INVESTMENT PHILOSOPHY

How I deploy capital

Buy Low, Sell High

I have long subscribed to the belief that financial markets are heavily driven by investor psychology. With each individual or entity having their own perception of economic circumstances, a variance between the prevailing market price of an asset and its fundamental worth might arise. This creates opportunities to deploy capital into assets which contain a high degree of intrinsic fundamental value but prove to be under-appreciated by the current market. If an asset is purchased during a time in which the broader market is selling, the lowest purchase price may be secured. Conversely, if an asset is sold during a period in which the broader market is buying, the highest sales price may be secured. A back-tested period of 85 years demonstrated that by employing contrarian investment philosophy for the purchase or disposition of securities, the optimal execution is attained.

Business Valuations & Liquidity

At its core, investing is the transfer of interest in a business or asset.

When I determine which business entities to acquire ownership interest in, the first step is a deep analysis of the fundamental value of the firm. Due diligence may be performed using several methodologies. My approach is aligned with the same methodologies employed by many of the prolific private equity firms on Wall St. This process begins with a bottoms-up look into the balance sheet, the earnings capabilities, the return on invested capital, the cashflows, and profitability potential, in tandem with the firm’s overall positioning and market share within the sector in relation to its competitors. This method of analysis is aimed at deducing the objective intrinsic value of a business to determine if the timing is optimal for investment.

Liquid (Public Equity)

Publicly traded equity securities, commonly referred to as stocks, are traded freely on the open market from the day they effectuate their initial public offering (IPO). The higher the volume of a given security, the more liquidity its holders enjoy. Securities with a high degree of liquidity generally demand a premium to be incorporated into the valuation. This is because the opportunity cost of a liquid investment is lower than that of an illiquid investment, thus reducing the risk that other opportunities are missed due to capital being ‘locked up’ within existing holdings. Prioritizing liquidity by paying a premium over the intrinsic value of a business creates the circumstance in which an investment is less lucrative, but more agile. Liquid capital allots the possibility to quickly adapt to prevailing market conditions during times when such pivots become advantageous.

Illiquid (Private Equity)

Privately transacted equity, commonly referred to as ‘private equity’ is the transfer of ownership of private business interests between two or more parties. Under most circumstances, the lack of a secondary market for the equity interest proves this type of investment to be illiquid. Private equity investments usually materialize liquidity in the form of an exit. An exit is the sale of the firm’s interests to either a competitor looking to acquire market share through acquisition, or another private party looking to take over ownership of the business. Because of this illiquid nature, private companies do not enjoy the same lofty valuations that publicly traded firms do. The valuation of this type of asset is usually done via a discounted cash flow analysis, which takes the cashflows of a business or asset and discounts them by the cost of capital. Another common method of valuation for private equity assets is the earnings multiple method whereby a firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA) is assigned a multiple based upon previous private equity transactions that have occurred in a comparable sector or field. This valuation method allows the purchasing party to minimize the price to earnings ratio (P/E multiple) of their investment by reducing the cost of acquisition. This happens because the transaction reflected little or no liquidity premium above the intrinsic value of the firm.

How I manage risk

Long term investors typically have one over-arching question.

What asset allocation has the highest probability of delivering positive returns over time through all economic environments?

I knew I couldn’t get to an answer through the traditional approach that depends on historical correlation and volatility assumptions. Correlations are unstable and unpredictable, as they tend to exhibit variances at the worst possible time. Similarly, asset risk is difficult to predict and when things get bad, risks tend to spike higher. Moreover, most measures of risk do not adequately reflect the potential for sustained adverse environments that can produce sustained poor returns. So to answer my question I returned to the first principles of asset pricing to find basic truths that I could rely on. I identified two timeless and universal truths about asset pricing, principles that form the foundation of my approach:

1. Asset classes outperform cash over time.

2. Asset prices discount future economic scenarios.

These are the primary determinants of asset pricing because they reflect the essential ingredients that investors require from an investment transaction. Regarding the first, when you make an investment you transfer liquidity from your pocket to someone else’s, and that transfer carries risk: giving up liquidity today creates the risk that you lose an opportunity to put that liquidity to work tomorrow. So an investment needs to offer you compensation (a risk premium) over and above what you could earn by keeping your money in cash. And by the same logic, the more risk you take, the more compensation you require. Regarding the second, the price of any asset reflects the discounted value of the asset’s expected future cash flows. These expected cash flows, as well as the discount rate, incorporate expectations about the future economic environment, such as the level of inflation, earnings growth, the probability of default, and so on. As the environment and expectations change, the pricing of assets will change. For example, if inflation rises, expectations of the value of money tomorrow change, and this change in conditions will be priced into the value of assets today. Given these two structural elements of pricing, the returns of any asset will have two main drivers: the accrual of and changes in the risk premium, and unanticipated shifts in the economic environment.

