Thursday, January 17, 2008

Economic ignorance hurts



Today, Fed Chairman Ben Bernanke testified on Capitol Hill before the House Budget Committee, giving prepared remarks and answering questions posed by lawmakers on the committee.

The proceedings were generally a cause for dismay. In fact, although no one ever knows the exact reasons for a market's movements on any given day (although the news media will confidently tell you that they do, which is nonsense), it is very possible that the markets were further rattled by the goings-on today in Congress.

The main thrust of the question-and-answer session was the issue of which would better assist the economy, rebates or tax cuts, with lawmakers using their questions more to make their own assertions on the topic and to get Bernanke to echo their opinions in a newsworthy soundbite than to hear what he had to say.

The question of tax rebate "stimulation" versus tax rate cuts is an excellent illustration of the very important conflict between the demand-side worldview and the supply-side worldview which we have discussed in numerous previous posts, most notably this one.

The mentality behind sending a tax rebate of, say, $800 dollars in the form of a check to every taxpayer ($1,600 to every taxpaying couple) is a classic demand-side attempt to "stimulate" the consumer (recall that in the previous blog posts we have also noted that demand-side thinking is also called "consumptionist" thinking). It is a very clear example of the thinking that "the consumer drives the economy."

On the other hand, the supply-side approach believes that the real engines of the economy are the business which produce goods and services (which is why it is also called "productionist" -- see the essay "Production versus Consumption" by economist George Reisman, first published in 1964). If the economy needs help, a productionist or supply-sider is much more inclined to recommend action that will enable the formation of new businesses, as well as enable greater investment (and ultimately greater production) in businesses which are already producing in the economy right now.

Greater investment in businesses creates more jobs, which stimulates demands far more than any $800 check will do. And, while demand-siders argue that the check is much faster, the primary tool of stimulating business formation and business investment -- cutting the tax rates on capital gains that result from successful investment in such businesses -- has immediate and dramatic effects.

If you are a venture capitalist and you know that if you risk $2 million in a start-up business which may pay back $12 million in a few years, but which may also go to zero if that start-up fails (as many start-ups do), you might be willing to risk that $2 million if you get to keep 85% of the gain (even though there is a risk that there will be a total loss). But if the government tells you that they will tax the gain at 50% (instead of 15%) you may calculate that it is no longer worth risking the total loss of $2 million for the possibility of making only $4 million (after taxes) instead of $8.5 million. In that case, you may not fund the entrepreneur at all, and a business will not form that (under a less onerous tax rate) might have blossomed and added great value (and many jobs) to the world.

Changes in tax rates cause immediate changes in the decisions of those who are allocating large amounts of capital for the formation of new businesses and the expansion of existing businesses. In fact, even the prospect of taxes rising within two or three years will have a big impact on the allocation of capital right now -- in the example above, that venture capitalist may very well have to wait at least two years before any tangible results come from his investment, so he is making his calculation based on his assessment of the future tax rates that will hit his potential capital gains. The prospect of higher tax rates in the future will have a big impact on the very important allocations of large amounts of capital today. These large allocations of capital, the productionist or supply-sider argues, are the engines which actually drive the economy.

Giving every individual taxpayer $800 is not going to create any new businesses (except in the highly unlikely event that 10,000 of those rebate-holders decide to band together and form a venture fund with their rebate checks and fund a couple start-up companies).

Today's remarks on Capitol Hill were particularly dismaying for a number of reasons. First, many of the members of the House Budget Committee displayed a complete disdain for the impact of tax rate cuts -- one lawmaker even suggested that the rate cuts of 2003 would cost the government trillions of dollars (when in fact, the rate cuts resulted in tax revenue increases, due to their salutary effect on the economy).

Even worse, that lawmaker was able to get Ben Bernanke to repeat after him that "tax cuts generally don't pay for themselves" -- causing listeners to the televised remarks to wonder if Mr. Bernanke is a demand-sider, although in defense of Mr. Bernanke it seemed that the Congressman was "leading the witness." It was clearly a shameless display of grandstanding to get a soundbite, as the lawmaker himself admitted at one point when he reminded the Chairman that many news agencies would pick up his comments.

Finally, the most embarrassing display of the day's proceedings came when Representative Marcy Kaptur (D-Ohio), who has been on the House Budget committee for an entire year as of tomorrow, confused the Chairman of the Federal Reserve with Treasury Secretary Hank Paulson. She obviously had no idea of Bernanke's background as an academic, which is simply astounding.

