October 15, 2015
To: Customers & Friends
From: Christopher Weil & Company, Inc. ("CWC")
In the frightening number of years I have been in the investment and financial advisory businesses I have learned (often at a cost of some serious money and pain) a number of truths. I do not claim that these truths are absolute or never to be challenged. I do claim that they are the most suitable ones for governing our financial lives.
Incidentally, the “our” in “our financial lives” refers to those who have achieved a significant degree of financial independence. When it comes to understanding the dynamics of wealth management there is an important distinction between those in the wealth development stage (where most people are and where many will forever be) and those in the wealth maintenance and enhancement stage. The tasks and attitudes associated with each stage are, to a large extent, different. CWC has much to say, and offer, to those in the wealth development stage but in this Commentary I want to address those who are already “there” financially.
1. Emotions too often govern important investor decisions
According to his widow and biographer, Mary Anna Jackson, General Stonewall Jackson, Confederate general and war strategist, was fond of the aphorism which comes down to the present day as “Never take counsel from your fears.” There is no more important truth by which an investor's behavior should be governed. Virtually everyone feels fear when markets jerk down, especially over an extended period of time. Virtually everyone “takes counsel from their fears” and too many respond accordingly: freezing in place or selling. Enormous amounts of wealth are lost when investors sell good assets at low prices (and return to the market at higher, often much higher prices) or freeze and so fail to invest at the low price opportunities on offer.
The qualification “good assets” is important. The business of not taking counsel from your fears is true if, and only if, the assets in question constitute quality merchandise. Some asset values decline after a boom period and never recover or drop in a way that catches some investors unprepared. Witness the experience of speculators who bought over-leveraged residential real estate during the frenzy leading up to 2008 or investors who participated in the great dotcom debacle of the late 1990’s.
“Quality merchandise" is a term of art but it can generally be understood to mean assets that are priced and bought on the strength of current rather than anticipated valuations. Almost all assets are priced to reflect some degree of anticipation. When you buy a growth stock at a price-to-earnings ratio of 30, you are paying for both current and anticipated value. As investors, we generally favor assets priced, as near as we can determine, close to current value. As speculators, which we occasionally are, different criteria apply.
2. Fluctuation can be your friend and need not be your enemy
Fluctuation in asset values is normal. But I suspect that “excess” fluctuation in securities markets is the new normal. Books are being written on why this is so but it has to do with the huge volumes generated by high speed traders combined (among other things) with the fact that the traditional “dampening” role of intermediaries (personal brokers) has diminished as millions of individual investors now trade (on fear, on impulse, on enthusiasm) directly with new vehicles such as leveraged ETFs. Then there are the countless thousands of institutional investors who are actively trading on what they believe to be the needs of their portfolios. But whatever the reasons, I am pretty sure that the longer-term consequences to investors (as contrasted with speculators) will be of little consequence. Why this is so would require yet another book but I will take a shot here of making a simplified explanation.
Some years ago Warren Buffett, and his mentor Ben Graham, made the case for something they called intrinsic value, that is, the value an investor “should” be willing to pay for a given asset (they were talking about companies but it applies to most other productive assets, particularly real estate). Again, books have been written on the Buffet/ Graham thesis, but I will give you the brief CWC version.
“Productive” is a key concept, which usually means “income producing,” current and/or contemplated. Sooner or later, the asset in question must demonstrate current or deferred income productivity, and that productivity must be quantifiable. The income may or may not be currently spendable by the investor. In theory, it doesn’t matter. (Well, it doesn’t matter if the earnings retained are deployed productively.) What you don’t get in cash flow you do get in enhanced equity. (Time out for a story to illustrate this.)
Some years ago I attended the annual meeting of a publicly traded REIT. During the Q & A an investor asked the CEO why he didn’t increase the dividend. (This company, like many, distributed only a portion of earnings, retaining the difference for reinvestment.) The chairman’s answer: “I am retaining as much of our earnings as I can because I am a better investor than you are.”
Income productivity must be matched with income sustainability and income growth. The notion that an investor buys an asset “for capital gain” is misleading to the extent that the anticipated capital gain isn’t tied to the anticipated earning capability of the company/real estate in question. There is no (real) capital gain without corresponding (real) earnings. And before you remind me that people realize capital gains all the time by virtue of owning assets that have no current earnings and whose prospects for earnings are problematic, let me remind you that I am talking about investment and not speculation.
So why doesn’t excess volatility matter to the investor? Because if he or she buys an asset at or near intrinsic value with the expectation of holding for the long term then price volatility is irrelevant - except to the extent booms give him/her an opportunity to exit at what might be a premium, and busts give him/her an opportunity to enter at what might be a discount. There is a caveat. Price volatility is not irrelevant if, for whatever reason, intrinsic value degrades and price declines reflect this. But it is (almost) a truism that over the long term, intrinsic value is driven by income productivity. If income productivity is sustained, asset values are sustained. Remember, I am talking to those who are already “there” and who have, presumably made provision for, or have the capacity to deal with, demands for capital. It is certainly true that if you are in the wealth development stage and you find yourself in the midst of a sustained down market and much of your liquidity is in equities and you have capital needs (education, costs, a health crisis, a house to buy, etc.), fluctuation can be your enemy.
