Investment Climate: Get out of the "Market"??

The Fed didn’t raise rates and the market still had a fit.  Many continue to say the next crisis is upon us, as they have for years now.  Europe is a mess.  China is collapsing.  The Middle East is a bigger mess.  Politics is…well POLITICS!  And, about the market?  Get out!

Our longest term clients, those who have been with us since the beginning 30 years ago (we still have our first client), have just been floored by that statement!  They’ve never heard us utter such words.  They are thinking we’ve either lost our minds or spent too much time in the beautiful California Central Coast sun and it has baked our brains.  But we really think this call is long overdue.  If you have bought into the market, then we do feel it is high time you get out.  Instead, invest in businesses.

Okay, now our clients are starting to feel a little better.  It’s the old Taylor Frigon mantra about to hit you square in the eyes. 

But it is true that we believe it is time to get out of the market, if it’s the market in which you think you are “investing”.  We’ve all heard, ad nauseam, the line that most “active” managers don’t “outperform” the market.  This is the biggest lie ever perpetrated on the investing public in the history of investing!  Active managers ARE the market.  The “just buy the market” crowd has survived on what our good friend George Gilder describes as “parasites living off of the backs of active managers.”  Think about it, taken to its fullest extent, if everyone “indexed” (as the phenomenon is called) there would be no market.  Who would be responsible for price discovery, the government (scary thought)? Or the corporations themselves (talk about the fox guarding the henhouse)?  Along that line of thinking, the hysteria over indexing has reached such heights that there are those who have suggested that the very execution of “active management” is somehow promoting socialism.  Huh???!!!

It has grown in acceptance because Wall Street has abdicated responsibility for making investment decisions to the few, mass-managed money behemoths who dominate the so-called “active” investment management world.  Like in so many instances Wall Street, in general, is a victim of its own success.  It is simply too big to be able to adequately “manage” anymore so it has gone completely to financial engineering and trading on the institutional side of the business, and “wealth management” (financial planning) on the retail side of the business.  They simply aren’t training people to make real investment decisions.  By investment decisions, we mean, which companies deserve to have one’s capital.  We do not mean, which mutual fund or ETF should one buy, or to which active investment manager (like Taylor Frigon) should one outsource investment decisions.

Gone is the era of the “stockbroker”.  A much maligned figure that once stood tall in the world of managing money for people.  Yes they picked stocks, and yes they made their money on commissions for selling stock to their clients.  But, back in the day, good stockbrokers did research…real research.  They analyzed companies and made recommendations to their clients that they believed would make them money.  They followed the companies they had invested in (and the good ones invested their own money in the same companies as their clients).  And those that lasted in the business made their clients, and themselves, money.

While we subscribe to a different model of how we get paid today (an asset-based fee), which we feel more closely aligns with the client, we were fortunate to have learned our profession from one who was cut from a similar mold.  Richard Taylor was mentored by Thomas Rowe Price in the 1960s and learned how to buy businesses.  At that time, that is all you did if you were in the business of investing other peoples’ money.  The concept of buying the market was nascent, at best.  Thomas Rowe Price believed that the great fortunes that were made in this country were “made by men who retained ownership of great businesses, through market cycles”.  It is with this concept that we feel true investment strategies can be built.


Contrary to what many would like you to believe, this is not rocket science!  It is simply tedious, time-consuming and requires nerve, or a strong stomach, as the case may be.  Anybody can do it if they commit to a disciplined thought process.  Those who don’t can still hire people like us to do it for them.  While this may sound overly self-serving, it is meant to emphasize the point that part of the problem we believe exists in the financial world today is that most people have gotten too distanced from the investment decision-making process.  We believe this has ramifications for the general market and has held many companies back.  However, we think that it is changing and it will become more important than ever to be diligent about investing in businesses and not just blindly buying the market.  And this will not manifest itself in a massive crisis, but a slow burn that will cause one to wake up many years from now and either be bewildered by the lack of return in the “market”, or be comforted in the knowledge that you owned some great companies and built your own fortunes very nicely.
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Fed This, Fed That...



Once again the financial world, and in particular the financial media, are all in a tizzy over the statement that will be coming out from the Federal Reserve Open Market Committee (FOMC) later this morning, September 17, 2015, regarding the decision on whether to begin the long awaited end to the Zero Interest Rate Policy (ZIRP).  Anyone who has read our commentaries over the years knows that we think there is far too much emphasis on the actions of the Fed in determining the outcome of the economy.  We in no way suggest what the Fed does, or does not do, is immaterial to markets and the economy, but the idea that the Fed is the ultimate arbiter of economic growth, or lack thereof, is simply ridiculous!

