September 17, 2013

Investment Philosophy Meets Reality

The Investment View from Prescott, Arizona

My investment philosophy has always been to first control the risks of investing and then, generate an acceptable rate of return for my clients.

There are several reasons I think this is the right set of priorities. First is the math of gains and losses.  The S&P Index**, representing the average investor, lost 56% from October 10, 2007 through March 9, 2009.  Let’s round that to 50% for an example.

If an investor starts with $1.00 and loses half their money, that is 50 cents or 50% lost.  From there it takes a 100% gain to get back to even because that investor no longer has $1.00 to work with, they have only 50 cents.  They must earn 50 cents on the 50 cents that is left, or put another way, they need to double their money to break even.

Doubling one’s money is extraordinarily hard to do, so the best thing is to avoid those kinds of losses in the first place.  Small losses are inevitable in market oriented investments, but priority #1 is no big losses.

In addition, investors feel the pain of losses twice as acutely as the pleasure of gains.  Compounding this problem is that when people watch their portfolio more frequently, they see more of the down periods that makes them so uncomfortable.  Large losses even more so.

For these reasons, for the last 12 years, our flagship strategy at Hepburn Capital has been our lower-risk Flexible Income* strategy.  It has always had very low volatility for a market oriented investment.  Blending it in with our Growth strategy*, to create Adaptive Balance* and Adaptive Growth*, means that almost all HCM investors have some Flexible Income* in their portfolios.

Flexible Income* has actually outperformed Growth*, too. Amazingly, my Flexible Income* strategy has also outperformed even the S&P 500** since its inception on March 15, 2001 through last Friday, September 13, 2013.  The S&P 500** posted 2.96% per year average annual return, with dividends reinvested, while Flexible Income* returned 6.95%.  That is over twice the return of stocks with about 1/10 the risk.  Not bad. 

Of course this backward sounding performance is largely due to the two major bear markets in stocks in 2000-03 and 2007-09 which saw the S&P 500** Index drop 52% and 56% respectively.  It takes a long time to earn back those kinds of losses.

However, it was also due to a decline in interest rates that helped income oriented investments post strong returns during that same period. 

However, there seems to be a long-term change happening with regards to the direction of interest rates.  History suggests that interest rates, after bottoming out in the summer of 2012, will generally rise, perhaps for many years.  This means that the performance advantage is shifting away from income oriented investments and will be with stocks.

For this reason I want to suggest that you consider shifting a part of your portfolio now allocated to Flexible Income* to include more growth (primarily stocks), and I will be trying to contact each of you over the rest of the year to explain my thinking.

In most cases, I will recommend that accounts that are now 100% Flexible Income* move to Adaptive Balance* which can have between 50% and 90% Flexible Income* but also between 10%-50% in stocks, and accounts that are currently managed with Adaptive Balance* be changed to Adaptive Growth* with between 20%-80% stocks and the balance in Flexible Income*. 

The sideways graphs on your monthly statement are both good and bad.  They are good because of their smoothness or lack of volatility.  No big zig-zags mean no really big losses.  But they are being held back in the growth department by the heavy allocations to Flexible Income*. 

It has been difficult to make money recently with the Fed holding interest rates to near zero, but if rates continue to rise over the next few years, as crazy as this sounds, income investments will carry more risk (meaning larger potential losses) than stocks.

I have already spoken with a few clients about this and I appreciate hearing your concerns about the lack of growth in your accounts.  It crystallized my thinking that things need to change.

Feel free to call and schedule an appointment to talk either in person or on the phone.  I’ll look forward to speaking with you about these changes over the next few months.

A Slice of Life

I’d like to send a hearty congratulations to my son Matt, who was married last week to Alison Cutter of Prescott. 

Some of you remember back in 1990 when Matt was born and how my life changed as a result. 

Alison has a lovely daughter “Mal”, age 2, so now Matt gets to be the daddy. 

Congratulations, son.

How’s the Market Doing?

These are interesting times in the gold markets.  I had been watching our holdings in gold rack up nice gains in August, and when they began to dip the past two weeks, it appeared to be a normal pull back in its recent rally.  The markets never go straight in one direction, but zig and zag their way up or down.  This looked to be an ordinary zag and we still had small profits in our gold holdings.

Last Thursday, however, changed all of that.  Gold trading had been quiet and orderly when at 3:00 a.m. eastern time a single trader placed a huge sell order with no attempt to get the best price or anything. They just dumped the stuff.  The order was so large that CME, the exchange where gold trades, had to stop trading until its computers could find buyers to take all the gold.

Was it a deliberate attempt to crash the price of gold and create a stampede toward the exits? We’ll never know for sure, but it sure succeeded in doing that.  Gold dropped almost $50 (3 ½%) in 24 hours amid heavy selling.

This also changed the technical indicators – all those charts and graphs that look like a foreign language to those not used to reading them – from positive on gold to negative.  So a sell of gold is suggested by the indicators.

However, due to the unusual nature of the action in the gold markets, and the fact that gold has begun to bounce back from this artificial drubbing, I have elected to watch a little longer while being ready to quickly sell if the bounce fizzles out.

There was a similar large, sudden sell-off in the gold markets on April 12th which led to a nice rally immediately afterward.  Gold was up a small bit on Friday, September 13th, the last business day before this writing, so perhaps that was the beginning of a similar bounce.  Rather than close the barn door after the horses have left, it is time to be patient.

Patient investors are generally the most successful, and hopefully this is one of those times that patience will pay off.  If not, and gold continues to break down, I will quickly sell our gold holdings.

The stock markets appear to be resuming their uptrends, after giving a pretty good head fake last month.  Let’s keep our fingers crossed that it keeps up.

What’s Going On In Your Portfolio?

As I mentioned elsewhere in this newsletter both our Growth* and Income* models have gold, or gold and silver. 

In addition, accounts following the Flexible Income* models hold two diversified (mostly) bond funds, a floating rate bond fund and about 23% in cash.

As of this writing on September 15th, growth accounts are about half in cash with the balance in a growth fund, health care and stocks along with gold.  With the market strengthening, I will be putting some of that cash to work this week.  Stay tuned.

Mental Floss

Q: What word of five letters has only one left when two letters are removed?

A: Money  

Remove the “m” and the “Y’ and “one” is left.

Scottsdale Office Date

For your convenience you have a choice of meeting with Will in Scottsdale or Prescott.  Please call the office (928 778-4000) to schedule an appointment.

Our Spotlight Strategy

With our Adaptive Balance Strategy we strive to provide high total return from a combination of investments in both the equity and income markets with an emphasis on the income markets.

Our proprietary Stock Market Exposure Indicator is used to determine a stock market exposure that adapts to both strength and weakness in the market, directing exposure to the HCM Long/Short Equity strategy ranging from 0% to a maximum of 50% of account value. The balance, 50% to 100% of account value, is invested in the Flexible Income Strategy*. The HCM Safety Net indicator is designed to warn of sudden potential declines in which case stock market exposure is quickly reduced.  Adaptive Balance

If you would like a current copy of our SEC Form ADV, Part 2, it is on our website at hepburncapital.com/form-adv.html

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in an Index.

Traditional Income
Flexible Income
Adaptive Balance
Adaptive Growth
Shock Absorber Growth

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.