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.