Archive for the ‘Topics of Interest’ Category

Capitalism is what people are experiencing who are looking for work: falling demand for the goods and services they provide has left them unemployed, or holding down jobs just to make ends meet. These are society’s real capitalists.

Socialism is what is being practiced on Wall Street: profit made with other people’s money goes home and losses go to taxpayers.

Banks remain part of the problem because they lobby (with taxpayer money) against reform. They should be part of the solution by working to legislate reform that will prevent the recurrence of the mess they helped create, as well as addressing today’s housing catastrophe.

Politically and economically, true north is the bi-partisan Simpson and Bowles report commissioned by the present administration, but shamefully ignored by all political parties in selfish pursuit of their own agendas (www.fiscalcommission.gov).

If capitalism is the preferred economic system to allocate our country’s resources, then “capitalists” need to face the issues raised in the many articles, books and documentaries written and produced about the financial crisis. (See Reading List.) Politics aside, the only way to justify the sacrifices being made by today’s real capitalists is the application of capitalism’s principles to everyone.

We all need to make sacrifices to get out of this crisis. We can start by stop subsidizing bad decisions and losses: bring capitalism to Wall Street.

But don’t take our word for it. Read or watch some of the following material and draw your own conclusions about corporate and political values in America.

Suggested reading and viewing…

Barbarians At The Gate, Bryan Burrough & John Helyar, 1990

Other People’s Money, Motion Picture, 1991

When Genius Failed, Roger Lowenstein, 2000

The Smartest Guys in the Room, Bethany McLean & Peter Elking, 2003/ Documentary Film 2005

Too Big to Fail, Andrew Ross Sorkin, 2009

The Big Short, Michael Lewis, 2010

The End of Wall Street, Roger Lowenstein, 2010

Inside Job, Documentary Film, 2010

“Robbing Peter…” Article by Sam Dreher, NAPFA Advisor, January 2011

Endgame, John Mauldin, 2011

November 17, 2011

Ms Indra Nooyi
Chairperson & Chief Executive Officer
PepsiCo, Inc
700 Anderson Hill Road
Purchase, NY 10577

Dear Ms Nooyi:

In light of the recent drama surrounding your company’s stock, we would like you to know why many of our clients own PepsiCo.

• In a world offering investors negative returns for the safety of short-term U.S. Treasury obligations, and less than 2.0 percent for a ten-year hold of the same, the current yield of your dividend—approximately 3.3 percent—is most refreshing.
• Speaking of the dividend and looking back, evidence reveals your company’s culture of rewarding shareholders

To continue reading please visit CLIENT AREA, or contact us for a complimentary copy of this letter.

Dividends for Income
By Sam Dreher
(August 2011)

Be Careful What You Wish For:
An old saying attributed to Will Rogers is “Return OF principal is more important than return ON principal.” Of course this would have been good advice for investors chasing high dividends on the stocks of risky companies that collapse at the first sign of a business downturn; or high interest rates on junk bonds that didn’t pay back the principal at maturity; or adjustable rate preferred stocks whose bids went to zero at failed auctions; and especially on the high-yielding Collateralized Debt Obligations—AAA-rated—that lost all the principal during the sub-prime mortgage crash of 2008-2009.

Loss of principal is the usual consequence one thinks of when investors get too greedy: “If it looks too good to be true, it probably is.” As discussed in our 2010 ANNUAL REPORT, however, in this upside down investment landscape we seem to have entered, some of the things we learned in school aren’t working anymore. Anyone shopping for Certificates of Deposit during the past three years is probably finding their “principal” to be a bit of a pain. (Nobody wants it; at least they don’t want to pay anything for the use of it!) And anyone having bonds called during this time has found that their “return of principal” at the very least comes at a bad time.

As reality sets in, aging baby-boomers are beginning to realize they could easily outlive their savings. The visions created by Wall Street to sell them financial products—retirement on a beach, world travel, leaving a large estate, etc—are beginning to fade with two dreadful bear markets in the past decade, lingering economic malaise, political gridlock and a manic Federal Reserve intent on eliminating any return from the obligations of our profligate Treasury. Indeed, many investors are coming to realize in a very real sense that they would give up their principal in exchange for a reliable income stream.

