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The Seven Dirty Words You Can’t Say About Investing

Market Summary – 2nd Quarter, 2008

We begin in remembrance of a man we greatly admired. He had an ability to see through conventional wisdom and help us appreciate a perspective on life that truly cut to the chase. This unique individual is George Carlin, the comedian who passed away in early July. Carlin’s humor is timeless and appeals to audiences across generations.

He often spotted the irony of our language – for instance, a common phrase you hear in the media of two aircraft nearly colliding is labeled a “near miss.” As Carlin pointed out, it was actually a near hit. A near miss would mean the planes actually did collide.

Carlin may be best remembered for his classic bit, “The Seven Dirty Words You Can’t Say on Television.” We won’t include those words here, but use that as a jumping off point for our primary topic this quarter – The Seven Dirty Words You Can’t Say About Investing:

#7 – Over-diversification

#6 – Over-diversification

#5 – Over-diversification

#4 – Over-diversification

#3 – Over-diversification

#2 – Over-diversification

#1 – Over-diversification!

Our focus on this idea has to do with perceived conventional investment wisdom, much of it based on the efficient market hypothesis. This theory argues that investment performance will generally track the market. The reason, we are told, is that all information is already priced into the value of a company’s stock. Therefore, in the opinion of efficient market believers, it is difficult to outperform the market. The theory also presumes that all investors react in a logical and rational way.

This leads many to believe the idea that they only need to invest in asset classes – stocks, bonds, cash, or even sub-styles – large-cap stocks, global bonds, etc. The market will take care of the rest. The broad acceptance of the efficient market hypothesis is probably one reason why many financial journalists promote the idea that investors put their money in index funds, and settle for whatever the market

gives them. They’ve raised the white flag on any thought of achieving more than that in an investment portfolio. Many credit the belief in this theory for the rise in index fund assets, now more than a $1 trillion industry.

A lost decade
A March 26, 2008 Wall Street Journal article referred to the last ten years as a “lost decade” for investors – specifically those who utilize passive investments that mimic indices such as the S&P 500 stock index. The numbers tell an alarming story of the S&P 500. The average annual return for that index over the last ten years (ending June 30, 2008) is 2.88%. It is hard for investors to get ahead (or even keep pace with today’s 4%+ inflation rate) by earning less than 3% per year on their investments.

Yet we know the last 10 years were not a disaster for all equities. The indices represent averages – meaning a good portion of stocks actually perform better than that. And, unfortunately, a high percentage perform worse than the average, sometimes much worse. As Yogi Berra is purported to have said, “Averages don’t mean nuthin’. If they did, you could have one foot in the oven, the other in a bucket of ice and feel perfectly comfortable.”

q208 cartoonThose who sought to “diversify away” risk by owning an index fund, discovered that approach does not work. Why? The simple reason is when you own an index, you own ALL of it, oven and ice included. And in a time when the bad is really bad, diversification may actually work against investors.

A major irony of index investing is that it runs counter to conventional investment wisdom to “buy low and sell high.” The makeup of the S&P 500 Index, for example, assures that you will “buy high,” because the better companies and industries perform, the greater their weighting in the index. As they peak in value, more of the money poured into index funds goes into those stocks that are rapidly becoming overvalued.

Financial stocks offer the latest example of how this strategy of diversifying by owning an entire index can backfire. As 2006 came to a close, financials represented the largest of 10 industry categories in the index, more than 22% of the value of the S&P 500. This was before the phrase “subprime mortgage crisis” had become part of the lexicon. Just 18 months later, the financial sector of the index has declined more than 45%. And now, financials represent just 14.2% of the S&P 500, and rank as only the third largest sector in the Index. That kind of slide, coming from what was the most prominent sector, takes a big toll on the millions of investors and the trillion-plus dollars invested in the S&P 500.

By contrast, energy stocks have grown from less than 10% of the Index at the end of 2006 to 16.2% in that same 18-month period. Energy is now the second largest industry in the S&P 500, barely behind the information technology group.

Remember diversifying across all sectors, as is done in index funds, can be counterproductive.

The limits of diversification
Diversifying via index funds is one thing. Others may try to diversify by investing in a mix of securities. In our experience, investors can go too far, owning too many securities to properly track and manage, and not really getting much benefit from doing so.

Here’s an example of what we mean. Back in 1987, a study by the Journal of Financial and Quantitative Analysis found that the benefits, from a diversification standpoint, of owning eight or ten stocks, are not greatly enhanced by owning many more stocks than that – even 75 or 100.

diminishing-impact-stock-diversification

By the numbers (and stated simply), this study suggests that owning a single stock can mean the return in any given year will fall within a range of about 50% plus or minus the stock’s average return. Add a second stock to the portfolio, and the predicted range of returns narrows to about 37% plus or minus the average return. By the time you reach eight stocks in a portfolio, the difference in adding even more stocks in terms of making the return more predictable is minimal – even if you go up to 75 stocks or more.

It is easy to get carried away with over-diversification. One can reduce risk, but only so far. Warren Buffet, a person who knows a thing or two about creating wealth, says rather than spread the risk over a number of stocks, he prefers to deal with a limited roster of companies. Buffet has said, “a policy
of portfolio concentration may well decrease risk if it raises,
as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.” In other words, fewer stocks in a portfolio mean you have to care more about the value each one brings to the table.

