Compass January 2014

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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Lots of Losers; One Big Winner

In a normal year, good returns can be had from numerous asset classes. A diversified portfolio having, say, 6 asset classes will tend to see at least 4-5 of those provide strong returns. In most years, all 6 would do well.

In 2013, only one of the core asset classes delivered after-tax returns above low single digits. That asset class was: Stocks from the developed countries. If we break the core asset classes down into a dozen sub-groups, only two delivered decent returns: US stocks and foreign developed stocks. High-yield bonds did OK, at 5.9%. Most asset classes were money-losers, or nearly so, in 2013.

Despite mundane earnings growth (below the long-term average), domestic stocks soared in 2013. Readers and clients will know that, throughout 2013, we were underweight to domestic stocks. It is not pleasant writing this annual commentary with the acknowledgement that we owned very little of the single asset class that defied all rational analysis. To the extent we owned stocks, we owned mostly the slightly lower-performing developed global stock categories.

The biggest winner from 2012 — emerging market stocks — lost money in 2013. We mention this as a warning to those thinking that they will add money in 2014 to 2013’s top performing category (the S&P500).

Such is the curse of the value investor – get out early, when everyone else is making money. And get in early, when everyone else is terrified. The latter worked in our favor over the past two years as we moved into municipal bonds when others were running away. But exiting the big-cap domestic stock market earlier than everyone else will test our clients’ patience.

And so, we find ourselves in the quandary we have long feared — the same one that value investors faced in the late 1990’s: Do we continue to avoid an over-valued asset class as it rises due to the market’s irrational exuberance? Or do we jump on the risk train, reacting to the year-end headlines, and take a chance on a big downside correction?

The answer is, clearly, no, will continue to underweight big-cap stocks. We have to do what is right, rather than follow the herd for the short-term.
Among the most successful value investors of the modern era is Jeremy Grantham, co-founder of GMO. Grantham has famously shared his firm’s experience from the late-1990s. GMO shifted client funds out of super-cap and tech stocks, and a sizable number of clients were not happy and moved their money over to managers pitching higher stock allocations. As we now know, investors that stayed the course set by GMO, and avoided the overpriced frenzy of stocks, ended up with far better results over the full course of the business cycle.

Moving into 2014, we are looking to increase allocations to emerging market stocks, certain closed-end municipal bond funds, and possibly emerging market debt.

As discussed on the facing page, we are optimistic for the overall economy going into 2014. However, most asset classes (with the probable exception of long-term high-grade bonds), are already priced in anticipation of a robust recovery. Corporate earnings are up about 8% over the past two years, yet share prices are up over 50%. In a sense, share prices already reflect the next five years of earnings growth.
So, despite our reasonably positive economic outlook, we will not increase allocations to domestic stocks unless valuations change. Over the next 5-7 years (or even longer) we fully expect emerging markets to exhibit faster growth than the US and other developed countries. As always, emerging stocks will exhibit some volatility, so we will keep allocations modest.

The last year was challenging. The “headline” investment return figure was north of 25%, yet prudent balanced account investors only realized returns in the 4.5% to 11% range. Their patience and prudence will be tested in 2014, especially if stocks continue to surge higher. We remind investors to look back at 1999 and 2007 and ask themselves if they want to repeat that experience.

Macro Picture Improving

The US economy grew at about 2% in 2013 (after inflation, which was low). Global growth was about a percentage point higher, at 2.9%.
The domestic housing market continues to improve. The share of homes below-water on mortgage debt declined from about 25% two years ago to under 15% today. The average household net worth has re-touched record highs. Tempering this good news is that the median household net worth is still stagnant going on 20 years now. Almost all of the household wealth gains have been in the top 5% of households. This means that consumer spending will likely not respond too strongly to this overall wealth increase.

The labor market is a bit of a conundrum. The headline unemployment figure dropped to 6.7% at year-end. But that drop was really due to the fact that able-bodied adults continue to drop out of the work force. Labor force participation declined to 62.8% — the lowest level since 1978. The growth of labor force participation in the 1980’s and 1990’s was a large factor in the strong economic growth in those two decades. A reversal of that stimulating factor is worrisome. Labor force participation is a complex matter, driven as much by sociological factors as economic. A two-worker household might become a one-worker household for a host of reasons, from income to expenses to caring for children or elderly parents. One thing we can know for certain — a stagnant or shrinking labor force is deflationary and is a headwind to robust growth. See: Japan over the past 25 years.

