Quarterly Investment Commentary - cscc76 meta name="keywords" content="Commentary October 2016

ent-seeking in the pharmaceuticals industry, more insider trading convictions, fraud at one of the nation's largest banks — Capitalism put on its best face during the third quarter. Shareholders of companies affected by the controversies were inconvenienced in the manner we have come to expect when questionable or illegal business behavior takes place, namely by paying fines and suffering lower share prices. Compensation "clawbacks" of $20 or $40 million dollars may shock the average wage slave, but do they really bite when the remaining awards exceed $100 million by a comfortable margin? Some executive egos may be hurt a bit, but we suspect that several generations of their wealthy descendants will scarcely remember or care about the patriarch or matriarch's weaknesses in the area of corporate governance.

Not that the financial world did not have enough to be concerned about already. Central bank policies-especially those at our own Federal Reserve-were much in the news, and with good reason: anything that impacts interest rates creates tension and stress nowadays. With rates at their current historically low levels, bond prices are vulnerable to sharp declines should rates increase. A mere 0.2% increase in long-term rates would reduce market values enough to wipe out an entire year of bond income. Many people (pension beneficiaries, for example) and institutional investors such as insurance companies would welcome an end to the "income drought," but given all of the "reaching for yield" that has taken place during this era of ultra-low interest rates, a significant rise in yields would be painful. There is no margin of safety in fixed-income.

Energy also attracted attention, especially in September, as OPEC seemed to change its collective mind about its two-year policy of flooding the world with crude oil. Growing economic stress in major producing countries seems to have tipped the scales in favor of some restraint, or at least a freezing of production growth. Speculation about future producer actions has brought volatility to the commodity and equity markets in the short term. Looking out over the next several years, however, we remain convinced that declines in investment in future production capacity (now approaching a trillion dollars) increases the probability of much higher oil prices eventually. Furthermore, despite the interest in electric vehicles and alternative energy sources, the world economy is a long way from ending its dependence on petroleum as its primary energy source. In fact, demand will probably continue to grow for quite some time.

While central banks and OPEC attracted much media attention, Gillian Tett, in an insightful Financial Times piece, writes of developments "in the weeds" of finance. As happened in 2008, "numerous tiny signals" of potential trouble are being overlooked. Negative mortgage rates in Denmark, or the high proportion of company ownership by Japan's central bank, for example, are both the result of monetary policies. She warns that policymakers should not become accustomed to operating in a "deeply peculiar financial world." Disregard of similar signals in the years before the financial crisis of 2008 made the excesses of the financial sector that much greater, and the ultimate impact of the collapse that much more severe.

Finally, while we customarily de-emphasize political issues in our remarks, it goes without saying that politics has been a major concern in financial circles this year. The chances of some turmoil notwithstanding, as investors it is important to remember that the impact of electoral changes tends to be transitory and not fundamental. As a financial writer once wrote (quoting Virgil), "Through chances various, we make our way."

The market "climbs a wall of worry," as an old Wall Street saying goes, and an apt description of this year's market action that is, for stocks overcame the many fears preoccupying analysts and observers to continue a multi-year advance. Despite a little volatility now and then, the popular averages reached all-time highs in mid-August, and finished the third quarter with gains of 3-4%. Year-to-date returns came in at 7-8%, making it roughly an average year for stocks so far.

"Eating your own cooking," "Skin in the game," "put your money where your mouth is" are phrases which connote personal involvement, acceptance of responsibility, and, ultimately, faith in one's self, methods, and abilities. The implication for business means businesspeople do not foist goods or services on customers that they would not accept themselves. In the investment business specifically this means that the investor puts his or her own money into the securities recommended to clients and shares in the gains or losses that ensue. It boosts clients' confidence to know that their advisor personally takes on the same risks.

We have always felt that skin in the game is important, especially when it involves so-called "agency" roles, where decision-making is entrusted to a "professional" such as corporate executive or fund manager. Imagine our dismay to learn that many of our professional colleagues do not share this sentiment. As reported in The Financial Times, "Half of the 15,000 mutual funds in the U.S. are run by portfolio managers who do not invest a single dollar of their own money in their products." Included in the list of firms with the lowest portfolio manager exposure are some of the largest and best-known fund companies. This should be of concern to fund buyers because manager ownership tends to be correlated with better investment results.

It could be argued that it would not be appropriate for managers to invest their own money in some cases (specific-state municipal bond funds or certain "target-date" products, for example), and at some firms manager investment is prohibited for some reason. Most of the time, however, there is no good excuse. Someone at one firm was quoted as saying that its managers did not invest in their own funds because "they would rather invest in something cheaper." This would be important information for fund buyers to have, but probably not something they would have ready access to.

Skin in the game is no guarantee of superb investment results, but evidence indicates it improves the odds. It should be required when at all possible.

Bye Buys

It is interesting and instructive to walk down stock market memory lane, back to the dark day of March 9, 2009, when U.S. market indexes reached a twelve-year low during the financial crisis that year. The S&P 500 had lost about 25% so far in 2009, and was down 57% from its peak in October 2007. It was a time of bailouts and massive selling. As reported by CNN at the end of that day, many money managers believed the "path of least resistance is down," and that "right now every rally attempt is being met with selling." While is was impossible to know for sure at the time, this was the market bottom.

From its low of 677 that day, the S&P 500 rose to 2168 by September 30, 2016, a gain of 220% (not including dividends). Such hefty gains would normally be accompanied by rising enthusiasm and public participation in the joy of owning stocks, but not this time. Individuals have been selling shares and the markets' rise has been met with great skepticism. This may be a consequence of lingering trauma from 2008-09; after 1929 the fear of stocks lasted until well into the 1960s. Changes in the investment management industry may also play a role as customers pull money out of traditional mutual funds in favor of "passive" ETF vehicles and products favoring foreign securities.

As it turns out, one group of market participants has been playing an outsized role since the crisis. The Financial Times last month reported that purchases of stock by the issuing companies themselves has had a major impact on stock markets for several years. From 2012 to 2015 U.S. companies purchased $1.7 trillion of their own shares, offsetting heavy sales by other shareholders. In fact, excluding the repurchases U.S. equity market flows would have been negative to the tune of $1.1 trillion. Clearly, without this source of demand the market experience since the crisis might have been quite different.

Why have issuers been so enthusiastic about their own shares? Executive compensation schemes probably play a significant role; stock option gains are directly tied to the stock price, for example. Institutional investors looking to boost share prices adds pressure to buy shares as well; corporate earnings calls would not be complete without at least one analyst clamoring for "balance sheet efficiency," meaning fewer shares outstanding and more leverage, and at the moment leverage (debt) comes cheaply. It has never been easier and more advantageous to issue debt, and companies have been doing so by the boatload, using much of the proceeds to reduce their share counts and boost stock prices at a time when sluggish earnings won't do the job.

Share buybacks provide a sugar high for owners, but such "financial engineering" represents a poor use of capital for the companies engaging in them. Shares are typically purchased at elevated prices, leaving companies in a weakened financial position, vulnerable to economic vagaries. Debt, which could have been used to fund productive investment, has instead been applied to rewarding speculators. We are beginning to see the consequences: cash on hand at companies is receding, while debt is at record levels. Not surprisingly, share repurchases are down 20% compared to the prior year. With this source of equity demand on the wane, it will be interesting to see if other players will make up the slack going forward.