To carry this line of reasoning a bit further, consider how most retirees would fare with the return of their Social Security contributions? Where would they invest the money? Bonds guaranteed by sovereign governments are being downgraded to junk, and governments—as well as corporations—in good financial shape pay almost no interest at all on their debt obligations. As for stocks, the last two bear markets have taught the folly of depending on growth for a steady income: selling investments to buy food when they are down 40% doesn’t work for long. Yes, these remarks may overstate the obvious, with too much drama and a bit too much generalization. But it’s hard to overstate the difficulty of finding reliable income in today’s financial arena, a fact about which individuals, professionals and institutions seem to be in denial. (1)

Clients and subscribers can view the entire article in the “Client Area” of our website. For a complimentary copy in PDF or print, contact us at H.S. Dreher Capital Management, LLC: 910-692-4330.

Dividends for Income

CASH: A NECESSARY EVIL?

(2011 Q2)

Ugly!

We have been receiving many questions regarding the amount  of cash in client accounts. And for good reasons:

• All of us are painfully aware that cash balances, such as money market funds and certificates of deposit, pay miniscule interest, if any.
• Worse, our government’s policy is to create 2.0% inflation. At the end of a one-year cash investment, therefore, investors could be left with $0.98 on the dollar.
• Subtract another 1% for a typical investment management fee, and a cash position looks down right stupid. Clearly, the negative aspects of holding cash are revolting.

Mitigating Factors

Despite these self-evident negatives, a cash position may not be as bad as it seems on the surface.

•  As far as inflation is concerned, it affects all investment the same. Whether one’s investment return is 0% or 10%, it is necessary to subtract 2% (if that is the inflation rate) to derive the real return. So it is unfair to ding the money market by the inflation rate. Comparing cash returns nominally with alternative choices is an apples-to-apples process.
• Cash is not the whole portfolio. Interpreting one, small negative cash flow as investment failure diverts attention from the current yield that may be generated from all of the investments held. For instance, a fully invested portfolio yielding 3.0% on a current basis, if put into a 10% cash position, would experience a decline in yield to 2.7%. Similarly, the same portfolio with a 20% cash position would yield 2.4%, and the yield would only decline to 2.1% with a 30% cash position.
• Another factor that is often overlooked when focusing on the negatives of cash is the amount of time investors hold cash, or at least high cash balances. Ideally, cash is a temporary holding between investment opportunities. A 25% cash balance resulting from some profit taking that is redeployed in a few weeks or months has a different ring to it than “OMG, my account is 25% in cash with no yield and I’m paying for this?!”

Thus, to a certain degree at least, when looking at the negative features of cash, it is easy to overstate the obvious.

Where’s The Value?

Cash may not be as bad as it seems, but what is the value of holding any? Think of it in terms of risk. In today’s low interest rate environment, it’s easy to equate small numbers (ie-2.0% or 3.0%) with low risk. But that 3.0% return in today’s Treasury market requires a 10-year lockup before the principal comes back. That may not seem too risky, but is a 10% cash reserve too costly if it only means a reduction from 3.0% to 2.7% on the overall portfolio? It might come in handy to buy more bonds if interest rates go up in the meantime. (1)

And so far we’ve only considered Treasury bonds, which are risk free on a nominal basis.

Investments in corporate bonds and equities contain more risk. The small, overall yield sacrifice of a cash reserve could pay for itself many times over if it puts investors in a position to take advantage of opportunities delivered by a volatile market.

With only rare exceptions, it paid to be fully invested during the decades of the 1980’s and 1990’s, But during the 2000’s, a buy and hold strategy was disappointing for many investors and even disastrous for some. Cash would have been a friend during this latter period.

What Kind of Decade Are We In Now?

The market crash of 2008-2009 laid to waste Wall Street’s traditional mutual fund model of being fully invested in a particular investment style. An astounding number of legacy mutual  unds experienced losses exceeding 40%. And many superstar funds have yet to get back to even, so horrendous were their losses.

Of course we can’t know the future, but we think it’s important to recognize the possibility of further market-disrupting events. The obvious possibilities are numerous: structural unemployment in the sluggish U.S. economy, European debt, declining world energy supplies, instability in the Middle East—including the U.S. conflicts in Afghanistan and Iraq—and our involvement in NATO’s no-fly zone over Libya. Makes us wonder what else is out there.