As we have stated, it is our view that the Fed is long overdue in ending ZIRP.  In fact, we believe the economy could have withstood rate hikes as long as two years ago.  At the very least, during last years' surge of growth (Summer 2014), it would have been an excellent time to begin the process.  Now that they have waited so long, they have backed themselves into a corner and are headed towards raising rates at a time when global growth has slowed.  This is what we feared about waiting too long to get on with the process.  That said, regardless of the problems with economic growth in the emerging world, and in spite of what we admit is a subpar economic environment in the U.S.  and the rest of the developed world, we believe that further putting off the inevitable serves to retard growth even more.

There are many reasons for subpar economic growth.  We have pointed out in the past that the regulatory burden on business is far too high; that government intrusion in the private marketplace is onerous and government spending too large.  We have suggested that the tax code is far too complex and creates disincentives to economic activity.

All of these things are drains on growth and yet the amazing thing is that we are growing IN SPITE of all this nonsense.  It is the entrepreneurial economy that ultimately drives economic growth over time and at this point, the Fed raising rates .25% is absolutely irrelevant in that bigger picture.  In fact, they could raise rates to 1 or 2% and it would not stop the engine.  We think the signal it would send is that the constant vigilance over "looking for the next crisis" may be put to bed for a time, and that ultimately provides the backdrop to get on with fixing the things that are really holding us back from what should be an amazing era of growth, given the significant innovation that continues in the world of the entrepreneur.
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Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets


Linked above is the latest whitepaper from Taylor Frigon Capital Management, entitled "Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets," published on August 27, 2015.

In it, we compare the massive growth of exchange-traded funds (ETFs) within financial markets to a runaway "toxic bloom" of algae within a body of water, citing evidence which suggests that ETFs by their very nature may have extremely damaging effects on financial markets, impacting everyone who relies on those markets, whether investors in ETFs or not.

Back in July we published a post discussing several longtime concerns we have had regarding ETFs, especially in light of some high-profile comments by well-known investor Carl Icahn, who was himself raising a warning about ETFs (and specifically about ETFs designed to try to track inherently illiquid securities such as high-yield bonds).

At the time we wrote that July post on ETF dangers, we decided that we should also publish a more extensive "whitepaper" discussing the specific aspects of ETFs which we believe are potentially hazardous, and providing some explanation of just how ETFs are basically structured.  

A big part of the reason for writing such a paper: we don't believe investors in general have a very good grasp of exactly what an ETF really is, and how it is related to the so-called "basket of securities" to which it purports to provide investment exposure. 

In fact, we actually believe that very few financial advisors who employ ETFs as part of the strategy that they recommend to clients fully understand ETFs, or understand the fact that the only linkage between the price of the ETF that they recommend to their clients, and the market value of the "basket of securities" that the ETF is supposed to be tracking, consists of the willingness of certain big financial firms to engage in arbitrage-driven trading activity.

Just as we were completing this paper, and before publishing it today, new evidence emerged which illustrated this phenomenon rather dramatically. During the plunge of the US stock markets at the open on Monday, the price of many ETFs plunged far more than the drop in the market value of the securities that they were supposed to be tracking, coming "unhinged" by a wide margin and causing serious consternation among those who owned shares in those various ETFs (here is a story discussing this ETF disconnect in the Wall Street Journal -- and there are many others).

The drop was so severe -- and the "gapping downwards" so rapid during the day -- that many investors and financial advisors who had placed stop orders and market orders to sell had those orders execute at percentages below the price they thought they would get for the trade, by 20% or more in some cases. The fact that many financial advisors placed stop-loss orders on these ETFs, and the fact that some are quoted in that article as saying the price drops and gapping of the ETFs that they saw that day "don't make any sense," tends to confirm the allegation that many financial advisors do not actually understand the principles of arbitrage and liquidity upon which ETFs by their nature must depend in order to keep the price of the ETF in line with the price of some basket of securities.

When liquidity becomes scarce -- or when the big Wall Street firms who are authorized to make those arbitrage trades for the ETFs decide to "step aside" and not make those trades (for whatever reason, usually because they see that there is not enough liquidity) -- then the price of the ETFs become unhinged in exactly the manner that was witnessed on Monday. 

In other words, that kind of "gapping" makes perfect sense: it is a product of the well-known laws of supply and demand, and is generally the way that prices will move in a market from which liquidity vanishes.

We believe that the tremendous growth of ETFs poses significant hazards -- and academic papers cited in the above whitepaper suggest that these hazards may in fact impact the wider market and not just ETFs. 

We believe that understanding how ETFs work is an important step towards trying to address some of these hazards.


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A Hissy Fit In The Market























The market opened this morning in a very chaotic manner which is indicative of the kind of reaction that comes from a market which is dominated by trading and non-economic decision-making versus investment based in business fundamentals.  Quite timely given our commentary recently about the disfunction caused by the ETF phenomenon.  Incidentally, even the talking heads on CNBC were referencing the potential that ETFs could be at the heart of the "dislocation" that seemed to be occurring in the trading apparatus this morning.  

