December 2007

Principles and Processes in Core's Portfolio Management

This memorandum describes investment activities of Core Asset Management Company and certain ideas that inform these investments. For many of our clients, Core manages substantially all of the family's investment capital. For this reason, our principal investment work is the determination of the allocation of clients' assets among the various investible asset classes. That is, Core decides what portion of a client's assets it will invest in US stocks, in US bonds, in foreign bonds, in foreign stocks, in real estate investments, in commodity-related investments, and in other investible asset classes. More narrowly within these broad asset classes, Core determines whether to focus on certain industries, for example, whether to concentrate equity investments in utilities, oil-related stocks, or other industries.

The investment goal. The understanding of one's investment goal or goals is the first step in determining how to invest one's capital. For those who have accumulated investment capital, the goal may be to preserve its purchasing power and to generate sufficient income to meet current and future expenses. For those building investment capital to provide for future needs, growth of capital may outweigh an interest in current income. One's capacity to add to investment capital in the future may determine the amount of risk to which one's present capital may be exposed.

At Core, we begin our work with a client by addressing these issues. Before considering how to invest a client's capital, we first reach an understanding about his or her investment needs and goals. It happens often that different portions of one's capital may have different intended uses--education and other support for children or grandchildren, charitable purposes, income for retirement, investment in new business activities, to name a few. In this situation, investment policy for one portion of a person's capital may be quite different than for another portion. After we consider these questions for a client, we form a plan to balance investment goals with investment risk.  

The asset allocation decision. Asset allocation determines one's investment success to a far greater degree than does security selection. That is to say, it is far more important how one allocates capital among the classes of investments--US stocks, foreign stocks, US bonds, etc.--than whether one invests in Coca Cola or Pepsico. To give an example: over the last century, the return from publicly-traded US stocks as a class has exceeded the return from bonds by an enormous degree. Thus, a completely ordinary portfolio of US common stocks earned a far greater return over these decades than the best portfolio of bonds.

The time horizon over which one measures one's investment success and returns is important in determining investment allocation. Although we might be confident that, over a period of fifty years, stocks will earn a better return than bonds, individuals cannot realistically take such a long view. However, it is not uncommon for people to save money for retirement and intend not to draw upon it for thirty years.

Because equities of various kinds achieve better returns over time than bonds, it is generally productive to have a greater weighting in equities than in bonds. There are exceptions. For portfolios in which capital preservation is paramount and investment risk must be kept very low, short-term and high-grade bonds are probably more suitable than equities. During periods when equities are very expensive and bonds quite cheap, it can be useful, both to lower risk and to increase returns, to own more bonds and fewer stocks.

Core's strategy is three fold: (1) to build portfolios with substantial equity orientation that take advantage of the long-term favorable performance of equities; (2) to diversify investments among several types of investment assets; and (3) to invest greater amounts in asset classes that appear to be rather inexpensive, while decreasing investments in riskier, higher-priced assets. A short survey about some large-scale global developments will provide a context for a discussion of how Core invests its clients' capital.

Some Global Events:   the Context

In the last decade, economic growth in China and other developing countries has reshaped investment markets and destabilized global political balances. Asian demand for oil, soybeans, timber--and every other kind of industrial and agricultural commodity--has transformed the markets for these goods. The ever-freer flow of goods and services and investment capital around the world has wrought unimagined changes. Hundreds of millions of eager, trained, ambitious, and low-paid workers have entered into the world's economy, shifting production of manufactured goods to Asia--and lowered the prices for these goods in the developed world. Living standards for workers in East Asia have risen, while those of blue-collar workers in the West have stagnated. American misadventures in Iraq have weakened American political influence and power. Although America's resilient and dynamic economy has grown vigorously in recent years, its growth has lagged that in East Asia. Investment markets have opened around the world and ever-greater investment flows have driven prices higher.

This very brief listing of some global developments is meant only to provide the context for a discussion about why it has made sense for investors to place ever more capital in non-US assets and foreign markets. How Core views various classes of investment assets is the subject of the next part of this memorandum.

Asset Classes in which Core Invests

Equities. US stocks have long been the biggest part of the world's stock markets and have been the central part of most American investors' portfolios. With the remarkable economic growth of China and India and other rapidly developing economies, the US portion of the world's economy has been shrinking. Today, about 35 percent of the world's equity market capitalization is represented by US stocks, down from 51 percent in 1995.   This trend will continue. Accordingly, it is sensible to invest less of one's capital in American stocks.

Rather than seeing the American stock market as the 'default' investment, it is better to analyze it in two ways: first, as one of a number of the world's equity markets in which we can invest, and second, as a market comprised of a number of industries of greater and lesser promise and risk. Core has invested successfully in the last several years in US industries that benefit from the unfolding global events. Substantial investments in utilities (electric and water) and in oil-related stocks for several years, and more recent alternative energy investments have provided very good gains while exposing our portfolios to a rather low level of risk.

