The Core / Satellite Strategy

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We like a core/satellite approach because it has several features in terms of portfolio design that is often ignored by rigid ‘check-the-box’ wealth management strategies. First, it has built-in modularity and by that we mean it can be easily adjusted and tweaked. For instance, suppose you wanted to increase you exposure to consumer cyclicals, financials and technology stocks. This could be easily accomplished by purchasing exchange-traded index funds for the core or satellite portion of the portfolio. Let’s suppose you wanted to reduce your exposure to energy and basic material stocks or increase your weighting to income producing instruments within in your core portfolio. By design we build the portfolio so that the exposure to any individual security, industrial sector or asset class is readily transparent and easy to modulate. The core/satellite approach enables us and provides you the flexibility to be more opportunistic or more defensive when market conditions change. A common complaint from new clients is that they have no idea where their exposure exists and their previous advisor had very little incentive or ability to manage it. The general explanation is that professional managers will make the proper adjustments to your portfolios when market conditions change. The reality is many so-called professionals are too big to be as nimble as they claim to be. Basically the investment process has been de-personalized and there is little accountability for the clients. We build clients a truly unique and transparent portfolios and then we work with them to help them understand what they own, why they own it and what the risks are. Clients deserve more than check-the-box wealth management and they deserve a personalized portfolio.

Investment Discipline

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We are bottom-up. That means we start by looking at individual companies and we build our investment themes from there. Initially, we look at company earnings, profitability, cash flow, products and management. We like companies that make money on a consistent basis, the earnings stream grows at a reasonable rate, the management is bullish on their businesses going forward and they have a good history of execution. The ultimate question is what will these company be worth if they execute their business plan, what is the price today and can we make money as investors assuming they are successful. This is called fundamental analysis. The second step is to utilize tools that enable us to purchase securities at opportunistic price points. Some people never pay retail prices because they always hit the sale when they go shopping. That is what we try to do. We like to buy when securities are on sale. The study of price movement is called technical analysis. As we go through this research process investment themes begin to emerge. Based on these themes we find investment vehicles for our client’s portfolio that are consistent with their investment objectives, time horizon and risk tolerance.

For example, based on our research process, we noticed that the companies that provide equipment, services and technology to companies that explore and drill for oil and natural gas have good earnings, profit margins, cash flow, and their earnings are not as sensitive to the price of oil as are the exploration and production or the refining companies. The managers in this industry are bullish on the long-term prospects of their businesses. Recently, oil prices fell from $149 per barrel to around $65 per barrel and these stocks have lost 50% to 70% of their value. We think this sell-off represents an opportunity to accumulate these securities as our current bottom-up research indicates these companies represent long-term value for our clients relative to other investment alternatives. For our client’s portfolios, we can achieve exposure to these companies through individual stocks, sector specific exchange-traded funds (ETFs) or even call options for our most aggressive clients. The solution depends on the client’s investment objectives, risk tolerance and time horizon. It is not rocket science, it is just work and we have a passion for it.

Be Global

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The total equity market capitalization of public companies globally is around $42 trillion.^ The U.S. represents about 39% of the world’s equity market capitalization. The U.S. economy represents about 21% of world’s economic output.* That means that the majority of world’s investment opportunities lie outside the U.S. When we are building investment portfolios for our clients we look for the best companies in their respective industries no matter what country their global headquarters may reside. We believe an investor’s core portfolio should be made up of a group the world’s best global companies through a combination of stocks, preferred stocks and bonds. In the U.S., we are particularly fortunate that many of the world’s best companies have taken steps to make their listings available to U.S. investors. Although, the world has become increasingly global we are still limited in our ability gather the all of the necessary information to make good investment decisions for some foreign securities. As a result, we rely on investment managers that are on the ground in places like Asia, Eastern Europe and Latin America to augment what we can do for our client’s from our corner of the world.

^ Source: World Federation of Exchanges, September 2008.

