As our country continue to recover from the greatest financial crisis since the Great Depression, our strategy remains focused on creating long-term value and income for client portfolios. Investments like Wal-Mart, Procter & Gamble, Merck, Johnson & Johnson, Abbott Labs, Microsoft and Sysco should deliver excellent long-term value and dividend income. Not only are these companies great businesses with sustainable competitive advantage, they deliver consistent income in the form of quarterly dividends. Unlike bonds, where the income payments are typically fixed, they have the potential to raise their dividends over time as businesses grow with the global economy.
Protecting the Brand
While such companies are of high quality, they continue to face challenges, some of which fall into the "self-inflicted" category. If there were a contest for "Excellent Companies Suffering from Bad Management", first prize would go to Johnson & Johnson with over 50 product recalls within the last 16 months. I attribute recalls to management abandoning the company's credo of putting customers' interests first. You will probably never hear a CEO say, "We've decided to cut quality control in favor of short-term profits", but that's exactly what Johnson & Johnson did without saying it. (If you ever hear such a statement, my advice would be to sell immediately!) Johnson & Johnson's management has given the 125-year-old brand several cuts and bruises but the financial impact of product recalls has been moderate. I do expect a full recovery as management quickly return to the once forgotten credo:
"We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services..."
Our second prize would go to Wal-Mart, which decided to pursue a "New" Coke strategy by abandoning a perfectly good formula of always low prices in favor of a perfectly bad formula of sales promotions and price gimmicks. Wal-Mart's management bruised the brand by causing customers to question their value as the trusted, low cost provider of retail goods. Fortunately, management has quickly come to their senses and is returning to their old formula, similar to what Coke did in 1985. Wal-Mart's customers should once again find "Classic" Wal-Mart very refreshing.
Recent troubles at Johnson & Johnson and Wal-Mart show the fragility of a company's brand and how management itself can damage it by pursuing short-term earnings growth rather than long-term shareholder value. Every business has this management risk. One of the best ways to mitigate such risks is to start first with high quality businesses, as they are more likely to survive periods of bad management. Regarding our third prize winner, I hope this prize goes unclaimed.
Inflation
Rising oil prices, continued unrest in the Middle East and increasing government spending are all considered inflationary risk factors. To better understand inflation and its potential impact on investments, I suggest we first break the term inflation into two time horizons: short-term inflation and long-term inflation. Short-term inflation is mainly influenced by short-term changes in the economy such as daily changes in labor supply, commodity prices, consumer behavior, etc. These changes are reflected in the daily movement of markets such as the prices you pay each week for groceries. Unlike short-term inflation which is primarily market driven, long-term inflation is ultimately determined by the actions of our government. These actions are given the fancy term monetary policy.
As investors, our primary concern should not be short-term inflation, which is temporary and unpredictable, but rather the wealth destroying effects of long-term inflation which is predictably permanent. Consider how the purchasing power of the dollar has declined more than 97% over the last 100 years. What has been the root cause? The answer is not short-term changes in labor or commodity supplies, but the government's monetary policy of continuously printing money.
Prepare Rather than Predict
Just like the short-term movements in the stock market, there are simply too many factors to predict short-term inflation. Many of these factors may cause or not cause short-term inflation. For example, while rising commodity prices are considered inflationary, consumers may be unwilling or unable to pay higher prices. In addition, if an abundance of labor keeps wages down, the cost of rising commodity prices could be offset by lower labor costs. Commodity prices, labor supply and consumer behavior are just three of the many factors that determine short-term inflation. Correctly predicting even three factors and in the right sequence is like pulling the lever on a slot machine with the hopes of getting three of a kind. While we want three of a kind, we are more likely to get a cherry, a strawberry and a lemon. So whether or not we know the root causes of short-term inflation, predicting the timing and severity is most likely impossible, which is just like playing a slot machine, but with even poorer odds.
As an aside, the slot machine analogy is not limited to just inflation. This analogy can also be applied to attempts to predict short-term changes in marketsincluding the stock, bond, real estate and commodity markets. Just like the slot machine, the odds are against us when it comes to making short-term financial predictions.
I do not believe economists, bankers, brokers, investment advisors (present company included) or the media will ever know how to predict the severity or timing of inflation. As long-term investors, we can only prepare for high inflation just like those who live on the coast should build their homes to withstand hurricanes without knowing when the next one will hit. If, unfortunately, our economy gets hit by a big storm of inflation, portfolios strengthened to withstand the storm should suffer far less damage than the weaker ones. So what can we do to prepare for the next storm? A tax-efficient investment strategy that focuses on high quality businesses with the ability to quickly raise their prices with inflation is one of the best ways to protect and grow your wealth over time. In addition, investing in companies and industries with an increasing amount of earnings in other currencies can also help reduce the effects of inflation.
