Compass July 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 second quarter of 2008 saw continuing declines in stocks and other long-dated assets. While foreign stocks had helped offset declines in our domestic holdings in the past year, they did not help much in Q2 2008. Large cap stocks were down 12% in the quarter, and core foreign holdings were down 11%.

At the beginning of the year, the high price of oil was on everyone’s mind. As the second quarter unfolded, the high price of oil was the only thing on everyone’s mind. Oil prices shot up so fast and so high that we concluded that we no longer understood the fundamentals. As we often remind our readers, we are value investors and we need to understand the basic cheap-versus-expensive proposition first. We cannot profess to understand that proposition any longer in the oil markets. We sold our natural resources mutual fund holdings in early June. Those funds were dominated by oil and oil services companies.

Our quick review of the major asset classes is on the back page.

Inflation picked up again in the second quarter after a brief pause for a month here and there. The year-over-year inflation rate is reported as 5%, and is almost entirely attributable to food and energy. If we are currently running at a 5% inflation rate, then yields on high-grade bonds and cash investments are decidedly negative in real terms. We’ve been squawking about inflation risks for two years now, and we’re not about to stop. At this writing, we can identify very few investment asset classes that we expect to stay ahead of inflation in the short term. 5% is an awfully high hurdle when so many asset classes remain at the high end of their valuation ranges, and when high-grade intermediate term bonds are yielding around 4%.

We do not expect the Fed to react quickly and harshly to raise short-term rates in reaction to inflation. So far, wages have not been able to chase prices higher. In the 1970’s, a wage-price spiral took root. Eventually, the Fed had to snuff out a big chunk of GDP growth and consumer spending via a huge rate increase in order to break the wage-price spiral. Today, the wage side of the spiral isn’t catching hold and we do not expect it to anytime soon. This gives the Fed some breathing room to allow the economy to cool down on its own under the pressure of debt repayment, asset valuation declines and the absorption of a new and higher price of oil.

While we don’t expect the Fed to act to raise short-term rates, we do expect the bond market to drive longer-term rates upwards. This process took place with a vengeance in early July as we wrote this newsletter, with the yield on 10-year Treasury bonds rising by __ percentage points. We will stay on the short end of the yield curve indefinitely – perhaps for several years.

At quarter’s end, and in the two weeks since, the major news story has been the continued struggles in the debt market. We wrote in last quarter’s Compass that debt ultimately has to be repaid from real, actual income, rents and earnings, not from asset sales. The value of the core asset in the lives of most households is plummeting in value. Those assets (homes) provide the security for about $8 trillion in mortgage debt. Most of that debt is held or guaranteed by a few large savings banks, and by Fannie Mae and Freddie Mac.

“The debt of Fannie and Freddie carries an implied government backing.”

The failure of IndyMac Bank is the largest shoe to drop so far. The recent moves by the Administration to rescue Fannie and Freddie are close behind. Numerous friends and clients have asked us our opinion about the government-led “rescue” of Fannie and Freddie. Being free-market types at heart, we are a bit torn on the issue. On the one hand, if these institutions ran themselves badly then they should be allowed to fail to make room for betterrun lenders. On the other hand, both companies have prospered under a long-established implicit government backing. By extension – so have all of us. Mortgage rates have remained low and mortgage money has remained available over the past several decades because of this implicit government backing. Every homeowner in America owes a debt to the implicit Federal guarantee of Fannie and Freddie mortgage bonds.

Debt issued by Fannie and Freddie has always traded in the bond market under the category of “Agencies” – meaning, “Government Agencies.” Are Fannie and Freddie actually government agencies? Of course not, but every Treasury Secretary, every Finance Committee Chairman and even every President going back 40 years has done nothing to dissuade the markets from that notion. The debt of Fannie and Freddie has always traded as if it were government- guaranteed. The government – meaning you and me – has a duty to now step up to the plate and honor the guarantee.

“ The stock of Fannie and Freddie does not.”

We cannot allow the $5 trillion in debt issued by Fannie and Freddie to default. If we did, the mortgage market might disappear for the better part of a generation and home ownership will be a pipe dream. Not to mention, of course, the catastrophic effect on house prices.

We can, however, allow the stock of Fannie and Freddie to go to zero. The moral obligation of the government to back Fannie and Freddie’s debt does not extend to protecting its shareholders. The shareholders of IndyMac will get nothing, and if Fannie and Freddie require a government bailout, the taxpayer should end up owning the companies. The current shareholders have done a lousy job of running the place and should walk away with nothing.

Rick Ashburn & Andy Hempeck Principals, Creekside Partners

Whose risk is it?

Investors are familiar with the risk that comes with any investment decision. Long-dated assets such as stocks and real estate present the risk that they can decline in value. Bonds present the risk of rising inflation or default. Even cash has its risk, as you run the risk of falling behind inflation.

