More Fed Fear

A client of TFCM recently brought to our attention this article by Anthony Mirhaydari, published in The Fiscal Times,  which queries if the U.S. Federal Reserve (the Fed) is about to begin a "war on the rich".  In it, Mr. Mirhaydari enlists the commentary of Merrill Lynch Chief Investment Strategist, Michael Hartnett, who appears to suggest that such is the case in his call for a "big top" in stocks sometime this autumn.  The article further suggests Hartnett advises investors to "...Get back into big cap tech stocks for one final push higher, but prepare for the looming downside in stocks and upside in long term yields by reducing exposure to credit, buying volatility, and avoid emerging market debt and high yield."

At TFCM, ​we couldn't disagree with this line of thinking more vehemently!

Not that a correction in stocks may happen, it surely may.  And suggesting it may happen in the autumn is no surprise given that autumn tends to be the weak part of the year, historically.  But it is with the "trading" mentality, and most significantly, the view regarding the Fed's influence that we take issue.

This view of the world, that the Fed is thoroughly responsible for what happens in the economy is nonsense, in our opinion! These ideas are what contribute to volatility and poor economic performance, quite the contrary to what the author suggests.

The Fed was not responsible for the move in stocks.  It was not TARP, QE, or anything government related.  These policies have only served to act as a weight on growth.  Instead, it is corporate earnings, driven by the business community's relentless ability to "get by in spite." that has driven markets higher and kept the economy growing, albeit very slowly.  

Our view is that the Fed is behind the curve on tightening!  They should have been tightening much sooner and that includes shrinking their balance sheet.  The expansion of the balance sheet at the Fed (QE) has done nothing to help the market/economy in that those money's have sat idle on reserve at the Fed, paying banks interest instead of incentivizing them to lend.  

QE was put into action in October 2008, in the midst of the "financial crisis".  After the November 2008 election, the market proceeded to drop another 30%.  It was not until March 9, 2009 that the market bottomed, consistent with the timing of Congress putting a stop to the insane mark-to-market accounting rule that relegated banks illiquid (and perceived insolvent).  QE has been a drag and will continue to be so until it is extinguished completely.

That said, looked at in the context of the 21st Century (17 years now), the market is not at all extended. It took years for the S&P 500 to cross back over the top it made in 2000.  And even more years for the NASDAQ to do the same.  People with the view of the world described in this article seem to have this uncanny ability to think the world began March 9, 2009, the very bottom of the bear market.  This is also nonsense.  The series of "crises" that began with the blow up (and tech/telecom meltdown that followed), the 9/11/2001 attack, and the mortgage and credit crisis (a self-inflicted wound due to mark-to-market), confounded by horrific policies from two presidential administrations from both political parties, has served to stultify the economy, create a "perma-crisis" mentality, and generally keep a lid on growth.

If the current government is successful in reforming the tax code (simpler, with lower/flatter rates), and continues to ease the excessive burden of government regulations on businesses large and small (most notably small), then the pace of growth will pick up and the Fed's move to "lessen" their impact by eliminating QE and keeping rates at a level commensurate with the new, higher rate of economic growth, will be further stimulative.  

The main worry, in our view, is the Fed underwhelming with its attempt to get out of crisis mode.  We shall see how this plays out, but should they even remotely be successful with this move, then many of the themes in our portfolio, which we believe have been held back by the policies of the last 15-20 years, will be unleashed in a much bigger way and be reflected in considerably higher prices.  If not, and the old ways continue to dominate, then we will "get by in spite".

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What About Productivity?

For years we have been arguing that the "heavy hand" of government, with all its best intentions, has served to stultify economic growth.  This comes in the form of tax rates that are too high and an overly complex tax code, both on corporations (which we would argue should pay no taxes) and individuals, as well as burdensome regulations that serve to limit the ability of businesses to grow.

There has been much talk about why productivity has been so slow in the last decade or so and we think these factors have had a direct impact on that phenomenon.  This has served to create an environment of extreme angst amongst the citizenry and has manifested itself in one of the most vitriolic political environments ever.  While we would argue some of the slower productivity growth is due to poor methods of measurement that don't accurately take into account the impact of technologies such as the smart phone, there is definitely a drag happening and the culprit is clear.

But how do we prove this?

Economists Michael Mandel and Bret Swanson, in their co-authored essay "The Coming Productivity Boom: Transforming The Physical Economy With Information", have hit the nail on the head and have backed up their claims with hard data that explains how we got to the point we are at and how to remedy the problem.

One of the key statements in the piece, from our perspective, and one that explains why lack of productivity growth is troubling, as well as why the tone of the nation is so sour:

     "...if we get stuck in a world of slow productivity growth, we face some tough choices.  With a fixed or slow-growing economic pie, the only way to make one group better off is to make another group worse off.  Politics turns mean and nasty."

Mandel and Swanson point out that traditional "physical industries" (healthcare, manufacturing, energy, transportation, education, agriculture, retail, urban travel services), which make up 75% of private-sector employment and 75% of private-sector GDP, have made up only 30% of investment in information technology.  Meanwhile, the "digital industries" which make up 25% of employment and only 30% of GDP have made up 70% of investment in information technology.  Mandel and Swanson call this "The Information Gap" and suggest the culprit is -- as we have stated for years -- too much taxation and regulation!

