The end of 2009

A year ago at this time we wrote a blog post entitled "Taking stock of 2008." It is worth revisiting because the issues we discussed then are still swirling around as pundits from all directions take stock of 2009.

We believe that the events of 2009 have borne out the interpretation we offered back in 2008. Back then we said that the "spectacular implosion of Wall Street" could well have been avoided if the government had removed the mark-to-market rule, which we had discussed all the way back in March of 2008 before the collapse of Bear Stearns.

As we would later see, when Congress finally forced the revision of mark-to-market during the first half of March this year, the recovery was rapid and impressive. It has been so impressive, in fact, that many are now saying that the markets have come "too far, too fast" -- but we would challenge that view by asking "too far from what?" In other words, we would point out that the panic-induced lows of early March, 2009 were an extremely abnormal situation, and it is very much appropriate for prices to rebound rapidly from the ridiculously low levels that they had reached.

Another important point to note is that we stated way back in September of 2008 our concern that, as a result of the financial panic (which could have been avoided, but wasn't), "government will become even more emboldened to interfere with the free-market system, just as they did after 1907." This observation has certainly come to pass.

Throughout 2009, we have published our view that TARP and the other extraordinary measures enacted at the beginning of the crisis should now be dismantled. One of the earlier posts on this subject, still relevant today, was April's "Four-letter government words."

Finally, our post from a year ago ended with this exhortation: "At the end of 2008, our most important piece of advice to investors is exactly the same as it was at the beginning of 2008: entrust your long-term financial well-being to the ownership of well-run businesses that are positioned in front of substantial opportunities for future growth." Those words turned out to be good advice, as the innovative companies we owned for our clients performed very well throughout the year, handily outpacing the broader markets for the second year in a row.

We would offer the exact same advice to investors as 2009 draws to a close.

Happy New Year!

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Issues raised by the indictment of Raj Rajaratnam

Today the Wall Street Journal ran an article entitled "The Man Who Wired Silicon Valley" full of colorful details from the career of former tech analyst and hedge fund manager Raj Rajaratnam, who has been accused and indicted by the SEC for profiting in the markets from insider information.

The Journal article's accompanying interactive graphic calls Rajaratnam's alleged web of Silicon Valley contacts "a far-reaching and complex scheme," but the story itself for the most part does not detail any actual criminal activity -- mainly it gives glimpses of Rajaratnam's history of aggressively asking for information at companies, along with descriptions of parties where "wealthy investors and executives swirled" around luxurious pools, "smoked cigars and hobnobbed with beautiful women" -- as if these scenes somehow indicate that all the wealth came from illegal or underhanded activity.

The one activity actually detailed in the report that may have been unethical, or even illegal, involved an employee of Intel* faxing prices and orders to Rajaratnam.

Let's be clear: at Taylor Frigon we do not condone trading on "material, non-public information" (which is illegal), nor do we condone the use of deceit or trickery in gaining information. We also do not personally practice an investment strategy based on short-term events such as the quarterly earnings performance that have become such a circus on Wall Street. We have explained many times that our strategy is built around the long-term ownership of good businesses, through many market cycles and short-term events.

However, we also believe that there is a tendency among many -- including some at the federal government -- to think that trying to find out everything you can about a business in which you are going to invest large amounts of capital should somehow be illegal. It may turn out that Mr. Rajaratnam did indeed cross a line between digging for information and doing something that the SEC defines as illegal, but the existence of such a line and where it is drawn are important philosophical questions.

There is a strain of thought which seems to believe that all investors should somehow be "equal" and that those who do no research should have just as much opportunity to make money as those who burn the midnight oil digging into the business details of a company and analyzing its future prospects. This misguided view seems to want to turn investing into nothing more than a roulette wheel, where everyone has an equal chance at winning and nobody has any more intelligence than anyone else.

We believe that this type of thinking is dangerous in that it undermines the important function of allocating capital to the best businesses. Investors should understand this misguided sentiment and be alert for it, and discuss these issues with their friends and families.
* The principals of Taylor Frigon Capital Management do not own securities issued by Intel (INTC).

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Some lessons from 2009

Over the weekend, the New York Times published an article which brings up a few important points we've made at length and which are worth revisiting as investors consider the lessons of 2009.

