Happy New Year!




As 2007 comes to a close, many investors prepare to enter 2008 with some trepidation regarding the outlook on the economy.

Economists are widely quoted in the media predicting recession. Today's online Wall Street Journal features a video clip with the Chief Economist of Nomura Securities saying the economic activity in the first half of 2008 will be "flirting with recession" (although he goes on to predict that the second half will return to growth and that "we'll avoid a recession, although it will be a very close call").

Last week's InfoChoice Weekly Banking Bulletin (emailed weekly to subscribers in the banking industry in Australia and parts of Asia) led with a story entitled "Australia should be concerned about US economy" which cited former Morgan Stanley Chief Economist, now Morgan Stanley's Asia Chairman, Stephen Roach asserting that the US is heading into a recession in 2008 (this is not new: Mr. Roach has been predicting recession for some time).

Earlier that same week, economist and former Clinton Treasury Secretary and former President of Harvard University, Larry Summers, gave a speech entitled "Risks of Recession, Prospects for Policy" in which he stated that, "In my view it is almost certain that we are heading for a period of heavily constrained growth, quite likely that the economy will experience a recession as technically defined and distinctly possible that we are headed into a period of the worst economic performance since the stagflation of the late 1970s and the recessions of the early 1980s." Happy New Year, indeed! Not only does he throw around the R-word, but tosses in the 1970s and stagflation for good measure!

A constant barrage of predictions like these have investors in some doubt about welcoming in 2008, and have many scurrying for cover. Yet these predictions keep coming from the same sources that have been predicting the demise of the economy for seven years. They have been dead wrong!

As we have pointed out previously, we believe the current recession drumbeat is yet another false alarm, one reason being that recessions rarely arise when everyone is concerned about a recession but are much more likely when few expect a recession and businesses spend bullishly and mistakenly build up huge inventories. Or even more likely, recessions occur because of bad policy decisions, both monetary (too easy or too tight money) and/or fiscal (tax increases).

Further, as we have also discussed in earlier posts, many in the media and many economists have a demand-side mentality which attributes more weight to the consumer as the driver of the economy. This view has led to consistent underestimation of the strength of the economy for the past seven years. It also ascribes a greater ability of the housing sector to derail the rest of the economy than it has in reality. Almost all of the predictions of recession heard in the news predicate their recession predictions on spillovers from the housing sector.

However, housing only makes up 4.5% of the overall GDP. Even though that sector has been in serious contraction for several quarters, GDP growth has continued to be positive, indicating that the rest of the economy continues to post expansionary numbers in spite of the drag from housing. In fact, the third quarter GDP number (the most recent we have) came in at 4.9% after its final revision. In spite of the assertion of well known bond manager Bill Gross, who stated that we are already in a recession, some supply-side economists predict the current quarter's GDP growth will be above 2%.

The difference in these two views is that demand-side economists believe that housing woes will spill over to the rest of the economy because the consumer is disproportionately impacted by housing market fluctuations, while supply-side economists include the very real problems in the housing sector in their calculations but believe that the production of goods and services (more than 95% of which are not part of the housing sector) continues to grow.

They also point to the strong productivity numbers posted by the current economy. Earlier this month, Q3 productivity was revised upwards from 4.9% productivity growth to 6.3% productivity growth. As we have stated before, our decades of experience have shown that it is the production side (often called the "supply side") rather than the consumption side (or "demand side") that actually drives the economy, and supply-side economists have consistently been more accurate in their assessments of the economic growth than the more numerous demand-side economists (only about 15% of economists are supply-siders).

While the current and upcoming quarters will likely show slower growth than the exceptional third quarter, we believe that prospects for growth continue and that the current recession predictions are overblown.

The prospects for a happy 2008 are not as bleak as the news is making them out to be!

for later blog posts dealing with this same topic, see also:




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It's time for year-end charitable contributions





It's the time of year for posting any contributions to charities and organizations working towards causes you care about. Typically, those donations must be received by the charity by December 31st in order to count towards your tax year for 2007.

