Counting our Blessings

As the Christmas season draws near and most of us spend our weekends shopping for gifts I think it’s important to step back, realize our good fortunes, and think long and hard about the best way to be charitable.  For some of us this means donating money and for others it means donating our time at places like soup kitchens, animal shelters, and even just helping out friends in need.

Many others define their philosophy on charitable giving better than I do so I will explain the philosophies that I subscribe to.  Warren Buffett and Ray Dalio are two who’s philosophy I admire and hope I can follow and improve on throughout my life.  As Warren Buffett says throughout his biography (The Snowball), he is a winner of the ovarian lottery.  He’s referring to being born and growing up in America, the land of opportunity, and with a mind built for capital allocation but with a body not suited for physical labor.  He’s right that he may not have been so lucky growing up in some poor country like Burkina Faso having to herding cattle and walk miles just to get clean water.  Basically what this gets at is that while talent is universal, opportunity is not.  So he gives to those that are less fortunate in hopes of the few talented individuals receiving such generosity can turn it into a life changing opportunity for them and maybe even their whole community.  We can all do this to varying degrees.

Although I don’t know Dalio’s philosophy on giving as well (since he’s not as public as Buffett), my understanding is that his family has setup the Dalio Family Foundation which has setup websites like Redefine Christmas.  The idea here is to reduce buying of material gifts (which often end up tossed aside and never used) and give to those who are in need.  Additionally, Dalio himself claims to give 10% of his income to charity.  Although he is very wealthy, this guideline and the philosophy behind Redefine Christmas is something that almost everyone can follow.

This is a great time of year to reflect on how fortunate we all are, even though that may be difficult to see sometimes, and think of those who are less so.  Think about how important that last 10% of your income is to you compared to how important it could be to those that are less fortunate than you.  Think about your gift giving choices this Christmas season and whether there are ways to be more impactful to those around you while still giving a gift that the receiver will appreciate.  Think about spending a free weekend volunteering your time, it may even turn out to be a quality way to bring the whole family together for a good cause.  I know that I will be sticking to the Buffett and Dalio philosophies that I have been following for the past couple years.

Investing in Emerging Market stocks

This week a friend mentioned that his financial advisor was bullish on Chinese stocks and asked for my opinion.  Many are bullish on emerging market stocks right now.  Although each emerging market country is different, the general dynamic that they have little debt and are able to grow their spending and productivity in order to achieve higher rates of economic growth.  In theory this should lead to rising stock markets and higher rates of return than in countries, like the developed world, where debts are high and productivity growth is slow.

Looking at China specifically, they are an investment/export based economy which has been facilitated by an artificially low currency.  The Chinese government has pegged the Yuan to the US Dollar by recycling Dollars they receive from exports into US Treasury bonds.  By China pegging their currency to the Dollar, China is indirectly subject to US interest policy (currencies are driven in part by local interest rates, a government can either control their currency or their interest rate, but not both).  As China’s growth is very strong, while ours is weak, China essentially ends up with extremely low interest rates in a booming economy.  This will certainly lead to overheating and hence a bubble (which is good for long-term growth in China but bad for investors in the short run).  China will have to let their currency float upwards to prevent this from getting out of control.  When the Yuan rises, it will hurt their exports (but properly cool their economy) and their bubbled up stock market will fall as their companies sell less.  This will be good for other countries (like the US) who export to China and therefore the stocks of companies who do this.  Therefore, the best way to get exposure to growth in China is by holding Chinese currency.

Since many people are thinking the same thing and investing in tiny emerging market stock markets, many of these markets are likely to be forming bubbles with the cheap money that the US is providing.  It is difficult to tell when the bubble will crash therefore I would rather stay out until the bubble pops and true opportunity presents itself.  Said another way, as with all of investing, beware of following the crowd.

The other problem with investing in Chinese stocks is that foreigners don’t have access to mainland Chinese stocks because of their capital controls.  Even if they someday open up their stock market to foreign investors, would you feel safe about the ability to get your money back if someday they close their doors to foreigners again?

These are some of the short term considerations.  Over the long term one of the most important factors is education.  The US still has the best higher level education system and the proof is in the number of foreign graduate students coming to America.  More than any other country, we encourage creative and independent thought over wrote memorization.  This the kind of thinking that drives innovation and therefore productivity growth.

