The first monthly decline in medical prices in 35 years!

Investors who watch the traditional financial media shows can be forgiven for not hearing about an amazing statistic that came out of this morning's monthly consumer price index release from the Bureau of Labor and Statistics, because it isn't getting much coverage.

The CPI was up in July, after showing declines for the previous three months. However, looking at the fine print, we see that prices for medical care declined in July by 0.2%. As economist Brian Wesbury points out, this is the first decline for the measure of the cost of medical care in any month for the past 35 years!

The previous month, the medical cost inflation reading was zero.

What's going on here?

It's hard to know for sure, but it could be that participants in the free enterprise system in the United States are attempting to address the need for medical care outside of traditional channels, and that this competition is actually causing a decrease in prices. For example, economist Mark Perry recently highlighted this article entitled "Dr. Wal-Mart" in his excellent Carpe Diem blog, illustrating the impact that Wal-mart's entry into the world of filling prescriptions has had on the cost of prescription drugs*.

The article cites a physician in Columbus, Ohio who says: "Because of their big role in the marketplace, they couldn't be ignored. And it really has affected the way I prescribe medication. That is true, and I'm not alone."

Elsewhere in the article Ron Galloway, a national speaker who specializes in giving talks on the impact of Wal-Mart on the US health system pinpoints what he believes is the cause of this demand for "outside the system" medical solutions: "Obamacare is going to have people looking for getting primary care in other places than hospitals. And Wal-Mart, they can ramp up quickly."

Competition, due to free enterprise, tends to drive prices down wherever government interference does not artificially prop them up. This has been the case in most areas of technology for example (think about the price for DVD players and e-readers), but not for medical care.

Back in July of last year, we pointed to LASIK eye surgery as an example of a procedure that is not covered by Medicare and has seen its prices drop rapidly over the years, as opposed to procedures such as MRIs, where government regulates reimbursement and where prices have not gone down at all over the same period.

While those who believe in central planning think that the government can simply mandate that prices be lower, it is free enterprise and competition that brings prices down, not government mandates. The government's attempt to mandate a 21% reduction in Medicare reimbursement for doctors, initially decreed last year, has been postponed by Congress several times at the last minute (it is currently postponed through November of this year).

If physicians cannot charge enough to make administering care worth their while, very few of them can afford to operate at a loss for all Medicare recipients, and will simply refuse to take patients on Medicare. Cecil B. Wilson, MD, the head of the American Medical Association, says that one in five physicians already limit the number of Medicare patients they will treat, and one in four Medicare patients searching for a new primary care physician are currently unable to find one, due to the fact that physicians cannot run charities at their own expense, regardless of lawmakers who think they can reduce prices by congressional fiat.

However, the free enterprise system motivates people and businesses to look for ways to fill unmet needs, which is exactly what Wal-Mart and other businesses are doing in the face of a "halfway private and halfway public" healthcare system that we have discussed at length in other posts.

We choose to interpret the unprecedented drop in medical costs (at least unprecedented for the last 35 years) as a sign of the often-underestimated strength of the free enterprise system.

In fact, we hope that today's CPI data illustrate that it is already working its magic in the healthcare industry.

* The principals of Taylor Frigon Capital Management do not own securities issued by Wal-Mart (WMT).

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The dance of the hippos

While most of the market players and financial media are focused on the Fed decision and whether it will be good, bad, or indifferent for various slices of the markets, we'd like to take a different tack and focus on our favorite topic, the allocation of capital to well-run and innovative companies.

We believe that one of the major pitfalls for investors of all portfolio sizes is the tendency to focus on "the market" -- the trading price for various items, including equity and debt instruments issued by businesses -- rather than focusing on the underlying businesses themselves.

In the past, we have outlined many of the structural drawbacks to mutual funds -- see for example "Some drawbacks of mutual funds" from May 2008, or "Invest like Mr. Howell" from May 2009. We have always stressed that the biggest problem with the mutual fund structure is its tendency to drive the focus of the investor away from the underlying business and more towards the market.

In fact, the structure of mutual funds can have a tendency to drive the focus of the professional portfolio manager -- the one who is steering the mutual fund -- away from the underlying business and more towards the market as well.

One way that this can happen is by the accumulation of assets under management.

The strength of the mutual fund is that it can give many smaller investors access to a professional manager -- access that they would not otherwise have. It is simply not worthwhile for a professional manager, with all his experience and all the professional research and investing tools at his disposal, to manage a small portfolio of $15,000 or even $45,000. Even if he were to charge a couple thousand dollars a year to do so (which would be a pretty hefty fee in terms of percentage of the assets), he would have to manage an awful lot of them in order to make that pay for itself. Therefore, mutual funds enable the pooling of lots of small portfolios together, into a pool that is large enough to be worthwhile.