However, as Steven Malanga details in this article in the most recent edition of City Journal, many charitable organizations (including, increasingly, religious ones) are actively involved in bashing the capitalist system which enables the creation of the very wealth that they receive from their contributors.

For example, the article quotes the co-president of Interfaith Worker Justice as saying that America must save itself from "its own arrogance, its selfishness and its greed" and as speaking out against those "wallowing in an obscenity of massive unearned wealth." The Executive Director and Founder of the same organization is quoted as saying that America needs "redistribution" to "shift wealth from a few to working families." That same organization (Interfaith Worker Justice) receives funding and financial support from over 100 religious organizations, including the National Council of Churches of the USA (NCC) and, the article notes, some key members of the NCC including the Episcopal Church, the Evangelical Lutheran Church, and the Presbyterian Church USA (PCUSA) "are particularly active."

The article also cites a quotation from Father Robert Sirico, the President of the Acton Institute, which (according to its website) promotes "integrating Judeo-Christian truths with free market principles." He states that if religious leaders targeted by groups such as Interfaith Worker Justice (in this case, seminarians) don't have an economic background, it's easy for them to fall into the fallacy "that our economy is a zero-sum game that demands conflict between business owners and workers."

We've written about the fallacy of the zero-sum mentality on this blog before, such as in this post and this post. It is sad that those who benefit greatly from the wealth creation enabled by a mostly free economy are often tricked by the rhetoric of those with a zero-sum view of the world.

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Holiday Wishes



















This giant sequoia (sequoiadendron giganteum) is the General Grant Tree, in Sequoia and Kings Canyon National Park. Discovered in 1862, it was named the General Grant in 1867.

In 1926, President Calvin Coolidge designated it the Nation's Christmas Tree and each year since park rangers have held a ceremony at the tree on the second Sunday of December.

In 1956, President Dwight Eisenhower designated it a National Shrine and a living memorial to those who have given their lives in wartime in the service of the United States of America.










Seasons Greetings from all of us at Taylor Frigon Capital Management!

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Anatomy of "style drift"









Previously, such as in this post, we have discussed the problem that is common to "mass-managed money" which is the fact that as they grow larger and larger, they are forced to own more and more securities -- and if they invest in equities, they are forced to own shares in larger and larger corporations.

The fact is that most investors in the United States, including ultra-wealthy investors, get their exposure to equities through what we call mass-managed money (money managers who are managing portfolios that exceed $5 billion dollars). In other words, the primary way that these investors connect to the ownership of businesses is through vehicles that are forced, by their sheer size, to own shares in hundreds of businesses, and to own shares in a very specific type of business: LARGE businesses.

This is because mass-managed money is not just a mutual fund phenomenon. Many wealthier investors use managed separate portfolios -- a form of managed money that does not pool the investments of different account-holders into one fund, but keeps them separate. We explain some aspects of separate portfolios in our publication Separate Portfolio Advantages, available here. But although the separate portfolio structure has many advantages over the mutual fund structure, especially for wealthier investors, most of the managers of separate portfolios are huge mutual fund companies who offer separate portfolios that may have more dollars under management than their mutual funds do! Many well-known separate portfolio strategies have upwards of $10 billion under management.

The diagram above is an illustration of what can happen inside a portfolio strategy (whether it is a mutual fund or a separate portfolio strategy) when it grows into the tens of billions of dollars in assets. The diagram shows the famous Fidelity Magellan fund, from mid-1982 through early-2000, and graphs its holdings by the SIZE of the assets. The different colors on the chart represent percentages of the holdings that are in stocks characterized as small-cap value or growth, and large-cap value or growth. This chart can be found on the internet in a Barclays Global Investors research paper entitled "In Pursuit of Performance: the Greatest Return Stories Ever Told" (see page 18 of the document).

Note that in the early years of the fund, before it began to grow to massive proportions, the portfolio was primarily composed of stocks characterized as small-cap growth:


















In this part of the graph, the lightest-colored section (making up more than 50% of the holdings) designates small-cap growth stocks, while the darker blue section above it represents small-cap value stocks, and the gray at the bottom represents large-cap growth stocks. This is the composition of the fund at the left side (earlier years) of the portfolio.

