Review & Outlook

Our take on the investing, financial, & economic themes of the day

A Walk Around the Firm, July 27, 2011

29 July, 2011 by Ben O'Brien in Commentary

Earlier this week, in the midst of worries about the debt ceiling debate in Washington and the struggling economy, we met with an institutional client. We thought we’d share here some of what we talked about. What follows is what Mark O’Brien said more or less. He takes a step back to describe our firm, how we operate and what we think of the current investment environment:

I am one-third of a three man investment team at O’Brien Greene. The second-third of the three “man” team is Sally Sulcove, who has been at O’Brien Greene & Co. for about 10 years. Both Sally and I are generalists but even so we tend to specialize. Sally tends to focus on stocks, whereas I tend to focus on bonds, and on big-picture questions, like why not own gold, or how about alternative investments, or should one trust rating agencies – – (the sort of questions perhaps better answered after 20 years of experience than 10 years.) But generally, whatever I do Sally can do, and some would say even better.

The third man of the investment team is the newest, Ben O’Brien. He is my son. A recent graduate of Notre Dame, Ben is what is known as a research analyst. He looks for new ideas, he gets into the nitty-gritty of financial statements, and he follows quarterly corporate earnings. That means when Abbott Labs reports good earnings, Ben finds out why they were good, or when Mercks reports disappointing earnings, Ben finds out why they were disappointing.

The three of us cover the new, the familiar and the old. That is to say, Ben tends to know about the new new thing, like Chipotle Restaurant and social networking and cloud computing, Sally knows about Pottery Barn and Olive Garden Restaurants, and I know about the Great Crash of 1987, when Ben was 2 years old, and Sally was not much older. And all three of us draw on the research and resources of Fidelity Investments and Charles Schwab.

There are others outside the investment team. The engine room, as she likes to call herself, is Dodi Nolly. She has been here longer than 10 years. (No disclosure of some information.) She handles trading and account reconciliation and lost dividend checks and untold other problems. There are some who say she does all the work. And then there is our compliance officer, Lisa. We are regulated by everyone: by the State Securities Commission, the Department of Labor, the IRS, you name it. It’s a big job. And Lisa also takes care of our internal accounting.

I have two other sons, both highly accomplished. One is sitting for the bar as I write these words, the other just finished his PhD and has committed to a two-year teaching stint at Villanova. I can imagine that one or even two might come into the business. If they did not and I wanted to hire more professional help, this is not a bad time to do it.

I want to pause here and emphasize the family nature of the firm. I think that is an important feature and one that is too often missing from the current scene. I began my investment career with a bank where the money came from the partners in the bank. If a loan went bad, the loss came out of the partner’s pocket. This is a very good discipline. Had there been a little more family in Merrill Lynch, Lehman Brothers, Bear Stearns and the like in 2008, I think they would still be independent strong companies.

What is our philosophy of investing today?

Here I cannot resist a sports metaphor, and being a tennis enthusiast, the metaphor will be from that sport. I have often thought that the test of a good tennis player is how good he is under bad conditions, not good ones. That is to say, when conditions are rotten – – bad lighting, a slippery surface, windy weather. You have to simplify your game, shorten your swing, swear off the flashy shot, take what your opponent gives you, avoid the unforced error.

Investing is similar. When the markets are on a tear, it’s easy to make money, because everything is going up. It’s like shooting baskets in the driveway; you cannot believe how easy it is. The test of course is when the markets are going to hell. I am thinking of the decade just past, which has been called the worse in modern history. The likes of Wachovia Bank, Washington Mutual, Merrill Lynch, and Lehman Brothers went broke.

How did we do? Pretty well. Every one of our portfolios is different, because everyone one of our clients is different. But on the whole we stayed positive in that decade 12.31.99 through 12.31.09 at a time when the market as a whole fell 9%.

