Investment Management

December 2013


Principles and Practices in Core's Portfolio Management

 This memorandum describes investment activities of Core Asset Management Company and certain ideas that inform these investments. For many of our clients, Core manages substantially all of that person's investment capital. For this reason, Core's principal investment activity is the determination of the allocation of its client's assets among the various investible asset classes. That is, Core decides what portion of a client's assets it will invest in US stocks, in US bonds, in non-dollar bonds, in foreign stocks, in real estate investments, in absolute-return hedge funds, and in commodity-related investments.

Core's investment practice of allocating among different asset classes makes it a generalist manager, in contrast to specialist managers that focus on single investment classes. Core is not, for example, a US small-cap value manager, with expertise in valuations and progress of small, US-based publicly-traded companies. That is a narrower expertise than Core's. Core seeks to invest across a broad range of investment assets in response to global economic and financial conditions.

 After making its determination of the proportions of a client's capital to invest in different asset classes, Core's next step is to choose specialized managers for each asset class. It makes investments for its clients in various exchange-traded funds ("ETFs"), mutual funds, real estate investment trusts ("REITs"), and other securities.

 The investment goal. The understanding of one's investment goal or goals is the first step in determining one's investment policy. For those who have accumulated investment capital, the goal may be to preserve its purchasing power and to generate sufficient income to meet current and future expenses. For those who are building investment capital to provide for future needs, growth of capital probably outweighs an interest in current income. One's capacity to add to investment capital in the future may determine the amount of risk to which one's present capital may be exposed.

At Core, we begin our work with a client by addressing these issues. Before considering how to invest a client's capital, we first reach an understanding about his or her financial needs and goals. It happens often that different portions of a person's capital may have different intended uses--education for children or grandchildren, charitable purposes, income for retirement, investment in new business activities, to name a few. In this situation, investment policy for one portion of a person's capital may be quite different than for another portion. After we consider these questions, we formulate a plan to balance investment goals with investment risk.    

The asset allocation decision. Asset allocation determines one's investment success to a far greater degree than does security selection. To give an example, over the last nine decades and more, the return from publicly-traded stocks as a class has exceeded the return from bonds by an enormous degree. Thus, a completely ordinary portfolio of common stocks earned a far greater return over these decades than the best portfolio of bonds.

 The time horizon over which one measures one's investment success and returns is important in determining investment allocation. Although we might be confident that, over a period of fifty years, stocks will earn a better return than bonds, individuals cannot realistically take such a long view. However, it is not uncommon for people to save money for retirement and intend not to draw upon it for thirty years. Because equities generally achieve better returns over time than bonds, it is usually productive to have a greater weighting in equities than in bonds, except for portfolios in which capital preservation is paramount and investment risk must be kept very low.

 Volatility and correlation of changes in price.  Prices of tradable securities, like common stocks and bonds, change day by day. The extent of price changes of a given security is referred to as its volatility. Examples of securities with high volatility are speculative, unseasoned technology companies, whose prices may swing quite widely from week to week. By contrast, the big oil companies like ExxonMobil, with steady and predictable earnings, are much more stable in price: less volatile. Volatility is accepted as a measure of an important type of investment risk. A security with high volatility is more risky than a low-volatility security, because one can be less confident about the price of the highly-volatile stock at any given time in the future when one may need to sell the security.

 For a portfolio as a whole, volatility is likewise an important investment consideration. A more stable and predictable portfolio is generally more advantageous than a highly volatile portfolio. However, the volatility of each individual security in a portfolio is not a measure of volatility of the portfolio as a whole. Indeed, a portfolio of twenty highly volatile individual securities may be less volatile than a portfolio of twenty low-volatility securities. The key is the correlation of the price movements of the individual securities within a portfolio.

If the individual securities in the portfolio of highly volatile securities do not move together in price, their separate price swings may cancel each other out and produce reasonably smooth returns. By contrast, if a portfolio holds low-volatility securities that are all of the same type, they will all move together. Such a portfolio may be more volatile than the other portfolio of securities that swing widely in price but in an uncorrelated fashion. Consider a portfolio of bonds issued by twenty different companies all of high credit quality. Assume that all the bonds mature in twenty years. The daily price movements of the individual bonds may be small, but the bonds will all move in lock step, in sympathy with price changes in twenty-year, high-grade corporate bonds. By contrast, if the other portfolio has twenty different volatile, but uncorrelated securities, it may be more stable over all than the bond portfolio.