Fifteen years later, however, the right side of the timeline shows a radical change in the composition of the fund:


















Note that by the end of the period under consideration, large-cap stocks (the gray area at the bottom of the diagram) have grown to consume over 80% of the portfolio's stock holdings. Small-cap growth stocks, the lightest of the four colors in the graph at left, used to be the largest portion of the portfolio, but by this slice in time they have been squeezed down to a sliver, and by the end of 1999 they were entirely absent from any meaningful role in the portfolio. By the very end, the lowest color band on the chart (large-cap growth) and the second-lowest band (large-cap value) make up almost the entire portfolio, except for the thin (and shrinking) band at the very top representing the remaining small-cap value stocks. In other words, the record shows a very strong migration of the portfolio from owning stocks in smaller-cap companies to owning almost entirely stocks in large-cap companies. What happened in the intervening years that caused such a transformation in the types of companies that investors held? The fund grew enormously. This X-ray of a "mass-managed" fund emphasizes the points we made in our previous posting (linked at the beginning of this post) about larger funds (or portfolios) being forced into larger stocks. It also reveals the fact that investors may have the same investment vehicle for many years, but that does not mean that they are getting the same portfolio management consistently for all those years: the management team may change their style, or the management team may leave altogether! In short, these diagrams present a picture of "style drift" that is forced upon many investment vehicles as they grow larger and larger. Investors need consistency not just for a couple years but for many decades (the chart covers almost twenty years -- most investors don't think about it, but their need for exposure to equities over their investing lifetime will be usually be even longer than twenty years). Consistency is very difficult to find in today's landscape, which is dominated by mass-managed money and Wall Street salesforces which use mass-managed money as their main investment tool for their clients.

For later posts on this same topic, see also:



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A portfolio manager's perspective on Fed critiques












As we have explained several times in various posts (such as the first one on this blog), our investment philosophy is based upon the long-term health of successful businesses (choosing good companies), rather than upon the shaky foundation of attempting to time market cycles or predict fluctuations of currencies, commodities, or interest rates -- including those controlled by the Fed.

The current market volatility has been widely blamed on recent decisions by the Fed and disagreement by market participants as to what the Fed should actually have done or not done.

Are they right? What should the Fed do? There are excellent economists whose works we have read for years who are at complete disagreement over the proper course of action. In fact, any position you can name right now will generate heated opposition on this subject.

However, although many in the media are pointing (as they have for several years now) to the specter of the 1970s and "stagflation" (a stagnating economy coupled with rising inflation), it is safe to say that whatever actually develops will not be the same thing that the conventional wisdom expects. In fact, an honest comparison of the fundamental economic scenario of the 1970s and the economy that we have today can lead us to conclude that whatever does develop, the 1970s are not it.

We would also argue that, as we have stated in previous posts such as this one from over a month ago, what is really troubling the markets may not have as much to do with the threat of inflation as it does with the threat of taxation. Although not everyone who participates in the market understands the ins and outs of monetary theory and what does and does not cause inflation, everyone understands that when taxes go up you have less money left. Taxes are pretty clear about what they will do to your returns. They give you an exact number of what they will take, unlike inflation which economists can debate all day long.

That said, we do not dismiss inflation's damaging potential by any means, and in a fiat-money system (currency not tied to an objective store of value), inflation is almost always present to some degree. We believe this is yet another argument for ownership of businesses.

All this is why we believe that the best investment philosophy is one that focuses on selecting sound businesses with management teams who are able to navigate through unpredictable fluctuations, whether those are caused by the banking system or by other factors.


For later blog posts dealing with this same subject, see also:


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What is the future of search?




Here is a link to an interesting story by Dean Takahashi of the San Jose Mercury discussing an internet start-up called Mahalo (named for the Hawaiian word meaning "Thank You").

The article reports that "Mahalo is a search engine that is powered by human judgment, known in Web 2.0 circles as 'curation.' Curation uses human expertise to weed out all the stuff that you obviously don't want when you're searching."