* Source: imf.org (as of 2007)

Demand More than Check-Box-Wealth Management

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In our opinion, investment advice has been increasingly commoditized. Wall Street, along with the massive mutual fund complex, has taught investors that proper asset allocation will help them achieve their financial objectives. In order to help investors develop a proper asset allocation strategy they have designed a system of boxes that most investors have seen. It divides investment strategies into value and growth; large, mid and small companies; international; emerging markets; real estate; commodities; alternative strategies; fixed-income strategies of short, medium and long maturities, varying credit quality, international bonds, bonds of emerging countries, etcetera. This is not meant to be an exhaustive list but is meant to illustrate the multitude of boxes that many advisors suggest investors ‘check’ to achieve a diverse mix of assets. Essentially, the product du jour of recent years for the mutual fund complex has been to create the new ‘must have’ box for investors. Check-the-box wealth management is a valid investment strategy, but we believe it is a commodity service. We think too many investors overpay for these asset allocation strategies and we attempt to provide more value to our clients than check-the-box wealth management.

Avoid Complexity & Financial Burritos

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It is our opinion that if an investment is difficult to understand or lacks transparency, then it should generally be avoided. In recent years, Wall Street has created a massive debacle as they have become victims of their own excessively complex financial products.

One such product is called the Structured Investment Vehicle (SIV). A SIV borrows money by selling short-term paper to one group of investors at low interest rates and then they use that money to buy longer-term instruments with higher yields. They enhance the yield by utilizing leverage up to 15:1. SIVs are then sold to another group of investors in chunks of $1 to $30 billion.

Essentially, a SIV is what we call a ‘financial burrito’ with all sorts of goodies inside including some spicy leverage. Many SIVs invested in solid long-term investments including mortgages, credit card debts, auto loan debts, student loan debts, royalties of various kinds, credit default swaps and complex derivative transactions. What really got SIVs in trouble was a class of investments now referred to as ‘toxic subprime debt’.

The marketers of SIVs went up and down the financial world selling these ‘financial burritos’ to banks, insurance companies, pension funds, endowments, investment companies, brokerage firms, governments, sovereign wealth funds – you name it – anybody with a billion bucks to pony up. When the housing market peaked in the United States in August of 2006, the falling prices of homes reduced the value of mortgage debt in these SIVs. The leverage factor compounded losses and once yield-hungry investors quickly shunned these investments.

As home prices continued to fall in 2007 some SIVs completely imploded. The so-called ‘smart money’ ran the for the exits all at once and many SIVs lost significant value putting additional pressure on the balance sheets of the financials institutions who owned them. In fact, the ironic double whammy came for some institutions who had loaned money to these SIVs. As losses piled up, liquidity evaporated and the value of SIVs continued to plummet and banks were strapped to make loans even to their most credit worthy customers. By the middle of 2008, over ½ trillion dollars has been lost by financial institutions and some people have estimated that the total losses will eventually be over $1 trillion^.

The lesson we take away from this along with many other examples from Wall Street is that investments that appear overly complex, illiquid and lack transparency should be viewed with a large degree of skepticism. And make sure you know what is in your burrito.

^Bill Gross, PIMCO, Investment Outlook, Moooooo!, August 2008.

Invest for the Long Term

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We call our investment philosophy the ‘new old school’ because it is getting back to what we consider the basics of investing. When we study some of our favorite investment heroes such as Warren Buffet (1930 – present), Sir John Templeton (1912 – 2008) and George Soros (1930 – present), a general theme emerges – they bought and held investments for significant periods time. Buffet is well known for buying basic businesses with strong management and good cash flow. Templeton’s legacy is to not follow the herd. Soros, who is often referred to as a speculator, was and is no ‘day trader’. Soros's investment strategy is based on long-term macroeconomic themes. He is recognized for pricking economic bubbles, crushing excessive valuation and punishing greedy and naïve speculators. These notable investment moguls were long-term investors and we believe much can be earned by studying and emulating their actions.