In summary, investing in emerging markets right now is not my choice for the following reasons: 1) everyone is saying that they are the next hot thing is risky because you are following the crowd 2) many of these countries are exporting nations and have cheap currencies, this dynamic will change as their currencies rise which should depress their stock prices and 3) the American culture of capitalism and innovation will prevail in the end.  Therefore I would prefer instead to invest in US companies like Coca Cola or Fastenal that are exporting to emerging countries that are growing quickly where these US companies are priced more reasonably and I don’t have to fear for the safety of my capital.

Betting on America

When Warren Buffett announced that he was buying the railroad company Burlington Northern Sante Fe, he branded this move as “a bet on America’s future“.  Whether you believe this as the real reason behind the purchase or not, I definitely think he’s on to something.

My view is that when it comes to investing, I want to invest in a country where capital is free to move where markets demand it and where education, laws, and culture encourage original thinking and entrepreneurialism.  And a lot of this is simply cultural and takes generations to change.  Think about the Mediterranean culture in Greece and Spain.  If you were to pay a worker in one of those countries twice as much as they earn today, instead of continuing to work hard and earn more money, they’re more likely to work half as many hours.  It really is a great philosophy on life but it doesn’t help produce new technology, keep business lean, and create wealth.

America on the other hand, relatively speaking, is a country of eager and enterprising immigrants.  All the way from those who descended from the days of Christopher Columbus to the Korean’s and Indians that are coming over today. The people who immigrate to america today are looking for opportunity and have a burning urge to grow and create.  Even our education system encourages creative thinking from a young age rather than teaching wrote memorization like most other countries do.  Even though our education system could be improved and not all immigrants will turn into the next Bill Gates or Vinod Khosla, a few will and that’s enough to continue driving our culture of innovation, free markets, and improving standards of living.

This is the ideal land for investors.  In america (and Canada), you don’t have to fear the government creating laws that will prevent the return of your capital (the First Principle of investing).  Also, good businesses are ones that grow and create new and better products and stay lean with fat profit margins.  It is too easy for such a business to rest on it’s laurels when overly protect from competition or worse when run by the government.  When surrounded by competition, such an organization will be incented to continue improving.  This is where I want to be and this is definitely where I want to be putting my hard earned money.

America’s debt problem

My friend Jason, a brilliant macro economist, and I were out on a walk last Sunday morning discussing the current US debt situation relative to the situation in Japan.  On the surface, the Japanese debt situation is much worse than ours currently is in the US.  Japanese gross debt currently stands at almost 200% of their annual GDP while in the US this figure is just under 100% of our GDP.   But which situation is really worse?

We can compare a country’s debt to our personal debt relative to annual incomes.  When you go out and buy a house, you buy a house on which you can afford the mortgage payment.  Maybe you limit the mortgage payment to a third of your annual income.  This metric also applies to a country.  How much of the US gov’ts tax revenues go to pay interest on our debt?  In 2008, the US paid about $250bn in interest on public debt, or about 10% of the federal government budget.  The interest payments in Japan are similar as a percentage of their federal government budget.

The second piece of the picture is who owns the debt.  In the US, public debt is composed of mortgage debt, and credit card and auto debt.  Much of this debt is owned by profit seeking financial institutions.  And US government debt is largely held by foreigners (China and Japan together own about half of it).  If we missed an interest payment or defaulted on our debt, this would be a disaster.  All our creditors immediately stop lending to us.  The same is true of our government debt.  While in Japan, much of their government debt is held by their people who have trillions of dollars invested in government bonds as a savings vehicle.  This means there is less incentive in Japan to inflate their way out of debt or to default on payments to their own people.

In the end, while the magnitude of Japanese debt is large, they don’t look to be in any danger of default.  The same is true for the US though we are in a slightly riskier situation because of who holds all of the debt.  Most importantly though, as we’ve seen with the Japan case (and may likely see continue) is that the accrual of debt will likely continue for some time and we shouldn’t be as concerned about current levels as most people are.

Who’s buying stocks?

 

Global stock markets bottomed during the current Great Recession on March 6, 2009 and have run straight up since then (virtually similar dynamic to the Great Depression of 1929).  Now, only 8 months later, the S&P is up over 60%.  So far in 2009, investors have made contributions of $314bn into US mutual funds with the overwhelming majority of these contributions going to bond funds, not stock funds.  Then who’s buying stocks to cause the market to rise so much so fast?

