July, 2011
“I don’t want to make the wrong mistake” Yogi Berra
Yogi frequently captures the essence of our thinking about issues that are difficult to get your head around. So it is with the cross currents of today’s financial markets. Because we are laser focused on Risk Management, we want to avoid the wrong mistake. Consequently, your account is presently invested virtually entirely in cash.
As we have communicated many times in the past, we consider cash to be an asset class. At this moment, holding a large cash position enables us (and hopefully you) to sleep soundly. Our present thoughts are that the risks of our being invested far outweigh the potential rewards. You are paying us for our judgment and to attempt to preserve your assets and at this moment, in our view, cash is a safe place to be.
In our first quarter letter, we said that we are constantly hearing from the talking heads and politicians that alternatively the world is ending or everything is going to be just fine. We feel the answer lies somewhere in the middle so our job is to be alert to how the markets discern the risks we face. The volatility of the markets recently indicates to us that the market is discerning considerable risk but not great rewards. For the balance of the year, our focus will be on the overall performance of our economy and the world economy and attempting to select the right vehicles to maximize return and minimize risk in this environment. At the same time, we want to be alert to any direction that the market chooses to take.
As an example of the extremes, consider the following: High yield bonds and many other investment vehicles have once again gone from being weeds to flowers - from pariahs to market darlings - and it has happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now
strike them as good buys at twice the price. The swing of this pendulum recurs regularly in the financial markets and creates some of the greatest opportunities to lose or gain. We consider our job to be being alert to those appropriate opportunities.
The economist John Kenneth Galbraith described investors thought on history this way:
Contributing to…euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes only in a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
When the markets get cooking, the lessons of the past are frequently dismissed. Investors have moved towards being overly risk tolerant rather than risk averse. It appears that investor’s tolerance of risk is out of synch with our tolerance of risk. Consider some of the data points we watch. Interest rates, debt markets, treasuries, corporate debt, munis, derivative markets, CDs, libor spreads, 10 year T bond, 30 year T bond, yield curve, junk market, commodity prices (copper, oil, grains), precious metals (gold, etc.), fed policy, China, and emerging markets.
Warren Buffett is quoted saying “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” These thoughts bring us to our present portfolio construction. At this particular moment we see very little reason to take risk and a great deal of reason to be ultra cautious. Investors are being forced toward pro-risk behavior because of the paucity of returns in the safer, low-risk portion of the risk/return curve. But that is for this moment and will likely change in the future when we hope to take advantage of the opportunities that could potentially arise. The markets are open every day and the ability to reinvest is virtually instantaneous these days.
Our focus has been on this question - should you worry more about losing money or about missing opportunities? We believe the answer is easy. The macro uncertainties that we see indicate to us that we are not likely to see a dynamic economy or a meaningful trend in market environment in the near future.
Our role as portfolio managers is to gauge the risk and reward and to try to select appropriate investment vehicles in the construction of a portfolio. Our role is not to be dogmatic and to recognize that there is always a price that incorporates value in the market and in individual securities. Too many investors find comfort in the momentum of rising stock prices and too many investors are frightened by the value of market drops. We prefer to be opportunistic investors. Our job for you is to try to make the best possible risk adjusted judgments, preserve capital, and get the fair risk adjusted return.
“We would rather accept the risk of lost opportunity than risk of loss of capital”
Our path remains disciplined. Here is our plan. In our Growth and Income and Income portfolios, when we feel the time is appropriate to reinvest, we will continue to focus on investment vehicles, including MLPs, potentially capable of producing stable income, and will try to capture some growth from select holdings. In our growth portfolios we will continue to look for those sectors and specific equities that we feel will yield the most appropriate risk adjusted returns. We will remain ready to reenter the market while seeking to avoid market extremes, in an effort to protect capital.
Past performance is no guarantee of future results. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the securities, markets or issues mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources we believe to be reliable. Opinions expressed herein are subject to change without notice.
