Saturday, August 23, 2008

Mutual Funds-Corporate Farming

If investing should be like farming, what if we really don’t want to be farmers? What if we want to own the land but let somebody else do the farming and produce rising income for us?

Delegation to professionals with more experience, judgment and tools of the trade is almost always a wise decision. This of course assumes that the professionals charge a fair price, where the value they provide exceeds the cost of their services—and they are competent.

Owning and working a 1000 acre farm can be a good source of income. Owning and renting out a 1000 acre farm can provide a modest income. What if we want more income than we can get from renting, but we don’t want to work the farm ourselves? And, what if we want to diversify our holdings so all of our “land” is not in one place and so we can grow many more different types of crops?

When we buy shares in a mutual fund, we are buying an ownership interest in an investment company. We share in the income generated by that company. Using the farming analogy, we can buy shares in a “corporate farm” with vast “land” holdings in many geographical areas, with a diverse group of crops, providing the benefits of diversification. The benefits of a mutual fund are primarily: Professional Management; and Diversification.

The goals and general activities of the mutual fund are outlined in a prospectus. Never invest in a mutual fund without reading the prospectus and gaining a complete understanding of the fund’s goals, activities, management, costs, financials and track record. (Have a professional assist you.)

Because the mutual fund has professional management and more resources, it can often add another dimension to your investment activities. Here, ongoing income from Capital Appreciation is perhaps possible by buying “land” when it is cheap, and selling it later when prices for it have risen. In other words, the management is not only engaged in the business of farming and producing income; they are engaged in a professionally managed form of “land speculation”. Unfortunately, many of these professional managers have no better idea of how to make money buying and selling land than the average Joe or their fees are so high that any value they add is more than offset by the costs.

So, how do you choose?

Our firm believes the right choices are finding mutual funds with competent management, with the right philosophy, that spend their time on truly value adding activities, and that keep their costs low. We define competent management as having sufficient experience to have learned the lessons of the past; that understand following the crowd is usually unwise. We define the right philosophy as a focus on managing risk: capturing “less of the downside” and “more of the upside” but not necessarily all of the upside in fluctuating markets. (You would be surprised how many mutual fund managers think doing a good job is simply following the market-up AND down!) The right philosophy also includes an understanding that it may take years for the wisdom of their decisions to show. Finally, there is only one way to gain an advantage in buying and selling property—real “in person” inspections of the property. The same type of in person inspections you would undertake yourself. There are remarkably few mutual funds that meet our firm’s criteria for being the “right choice”.

With professional management and the potential for the added dimension of “harvesting” long term gains from Capital Appreciation, a professionally managed, highly diversified portfolio can produce a relatively stable long term source of rising income. In many cases this rising income can be more predictable.

This commentary and information is provided for the benefit of clients and should not be considered a sales presentation.


See http://www.waynestrout.com/ for more complete info: Investment advisory services are offered by WS Wealth Managers, Inc., an investment adviser registered with the SEC. Wayne Strout is an Investment Adviser Representative with WS Wealth Managers Inc. in addition to serving as President/CEO and Chief Compliance Officer of the firm. Scott Sebring is an Investment Adviser Representative and Vice President. WS Wealth Managers Inc. is not affiliated with Glen Eagle Advisors LLC or Pershing LLC. Wayne Strout and Scott Sebring, dba WS Wealth Managers. Securities offered thru Glen Eagle Advisors LLC, Member of FINRA And SIPC, with clearing thru Pershing LLC, Division of Bank of New York Mellon Corporation, also Member of FINRA and SIPC.

The Goal-Think Like a Farmer

“Everything should be made as simple as possible, but not simpler.”- Albert Einstein

Whether the client intends to take income (now or later) or to build a legacy to be gifted to others, we assert that the universal goal of investing is to create a present or future source of rising income. Rising income is defined as income that grows at a rate that exceeds inflation. Sometimes that income is spent, sometimes it is reinvested. When past or present income is spent, the investment portfolio is deemed to be in the “Distribution” phase. When new funds are being added or income is reinvested, the investment portfolio is deemed to be in the “Accumulation” phase. There are only three sources of income from investments: A) Interest; B) Dividends; and/or C) Capital Appreciation.

We believe that a simple way to illustrate this concept is to use the analogy of investing compared to farming. A farmer can take income in three ways: A) Renting the land; B) Growing and selling harvested crops or mature livestock; and/or C) Selling off parts of the land. Rent is like interest. Dividends are like the income from growing and selling harvested crops or mature livestock. Capital Appreciation is like income from selling off parts of the land that have become more valuable.

