Compass April 2008

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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Investment Commentary

The headline story from the first quarter was an across-the-board decline in stocks of every category. Large-cap domestic stocks declined by 9.5%; small-cap domestic declined by 9.2%; and the broad international stock index declined 8.5%.

Some sub-categories declined even more: emerging markets stocks fell 10.5% and small-cap growth fell 12.8%.

These are big numbers, my friends — the worst quarterly performance from the equity markets in more than five years.

Naturally, we are pleased that we are underweighted in all of these categories. Still, we do own some amount of stocks in nearly all client accounts and a quarter like this one gives us all some heartburn.

High-grade government bonds continued to rally, driving prices up but yields down. Yields are so low on short– and medium-term government bonds that we are tempted to invoke Greenspan’s infamous “irrational exuberance” remark. Real yields (i.e., after-inflation yields) on short-term Treasury Inflation-Protected securities have actually turned negative.

Our portfolios benefitted from this rally in Treasuries and TIPs, and from our long-held diversifying investments in foreign bonds, gold and natural resources.

The story behind all of these results is really just a continuation of what we wrote about in January. Economic activity has had a wet blanket thrown over it due to the continued suffering of the financial sector. Lending and investment is the lifeblood of economic growth. When banks and investment houses are writing down upwards of half a trillion dollars in asset values, those writedowns go directly to the heart of the balance sheet. For every dollar that a bank writes off in capital losses, that is ten to twenty dollars that it cannot lend to businesses.

All over the globe, investors are moving away from assets perceived to carry risk. Accordingly, the risk assets that still offer long-term viability have seen yields rise. The so-called risk premium is on the way up for the first time in a decade.

For example, we sold our high-yield bond holdings more than two years ago when the spread between high-yield bonds and Treasuries fell to around 2%, meaning that we got paid an extra 2% to own riskier bonds rather than idiot-proof bonds. We decided that 2% wasn’t enough and we moved on to other things.

Over the next year after we sold those high-yield bonds, the risk premium fell even further, down to around 1.5%. As you know, when yields fall, prices rise and the price of the bonds that we sold continued to go up. In 2006, high-yield bonds as a class returned about 11% . We didn’t own any.

Such is the curse of the value investor. We might get out of an asset that we perceive as over-priced, only to watch it keep going up.

But, rule No. 1 of our investment approach is: If something can’t go on forever, it won’t.

High-yield bond spreads stopped falling, changed direction and have now widened to more than 7% as other investors (besides this one) have awakened to the fact that good times come and go. High yield bonds have lost over 6% in the past 12 months. The total return since the time we got out has been below cash yields.

Rule No. 2 of our approach is: If something is inevitable, it will happen. It is inevitable that high-yield bond spreads will stabilize and we will want to buy them again. Time and economic conditions will tell, but we have our eye on the asset class. Somewhere between now and a 10% spread we will be tempted to dip our toes back into highyield bonds.

And so it goes on down the line — risk assets get over-sold and become cheap again. The story of the past nine months has been investors fleeing from risk assets. They tend to throw the proverbial baby out with the bathwater, and even highquality risk assets (“high-quality risk assets” is not an oxymoron, by the way) get pushed out of portfolios.

We might like domestic large-cap stocks if the S&P 500 gets down around 1,100 (from its current ~1,350 level). We might like REITs again if dividend yields climb back into the 7-8% range. Time will tell.

“If something can’t go on forever, it won’t”
“If something is inevitable, it will happen.”
Yeah, but…

This is the part where every red-blooded economist says, “Yeah, but…”

It’s the “yeah, but” in life that keeps things interesting.

The “yeah-but” element right now is, of course, the prospects for a domestic and/or global recession. We believe in accounting for one’s past claims, and we wrote at numerous times over the past few years that, if and when the next recession arrived, it was going to be a whopper. Now that a recession appears to be on our doorstep, do we still think it’s going to be a whopper?

In a word, yes.

In more words, yes, the recession will be of the genuine kind with job losses and falling corporate earnings. Some downturns are driven by excess productive capacity that needs to be laid idle for a while so that demand can catch up to it. In fact, most recessions are characterized this way.