3. Quality or trouble, you choose
If you don’t take anything else away from this material, please take this. Much/most of your investable net worth should be committed to “core” assets, assets characterized by their quality - which means their intrinsic value. “Much/most” will differ from case to case but almost always means at least 75% and maybe more. The balance of your investable net worth should be available for lesser quality merchandise (speculative stocks, venture opportunities, private equity and so on) where the risk of permanent capital loss is matched by the opportunity for outsized gains. And as to the core assets, they are there to provide you some (hopefully) optimum combination of safety, income and growth potential. They are there to provide you (and those that follow you) the promise of economic security and the freedom of action that is its corollary. It is, or should be, axiomatic that sustainability of core holdings trumps short term performance. Wealth maintenance (including inflation protection) is the function of core holdings. Wealth enhancement is the function of the other 25 (or whatever) percent.
I assume that when I talk of core holding you will understand that I am talking about a well diversified portfolio of equities, meaning, companies public and (where appropriate given family circumstances) private, as well as debt instruments and real estate. The allocation between debt and equity is usually a judgment call but certainly 50/50 is a good place to start the discussion. Some will question any material allocation to equities, given the volatility of equity markets. I have three responses to this. First, there is no way to achieve any reasonable prospect of capital growth without an equity allocation (as with life, so with investing - you are either going forward or you are going backward, there is no stasis). Second, debt carries its own risks. Consider the plight of an investor during recent years who is dependent on interest income for his/her wellbeing. And if this investor, in a fit of impatience or desperation, should have converted his/her investments to long-term debt so as to increase yield, the risk of both capital loss and purchasing power as/when interest rates rise is huge. Third, loss (permanent capital impairment versus unrealized losses due to market fluctuation) is inevitable, even in a portfolio of core assets. And inflation is inevitable. (Don’t believe those doomsayers who promote deflation as the next big thing. They are taking counsel from their fears. The truth of the matter is a subject for another day, a day that may come in time for the next CWC Commentary.) A commitment to quality equities as a material part of core holdings is the only practical way for most of us to hedge against capital loss and loss of purchasing power.
4. We all need help
And so to the question of advice and advisors. The world is complex, life is complex, wealth management is complex. If you have the time, the temperament and the talent to do it yourself then you should self manage. A negligible percentage of the population satisfies all three requirements. Just so you know, I need an advisor. (I will let you guess, should you care to do so, where I am deficient.) Fortunately, I am embedded in a team of CWC advisors with whom I share my family and business wealth-management concerns and challenges. I look to the team for advise and implementation across the wealth management disciplines (investment, tax, risk management, succession planning, philanthropy, estate planning, qualified plans, and so on and on). You may think me bold in saying so but what’s good enough for me should be good enough for you. (This is not a pitch for CWC as your wealth manager. It is a pitch for a good wealth manager/advisor in your life.)
A word about a controversy much in the news: the fiduciary standards debate. Without getting into the weeds (which are thick and extensive) my view is that it boils down to this. In theory, it is better to have a relationship with an advisor who is a fiduciary, one whose obligation is to serve your best interests, versus a non fiduciary whose obligation is to assure that recommendations are suitable. (The distinction between “best interest” and “suitable” is material, in law and in practice.) CWC and its advisory team are fiduciaries. However, I don’t need to remind you that everything depends on the character and competence of the advisor. And there are certainly non- fiduciary advisors who act like fiduciaries just as there are fiduciary advisors who act like non-fiduciaries. Obviously you want to find it all in one package.
5. Your life is an open book. Get used to it
The folks at Ashley Madison awakened a while back to discover that there client list had been hacked. The hacking, and subsequent disclosure of client information, revealed for all the world to see many thousands of names of actual, would-be and/or fantasy adulterers. The Ashley Madison story is another reminder (how many do we need?) that you never want to put in writing or send any personal data into the ether that you wouldn’t want published on the front page of the Wall Street Journal tomorrow. This is not new news. “For nothing is secret, that shall not be made manifest; neither any thing hid, that shall not be known and come abroad.” (Luke 8:17)
Sometimes this is translated “there is nothing hidden that will not be revealed” but, however rendered, the import is clear. You just think you can keep it quiet, secret, among friends, in the family, compartmentalized, among a few colleagues (think VW) or between you and Ashley Madison. What technological advances have done is to make the fallacies of privacy screamingly obvious.
So what does this have to do with wealth management? Well, we are faced with something of a paradox. On the one hand, CWC as a financial institution is committed to maintaining the privacy and security of client data. Sound business practices and regulatory demands require that we (and Fidelity, our correspondent) have as nearly fail-safe, bomb-proof client security systems as possible, which we do. But while we are not and cannot be transparent as to client data, we are committed to transparency when it comes to client relationships. There is nothing about our operations, our people, our advisory methodology, our history and our performance we will not gladly disclose.
Correspondingly, we expect clients to hold nothing back in their relationships with us. We are a vendor seeking to sell a product. We are advisors and fiduciaries, committed to serving our clients’ best interests. We are unable to do our job unless we have a comprehensive understanding of all that makes up the client’s life circumstances. I think it fair to say that if we detect a lack of transparency in any of our relationships or engagements (prospective venture partners, companies we are researching, sellers of real estate, lenders, venders, as well as clients) we assume that there is something we are not supposed to know. This morphs into the further assumption that if we knew, we wouldn’t go forward.
So, closed tightly with regard to data privacy but completely open with regard to relationships.
As always, please let Rob, Matt, Tyler, Joe, John or me hear from you with questions, concerns or challenges.
Chris Weil
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