Who really knows?  And that is not comforting!  

However, it is not as if we haven't seen panic-type markets before.  We experienced the one day drop of 22% in the DJIA in 1987 and the wild swings in 2008-2009; much more severe than today's move.  And since then there have been several "headline events" such as the Greece debacle, Dubai Ports World, disruption in Cypress, geopolitical tensions in the Middle East, just to name a few.  This underscores the need to be centered on a long term investment approach, similar to that which we provide.  One which is based in sound fundamental research and is not dependent on the move in stock prices on any given day, week, month, quarter or year, for that matter!

Ironically, this down move across the board is happening at a time when we think some of our most important themes are showing signs of kicking in after being on hold for the last couple of years.  These would include the transformation towards virtualization across the data center universe, the advent of sensor technology in wearables and the "Internet of Things" (IoT), the transformation of the enterprise into a fully cloud-based platform, and others.  

These are just some of the business innovations that we are focusing on at this time.  We expect that regardless of where the markets ultimately settle today, this week or this month, these trends are and will continue to be powerful drivers of business and ultimately portfolio returns in the years ahead.

That said, we have warned in previous commentary that the market may throw a "hissy fit" when the Fed decides to finally raise the target for the Federal Funds Rate from zero.  This may be that "fit"!  Followers of our commentary know that we have been advocates for raising rates for some time and it would seem the Fed is finally ready to acquiesce.  While it is impossible to say that when the Fed meets in September they will definitely raise rates, it is likely to happen by the end of the year.  Will there be more market turmoil when the event finally comes to pass?  Possibly, but likely the "return to  normalcy" that a Fed rate hike would bring will ultimately allow the market to move higher as it turns its focus back to business, where it belongs.

Whether or not recent market weakness is solely due to the expected actions of the Fed, or China's so-called meltdown, not all that unusual for a market that has had a meteoric rise in just a matter of months, the key is to be centered and still in volatile times, and even look to buy great businesses while they are on sale!
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Carl Icahn says what he means on a very important subject: all investors should pay close attention




















We have been concerned about the rapid rise in popularity of exchange-traded funds (ETFs) for a long time.  Over ten years ago, at a conference on the topic of ETFs, we were given a book that explained how they worked and how to use them in strategies; the book was almost 700 pages long.  It struck us that any investment vehicle that took 688 pages to explain was problematic.

This past Wednesday, July 15, there was an extremely interesting conversation at the "Delivering Alpha" conference in New York City, hosted by CNBC and Institutional Investor, in which investor Carl Icahn raised some extremely important points about ETFs which we believe every investor should consider very carefully.

During a panel which was apparently going to be about "investor activism," Carl Icahn made some very hard-hitting remarks about dangers posed by ETFs (exchange-traded funds) and most particularly the danger that ETFs may be seen by many investors as offering a degree of safety and a degree of liquidity which they do not possess.

This subject is one of tremendous importance because ETFs have grown to be an enormous segment of the global and US investment markets in both stocks and bonds and also in commodities. According to the Investment Company Institute, there are about $2.7 trillion invested in ETFs world-wide, about $2.0 trillion of which are in ETFs based in the US.

Therefore, when Carl Icahn (whose professional investment career started in the year 1961, and whose company Icahn Enterprises manages over $24.5 billion in assets) says that he believes ETFs are perceived as having a level of safety and a level of liquidity which they do not possess, we believe investors should pay very close attention to what he is saying.

While the discussion between Mr. Icahn and BlackRock CEO Larry Fink included a debate about whether higher interest rates are going to negatively affect high yield bond prices, that was really a sidelight to what we feel is the more-important discussion about the perception that ETFs are safe, liquid investments that are inexpensive and “easy” for the average investor to “own."

It is this last point that we feel is the most important, and wasn’t directly addressed by Mr. Icahn -- although he did make reference to the fact that in order to discuss what's going on inside an ETF he "could get into some arcane stuff" -- is that the “investor” is really not “owning” anything when “investing” in ETFs.  At its core, the ETF is just another form of derivative.  If there is anything the 688-page book taught us it is that it is not the average investor, but rather the supporting banks that can “ask for their shares” at any time from the funds.

As advocates of true price discovery, it occurs to us that the farther away the so-called “investor” is from the ownership of the investments they think they are making, the more potential pitfalls there are when times get tough.  This is why an investor with the stature of Carl Icahn making points about the pitfalls of ETFs is worth noting.