Unfortunately, too many so called “investors” believe that investing is all about Capital Appreciation. Coming from a family with a long farming tradition, we can say that most farmers and growers do not calculate the value of their farmland on a daily or monthly basis. And, few even think about selling it off. Farmers understand that the source of their wealth is the land, but that the value of the land is determined primarily by the income derived by growing and selling harvested crops. We like to think of the client’s investment portfolio as the “land” and dividends and interest as the “harvest”. If we don’t need the income from the “harvest”, we buy more “land” by “reinvesting” the dividends and interest (Accumulation). If we need the income, we take money from the “harvest” and spend it on ourselves (Distribution).

We tell our clients that the value of their investments is determined primarily by the income generated now or likely to be generated in the future, from dividends and interest. We worry little about the daily market value of the “land” except when we are adding new money and “buying” more. If we learn that the value of “land” has increased, we have mixed feelings..we feel wealthier, but..if we are buying land, we will be able to buy less with our money.

We submit that the only time that Capital Appreciation is important is if we intend to sell, and the only time we would sell our “land” is if our income was insufficient for our needs. (Or maybe if we want to buy more “fertile” land that will produce more income.) The goal of investing, particularly for retirement is for our portfolio to produce income sufficient for our needs. This is investing as opposed to speculation.

While earning interest (renting the land to another farmer) is an important and relatively stable way to create income, unless the portfolio is very large and our income requirements are very small, dividends are generally the most important source of income. Owning stocks, in the farming analogy, is like the growing and selling harvested crops. Some stocks are like growing corn or milking dairy cattle, where the income comes right away, some stocks are more like planting orchards or trees, where income comes after a period of time.

Spend less energy worrying about the daily value of your investment portfolio and more about how much income it is producing or will be producing in the future.

This commentary and information is provided for the benefit of clients and should not be considered a sales presentation.

Saturday, August 16, 2008

Speculation vs. Investment

“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”- John Mills (1868)

A simple definition of speculation is that it is a process, a form of gambling driven by greed, where something is purchased primarily because that something’s price is expected to rise over time. Speculation is a process that feeds on itself, for a period of time, where buying something in limited supply, drives the price up for a period of time, creating demand for more buying, simply on the premise that the price will continue to rise. The most dangerous forms of speculation is where borrowed money is used in the process. Widespread and increasing use of borrowed money allows prices to rise in the short term at unsustainable rates.

Continued increases in prices require rising demand without a corresponding increase in supply. The greatest misperception is that demand and prices will rise indefinitely because supply is somehow permanently limited.

Some would argue that for “scarce” goods like real estate or oil with finite quantities available for supply, prices can rise at faster rates. This argument fails to consider the creative ability of humankind to create “competitive substitutes” and to become more “efficient”. When the price of something is perceived as “too high” then buyers begin to consider alternatives or become more efficient, and demand for the “scarce” good falls---and the rate of price increase slows. When the price of something becomes sufficiently high, new sources of supply of the “something or it’s substitute” are found and even with rising demand, prices fall.

Hence, successful speculation requires an ability to determine when to sell, before prices fall. Here is where fear enters into the process, because greed tells buyers to “stay in the game” while fear tells them to “get out while the getting is good”.

There are only two long term causes of sustainable increases in demand and aggregate wealth: increased population, and increased productivity of humankind allowing each person to consume more. Increased productivity requires capital, tools and free trade. Increased productivity requires investment, not speculation. In fact, speculation and investment are really in competition with one another.

Speculation does not increase wealth—it only transfers it. Speculation is seldom a productive use of time or any other resource and repeated speculation usually results in losses that offset the gains. Our firm believes the process of investing is the intelligent application of capital for the purpose of increasing humankind’s productivity over time. This increased productivity is in our opinion the most reliable way to increase wealth over time.

There will always be speculation—it is a part of human nature. But during periods when speculation has proven to be unprofitable for the majority of participants, it becomes relatively less popular. Our firm advises clients to seek out well managed companies that use capital wisely for the purpose of increasing the productivity of humankind. These are the investments that more reliably create wealth and value. During periods with “corrections” of past speculation, the price to buy these companies is particularly attractive. When speculation becomes less popular, true investing for long term results becomes even more rewarding.

This commentary and information is provided for the benefit of clients and should not be considered a sales presentation.

See http://www.waynestrout.com/ for more complete info
Investment advisory services by WS Wealth Managers Inc., a registered investment adviser.
Securities thru Glen Eagle Advisors, LLC, Member of FINRA and SIPC
Clearing thru Pershing LLC, Div of Bank of New York Mellon Corp.
WS Wealth Managers Inc., Glen Eagle Advisors LLC, and Pershing LLC are not affiliated.