This time, things are different. It’s not so much excess capacity that is the problem. It’s the excess debt that needs to get repaid, re-priced and written off. The chickens have come home to roost and consumers and private equity fund managers are learning that debt ultimately has to be repaid from real, actual earnings and savings.

We have become accustomed to repaying our debts by selling, at a profit, assets (homes, office buildings, companies,…) bought with that debt.

However, rising asset values cannot supply the funds to repay debt, in the economy as a whole, especially when asset purchases are largely financed with more debt. While any given individual might be fortunate to have rising asset values (stocks, houses, etc.) sufficient to repay his/her own debt, that relationship does not and can not hold across the entire economy.

And in the fullness of time, only the entire economy matters. It is the entirety of the economy that drives the investment returns of a diversified in-vestor. Across the entire economy, debt is repaid with incomes, rents and earnings. As incomes, rents and earnings are diverted to the repayment of debt, consumer spending and business expansion slow down. We expect this process to weigh heavily on the economy. It might happen quickly, and produce a sharp and harsh recession, or it might happen slowly and over a decade or more. That would produce a long drawn-out period of belowaverage growth, and a disappointing investment environment.

Two Steps to Decision-Making

We make our tactical investment decisions on two levels:

1. Valuation. Is the asset cheap or expensive?

2. General conditions. Do we have a headwind or a tailwind?

The first of these is, by far, the most important. The price paid for an asset is the principal determinant of the investment return when it is ultimately sold. No matter how well a company does, if you pay too much for the stock you will struggle to have a good return. Microsoft has earned tens of billions of dollars in the past 7 years, but its stockholders have lost money over that time.

The second element — General conditions — refers to our reading of the economy, interest rates and other intangibles that can indirectly affect the price movements of assets. In early 2003, we felt that domestic stocks were still a little overvalued. Nonetheless, the general conditions were strongly favorable for stocks. Namely, the Fed had dropped short-term interest rates to 1% and corporate earnings seemed to have bottomed out.

“Debt ultimately has to be repaid from real, actual earnings and savings. ”

That situation created a strong tailwind for stocks, and we moved back to full allocations. Stocks subsequently rose strongly, in the face of our core belief that they were above fair value.

It is very difficult to apply these general conditions to our asset allocation decisions. Too many of the economic data points require us to look into the future, and we are skeptical of our (or anyone else’s) ability to do that with consistency and profitability.

At the moment, we believe that both stocks and bonds face a headwind. General economic conditions are not favorable, and we will continue our underweights of these two core asset classes.

“ We believe that both stocks and bonds face a headwind. ”

Rick Ashburn, Greg Solari & Andy Hempeck
Principals, Creekside Partners

On the Horizon

We can all agree the recent market turmoil is not your average correction, but is it a bear market? Possibly. We were recently reviewing a memo from renowned investor Howard Marks. He describes a bear market as having three very distinct stages. 1) When just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy. 2) When most investors recognize things are deteriorating 3) When everyone’s convinced things can only get worse. We agree with Mr. Marks and think that we are well into stage two. That being said we do not want to become perma-bears. There are always opportunities presenting themselves. We consider the stock market to be the 800 pound gorilla of investments and we would not recommend wrestling with the large fella at this point in time. When we begin to see a continuous stream of headlines and magazine covers with titles such as “The End of Equities” or “Put your Money in your Mattress” we will begin to smile and allocate our clients money where true values present themselves. In the meantime we will let Mr. Bernanke continue to play a futile game of “Whac-A-Mole”. This is an environment where a good portfolio manager exercises patience and control. This is not the end of investing or the stock market, but is certainly a time where you need to do a great deal of analysis before allocating hard earned dollars.

The Two Worlds – Mediocristan and Extremistan

I studied economics at The University of Maryland as an undergraduate and at UCLA in graduate school. All through those years, I did a dutiful job of absorbing the lessons and repeating them back on exams and in papers. Still, I had this nagging doubt about whether or not the things I was learning actually applied to the real world. I recall sitting in a graduate school classroom listening to the familiar recitation of the key assumptions of the socalled neoclassical economic theory.