It's hard to blame the markets for reacting in a negative way today to the various displays of economic ignorance coming out of the House Budget Committee, a government body with some degree of power to directly impact the economy.

For later posts related to this same subject, see also:
Subscribe to receive new posts from the Taylor Frigon Advisor via email -- click here.
Continue Reading
2 comments
Tuesday, January 15, 2008

Remaining calm without being blind or obstinate





In the current turbulent market environment, some subtle aspects of the Growth Stock Theory of Investing are valuable for investors.

As we have explained in previous posts, one of the key tenets that Rowe Price outlined in his 1973 essay entitled "A Successful Investment Philosophy based on the Growth Stock Theory of Investing" is that most of the big fortunes of the country were made not by timing market cycles but by "retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years."

During periods of stock market capitulation, it often takes a cast-iron stomach to "retain ownership" in a company even when you believe it still has solid growth prospects. But if you want to own those companies for "a long period of years," there will be periods in the interim when the market interrupts with sickening drops that have little or nothing to do with the actual growth prospects of those successful business enterprises.

However, just as it is opposed to the market-cycle approach followed by most "investors," the Growth Stock Theory of Investing is also opposed to a passive "buy and hold" strategy! A shallow view of the previous paragraphs might lead one to conclude that Price was advocating a blind, obstinate resolve to hold a company for decades through hell and high water. But nothing could be further from the truth.

The very term "growth stock" that he selected came from his observation that "corporations have life cycles similar to those of human beings" -- an assertion Price made in a series of articles published in Barron's Financial Weekly in the spring of 1939. He wanted to select companies that were still in the "growth" part of their life cycle.

This observation enabled him to continue to hold a company (if it was still in that growth phase of its life-cycle) regardless of the inevitable market cycles.

BUT it also meant that he was not in the camp of the typical "buy-and-hold" investor, who can sometimes be accurately accused of holding onto a stock that is in the declining phase of its life cycle. Holding onto a company that has stopped innovating may seem conservative, but it can actually be very risky, even foolhardy (as we pointed out in another previous blog post).

Price's 1939 observation (he actually published it in Barron's in 1939, but said that he recognized the truth ten years earlier, so it could in fact be called a 1929 observation) has received a modern re-formulation in a term called the "topple rate" published in a February 2005 McKinsey paper called "Extreme Competition." In that article, authors William I. Huyett and S. Patrick Viguerie examined the rate at which companies in an industry's top quintile (by revenue) fell out of that top quintile. This rate they called the topple rate.

We heard the term in a talk given by Rich Karlgaard in 2005, who later discussed it in a blog article he wrote the same year.

The conclusion of the McKinsey paper (and Rich's 2005 blog post) is that the topple rate has been increasing in recent decades. In other words, the amount of time a company spends at the top of its industry has been dropping rapidly.

The "life cycles" identified by Mr. Price have (in general) been speeding up. While a growth stock investor in 1939 might have been able to own a business that would continue to grow and prosper for many decades, it is now more likely that a growth stock investor can own a business that will continue to grow and prosper for many years, but not for many decades. Rather than obstinately holding companies for some predetermined number of years, someone with a deeper understanding of the Growth Stock Theory of Investing will watch those companies closely for signs that they no longer fit the criteria of a growth company, for signs that they are no longer in the phase of their life cycle that warrants their retention for the future.

However, those signs are found in the company, not in the stampedes of markets like those seen in recent weeks. A true growth stock investor can remain calm during market volatility, without falling into the opposite trap of blind or passive "buy-and-holding."

For later posts dealing with this same topic, see also:
Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.

Continue Reading
2 comments
Friday, January 11, 2008

Volatility is back in the market











Volatility is back in the market, after several years of below-average volatility.

The current volatility is above average and is a reminder of what equity markets are more commonly like.

The current stormy weather is threatening to get worse before it gets better.

As discussed in this previous post, research suggests that "investors make most mistakes after down turns," which is akin to jumping off a ship in the middle of a hurricane. With a full-force correction (a market retreat of 10% or more from the previous high -- the third this year) in force, many investors are jumping ship or preparing to do so if the plummet continues.

We wrote two months ago that "all the loudspeakers of the giant financial retail firms and the financial news media are constantly blaring a message that you have to time cycles -- cycles of the dollar, cycles of the Fed, cycles of quarterly economic acceleration or deceleration."

If, however, you base your strategy not on timing cycles but on the real source of most of the great wealth created for families in this country for the past hundred years, the ownership of shares in successful businesses for a period of years or even decades, then you should both expect interim volatility and be prepared to weather it.

