Sunday, November 7th, 2010

We are in the midst of confusing, challenging and some might say perilous times.  In such periods many people including heads of state often look to the works of Shakespeare for some guidance. So taking that cue we shall seek out some Shakespearean words of wisdom that might help us better navigate a difficult investment environment.  Here are some examples.

There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy…Hamlet Act 1, Scene 5

Horatio, Hamlet’s closest friend and fellow student at the University of Wittenberg, has just witnessed the end of Hamlet’s initial conversation with his father’s ghost.  Horatio has not actually seen the ghost (he’s not entitled to do so), only Hamlet’s reaction to it.  Wittenberg was known at the time as a center of Rational Philosophy and Protestant Humanism.  Hamlet and Horatio would have engaged in studies and debate about Aristotle and natural phenomena:  a talking ghost demanding his son take revenge on a libidinous uncle was definitely not part of that discussion.  Hamlet, however, has just been jarred out of his comfort zone and lets Horatio know that in no uncertain terms.

During the past two years many investors have been jarred out of their comfort zones, or certainly should have been. Belief in the equity culture along with the sanctity of real estate investing has been badly damaged, perhaps permanently. Yet the same philosophical debates about buy and hold strategies for the long run versus active management still go on as either/or propositions.  The passive index Modern Portfolio Theory (MPT) proponents still claim that what successful investing is all about is capturing the return of respective asset classes, that the only drag on performance is fees and that risk management  strategies and trading disciplines used by active managers provide no lasting benefit. The academic evidence notwithstanding, investors who held the S&P and other broad based domestic market indices for the past decade have indeed successfully captured that asset class but have not made any money doing so: something akin to asking Mrs. Lincoln how she enjoyed the play. Nevertheless, the largest domestic equity fund is still the SPDR S&P 500 Fund, followed by the Vanguard Total Stock Market Index fund. It is interesting that the economists who devised MPT hail from the University of Chicago, where the business school is named for one of the theorists who built a mutual fund empire based on its teachings.  The University of Chicago is described by its founders as being modeled on a German University so it might be the closest domestic approximation we have to Hamlet and Horatio’s University of Wittenberg.  Hamlet’s experience of being jarred out of his comfort zone by events out of his control and seeing things differently as a result is instructive for investors.   Perhaps a comparable case in point  is the August  2010 Bloomberg Investment Magazine cover article about Pimco’s Bill Gross, the manager of the largest bond fund in the US and probably the most respected fixed income investor on the planet.  The article is entitled “Why Bill Gross Likes Stocks: The Pimco Bond King says it’s time to Buy Equities.” Did the bond guru see a ghost?  To some of his followers, Mr. Gross is making as jarring a pronouncement as Hamlet. Not surprisingly, on both CNBC and Bloomberg Television, Mr. Gross still holds court as the resident bond market expert and is rarely, if ever, asked about equities. The Bloomberg article appeared this past summer as nervous institutional investors pushed Treasury yields to lows not seen in 30+ years and the Investment Company Institute reported that for fifteen straight weeks retail investors had yanked their money out of equity funds and placed it in bond funds, presumably a lot of it going into the Pimco Mutual Funds managed by Mr. Gross. But Mr. Gross, like Hamlet is saying that he has been jarred out of his comfort zone, is looking beyond his “philosophy” and we should all pay some attention to this.

“Put money in thy purse…” Othello, Act 1, Scene 1

This phrase is repeated several times in the play’s opening scene by Iago and directed at the clueless wealthy Venetian Rodrigo. Spiced with some lurid bedroom depictions of Othello and Desdemona, Iago uses the phrase as a patter song as he manipulates Rodrigo’s hopeless love for Desdemona. It is also a way for Iago to enrich himself and advance his pursuit to destroy Othello. Rodrigo has little else to do in the play other than provide Iago with steady source of funds.  Although neither man’s motivation has much to do with investment advice, Rodrigo does admit that he is getting no cash flow from his lands and will sell them.