The goal of strategic asset allocation then becomes clearer: it is to collect the risk premium as consistently as possible, by minimizing risk due to unexpected changes in the economic environment. This framework also exposes why the traditional approach of relying on correlation and volatility assumptions to achieve this goal is flawed. For example, consider the correlation of stocks and bonds in light of the fact that they discount future economic conditions. Stocks give you a claim on future earnings, so they discount a future path of earnings growth and are worth more when earnings and the economy are stronger than expected. Bonds give you a fixed stream of payments and discount a forward path of interest rates for valuing those payments, so bonds do well when interest rates unexpectedly fall due to unforeseen economic weakness. In other words, these asset classes have opposite sensitivities to growth surprises. But they have the same sensitivity to inflation surprises. These relationships are summarized in the diagram below.

So if inflation were the only thing that mattered you would think that stocks and bonds would be positively correlated. But economic growth is also an important influence, and if economic growth were the only thing that mattered you would think that stocks and bonds would be negatively correlated. Given this, what will be the future correlation of stocks and bonds? You really can’t know without knowing the future economic environment, which is a problem if you are trying to build one portfolio that performs well in all environments. This approach recognizes that the only way to achieve reliable diversification is to balance a portfolio based on the relationships of assets to their environmental drivers, rather than based on correlation assumptions, which are just fleeting byproducts of these relationships.

To do this, we recognize that while asset classes offer a risk premium that is by and large the same once adjusting for risk, their inherent sensitivities to shifts in the economic environment are not the same. Therefore, you can structure a portfolio of risk-adjusted asset classes so that their environmental sensitivities reliably offset one another, leaving the risk premium as the dominant driver of returns. I explained the instability of the correlation between stocks and bonds in terms of their opposing biases to economic growth and their similar biases to inflation. Indeed, while asset prices incorporate expectations about a wide range of economic factors, growth and inflation are the most important. This is because the aggregate cash flows of an asset class and the rate at which they are discounted are determined largely by the volume of economic activity (growth) and the pricing of that activity (inflation). As a result, asset class returns will be largely determined by whether growth comes in higher or lower than discounted and whether inflation comes in higher or lower than discounted, and how discounted growth and inflation change. The relationships of asset performance to growth and inflation are reliable—indeed, timeless and universal—and knowable, rooted in the durations and sources of variability of the assets’ cash flows.

The aforementioned framework exploits these reliable relationships by holding similar risk exposure to assets that do well when (1) growth rises, (2) growth falls, (3) inflation rises, and (4) inflation falls (all relative to expectations), through four sub-allocations which are designed to capture these four risk exposures. I spread risk evenly across these four sub-allocations because I do not assume that the market has any systematic tendency to over- or under-discount future growth and inflation.

The result of this balance is that the underperformance of a given asset class relative to its risk premium in a particular environment (e.g., nominal bonds in higher than expected inflation) will automatically be offset by the outperformance of another asset class with an opposing sensitivity to that environment (e.g.,commodities), leaving the risk premium as the dominant source of returns, and producing a more stable overall portfolio return.

How I minimize cost of ownership

Many investors are not privy to the actual underlying cost of what they own. Throughout the previous decades, the ‘Average’ investment portfolio has been comprised largely of mutual funds. An investment vehicle that pools investor capital into a strategy that usually employs active management of the holdings within. For many Investment Advisors, this can prove to be an attractive ‘Auto-Pilot’ investment vehicle to employ within their client’s portfolios.

But at what cost?

Many investors might be surprised to learn that the total cost of ownership of a mutual fund proves far more expensive than the Expense Ratio, the formal percentage rate that the mutual fund manager publishes, might have you believe. Forbes recently released data surrounding the average annual cost of ownership of U.S. based mutual fund investment vehicles, and here are the results;

Average cost of ownership per-annum for domestic open end investment companies (Mutual Funds)

Depending on the size of the portfolio, an advisory fee ranging from 1.00% to 1.25% is typically added on top of this, creating an aggregate cost of ownership of between 5.37% and 5.62% per annum for most investors. As you can see, the average cost of owning a mutual fund can become quite expensive. This expense puts a continual drag on the performance of the portfolio, causing potential returns to be reduced by the net expenditures and leaving investors with less return for taking the same degree of risk.

How my portfolio construction differs

Although mutual funds are utilized sparingly ad hoc, I implement portfolio allocation methods that utilize predominately individual stocks and ETFs, which reduces the average cost of ownership and leaves my clients with a higher total return per unit of risk taken on.

How I mitigate tax liabilities

Tax-loss harvesting is the practice by which shares are sold from a security that has outperformed relative to the portfolio, in tandem with shares sold from a security that has underperformed. This strategy mitigates tax liability because the capital gains realized from one sale are offset by the capital losses realized from another.

How to get started

Discovery

Your process always begins with an in-depth discovery meeting where we will discuss not only your goals and objectives, but your vision for the future. A financial plan will be crafted from scratch using the information gathered to ensure that all of the unique variables within your financial picture are considered.

Proposal

Your next step is the presentation of your personal financial plan, alongside the portfolio recommendation to bring your plan to life.

Relationship Review

Your relationship-driven review process involves us meeting throughout the year;

1. To update your financial plan with any changes that might have occurred within your life or financial picture.

2. To review your portfolio allocation to adjust for any updates in your plan or to adapt to changing market conditions.

Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.