International stocks have enjoyed the benefits of strong economic growth in China and other developing countries, accommodative monetary policies by major central banks, and the free flow of investment capital around the world. Central banks have provided liquidity for investments, markets have opened up around the world, and many foreign stock markets have taken actions to attract foreign investment capital. Against the backdrop of dynamic growth in China, East Asia, and India, these factors have given rise to excellent returns in many foreign stock markets.

The range of investment opportunities in stock markets outside the United States is appealingly broad. Western Europe offers well-developed and stable economies; its exporters, especially in Germany, are thriving. Japan is awakening from more than a decade of recessions, bouts of deflation, and a very poor stock market; it derives extraordinary benefits from its capacity to meet China's nearly insatiable import demand. East Asian and Latin American countries and their economies have rebounded from the painful period from 1997 to 1999. The stock markets of many of these countries have risen greatly in recent years and investment risk in some markets is certainly higher than a few years ago. Other important markets, especially Japan's, have only begun to recover from long-depressed levels. As a group, foreign stock markets will probably grow faster than America's in the coming years. They warrant attention from American investors and a healthy allocation of our investment capital.

Bonds appear to offer only modest returns. The Federal Reserve Board began raising short-term interest rates in 2004, then "paused" in June 2006. In August 2007, the Fed began easing in response to the US "sub-prime" crisis, which was largely driven by lax underwriting standards of US banks in a variety of credit instruments. Goods and material inflation, after being very low for an extended period, has risen; higher energy costs appear to have worked their way into the system. Long-term interest rates have remained low, reflecting concerted purchases of US treasury bonds by the oil exporters and Asian countries that generate huge trade surpluses with the United States.

Other important central banks, including Japan's, Europe's, and the Bank of England, were all engaged in tightening monetary policy, by raising interest rates or by restricting the growth in money supply or both, until the sub-prime crises roiled financial and credit markets around the world in the summer of 2007.   In response to the US credit problems and similar weakness in the credit markets in the United Kingdom, the Bank of England announced a guarantee of all deposits of a British bank and cut interest rates this month.   Although the European Central Bank has not cut interest rates, it has loosened monetary policy in other was to counteract the problems in credit markets.   Thus, the world's important central banks have recently shifted policies away from monetary tightness and toward accommodation.

Core has invested in money markets as a better alternative to bonds for a few years, because short- and long-term rates have been very similar.   Why, in such circumstances, should an investor take long-term interest rate risk when short-term investments have offered similar returns?   Now, long-term bond investments again yield more than money funds.   We still favor short-term fixed income investments, because of the uncertainties and risks in credit markets.   For now, short-term fixed income investments are still better than the riskier long-term bonds.  

In the last decade, a new and attractive type of bond has appeared. These are so-called inflation-adjusted bonds, whose principal repayment amount increases each year by the rate of inflation. Thus, the buyer of such a bond is guaranteed a "real" return, that is, the bond will be repaid in an amount equal to its inflation-adjusted cost. Inflation-adjusted bonds give assurance that inflation will not erode the principal value of the bond, a very attractive feature.

Foreign bonds offer a means of holding investments in currencies other than the US dollar. To hold a bond issued by France or Japan is to hold a security essentially as credit worthy as one issued by the United States. The difference is that the interest payments one receives are denominated in euros or yen and the principal repayment will also be in one of those. There are periods when the likelihood is high that the US dollar will depreciate against major foreign currencies. At those times, a portfolio of high-grade bonds denominated in foreign currencies is a low risk way to profit from that depreciation. Similarly, there are times when, apart from currency exchange matters, euro-area bonds, or Japanese bonds, or others are attractive. When these two factors coincide, as they did from 2002 to 2004, investment in foreign bonds is very profitable.

Since the beginning of 2006, the dollar has declined again in relation to foreign currencies, particularly the euro. At this writing, the US dollar is trading at its lowest levels in four decades in relation to major foreign currencies. Neither Japanese nor euro-area bonds are particularly undervalued. Just as US money market funds are more attractive now than US bonds, so foreign money market funds offer somewhat better value than foreign bonds, and provide the same hedge against dollar depreciation. Core holds foreign currency money market funds in most of its clients' portfolios.

Currencies. After a large decline from 2002 through 2004 in the value of the dollar against major foreign currencies, the dollar gained in value in 2005. In 2006, the dollar began to fall again in relation to other currencies, as discussed above. Because America's current account deficit (the measure of its trade, borrowings, and investments with the rest of the world) is still unsustainably large, it is likely that the dollar's value will fall even from its present levels. Because the Fed is taking aggressive actions to offset the problems in credit markets, the dollar has fallen quite sharply in recent months. These short-term actions and short-term interest rate differences among the major currency may change in coming months and the dollar's rapid slide may end soon. However, given the long-term term factors favoring faster economic growth in Asia than in the United States, it is sensible for investors to invest in currencies and markets outside the United States. Holding investments in currencies other than the dollar provides a very valuable hedge against the dollar's future decline.