As an analyst, one of the best ways to gather information about the market is by talking to other analysts.  Whether I read Jeremy Grantham’s quarterly letter, Mark Faber’s “Doom, Gloom, and Boom” report, Mohammed El-Erian’s articles in the “Financial Times”, or just plain talk to fellow analysts everyone is thinking the same thing – stocks are over priced given that consumer spending is down and the economic future looks bleak to put it lightly.  Yet while all these experts are predicting the next down leg, my favorite investor is making headlines with his $26bn purchase of Burlington Northern Santa Fe Corp.

There are many reasons why Warren Buffett has achieved the success he has.  He’s one of the few who has had the discipline to stick to his simple adage of “Sell when others are greedy, and buy when others are fearful” over almost 60 years!  Solely according to this mantra, we are faced with the buying opportunity of a lifetime.

When I look at fundamentals of solid companies like Coca Cola, Paychex, Altria and CN Rail they all seem to be selling at reasonable prices.  It is definitely hard to predict the future state of the economy and hence the earnings of businesses, but when has it ever been easy?  A few great businesses like the above have competitive advantages and are returning to growth even in the current environment.  Don’t Buffett and his vice chairman, Charlie Munger, constantly remind us to buy great businesses at fair prices?  Remember that old saying “It’s always darkest before dawn.”

Many who are sitting out this rise in stocks may be missing an opportunity of a lifetime to buy great businesses at fair prices.  Economic fundamentals are improving (albeit slowly) with the help of government stimulus and low interest rates.  Given the level of pessimism and fear, it’s possible that stocks continue rising for some time.

 

Smaller advisors may be better

 

Selecting a financial advisor is a difficult task.  As I’ve discussed in the past, selecting your advisor can be the most important financial decision you’ll ever make.  They should be someone you trust to give you truly independent financial advice, be qualified to do so and be free of conflicts of interests so that they are incented (both financially and morally) to put your interests first, and finally should have the flexibility to implement their best ideas for you.  The type of firm your advisor is associated with may have a lot to do with whether they can provide superior and independent advice.

Large firms often have large and highly paid research staff to develop views on the markets and lists of securities for their advisors to recommend for buying or selling by their clients.  Some of these firms also offer their own, internally managed, products that they try to get clients to invest in.  For example, an advisor representing Goldman Sachs (or any large broker-dealer for that matter) is likely to recommend a Goldman mutual fund to their clients and a stock that Goldman’s research group is recommending as a buy.  While reasonable to invest in a Goldman Sachs mutual fund, the recommendation by your advisor is rife with conflict of interest.  Goldman earns revenues from their mutual fund so the firm serves to benefit from your investing in their fund over a competitors.  Your advisor therefore may be incented to recommend the internal fund over the possibly better external fund.  There are multiple layers of conflict beyond this; the mutual fund fees and kick backs to the advisor are just the beginning.  The point is that in this situation you’re likely not receiving independent financial advice.

Equally importantly, large firms are applying their views on markets across more clients and more investment dollars. Market prices are determined by the average of all buys and sells and therefore by the average views of all market participants.  The larger the firm, the bigger their impact on the market.  Therefore the harder it becomes to “beat the market” with the research from a large firm … this knowledge is already discounted into market prices.

In comparison, small firms are usually employee owned and only sell investment advice, nothing else.  Well at least, these are the firms you should be looking for.  At such a firm, there is little room for conflict of interest as the only source of revenue is from the investment advisory fees paid by clients.  Therefore, over time, if this small firm does not provide good advice, clients will take their money elsewhere.  Hence, the advisor’s interests are more closely aligned with yours.  Ofcourse you still need to evaluate whether your advisor’s moral values are such that they will put your interests before theirs.  And regarding investment research, assuming owners with the right intelligence and qualifications, small firms can take advantage of unique market insights because they control less money and hence can put their clients money to work without moving markets.

Bigger is not always better.  A boutique firm setup to align their principals interests with those of their clients is likely a better choice for most individuals and institutions seeking financial advice.  And when it comes to investment performance, although it is just as difficult to find qualified small firms as it is large firms, the larger firms often have a performance headwind simply because of their size.  Combine this with potential conflicts of interest and everyone should consider their local financial advisor before simply jumping on board with a Morgan Stanley or Raymond James representative.