The most heavily regulated industries are those defined as "physical." It is not coincidental that the effects of slower productivity growth have been felt the most in those spaces, as the data suggests in Mandel and Swanson's piece.

Michael and Bret make the case that this is all about to change as the physical industries are "freed up" to spend more heavily on the necessary information technology that will allow them to "catch up" in the productivity growth race.  Their piece is crucial reading for those that want to be adequately informed about the issues that drive economic growth, or, conversely, keep the economy weak.

We believe we are well-positioned to benefit as physical industries make this adjustment!

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Meet your new robot asset manager

Yesterday afternoon, the Wall Street Journal, New York Times, and other outlets reported that Black Rock, the world's largest investment fund management company with $5.1 trillion in assets under management, is radically revising its equity management offerings by announcing what the Times calls "an ambitious plan to consolidate a large number of actively managed mutual funds with peers that rely more on algorithms and models to pick stocks."

The move is being heralded as a sign of things to come in the world of asset management. Only a small percentage of assets managed at Black Rock were actively managed before the move -- about $201 billion at present, according to the Times story -- due to the firm's focus on so-called passive strategies, including ETFs (Black Rock owns iShares, acquired from Barclay's) and index funds. Now, the firm is reducing its emphasis on active management still further, firing several active portfolio managers and supporting staff, and instead emphasizing a lineup of "quant" funds, which rely more on computer models and algorithms. The news headlines are calling this move "Machines Rising over Managers to Pick Stocks" and "Relying more on robots rather than humans."

Reading further into the company's reasoning reveals that the firm's equity asset managers had underperformed index funds in recent years, that the shift to algorithms rather than managers allows lower management fees, and that leadership believes new technologies such as "big data or even artificial intelligence" are making human-based investing less relevant. The executive in charge of the change says, "The old way of people sitting in a room picking stocks, thinking they are smarter than the next guy -- that does not work anymore." 

The Journal article does note, however, that Black Rock will retain some actively managed offerings, including "country- and sector-focused stock products in which executives believe they can outperform, funds that pursue specific outcomes such as social impacts, and riskier funds that make more concentrated bets" but that "The changes weed out actively managed stock funds that closely follow indexes."

As active managers ourselves, we approve of these changes at Black Rock, and do not see them as the "end of active management" due to the "superiority of the robots" (or the quants) at all. In fact, we believe that the largest mutual fund company in the world has just publicly acknowledged the drawbacks of huge funds that are forced by their size to "closely follow indexes" and has made a rational decision to focus on other strategies -- including those that make "more concentrated" investments (which is a strategy that we ourselves favor, and one we have used to outperform indexes over long periods of time). 

In fact, we noted almost two years ago that the Black Rock CEO had inadvertently admitted what we believe to be one of the central problems of index and ETF investing -- the fact that they are forced to own everything, good and bad -- during an interview alongside Carl Icahn that turned into a fairly exciting debate. The same criticism can be applied to "actively managed stock funds that closely follow indexes." 

That said, we personally do not favor quant strategies, for reasons we have detailed in previous posts (including one from 2010 discussing a story touting "AI that picks stocks better than the pros"). We believe that the single most important factor of successful investing involves having a consistent investment philosophy which informs your selection of companies whose stock you will own. This is the opposite of what algorithm-based strategies usually do -- because those algorithms are frequently changed to try to capture "what's working now." And, on a larger scale, Black Rock's shift towards more emphasis on quant strategies (in addition to their existing emphasis on ETFs and indexes) can also be seen as a shift towards "what's working now." 

Of course, if their strategy is flawed, then they should change their strategy. However, we advise investors to be very careful when selecting these new strategies, if those strategies themselves are not grounded in a consistent investment discipline. Otherwise, in a few years, they might find themselves being told that now it's time to shift into the new "next best thing."


Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon Capital Management LLC.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon Capital Management LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon Capital Management LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request. Please Note: Taylor Frigon Capital Management LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Taylor Frigon Capital Management LLC’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
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Investment Climate Jan 2017 - Favorable Winds of Change

The markets reacted to the surprising results of the U.S. Presidential election with a resounding vote of confidence and have raced on to new highs recently.  Once again, conventional wisdom was turned on its head as virtually nobody saw this coming.  What was equally remarkable was that those market pundits who chimed in with a prediction on what would happen in the event of a win by Donald J. Trump virtually were unanimous in their view that the market would surely collapse if Trump were to win.  Oops!

We had no idea who would win the election, or what the market would do in the aftermath regardless of the results. Yet, it really does not surprise us that the market has reacted well, especially in light of the policy issues that Trump has espoused, most notable of which is a reduction in tax rates and simplification of the tax code, as well as a reduction in the level of regulation that has held back businesses for so long.