To truly manage risk, recognize excess
Markets do not move straight up; therefore, a lot of emphasis is placed on the most effective ways to defend against potential market downturns. We’ve already shown the limitations of diversification as many people approach it today – with index investing. Index investors must be willing to accept whatever the markets and economy give them.

We think a better way to play defense is awareness of potential excesses that have been created, and steadfastly avoid exposure to those areas. As an example, in the late 1990s, the excesses were easy to spot in technology issues. Stocks with unrealistically high valuations such as the price/earnings ratios and other metrics are good examples of fairly obvious excess. In other words, avoiding that kind of stock is a good way to defend against market risk.

If you choose to index, thereby investing in all sectors of a market, you can’t help but subject yourself to excesses. Our belief is that rather than diversify across all sectors good and bad, a portfolio is better served by trying to identify areas that should be avoided and those that offer real opportunity. In the past few years alone, the drivers of U.S. stock market disappointments are mostly tied to excesses we identified earlier. As a result, our portfolio managed to avoid most of these excesses:

#1 – The real estate bubble
It is now clear to most everyone that, contrary to previous conventional wisdom, housing prices don’t always go up. Like everything else, they are subject to laws of supply and demand. The sub-prime mortgage crisis may have played a role, but the truth is home prices reached bubble proportions. Avoiding anything related to real estate (including construction) proved to be a great hedge against risk.

#2 – The financial house of cards
Another recently exploded myth was that we had a financial system in rock-solid shape. The giants of industry knew what they were doing, and would not go down a path that would lead to major write-offs. Turns out, they got involved in all sorts of businesses (most notably, subprime mortgage loans) that went beyond their core base of knowledge. The big investment banks were supposed to represent the “smart money” on Wall Street (and in other world financial capitals). Our concern about the state of these companies was well founded, and staying away from them in our portfolio rewarded our clients.

#3 – The dollar’s free fall
Previously, the U.S. dollar was seen as king. But (as we’ve chronicled before), the government continues a fiscal management policy that devalues the dollar. Hence, a dramatic decline has continued. As a result, the Federal Reserve may be forced to manage the economy in an effort to strengthen the dollar, rather than keep inflation at bay or help avoid a recession. We have used gold mining stocks as a way to protect against a declining currency. Oddly enough, metals are a segment of the market that is barely represented in the S&P 500. We believe that’s a major diversification oversight.

How do you pick the “right” investments?
There is no magic solution that works for everybody. Active managers enjoy an edge over index investors by using the power of observation. It is an advantage, we should say, provided those observations are accurate and acted upon. Your initial reaction to this may be, “but that is difficult to do. How can you be sure you are acting on the right opportunities?”

If it were easy, then all would succeed. The efficient market theorists suggest that everyone could succeed by simply buying an index. They treated investing as a commodity, not an art form. Today’s markets have exposed this hypothesis for what it is – a theory. The real world says excesses happen because of market “inefficiencies.” Those inefficiencies occur due to emotions like greed, fear and the herd mentality that can cause significant excesses in the market. The idea that there is an easy way for everybody to get rich is nothing new. In Holland centuries ago, it was tulips that were the commoditized “get rich” scheme. Today, it is index investing, and the record shows there are plenty of holes to fill in the dike.
By assessing investments based on what is going on in the world, we can gain a valuable perspective that is overlooked. Those who focus on mechanically diversifying among sectors or asset classes in order to protect against the downside may miss great investment opportunities.

q208 cartoonRather than focus on diversification as a way to offset risk, the best protection is to pay attention to what is happening that can affect the fortunes of companies. If the housing market looks overheated, and built on a financial structure that appears suspect, it is best to avoid real estate and financial stocks. Index fund investors do not have that option.

At the same time, the observation that the world’s growing demand for energy and limited supply, spurred on by economic growth in developing economies like China and India, would indicate energy companies were worth an increased emphasis in the portfolio. Sure enough, in the last few years, energy stocks have performed consistently well. Index investors, by contrast, only participated in a limited way, and the benefit was not enough to offset the losses suffered in the financial and other sectors.

The events of the past decade reinforce Warren Buffet’s 3 “I’s” of capitalism:

• Innovators who create successful new products, services and businesses
• Imitators who take those ideas and improve on them, or at least mimic them successfully
• Idiots who take it to extremes, and eventually pay the financial price.

One key to our style is to avoid the last “I” in Buffet’s group. Success in the investment markets is multi-dimensional. Among other things, it requires that you:

Avoid over-diversification
Don’t have a portfolio that tries to be all things to all investors. Take a more focused approach.

Pay attention
Be aware of excesses in the markets and the subsequent risks they create. By doing so, we can avoid paying a premium for stocks that are likely to produce disappointing results.

Be observant of opportunities that are created
Carefully view the world we live in, discover appropriate investment opportunities and capitalize on those observations.

We’ve already quoted observant men as diverse as George Carlin, Yogi Berra and Warren Buffet. So why not end with a quote from Henry David Thoreau. The famous writer/philosopher/naturalist wrote – “It’s not what you look at that matters; it’s what you see.”

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.