Posts Tagged ‘financial markets’

Our primary goal is to create smart and hard working portfolios that focus on the goals our clients tell us are important to them. Generally, if we can do more with less money then we are on the right track. With that in mind and since we want to outperform the public stock markets, we are most interested in any assets that provide greater returns than stock market indexes.

We include private investments in our portfolios because the returns are potentially higher. We think they are higher because investors demand more return to invest in a market where information is not readily available and where liquidity is challenging. We know from the evidence that institutional investors as a group are also increasing the percentage of their overall portfolios allocated to private equity. Extra return comes at a price and the price in private equity markets is access to information and networks of trusted contacts.

Many of the people we talk to have had experience investing in a “friends and family” round of a private company. While this investment is a private transaction, it doesn’t compare to our approach in this market. We expect that as a whole, the returns to private equity are higher so we want broad diversification. We win by accessing a broad exposure to this asset class. In our pooled approach we own 2-3% positions in any one private company on average. We think throwing all your money at one position represents too much risk of total loss of capital. In addition, there is excess reward available by using relatively better information to guide investment activity. Friends and family may be less focused on relative value than they ought to be. Private companies should pay a fair price for capital.

Publicly-listed securities represent a small percentage of all companies. There are 3 or 4 private companies for every public one. According to Tom Kennedy, Managing Director of Kensington Capital, there is profit available when markets are unbalanced:

“There are approximately 100 billion dollars chasing one trillion dollars in potential transactions in the private Canadian marketplace.  Excess demand for capital represents a great opportunity for potential investors.”

In Canada at least, there is much greater demand for capital than potential supply available. We like these odds, as market imbalances tend to favour one side; in this case the suppliers of capital as a group, who should expect to be rewarded with higher returns for risk assumed. It is important to understand that investors still have to do their homework and not all participants in private equity investments will be rewarded equally.

Public markets are often referred to as “efficient” in that most information about public companies is broadly understood. Information is readily available and instantaneously transmitted to a large audience. By comparison, information about private companies is generally not available. As a result, better information is a source of returns in the private markets.

The total return to public stock markets is the sum of all return to the participants in that market. Overconfident financial marketers are paid to encourage us to consider strategies to perform better than the probable outcome. By definition, not everyone can do better than average, and once fees are considered most will underperform the average of the group. We can’t all eat someone else’s lunch. If we want portfolios that perform better than average, then we should include assets like private equity that provide higher returns.

Patrick

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Please join us for a focused discussion on Investment Returns as part of our 2010 Educational Luncheon Series.This will be a great opportunity to explore what has happened in the financial markets over the past 10 years and how returns have affected the retail investor.

We will explore what some people are afraid to talk about: Actual Historical Returns, What Do They Mean? What did we learn? How do we apply these realities to our future investment decisions?

Please be our guest over lunch and learn about how you can improve your chances. This is also a great opportunity for you to bring along a family member, friend, or colleague to engage in our discussion.

Speaker: Patrick Mullins CFA, Director- Wealth Management, Richardson GMP

Date: Tuesday, September 21st (added due to demand) and September 22nd, 2010 Time: 11:50 a.m to 1:00 p.m

Location: 343 Preston Street, Suite 300 Ottawa, ON K1S 1N4

Lunch will be served

Please RSVP to Lisa Beartup. lisa.beartup@richardsongmp.com or 613-788-8015.

Financial marketers know that human wiring encourages us to judge decision-making skill based on the recent outcome. This is true even if that outcome is a random result. So in the investment world, tossing a coin and producing heads three times in a row is seen as skillful. Predicting the wrong result of a toss is viewed as a repeatable and flawed approach, and this is true even though the probabilities for the next toss remain unchanged. My take is that it is much easier to focus on short term results than to try and uncover whether-or-not an approach is increasing the probability of success for a significant period of investment results. Counting and sorting random results has the illusion of a scientific method. It can also encourage manipulation of meaningless periods of data so as to infer skillful management and decision-making. It opens the door to manipulation by inference.

Unfortunately, from a purely statistical basis it takes about 30 years of data to make a confident assessment of skill for investment management.  The evidence of “beating the street” simply cannot be identified in one, three and five year tables.  For practitioners, this presents a big problem as 30 years is an investment lifetime. Also, the skillful manager is generally about to retire once you have confidently identified his or her ability. It would be much more convenient if we could confidently identify future out-performance. Unfortunately, there is always uncertainty. If we knew the outcome, returns on stocks would be equal to returns on bonds.

