 MARCH 2007 INTRODUCTION This issue of the Newsletter is devoted significantly to investments. The first article, while very long, is really three or four articles in one. We begin by looking at a part of the big picture. From there we turn to the current situation with Closed End Funds and two "alternative" investments: oil and gas, and real estate. The next article is on "value" investing, more accurately called "deep value" investing, and it reports on a seminar led by one of the deep value investors. That article is followed by a story about "The First National Bank of Grandpa." A speech by Arthur Levitt, former chairman of the SEC is the basis for a concluding article, followed by a brief "Final Notes," and "Office Matters." THE O&A INVESTMENT SCENE How many times, in print and in person, have we at Otto & Associates said that we are cautious on the U. S. stock market and expect low returns, on average, for a number of years? Despite our predictions, the market keeps moving higher. In 2005, the market return was mediocre, at 6.3%, but a bit above our expectations. In 2006, the return was 15.9%, way above what we had anticipated. Nevertheless, because of our concern about the stock market, we have generally tilted client portfolios toward the conservative side. The price for having a portfolio with a conservative tilt generally means that investments will not soar when the market soars. The advantage, however, is that portfolios should not lose as much when the market goes down. So how did we do last year when the market soared? As it turns out, pretty well. Last year the typical O&A client squeaked ahead of the market by about .2%, with an average return of 16.1%. Our average client return every year since 2000, after all expenses, has exceeded the U.S. Stock market, with one exception.1 However, our basic target is not simply the U.S. stock market.2 Because our clients invest not only in the U.S. stock market but also the international stock market and the U.S. bond market, our goal is to stay even with a blended index, which combines the returns in the various stock and bond markets. In the last four years, that blended index has trailed the U.S. stock market. However, that same index exceeded the U.S. market when that market lost money during the three previous years (from 2000 through 2002). Our goal at O&A is for our clients to at least match the blended index, and last year our clients surpassed the index by 1.6%. How have we been able to continually surpass that benchmark? One major way is by selecting exceptional managers of the mutual funds we hold. A second way is by finding investments that others overlook. We have purchased Closed End Funds for our clients for a number of years, and they have generally enhanced client returns. A final way is by looking for "alternative investments" that are not easily available to the general public. The remainder of this article is about three of these non-traditional investments. CLOSED END FUNDS Making money with Closed End Funds (CEFs) is not easy to explain. While CEFs are worth a stated amount, they trade occasionally at more than their value, but mostly below the stated value. For more information on how CEFs are different from traditional mutual funds, see the "Investment Performance" article in the September, 2004, Newsletter on our website at www.ottoandassociates.com. CEFs are fickle; one cannot predict when they will become attractive. Working with the consulting firm of Thomas J. Herzfeld & Company, we buy CEFs at a discount and plan to sell them at a profit when the discount narrows. For several years we had been able to depend on buying many bond CEFs at the end of the year, at an attractive price. Unfortunately, this past December we had difficulty finding attractive CEFs. We bought a few, but we had set aside a good amount of cash in most of our client accounts, much of which we were not able to invest. We continue to monitor the situation and hope to find a buying opportunity soon, perhaps in April. In the meantime many of our clients still have more cash in their accounts than is usual. That is not all bad. Interest rates on money market accounts are high; Schwab is paying almost 5%. And cash is safe in that it does not lose money. OIL & GAS O&A clients with larger portfolios have sometimes invested in oil and gas limited partnerships. We began investing client money with Five States Energy in 1993 and continued to invest through 2005. These investments have been very successful. More than a year ago, however, Five States Energy, the owners of which are conservative investors who have been in the oil business for two generations, found it difficult to buy producing properties that met their criteria. When the price of oil approached $75 a barrel, they saw the price of oil and gas properties move to what they thought were unrealistically high levels. At that point Five States began to put some of these properties owned by the various limited partnerships on the market. They ultimately sold a number of them - well over half of what they owned. This has created a problem for us at Otto & Associates. The Five States Energy investments have been very good for our clients, but now the company is returning our money. Five States Energy has recently announced a new program for investors. The investment opportunity will focus not primarily on bringing oil out of the ground and selling it, but rather on financing the people involved in that process. Unfortunately, for complicated reasons having to do