Exchange Traded Funds versus Individual Stocks
Exchange traded funds (ETFs) are a relatively new invention in the financial world. They can be used to build a foundation of diversification for your portfolio while providing long-term growth and income opportunities. ETFs like the Vanguard Financial Index and Vanguard Consumer Staples Index provide a very low cost way to diversify across a number of companies within specific sectors of the economy. Like individual stocks, they are also transparent and tax-efficient if used properly.
ETFs at times will do much better than some of the individual stocks that make up their portfolios. But similarly, individual stocks will at times deliver much better results than ETFs investing in the same sector. In addition, individual stocks can offer higher dividend payments compared to ETFs in their sectors. The key benefits with ETFs are diversification and less risk, while the key benefits of individual stocks are often more income and growth potential but with higher risks. If we think of ETFs and stocks as tools in a toolbox, there is no perfect tool for every job. As a result, I suggest we continue to use both tools, as the nature of the job will change over time due to changes in the markets, the economy, your personal financial goals and your comfort level with investing.
Fixed Income
For your fixed income investments, focusing on short-term bonds should continue to give your portfolio income with much lower risks than long-term bonds. A scenario of higher interest rates caused by high inflation could greatly reduce the value of long-term bonds. As a result, I recommend we favor short-term bonds due to their lower risks. In addition, I recommend that your fixed income investments be highly diversified across a number of different bond issues and types to mitigate the risks of an individual bond defaulting.
Our Economic Future
The global economy will continue to become increasingly competitive with each country competing for more resources, including the most precious resource of all, human talent. Our human talent is like a star athlete competing in a marathon with the rest of the world. Unfortunately, we have chosen to weigh our marathon runner down with a heavy backpack of government debt, consumer debt, increased government regulations, high taxation, poorly constructed immigration policies and ever increasing healthcare and military spending. While the path ahead is a long and arduous one for our star athlete, I am confident we will lighten our runner's load.
As a country, we have a number of choices to help our star athlete including saving more, reducing debts, more efficient and competitive tax codes in the global market, reducing military spending in favor of education and infrastructure investments and implementing immigration policies that favor highly skilled jobs over low skilled ones. I believe that increased global competition will necessitate and ultimately dictate many of the hard choices. This is not to say we will make the right choice quickly, but eventually we will do what is necessary to remain prosperous. To quote Winston Churchill, "The Americans will always do the right thing, after they have exhausted all the other possibilities."
In summary, we have plenty of opportunities to give our star athlete a winning chance. Given these opportunities and our country's incredible ability to harness the creative energy of our people, I believe our best days are ahead of us.
Protecting the Brand
While such companies are of high quality, they continue to face challenges, some of which fall into the "self-inflicted" category. If there were a contest for "Excellent Companies Suffering from Bad Management", first prize would go to Johnson & Johnson with over 50 product recalls within the last 16 months. I attribute recalls to management abandoning the company's credo of putting customers' interests first. You will probably never hear a CEO say, "We've decided to cut quality control in favor of short-term profits", but that's exactly what Johnson & Johnson did without saying it. (If you ever hear such a statement, my advice would be to sell immediately!) Johnson & Johnson's management has given the 125-year-old brand several cuts and bruises but the financial impact of product recalls has been moderate. I do expect a full recovery as management quickly return to the once forgotten credo:
"We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services..."
Our second prize would go to Wal-Mart, which decided to pursue a "New" Coke strategy by abandoning a perfectly good formula of always low prices in favor of a perfectly bad formula of sales promotions and price gimmicks. Wal-Mart's management bruised the brand by causing customers to question their value as the trusted, low cost provider of retail goods. Fortunately, management has quickly come to their senses and is returning to their old formula, similar to what Coke did in 1985. Wal-Mart's customers should once again find "Classic" Wal-Mart very refreshing.
Recent troubles at Johnson & Johnson and Wal-Mart show the fragility of a company's brand and how management itself can damage it by pursuing short-term earnings growth rather than long-term shareholder value. Every business has this management risk. One of the best ways to mitigate such risks is to start first with high quality businesses, as they are more likely to survive periods of bad management. Regarding our third prize winner, I hope this prize goes unclaimed.
Inflation
Rising oil prices, continued unrest in the Middle East and increasing government spending are all considered inflationary risk factors. To better understand inflation and its potential impact on investments, I suggest we first break the term inflation into two time horizons: short-term inflation and long-term inflation. Short-term inflation is mainly influenced by short-term changes in the economy such as daily changes in labor supply, commodity prices, consumer behavior, etc. These changes are reflected in the daily movement of markets such as the prices you pay each week for groceries. Unlike short-term inflation which is primarily market driven, long-term inflation is ultimately determined by the actions of our government. These actions are given the fancy term monetary policy.