The Mahalo site itself states, "With traditional search engines you need to figure out the right search term and find relevant results within an unorganized list that often contains irrelevant results, spam, and some mediocre sites" and "Search results for certain categories such as products, travel, cars, and health, are cluttered with people selling things, making it difficult to find great information on those topics."

Regardless of the actual usefulness or success of this particular Mahalo site and their approach (which they claim is "the world's first human-powered search engine"), the issue should raise important questions if you are thinking like a portfolio manager. What other ways will we "search" (navigate the vast and growing amount of information available on the internet) in the future?

Right now, Google is the acknowledged champion of search. Their share of search is more than twice that of their next competitor (Yahoo!). According to NetRatings, Google share of all search in the US is just over 50%, with Yahoo! second at about 20% and MSN third at less than 15%. Globally, Google represents an even greater percentage of search, at nearly 70%.

However, the search engines mentioned above yield results based on algorithms such as Google's PageRank, which ranks search results based on the web of links to and from different pages. While this method has its strengths, it certainly has disadvantages as well. You may value the input and opinions of certain circles of friends or experts on one subject or another greater than you value the rankings generated by measuring the links on the web.

There are a variety of things that you search for that could be improved with forms of search that include conscious human input, including the input of the various circles of people with whom you associate (your friends from business school for some information, the other parents of children at your kids' school for other information, fans of the Boston Celtics for other information, and so on). Mahalo may well be just the first in a shift in the way that the information on the web is found and navigated. While the existing method will probably continue to have usefulness, in five years it may be just one of many players in the cast of internet facilitators, and a small one at that .

* The principals of Taylor Frigon Capital Management do not own securities issued by Google (GOOG) or Yahoo! (YHOO).


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Deworsification




















In yesterday's post, we discussed some of the drawbacks caused by portfolio size. As "mass-managed money" pools grow larger, they are forced to own more and more portfolio holdings and those holdings typically need to be in larger and larger companies as well.

Some of the largest mutual funds have well over two hundred names -- one fund mentioned as an example had 286. A common question you might have is, "But doesn't that at least give you diversification?"

Diversification is an important concept in investment management. However, the marketing machine of Wall Street has taken an important investment concept and used it, in some cases, to convince people that they need to own more different products, and therby more holdings, than they actually need.

As the graph above illustrates, diversification does reduce the volatility of a portfolio. However, the reduction in volatility is great when you take a one-stock portfolio and make it a two-stock portfolio. There is another large reduction in volatility when you make the two-stock portfolio a three-stock portfolio, but the reduction is slightly less than it was when you went from a one-stock portfolio to a two-stock portfolio. Each additional stock reduces volatility a little less than the last one did. After ten stocks, the reduction in volatility begins to slow dramatically with each additional holding, and after twenty-five stocks the reduction in volatility is very slight, becoming asymptotic after thirty or so holdings. This property of portfolio volatility is well-researched and has been published in many different places for over forty years.

In other words, mass-managed portfolios do not own 286 stocks for diversification purposes. The reason most investors (even wealthy investors) do not know about this principle is probably because there is a vested interest in the investment industry in having people buy numerous products. If people realized that the capital they allocate to the financial markets could be properly invested in a relatively small number of individual stocks and bonds (likely no more than fifty companies), it would seriously threaten the business models of those who make a living selling investors slices of everything under the sun (each slice containing hundreds of individual stocks or bonds, in some cases).

There are many costs associated with owning many more investment vehicles than you need. There are obviously transaction costs and management costs involved, but just as important are the potential opportunity costs. It is true that some businesses are better than others. The more companies you buy, the more chance you have of buying into average or below-average companies. This problem could be called "de-worsification" and it is a serious problem for many investors (although not necessarily a problem at all for Wall Street).

For later blog posts dealing with this same subject, see also:

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The further you are from owning individual companies . . .











The further you are from owning individual companies, the more your investment management tends to be rooted in the performance of markets (or sectors of the market) rather than rooted in the performance of businesses.

In a mutual fund, as we explain on our web site in this recent commentary, you don't actually own the stocks of businesses. The mutual fund owns -- in a giant pool -- those stocks in the businesses, and you own shares in the pool.