                                                     The Investment Environment as 2013 Comes to its End

 Core's strategy is to build portfolios with substantial equity orientation, to take advantage of the long-term favorable performance of equities. Core also seeks to invest in asset classes whose price movements have low correlation with each other, so that month-to-month swings in overall portfolio value are rather low. (Consider, however, that in some periods, virtually all securities become highly correlated. For example, during the most intense months of the financial crisis of 2008 - 2009, most securities fell in price, regardless of their lack of correlation during "normal" periods.) Additionally, Core seeks to invest greater amounts in asset classes that appear to be rather underpriced, and to decrease investment in riskier, higher-priced assets.

 A brief recapitulation of the financial crises and the policies undertaken to ameliorate the economic and financial system calamities will provide the context for a review of the present economic conditions in the world. This in turn suggests a framework for a discussion of various investment asset classes in which Core invests.

 The financial crisis and its aftermath. The crisis of 2008 and 2009 and the responses by governments and central banks in its aftermath give rise to the conditions that now prevail in various asset classes. The crisis arose from the collapse in prices of pools of mortgage-backed securities that were held in vast quantities by many banks, insurance companies, and other financial companies in the United States and Europe. When housing prices fell, the prices of these ostensibly AAA-rated securities fell even more sharply and threatened the capital bases of major global banks and investment banks in the US, the UK and Europe. Governments stepped in to provide emergency capital to a large number of banks and forced others to merge into more creditworthy banks. The failure of Lehman Brothers, a large US investment bank, in September 2009 ushered in the acute phase of the crisis. Commercial paper markets froze over night; money market funds showed huge losses. Overnight the Federal Reserve guaranteed the assets of all money market funds and began to participate directly in the commercial paper market. Congress passed emergency authorization to permit the US Treasury Department to recapitalize distressed banks to the tune of $800 billion. The global financial system, at the edge of the precipice, was hauled back from the brink by these emergency measures.

 The scare was so great, however, that private companies and people realized the fragility of the system and the great extent of private debts. The response was to cut spending and increase savings to rebuild balance sheets. The curtailment of spending and increase in savings caused economies, especially in Europe and the United States, to shrink dramatically. The recession that ensued was the most severe since the Second World War.

 Monetary policy. Beginning in 2008, central banks of developed countries, led by the example of the US Federal Reserve, vastly increased their assets and began a series of unconventional monetary policies that persist to the present. To give an indication of the scale of central bank actions, consider that before the crisis, the Fed held about $800 billion in assets, virtually all in Treasury securities. Through its ongoing series of asset purchases designed to restore economic growth, the Fed now holds about $4 trillion in assets, including nearly $1.5 trillion in mortgage-backed securities. The various programs of the Federal Reserve, the Bank of England, the European Central Bank (the "ECB"), and the Bank of Japan have provided unquestioned support for economies of the developed countries and, in the case of the ECB, have supported the weak member countries of the European Union during the Eurozone crisis. An ancillary consequence of these central bank actions has been exceptional support to stock, real estate, and bond markets.

 Fiscal policy. By contrast to the supportive monetary policies of the central banks, governments in Europe, the UK and the US have engaged in restrictive fiscal policies, that is, the policies of taxation and spending of these governments. Out of concern for the expanding government deficits that arose in the great recession (as tax revenues fell and spending on unemployment insurance and the like rose), governments began to cut spending to prevent what were thought to be dangerously high levels of government debt. These policies of fiscal austerity, in the context of constrained spending and increased savings by the private sector, brought the UK and the Eurozone back into recession and caused economic growth in the US to slow to a crawl. Thus the recovery from the Great Recession of 2008 - 2009 has been halting and weak, causing unemployment in Europe and the United States to remain at high levels.

 Japan's fiscal and monetary policies have been timed differently than those in the US and Europe.  A year ago, as the election in the lower house of its parliament approached, it became clear that Shinzo Abe would lead his party to a large majority and serve as Prime Minister. He pledged very easy monetary policy--it would be his prerogative to appoint a new head to Japan central bank--and expansionary fiscal policy. He has delivered on his promises, although whether Japan will enjoy sustained economic growth and an end to its long era of deflation remains in doubt.

China's torrid rate of growth from a decade ago has slowed, but it is still strong. Emerging markets generally were less afflicted by the great recession than were the developed economies, but these economies are generally growing more slowly now than in the last decade. Meanwhile, the expansionary policies of the Federal Reserve, which poured liquidity into the global financial system, caused large inflows of foreign capital to developing countries. Now, as the Fed tells us that its huge asset buying program will be coming to an end, capital is flowing out of developing countries, raising risks to their financial markets and their real economies.

As 2014 is set to begin, the economic picture is of slow growth in the developed countries and somewhat more rapid growth in developing economies. The US economy is likely to expand at 2.5% to 3% in 2014; Europe at perhaps 1%; Japan will grow somewhat faster than Europe; the UK somewhat faster than Japan. China and India may grow around 6% to 7%; the other East Asian countries at about half that rate. Latin American economies are likely to be weaker than Asian economies.