You're welcome to skip down and watch the videos at any time -- here, in a list format, are some of our thoughts and comments about this very important subject:
  • At Taylor Frigon Capital Management, we invest in companies directly, by owning individual securities issued by those companies. This means that we are obviously biased in this argument, because we compete against investment advisory services using ETFs. But we could have chosen to use ETFs if we wanted, and after significant analysis decided that, at best, the underlying complexity was problematic, and at worst, the ETF is a potential time bomb that may have systemic implications if they continue to grow without adequate understanding on the part of investors as to exactly how they work.
  • While we don’t likely agree with Carl Icahn on everything, we do invest in individual companies on behalf of our clients, including some companies in which Mr. Icahn, through Icahn Enterprises, is a very large shareholder, such as Apple (AAPL) and CVR Energy, Inc. (CVI).*
  • We also believe in investing in those companies directly for both our clients and ourselves.
  • We believe that Carl Icahn is doing the investment community a great service by forcefully calling attention to what he believes is a potential problem: the fact that investors may be mistaken in attributing to ETFs a level of safety and liquidity which may be unwarranted (specifically with regards to ETFs which own an inherently illiquid and sometimes risky investment: high-yield bonds). Note that Carl Icahn says in some of the video segments below that he feels some remorse for not being more outspoken about concerns he had prior to 2007 and 2008 about a different category of pooled investment vehicles, but that he wants to say now very clearly that he perceives some potential problems of a very serious nature (while not specifically predicting any sort of immediate crisis).
  • Although Carl Icahn did not specifically say it -- and this post is not intended to imply that he did -- we believe that some of the same criticisms that he applies to high-yield bond investing through ETFs can be applied to many other types of investing through ETFs. Specifically: just as Mr. Icahn is saying that investors in high-yield bond ETFs feel a certain "distance" from the underlying security (in this case, high-yield bonds) and don't feel that they need to perform the kind of individual due diligence on each individual security connected to that ETF, and just as investors in those high-yield bond ETFs feel that the ETF makes high-yield bond investing more liquid and more safe than individual high-yield bond investing (but the reality may in fact be quite the opposite), we believe that investors in almost any kind of ETF including those which invest in stocks end up distancing themselves from attention to the specific business factors of the business in which they are investing. And we believe that this can be a dangerous pattern, no matter what the underlying investment happens to be.
  •  We also find it interesting that some of Mr. Fink's comments in the video can be seen as indirectly or perhaps unintentionally providing support for the point we just made. For instance, in the very first clip beginning about 10 or 15 seconds from the start of the clip (before Mr. Icahn even begins his hard-hitting criticism of ETFs), he says (as a function of how much his investment management firm manages in index funds):
So, we have to own companies that are poorly-run, and companies that are well-run. We own all the companies [expansive hand gesture]. Unlike active investors -- and a lot of our money . . . we manage active, too -- our investors can't sell those stocks if they hate the company. We're only . . . we have to own the stock whether we like it or not, and the . . . so, we have a much greater responsibility in working with companies, and hopefully over time working with the companies to build the proper returns that we expect from them. And then sometimes, we will even agitate, but we will do it privately and quietly. [Punctuation in the above quotation uses ellipses to indicate a pause or a change in direction of the sentence, and not to indicate words omitted from the quotation: no words were omitted from the quotation in the clip, as we hear the audio].
  • We find that admission to be a pretty good description of what we believe is the core problem with the whole category of index and ETF investing. The premise on which these forms of investment are built is inherently opposed to the kind of scrutiny of the underlying investment (whether it be a stock issued by a company, or a high-yield bond) that we believe is the very heart of responsible investment.
There is much more that could be said about some of the many important related subjects raised during this exchange between Carl Icahn and Larry Fink. However, we believe that this one central issue -- about the perceived safety and liquidity in an investment vehicle which makes up an enormous percentage of the global investment landscape -- is the issue that investors should take the time to consider very, very carefully.

Towards the beginning of his own remarks, at the start of the second video segment, Carl Icahn says: "And I really mean this -- I'll just say what I mean. I'm too old not to say what I mean, and I don't hold back."

No matter what your opinion of Carl Icahn or of what he says after that, you have to respect him for making that statement, and then for very bluntly "saying what he means" because it is what he believes investors need to hear, and what investors need to know.

And when someone with as much market experience and success as Carl Icahn has, sits down and very plainly tells you that he is going to freely say what he means, we think investors should pay attention. And we applaud him for doing it.





video one http://video.cnbc.com/gallery/?video=3000397684


video two http://video.cnbc.com/gallery/?video=3000397844


video three http://video.cnbc.com/gallery/?video=3000397885



video four http://video.cnbc.com/gallery/?video=3000397886




video five http://video.cnbc.com/gallery/?video=3000397882



video six http://video.cnbc.com/gallery/?video=3000397887



* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by BlackRock (BLK). At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Apple (AAPL) and by CVR Energy (CVI).
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