Inflation remains low. As always, food and energy prices will move up and down in the short-term completely independent of the actual price-wage environment. For example, California’s severe drought could translate to higher food prices in the next few months. However, that isn’t really what we mean by “inflation.” The inflation we worry about is the classic spiral upwards of all prices along with wages. At present, there is little evidence that broad swaths of product and service providers are raising prices, or that workers are successful in demanding big raises.

While you weren’t looking, the federal budget deficit has fallen sharply, from a peak of $1.4 trillion in the fiscal year that ended 9/30/09, shared by the Bush and Obama administrations, to a projected $744 billion in the current FY that ends on September 30, 2014. That is a 47% decline, and has been accomplished without a dramatic negative effect on the economy. In terms relative to GDP, the deficit has fallen from over 10% of GDP to under 5%. The deficit is now in line with levels realized in the 1980’s under Reagan and Bush I. We think a deficit closer to 2% is better for the long haul, but we are moving in the right direction.

The improvement in the ongoing deficit is good, but overall debt remains high and worrisome. Perhaps more worrisome than the federal debt are the massive unfunded pension promises made by state and local government. This threatens to make some already-high tax states into even-higher tax states. Not good for attracting businesses and workers…

Two Types of Investing: Value or Guessing

Investors come in different styles. Analysts and mutual fund managers generally approach the task from a particular point of view. You have heard of “growth” managers and “value” managers. There are as many ways of analyzing investments as there are investment analyzers.
In our view, there are two and only two styles of investing. Value investing, and guessing. Any investment analysis not rooted in valuation is just guessing. You might as well flip a coin.

Humans like to control the outcome of decisions. At least, we like to imagine that we can. However, you need to understand a fundamental concept of investing: Once you make the investment, the eventual return on your money is utterly out of your control. You control things up to the point that you write the check or click the mouse button, and you then have to sit back and take whatever comes back. If you don’t like the results…water over the dam.

Before you write the check, you need to analyze the prospects for the investment. Since the amount of money that will eventually be repaid to you is beyond your control, you need to ascertain with as high a degree of certainty how much money will come your way. In the case of an income-producing investment, such as bonds or income property, this is not a complicated task. Bonds have the return printed right on them, and property will produce a relatively predictable stream of rental income.

Once you have these figures in hand, you can decide how much you want to pay for the investment. If the rental income from a building is $10 thousand per year, you know that paying $100 thousand for it will produce a 10% return; paying $200 thousand for it will produce a 5% return. You decide 5% is too low, so you offer $100 thousand for the building. Congratulations – you’re a value-driven investor.
Now let’s imagine that the building owner declines your offer and points to comparable sales at $200 thousand. The broker is telling you that buildings in the area have been going up at 20% per year, and that you will make plenty of money. How is this possible? The rental stream has been the same, rising only with inflation. If you go into this $200 thousand purchase price expecting to earn more than 5%, plus inflation, you are just guessing. You are guessing that another investor will come along and pay more for the building than you did. Is there anything in the numbers that leads you to believe this will happen?

What would have to occur for someone to come along in two years and pay you $250 thousand, when the rental income is still only $10 thousand? That new investor will have to accept a rental yield of 4%. What would lead you to believe that will actually occur? A simple guess, that’s all.
I do not mean to suggest that so-called growth investments are a bad thing. I want the earnings of my stocks to grow as fast as possible. I merely insist that the price I pay for the stock is rooted in a sensible evaluation of its true worth. The very best “growth stock” managers use a valuation discipline to choose fast-growing stocks. The worst growth stock managers just jump on the bandwagon and guess that other investors will come along and trade places with them before the wagon runs off a cliff.

All investment analysis must address the questions: What are the prospects for the future return of my money, and how much am I willing to pay for that stream coming back to me? I need to adjust the price downward if the return stream is uncertain or risky, and perhaps upward if the return stream is quite safe. In either case, I use the simple tools of valuation to guide my decisions.

Whether it is stocks or real estate or foreign government bonds, all wise investment decisions are rooted in valuation. The only thing you can control is the decision over how much to pay for an investment.