Growth by stress

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

Morningstar's "Redefining Growth" panel included Robert Hagstrom of Legg Mason, Dennis Lynch of Morgan Stanley (and Van Kampen), and Alex Motola of Thornburg. But before the panel got under way, Robert Hagstrom met a few of us in the press room for a quick sitdown whose topic was electric, to say the least (free-form paraphrase, as usual)...



Robert Hagstrom
of Legg Mason.
Hagstrom: Inflation in electric rates will accelerate for the US consumer, and people will be getting pretty upset. The demand for electric power and exceed supply. In fact, when asked what kept them up nights, Google named the supply of electricity as their #1 concern going forward. That's because Google is the #1 consumer of electricity in the state of California.

After the panel assembled, the conversation focused on other topics.

Lynch: All sensible investing is value-based. The difference is that growth investors invest in higher than average P/E ratios and value investors invest in lower P/Es. Higher P/Es are not always expensive — earnings are often driven by accounting assumptions. We seek value beyond the obvious P/E.

Motola: We seek seek securities that are mispriced based on misperceptions. The marriage between value and growth approaches characterizes some of the best investment strategies.

Lynch: Momentum sounds dirty, but we don't sell our winners right away because we want to capture some of it. Indexes don't sell their winners. To quote Robert Hagstrom, who said several years ago: "When everyone hates 'em, we buy 'em. When everyone loves, we hold 'em."

From left: Moderator Karen Dolan of Morningstar, Robert Hagstrom of Legg Mason, Dennis Lynch of Morgan Stanley (and Van Kampen), and Alex Motola of Thornburg.

Hagstrom: Since March we started repurchasing financials because that's where we believe the doubles, triples, 4-baggers and 5-baggers of tomorrow are. The problem is which, and when. Mispricing goes up with complexity (of the balance sheet).

Motola: Recently we've moved toward biotechnology with names such as Gilead, Alexian, Genentech, and Celgene, which we believe have a good growth profile.

Lynch: Inflation and demographics are pluses for healthcare, but government regulation and creative destruction are big ifs. Reimbursemnent changes, for example, can come quickly and catastrophically.

Hagstrom: The healthcare model is broken, and biotech is probably its best growth opportunity. Big pharma is no longer growth. Under a new administration we may be insuring 43 million people and we don't know how that will affect earnings.

Hagstrom: [on turnover] Value managers buy crappy companies and hold on forever. We buy great companies and hold on forever. Growth guys should keep their turnover ratios lower, but value guys' should go up.

Hagstrom: [on quality of management in financial service] Goldman did it right because they're great at risk management. They watched out for the black swan.

During a gaggle after the panel discussion:

Hagstrom: You don't make a lot of money unless it's accompanied by a lot of stomach-churning stress. The probability of recession is going up, and that hurts GE. I think our next problem is deflation — of real estate, M&A prices of businesses, and wages. Everything but commodities is going down in price. That would have a big impact on financials. I would hope Bernanke would drop the rate to 1 percent. Europe is even more pessimistic than the US. They're even closer to deflation because they've raised rates. Meanwhile, I'm still a bull on emerging markets.

Alex Motola of Thornburg in the Exhibit Hall at the Morningstar Investment Conference 2008.

Berkowitz: "Study the jeweler"

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

This morning two stock pickers, Bruce R. Berkowitz of Fairholme Capital Management and Susan M. Byrne of Westwood Holdings Group, discussed their approaches to finding the best values in today's market in a chat entitled "Let's talk bargains." The following is a free-form paraphrase of what was said.

Susan: We're devotees of growth overseas, but we're value managers. That has led to buys like MasterCard, which went from $50 to $300 in 18 months because no one understood the the increasing market share of consumer credit in the developing (as opposed to the mature) markets. Likewise, Nike. Two-third of their business is outside the US, the pressures felt by US consumers that would make this stock unattractive are irrelevant. Nike is growing 20 to 30 percent elsewhere.

Bruce: Healthcare is becoming attractive again with low P/Es now (as low as 10) versus 40 to 50 not so long ago. And the tidal wave of aging baby boomers, combined with rising oil prices, means we're driving less and needing more healthcare.

Susan: The US may make the effort to conserve energy, but if we do, will some other nation take up the slack, keeping prices high? We own energy without overweighting, but we don't know what the answer as to whether US energy conservation will make a difference in this new world.

Bruce: With oil over $70 a barrel, alternative sources of energy may make economic sense, but they take so long to bring to market (over 10 years for nuclear plants, for example). Energy prices remind me of the Internet bubble — too much media euphoria and crawls on cable news alerting you to the minute-by-minute price of oil.