In my opinion, the time and effort to identify a hot hand is better spent on good portfolio construction. Good financial advisors have processes that generally guide clients towards strategies designed to minimize errors of judgement. They focus on cost control. They provide guidance around matching fixed income from your portfolio to income you require from the accounts in retirement. Good advice often encourages investors to patiently allow stock market return to be realised by the portfolio in a consistent repeatable approach. There is generally much less of a focus on market timing. They recognise that the recent past offers little in the way of predictive power.

In our practice we focus on repeatable investment success. Our portfolio approach has been refined through more than thirty years of combined, on the job, experience. If we are already working with you great – if not, let’s meet to see if we can be of service.

Patrick

A review of the US monetary System – Suppliers, Dealers and Users

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

Today’s  Opening Value

We posted new lows last week and the S&P 500 is priced at less than half of the value in November 2007.  The recent investment experience has been brutal. Last week was one of the worst in terms of stock market performance that we have seen in the past couple of years and just about everyone is looking for the misery to continue.

Last Thursday Bank of Montreal economist Douglas Porter, suggested the worst was over and we should begin to consider the prospects of a better economy by the end of 2009. His opinion wasn’t appreciated by those that offered comment. Practically no one agreed with his point of view. The average opinion was outright critical and many dismissed his thoughts as someone who is shilling for a bank, his opinion therefore bought and paid for. I don’t know Douglas Porter other than by his reputation as a good economist.  I do have some respect for his decision to release information to the hostile crowd. He was, I think,  aware of the probable feedback. So what is going on here? Is everyone so sure that they know the future will be a continuation of the recent past? Is Porter simply rolling the dice with other people’s money (risk) to generate profit for his bank? It seems to me that investors understand there is higher risk in the investment markets. Their recent experience is bad and they look for this to continue. The idea that economists or financial analysts can predict the bottom for investment markets is a source of irritation bordering on anger.

For the sake of clarity here are some basic financial principles in which we can rely:

• Higher return comes with higher risk. The risk premium or compensation for risk is higher when things are not going well.
• Investment decisions should be made on a forward-looking basis not by looking at the recent past as prologue.
• It is improbable to predict or time the turn in the investment markets.
• Short term returns from a trough, or market low,  is very high.
• Selling after a significant drop in prices means you will probably give up significant short term return when the market recovers.
• Some short term traders will correctly predict the turn in the market but only by chance.

It’s 3 o’clock, an hour before the close of the markets. I really don’t prescribe to technical analysis for stock trading, but like reading your horoscope, it makes you feel better to see a five star day.  We are currently equal to the old low from last November. Optimists (bulls) cling to the notion that this value represented a low level from which the markets would slowly and carefully resume an new upward trajectory. So to avoid a problem I am posting this before the close of market trading. Maybe the market (world) cares about the S&P 500 staying above 752 or maybe not. Intellectually I know it doesn’t make any difference. Emotionally I could use the boost.

The financial press appears to be drawing parallels between our current financial challenges and the depression of the 1930s. To some it may seem reasonable. Yesterday, British Prime Minister Gordon Brown, in the House of commons, referred to the economic environment as a depression, though he later explained that he simply got the words wrong meaning to say recession. This is how rumours start.

While drawing parallels may make it easier to explain complex subject matter, there are many differences between now and then.

1. In the 1930s there was no social security. Today these cheques, delivered monthly, provide a basic level of subsistence.

2.  Peoples’ savings are protected from bank failures through federal deposit insurance. In the 30s investors lost their savings when banks defaulted.

3. Governments around the globe have lowered interest rates in response to a weak economy. In the 30s the U.S. actually raised rates simply getting the monetary policy wrong. These rate cuts are significant. The Bank of England is currently at 1% for fed funds, the lowest level since the Bank was established in the the 1700s . Japan has lowered the rate to zero. Canada and the U.S. are at 1%.

4. There has been a global increase in money supply unlike the contraction experienced in the 30s.

5. International trade agreements now promote trade between economies. The escalating trade barriers introduced in the thirties had the opposite effect.

6. As a global trend, corporate and individual taxes are low when compared to the rising tax environment which typified the 1930s.

7. We now have single digit unemployment. In the thirties unemployment exceeded 20% in North America.

8. Governments have acted quickly, introducing a fiscal stimulus package in a globally co-ordinated effort. In the 30s Roosevelt’s “New Deal”  took several years to launch.

