The Known Unknowns
By R. W. Roge & Company
June 19, 2012
On Friday, June 1, 2012 we had an all day investment strategy meeting. The purpose of this semi-annual meeting is to review our current portfolio strategy and evaluate it against the current state of the global economy...Easier said than done.
It gives everyone a chance to express their views and have those views vetted or disproved with data where possible. In addition, this meeting provides a tremendous learning experience for everyone involved. We all learn from one another. It is proof, that no man or woman is an island. It's my job, to consolidate those views, bringing them together in a coherent and organized manner, so we are all aboard the same vessel on our journey together into the future.
Reaffirmation of our Philosophy
We start by reaffirming that we are here to do our very best to grow the assets our clients have entrusted to us, without taking unnecessary risk. We also reaffirm that the asset allocation decisions control the majority of the risk in a portfolio, except when there are systemic problems with the global economic plumbing. When this happens, as it did in the fall of 2008, everything goes down in value at about the same rate. Although painful, this lasts for relatively short periods of time and as long as we have cash available as part of the asset allocation, we can weather these storms as we did beginning in March 2009, without too much difficulty.
Discussion of the Known Unknowns
1. Political dysfunction? Policy making has been on hold for more than three years now. Elections in November could be game changers. Perhaps we need a Sputnik moment to rally the nation to move forward and get us out of this political gridlock. The upcoming election may provide that willpower to create such a moment in Washington, D.C.
2. How will the global system continue to operate? Will Europe agree on a path to recovery? Will we have a United States of Europe? Will the European Central Bank create their version of our Federal Deposit Insurance Corporation (FDIC) to guarantee their bank deposits and prevent a run on their banks? Will Greece exit the Euro?
3. Geopolitics? Dangers in the Middle East and global elections.
4. Technology, Social Media and the Cloud? How will the development of these new ways of computing and communicating affect society, politics and the way we work. It's already impacting us in ways we may not even realize. It has already displaced the number of workers we need to operate a business and has increased the speed and methods by which we communicate. It has entirely eliminated the need for some businesses and created others.
Basically, we know these are issues, but we just don't know their outcome. So how do we structure our portfolios while we wait for more clarity? We have been calling our strategy the "Muddling Through Strategy" since 2008. Our strategy is based on answering the question, ---How do our clients get paid while we wait for more clarity on the "Known Unknowns?" The answer has been a move to more dividend growing stocks, a normal allocation to short to intermediate term bonds - as long as the Federal Reserve remains on hold, higher yielding cash substitutes for those allocations to cash, that will remain in cash for more than 18 months, and some exposure to gold bullion to help protect against a devaluation in currencies.
Discussion on the Knowns
1. Unemployment rate is too high.
2. The expiration of the Bush Tax Cuts effective January 1, 2013, also known as the "fiscal cliff." Will Congress act before January 1, 2012?
3. Euro crisis. Seventeen countries, with very different cultures, can't print their own currency.
4. Too much debt globally (Sovereign and Private).
5. China's economy, although still robust by any standards, is slowing down.
6. Artificially low interest rates (actually, negative real rates of return from what are perceived to be the safest investments (treasury bills, notes).
7. Governments are printing money at unprecedented speeds (eventually becoming the causation of inflation).
8. Private sector is deleveraging (paying off their debts), which is currently a deflationary force.
Outlook and Strategy
It seems like the world is upside down. What used to be considered relatively safe (low volatility) investments over time are becoming unsafe. For example, bonds were considered a relatively safe investment. Interest rates have been held artificially low by our government, and rates can't go much lower without becoming negative. Therefore, when the government stops holding rates artificially low, interest rates will rise to a more normal market value and bonds will decrease in value, which creates a real dilemma for portfolio managers, who manage balanced portfolios of stocks, bonds and cash.
For now, we are comfortable with having a normal allocation to bonds. That's because the Federal Reserve has publically announced that they are on hold until the end of 2013. So we know we have at least 6 to 12 months before we have to reposition our bond allocation. The only problem is that with rates so low, how do we grow assets? The answer lies partly in stocks, which are normally considered riskier than bonds. Yes, the world is upside down. We are talking about having a portion of our portfolios in dividend paying stocks. Dividend paying stocks, in general are less volatile than the average stock because they typically have solid balance sheets, good cash flow and low levels of debt. We particularly like companies that not only pay dividends, but also grow their dividends. We have exposure to these types of stocks through the use of individual securities as well as mutual funds. We have been doing this for almost a year now.
In addition to adding dividend growing stocks last year, we thought it would also be important to have exposure to growth stocks since we anticipated the economy would grow slowly, which it did. At our meeting on Friday, we were somewhat surprised at just how well our growth stock mutual funds had performed during the past year. They outperformed the market and did substantially better than the dividend growth portion of our portfolios. These stocks are represented by Akre Focus Fund, Westport Fund, and the RiverPark Wedgewood Fund. Having good managers picking good stocks in a slow growth environment, was certainly part of the reason for this success.
On the bond side of the portfolio our major holding was PIMCO Total Return Fund, managed by the famed bond manager, Bill Gross. As you may remember PIMCO Total Return had underperformed it peers for the first time in its history in 2011, hurting our overall performance. This year as of May, 30, 2012, as we anticipated, it is again outperforming its peers considerably. So we are on hold with our bond allocation for now but monitoring the Federal Reserve carefully.
We found a new fund last year that we thought would be a good place to hold cash that was not required for at least 18 months, without taking on too much risk. Instead of earning less than 0.01% on money market funds this fund worked as we expected. This fund is categorized as a bond fund, however, we consider it a cash alternative, albeit, not as low of a risk as money market funds.
As for commodities, we have always had a position in gold bullion and increased it last year. We expect we will continue to hold this position until the global economy sorts itself out.
After a solid 7 hours of meeting time, and reviewing more than 200 charts and performance records, we concluded we would probably have to start reducing our bond exposure (and bond duration) over the next 6 to 12 months, depending on the Federal Reserve and the elections in November. The proceeds from that reduction would most likely flow to the dividend growing strategy and the growth fund strategy we have been using (depending on our outlook for Gross Domestic Product (GDP) 6 to 12 months from now). We will continue to use the short term bond fund as a holding place for funds not needed for at least 18 months and monitor both the Known's and the "Known Unknowns" for policy changes that could have an effect on our strategy going forward.
As always, we manage risk first and return second. This has helped us navigate the many ups and downs the markets have sent our way over the past 25 years and helps everyone sleep a little better.
On behalf of our entire team, we hope you and your loved ones enjoy the summer.
(c) R. W. Roge & Company