Saturday, August 2, 2008

Uncertain Times Require Courage Wisdom and Patience

  • Unemployment rates go up. Dollar rises.
  • Oil prices down. Gold prices up.
  • Money supply and credit contracts. Inflation up.
  • 2nd Quarter 2008 GDP up. 4th Quarter 2007 GDP revised down into negative territory.

The stark truth is that nobody knows for sure what the near term future holds. This is why there is so much volatility in the markets. We are in a period where “frightened money” jumps in and out of markets and anxiety rules.

Uncertain times bring to mind a quote from John F Kennedy: “The Chinese use two brush strokes to write the word CRISIS. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger – but recognize the opportunity.”

From my experience, the biggest error that can be made is trying to predict the future by looking backwards. It is sort of like driving by looking out the rear view mirror instead of the windshield. Always remember, there is a BIG DIFFERENCE between predicting the short term future from recent past events and preparing for the future by studying history and what it teaches us. Being prepared is how money is made, not by making predictions. Markets move because of what is NOT KNOWN.

J. P. Morgan, the famous financier, and one of the richest men in the US, was once asked what he thought the markets were going to do. His answer was “The markets will fluctuate!” We can learn from history by looking back on periods when necessary corrections always follow the inevitable periods of human excess. Go back to the Panic of 1907…Speculation in the 1900’s was rampant. Trusts Companies then, like the Investment Banks and Hedge Funds now had fueled this speculation. There was a run on a major financial institution, followed by a bailout. The markets slid downward as anxiety continued. The Dow Jones Average fell from 86 to 53 over 8 months (March thru November). The total return for US Equities in 1907 is estimated to have been a negative 30%. The total return for US Equities the following year was UP 44% with another UP 18% in 1909.

(Keep in mind that 1907 was the year before the 1908 election. During the election year of 1908, the market was up considerably—more than 40%. Markets are usually up during election years. There is still another 5 months to go in 2008!)

Why study a period more than 100 years ago? Things are different—right? Our firm believes that markets in the short term are driven more by human nature than by facts. Markets always overreact. Greed and Fear—the two Enemies of investing (or Allies if you use them to your advantage) have not changed much and there is much to learn from history.

A “buy and hold” investor owning the “index” would have achieved a theoretical average return of 6.5% over the three year period 1907-1909. An investor with courage and patience, buying in August of 1907 would have achieved an average annualized return of over 10% owning the “index” thru the end of 1909. (The ride would have required a great deal of courage indeed. The DOW fell more than 30% from August thru November of 1907!) It would take another 18 years before the market index doubled, providing an average annualized return of only 4% during that period. Above average returns from investing required careful stock picking, a preference for stock where dividends added to the total return, and careful selection of interest paying bonds.

The point here is that buying the “index” and “passive investing” may not be the most prudent investment strategy going forward. Periods of speculation are generally times when it is easy to make money—follow the crowd and put it on auto-pilot. Perhaps a strategy with more focus on value and income will be the best strategy going forward. Corrections and the years following periods of speculation are times when it is harder to make money and it is usually wise to go the exact opposite direction of the crowd. Using a trained professional is also advisable.

Focusing on value and rising income is a good strategy ALL OF THE TIME. It takes work, and it is usually easier if you rely on the assistance of professionals. Being a growth oriented value investor takes courage, wisdom, and patience.

Nobody knows whether the market is going to go up or down in the near term. What is more important is: Overcoming fear, buying good quality investments at favorable prices and holding them, having patience, until they substantially increase in value has proven to be a winning strategy. (Be sure to keep some cash on hand and/or income producing investments as needed to hold you over during the rough times.)

See http://www.waynestrout.com/ for more complete info: Investment advisory services are offered by WS Wealth Managers, Inc., an investment adviser registered with the SEC. Wayne Strout is an Investment Adviser Representative with WS Wealth Managers Inc. in addition to serving as President/CEO and Chief Compliance Officer of the firm. Scott Sebring is an Investment Adviser Representative and Vice President. WS Wealth Managers Inc. is not affiliated with Glen Eagle Advisors LLC or Pershing LLC. Wayne Strout and Scott Sebring, dba WS Wealth Managers. Securities offered thru Glen Eagle Advisors LLC, Member of FINRA And SIPC, with clearing thru Pershing LLC, Division of Bank of New York Mellon Corporation, also Member of FINRA and SIPC.