I was struck by the thought, “Do you guys really believe this stuff?”

By “this stuff” I mean the assumptions that human beings are perfectly rational, allknowing, forward-looking (infinitely so) and that the outcomes of their behaviors are as smoothly predictable as the bell curve says they are. If economists were asked to explain the game of chess, they would insist that after the first move, both players would stand up and shake hands, and one of them would be acknowledged as the winner. The players would be able to instantly calculate all future moves of the game without error and they would know immediately who would win — so why bother playing?

In his book The Black Swan Nassim Taleb crafts a wonderful analogy to describe the difference between the actual world we live in and the world that theoretical economists think we live in. The world described by neoclassical economics is a world where uncertainty is characterized in the same way as casino games. While the next roll of the dice is unknown, the cumulative outcome of thousands of dice rolls is known with near certainty. Casinos don’t have surprises.

Economic and investment theory assume that the markets work like casino games. Taleb calls this imaginary world Mediocristan; a world where uncertainty is, well, predictable. The assumption that uncertainty is predictable is at the root of the financial analysis performed by the rating agencies and bond insurance companies during the explosive growth of subprime and other exotic debt instruments. The models as-

sumed that chance events fit on a bell curve. The chance of extreme losses was so remote as to be nearly impossible, just as the chance that dice come up snake-eyes ten times in a row is so remote as to be nearly impossible.

Yet the extreme losses happened, didn’t they? More than one financial analyst was quoted in the media as saying something along the lines of, “But our models predicted this could only happen once every few billion years…”

The other world Taleb writes about is called Extremistan. That’s the one we all live in. It’s the one in which cumulative things, like portfolio values, are dominated by a very few extreme events. In Extremistan, uncertainty is really quite uncertain. The dice will occasionally come up snakeeyes ten times a row. In fact, they seem to a couple times a decade. We are experiencing an Extremistan episode at the moment, and you can be sure the future holds many more.

Rick Ashburn, CFA

Asset Class Overview – What we’re doing right now.

The value ranges stated below are on a scale of 1-5, with 1 being cheap and 5 being expensive.

Domestic Stocks. Value range: 4. In our valuation methodology, stock valuations are in the highest 10% of periods over the past 100 years. Returns over 5-year periods following valuations like we see right now have been near zero over inflation. We are underweight domestic stocks by 15-50%, depending on client objective.

Foreign Stocks. Value range: 3. The fundamentals point to fair value. Currency issues and earnings multiples point to more upside than for domestic stocks, and we are neutrally-weighted in foreign stocks. Within the category, we are not making a special allocation to emerging markets at this time.

High-Grade Bonds. Value range: 4+. Expensive — meaning low yields. If a harsh recession arrives, bonds will look to have been cheap, but only in hindsight. Current yields on the 10-year are below inflation. We think fair value for high-grade bonds will be achieved with the 10-year at 5% or so, unless inflation picks up, in which case we will continue to dislike Treasuries.

Municipal Bonds. Value range: 1.5-2. Relative to taxable options, we really like muni bonds right now. We focus our purchases on small, infrequent issuers that offer higher yielding bonds than those traded by the big brokerage houses. We also like some closed-end mutual funds that are trading at sizable discounts to the market value of the underlying holdings.

High-Yield Bonds. Value range: 3. Our valuation opinion here has dropped from 5+ a year ago. If the current trend continues, high yield bonds might become attractive again. We’ll be watching…

REITs. Value range: 4. Like high-yield bonds, REITs have gone from wildly overvalued to merely overvalued. We’re not buying now, but we’re starting to keep an eye on them.

Foreign Bonds. Value range: 3. We are essentially neutral on foreign bonds from a pure valuation perspective — meaning yield and income potential. Our main reason for having a slight overweight to the class is to provide diversification from US currency. It’s a truly global economy we live in, and we should all have some of our capital denominated in foreign currencies.

First Quarter 2008 Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks


High-Yield Bonds

High-Grade Bonds











Wherever applicable, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at