                                                                     The Asset Classes in which Core Invests

 US stocks have been quite strong in the last year and have exceeded the highs set in late 2007, before the crisis began. In the recovery from the crushing bear market of 2008 to early 2009, corporate profits have been exceptionally strong, while the share of corporations' revenues that go to employees has been weakening. This phenomenon, in which capital enjoys such an advantage over labor, has had the effect of keeping wages low and constraining employment in the United States. This trend appears intact and, in light of moderately accelerating economic growth, the US stock market appears to be only somewhat overvalued. It is reasonable to expect modest further gains in US stocks.

International stocks offer different opportunities. During the intense periods of the Eurozone crisis, from 2011 to the middle of 2012, European stocks fell far behind US stocks, as concerns rose for the viability of the single currency and the solvency of the so-called peripheral countries. Since the promise of ECB President Mario Draghi in the summer of 2012 to do "whatever it takes" to preserve the Euro, European stock markets have rallied strongly and somewhat closed the gap with the performance of US stocks. More ground is still to be made up. With strengthening European banks and modest economic growth, it seems likely that European stocks will continue to perform well.

 Japanese stocks enjoyed a very strong rally in 2013 with the implementation of the promised policies of Shinzo Abe. Further stock appreciation probably depends upon the realization of promised economic growth, by no means a sure thing. With its new and forceful president, Xi Jinping, China's path to continued growth seems a reasonable bet, but the translation of that growth to stock market gains is not a foregone conclusion. Other Asian and Latin American stock markets are at risk to further capital flight as the Fed pulls back from its $85 billion per month in asset purchases.

 US bonds present serious challenge to investors. From 1981, when the yield on the US ten-year Treasury bond stood at 15.7%, yields fell and bond prices rallied until May 2012, when the ten-year Treasury yielded a mere 1.4%. This extraordinary three-decade rally in fixed income appears to have come to an end. At this writing, the ten-year yields 2.9%. With the near certainty that the Fed Reserve's long-standing asset purchase programs will draw to an end over the coming years, it is reasonable to expect Treasury yields to rise further, probably to 4% or so. In this environment, most other bonds around the world will also fall in price and rise in yields. A very careful approach to fixed income investing is needed.

 Foreign bonds and foreign currencies. Non US bonds will generally not fare well as US interest rates rise, although there will be exceptions. The differences between Fed policy (which is heading toward the realm of less easy--if not tighter--monetary conditions) and ECB policies will tell on European bond prices and the value of the Euro. Given the greater economic weakness in Europe and the persistent frailties the banking sector and of sovereign liquidity and solvency in many European countries, it is likely that ECB monetary policy will be easy, even as the Fed becomes somewhat tighter. This probably will support the prices of European bonds as compared to American and it should weaken the Euro in relation to the dollar.

 US investors can fare well in foreign bond markets when the dollar's value is falling in relation to those of other major currencies. When a US investor owns a bond denominated in a foreign currency that is rising in dollar terms, that US investor will earn the interest paid on the bond as well as the increased dollar value of the currency in which the bond is denominated. This situation does not obtain now. The US dollar on a trade-weighted basis has been fairly flat in recent months, rising against the Japanese yen and falling against the Euro. Expected monetary policies suggest that the US dollar will be stronger rather than weaker in the coming year.

 Although currencies do not offer appealing opportunities at present, they often do. Currency markets are characterized by long-trending cycles and by the tendency of valuations to go to extremes. For example, the value of the dollar fell fairly steadily throughout the 1970s, then nearly doubled in value against a basket of major currencies in the early 80's as the Federal Reserve, under Paul Volcker, began its successful campaign to lower interest rates and inflation. From 1985 until 1995, the dollar lost half its value, then increased by 50 percent from 1995 to early 2002. After 2002, the dollar fell again until the financial crisis of 2008 and 2009, when the dollar's safe-haven status caused its value to rise sharply.

 Commercial real estate investments represent ownership of real property. Publicly-trade, pooled investments vehicles called Real Estate Investment Trusts ("REITs") trade on the New York Stock Exchange and elsewhere. These offer the liquidity of common stocks and offer ownership in broad pools of commercial real estate properties. REITs are characterized by relatively high dividends and modest growth in the underlying properties. At present, Core holds no real estate investments, although it is quite likely that Core will make such investments in the future.  

 Commodity investments. Core makes unleveraged investments in broad baskets of physical commodities during favorable periods in the commodities markets. For several years recently, Core made gold investments for clients. At present, the commodities cycle is weak and Core's clients' portfolios hold no commodity investments.



John N. Mayberry