Unlike most of what you hear, we advise that you realize that there will always be ebbs and flows in the mighty financial ocean, but that these by themselves don't make you change your mind about businesses with solid prospects that you intended to own for many years.

You can read more on this subject in our most recent market commentary, which is posted in the commentary section of the Taylor Frigon Capital Management website.
Continue Reading
Leave a Comment
Monday, January 07, 2008

Investor behavior. . . or Advisor behavior?


















Every year the Dalbar Quantitative Analysis of Investor Behavior (QAIB) is released, showing the results of the financial research firm's examination of investor behavior a twenty-year period beginning in 1987. The results for 2007 are not in yet (that QAIB, which will be called the 2008 QAIB, will come out in March or April 2008), but the 2007 QAIB shows results for the 20-year period stretching from the beginning of 1987 through the end of 2006.

As in previous years, the study's results have shown that "the average investor earned significantly less than mutual fund performance reports would suggest," according to the study. The reports have consistently demonstrated that over time, investors underperform the actual investment vehicles available to them. The study found that the average annualized return over the twenty year period was only 4.3% (the overall market had an annualized return of 11.8% over the same twenty year period). Dalbar's analysis argues that it is erratic investor behavior, rather than the funds selected, that causes this tremendous performance erosion over time.

Dalbar's examination of the data for the entire mutual fund industry over a long period of time reveals that the tendency to rush in when the market is going up and rush out when the market is going down reduces investor returns to a fraction of what they would have made if they invested consistently over the same long period. The study found that "investors make most mistakes after down turns" and suggested that "These mistakes occur because investors are driven by the fear that the markets will not recover -- even though broad indices show that markets do indeed recover."

The study provides a variety of data that shows that it is not the investment vehicle that is the problem, but rather the investor behavior. It suggests that professional advisors can help with this behavioral problem.

BUT the Dalbar data does not differentiate between investors who have a professional advisor and those who do not!

Dalbar uses equity mutual fund data from the Investment Company Institute, which tracks a variety of data concerning the mutual fund industry .

A review of the 2007 ICI Fact Book reveals that ICI states that "ICI research finds that approximately 80 percent of mutual fund investors seek professional advice when buying mutual fund shares outside of retirement plans at work" (Section 5 -- 12b1 fees).

This suggests that a significant percentage of the mutual fund investors who are following damaging investment patterns discussed in the annual Dalbar surveys have professional advisors!

Our experience suggests that the heart of this problem lies in the fact that the vast majority of advisors today (whether they are at a big brokerage firm or a tiny independent shop on Main Street) are basically "selectors of other managers." In other words, they are in the business of selecting mutual funds or other managed vehicles for their clients.

Because of the divide between those who actually manage the money and those who advise clients (see this previous post on the subject), advisors can show performance records that go back many years but which none of their clients were in during those many years. In other words, they can have the same kind of "rear-view mirror" selection of investment vehicles that causes the results found in the Dalbar studies every year.

When an advisor holds up the performance record of a potential investment vehicle to a client (whether the vehicle is a mutual fund, an index fund, a separately managed portfolio, or something else), very few clients ever ask "I see how that investment has performed, but how long have your assets and your clients' assets been in that vehicle?"

In other words, the track record that you see on any managed portfolio (or an index fund or ETF) only represents a potential return. Actual returns have been shown to be significantly lower among the population that shops around (erratically) among all those potential investment vehicles.

Because the vast majority of advisors do not manage their clients' assets themselves, but instead select other managers (or index funds) to manage their clients' assets, could it be that they are as prone to switching vehicles as anyone else?

The actual portfolio managers who invest in their own portfolios ("eat their own cooking") year after year will receive those actual portfolio returns (their actual returns will be the same as the "potential returns"), but advisors and other investors who switch in and out of those portfolios (studies consistently find) achieve only a fraction of the potential return.

It is interesting to note that this is probably a fairly modern phenomenon, coinciding with the rise of the mutual fund industry and the "outsourcing" of money management. The period covered by the Dalbar studies is the same period in which this outsourcing of money management grew astronomically.

It's easy to forget that prior to the advent of the internet, the ordinary person could see stock quotations only once a day, in the morning paper. If he wanted more information, he could call a broker for a quote, or go down to a local brokerage branch office and "watch the tape" in the lobby. Back then, brokers truly had access to more information than the average investor.