One important thing to realize about these pools is that, as they grow very large, they are forced to buy more and more companies in order to find a home for all the dollars in the pool. Look at the list of the top twenty mutual funds by holding, as listed in Wikipedia (but available elsewhere as well).

If you are a money manager with a pool of $94 billion under management, you cannot own just forty or fifty companies. You could not even own just ninety-four companies. You are forced, by sheer size to own hundreds of companies -- not because you particularly want to own hundreds of companies for investment reasons, but because you must find a place to spread all those assets. The top fund on the list above, for example, owned 286 companies in its portfolio when it last disclosed its holdings at the end of the third quarter of 2007.

In fact, you will be forced not only to own a large number of companies, but you will be forced to find relatively large companies (companies with a large market cap) to own. You won't be owning many companies with market caps under a billion dollars, because you will almost buy those companies outright if you put even a small percentage (less than one percent of your assets) into the shares of those companies.

This means that as these pools get larger, these companies own more and more of the same names in the S&P 500 (some may own more than half of the "entire market" if the S&P 500 is taken as a proxy for "the market"). It also means that they own many of the same companies as one another! There are only about 290 companies in the U.S. with market caps of $10 billion dollars or more (these numbers fluctuate slightly every day as stock prices rise and fall). There are only about 23 companies in the U.S. with market caps of $100 billion or more.

As mutual funds own more of the same companies as one another, and as the overall market, they cannot differentiate themselves by owning different businesses. It is hard for them to be able to say, "You invest in Apple, and I will invest in Google, and we'll see who chose a better company after five years." Chances are, they both will own Apple and Google and a whole lot of other large companies as well.

So, investors who build their investment foundation upon mutual funds are resting upon a foundation not of business selection, but of market movement. The mutual fund may move from one sector to another sector during the year (as the manager predicts better or worse performance for this or that sector during the next few months), but this is more a system of predicting markets (or slices of markets) than of analyzing companies (for a discussion of the fact that index funds by definition are built on a foundation of markets rather than companies, see our commentary entitled "The Emperor's New Index Fund").

The growing size of the pools inside individual mutual funds can also lead towards increased portfolio turnover in some (although not all) mutual funds. Because they own a huge number of identical companies as those held by everyone else (not because they want to, but because of the forces described above), they cannot differentiate themselves by owning different companies. Instead, in a very competitive marketplace, they can differentiate themselves by owning the same company but for a different quarter than their competition owned it.

In other words, they realize that they own Apple and their competition owns Apple, but they will differentiate themselves by owning it for a better quarter or two than their competition owned it -- creating higher turnover in some cases, as well as creating a tendency to focus on short-term events rather than on the long-term business outlook for a company over a period of many years.

In short, investors should be aware of the fact that the further they are from owning companies directly, the more likely it is that their investment philosophy tends to be rooted in market-timing activities rather than in lining their fortunes up with the long-term performance of exceptional companies. And, as we explained in this previous posting, most of the big fortunes in this country (over the past twenty years as well as over the past one hundred years) have been made by lining up with successful companies for a period of several years.

For later posts dealing with this same subject, see also:



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Don't isolate your forces




















Deploying your capital has some parallels to deploying forces on the battlefield.

In both cases, for instance, you don't have unlimited resources to accomplish everything you want to do. You can't put troops on every single hill -- you have to weigh the costs and the risks and decide where you are going to deploy your forces. Furthermore, you are making these decisions in a very fluid environment (constantly changing) and you never have perfect certainty. In military operations, you have to make decisions that have real consequences and you have to make those decisions in conditions of some uncertainty.

Similarly, in financial operations you are also making decisions in a fluid environment that changes constantly. You must make decisions that have real costs and consequences. And you must make those decisions in conditions of uncertainty as well (at any given time, some people are bullish and some bearish about the same issues, some people think jobs growth will be X and others feel it will be Y, some think the Fed will do A and others are certain it will do B).

Just like in military operations, you don't have unlimited troops to spread around everywhere that you want to put them. If you sign up for Long-Term Care Insurance, for instance, then you are committing resources (capital) on an ongoing basis, typically for many years, and that capital cannot be used towards buying a piece of real estate or investing in a promising company, for instance.

