January 2010: Investing is a Long Distance Event

Open Client Meeting Review:  January 2010

Investing Is a Long Distance Event

Successful investing is a long distance event.  Winning the race doesn’t necessarily mean you need to be the “fastest” and post the highest returns every year.  Think of it this way --- we’ve been the tortoise in Aesop’s fable, “The Tortoise and the Hare.”  Our investment strategy is a lot like the tortoise… it’s not very glamorous, but it’s durable and has worked well.

Since we revamped our investment strategy five years ago, our typical client portfolio outperformed our benchmark of balanced mutual funds in four of the past five years.  Our typical portfolio gained 19.3% in 2009.  But, we were not the fastest last year and trailed our benchmark of comparable balanced mutual funds.  More importantly, for the trailing three and five year periods we outperformed our benchmark of comparable balanced mutual funds as well as all major domestic stock market indexes.

You can’t follow the crowd and expect to do better than average.  Any quest to be above average requires being different, and that takes a willingness to be out of sync with the crowd from time to time.  In turn, there will be occasional periods of underperformance. We expect there will be times when we will not outpace our benchmark every quarter or every year and we accept that as a necessary part of long-term successful investing.

Faster Is Not Always Better

The stock market rally that began last March was nearly straight up.   It was not surprising to us that we lagged in that environment.  Historically, our returns have outpaced our benchmark (and even the stock market) during lackluster markets, like 2005, 2006 and 2007, when the selection of individual stocks and bonds and the asset allocation mix of your portfolio matter the most.

The mutual fund managers selected for your portfolio are among the most seasoned, grizzled veterans in the industry.  We believe the keys to their past successes are their selections of individual stocks and bonds, and understanding of when and how to adjust the asset allocation of their respective mutual funds.

Outlook for 2010

This year will be a period of repairing and rebuilding economies worldwide.  Progress will be slow and uneven, sustaining doubt (i.e., the “Wall of Worry” that bull markets tend to climb), but there will be more positives than negatives in 2010.  Some areas in the economy will improve while others will falter.  But, that’s always the case coming out of a downturn.  It’s never one-sided.

The stock market is a forward-looking phenomenon.  Much of the rally witnessed last year in stocks and bonds was based on anticipation of the world’s economies making tangible improvement.  The stock market usually starts to decline before the reasons are apparent, and it usually starts to climb before the reasons are apparent.  But, the reasons must ultimately become evident to justify those moves.  That means visible improvements in the economy must become a reality this year to justify last year’s stock market gains.  So, even if evidence of a recovery becomes clear, it may result in only a slight or modest advance in the stock market.

Our outlook for 2010 is subdued returns in stocks and bonds, not the double-digit returns of 2009.  That will set the stage for a stock-picker’s market --- those with exceptional stock picking skills will be rewarded.  That’s not a bad thing, since we think our investment style and the mutual fund managers we’ve selected are favored in that type of environment.

Lessons Learned

In today’s world of corporate and government shenanigans, we thought we would do something that no corporate executive or government official would dare dream of doing --- own up to the facts and “tell it like it is.”  We suspect that you, too, are as fed up as we are with the way executives and politicians are quick to take full credit for anything that turns out well, but when things don’t go their way, they point fingers, blame others and accept no responsibility.  We believe that credible people call it both ways.  So, here it is…

We asked ourselves, “Despite the high returns we captured in 2009, why did we trail our benchmark?”  There were two factors: 1. our portfolio asset allocation decisions, and 2. our bias toward a value-oriented investment style. (Note: we are pleased with the results we have posted during the past five years, yet our ongoing goal is to improve our results.  Analysis of results and accountability for those results are necessary to the process.  We wish corporate executives and politicians abided by the same beliefs as we do.)

1.  Asset Allocation Decisions:  As the stock market declined in late 2008 and into the early months of 2009, we sold several mutual fund holdings to reduce our stock allocation and thereby reduce our exposure to further stock market declines.  We faced a classic investment management tradeoff:

 a. protect capital (but with a tradeoff of potentially missing an opportunity for higher profits if the stock market moved higher), or

 b. reach for higher profits (but with a tradeoff of potentially incurring greater losses of capital if the stock market continued lower).

We placed a higher priority on capital preservation, reasoning the lesser of two evils would be to miss opportunity rather than lose capital.  Opportunities are much easier to replace than capital.  We chose to proceed cautiously, opting for the first choice of protecting capital by reducing our exposure to stocks.  Given a similar scenario, we would again choose to err on the side of protecting your capital and forego potentially higher profits if it meant avoiding the possibility of incurring greater losses.

These actions helped us initially as the stock market continued to decline and resulted in our portfolios outperforming our benchmark in December, January, February and early March.  However, as the ensuing stock market rally gained steam, it caused us to trail our benchmark, giving back the earlier advantage we gained from having a more defensive portfolio (i.e., lower stock allocations).  As the rally began to show what we believed were signs of lasting strength, we began boosting our portfolio stock allocations and capturing more of the stock market’s rise.

Despite the overall performance disadvantage from being more conservative and taking proactive measures to protect capital, we believe it was the right thing to do for our clients and would do so again.

2.  Value Investing Bias: The mutual fund managers selected on your behalf typically favor a value-oriented investment style over a growth-oriented investment style.  A value-oriented investment style seeks stocks believed to be priced below their true worth with the potential for gains if and when their worth is recognized in the marketplace.  A growth-oriented investment style seeks stocks that can increase their business and earnings beyond consensus expectations, thereby causing their prices to rise.  In the simplest of terms, value-oriented investing is buying merchandise on sale at a discounted price. Growth investing is paying full price, but hoping the price will move higher (like many real estate investors did in years past).

In 2009, the overall U.S. market climbed 28%.  But, there’s more to it than that. Breaking it down between value and growth, value stocks rose 18% while growth stocks increased 43%. The more an investor relied upon value investing this year, the more their stocks lagged behind the return of the overall stock market.  That was our case.

We have always had a bias toward value investing and have no regrets for doing so last year.  Value out-performed growth in seven of the prior ten years (1999 through 2008), but not in 2009.  Keep in mind that neither growth nor value consistently out-performs the other year in and year out.  It can be expected that one style will lag the other style in any given year.  Our viewpoint is that value investing appeals to our common sense and core beliefs --- it’s the equivalent of comparison shopping and buying quality merchandise when it’s on sale.  It just makes good sense.

Thank You

As we begin another new year, we are cautious of the perils that are an inescapable part of investing, we are optimistic about the future and the opportunities it will bring, and we are grateful for the trust and confidence you have placed in us by allowing us to manage your portfolio.  Thank you. ***

Greg Schultz & Bruce Grenke
© 2010 Asset Allocation Advisors, Inc.