The advent of the internet changed the entire model. Today, the old-school "broker" is a thing of the past. He has been replaced with the "financial advisor" who no longer "picks stocks" for his clients but instead picks managers. The fear in the brokerage days was that there might be unscrupulous brokers who "churned" their clients' accounts for commissions. But, since the advisor typically works for some kind of annual fee (often some portion of the fee stream paid to the mutual funds or other managers he selects for his clients), the danger is that the advisor will change managers more frequently than he should, both because he can fall into the same performance-chasing traps that the annual Dalbar surveys discuss, and in order to justify his existence as the "picker" of good managers.

This is not an "investment vehicle problem" -- the solution is not to say "Oh, that means you should buy index funds, or ETFs, or SMAs, instead of mutual funds." This is a financial industry problem. Mutual fund managers and other professional managers are vitally important to investors -- it is the "advisor" system that has grown up after the era of the broker that may be the problem. We would argue that the data in fourteen Dalbar surveys argues strongly that something is wrong not just with individual investors, but with the rise of advisors whose job is basically to "pick managers."

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

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

Continue Reading
1 comment
Thursday, January 03, 2008

Look for Paradigm Shifts



















In every business landscape, the current predominant business model is always subject to being overturned by a new and more efficient business model that delivers new value over the old one.

If a company can find a way of completely changing the landscape in a particular field, that company can "outflank" its competition by shifting the entire paradigm.

A familiar example would be Apple's development of iTunes and the iPod players, which took a new delivery model for music (one that already existed, but was only used by a small number of consumers) and made it so practical and easy that it rapidly displaced the currently dominant means of obtaining music. Several companies that relied on the old model (buying music in a store) went out of business as a result. Apple's new developments completely changed the existing paradigm.

A paradigm shift is an important concept in the classic Growth Stock Theory of Investing. In his 1973 treatise on the subject (discussed in this previous post), T. Rowe Price stated:

"Most corporations, like people, pass through a life cycle of growth, maturity and decline. Common sense tells us that an investment in a business enterprise affords greatest gain possibilities and involves less risk while the long-term earnings trend is rising. [. . .] The risk factor increases after maturity is reached and decline begins."

In other words, although many people think that big, established companies are "safer" investments than average, it is important to realize that every established company must continue to deliver more value than the alternatives, and that other companies are always looking for ways to usurp their position of leadership. If a large company is not alert, it can be outflanked by a more effective new company, especially if that new company is able to change the entire paradigm with a new business model that is more efficient than the existing model.

This concept is closely analogous to the military concept of a "flanking maneuver." One of the clearest visual examples of this concept took place on May 2, 1863 in the famous flanking movement executed by the Confederate forces in the second day of Chancellorsville. In the illustration above, from the 1865 biography of Stonewall Jackson by his friend, chaplain and onetime Chief of Staff R. L. Dabney, we see one of the most famous flanking movements of the American Civil War.

On the second day of the battle, Lee sent 26,000 men -- well over half of his available forces -- under Stonewall Jackson on a flanking maneuver depicted on the map above by a large red arrow. The Union forces had been reacting to what they thought was the real threat posed by Lee's main body (see the small blue arrows in the map above) but were completely outflanked by Jackson's bold and deep flanking maneuver and were forced to withdraw to later positions which are sketched in the original map above but not colored in blue.

A flanking maneuver is particularly effective because your opponent is positioned with his fields of fire primarily in one direction, and your arrival on his flank or in his rear forces him to reorient rapidly to try to deal with the new threat. Often he is unable to turn effectively in time.

A paradigm shift "outflanks" the existing business model in exactly the same way. The existing business must rapidly try to catch up, but if they did not see it coming in time, they will often be unable to shift fast enough. All of their production systems and incentive structures are geared towards the old model, and they may be unable to effectively re-work those in time to prevent the new company from completely dominating the landscape.

It is also important to realize that a paradigm shift does not always take place because of new technology. New technology often does enable a paradigm shift, but a paradigm shift can take place from the creative application of almost any new and more efficient business model, whether it uses some new technology or not. A company with a clear vision and a more efficient way of providing greater value can outflank an entrenched leader and completely alter the landscape, and the history of business is replete with examples of this taking place.

Paradigm shifts are always taking place in one part of the business landscape or another. We believe that some important paradigm shifts are taking place right now, and others are being set up to take place in the next few years.

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

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

Continue Reading
Leave a Comment

Subscribe

Return to top of page
Copyright © 2013 · The Taylor Frigon Advisor