From left: Moderator Russel Kinnel of Morningstar, Susan M. Byrne of Westwood Holdings Group, and Bruce R. Berkowitz of Fairholme Capital Management.
Susan: Banks, if not the most hated area of investment right now, are maybe the most confusing. They were never the most transparent industry, but it as if they said, "We can't lose market share to London, so let's go nuts." There will be a race to the bottom in the next two to three years among those that are deleveraging. We don't yet have the answers as to who will be left standing to support the weaker when it all shakes out.

Bruce: [Of the bank crisis] "If you don't know jewelry, know the jeweler." In this case, the jeweler is not so hot. A decade of non-cash profits just exploded. That's why we count the cash, not the clicks, eyeballs, or other non-cash measurements of a business.

Susan: [Of value investing] We're not patient, so we seek good value and "something happening." For instance, in drugs, we examine what they are doing, where they are headed, and which aspects of their business strategy are undervalued. Exceeding inflation is the point of owning equities, so that's why we seek "something happening."

Bruce: We look for three things: (1) free cash flow yield, (2) a rock solid balance sheet, and (3) a good sense of what management does with that free cash. The current environment is where the seeds of great performance are planted. Sears, for example, generates $6 billion in free cash on 130 million shares, has a strong balance sheet, lots of land, and very strong brands.

Susan: [to Bruce] But you don't know if management will make the highest and best use of that land that you feel is the value behind the stock.

Bruce: That's when you study the jeweler. Reading between the lines, we observe how they renegotiate leases, how they buy and sell real estate, and we come to the conclusion that they're doing it right, but it's happening under the hood, Buffett-style. Value investing is not rocket science, it's investigative reporting — do it right, and maybe something good will happen.

Accentuate the cognitive

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

This morning Bill Bernstein, a former neurologist who has since become a financial guru and founded EfficientFrontier.com, gave a free-form talk about his investment approach.

Various rebalancing tactics were examined
Bill Bernstein. Photo
via Leigh Bureau.in order to take advantage of differences in return that exist among asset classes. "I believe threshold rebalancing is better than calendar rebalancing — but I can't prove it," he stated, noting that wide thresholds (1-2 years) were better than narrow (3-4 times per year), and that calendar rebalancing should occur no more frequently than once annually. This gives your winners (and losers) a chance to run and receive the benefit of their momentum before the rebalancing takes place.

Bernstein claimed not to be especially interested in behavioral finance, despite his having practiced as a neurologist for 25 years. He did assert that it was good for examing and exposing one's own biases, however. Like piloting a plane, investing is an exercise in learning to master (and often contradict) your instincts.

Emotions generally pose a greater threat to individual investors than to financial professionals. Bernstein suggests that the greater threat to investment professionals is cognitive, versus emotional, mistakes. The two most important errors he cited were (1) not knowing enough investment history to give proper context to whatever upheavals are occurring in today's markets, and (2) making the mistake of equating economic growth with equity returns. The example he gave for the latter was China, where massive economic growth over the last decade and a half was not matched by comparable equity returns over the identical period.

"This time it's different"

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

The opening address at the Morningstar Investment Conference in Chicago was given by Mohamed A. El-Erian, Co-CEO and Co-CIO of PIMCO.

Three weeks ago in Barron's, he identified four major global trends:

• Realignment in global growth


• Return of inflation


• Structured finance diminishing the barriers to entry


• Wealth transfer among nations

His latest book, When Markets Collide (McGraw-Hill), describes the causes of the recent traumas in the financial system, and will be published this month.

Today El-Erian characterized investment infrastructure as undergoing a vigorous global retooling that will will affect the financial services industry as much as the individual investor. In front of a chart that depicted the market's regard of Citi and Goldman Sachs as riskier than Brazil or Mexico, he hammered home the point that in our new, different world, smaller countries and institutions would have suffered more from recent dislocations in the markets. But now it is precisely the most sophisticated financial systems, particularly in the US and the UK that are suffering the most. Government policies are not up to the new challenges and have failed to act as circuit breakers in this new environment. "Just in time" risk management, as practiced by industry leaders, has failed.


Mohamed A. El-Erian at the Morningstar Investment Conference
The US consumer faces headwinds because of the housing market, and the fact that a house can no longer be used as an ATM when home prices fall. Meanwhile, in emerging markets, consumers are getting richer and are building new middle classes and reaching new heights of consumption. Both these newly enriched consumers in India, China and Brazil, as well as the stressed US consumers, will be facing new inflationary pressures to which neither is accustomed.

The implications for investors will be to insist on clarity about their return expectations as well as risk tolerance. They will need to revisit asset allocations for secular robustness and choose among new investment management vehicles in the context of new configurations of risk.

PIMCO's ways of addressing these phenomena include "constructive paranoia," which consists of management constantly asking itself "What can go wrong?" and hardwiring mechanisms to second-guess its own conclusions.