The Times article notes that many investors underperform available investment vehicles. We have discussed this phenomenon previously, linking it to the situation we call "The Intermediary Trap."

The article also notes that many investors pulled out of the market and thus missed much of the powerful rebound that began in March. This reinforces the intermediary problem, as many of them pulled out based on the advice of an intermediary. It also raises another important lesson, which is the speed at which market moves take place. The Times article says, "History shows that market rebounds can be so quick that they are easy to miss."

This point cannot be repeated often enough. We ourselves made it in an article entitled "Don't get off the train" which we published on March 2, before the rally began.

Finally, the article ends with a good quotation about patience, tying it to patience with one's investment process. This kind of patience is easily confused with "buy and hold forever" type obstinacy, and this confusion leads investors to make serious mistakes. We discuss the distinction between the two in "Remaining calm without being blind or obstinate," "The importance of a proper sell discipline," and "Seeing beyond a huge false dichotomy," among other places.

The ending point about trusting one's investment process for long-term success is the most important one in that article. It ties all the lessons mentioned above together. The main problem with the intermediary trap is that it makes it almost impossible for investors to maintain a consistent investment process, and leads to a lifetime of jumping from one train to another, so to speak. We discussed this point in 2009 as well, in "The same thought process for 30+ years."

Investors would do well to consider these lessons as 2009 draws to a close.

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We get by in spite

Over a year ago, we published one of our quarterly commentaries on the investment climate (dated October, 2008) in which we began with one of Richard C. Taylor's favorite phrases: "We get by in spite."

In that commentary, we explained that to Dick Taylor, "We get by in spite" was a kind of short-hand expression which meant that "in spite of the lunacy of government and its intervention in the free enterprise system, great businesses and the entrepreneurs who lead them find ways to profit and ultimately make money for their owners."

He would often use that phrase when government lunacy seemed to reach a fever pitch, and legislators were enacting laws threatening unprecedented intrusion into the right of the individual to be able to do what he wanted with his own private property (and his money).

We believe he would find occasion to use that phrase quite often right now.

The wisdom of his observation, "We get by in spite," is in its recognition that such intrusion and restriction of freedom has taken place in the past, but that great businesses have still found ways to deliver value, economic growth, and better living standards in the past, and that they will do so in the future.

Even now, there are momentous business opportunities for innovative companies. We touched on some of them in our blog post yesterday. This perspective is very important for investors to understand, especially during times when many in the financial world and media are being distracted by the political news of the hour.

Richard C. Taylor managed portfolios alongside Thomas Rowe Price, and his investment philosophy directly influenced the consistent process that the principals of Taylor Frigon Capital Management have employed for many years.

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For later posts on this same subject, see also:
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Unstoppable Wave: Revisited

Mary Meeker and the rest of her tech research team at Morgan Stanley* recently released a trio of research documents entitled the Mobile Internet Report.

They can be downloaded at the Morgan Stanley link above, and also read online in their entirety at ReadWriteWeb.

Meeker and her team are one of the first major Wall Street firms to delve into the enormous paradigm shift which we have written about in several places earlier, such as last January's post entitled "The Unstoppable Wave."

We would recommend that all investors understand the enormous wave that has already begun to radically transform the technology landscape and which will work its way through just about every other business during the next several years. It promises to be even more transformative than the tidal wave of technological change that hit the world in the 1990s, and may be even more rewarding to investors if they align their capital with the right businesses.

As we noted in the Unstoppable Wave, this is a paradigm shift that refuses to be stymied even by inept government meddling, of which there seems to be plenty these days.

Also, while they are now beginning to pay attention, this impending paradigm shift has been largely overlooked by the traditional investing voices, which have been distracted over the past two years (and, in fact, over the past decade -- see here).

Investors may wish to review some of our previous notes on this topic, such as:

* The principals of Taylor Frigon Capital Management do not own securities issued by Morgan Stanley (MS).

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The 97-pound weakling

Who isn't familiar with the iconic and long-running ad campaigns for the bodybuilding techniques of Charles Atlas, featuring the "97-pound weakling" being bullied on the beach?

Becoming "fed up" with having sand kicked in his face, the former bag of bones bulks up and returns to the beach to put down the bully, restore order to the beach, and earn the respect and admiration of all the onlookers.

