Acorn Fund founder, Ralph Wanger has thoughtful words on the subject of RISK which bear repeating:
“Zebras have the same problem as institutional portfolio managers. First, both seek profits. For portfolio managers, above-average performance; for zebras, fresh grass. Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions. Third, both move in herds. They look alike, think alike, and stick close together.
If you are a zebra and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think that conditions are safe, the outside of the herd is the best for there the grass is fresh while the middle sees only grass which is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better. On the other hand -- or other hoof -- there comes a time when lions approach. The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well but they are still alive.”
That said, from a tactical standpoint, risk-control can be almost as important as being positioned properly when it comes to seeking superior investment returns. If one has not lost too much capital, even if wrongly positioned, an investment manager can be well-positioned when he gets back in sync with the markets.
When the history of our time is written many will disagree about this “Great Recession’s” place but everyone will agree that it has deeply shattered long held beliefs about the functioning of the stock and bond markets. It has been one year since the weekend that shook the foundations of Wall Street and of the global financial system – when Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity and AIG was taken over by the U.S. government.
In light of that, we believe it is important to briefly summarize where we’ve been this year, where we are today and our investment philosophy for the period ahead.
Where have we been?
Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression-like economy dominated the media. Understandably, fear was rampant and stocks responded to these nightmarish scenarios by hitting the lowest levels in years with financials especially hard hit.
Although no one knew it at the time, it now appears that turned out to be the bottom. Since then, the financial markets have moved back from the precipice.
Two years ago the market was characterized by rampant optimism. The U.S. market had hit a new high in October of 2007 and any concerns were set aside as minor annoyances.
By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.
Recently the August Business Week ran a cover story called the “The Case for Optimism.” The premise is that beyond the issues facing the global economy there are many underlying positives that give cause for optimism as we look out two, three years, or beyond.
Where are we going tomorrow?
Today, we see the market as difficult to understand. Many investors can be characterized as extremely nervous. Although the market has been performing well, there are many underlying economic indicators that are extremely negative. One of our favorite economists, David Rosenberg, recently wrote “The current and prospective level of employment and wages suggest that there remains at least $5 trillion more of deleveraging in the consumer sector.” And “although the combination of dramatic fiscal and monetary stimulus and pledges of even more largesse is absolutely generating a high degree of excitement in the stock market, …the question remains one of sustainability and what the economy really looks like without all this medication.”
We are always skeptical of rallies that are purely premised on technicals and liquidity but bereft of a solid economic foundation. The growth we have seen globally, and in the U.S.A. in particular, is because of unprecedented government stimulus. There is little organically in the economy to get us excited. One of our major challenges in managing your portfolio is to make judgments on the controlling of risk and the distinction between the direction of the economy and the direction of the market. A favorite market axiom is “don’t fight the tape” meaning you do not want to be in the way of a market that is going in a different direction than your market call.
One of the critical elements in assessing the markets today is the yin and yang of inflation vs. deflation and the interaction of the dollar. In an inflationary environment, the sectors that we would want to emphasize in our portfolios would be natural resources, commodities, materials, gold, and tech stocks. If the dollar continues to be weak, and it appears that will be the case for the foreseeable future, these sectors along with consumer staples should appreciate. On the other hand, we might not want to hold those sectors in a deflationary environment unless we have a weak dollar along with deflation. A deflationary atmosphere and a strong dollar (flight to safety) would cause us to liquidate our portfolios and have a large cash position, probably invested in treasuries. Again, according to Rosenberg, “The name of the game has been trying to garner solid equity like returns without having to unduly expose ourselves to the vagaries of the stock market, which as we know in the past decades, is highly volatile, vulnerable to sharp and sudden setbacks….” In other words “risk management transcends everything” and we have to apply diversified strategies that involve capital preservation and income orientation.
We are very alert to what Bill Gross of PIMCO calls the “new normal” – which is his term for a sustained period of annual growth of about 2%, much slower than we have been used to, as Americans adjust to a world where credit and jobs are less plentiful.
At L & S our focus continues to be on “Absolute Return”. Absolute return of a portfolio has as its goal the production of returns superior to cash and doing it with as little volatility and general market risk as possible. Yet we try to have no preconceived notions of which asset class to be invested in even if that asset class is cash. While this quarter’s performance was excellent as compared to the general market indices, what we believe to be significant is our risk management controls in order to get those returns.