As investors, our primary concern should not be short-term inflation, which is temporary and unpredictable, but rather the wealth destroying effects of long-term inflation which is predictably permanent. Consider how the purchasing power of the dollar has declined more than 97% over the last 100 years. What has been the root cause? The answer is not short-term changes in labor or commodity supplies, but the government's monetary policy of continuously printing money.
Prepare Rather than Predict
Just like the short-term movements in the stock market, there are simply too many factors to predict short-term inflation. Many of these factors may cause or not cause short-term inflation. For example, while rising commodity prices are considered inflationary, consumers may be unwilling or unable to pay higher prices. In addition, if an abundance of labor keeps wages down, the cost of rising commodity prices could be offset by lower labor costs. Commodity prices, labor supply and consumer behavior are just three of the many factors that determine short-term inflation. Correctly predicting even three factors and in the right sequence is like pulling the lever on a slot machine with the hopes of getting three of a kind. While we want three of a kind, we are more likely to get a cherry, a strawberry and a lemon. So whether or not we know the root causes of short-term inflation, predicting the timing and severity is most likely impossible, which is just like playing a slot machine, but with even poorer odds.
As an aside, the slot machine analogy is not limited to just inflation. This analogy can also be applied to attempts to predict short-term changes in marketsincluding the stock, bond, real estate and commodity markets. Just like the slot machine, the odds are against us when it comes to making short-term financial predictions.
I do not believe economists, bankers, brokers, investment advisors (present company included) or the media will ever know how to predict the severity or timing of inflation. As long-term investors, we can only prepare for high inflation just like those who live on the coast should build their homes to withstand hurricanes without knowing when the next one will hit. If, unfortunately, our economy gets hit by a big storm of inflation, portfolios strengthened to withstand the storm should suffer far less damage than the weaker ones. So what can we do to prepare for the next storm? A tax-efficient investment strategy that focuses on high quality businesses with the ability to quickly raise their prices with inflation is one of the best ways to protect and grow your wealth over time. In addition, investing in companies and industries with an increasing amount of earnings in other currencies can also help reduce the effects of inflation.
Exchange Traded Funds versus Individual Stocks
Exchange traded funds (ETFs) are a relatively new invention in the financial world. They can be used to build a foundation of diversification for your portfolio while providing long-term growth and income opportunities. ETFs like the Vanguard Financial Index and Vanguard Consumer Staples Index provide a very low cost way to diversify across a number of companies within specific sectors of the economy. Like individual stocks, they are also transparent and tax-efficient if used properly.
ETFs at times will do much better than some of the individual stocks that make up their portfolios. But similarly, individual stocks will at times deliver much better results than ETFs investing in the same sector. In addition, individual stocks can offer higher dividend payments compared to ETFs in their sectors. The key benefits with ETFs are diversification and less risk, while the key benefits of individual stocks are often more income and growth potential but with higher risks. If we think of ETFs and stocks as tools in a toolbox, there is no perfect tool for every job. As a result, I suggest we continue to use both tools, as the nature of the job will change over time due to changes in the markets, the economy, your personal financial goals and your comfort level with investing.
Fixed Income
For your fixed income investments, focusing on short-term bonds should continue to give your portfolio income with much lower risks than long-term bonds. A scenario of higher interest rates caused by high inflation could greatly reduce the value of long-term bonds. As a result, I recommend we favor short-term bonds due to their lower risks. In addition, I recommend that your fixed income investments be highly diversified across a number of different bond issues and types to mitigate the risks of an individual bond defaulting.
Our Economic Future
The global economy will continue to become increasingly competitive with each country competing for more resources, including the most precious resource of all, human talent. Our human talent is like a star athlete competing in a marathon with the rest of the world. Unfortunately, we have chosen to weigh our marathon runner down with a heavy backpack of government debt, consumer debt, increased government regulations, high taxation, poorly constructed immigration policies and ever increasing healthcare and military spending. While the path ahead is a long and arduous one for our star athlete, I am confident we will lighten our runner's load.
As a country, we have a number of choices to help our star athlete including saving more, reducing debts, more efficient and competitive tax codes in the global market, reducing military spending in favor of education and infrastructure investments and implementing immigration policies that favor highly skilled jobs over low skilled ones. I believe that increased global competition will necessitate and ultimately dictate many of the hard choices. This is not to say we will make the right choice quickly, but eventually we will do what is necessary to remain prosperous. To quote Winston Churchill, "The Americans will always do the right thing, after they have exhausted all the other possibilities."
In summary, we have plenty of opportunities to give our star athlete a winning chance. Given these opportunities and our country's incredible ability to harness the creative energy of our people, I believe our best days are ahead of us.
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