Independent Thinking

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Independent thinking is one of the cornerstones of successful investing. When you read the histories of investment icons like Warren Buffet, Sir John Templeton and George Soros, their best investments were not popular or well-known ideas at the time. These ideas were based on an assumption that the ‘crowd’ had not recognized the correct future value of the investment in question. In order to be a successful investor, you have to look into an uncertain future and make correct assumptions today. This is a counter intuitive exercise because by the time the bad or good news arrives it is too late. The basic theory of the efficient market hypothesis is that the value of an investment will be fully realized almost as soon as any information affecting its value becomes public knowledge. When the peddlers of investment ideas from Wall Street make recommendations public knowledge then that news should already be priced into or will be rapidly priced into the investment as soon as news is released to the public. Therefore, you need develop your own ideas long before the Wall Street ‘crowd’ jumps on board because it will be the crowd who will move prices to where you think they should be. That is why you must utilize truly independent thinking and develop your own investment ideas. It is probably no coincidence that Buffet is from Omaha, Templeton stayed in the Bahamas and Soros had to start his own firm to pursue his own investment ideas.

Do Your Own Homework

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'I trust only those statistics I have manipulated myself’ is a quote often attributed to Sir Winston Churchill. When it comes investing, and speaking from experience, it is best to do your own homework. Wall Street is a business of selling information to people to get them to buy or sell something in order to generate a fee. While some research from Wall Street is very good, most of must be taken with a grain of salt. There is no definitive study that proves that Wall Street research is good, in fact, it is quite the opposite. Analysts tend to be overly bullish most of the time and then overly bearish when they should be bullish.^ They are just human beings after all. But don’t get us wrong, there are some good analysts out there. Further complicating this matter, the media gives you snippets generally showing pundits with opposing points of view. So how do you make sense of this noise, or know what to do or whom to trust? Well, the only way we know how to do this is by doing our own research. We trust ourselves. This is truly independent thinking.

^ Cusatis, Patrick, and Woolridge, J. Randall, "The Accuracy of Analysts' Long-Term Earnings-Per-Share Growth Rate Forecasts,” Press Release, Penn State Smeal School of Business, March 2008.

Generate Good Ideas

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In the increasingly commoditized market of financial services it has become more important for investment advisors to differentiate themselves. One method has been to offer a new financial product that either has more bells or whistles such as an insurance product. The strategy of the mutual fund complex is to offer the next ‘must have’ investment product that will help you ‘check off’ another box in your asset allocation or peddling the fund-of-funds retirement product with a name of the year you would like to retire. Another recent fad has been to offer exclusive access to the hottest ‘hedge fund’ manager last year. While each of these investment strategies may be appropriate for some investors, we believe the simplest approach that can achieve a client’s goals with less fees and is easy to understand is probably the best. For instance, a client may want income in retirement. An old-fashioned laddered bond portfolio combined with a simple term life insurance policy may achieve the same objective as a fancy insurance product at a fraction of the cost. In fact, you might not even need the insurance. We like the idea of a laddered bond portfolio because we can control what we own in terms of the credit quality, yield and maturity of the portfolio. It is transparent, there is minimal complexity, we control the turnover of these bonds and it has modularity meaning we can sell any of the bonds, at any time, for whatever reason. We keep it simple. It seems like a good idea to us.

Know What You Own and Why You Own It

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Our core philosophy can be summed up with the phrase ‘know what you own and why you own it’. If your financial advisor cannot adequately explain to you why you own something or what your underlying investments are, then you probably should not own it. If you cannot easily understand all of the fees and are able to make a true assessment of your total cost of ownership, then you should probably skeptical of such an investment. If you feel you are part of the investment ‘herd’ or paying to much for a ‘cookie cutter’ asset allocation strategy then you probably are. If you feel that you have to much turnover or trading in your account, then you probably do. If your statement is full of pages and pages of transactions and you are uncomfortable because you are not sure what is going on in the account, then you should probably make some changes. If your advisor doesn’t do his or her own homework and is peddling his or her firm’s latest ‘best idea’ then you should probably think twice. If your advisor does not develop his own independent ideas or has not brought you a truly unique investment idea, then you are probably a member of the Wall Street crowd. We call our philosophy the new old school because it is about getting back to the basics of investing, avoiding complexity, minimizing extraneous fees and investing for the long term.