9. We have the experience of the depression as our guide.

For a great read and perspective of economic cycles I recommend The Ascent of Money by British Historian  Niall Ferguson. It it densely written, and therefore a moderately difficult read but gives an excellent review of how governments have dealt with crises beginning with the advent of money.

This week is all about setting a new agenda - Obama style. His star will indeed have to shine bright in order to pierce the hazy veil of bad news and worry that is today’s abundance. It seems the world is waiting for him and at least in the short term, looking forward to the honeymoon.

The leader is responsible for setting the vision. This president appears to have the unique set of skills to get this done and done well.  Governments will and have provided the liquidity to the banking system. There may be more to come. The executive office is charged with providing leadership and confidence to the system.

I think the interesting part of any global transformation  will come from entrepreneurs. A return to a “normal” economy will require compensation for risk taken. This risk premium makes our world go round and has been missing for many months. It seems to me that entrepreneurs as a group are responsible and eager to figure out how to re-establish return.  Borrowing money and investing in businesses employs people, provides consumers’ money and normalizes the stock markets. Governments and bureaucratic institutions provide the platform but it’s the small and medium sized businesses that get the job done. Given the size of the problem we all have significant contributions we should and will make.

I am pleased to point out that Capital Stories is receiving some recognition from peers. Guy Kawasaki’s Alltop site has included us as “best of the best” in  personal finance. Guy Kawasaki is co-founder of Alltop, an online magazine rack, managing director of Garage Technology Ventures, an early-stage venture capital firm and a columnist for Entrepreneur Magazine. Guy is the author of nine books including Reality Check, The Art of the Start, Rules for Revolutionaries, How to Drive Your Competition Crazy, Selling the Dream, and The Macintosh Way. He states on his website that he is a hockey addict. Everything is relative, of course, so this is for a Hawaiian – we need to invite him to Hockey Country!

Chris Brogan has stamped us a “Rock Star” on his website.  Chris is a ten year veteran of using social media and technology to build digital relationships for businesses, organizations, and individuals. Chris speaks, blogs, writes articles, and makes media of all kinds at chrisbrogan.com.

You can find out more about each of these social networking gurus by clicking on the logos at the RH side of this page.

Market volatilty is a true test of the merit of an investment approach. Recent market performance while not probable, may help us to build better future portfolios.

1. Leverage turns a big problem into a life altering event.

2. Diversification works and importantly having a series of maturities to cover cash-income requirements really helps. If you have had a well diversified portfolio and do not have to sell your equities to meet income requirements your chances for success are greatly increased.

3. Individual stocks capture significantly more risk than the market as a whole.

4. Active managers of mutual funds and pension plans as a group have an expected return that is less than the return to the markets in which they invest.

5. The sense that active management outperforms in declining markets has been challenged.

6. Stocks outperform bonds - just not every month.

7. After a market crash, a big diffentiator for future success is those companies that need external capital vs. those that can look internally for financing needs. High dividends increase the likelihood of requiring external capital.

8. When risk manifests itself and markets drop rebalancing programs lose you more money than a buy and hold strategy.

9. Diversification includes and requires that we diversify by currency as well. Hedging out the currency reduces return and cost additional fees.

10. Volatility ia a measure of long term experience so that average volatility can be somewhat meaningless as an assessment of risk. In general “average assessments of risk” don’t work when you need them.

11. Liquidity providers win in the end.

12. Stock prices have no memory. If a stock is down 20 or 50% the risk of ownership is increased even if expected return is greater.

13. Fear sells media products at a much greater rate than greed.

The recent drop in global markets resembles an Atlantic hurricane. The immediate impact of a storm is obvious and sometimes frightening. Life courses can be altered, usually for the worse. Most storms don’t capture our attention and there are many each and every year. But when a category 4-5 hits everyone is watching.  Storms in 2008

We just had a category 5 financial hurricane. There is some good evidence to suggest that the storm has passed. At this point governments across the financial world have guaranteed inter-bank receivables. As a direct result, In my opinion, it is unlikely that we will see another large financial insolvency as a result of this credit crises.

 The TED spread measure is the ratio of 90 day US treasury Bill to LIBOR, the London inter bank offered rate of interest.

The spread has now narrowed to 248 today and continues to fall. Banks are much more likely to lend to each other with a federal government guaranteeing the contract.

Financial storm damages are borne by investors across the world. Unlike an Atlantic hurricane the largest losses are experienced by those that sell and run.