stock dropping about 10% in one day. It was, in an sense, a "gut check" for investors who thought that "the trucks would be here by now," so to speak -- and many investors (including some who may have invested in EZchip for many years) threw their rucks on the ground and said they were done with it. In other words, they sold their shares.

We bought more.

The reason we bought more in this case is that, while we don't know exactly how much further we will have to go before the situation suddenly gets better, in this situation we are absolutely convicted that the situation will in fact get dramatically better. 

The conditions that investors and industry participants have been talking about for years have not changed: the demand for more and more data, delivered more and more rapidly, and at higher and higher levels of sound and visual quality and resolution is growing exponentially, and the infrastructure to deliver all of that data at higher speeds and higher levels of quality has not been keeping up, and will necessarily have to be upgraded. 

This fact is no secret in the industry: it is the focus of nearly every company involved in the networking world. The carriers are facing billions of dollars in spending (actually, tens of billions of dollars in spending) and we believe that they have been evaluating their options and weighing their deployment of so much business capital very carefully over the past several years. 

At the same time, many new transformative approaches to the underlying problem have been developed, including the industry-changing approach known as NFV, or "network function virtualization," which has radical implications for the makers and buyers of network equipment and for the designers and architects of data centers and data networks. In light of this fact, it is to us no surprise that the carriers want to thoroughly evaluate the situation and look at all of their options prior to committing to courses of action which will involve billions and even tens of billions of dollars.

We believe that this process has been going on for some time now, and that it is still going on -- but we also believe that it may be nearing an end and that the move may begin to take place very soon. We don't know exactly when the evidence of this move will begin to be evident, but we are fairly certain that it will in fact happen. 

Obviously, this move will involve industry dynamics which are bigger than any single company or any single investment name, including EZchip -- we just use EZchip as a timely example in this discussion. We invest in other businesses which we believe are positioned to benefit from this same dynamic, not just EZchip, and we would advise other investors who want to benefit from these types of major industry paradigm shifts to follow a similar course. 

The bigger point is the concept of the "gut check." Many market participants are very short-term oriented in their focus, for various reasons (sometimes for very good reasons). For whatever reason, they simply cannot continue to march after the trucks, even if those trucks have only gone over the next ridge and around the next bend. When investors with a longer focus see others around them "throwing down their rucksacks," so to speak, and declaring that they are done with this road march, it can be very disconcerting -- and some investors may be tempted to do the same thing just because everyone else is doing it.

Please note that we are not advocating that investors never sell an investment, or that selling an investment when new information requires a re-assessment indicates some kind of failing: if the new information changes the investment thesis to the point that the original assessment is deemed to be no longer valid, then selling the investment may in fact be the right thing to do, and failing to sell it at that point would be the real failure!

But if, on the other hand, the original investment thesis is still valid, and it is the market which is being short-sighted and throwing a tantrum when the trucks drive on a few more hundred yards out of sight, the right thing to do may well be to press on. 

We believe that this may well be the actual situation right now in the networking solutions space, but we also believe that this valuable and important principle of the "gut check" is one that is broadly applicable in the business of investing -- and in life.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by EZchip Semiconductor (EZCH).

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A Market Transition? We Hope So!

image: Wikimedia commons.

It has been a lousy stock market lately, although we suggest that this is part of a healthy reassessment which has actually been going on for a long time -- well over a year, in fact, since many small and middle-sized companies are already considerably off of highs reached before then. We believe the market needs to shake off its dependency on the U.S. Federal Reserve's easy monetary policy.  Essentially, we think we may be starting the much-needed process of weaning markets off of the perceived need for liquidity from the Fed as the basis for keeping the markets afloat.

It is our view and has been for some time that the world needs to transition from liquidity as the driver of value to business fundamentals; that we need to get back to investing for investment's sake and off of financial engineering, whether that engineering is done by the Fed or by businesses themselves. And while the process may be painful in the interim, particularly because growth oriented companies get caught up in a "risk off" mentality, we think the focus will eventually turn to business acumen, and the business merits of companies as the determinant of stock values.

At this time, the mentality of the market is to be afraid of a stronger dollar and higher interest rates.  The truth be told, many of today's market participants have only experienced the Fed-induced market of the 21st century in their careers. They've only been in this business during this period of great Fed influence. We believe we will eventually return to a 1980s-90s-type of market in which the U.S. Dollar, interest rates, and stock markets are more positively correlated (at least in the sense that the absolute level of interest rates is higher, not that interest rates need to drop) and commodities ease, including gold (maybe most notably gold).  This will allow for a much healthier market environment and one which is more friendly towards businesses that are performing well from a business standpoint, not just those who are managing stock buy-backs and "tax inversions" as the means to drive stock prices.  It will also incentivize businesses to increase capital investment, which has been sorely lacking in this anemic economic recovery, thereby fueling more overall business activity, and solid growth.  As we stated earlier, this may be a bit painful but in the longer term it is very healthy.  And we would also add that in order to really get this transition on track, we will need more business- and investment-friendly policies out of Washington.  