Investors should not treat the recent behavior of the market as a "one-off" — don't think we're going back to business as usual. The crisis we are facing also involves opportunity, as long as investors don't fall into the trap of narrowly framing asset classes.

Additional quotations: "The rest of the world will still outgrow the US." "We are living in a world of permanently higher (and more volatile) commodity prices." "Correlations among asset classes will change." "The financial services industry must evolve from products to solutions." "We [PIMCO] see 1-2 percent growth in the US economy for the next two years." "This time is different, and I say that very seldom."

Crystal ball alert: He also revealed that PIMCO is working on a forward-looking [!] index for the bond market.

The takeaway: Invest more heavily in both international equities and bonds as well as additional asset classes (see his portfolio above).


Mohamed A. El-Erian

The checkerboard economy

Over the next several years our economy is expected to become a crazy quilt made up of regional patches of prosperity and decline, based on local susceptibility to the recent epidemic of housing fever (Janet Morrissey, InvestmentNews):

"Housing is a very local business," said David Goldberg, an analyst with UBS Securities LLC in New York. Although certain issues are affecting housing demand nationwide, "recovery and timing of recovery" are going to be much more locally driven, he said.

"We believe Texas; Charlotte, N.C.; and Atlanta will be among the first to recover," Mr. Goldberg said. On the flip side, he added that Florida, inland California, Phoenix and Las Vegas will likely lag the rebound. [...]

A report issued in May by New York-based RREEF Alternative Investments, the asset management branch of Deutsche Bank AG of Frankfort, Germany, made similar predictions about an earlier recovery for Texas and the city of Washington but added a few other markets as well. It also named Baltimore, Boston, Charlotte, Chicago, Portland, Ore., Raleigh, N.C., San Francisco, San Diego, San Jose, Calif., Seattle and the New York/ New Jersey corridor as housing markets able to clear out their housing inventory within a two-year horizon.

"There could be some attractive opportunities in these markets, where the turnaround horizon is relatively short," the report said. Markets that will take more than three years to rebound include Miami, Jacksonville, Orlando, Palm Beach and Tampa, Fla., Las Vegas, Phoenix, and Riverside and Sacramento, Calif., according to the report.

Some financial advisors are recommending that clients who are looking to relocate should consider the early-recovery markets first.

Unfortunately, the fever that gripped south Florida and similar areas will have a depressive effect on those areas for at least several years, as affluent families choose to avoid the specific regions that lag behind the housing recovery.

Something's gotta give

A disturbing trend among 401(k) investors (Sue Asci, InvestmentNews):

While workers continue to put money into their 401(k) plans during the current downturn in the economy, they are investing at a lower rate, a survey released yesterday by Putnam Investments found.

The 152 advisers that responded to the online survey, conducted in May, reported that 89% of plan participants are continuing to save and 85% of plan sponsors are continuing to provide matching contributions.

But 21% of participants are now contributing at a lower rate and 4% have stopped altogether.

Obviously, energy and food prices are rapidly rising, and everyone needs to pay for these necessities somehow. But to steal from your retirement income tomorrow just to burn a few gallons of gas today is counterproductive. Your future is literally going up in smoke — as car exhaust.

Pay for a present necessity with a future necessity, and you will never be able to make up for the lost time that will erode the compounded value of whatever you save later. Beyond the money not contributed today, the money that money would earn is lost forever. Better to cut some other unnecessary expense out of your life today rather than to take food off your own table tomorrow.

401(k) plans underperform

There is a clear advantage to having a professional manage your retirement assets: more money (Pensions & Investments):

Defined benefit plan rates of return outpaced returns for 401(k) plans during the most recent bull market, according to analysis released today by Watson Wyatt Worldwide. Defined benefit plans outperformed 401(k) plans by 1.6 percentage points in 2006, 1.1 percentage points in 2005, 2 percentage points in 2004 and 1.7 percentage points in 2003.

Watson Wyatt also found that from 1995 through 2006, DB plans outperformed DC plans by an average of one percentage point per year, which would translate into a cumulative dollar difference of nearly 14% for money invested in 1995.

One significant difference between 401(k) plans and defined benefit plans is that the former are self-directed, meaning that investors choose among available investments themselves. The lesson for retirement investors is that if you enjoy DIY projects, head to Home Depot. With something as important as your retirement assets, don't go it alone — have a professional advisor help you figure out how to invest your 401(k) contributions.

Some chefs refuse to swallow their own cooking

No wonder so few funds can beat their benchmarks — their managers don't trust their money to them either (Sue Asci, InvestmentNews):

Morningstar Inc. today released a study indicating that many fund managers live by a philosophy of “invest as I say, not as I do.”

The Chicago-based fund tracker found that 47% of the managers of U.S. stock funds reported no ownership in their funds at all.