with the number of participants who can be involved in this investment, and because of the large amount of money they need to raise, their minimum investment has increased to $250,000. That minimum will eliminate most clients of Otto & Associates from consideration. We have had a long, enjoyable, and profitable relationship with Five States Energy and hope that they will again have offerings that our clients can take advantage of. It is the expectation of Five States Energy that the frothiness of the oil and gas markets will eventually settle down and properties will again be available at prices they consider reasonable. For now, however, we will look for investment opportunities in other areas. REAL ESTATE Three years ago we began to invest in limited partnerships with a real estate company in Texas called Macfarlan Capital Partners. They buy various kinds of real estate (hotels, office complexes, corporate headquarters, etc.) and, to a limited extent, lend money to others who are investing in real estate. They then put groups of these properties together in order to offer limited partnerships to investment advisors. It is important to note that these investments are in various kinds of commercial real estate and do not include the residential market. These real estate investments have worked well for our clients, and we have recently expanded our horizons to include another company, Realty Capital Partners (RCP). Unlike Macfarlan, RCP does not put together groups of properties but rather encourages investors to buy into one property at a time. We are currently investing client money through RCP in two real estate mortgages, along with an individual investment in a California hotel. We expect to continue to expand our investing in real estate and will also be alert to other non-traditional investment opportunities as we look for ways to enhance returns without increasing risk. It is important to note that many of the oil and gas investments and the real estate investments discussed above are available only to people with larger accounts. Even so, we are able to attain some of the same goals for other clients by using mutual funds. For instance, we buy natural resource funds that have oil and gas as a major component, and we have also bought real estate mutual funds for many years. 1 In 2003, the U.S. stock market made 31.7%. We were satisfied that the return for the average client that year was 22.8%. 2 When we refer to the U.S. stock market, we normally use the broad market index called the Wilshire 5000, which we prefer to the Dow Jones Industrial Average because the Dow includes only 30 stocks. We also prefer the Wilshire 5000 to the S&P 500 which includes the largest 500 stocks but still omits small stocks. THE PROBLEM WITH VALUE INVESTING Benjamin Graham is often called the "Father of Value Investing." Born in London in 1894, he grew up in New York and eventually became a professor of economics at Columbia University. Security Analysis, his book written in 1934 with David Dodd, has long been regarded as the bible for value investors, along with another book written by Graham and published in 1949, The Intelligent Investor. Graham drew a fundamental distinction between investment and speculation. He wrote, "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." Graham wrote about stocks, not stock mutual funds - which were not readily available until near the end of his life. (Graham died in 1976.) He wrote about how stock investors should see themselves as owning part of a business. With that perspective, investors should not be too concerned with erratic fluctuations in stock prices. In what has become a famous analogy, Graham said that in the short run, the stock market behaves like a voting machine (i.e. something investors should ignore), but in the long run it acts like a weighing machine (i.e. the true value will eventually be reflected in its stock price). After studying a stock, Graham wrote, an investor should think like a business person and wait to buy a stock only when it is available at a significant discount. A quote from the Wikipedia website continues the story: "Graham's favorite allegory is that of Mr. Market, a very obliging fellow who turns up every day at the stock holder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often is ridiculous. The investor is free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn't mind this, and will be back the following day to quote another price. The point is that the investor should not regard the whims of Mr. Market as determining the value of the shares that an investor owns. He should profit from market folly rather than participate in it. The investor is best off concentrating on the real life performance of his companies and receiving dividends, rather than being too concerned with Mr. Market's often irrational behaviour." The billionaire investor Warren Buffett, who studied with Graham and reportedly was the only student to ever receive an A+, is probably the best known value investor today. One of the observations Buffett makes regarding Graham shows him as a person interested in more than just investments. Graham wished every day to do something foolish, something creative, and something generous. Graham's and Buffett's theories are in significant opposition to the currently popular "Asset Allocation" model, but that is outside the scope of this article. Since we at O&A do not normally invest in stocks, we sometimes try to find mutual funds which have value managers who hold closely to the ideas Graham developed, sometimes referred to as "deep value." Recently Deborah and David had an opportunity to attend a seminar with just such a person, the well-known investor Jean-Marie Eveillard. Some readers may recognize the name of the SoGen International Fund, which Eveillard managed for many years. The fund was more recently bought by First Eagle and is now called First Eagle Overseas. While Mr. Eveillard has retired, his long time protégé Charles de Vaulx is managing the fund using the same basic principles. Listening to Eveillard was enlightening and his anecdotes were enjoyable. What follows are some quotations - perhaps not exact - from the seminar with Jean-Marie Eveillard. His last comment is particularly poignant. According to Eveillard,