Lately, the US dollar has been playing the role of the "97-pound weakling," having sand kicked in its face daily by just about every other currency on the planet. Just as in the comic strips, this situation is a recipe for disorder and disharmony, and something needs to be done about it.

The problems with the current "bag of bones" dollar are numerous, as economist David Malpass pointed out last week in an excellent guest opinion piece in the Wall Street Journal. Having a disproportionately scrawny dollar floods other regions with capital that would not otherwise flow that way, feeding speculation and asset bubbles, starving more worthy business ventures of capital, and generally encouraging malinvestment that leads to disastrous boom-and-bust patterns and retards real progress that could otherwise take place.

Furthermore, when currencies fluctuate wildly from being strong to being weak, or vice versa, businesses must allocate more and more resources towards hedging currency risk. Businesses today actually staff entire departments devoted to this function, which really adds no economic value whatsoever into the economy. Those people and their talents, and the business resources they use in pursuit of this goal, could be directed towards creating other value, if currencies were stabilized.

While the recognition of these problems might lead some to call for a strong dollar that can dominate all the other currencies (somewhat like the end of the comic strips, in which "Mac" comes back and knocks out the bullies), what investors should really hope for is not necessarily a disproportionately strong dollar but rather a stable dollar.

Some businesses (both foreign and domestic) benefit from a stronger dollar, while others benefit from a weaker dollar. But investors should not be looking for companies (or other investments) that only make money because they receive a handicap one way or another from this or that government policy! Instead of tilting the playing field one way or the other, government policy should aim to provide equilibrium, and let the best business win.

We'd like to see the dollar put on some muscle and stop getting sand kicked in its face, but only so that order is restored to the beach, not in order to reverse the situation that is going on right now and simply create a new bully on the beach.

The lesson for investors is to search for companies that are able to make money by adding value, and not to be led astray by chasing after investments that are primarily successful because of the swings in the relative value of currency.

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What Rube Goldberg could teach us about economics

Rube Goldberg was a San Francisco-born American cartoonist and the genius behind a long-standing series of cartoons illustrating impractical humorous and endlessly-enjoyable contraptions. His name, in fact, became synonymous with "a comically involved, complicated invention, laboriously contrived to perform a simple operation." Some of his inventions can be found at the Rube Goldberg website, as well as elsewhere on the internet.

If someone were to actually build a device modeled on his illustration for automatically snapping a photograph or for automatically wiping one's mouth with a napkin after taking a spoonful of soup, he would put in a lot more effort than he would save with the machine, and what's more would have to constantly monitor the thing in order to replace the popped balloons, frightened dogs, flying birds, spilled cups of molten metal, and other components that would be used up with every iteration!

In spite of the obvious silliness of such machines, many people are under the misconception that the economy (and the business world that drives the economy) resembles some kind of huge Rube Goldberg device, always prone to breaking down unless the government hovers over it to adjust and regulate and repair it at every turn.

In the long-running debate over whether free enterprise and free markets tend to blow up without careful government supervision and restraint, or whether well-intentioned government regulation of free enterprise and free markets tends to lead to unintended consequences and even to economic disasters, many people today have been fooled into believing the first scenario is true.

Put a little differently, the debate is between those who see the economy as an elaborate Rube Goldberg contraption, always in need of tinkering to prevent a huge calamity, and those who see the government as the Rube Goldberg contraption, creating a problem where none really existed and inviting disaster with its well-intentioned, but ill-conceived, solutions.

This very issue is on display this week in the Supreme Court, which is considering a challenge to the accounting oversight board known as the PCAOB, or Public Company Accounting Oversight Board, created by the Sarbanes-Oxley legislation that was signed into law in 2002. Sarbanes-Oxley and the PCAOB built an enormous and unwieldy bureaucratic apparatus where none existed previously, and its supporters argue that without it the entire economic system will no doubt break down. In fact, the problems it creates far outweigh any dubious benefits (just like the humorous devices envisioned by Mr. Goldberg).

In a story discussing the PCAOB that aired yesterday on National Public Radio, the case facing the Supreme Court is framed as another attack on the New Deal legacy of creating unelected government agencies (the "alphabet soup" we blogged about in "Four-letter government words" and about which Milt Friedman once joked: "any three letters chosen at random would probably designate an agency or part of a department that could be profitably abolished").