One very important principle of military operations is that you don't want to isolate your forces -- you want them to be "mutually supporting." In the map above, if you are in command of three platoons or three companies or three battalions, you don't want to send one force way off to the left "just in case" the enemy comes that way and then find that the enemy comes from the right and your unit is too far away to come back and support the unit on the right that is under attack. Far better, given the fluid conditions of uncertainty described above, is to be able to shift your forces to the place they are needed and to keep them in positions that can mutually support one another.

This same principle holds true with your capital. You want your capital to work in a "mutually supportive" manner. You don't want to isolate your resources by sending capital off in one direction "just in case" and then find out that you needed it somewhere completely different. However, most people tend to do just that (largely because the players in the financial world want you to "silo" your assets in their domain -- your financial market assets are usually not well coordinated with your real estate assets, and your insurance instruments are in a completely different "silo" and not integrated with either of the others).

Thinking in these terms about the way you are deploying capital is a good way to approach the financial battlefield. Look for ways in which you are "siloing" or isolating your forces and potentially causing attrition that you could avoid.

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Stick that in your pipe and smoke it


Here is a link to a video presentation of a talk given by Professor Noah Robinson of the Oregon Institute of Science and Medicine at the annual Gilder Telecosm event in October, 2007.

Of course, a fairly large segment of the population does not permit any discussion of this side of the global warming argument to be so much as whispered. Simply uttering such views makes one a target for abuse, ridicule, and personal attack.

The presentation by Dr. Robinson contains evidence about the retreat of glaciers and the increase in CO2 that should be considered by any thoughtful participants in the "global warming" and "climate change" discussion. The data presented cast serious doubt on the connection between human hydrocarbon use (first coal, then coal plus oil, and ultimately coal plus oil plus natural gas) and temperature change and ice melt. Data on glacier retreat show that the retreat began long before significant human hydrocarbon use and that the pace of the retreat has not increased along with the increase in hydrocarbon use.

This issue is one with serious economic consequences, as the calls for international reduction of carbon use grow louder and louder. The same voices denouncing anyone presenting evidence like that shown in this film are often the voices calling for greater government regulation of business through carbon taxation, "cap and trade" regulations, bans on incandescent light bulbs, taxpayer funding for the weatherization of homes, and so on. Over the next several days, you will be hearing about the international gathering in Bali where participants will be discussing these and other government measures.

Influential media outlets such as the New York Times are carrying prominent stories such as those featured on this page, all of which are from the perspective that the connection between human carbon use and climate change is settled science and that "federal regulation of greenhouse gases" is the logical way forward. A prominent story in today's edition of the Times features the title "A Future Without Skis: Alpine resorts are trying to stay ahead of global warming." A New York Times blog entitled "Dot Earth" features an entry today entitled "A Few (Hundred) Things the Next President Can Do to Limit Warming."

National Public Radio, which is primarily funded by taxes, features a similar collection of "Climate Change" stories to those found in the Times. One story from today's Morning Edition features the human-interest angle of a family in Iceland which has been trekking out to the glaciers every year, only to find that they (the glaciers, that is) are shrinking.

"The trip is no longer just about adventure and companionship," says the story's author. "This group has become unintended witnesses to climate change. Leifsdottir says the last 10 years have been much warmer. But global warming isn't good for the world, she says."

Other links on the page take you to "Top Ten Tips for Fighting Global Warming" which urge you to forgo red meat, dry your clothes on a line instead of in a dryer, and "leave the car at home and take public transportation to work," among other suggestions. Calls for "federal regulation of greenhouse gases" mentioned on the Times website are merely calls to make "suggestions" become mandatory for all, and to enforce similarly-minded restrictions on businesses as well.

There are real economic consequences to suggestions like these. Before we return to levels of government regulation of business last seen in the 1970s, we should at least be unafraid to examine compelling evidence showing that such regulation may have no impact on climate change at all. (Even if carbon reduction would be effectual, it does not necessarily follow that governmentally-mandated carbon reduction is the best course of action, but that is a subject for another day).

For more recent posts dealing with this same issue, see also:



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