2014 – 3rd Quarter Letter – Liquidity & Volatility
October 22, 2014
I can’t remember the exact date but it had to be in the late 1980s. I was working at Dean Witter and attending a company-sponsored cocktail party in New York City with a number of other producers from around the nation. The company liked to call us producers because they thought of us as people who produced commissions. Michael Milken’s junk bond reign of terror was in full swing and Wall Street’s financial predators were buying out overcapitalized companies right and left. The intent was to pay for the companies with their own money by leveraging the balance sheet. Most of the debt that was generated was high-yield (think junk) and the proceeds of the bonds issued was used to buy back company stock (owned by the corporate raiders). Once a target company was identified, the denizens of Wall Street would bid the price of the stock up in anticipation of still higher prices.
The guys at the cocktail parties were small fish, not corporate raiders. It was their lifelong ambition to own the shares of a buyout target one day before the raider’s announcement and be able to sell that stock one day later for a profit. They thought in pretty small patterns. Witter had just hired a team of brokers from the Salt Lake City branch of E.F. Hutton, a firm where the inmates ran the asylum. These guys would do anything for a buck and were encouraged to mingle with the established Witterites and extoll the resources that attracted them to our staid and dry firm (without revealing their signing bonuses which they probably thought would be increased).
I became a reluctant participant in a conversation dominated by a slick dressed piranha that bragged about all the buyout stock he had flipped since arriving at Dean Witter. His audience was gullible by design and easily impressed by the full-fare commissions the piranha charged when the money was re-invested (think producer). I wandered off scratching my head about things like liquidity, short-term vs long-term capital gains, dividend growth, and commission rates.
The need for liquidity…
I brought this story home to Dan and he shared my disapproval. We were bond guys with institutional backgrounds and thought in entirely different patterns than the refugees from Hutton. We understood the need to diversify portfolios by asset class, industry, duration, and capital structure. We also knew then what we still know now…..long-term is the only term.
First of all, let’s define liquidity. It’s the ability to convert an asset to cash quickly, without significantly affecting the asset’s price. Liquid assets are characterized by a high level of trading activity, narrow spreads, and short settlement periods. It is very easy for the owner of a liquid portfolio to be fully invested. Emergencies as well as indulgence can be easily provided for without interrupting the task at hand.
So short-term gains are taxed at ordinary rates, historically twice the rate of long-term capital gains. Flash back to the braggadocious Huttons and consider how difficult picking multiple stock home runs is. We’re talking about trades which generate 50% + returns within a calendar year…very hard to do. And, in order to do it a manager would have to maintain a significant cash or opportunity position. This would be a very tough job for any portfolio manager. On the other hand, building a portfolio that will hold multiple 50% winners over a 3-5 year period is fairly doable. Still not an easy job, but a reasonable outcome if staged on a large playing field. When either of these strategies fulfills, liquidity increases. Opportunistic, Illiquid portfolios are parasitic by nature, they require the owner to hold large cash positions.
Every Picture Tells a Story….
Let’s use our most popular asset allocation: 75% stocks/25% bonds:
The take away here is pretty simple. Have as much of your money working at maximum rates as possible. Do it over the long term. A $1 million portfolio invested like portfolio A would underperform portfolio B by $5,400 per year or $27,000 over 5 years. We prefer plan B.
Those of you familiar with Modern Portfolio Theory know that the stock/bond asset allocation producing the lowest risk/return ratio is roughly 30/70. It is not 100% fixed income because bonds are subject to a variety of risks not described by the price action of equities. Since equities significantly outperform bonds over time, it is very fair to assume that they should be able to shoulder some of a portfolio’s liquidity requirements as well.
It is common for financial pundits to recommend bond investments to satisfy known liquidity requirements at future date. Bonds have a maturity certain and a promise to pay; stocks don’t possess those qualities. However, equities have a pleasant habit of growing over time. The longer the comparison period, the more certain their success. Given this phenomena, it is our opinion that risk tolerant, successful equity investors can wean themselves from high fixed income allocations without sacrificing liquidity. In today’s market that means shifting from 3% assets to 10% assets. Remember, liquidity is the ability to convert assets to cash quickly without incurring a significant cost…gains are acceptable.
When our clients need cash it is almost always for a higher calling: taxes, gifts, home improvement, philanthropy, or check marks on the bucket list. In any case the decision to trade investment assets for use assets has usually been made before they call P&A. We are okay with any of these decisions. Once a request for liquidity is made, we review the portfolio and determine the best assets to sell. We never know if they will be equities, fixed income, or alternative assets. We make those decisions based on asset allocation, tax consequences, and market conditions. Liquidity does not have to come from traditional sources; it pays to be flexible. As John Maynard Keynes once said, “When the facts change, I change my mind.”
Ask yourself these questions: “What are my chances or anyone else’s becoming terminally infected with Ebola or beheaded by Islamic terrorists?” “Are these two risks actually greater today than they were a year ago?” “Would either of these events be considered avoidable?” The odds of just one of these events coming to pass is low. The chances of both coming to pass would rival being struck by lightning, mauled by a polar bear, and mauled by a regular bear all in one day. It pays to be vigilant, but this too shall pass.
The market has shrugged off a lot of bad news in the last five years. I expected the averages to drop precipitously several times. Interestingly enough, October is a magnet for negative price activity. However, students of cashology know that more bull markets have started in October than any other month. If you have investable dollars this would be a good time to add them to your account. Don’t be concerned if you added to your account June through September. Your faith will be rewarded and the market will continue to go higher.
We continue to “Like” the market. A deeper correction would cause us to “Really Like” the market and a deep drop would initiate a new “Love” affair. We don’t see the last two on the horizon. Fixed income assets do not compete with equities at all. There is enough money on the sidelines to prevent the market from making a 10% correction off its highs.
James S. Pittenger, Jr,