It was just in our last Investment Climate where we pointed out, yet again, how big government has held back business.  If the new Trump administration can be successful in moving forward on those two major policies, then much of the “trade” issues that Mr. Trump has also railed about should take care of themselves because we should witness considerable increase in capital investment and general business activity.

If the investment climate should finally become more favorable, then that should only enhance the prospects for many of the investments themes on which we have focused  in our portfolios.  Additionally, and perhaps most importantly, such an environment would likely benefit small business the most. We have been quite concerned about the lack of new, innovative businesses coming about, and the resulting lack of initial public offerings in the stock market.  This desperately needs to change, and if it does, we could witness the type of market activity that was brought about by the sea change witnessed back in 1980, which led to the significant market moves of the 1980s and 1990s.

We are very encouraged and would argue that it’s been quite a long time since the wind has been at the back of businesses.  This isn’t altering our investment approach at all.  We just have even more confidence in its ultimate success!

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Why smaller can be better for equity investors

When it comes to investing in a managed investment strategy -- a mutual fund, for example -- many investors do not realize that total amount of assets under management (AUM) can be an important differentiating factor in the portfolio's performance.

For example, an equity investment strategy with fewer AUM, say below $2 billion, has far more investment choices than a strategy with AUM in the tens of billions of dollars.

The reason for this situation is fairly straightforward, although it is not widely discussed in popular investment literature. 

Imagine a mutual fund which owns 50 stocks in different promising businesses, allocating 2% of the total portfolio to each company in the portfolio.

If the fund has $100 million in total assets under management, the hypothetical portfolio described above would buy $2 million worth of shares in each of the 50 different stocks. 

However, if the same hypothetical fund had $10 billion in total assets under management, the same 2% per company would now amount to $200 million worth of shares in each of the 50 different stocks.

There is a big difference between buying $2 million worth of shares in a company, and buying $200 million worth of shares in the same company. 

For one thing, placing a trade for $200 million of shares in a company will move the price of that stock much more, even if the company in question is very large with a large volume of shares traded each day.  And it will usually necessitate several days of carefully-considered trades in order to move into (or out of) that complete 2% position during which time its price can fluctuate.

But an even bigger problem for the larger fund is the fact that its sheer size will make placing 2% into many companies an impossibility, without buying the company altogether, or buying such a large share of the company that the portfolio would own 20%, 30%, or even 50% of the company (depending on the total market capitalization of the company).  

A fund with $10 billion in assets under management cannot even invest 1% in the stock of a company with a market capitalization of $100 million without buying that company completely, or in a company with a market capitalization of $200 million without buying half of the entire company. And if the fund goes up to $20 billion, then the fund cannot put 1% into a $200 million company without buying the entire thing, or into a $400 million company without ending up owning half of the entire company. 

Most investors will also understand that putting less than 1% of a portfolio into a company is not really very productive: if that company turns out to be a real winner, it won't really create very much gain if the portfolio only has 1/2 of a percent allocated to that company (hardly worth the time it takes to thoroughly research that company and to monitor its performance over time).

There are literally thousands of innovative companies with market capitalizations below $1 billion which are effectively too small for many large funds. In fact, out of the roughly 4,000 publicly-traded companies in the US listed on the major exchanges, more than 2,000 of them have market capitalizations below $1 billion, and over 2,500 have market capitalizations below $2 billion (as of 12/09/2016). 

This means that over half of the companies trading on the major exchanges will be effectively "off limits" for practical investment for a mutual fund with tens of billions of dollars in assets under management, simply by virtue of the fact that those funds are too large to be able to take a position in those smaller companies. 

To make matters worse, many of the biggest opportunities for growth will be found in companies with smaller market capitalizations. Companies that have only recently gone public, for example, may begin their careers as public companies with market capitalizations in just this capitalization range. For example, the innovative Internet-of-Things company Impinj* (ticker symbol PI) came public in July of 2016, and its current market capitalization is in the neighborhood of $600 million.

A fund with $60 billion in assets simply cannot invest even 1% in this name without buying the entire company (thereby taking them private again), while even a fund with just $15 billion in assets cannot take a 1% position of Impinj in its portfolio without owning 25% of the entire company.

However, a fund with only $1 billion in assets, or even $2 billion in assets, would have no trouble taking a position of 2% in a $600 million company like Impinj.

If you think of the job of running an investment strategy as somewhat analogous to participating in a fantasy football league, the reality described above basically means that portfolio managers of larger funds have more and more potential "players in the league" off-limits to them -- and the number of potential players who become off-limits grows as the investment portfolio gets larger. At around $2 billion and upwards (in terms of AUM), investment portfolios begin to have a harder and harder time investing in small-capitalization companies.

Note, however, that while a portfolio manager with tens of billions of assets under management cannot effectively own smaller capitalization names, a portfolio manager with fewer assets under management can still invest in BOTH larger and smaller capitalization companies without any problem. 

Investment options diminish as an investment strategy gets bigger,as does the speed with which the strategy can buy or sell an investment position. For these reasons, we believe that for some investment goals, investing in funds with fewer assets under management can offer greater opportunity.

* Disclosure: at the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Impinj (PI).

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