Investment Outlook - Second Quarter 2015

First Quarter Review

"Financial Noise"

A mutual fund company has been running an amusing series of television ads about individuals being bombarded all day long with financial news. They call this relentless news chatter "financial noise." Much of the noise is generated around monthly economic data and its accompanying analysis by the media and Wall Street. The mutual fund firm goes on to state that their experts can separate "financial knowledge" from the "financial noise." Financial noise is, to be sure, louder than ever. Even serious, reflective Federal Reserve Governors fill the airwaves with their diverse opinions about interest rates, employment levels, inflation, and so forth. Not to be outdone, the Chair of the Federal Reserve issues a much anticipated proclamation every quarter that summarizes the Board's consensus economic view. The most recent declaration from Fed Chair, Janet Yellen, went something like this: "the Federal Reserve will no longer be patient about raising interest rates … but also will not be impatient." Hmm.

So, how does an investor, or an investment manager, separate the so-called knowledge from the noise? Maybe the mutual fund company with the funny ads has the answer. In this Outlook, we have opted instead to borrow a few observations from Warren Buffett's most recent Berkshire Hathaway shareholder letter.

"Financial Knowledge" from Omaha

Most investment professionals either scan or carefully read Warren Buffett's annual letter to his Berkshire Hathaway shareholders. Mr. Buffett's insights into investing are geared to long-term investing with little apparent concern about monthly data. The most recent letter commemorated his company's 50th year in operation. It was particularly long, but it contained three statements that stood out to us in this noisy financial news climate. Here's Mr. Buffett's insight into long-term investing (underlines are ours) followed by our reaction to his opinions:

Mr. Buffett: "Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions."

  • Wow! Mr. Buffett says holding cash, currency-denominated instruments, is riskier than holding stocks long term. We agree with Mr. Buffett. Most of our clients also adhere to this strategy. A few years ago, during one of the deepest bear markets in history, our clients were severely tested. Nearly all stayed invested. Having the emotional strength not to sell in a nerve racking bear market is clearly a more important personal characteristic than tracking the minute-by-minute financial news.
  • A widely-diversified portfolio is a relatively new epiphany for Berkshire Hathaway itself. Mr. Buffett's partner, Charles Munger, once suggested that the ownership of one good company is a better strategy than excessive diversification. Over time Berkshire has become a widely diversified conglomerate. Academics can dispute where the line between adequate and excessive diversification is, and it is our opinion that the current trend to index through an endless number of funds meets the definition of excessive diversification. However, undiversified portfolios are likely to do more harm than one with too much diversification.
  • Emphasizing the importance of acquiring stocks over time is also an important strategy for Mr. Buffett who benefits from the steady flow of insurance premiums that his company generates. It does not always apply to individual investors, who may be retired and not have the income to continually invest. The Wall Street Journal recently profiled a man who passed away at the age of 92. He held 95 stocks worth $8 million that he had acquired and held over many decades. His job was pumping gas in Brattleboro, Vermont. Thrift overcomes lack of income.
  • Portfolios that are owned invoking token fees and commissions. Excessive fees do have a material impact on investor returns. Even large state pension plans are reevaluating their commitments to high fee, hedge fund investments that have produced subpar returns for many years. We would add that the ability to manage portfolios in a tax efficient manner can enhance returns over time as well.

Mr. Buffett: "Though we will always invest abroad as well, the mother lode of opportunities runs through America. The treasures that have been uncovered up to now are dwarfed by those still untapped."

  • We agree with Mr. Buffett that the best run, shareholder-minded companies in the world are based in the United States. Many of these companies are large, battle tested multinationals that take advantage of opportunities across the globe. Of equal importance, the U.S is the leader in creating innovative smaller companies, many of which prove to be spectacular investments. Ironically, some of these companies are led by individuals born outside the U.S. but educated in scientific disciplines at U.S. colleges and universities. Google is an obvious example. However, there are international companies that can provide unique investment opportunities and cannot be duplicated with U.S. based companies. Alibaba in China fits that profile. And there certainly are great companies in Europe that sell iconic products that will at times perform better than their U.S. based competitors. Is there really a U.S. knock off of LVMH Moet Hennessy?

Mr. Buffett: "We prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It's better to have a partial interest in the Hope Diamond than to own all of a rhinestone."

  • We agree again with Mr. Buffett's emphasis on quality with the caveat that many a wonderful company ended up severely tarnished. Companies such as Apple, Disney, Visa, 3M, Automatic Data, Schlumberger, and Johnson & Johnson are all wonderful companies in terms of their products and services and financial metrics. But will they continue to be? Many investment professionals, including on a rare occasion Mr. Buffett, have missed the glacial transformation of a corporate diamond to a corporate rhinestone. Mr. Buffett likes to invest in companies with what he calls "moats," or unassailable business models. Moats appear to be getting narrower and narrower in today's competitive climate.

Our Current Take on Things

In these quarterly Investment Outlooks, we hope to focus on the issues that we think are most important to financial markets and our clients and ignore the "financial noise." The key factors that we assess each year are:

  • The trajectory of global economic growth
  • The trend in interest rates
  • Corporate profit growth
  • Stock market valuations

Nonetheless, there are other factors that surface each year that cannot be overlooked by investors or viewed as financial noise. Declining oil prices, volatile currency rates, recessions in Brazil and Russia, Mideast turmoil, and China's slowdown are currently weighing on the market.

The most obvious development that could derail the market would be more aggressive actions by the Federal Reserve. Fed Chair Yellen is hedging on when the Fed will start to increase interest rates, but the Fed is not hedging on whether they will increase interest rates. At the current time, the market expects gradual increases in rates over the next few years. Fed Chair Yellen is reinforcing this view with her most recent comments. However, over the past few years, the Fed has been dead wrong on its expectations for U.S. economic growth and on how fast unemployment would fall. They have been too optimistic on economic growth and too pessimistic on employment growth. Now that the Fed has moderated its economic outlook, it would surely surprise investors -- and the Fed -- if stronger economic data led Dr. Yellen to increase rates faster or to higher levels. In a bull market driven to a large extent by incredibly low interest rates, investors will continue to cling to Janet Yellen's future pronouncements … Patient … Impatient … Not sure.

Bob Milnamow
President and
Chief Investment Officer
April 2015