A less familiar risk, and the source of risk that advisors don’t like to talk about, is agency risk. The term “agent” refers to a person who makes decisions on behalf of another person. Your gardener is your agent in the realm of your backyard; your investment advisor is your agent in the realm of your investments. Most investment decisions out here in the real world are not made by the actual owners of the investments. They are made by folks like us, who represent investors. Even large endowments with professional staffs don’t make their own investment decisions — the staff mem-bers make the decisions, and the staff members don’t own the investments.

In theory, an agent’s decisions are made purely in the best interests of the investor. In reality, an agent’s personal interests can conflict with those of the investor. Let’s imagine you work for a large pension fund. The pension fund has computed its obligations to retirees under an assumption of a rate of return of 9%. As a professional analyst, you only expect the normal mix of stocks and bonds to pay about 5% over the next five years. If you tell your boss this, you’ll find yourself in a basement office with no windows or phone until you quit. If you buy that portfolio and it earns the 5% you expect, you might just get fired.

You do have some options in choosing investments with the potential to earn 9%, but those are very risky investments that you normally wouldn’t choose. So, you find yourself in a quandary – do you cut your career short, or do you buy the risky investments in the hope that you might make your boss happy? The interests of the agent can become at odds with the interests of the investor. This is true whether the agent is a fee-only advisor, a commissioned broker or a salaried staffer at a pension fund.

Another term for agency risk is “career risk.” An advisor who disappoints clients places his or her career at risk.

Scary stories are told in the hallways of valueoriented and conservative investment firms of client disappointment in the late 1990s. Firms such as Grantham Mayo van Otterloo saw huge withdrawals by clients. The firm followed its discipline and stayed out of the irrationally exuberant NASDAQ market while it exploded upwards. Clients were unhappy and moved to what they perceived as greener pastures with the growthstock advisors. GMO reported losing almost 40% of its assets under management and had to lay off employees. GMO placed clients’ interests ahead of its own business risk, and did the honorable thing. In time GMO was proved correct and its practice has fully recovered.

When we at Creekside survey the investment landscape, we see very few asset classes with the potential to pay high real risk-adjusted returns. Our portfolios are tilted away from assets with high historic returns, and toward assets with more mundane expectations such as cash, short-term bonds and TIPS.

We will confess that more than one client and prospective client has pressed us on this weighting — how are they going to earn the 5-6% afterinflation return they expect in the long run if we are sitting in assets paying 1-2% after inflation? Naturally, the implication is that we’d better get something going or we’ll have unhappy clients on our hands.

If we begin to try “too hard” to produce quick results for our clients, we will load up on the risky and uncertain assets. To do so would put our personal success ahead of the clients’ interests.

We invoke the parable: You can’t squeeze blood from a stone. If the returns aren’t out there to be had, we’re going to lay low until they are. In the past 18 months, our decision to reduce stock positions and stay entirely away from REITs and highyield bonds has produced benchmark-beating results. That doesn’t mean we’ve made a lot of money for our clients — cash yields are low and we did own some amount of stocks in almost all accounts.

Sometimes the best course of action is like the physician’s oath: First, do no harm.

Such is the business world of the investment advisor. Ultimately, we have to stand by our fiduciary duty to do what is best for the client, even if it presents us with our own challenges.

Rick Ashburn

Warren the Wizard

On a weekly basis we read about Warren Buffett and his investing prowess. He has a folksy, salt of the earth way about him that allows people to identify with him. He is able to do this while being the richest person in America.

That folksy charm glosses over the complexity of Berkshire and its moving parts. Most investors think of Mr. Buffett as a buy and hold investor, but in reality he operates much more like a hedge fund.

When you sort through the 10-Q that Berkshire files with the Securities and Exchange Commission, you quickly see he is not just buying stocks and bonds like most investors. Below is a list of investing vehicles he is currently using:

  • Credit default obligations
  • Equity index put options
  • Fixed Income Securities (Level 1, Level 2, and Level 3)
  • Equity Securities (Level 1, Level 2, and Level 3) (Level 3 definition: “Inputs are unobservable inputs that are used in the measurement of assets and liabilities.”) Entertaining definition!
  • Derivative Contract Liabilities
  • Loans and Receivables
  • Property
  • Inventories
  • Notes Payable

Now, if your portfolio resembles the above assets, I’m not sure why you are reading this. I’ve been in the investment industry for almost two decades and have not seen one private investor with a portfolio resembling the one above.

My point is that, as folksy as Warren is, as a common investor you are not able to invest like he can. Investors need to realize the days of investing in just stocks and bonds have passed. The landscape has changed and you need to review a much wider spectrum than you have in the past.

Bottom line, today’s investing world is complex and most investors need help. If you can find that intelligent, trustworthy advisor who communicates with you, then you are well on your way. That is exactly what Mr. Buffett followers discovered forty plus years ago.

Andy Hempeck

Asset Class Overview – What We’re Doing 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 remain expensive, despite the decline over the past year. 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 are no longer in our favor, 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 favor 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 closedend 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.

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.

Year to Date 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