That was then and this is now. So how about now? Conditions are still bad, maybe even worse than ever. To continue the sports metaphor, the court is chewed up, the surface is wet and slippery, it’s windy – – you get the picture. One reads that the economy is in a recovery, but it is the worst recovery since the Great Depression in the 1930s. Unemployment is still over 9%, businesses are sitting on record amounts of idle capital, afraid to hire, the government is printing money to pay its bills, all of Europe is in disarray and Greece, Italy, Ireland, Portugal and Spain are on the verge of bankruptcy, and so on. What’s the right investment response? As before, keep it simple, use plain vanilla stocks and bonds of the highest quality, and avoid complicated new Wall Street products. Curious to say, Wall Street product creations seem often to have design flaws that appear only in times of crisis. Here I am thinking of collateralized debt obligations (CDOs), which were billed as a better and higher-yielding sort of bond, and they were up to the time they blew apart in the 2008 recession.

One must also be willing to take what is often out of favor. Let me give an example from the recent past. Last year tax free municipal bonds suddenly became very unpopular. The financial press worried that states might go bankrupt, and overnight all municipal bonds – – those from “good” states as well as those from “bad” states – – became very cheap. Taking the long-term perspective, we took what the market gave us, and we bought tax-free municipal bonds from the good states. Just a year later, that decision has been borne out.

What else? One more practice: keep expenses and buying and selling low (the latter is called turnover). It is always good to have a brilliant money manager, but it is better in the long run to have low expenses and low turnover, especially as regards long-term investments like retirement accounts. Too often 401(k)s offer daily valuation of every participants holdings and the ability to switch from this fund to that fund at any time, even at night and over the weekend. These features are nice, but they are also enormously expensive. Investors did not pay much attention to fees and expenses in the 1990s when the markets soared, but in the current era of low investment returns, fees and expenses are often the difference between a positive return and a negative one.

These practices will tend to help in difficult market conditions, but they will tend to hold back performance in Goldilocks markets. As long as you are prepared for that, it shouldn’t be a problem. But often people are not prepared. They want to do better than the market all the time. The notion is misguided.

This is growing a bit long. Let me wrap things up with the current outlook. As I said above the worst decade since the Great Depression is now two years behind us, but conditions are not good. Some would say they are worse than ever. I am not sure that they are that bad, though a lot of things could go wrong. Let me explain in these concluding words not what could go right, but rather, what I think is most likely to happen.

Two years into a recovery the economy should be growing 7 or 8% a year; instead it is limping along at around 2%. Why is growth so subdued? The Democrats say it is because there is not enough demand and the Republicans say it is because of uncertainty over government policy. Both are right, of course, but there is more. This is the first time we have ever had a credit-less recovery. Usually the banking sector leads the economy out of recession. But this time the banking sector is not making loans. It is capitalism without the capital. No wonder the recovery is meager; it has no fuel. Without loan growth we can expect the recovery to continue to be subpar – – a half to a third of a normal one. And I think the recovery may last longer than people expect. What usually kills a recovery is excess, but if there is one thing which this recovery lacks, it is excessive enthusiasm.

The third point: stocks are the cheapest they have been in 20 years. Whenever stocks are cheap, and bonds are expensive – – and bonds are very expensive at the present time – – and when there is a lot of fear, as there is now, then stocks tend to do “all right.” What’s all right mean for our purposes? At the least stocks will return their dividend, which means 2% on average. As for the other part of return – – share price appreciation – – I expect them to grow at the 2 to 3% growth of the overall economy. I think we will be surprised on the upside. But if we are not, then I will take 5% from stocks. It beats the yield of a 10-year Treasury note, which is 2.8%.

What about the disarray in Europe and the drawn-out bankruptcies of Greece, Ireland, Italy, Spain and Portugal? They are a very useful cautionary tale of what happens to a country when it spends beyond its means. Could a cautionary tale be more fortuitously timed, at least as regards the interests of the United States?

What about the debt ceiling standoff, and the possible credit downgrade of the United States? The rest of the world is saying these are not serious problems or even problems at all. The rest of the world is betting that America will put its house into order. Consider that the rest of the world demands interest of 29% to loan money to Greece for two years, whereas the world requires the United States to pay 37 basis points (.0037%) for the same two year loan. Now that’s confidence.

Is there anything one can say in support of current bond yields? That is to say, can we expect the 10-year Treasury to continue to pay 2.8%? I can think of only one thing, and it is the bulging baby-boomer population that is preparing to retire. They will buy bonds to provide a steady and predictable stream of income. Otherwise I find it difficult to imagine that interest rates will not ratchet higher once greater confidence and prosperity return to the United States.