Morningstar also found that 61% managers of foreign stock funds do not hold positions in their funds, compared with 66% of managers of taxable bond funds, 71% of managers of balanced funds and 80% of managers of municipal bond funds.

The study was the first comprehensive look at fund ownership among the some 6,000 funds in the firm’s database, said Russel Kinnel, director of fund research at Morningstar.

The article notes certain circumstances in which it is inappropriate for managers to invest in a fund (e.g., managing a single-state bond fund for a state in which they do not reside), but overall this result shows that a significant minority of funds are "gimmicky, market-driven" products, as lovingly described by Morningstar's Kinnel.

Keith Van Horne, The Sub Prime Mortgage and Financial Literacy

The Answer: Keith Van Horne, the Sub prime Mortgage Market, Financial Literacy
The Question: (hermetically sealed in a Mayonnaise Jar) Name three reasons the Economy is in bad shape?

Twenty years ago, late-night legend, Johnny Carson’s all seeing Karnack would give the answers to questions before they were asked to the enjoyment and laughter of millions in his TV audience. Unfortunately, the above question and answer isn’t funny, but is true in many ways.

How did so many people “get talked into” sub prime mortgages without fully understanding the potential risk that they faced when rates escalated? You could blame financial literacy, because as a nation we failed to teach people how to budget, how to balance a checkbook and how to save for retirement.

And, what about our children? What are we teaching them when they want to spend hundreds of dollars on MP3 players, phones, gaming systems, designer purses and shoes? The examples they follow come from the headlines and “Unreality” shows on TV which makes entitlement a divine right. It also comes from seeing people like Keith Van Horn.

Nets forward Keith Van Horn landed $4.3 million after being involved in a sign and trade from Dallas in the Jason Kidd deal Feb. 19. Van Horn, who was enjoying post-basketball life in Colorado at the time of the trade, did not play one game for the Nets after he was acquired.

I don’t have a problem with Keith Van Horn. He worked hard for his money (or did at one time.) It is another example of how “Deal or No Deal”, the lottery, and Texas Hold’em has replaced the Passbook saving account, Christmas Club and “Saving for a Rainy Day ”as a strategy for financial security.

Robbing from the future to pay for the past.

A disturbing trend is emerging as workers begin borrowing from tomorrow’s retirement accounts to pay for today’s lifestyles (Investment News):

With the economy deteriorating and prices for gas and heating fuel skyrocketing, consumers who are seeking new sources of cash are increasingly jeopardizing their retirement income by taking out loans from their retirement plans.

The number of such loans has been growing at double-digit rates, according to top plan providers. [...]

The T. Rowe Price Group Inc. reported that loans from retirement plans it manages were up 10% in each of the past two years, and the trend has continued in 2008, with loans in January and February up 6%, compared with the first two months of 2007. [...]

The Merrill Lynch Retirement Group of Pennington, N.J., reported a similar trend in its proprietary business of 1,500 clients, representing 2.6 million participants and $103 billion in assets.

The firm, a subsidiary of New York-based Merrill Lynch & Co. Inc., said that between the first and fourth quarters of 2007, the number of general-purpose loans from 401(k)s increased 14%, while residential loans decreased 40% and hardship withdrawals jumped 42%.

"We do a lot of education on our website and in statements," said Kevin Crain, managing director for business retirement and corporate market integrated benefits at Merrill Lynch. "They have the right to take out loans, but we want them to think about some of the issues." [...]

Fidelity Investments reported that the number of loans taken by participants in 401(k) plans administered by the Boston-based firm's retirement services division increased in 2007 by just under 4% from 2006, according to company spokesperson Jennifer Engle. Fidelity declined to disclose the number of plans or assets it has under management or the number of participants.

The company also saw a 17% increase in hardship withdrawals between 2006 and 2007. In total, the number of participants making hardship withdrawals is just over 1%, Ms. Engle said.

As Alicia Munnell, director of the Center for Retirement Research at Boston College in Newton, Mass., points out in the article, "If you take out a loan and repay it over five years, the [401(k)] plan suspends your contribution for five years. You'll end up with 82% of what you would have if you left the money there."

Unfortunately, many 401(k) plan particiapnts believe that because their accounts hold their own money, they are doing themselves no harm by self-borrowing. The problem is that no one — including themselves — will lend them money later in retirement if there’s not enough to be had for a comfortable retirement. By borrowing today, they are robbing their accounts of the ability to grow, including years or even decades of the investment power of compound interest.

Asset managers, investment companies, 401(k) platforms, financial advisors, take note: Unless you step to the plate and explain to participants how much harm they are doing, they will continue to cannibalize their own futures to pay for their past mistakes.

What’s needed: a proactive educational program that financial advisors or even plan sponsors can use to to teach plan participants that a 401(k) loan really is a last-resort measure. Don't burglarize your own house — borrow from someone else before you borrow from yourself.