 

Stocks and Businesses

I’m currently reading the Warren Buffett biography, The Snowball.  I love books about famous people when they give you some insight into how this person thinks – both their inner genius and inner demons – The Snowball fits the bill.  One of the most interesting things is how Buffett was interested in business from a very early age; selling Wrigley’s gum  door to door (now he owns the company) after buying the gum in bulk, buying a classic car and renting it out with a business partner, and leasing pinball machines to barber shops.  Through these many experiences he learned the most valuable lessons about the characteristics of businesses you want to buy.  One of these characteristics is businesses that earn high returns on investment where the term investment also includes labor and human ingenuity.  Leasing pinball machines was one such business with great economics – buy the pinball machines at auction then collect the profits from other people using them at the end of each week – not much work required beyond that.  It’s no wonder why Coca-Cola is one of Buffett’s favorite stocks.

As I read about Buffett’s adventures and many business successes it reminds to look beyond just the stock market and to investment opportunities in the local business arena.  In the same way that there are a few public companies like Coca Cola and Paychex that offer the wonderful business economics that everyone should look for, there are also such businesses available locally.

Just last weekend I was at one of the local laundromats.  It is small with about 20 washers and 20 dryers but is completely unmanned.  This specific laudromat doesn’t offer a wash ‘n fold service or dry cleaning or anything else for that matter – just washing and drying.  Being in there, seeing all the traffic, and just about every washer and dryer full of clothes got me thinking about it as a business idea.  It sure seemed like a cash cow from this perspective.  No labor costs other than collecting the quarters at the end of the week.

Another good example is a friend’s optometry practice.  I’ve been consulting with this friend on her buying into her practice.  The price she is paying for her share of the practice is only 3 times her share of the profits, after paying her own salary.  If you add her salary to the mix, then she’s only paying 2 times her annual income.  This translates into a 50% return on investment!!!  That is, her income pays for the investment after only 2 years!  What a steal.  Even as an outside investor earning only the 33% ROI, that is still better than most companies listed on the New York Stock Exchange will earn.  Only a few like the Coke’s and Paychex have the economics to consistently earn such high returns on capital.

Stocks simply represent shares of real businesses.  Therefore buying stocks should be looked at in the same light as buying a business.  Warren Buffett has always looked at stocks in this way while remaining disciplined about only buying those with the ability to continue to earn high returns on investment.  In hindsight, it’s no surprise he has had the success he’s had.  There’s no reason the rest of us can’t achieve high returns on our investments as long as we stay disciplined about only buying businesses with superior economics.

Spending down in retirement

When accumulating savings for retirement, many people take the view that the road ends at retirement as if magically on that day the world changes.  While saving for retirement you must slowly shift towards the portfolio you will hold while in retirement.  And then during retirement, the challenge shifts to making sure you always have enough money to meet current liquidity needs while also figuring out how to properly spend down your savings to last the rest of your life.  That’s what I’ll talk about this week.

Many articles recommend a spend down rate that starts somewhere between 4-6% and rises as you get older and your portfolio shrinks in size.  But what happens if the market crashes in your first year of retirement like it did in 2008?  Do you continue the same spend down rate on a smaller portfolio and manage on less income, or do you temporarily increase your spend down rate to maintain your target income?

The answer to this question comes back to how you structure your portfolio as you phase into retirement.  Just like an insurance company buys bonds with its premiums to hedge against the liability of paying out future insurance claims, individuals need to also “hedge” their spending liabilities, especially in the short-term.  One way to do this is to think about your portfolio as a group of buckets where one bucket is a short-term one that is meant to be withdrawn as income for the first 1 to 5 years, a second medium term bucket of laddered bonds, and then possibly a third bucket of riskier securities like stocks that do not have to be touched for at least 7 to 10 years.  With this structure, you have essentially guaranteed your income in the short- and medium-term while also giving yourself the flexibility to allow your stocks to recover following the crash if that were to occur early during your retirement.

So how much money do you allocate to each bucket?  That depends on a few factors including how much annual income you desire from your portfolio traded off against how long you hope your portfolio to last.  The size of the first bucket should essentially equal the amount of income you need for the first 3-5 years.  The second bucket, similarly for the next 3-5 years, but discounted by current interest rates.  Finally, the remainder of your portfolio can be invested in the third bucket.  Ideally, over time, as the final bucket grows in value, you can replenish the other buckets with earnings from this one though the more likely scenario is that you will end up slowly selling down assets in the third bucket to make sure you have enough in the other two buckets.  Either way, if constructed properly, this structure should get you through retirement without being buffeted around by big moves in the stock market.

