Posted by David Tillson 2013 Fourth Quarter 

 Our last year-end letter spoke of thinking ahead to 2024 and imagining how the prior decade turned out. Our crystal ball predicted among other things at least an 8% annual return from stocks. At the time, we didn’t realize that we would have three years’ worth of returns crowded into 2013. April’s letter talked about the stock market’s setting new highs and asked: “So, now what?” July continued our theme of: accept the “good-news, bad-news” vacillation in the market and instead, concentrate on the long term underlying value of individual companies. Finally, last quarter spoke of our belief in “25,000 in 2020” and how we get there. Our philosophy and process is based on two foundations: (1) understanding a company’s potential and (2) investing (versus trading) for the long term. The science of the investment business is the thorough analysis of the fundamentals of a company; the art is managing risk and appreciating the impact of human behavior and emotion. 

Most clients want to participate in the long term rising trend of the stock market but also be protected from sharp market declines. It is basic human nature to enjoy watching one’s wealth rise. It is also basic human nature to dislike any declines in that wealth and in fact, studies have shown that people’s aversion to loss is twice as powerful, psychologically, as acquiring gains. Loss aversion is influenced by many factors including how much wealth one has. For most people, the answer to “How much wealth do I need to feel secure?” is “More than I have.” In order to increase wealth, risk must be accepted, but also managed. Losing money is easy to understand, and buying a bond that defaults is a good example. Buying a stock that goes down in value is not as clear. If sold, the money is lost; if held while it recovers, it is not lost. Volatility appears to be risk, but it is not true risk for an investor with an owner’s mentality. On the surface, timing the market appears to be an easy way to avoid the unpleasantness of negative volatility while trying to build wealth. In practice however, trying to consistently guess and profit from what other investors are thinking is very difficult. Emotion drives valuation and as we have seen many times during the past two decades, Mr. Market is highly unpredictable. In fact, if one missed the 10 best days in 2013, instead of earning a 32% return for the year, the market timer would have made only 13%. In our opinion, clients are far better off investing in companies and being patient while letting Mr. Market react to day-to-day news events. 

We believe that it is our job to help clients increase their wealth in order to maintain or enhance their standard of living. As readers of our past letters know, we are influenced by the historical record to gain a better understanding of what is possible and probable. Our 85 year Price Trend chart illustrates quite clearly how stocks have fared through wars, inflation, recession, recovery and even depression. While year-to-year and even decade-to-decade we can experience stagnation and declines, the long term trend has been up, and we have no reason to believe that this will change materially. Furthermore, our belief is that we have finally exited a 15 year market-resetting period and entered an era of more normal secular growth not unlike that experienced in the 1950’s and 1960’s. 

Since 2009, we have used our investment philosophy and process to help our clients stay focused on the long term, to not be overly influenced by all of the fear and negative news reports, and to continue to be heavily exposed to equities. At times some clients were probably nervously wondering if we were paying attention to current events, but they trusted us and stayed the course. Their wealth recovered from the 2009 bottom which allowed for a sigh of relief, and after very strong 2013 results, most have become true believers in being an owner rather than a trader who tries to determine if prices are too high or too low every time they look at their statements. But, with this recovery and strong performance, we are compelled to now discuss with clients normal concerns such as:

“I don’t want to lose any money,” “Should we sell now?” and “Do I have enough?” 

Our conversations with clients usually start with providing some context for the investing environment so that they can better understand the trade-offs. For those who are concerned with losing money, we first ask if “money” is in today’s dollars or in future dollars (purchasing power). If in today’s dollars, the answer is easy – buy short term US Treasuries. If it is purchasing power, the solution is more complicated and some type of risk must be accepted. Our view of the investment environment today is quite positive. In short, we believe that the US is in a very strong position relative to the rest of the world. We led the way into the 2008 melt down, and massive write-offs and bankruptcies were taken early. Europe followed while most of the Emerging Markets escaped major damage. The US is now growing, albeit slowly, while Europe remains mired in difficulties and the Emerging Markets are showing signs of considerable strain. The Fed has begun tapering its bond buying program with very little negative reaction by the markets. However, the Fed has also let it be known that it has no intention of taking any action that will jeopardize an economic recovery; thus, rates will remain low for some time. Under this scenario it is very unlikely that holding bonds will allow investors to maintain their future purchasing power. This reasoning leads us to continue to counsel clients to hold only the amount of money needed for near term cash needs and for a “sleep-well-at-night” cash reserve. The rest should be put to work. 

“Should we sell now?” is a fair question since last year’s 30%+ rise has finally pushed the market averages to new highs. To repeat: we are owners of businesses, not traders of stocks. Our fundamental research leads us to a calculated sell target which drives our purchase decision. Knowing when to sell makes it easy to buy. As an owner, we are focused on the ability of the company to pay its owners a dividend, which is really the only thing that any owner gets. Dividends, both current and future, are paid from earnings and cash flow, making growth in both of those very important components of the price of a stock. Strong prior year performance is not a valid reason to sell; exceeding or nearing our sell target is. When someone is willing to pay us a price that is too high relative to what we believe is reasonable, we automatically sell. In the meantime, stay the course and enjoy the ride, but just remember that you are on a roller coaster at times. Despite last year’s strong performance, we are still finding many companies trading at compelling values. 

Finally “Do I have enough?” is one of those questions with no answer until the very end. Few people have “enough” and thus most must invest in risk assets. It’s like the “It’s Not Complicated” AT&T commercials: Bigger is better, and more is usually the answer to “How much do I need?” Most people save and invest as an insurance policy for the unknown and unexpected events in the future. We strongly believe that in the current environment stocks are still the best way to build that nest egg.