Dynamic Versus Static

We believe recognizing these uncertainties means being willing to make adjustments. For the past three years, we have sought out and invested in mutual funds that change their allocations between stocks and bonds depending on management’s assessment of these macro risks. Of course, they don’t always come to the same conclusion, and they are not always correct, but at least they invest looking over their shoulder for exogenous risks.

The willingness to be opportunistic and adjust positions does not mean investors have to become traders. And the strategy is not new. In The Intelligent Investor, Ben Graham (Warren Buffett’s mentor) recommended an asset allocation system calling for a minimum 25% exposure to bonds and the same for stocks. The remaining 50% can be adjusted depending on economic conditions.

As we have written before, in today’s investment landscape it is naïve to put on the blinders and remain fully invested in one style unaware of opportunities, values and risks in other markets. (See ANNUAL REPORTS 2008, 2009, 2010). This may require higher cash balances from time to time as capital is warehoused for redeployment.

Hedging (2)

View cash reserves as a hedge. Most investors embrace the logic of owning gold, silver and basic commodities to hedge their investments against inflation. And judging from the market action in currencies and derivative bond exchange-traded funds, these too are finding their way into investor portfolios.

We sometimes joke that when we get all the risks hedged, we won’t have any money for investments; we’ll just own a portfolio of hedges. But like investments, hedges also contain risk. Gold could drop $500 an ounce and still be selling at double its cost of production. As for currencies, it may be well to remember that John Maynard Keynes, the famous economist and astute investor, went broke trading them.

Investors need to recognize that if they don’t need the hedge because their investments turn out OK, there is a high probability of loss in the hedging mechanism. It is possible, therefore, that cash is a superior hedge. Its costs are transparent, as described above (2.7% current yield versus 3.0%?), and there are no market losses in the end.

What About The Holding Tank?

Yes, the Holding Tank is designed to hold excess cash to maintain a defined exposure to stocks and bonds. Depending on our market outlook, the HT can represent a conservative, moderate or aggressive posture. As discussed in our Q1, 2011 Report to Clients, however, success of the HT is relative: investors can still lose money even if the HT outperforms on a relative basis in a down market. (And, of course, there is no guarantee of this: it is possible the HT could under perform.) Thus, as stated, the HT is only a partial solution for high cash balances.

Stock Market Risk

It’s interesting that disdain for cash seems so high at this time (beginning of May). In the process of “buying low and selling high,” one might expect equity exposure to decline as valuations rise and profit taking ensues following a two-year, 100% increase in stock prices. Yet this is not the case, according to Investors Intelligence as reported in the Investor’s Business Daily. This contrarian indicator peaked in May with almost three times as many bulls as bears, a two-standard-deviation reading.

Again, we claim no clairvoyance when it comes to the market. But in assessing the ebullience evident in these numbers, we think it might behoove us to remember another statement from Ben Graham’s Intelligent Investor. To paraphrase, Graham said that the greatest risk of loss in stocks comes from buying the stocks of mediocre companies during ebullient times.

If our research on equities is successful, it will help us identify the high quality companies. Then, if we’re patient, we may be able to buy their stocks at prices that reward us in the future. Cash reserves are an integral part of this process.

Conclusion

We hope this discussion of cash balances dispels some of the concern investors may have about holding cash.

• As stated, we recognize that it is a problem, but not as onerous of one as it appears on the surface.
• Plus, to the extent that balances may spike from time to time, remember that profit taking and otherwise selling positions to reduce risk generates cash. Such balances should recede with redeployment of the proceeds, so they need to be regarded as temporary and not permanent.
• Finally, having cash available to capitalize on an opportunity could turn out to be an attribute instead of a problem.

____________________

(1)     Reinvestment of dividends and interest is an important part of the overall return investors will experience on the investment. Counterintuitive as it may seem, falling bond prices and rising yields can actually improve investment results. For a more in-depth discussion of this phenomenon, we would be happy to send you a reprint of our article in NAPFA’  investment Advisor: “Investment Risk 101: Some Straight Talk on Bonds.”

(2)     Of course we may be wrong, and we don’t agree with many of our constituents, but—based on the studies we have seen—we don’t think gold is an effective hedge against inflation. We do believe, however, that it could become the world’s default currency on a temporary basis as the destabilizing effect of currency devaluations spreads around the globe. Many of our clients own small—hedging—positions for this reason.

By: Sam Dreher