The slide of the US dollar

Over the past couple weeks, the slide of the US dollar has made headlines after having spiked in value during the peak of the credit crisis during the Fall of 2008.  Recent news reports have leaked that some countries are colluding to force the downfall of the US Dollar as the World’s reserve currency.  In addition, reports about the health of the US economy are beginning to come in weaker than expectations leading to a renewed loss of confidence among investors.  All this while the US Fed continues to print money in an attempt to reflate the economy and move past the debt crisis.

What does this mean for investors?  A falling dollar means foreigners find US goods and financial assets cheaper.  This is good for manufacturers and companies with significant foreign operations and therefore could be good for the stock market.  If this were the only part of the story, this would be good for most US investors (as long as most of your spending is in US Dollars it shouldn’t matter what happens to the currency relative to other countries).

Many are worried about the risk of inflation if the Dollar falls too much.  For someone who must import much of what they consume, a falling Dollar means increasing costs because the price of imports will rise.  But while this happens, domestic producers become more competitive limiting some of the cost increases hence costs increase less than proportional to the fall in the Dollar.  Therefore inflation from a falling currency is only a risk if much of our consumption remains from imports.  Since commodities like oil are largely imported, if we continue to remain dependent on oil, this may lead to some inflation.  But we all know that as a nation we are less than half as dependent on oil as we were in the 1970’s when oil shocks did lead to inflation.

Deflation (or stagflation) are also very possible outcomes from a falling Dollar.  What does it mean when the Dollar falls?  It means that there are less people buying US Dollar goods (imports) and assets (bonds and stocks) than there are selling these same assets.  As foreigners sell US assets like bonds, interest rates rise (as we know, China and Japan are the largest holders of US bonds).  As interest rates rise, the cost for consumers and businesses to borrow rises.  Therefore the cost to expand your business or to buy a new car or house rises.  When the buying of houses, cars, and stocks falls so too does their price.  Therefore a fall in the Dollar can actually lead to fall in prices (i.e. deflation).

I am more worried about the deflationary scenario than I am about the inflationary one.  Both are bad but the deflationary one is worse for investors.  The Fed will not continue buying US debt in order to keep rates low.  They have set a limit as to how far they will expand their balance sheet.  Once US government debt levels exceed what the Fed is comfortable with, it’s game over for the US economy.  Deflation will force the debt restructuring (through the more destructive process of bank bankruptcies and high unemployment like the 1930’s) that the government is trying to facilitate right now.  With such an uncertain future, this is a time to emphasize conservative investing more than any other time in recent history.  Only high quality bonds and cash will hold their value in a deflationary environment.

Do you know what you don’t know?

It’s easy to fall into the trap of only planning for the expected.  But we all know that the expected rarely happens and it’s the unexpected that determines the final outcome.  Just this past week, a co-worker of mine was hospitalized and almost had to have his kidney removed (luckily the surgeon was able to fix the problem).  He is only 26 years old and was healthy and active.  Now, who knows how this past week might change his life.

Similarly, it would be nice to only have to worry about retirement when building your portfolio but you have to “know what you don’t know” and plan for the unexpected.  And I’m not talking about planning for various economic scenarios, such as hyperinflation or a default of the US government.  I’m talking about do you have a plan if you lose your job in 5 years?  Do you have enough savings to cushion against this setback?  What if you want to open a business down the road?  Do you have enough savings set aside in a vehicle where you won’t incur penalties for early withdrawal?  The unexpected should make you invest a little more conservatively than you would otherwise.  The possibility of forced early withdrawals tend to shorten what is hopefully the “long-term”.

This is why I like to structure a core portfolio of low risk instruments (nominal and inflation-linked bonds) and build a risky portfolio around it as excess savings permit.  If the savings that you absolutely need to meet your retirement spending needs are invested conservatively then you don’t have to worry about them whether you actually sit on this portion of your savings for 30yrs or draw on it slowly while you are sitting unexpectedly unemployed and looking for a new job (it’s also most likely that you’re unemployed during a recession when risky assets like stocks have fallen in value).

Only risk what you can afford to lose.  The part of your portfolio that represents extra savings can be invested in stocks and real estate and whatever else your heart desires and gut can tolerate.  And ofcourse, even with these riskier investments, following the principles of capital preservation and doing your research will help minimize the risk of loss.