Back-to-Basics

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There are essentially two core investments instruments. The first is stocks or equities that make investors shareholders or owners of companies, and the second is bonds or fixed income that make investors lenders to companies. Stockholders enable investors to share in the profits of the company whereas bondholders are entitled to a periodic interest payment from the company. Investors, either as stockholders or bondholders, can manage their risk by the number of securities they own and the credit quality of these companies. Individual investments or sector specific investments have more risk whereas widely diversified investment vehicles such as mutual funds have less risk. At the end-of-the day, we believe investors either want to be stockholders or bondholders in what we believe are great companies. Somewhere along the way investing got really complicated for the majority of investors. We try and help investors get exposure to great companies in a sensible and transparent way while minimizing fees and other layers between the investor and their investments. We call it getting back-to-basics.

Minimize Extraneous Fees

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Most investors have no idea what their real cost of ownership is for many investments. The popular mutual fund-of-funds comes to mind to illustrate the potential fees incurred by investors. Initially, the investor may pay an ‘advisory fee’ or a ‘load’ to buy or sell the fund in order to compensate the investment advisor or broker who recommended the purchase of the fund. A fee is paid to the manager of the fund-of-funds who selects which funds to invest in. Another fee is paid to managers of the actual funds inside the fund-of-funds. Each fund at both the fund-of-funds level and the underlying fund level have operational and marketing expenses it may charge. The fund may pay a marketing fee often referred to as a ‘trailer’ to the advisor or broker who sold the fund. The underlying funds have transaction fees in the form of commissions paid to buy or sell the underlying investments in the funds, which may include the purchase of even another fund product with its own layer of fees. The more turnover, i.e. the purchase and sale of securities, in the underlying funds increases the amount of fees paid by the investor. If this sounds complicated then it probably is. All of these fees are a ‘drag’ on the potential return to be enjoyed the investor. A fund-of-funds may be an appropriate solution for a client. We are open-minded. However, simple is better in our view and keep the fees down.

Minimize Turnover

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We try to minimize the amount of turnover that a portfolio will incur. Turnover is the number of times a portfolio is traded relatively to its total value. 100% turnover would mean that the entire portfolio was traded at least once during the year. Many studies have shown that turnover leads to inferior investment performance mostly due to transaction costs (and taxes) even at the institutional level. Some portfolio managers have superior trading skills and generate extraordinary returns through their trading activities. However, this is the exception rather than rule.^ In recent years, many investors have been introduced to the separately management account (SMA). This investment product allows one investment advisor to hire another investment advisor to manage the portfolio of his or her client. While this may make sense for some clients, our general experience is that many investors find themselves having several managers and owning hundreds of securities in tiny amounts relatively to their total portfolio. Sometimes these portfolios have significant amounts of turnover. New clients routinely testify that on a monthly and quarterly basisthey receive pages and pages of statements that make little or no sense to them, and their advisors know very little about the investments in the portfolio. They also have very little access to the person(s) whom they pay to manage their portfolio. Our clients usually want fewer investments, less turnover and want to own companies for the long-term. We help clients simplify their investments and their statements.

^Bauman, W. Scott, Managing Portfolio Turnover: An Empirical Study, Quarterly Journal of Finance and Accounting, Summer 2005.

Simple is Better/Avoid Selling ‘Products’

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In our view simple is better. Wall Street is great at inventing wrappers to put around stocks and bonds, the instruments that make investors owners and lenders to corporations. Probably everyone has brought something home from a store and thought the packaging was either excessive or illogical. We try to avoid products that have too many wrappers.

Some products from Wall Street are great. They are reasonably priced and help investors achieve their objectives. However, many client objectives can be achieved without a ‘product’. When we design investment solutions we generally want a solid rationale to utilize a financial product.