However, the primary problem is one of the things Jean-Marie Eveillard said above: value investing sometimes takes tremendous patience. Eveillard told his personal story: In the last half of the 1990s, while the returns of SoGen International matched the appropriate world index, the fund lagged the U.S. market by 10% to 15% each year. To do that for five years is very discouraging for everyone. Investors noticed Eveillard's underperformance and they took money out of the fund. Eveillard said that 7 out of 10 investors left the fund. Since research shows that somewhere around 20% of investors don't pay attention and simply leave their money wherever it is, he figured that about 10% of the investors understood what he was doing and supported him by keeping their money in the fund. Eveillard said that this was painful for him and undoubtedly contributed to his retirement in 2004, even though by then the fund had outperformed the U.S. market for several years. In the first three years of the current decade, when the U.S. stock market indices were losing significant money every year, Eveillard's fund made an average of 7% annually. The returns for that fund for the past 10 years demonstrate that value investing over the very long haul often leads the market indices. The fund has returned 15.5% annually for 10 years. The U.S. stock market has returned 8.6% during the same time. $10,000 invested in Eveillard's fund would have grown to $42,250, while a U.S. market index fund would have grown to only $21,590. But staying with a value discipline is difficult. O&A was one of Eveillard's investors that deserted him. Looking back on our records, we find that we sold virtually all of that fund by the end of 1998. During that year the U.S. market returned 28.6%. SoGen International returned 2.5%. We thought Eveillard had lost his touch, even though we were in close contact with him. At the time David was in charge of the NAPFA New York Study Group, and Eveillard spoke to that group on two occasions in the 90s. We have since realized our error and have reinvested in the fund to our clients' benefit. Some readers may remember that a few years ago, Warren Buffett's Berkshire Hathaway stock lost money, or at best made very little. Many wrote at the time about how Buffett had apparently lost his ability to make money. Today no one is saying that, because his fund is again doing well. This article does not have a nice conclusion. While the Graham style of deep value investing has proven to pay large dividends over extended periods, there will be long dry spells when investment returns are puny. It may be that neither we at O&A nor our clients have the stamina for such investments. GRANDPA'S BANK The September, 2003 Newsletter carried an article about a creative book entitled THE FIRST NATIONAL BANK OF DAD: The Best Way to Teach Kids About Money . Then, just over one year ago, one of our more careful readers casually asked if I was going to institute the concepts outlined in the book with my own grandson, Carter. The more I thought about it, the more it intrigued me. This is a report of the agreement Carter, then eight years old, and I came to. In December, 2005, I proposed to Carter that he could save his money with the "First National Bank of Grandpa" (FNBG) if he wanted. He had saved a little money as a result of being paid for certain jobs he did for his parents, and he was keeping the money in his wallet. I told him that I would pay him interest on any money deposited with FNBG at the rate of 10% per month. (It was the book that helped me figure out that young children have no motivation to get a few cents a month interest. If I was going to succeed in getting Carter excited about saving money and not just buying more Legos, I had to make the interest rate attractive. I should add that I have had any number of adults ask if they could also open an account at FNBG on the same terms.) Carter decided, after checking with his dad, that he would give it a try. So each month during the past year, I have entered the interest he earned for the month and asked if he wanted to take any money out. So far he has not withdrawn any money, and every so often he adds to the balance. I bought a little ledger book, wrote out the name of the bank, The First National Bank of Grandpa, and the name of the account holder, Carter P. Goodell. All deposits, withdrawals, and interest payments were to be recorded as they occur. The interest rate agreement is spelled out on Page 1: "The First National Bank of Grandpa will pay interest on all money deposited with FNBG. The interest rate will be 10% per month for the first year. Interest rate will be reduced after first year and will be re-set on the anniversary each year. David W. Otto, President." His