Many investors in land and commercial real estate can easily empathize with Rodrigo. But they should have been aware of the pitfalls.  A much larger contingent with a similar problem are the countless numbers of people getting little or no yield on their Treasury Bills and cash deposits in what will likely be a protracted low interest rate environment. In a recent Op-Ed piece in the Wall Street Journal, Charles Schwab admonished the Federal Reserve to raise interest rates and stop penalizing savers and retirees (“Enough With the Low Interest Rates!” October 2, 2010).

Despite his treacherous motivation, there is something to be said for Iago repeatedly reminding us of the importance of cash flow especially in uncertain and volatile market conditions.  Ultimately all investments turn out to be yield plays and there is ample accumulated research over good market times and bad that higher yielding stocks and corporate bonds outperform the competition with less volatility.  In other words cash flow is king and has been for a very long time. Increasing cash flow through dividends, bond interest and option selling is a prudent and proven means of both enhancing returns and practicing risk management.  In the 19th century some of the great actors playing Iago were injured by objects thrown by audience members outraged by his villainy. But let us not shoot the messenger: Iago had it right and is promoting a sound investment strategy.

“But mistress, know yourself, for I must tell you…Sell when you can, you are not for all markets.” As You Like It, Act III, Scene 5

The play’s heroine, Rosalind, has disguised herself as a young boy called Ganymede so that she may move freely after her father, known as Duke senior, has been banished by his younger brother.  The disguise is a fine idea except that young women fall in love with “Ganymede” which puts Rosalind in a difficult position since she is pursuing her own love interest and must also maintain her disguise. In Shakespeare’s time women were not permitted to act in the theater so we would have had a young boy actor playing a young woman who disguises herself as a young boy; hence the play on words in the title. One of Rosalind’s ploys to deflect the unwanted attention and advance her own interests is to provide impromptu relationship counseling as in the example cited above. In no uncertain terms the disguised Rosalind tells Phoebe that she should accept the proposal of the good hearted shepherd Silvius whom she has been treating badly.  In other words: be realistic-it’s not going to get better than the fellow standing in front of you.  Not unexpectedly, Rosalind’s directive takes a while to sink in.

The advice is more than pertinent for a wide range of investors who like Phoebe tend to have inflated opinions of themselves and their abilities, or are determined to remain out of touch with market realities. Back in 1980’s when there was a vibrant and often overheated IPO market, in road show after road show CEO’s would often chime the same refrain:  “You know, we really don’t need the money we’re getting from this offering.”  Such remarks were aimed to assure investors that the company was a viable entity.  But that begged the question of why are you standing in front of us trying to raise capital?  Occasionally a CEO would speak honestly and answer, “in all honesty, we’re raising money because we can.”  That was a sanguine appraisal since for the past decade the IPO market has been effectively non-existent and only functions for large and already successful companies like Google who raised $1.6 billion at an offering price of $85 per share in 2005 without the aid of an investment banker managing the syndicate.  Oracle Computer, by contrast raised $31 million in its IPO in 1986 at a share price of $15—an offering that would be difficult if not impossible to replicate since a $30 million deal is now considered too small and more significantly Oracle in 1986 was nothing like Google in 2005.  Both companies today are worth about the same ($30+ billion).

The challenge to remain realistic based on the environment at hand also has application to those of us further down on the food chain with respect to investment management. Baron Nathaniel Mayer Rothschild, arguably the most successful banker and investor of his era once noted the key to his success:  “I never buy at the bottom and I always sell too soon.”   At any level it has always made very good sense not rely on one’s perceived prognosticating ability for success.  Benjamin Graham, the founder of modern value investing who was Warren Buffet’s mentor had a guiding principle that made sense in 1934 in his book Security Analysis and perhaps even more so today:  “The essence of  portfolio management is the management of risks, not the management of returns.”

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