2008 Report to Clients

MISTAKES WE MADE IN 2008

In 2008 the benchmark we use to measure our efforts on your behalf declined 22.2% (1). Some of your investment portfolios declined more, some less, but everyone experienced negative results that were as alarming to us as they were disappointing. We have read and listened to the explanations of other professionals regarding what happened during the year. (Mutual funds and investment managers have reported losses exceeding 50%.) Surprising to us, several mutual fund managers believe they were victims and attribute their disastrous year to things that happened to them (2). We agree that many things beyond our control went wrong in 2008; however, the crash in financial markets gave all investor strategies a stress test that most failed. As a result, we think it is important for investors and managers to review the year and examine mistakes. In our opinion, if one can’t learn from an experience like last year, either one knows it all or shouldn’t be managing other people’s money. Following are a few of the things we learned (3).

  • In our Level I investment category, Conservative Income, we focused too much of our attention on interest rate risk instead of fundamental risk. In some isolated cases, fundamental risk caused investment losses. While all of these losses were contained with diversification, nevertheless it is possible they could have been prevented by more vigilance being exercised with regard to fundamental risk. Upon examination of our investments in Level I, we can identify some additional positions that make us uncomfortable fundamentally. Even though these are investment-grade rated, we will remain on the watch for exit opportunities. Importantly, future positions in Level I will receive more scrutiny before they are added. Our Level I investment category provides reliable income. This is an important element of your overall return, and it is essential to maintain the integrity of this category.
  • Especially disappointing were the losses we experienced in Level II, Aggressive Income. Utility stocks fell precipitously, but real estate investment trusts (REIT’s) were virtually annihilated, some plunging by a much as 75% in just the months of October and November. While we identified risk in REIT’s two years ago, and reduced your positions accordingly, we had no idea of the devastation that could take place in this market. The combination of deteriorating real estate fundamentals and the credit-dependency of many REIT’s proved deadly as the credit markets were drained of liquidity. Individual REIT’s and REIT mutual funds fell alike. Of course, it is possible that the pendulum in this area has swung too far, but undoubtedly some REIT’s will need to reduce their dividends, and we don’t expect REIT stocks to regain their levels of a year ago anytime soon (4). Less exposure in this area would have prevented considerable disappointment. Our Level II category is designed to act like a shock absorber, with stock price declines limited by high dividends; needless to say, our “absorbers” went flat in 2008.
  • In Level III, Conservative Growth, a mistake that is glaring at us is the woefully lacking investment acumen of our active managers, or the NoLoad mutual funds we select for your portfolios. Some, if not most, of our mutual fund heroes experienced losses that matched or exceeded their benchmarks for the year. Because we select mutual funds based on their managers’ investment philosophies, we were slow to realize the concentration of these mutual funds in financial stocks. Although it may be fair to say it didn’t matter where one was invested in 2008, because virtually all stocks fell, the disappointing results of our mutual fund selections in Level III leads us to believe we relied on these managers more than we should have. Buying individual securities and allocating fewer resources to Level III in the first place are two options we will consider in the future. Additionally, we will study the reports of these managers to see how much they learned from their own review process; certainly there will be some who will be dropped from our list (2).
  • Like the rest of the investment community, we have been guilty of substituting liquidity for knowledge. When this happens, investors identify investment ideas that seem valuable because of their relative metrics. For example, a stock may be cheap because its price-to-earnings ratio is lower than it was two years ago, or its dividend yield is higher than stocks of other companies in the industry. Too much emphasis on metrics increases the reliance of being able to sell the stock to another investor who agrees with one’s assessment. Liquidity, in other words: if the stock can be bought for 20 times earnings and sold for 20 times earnings, understanding the company is not as important. Unless the company goes out of business; then all the metric analysis in the world doesn’t help. As liquidity dried up in all financial markets in 2008, investors learned they didn’t have as much knowledge as they thought they did, and we were no exception. (5)

(1)     We use the Vanguard Balanced Index Fund as our benchmark. See the inside back cover of this report for more details.

(2)     Laments one such mutual fund manager following a disastrous third quarter, “While in each of these cases we believe that our assessment of the strength of the company’s business franchise and its long-term prospects was justified, in the end the regulators crafted arrangements to address broader systemic concerns at the expense of each company’s shareholders. ” (In other words, the portfolio managers and research analysts were right in their judgment, but the government took  the investments—companies—away, ie—AIG? Fannie Mae? Wachovia? CitiGroup? Genworth? We agree that once the government gets involved, “greater-good” decisions will take place at the expense of individuals and individual investors. However, this seems like a lot bad investments in imploding companies to explain away by blaming the government.) Given that the S&P 500 fell another 22% in the next quarter, it will be interesting to see what this fund’s results were and who or what their managers blame for any further decline in the fund’s value. It is doubtful that we will be sending any more of your money to this management team.

(3)We think this list is preliminary; most likely we, like all investors, will be affected by the    lessons of 2008 for many years to come.

(4) In fact, absent liquidity in REIT shares, the valuation process became quite disorderly, and we believe investors able to remember the universal laws of compounding, subject to doing a little homework, will uncover intriguing opportunities in this area (5).

(5)  See BUSINESS OF RETIREMENT, “Liquidity Versus Knowledge.”

*Complete reports available to clients and subscribers in Client Area.