first deposit was $20. He actually had $26 at the time, but he didn't want to invest his entire life savings in one project that had yet to prove itself. He was pleased that at the end of the first month, he had earned $2. Over the year he deposited another $71. Including interest earned, he had $203.95 on December 31, 2006. This process has had an added benefit because each month I ask him to figure the amount of interest he has earned. It is easy for most adults to figure out 10% interest in their head, but it is not so easy for a (now) nine-year-old to calculate 10% interest on $185.41. As per our agreement, the 10% interest was for the first year only. Because the bank book clearly states that the amount will be reduced after the first year, Carter and I have agreed that the interest rate will be 5% for the second year, resulting in an even greater challenge for him to calculate. This has been a wonderful experiment. It has gotten Carter started down the road of being a saver and Grandpa has not gone broke paying the exorbitant interest rate. In fact, Grandpa thinks it has been an inexpensive way to teach a grandchild a very important lesson. Does this give you any ideas on which to build for your children, grandchildren, or favorite neighbor child? ARTHUR LEVITT EXPOUNDS Arthur Levitt, the chairman of the Securities and Exchange Commission (SEC) from 1993 to 2001, was a keynote speaker at an October, 2006, conference sponsored by NAPFA, the fee only financial planning group. While neither Deborah nor David was able to attend the conference, his speech was summarized in a recent journal. Levitt is important in investment and regulatory circles and some of his remarks were very pointed. What follows are a few quotations from the speech. "Fire your broker. I think it's idiotic for a person, for investors, to be stock pickers. I think it's more idiotic for them to pay the expenses of a stock broker. "I have never in my life met a consistently, year-in and year-out, good stock picker (broker.) So to expect an investor… to be spending time and effort on picking stocks and determining asset allocation is largely unrealistic. Sure there are exceptions. But as a general rule, I do not believe that individual investors should be using stock brokers. "I believe that individual investors should be striving for the very lowest cost that they can possibly find; [and] I think they should be dealing with investment counselors and investment advisors…. I think that investors of all sizes can make smart decisions, even if it's just deciding where to get the best advice." Levitt concluded by saying that investors should receive accurate information from advisors on their investments and that all conflicts of interest should be disclosed. (Conflicts of interest are mostly a non-issue with fee only advisors.) These are radical thoughts from someone who was chairman of the SEC. Such candor is not often heard from people on Wall Street and a good many people would do well to listen to this voice of experience. FINAL NOTES In the wake of the market's decline during the week of Feb 26 - March 2 (this Newsletter went to press the following week), we want to mention that as long-term investors, we are not concerned by this type of market volatility. The pull-back was about 3.5%, which is a painful single day loss, but is by no means catastrophic, or even rare. The S&P 500, for instance, lost 3% or more during 16 trading days in 2002. And one more note: the Charles Schwab Company has always attempted to created leading-edge technology for clients and financial planners alike. In the past year they have made available on their secure web site all monthly client statements for the past 10 years. Beginning this year they are also making available 1099 tax forms for all (taxable) client accounts. As many readers know, a number of mutual funds (most of the time it is funds that hold foreign securities) have become notorious for modifying their tax reporting, which results in Revised 1099s. (The good news is that generally the revisions are in favor of the taxpayer.) Schwab posts the Revised 1099s no later than the day they mail out the revisions. If you are a Schwab client, you would do well to check the web site for any Revised 1099s before you pass on your final documents to your accountant. While later revisions are always possible, most of them should be done by March 20. OFFICE MATTERS Judy has become a grandmother! Raegan Elizabeth was born on February 13 to Judy's daughter, Kim, and her husband, Shannon Kelly, who live outside of Philadelphia. We send our congratulations and wish them all the best. David and Mary's younger daughter, Libby, is expecting a baby at the end of March. David will take a few days off when that event happens to visit Libby and Tobias in Buffalo. David will attend the annual National NAPFA Conference on May 3-6, and will go to Chicago two days early to meet with the Gateway Group, composed of 20 financial planners from around the country who get together to share information twice each year. His daughter Susan will again accompany him to this national conference, as will his wife, Mary. Then, David and Mary will go to London in mid-May for a combination work and pleasure trip. (O&A continues to have a few clients in London from the days in the early 1990s when Mary worked there.) Judy and her husband, Joe, will celebrate their 35th wedding anniversary in Italy, the Amalfi Coast and Rome. She will be out of the office from April 23 through May 4. |