However, this strength is also their drawback. As certain mutual funds do better than others, investors seek them out, and today the top ten mutual fund companies manage almost $4 trillion of the total $10.8 trillion invested in mutual funds.

This concentration of assets among the largest fund companies is reflected in the largest mutual funds. In fact, the ten largest mutual funds are all managed by companies in the ten largest fund companies. The assets under management for these largest mutual funds are all in the tens of billions, and this is where the difficulty begins for a mutual fund manager who wants to focus on business fundamentals rather than market factors.

The largest mutual funds (not counting those that are money market mutual funds) currently range in assets from over $239 billion for the largest down to about $54 billion for the tenth largest.

In portfolio management terms, this means that the manager of a fund with $60 billion under management who wants to invest 1% of its funds in a single company is talking about a $600 million allocation of capital (1% of $60 billion). With 1% positions in all of his holdings, this manager could allocate capital to 100 businesses (in reality, portfolio managers hold some percentage in cash, but that is another discussion and for the sake of this example we can ignore the cash position right now). If he wanted to be more concentrated, with 2% positions, he could own 50 companies and allocate $1.2 billion to each one.

Many investors have no idea how few companies exist that can absorb an investment of $1.2 billion or even $600 million. Obviously, a company with a market capitalization of $600 million could be bought outright by an investor with $600 million to invest. This makes it all but impossible for portfolio managers of larger funds to invest in companies of this size (unless they make a tiny investment of a fraction of a percent of their assets, but that is hardly worth while, since even if the company's stock does really well, an investment of such a small percentage of capital will barely move the performance needle at all).

Thus, portfolio managers overseeing large piles of money are forced by necessity to own more and more names, and to own larger and larger companies, simply to find a place to put all those assets. What this means in practice is that these large portfolios typically have more than 100 names, often closer to 200 (and in some cases even more), and each one is typically a company with a market cap of $10 billion or more.

What many investors fail to realize is that there are not that many companies with market capitalizations over $10 billion. The Ford Equity Research database of 4,247 US-listed stocks reveals that, as of the market close yesterday, there were only 356 companies with market caps of $10 billion or more (back in February of this year, when market prices were a bit lower, there were only 299).

If all the large fund managers are owning hundreds of names, and they are forced by necessity to pick from among the same 300 or 350 companies, then they are owning an awful lot of the same companies.

This might not seem like much of a problem, but it does mean that fund managers have a harder time differentiating themselves by selecting superior companies. If you are managing Fund X, and you are competing against your buddy over at Fund Y, you can't say, "Let's each pick different companies, and after five years we'll see who was better at picking innovative, well-run companies." The companies you each select will have a lot of overlap, because you are both forced into the same holdings by the necessity of placing all that capital somewhere.

Therefore, in order to differentiate yourselves, you may say "I will own company Z, and I know my competitors will also own company Z, but during the next 5 years I will own it at the best times to own it, and ditch it at the worst times, and in that way I will beat my competitors."

In other words, your focus may shift from the underlying company itself to the market. You are now interested in owning "slices of time" -- you want to own semiconductors when they are temporarily in the market's favor, and rush out of them the moment they seem to be going out of favor for a few weeks or months.

It should be evident that this type of activity is based more on making market predictions than on trusting in the long-term performance of carefully-selected businesses. We have noted that in his own explanation of his investment philosophy, Thomas Rowe Price rejected the "various systems" for predicting short-term market gyrations and argued for the "simplicity and soundness" of trusting in carefully-selected, well-run businesses.

What should investors do to base their investment discipline on a more business-focused footing? We've argued previously that investors can become their own investment managers, selecting individual stocks and bonds -- see for example here, here and here.

Those who are not inclined or not able to take on investment management duties themselves can search for professional management that can demonstrate a business focus in their investment process. Avoiding mutual funds by no means guarantees one is avoiding the "mass-managed money" problems described above; in fact, many "separately managed accounts" offered by large investment management firms have as many assets under management as mutual funds run by the same firm -- or even more assets than their brother or sister mutual funds. Similarly, some smaller mutual fund companies offer funds that do have a business-focused investment process. We discuss selecting an investment manager in previous blog posts such as this one, this one, this one and this one.

We believe that this is an important and little-understood concept among those not in the portfolio-management business. Please be sure to share it with your friends and family.

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Have you heard of this company? IIVI

We have noted before that a company does not have to hail from Silicon Valley in order to fit the description of a classic Taylor Frigon growth company (although some Silicon Valley companies do fit that description).