That NPR segment concludes with a serious-sounding quotation from former SEC Chairman Rod Hills (1975-1977) who declares that the issue may be "a philosophical argument that's kinda fun, but it's too serious." In other words, attacking the constitutionality of these government agencies is dangerous. He states gravely, "What they are really trying to do, after all these years, would do far too much damage to our system," apparently referring to those who would dare to challenge the legitimacy of government bodies such as the PCAOB.

The first response to this argument is to note that it demotes serious constitutional questions to the status of frivolous, esoteric debates for philosophers (akin to the oft-pilloried debate over how many angels can dance on the head of a pin). Such arguments, while "kinda fun," must take a back seat to pragmatism: if we don't do this (never mind if it's constitutional or not), you businessmen will blow yourselves up, and take the rest of us with you!

The second response to this argument is that it is by no means a given that without Sarbanes-Oxley style regulation there would be irreparable "damage to our system." In fact, we would argue that such regulation often leads to disastrous unintended consequences.

Proponents of ever-increasing regulation point to the recent financial panic as proof positive of their position. The authors of the script for the NPR story, for instance, have reporter Nina Totenberg begin her comments the with the line, "sitting here today, as Congress debates what measures are needed to avoid a repeat of the financial institution failures of the last year . . .” -- as if it is obvious to everyone that more legislation from Congress is needed in order to keep the system from blowing up again. Invoking the recent catastrophe is a way of tilting the discussion that follows towards the concluding quotation from Rod Hills.

What is not mentioned, of course, is that it was a misguided attempt to pile up more accounting regulation (and remove flexibility) that helped cause the financial meltdown of 2008 in the first place. New mark-to-market accounting regulations that went into effect at the end of 2007 -- and which were the brainchild of another former SEC Chairman Richard Breeden (1989 - 1993), who argued extensively for such regulation in the early 1990s and whose cause was taken up by later SEC Chairmen -- contributed more to the financial implosion of 2008 than any supposed lack of government regulation.

We are not arguing here that there should be no accounting rules, and that markets should become the "Wild West," where anything goes. We have explained previously, such as in our earlier post entitled "Free enterprise vs. free markets," we acknowledge that markets absolutely require what we called "a series of rules and regulations in order to ensure smooth and orderly operation and the ability of all parties to evaluate and compare different capital investment opportunities, much the same way a game of basketball requires rules to enable the game to take place."

But fraud was already illegal before Sarbanes-Oxley. The idea that more and more regulation will somehow make fraud go away is a fantasy. Penalizing everyone to try to stop a few bad actors has an enormous cost -- and the bad actors typically figure out ways to try to go around the new regulations anyway.

Almost lost in the NPR story is a quotation from frustrated accountant Brad Beckstead, who notes that the onerous and sometimes arbitrary requirements of the Sarbanes-Oxley legislation created a serious obstacle to his clients, who were primarily small, entrepreneurial, start-up companies -- the very agents of the kind of innovation essential to economic health and economic growth!

While some might say this is just the price of safety, as Rod Hills in his quotation above seems to say, it can be argued that government regulation that goes beyond preventing fraud and violence actually can have other unintended consequences that can lead to huge disasters. The mark-to-market rule is one example.

Other well-intentioned government intrusion we have noted as partially culpable in the 2008 disaster include the CRA, the quasi-government entities Fannie Mae and Freddie Mac, and the Federal Reserve in its attempts to steer the economy instead of simply providing a stable currency with which individuals and companies small and large could transact their business.

The view that government must constantly tinker and regulate to prevent the economy from blowing itself up has enjoyed such a long period of acceptance, and is reinforced by so many voices in the media and in the classroom, that many investors are unaware of the arguments we have laid out here for the opposite view.

Implicit in the joke behind every Rube Goldberg cartoon was the clear common-sense understanding that those elaborate contraptions were entirely unnecessary and that left to themselves, people in general have no problem opening doors, wiping their mouth with a napkin, teeing up a golf ball, or sharpening a pencil. When government builds ridiculous contraptions that are totally unnecessary, it shouldn't surprise anyone when they break down. Rube himself in the video clip above acknowledges that "you can't get something for nothing," although the government often seems to try.

The recent financial disaster should actually cause people to reexamine the assumptions that have led to the kind of well-intentioned government regulation that contributed to the crisis.

