It was about five years ago that the current equities bull market began, although you would have had to search far and wide to find any investor, professional or retail, who properly called that bottom at that time. At Trusted Financial, suspecting we were in a bottoming pattern, we were continuing our program of selective buying of stocks and bonds at what were bargain prices. Please take a few minutes to read the words I wrote for our Trusted Advisor Client Newsletter – April, 2009.
For Quarter ending March 31 2014, client accounts saw a modest gain of 2% to 3%. This topped most domestic stock indices. New price highs were experienced in cyclical holdings and in non-cyclicals such as Utilities. In other words, it was a pretty satisfying quarter.
Fixed Income Strategy
I share a widely held belief that we are in the trough of interest rates and that the next move will be higher. However, this change appears likely to manifest itself only gradually. I’m not one who believes that the massive money creation by monetary authorities across the planet will lead to runaway inflation or to interest rates rocketing upward to contain it. That was the scenario between 1972 and 1981, but that was forty years ago and something has changed: productivity. We are still in the early-to-mid innings of an electronic (i.e. silicon based) productivity revolution. Fewer employees can accomplish more tasks at lower costs than at any time in the past fifty years and this trend continues apace. Labor costs, on a unit of production basis are falling. Further, the North American energy bonanza will, for decades, dampen the cost of energy, a key input to inflation.
If I’m correct, this implies low inflation and relatively high unemployment, which means that monetary authorities will not goose interest rates higher, but may in fact continue with measures that keep rate near historic lows. In fact, technical behavior of bonds right now suggests rates could again drop. This presents a dilemma for those depending on income from their investments and those of us who seek to satisfy this need. If Certificates of Deposit can only offer yields of .75% to maybe 2.00% over the next decade or so, and quality bonds and preferred stocks remain in the 3%-5% range, from where will the income be derived? My answer: Dividends on quality wide-moat stocks. Right now, I’m reluctant to hold more than about 15%-20% of client portfolios in the fixed income sector (which includes preferred stock). In fact, most of our current holdings are legacy positions from the days when we could obtain fat, safe yields (again, see link to my April 2009 newsletter, above) Today, there is little juice in this sector, little chance of earning more than the rate of inflation. Bond funds, if well managed, can play the yield curve game, borrowing at short term interest costs and buying long term bonds, but this is potentially risky. As last year’s rout of many bond funds demonstrated, bond mutual funds are not a risk free investment.
So, should investors worry about over-allocation to equities? Please consider that there are a wide range of risk profiles for investments known as “equities.” Trusted Financial clients hold many excellent quality stocks that pay good dividends, often in defensive industries. With few exceptions, they have bulletproof balance sheets with low debt-to-equity ratios. “But isn’t the stock market volatile?” might be the concerned response. To which I would reply, “yes it can be volatile, but we do not own the Market.” Rather, client portfolios are a collection of businesses purchased for their individual, unique characteristics. High on the shopping list of investment criteria is companies with relatively low volatility. For example, an established utility like Southern Company (SO) is nearly always less volatile than a currently popular over-the-counter darling like Tesla, Facebook or Netflix. Volatility becomes worrisome when a company is highly dependent on borrowing. Volatility is a risk when a company depends on a narrow list of products or a narrow geographic or demographic distribution of its product. By example, consider a company that depends on customers known as “gamers”, Electronic Arts (EA). In the past three years EA’s share price has fallen from about $24 to about $11 per share then rebounded to $30. None of our clients hold that one! Volatility is a risk when a company’s profit margins are narrow, leaving little room for error by management. Airlines are typical offenders in this department, and we own none of them. This could change due to airline mergers and use of load management software: the U.S. Airline carriers have created regional oligopolies that are currently controlling prices and creating historically high profit margins.
Trusted Financial portfolios tend to emphasize wide moat businesses that have the characteristics of toll roads. True, if the stock market melts down with little warning, even defensive equities will likely suffer some price erosion. Trusted Financial’s key value added service is to manage risk in the markets, something we have accomplished through two big bear markets over the past thirteen years, I feel confident in sharing my belief that even the most cautious investors are unlikely to be seriously injured, even in an outsized bear market.
Position Changes In The Quarter
Notable changes in positions included the addition of Apple Computer to many portfolios. Apple has only been in portfolios for less than two months, but so far we have a healthy unrealized profit of about 6%. We also sold AIG, the insurance giant, having held it for a little over a year and were able to close the position with a significant profit for those involved, taxed as long term capital gains for those who owned the stock outside of a retirement account. For more risk averse clients, we reduced or closed a position in Lazard International Equity mutual fund. I began the year feeling optimistic that the European economy had bottomed, which is why we assumed this position in January. However, The land grab by Russian dictator Putin is of great concern to me. At worst, Russia may continue to advance into Ukraine, provoking a military response from NATO. At best, sanctions by the United States and Europe are likely to result in a hit to European GDP. Neither scenario is good for European stocks, featured prominently in the Lazard fund. We have held on to this fund only for clients that can accept a greater level of risk, but it remains a candidate for full liquidation.
In the first three weeks of April, firms in the energy exploration and production space are doing well as are more traditional healthcare companies. Trusted Financial clients have significant weighting to both sectors. While remaining optimistic, I note that we are headed into a seasonally weak period for stocks (although last year was a pleasant exception). This may present some bargain buying opportunities.