Today, we highlight a long-time portfolio holding based in Saxonburg, Pennsylvania -- advanced materials and laser component manufacturer II-VI, Inc.*

The company takes its name from the Periodic Table of the Elements, specifically in reference to elements found in columns II and VI (see diagram above), a name which stretches back to 1971, when the founders saw an opportunity to build a business around providing the highest-quality cadmium-tellurium material available, a material needed for the optics used to produce high-powered industrial CO2 lasers.

Cadmium (Cd) is found in the II group (atomic number 48) and tellurium (Te) is found in the VI group (atomic number 52).

Today, the company announced earnings of $0.51 per share, versus the consensus Wall Street expectation of $0.38 per share, on year-over-year revenue growth of 71% (also beating expectations on revenues) and earnings growth of 162%.

In his prepared remarks this morning, CEO Francis J. Kramer touched on some of the growth fields in which products manufactured by II-VI are participating.

He stated that "increased demand in the telecom segment is mainly driven by increased bandwidth demands that are resulting from increased Internet traffic worldwide, along with the worldwide deployment of 40G optical networks, and major infrastructure investments in Asia that are scaling in order to support mobile communications and computing applications."

We would note that the demand he is describing matches some of the trends we have tried to explain in numerous previous posts such as this one from February 2008, this one from June 2009, and this one from June 2010. The discussion of infrastructure for mobile communications was also highlighted in conjunction with another Taylor Frigon growth company in this recent post.

The laser components and other advanced materials produced by II-VI are used in many other industries besides networking and telecommunications. In another part of his call, the II-VI CEO described business activity from the most-recent quarter in many other potential fields of growth, including "a large order for UV filter assemblies which go into systems used for missile threat detection on airborne platforms. [. . .] On the commercial market front, VLOC [a II-VI business segment producing components for near-infrared optics, named for a company acquired by II-VI in 1996 that itself was a combination of two companies called Virgo Optics and Lightning Optics, hence the acronym] experienced growth with bookings increasing 20% versus last year. In the U.S. market, the growth is driven by an increase in demand for aesthetic medical application products. In international markets, demand for low-, mid-, and high-power industrial products supporting laser-based marking, welding and cutting applications is growing. [. . .] In China, VLOC is experiencing growth related to laser welding and marking systems being utilized in the industrial arena, as well as for the lasers being used in the manufacture of consumer products such as MP3 devices, iPhones, and batteries."

Did he just say iPhones?

II-VI is another excellent example of the focus that we recommend for investors. While there are aspects of government activity which will restrict the economy from growing as strongly as it could grow (and there always are, to greater or lesser degrees), investors should focus on finding innovative, well-run companies positioned in front of fertile fields for future growth. Doing so is always important, but doing so during more "unfriendly" business climates is even more critical.

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* The principals of Taylor Frigon Capital Management own securities issued by II-VI, Inc. (IIVI).

For later posts on this same subject, see also:

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

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

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

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"Reducing taxes is the best way open to us to increase revenues"

Yesterday in the Wall Street Journal, Art Laffer published an opinion piece entitled "The-Soak-the-Rich Catch-22" which offered evidence from history that increased tax rates have actually led to lower tax revenues as a percentage of GDP. He also demonstrates that higher tax rates have historically led not just to lower revenues as a percentage of GDP but also to lower GDP growth rates and lower overall GDP -- "a double whammy," he calls it.

This is the important distinction we pointed out to readers in our post last week "Lower tax rates stimulate growth."

Art's piece opens with a quotation from President Kennedy's Economic Report of the President from January 1963: "Tax reduction thus sets off a process that can bring gains for everyone, gains won by marshalling resources that would otherwise stand idle—workers without jobs and farm and factory capacity without markets. Yet many taxpayers seemed prepared to deny the nation the fruits of tax reduction because they question the financial soundness of reducing taxes when the federal budget is already in deficit. Let me make clear why, in today's economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarged the federal deficit—why reducing taxes is the best way open to us to increase revenues."

These are important points, because the primary argument from those who want to raise tax rates is that we "can't afford" lower tax rates. The point of Art's article is that tax rates influence behavior, and that higher tax rates lead to lower growth, fewer jobs, and less tax revenue.

We realize that if tax rates were lowered to zero there would be no tax revenues at all, but we wish that all the politicians would similarly realize that keeping tax rates low stimulates the growth that President Kennedy describes as the "best way open to us to increase revenues." Is "taxing the rich" so important that it is worth sacrificing growth, jobs, and revenues? As we have demonstrated in previous blog posts, it is precisely the rate on the highest tax bracket that has the greatest impact on the business and venture investment that drives economic growth.

This is such an important point that it bears repeating.

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It's all about the thought process

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

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

a) the soundness of this basic thought process

and

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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