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The best defense is a good offense!

Recently, independent investment research firm BCA Research published a weekly bulletin (available by subscription only) with the subject of "Wealth Preservation."

In it, author Chen Zhao noted that he has found from his conversations with ultra-wealthy investors and their advisors that they are often "natural bears."

"As one gentleman put it," the bulletin relates, "their job is to be worried. They need to make sure that the family money is passed on to the next generation, hopefully with an expanded capital base. Many families have lived through wars and social upheaval over the last several decades, and they want to make sure their money is not robbed by people like Madoff, lost in financial crisis or confiscated by governments. Therefore, wealth preservation is always a big topic for this group."

The report notes that these wealthy families and their advisors are often looking for 5% to 6% returns without much volatility.

While this may seem like an "un-ambitious goal," the author correctly notes that it is actually very difficult to find such returns. We ourselves have long held that the decline in overall bond yields during the late 1980s and 1990s (and through the current time) from the double-digit yields that prevailed during the late 1970s and 1980s played a big role in the huge explosion in hedge funds, as investors with the mindset described above looked for someone who could give them the kinds of returns they could no longer obtain with a straightforward bond portfolio. The dismal performance of many of these hedge funds, especially during the recent financial panic, has caused investors to realize that they are often the wrong prescription for the kind of returns wealthy families seek.

We would also note that the desire among wealthy families for this kind of steady return no doubt contributed to the fraudulent practice of the aforementioned Bernie Madoff, who offered just such steady "un-ambitious" returns to his victims. We have discussed some important lessons for investors from the Madoff scandal in previous posts, such as this one.

The report also points out that bonds lately have not presented much of a solution either, with very low yields on governments, and very high volatility on investment-grade corporates. Junk bonds (or "high-yield bonds," as brokers often euphemistically call them) can provide even higher yields than investment-grade bonds but at risk levels that make them unacceptable for the goals articulated wealthy families and their advisors.

We believe this issue is a very important one to consider. We even agree with the general conclusion reached by the author from BCA, when he says: "In the end, the best defense is probably offense. I have found that many of these 'super rich' investors are highly entrepreneurial and extremely industrial. They have been involved in all kinds of very innovative projects and exotic ventures all around the world to extract returns."

However, he then concludes that "asset allocation has to become more imaginative and dynamic to obtain 'excess rent.' The trick to sustaining and preserving wealth is to take risks when the time is right." The remainder of the bulletin discusses whether it is time to shift capital from US equities to global equities, from small cap to large-cap, from dollars and yen to euros or other currencies or gold, from the debt of the US to that of other nations, and so forth.

We would argue that the author's observation about the fact that many wealthy investors are very entrepreneurial is right on -- in fact, we have noted many times before that most of the wealthiest families in America became that way precisely by being entrepreneurial (see for example here, and here, and here).

Given that important observation, however, why would one argue that they should now abandon investment in innovative and entrepreneurial companies and instead entrust their wealth preservation to an attempt to time the market moves of one sector versus another, one currency versus another, one style or capitalization band versus another, and so on? These kinds of guessing games, which we have previously classified under the broad heading of "sector rotation" (under which we could group countless variations and permutations), are more properly understood as speculation. While it may seem that they have superficial similarities, they are actually very different from the kinds of entrepreneurial activity mentioned as being so central to the stories of many successful and wealthy families.

We agree wholeheartedly that in the current environment, the best defense is a good offense, and that to achieve satisfactory returns (even "un-ambitious" returns of 5% or 6% per year), investors must expose themselves to investments that may be seen as more aggressive than the bond portfolios of past generations. We have discussed this very idea in previous posts, such as "Panning for gold in unfriendly business climates" and "Return of the 1970s, part 2," among other places.

However, we would argue that the proper prescription for the "good offense" is to allocate capital to carefully selected, innovative, growing businesses. While this may seem to be just as aggressive as the speculative strategies outlined above, the opposite is more likely true over time, as we have explained before. This "aggressive" capital can be balanced with more conservative strategies, including cash itself (accepting the lower returns it offers as the price of stability).

In spite of this point of disagreement, we believe that Mr. Zhao's discussion of "wealth preservation" and the issues he uncovers -- as well as his insightful comment that "the best defense is probably offense" -- are all incredibly important subjects for investors to consider and to understand.

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