Stay tuned!

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Have you heard of this company? PRAA

The previous post discussed the investment philosophy of Thomas Rowe Price, Jr., and his conviction that investors should focus primarily on the business merits of the company, and on finding well-run businesses positioned in front of fertile fields for future growth, and then should consider owning those selected companies through the inevitable ups-and-downs of market cycles.

This approach was a stark contrast to the much more prevalent investment styles, both in Rowe Price's day and in the present day, of trying to predict different turns in the economic cycle or the market cycle, and trying to jump in and jump out of different stocks, sectors, geographies, currencies, or other asset classes based on those predicted inflections (we've written about the problems with this approach many times in the past, including here, here, and here). 

In the past, we've published several short profiles of companies that we own in the portfolios that we manage and that exhibit the classic growth-stock characteristics that Thomas Rowe Price and Richard Taylor sought out, and that we have owned through the cycles of relative popularity or unpopularity on Wall Street, often with happy results for our clients (see lists in these previous posts, here and here and here). 

An example of a Taylor Frigon growth company which we have owned for many years and which often falls in or out of favor with Wall Street based on the popular attempts to predict different turns in economic cycles is PRA Group, a specialty finance company providing accounts receivable management*. "Accounts receivable" is an accounting term referring to an asset in which another party has yet to pay for a good or a service, and therefore owe some payment, which the asset owner expects to someday receive -- hence, a "receivable." 

PRA Group helps to encourage the payment of the receivable payment: simply put, PRA Group performs debt collection. The business model that PRA follows is fairly straightforward. It buys the receivables of companies who have given up on trying to collect on those receivables and who just want to get something for them rather than nothing. PRA can buy these defaulted receivables for literally "pennies on the dollar," because the originator of the accounts has basically despaired of getting anything on them at all. PRA then assigns their own experienced and well-trained teams to work on getting some of the receivables.

PRA has tremendous experience in valuing and purchasing the debt that they believe they can still collect on, and because they have now paid off the first lender, if they are able to recover more than what they paid for the receivable that amount will belong to PRA. They thus perform a service for the original owner of the receivable (who would prefer to get something back on a defaulted extension of credit to another person) and often to the party who owes the money as well, since simply continuing to not pay is often not the best choice unless bankruptcy is imminent. 

In some cases, PRA will work on a "contingency" basis, in which they do not actually purchase the receivables from the originator, but instead will perform the collection services on a contingency basis, keeping a percentage of the collections as a fee from the originator who has chosen for whatever reason to outsource the collection instead of making all the calls themselves.

Although this business model is fairly straightforward, that does not mean it is easy to be successful at it: PRA has seen most of their competitors in the same field drop out of the business. Many of their competitors relied on borrowing huge amounts of money (leverage ratios well above 1) in order to finance their own purchase of receivables, and/or on bundling up and "securitizing" the receivables that they themselves bought, to sell them to Wall Street as a security to sell to investors. PRA Group relied on neither of these two strategies, and have watched many of their competitors who did use these approaches exit the business or fail. This has left PRA Group in the enviable position of dominating a market with little competition -- and while there are not necessarily that many barriers to entry, history has shown that succeeding in the market can be difficult.

PRA Group has managed to grow operating earnings by a compound annual rate of 28.7% for the past five years. The company's return on assets is approximately 10.9%, and return on equity is approximately 17.1% (on total debt-to-assets of 0.46). This previous post cited some of the "hurdles" in some of those departments that Thomas Rowe Price used to look for in a company, and PRA exceeds the standard in each category by a wide margin.

Some investors may have some qualms about investing in a company which performs debt collection services, on the grounds that consumer credit problems are often a major burden to individuals and families in difficult circumstances and difficult economies, which is a valid concern (and one that is tied to the larger problems of erroneous neo-Keynesian economic theory and excessive central bank "perpetual emergency stimulus" policy).

However, while we agree that this is a serious issue and a serious problem, it would be foolish to argue that credit or receivables are not very important aspects of an economy. Without such mechanisms, no one would be able to start restaurants or dry cleaning businesses unless they had enough cash of their own before they even opened their doors (which would exclude all but a very small percentage of the population). There are many other examples of places in which purchases using credit can be appropriate and prudent. 

If we grant that receivables have an important role to play, then it stands to reason that the recovery of receivables is an important task as well. We would also hasten to point out that PRA Group approaches this necessary task in a professional manner, and can be held to account in doing so by the fact that they depend on their reputation for business -- and for investors!

While the economy has gone through many gyrations since we first invested in PRA Group, we believe that it is better to own good companies through cycles than to try to predict when things will be better or worse for their specific industry and try to "jump in" and "jump out." The name is up well over 230% since we first invested in PRA Group.

We believe that this is a valuable example of a well-run business operating in a market with significant potential for future growth -- and an even more valuable example of a name that many investors would be tempted to trade based on predictions about economic cycles, but that proves the value of the Growth Stock Investment Philosophy's emphasis on owning good companies through the inevitable cycles.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by PRA Group (PRAA).

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