Core does not invest directly in foreign currencies, but since 2002, Core's clients have had substantial investments in foreign stocks, bonds and money market funds. These have been very productive investments; we expect to continue to invest a large amount of our clients' capital in foreign securities. Through these investments, we expect to benefit both from dynamic growth outside the United States and from the decline in the dollar's value.

Commercial real estate investments represent ownership of real property. Publicly-traded, pooled investments vehicles called Real Estate Investment Trusts ("REITs") trade on the New York Stock Exchange. These offer the liquidity of common stocks and an ownership interest in broad pools of commercial real estate properties. Historically, REITs have been characterized by high dividends--because they are required by tax rules to pay as dividends essentially all their earnings--but since the beginning of 2003, REITs have rallied to extremely high prices. As a result of extraordinary inflows of capital to the real estate sector, REITs no longer offer high dividends or attractive valuations. Because REIT prices are so high, Core's investments in this sector are quite small. During 2007, REIT prices have begun to fall; the commercial real estate market is very exposed to the problems in the credit markets as a whole.   We will welcome further declines in REIT prices; we will readily invest in REITs at attractive prices.    

Commodity investments. From early in 2004 until the summer of 2007, Core's clients held investments in a broad range of physical commodities though exchange-traded funds and a mutual fund. There has been growing demand for commodities from China and elsewhere in Asia. At the same time, there are significant constraints to the extraction, production, refining and transport of these commodities. While these conditions prevail, commodities present an attractive investment opportunity. The economic demand factors that make energy stocks attractive at present also support prices of other physical commodities. In the summer of 2007, Core sold some commodity investments and invested proceeds in the equities of commodity-related industries.   By our analysis, the companies involved in the oil and mining businesses offered better values than the markets for the physical commodities.

Water and alternative energy investments. In the last two years, Core has begun investing in water-related industries and alternative, non-oil energy industries. There is no substitute for water.   As populations increase and economies grow, the demand for water rises at greater rate.   Sadly, of course, economic growth is often accompanied by degradation of existing supplies of fresh water, in effect lowering supply as demand grows. Water-related industries, including utilities, filtration and pumping systems, desalinization and others find ever-greater demand for their products and services. The long-term investment prospects for water are very favorable. Mutatis mutandis, the same analysis applies to alternative energy. We expect to continue to make investments in water and green energy and we expect to reap the rewards of these investments in the decade ahead.

Portfolio Management Practices

Given the broad--and ever broadening--palette of investible asset classes, how does Core build its portfolios? Three ideas inform our practices: diversification, emphasis on cheap assets with good prospects, and a long-term view.

Diversification. We diversify our portfolios broadly in a wide range of investment assets, both to avoid concentration in risky investments and to seek opportunities. A rigorous practice of diversifying portfolio investments lowers risk and increases the likelihood of relatively stable and positive returns. Portfolios concentrated in narrow investments are those most at risk. Vivid illustration of this was provided by the boom in technology investments in the late nineties and the crushing bear market in these investments in the first years of this decade. The very success of tech investments through the nineties attracted ever more capital; many investors came to have portfolios concentrated in investments that had become very high priced and very risky. Because of the huge losses in a narrow class of investments, many investors lost three quarters of the value of their investment capital in a short time.

However, just as technology stocks were on the point of collapsing, several other asset classes were on the point of dramatic and long-term advances. For example, investments in REITs and bonds had produced very modest returns in the late nineties, particularly when compared to the headline-grabbing returns enjoyed by tech investments. Bonds rallied very strongly through 2004; REITs produced wonderful returns from 2002 to the end of 2006. Diversified portfolios avoided significant loss during the bear market of 2000 to 2002 and earned useful returns from the very investments that had seemed so unattractive while technology stocks flourished.

Undervalued assets. The long cycles by which different asset classes fall into and out of favor are an enduring characteristic of the investment markets. Hence, investors can benefit from understanding whether a given investment is expensive and risky, and from recognizing out-of-favor assets with low risk and good prospects. We seek to understand valuations and to direct our clients' capital toward the cheaper investments and away from those that have become overvalued and risky.

An illustration: We came to recognize in 2003 that economic growth in Asia and America would cause demand for commodities, notably but not only oil, to grow at rates that would surpass the growth in capacity to extract, refine, and deliver oil and other commodities. Hence, we considered oil and commodity investments to have low risk and very good prospects for growth. We began to build positions in commodities and energy stocks in the beginning of 2004 and have enjoyed the growth in those assets since then.

A long view. A third feature of our portfolio management practice is to invest for the long term. Much of the capital entrusted to us is taxable. For that reason alone, it behooves us to make investments that we expect to hold for more than a year. We are not merely concerned with the favorable tax treatment accorded to long-term capital gains. We realize that the broad trends--economic, monetary and political-- unfold over a period of years. We seek to align our investments with these broad developments. Although our portfolios go through modest changes during the course of any given year, and although we stand ready to react to significant new developments, we hold most of our investments for periods of a few years. When we make a new investment, we generally expect that it will earn good returns over a period of several years.

Jack Mayberry

John Forlines III