Investors fleeing equity funds for bond funds

The above chart illustrates net monthly investment flows for US equity mutual funds (red line on the chart) and for total bond funds (taxable plus muni) for the period from January 2007 to July 2010 (as reported by the Investment Company Institute).

For each month, some investors added funds to US equity funds and some withdrew funds -- the net (inflows minus outflows) was tallied, and if outflows were larger than inflows, the net flows that month were negative.

As the chart shows, and as the New York Times reported in a story entitled "In Striking Shift, Small Investors Flee Stock Market," outflows from US equity mutual funds have been dramatic in recent months, while net inflows to bond funds have been extraordinary since the start of 2009.

Net outflows for US equity funds through the end of July have totaled $31.1 billion, with over $12.6 billion in net outflows for July 2010 alone. Over the same period, net inflows for bond funds have totaled $182.9 billion.

This data backs up the anecdotal cases we have come across of investors pulling their money out of the stock market at or near the most recent market bottom in March 2009, thereby missing the recovery after riding most or all of the way down. (Note the point in the graph above showing heavy net outflows from equity funds in February and March of 2009, just before the turn).

This kind of behavior is exactly what leads to the dismal long-term returns highlighted by numerous Dalbar studies year after year, which we have discussed in several previous posts. While many articles (such as the Times article) focus on this as the behavior of the "small investor," it is important to note that many of these small investors (who may be quite wealthy indeed, but are referred to as "small investors" in contrast to large institutional investors) are in fact advised by professionals who bear much of the blame.

Lately, many investors are jumping out of the equity markets because they are hearing all kinds of predictions of a "double dip" return to recession, or even declarations that the recession never ended at all and the so-called recovery was nothing but a head fake.

We advise those who have fallen for such arguments to go back and read our previous posts about the danger of listening to such confident economic forecasts -- even if those forecasts come from economists, and in fact especially if they come from economists.

We would also advise them to read our post about "market-timing and train-timing," which refers back to a post we wrote entitled "Don't get off the train" -- published seven days before the market bottom on March 9.

Instead, investors should continue to focus on allocating capital to well-run, growing businesses (whether through ownership of equity or through ownership of debt securities -- we don't advocate using open-end mutual funds). Instead of fleeing in anticipation of what the market will do next (which no one can predict), they should be paying themselves first, which will result in the opportunity to buy more equities when prices fall.

The fund flows depicted above tell the sorry tale that most investors are not following these common-sense principles, and many will wind up getting seriously hurt in the process.

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Professor Amar Bhide's latest essay, "The Judgment Deficit"

Professor Amar Bhide has just written an outstanding examination of the interplay between centralization and decentralization in a free economy, published in the Harvard Business Review and entitled "The Judgment Deficit."

In it, he articulates the insights of economist Friedrich Hayek from the latter's 1945 essay "The Use of Knowledge in Society." Professor Bhide examines the interplay between the decentralization that Hayek demonstrates is ideal for innovation and increasing prosperity, and the need for legitimate constraints on individual choice required to enable that innovation and advancement to take place. He also gives examples which demonstrate that those who have fallen into the temptation to take this necessity for some control and argue that "if a little is good, more must be better" have always ended up impairing or destroying the very prosperity they hoped to enhance.

Professor Bhide then makes a startling and brilliant observation: the financial apparatus of the free world, so important to entrepreneurial activity and continuing innovation, has fallen into exactly that trap of centralization!

Over the past several decades, decentralized knowledge and "boots-on-the-ground" examination has been increasingly replaced by theoretical models and computer algorithms. "In the financial sector," he argues, "funding mechanisms have become increasingly centralized and mechanistic. They no longer reflect the decentralized real economy they were meant to serve."

Professor Bhide illustrates this argument using the example of home loans and securitized lending -- an area that clearly became more and more divorced from reality over the past thrity to forty years and eventually resulted in a worldwide financial meltdown.

We believe he is right on target with those examples, and would argue that his arguments apply just as powerfully to the funding mechanisms for allocation of equity capital (and we know he is aware of this aspect of the problem that he identifies, based on statements he made back in February of 2009 which we quoted in a blog post here).

In fact, we believe that Professor Bhide's criticism of what he calls "robotic finance" is the perfect counterargument to those who have used modern portfolio theory as an excuse for rejecting the old-fashioned examination of individual companies that we believe must form the foundation of any successful investment process. Amazing as it seems, there are huge constituencies who advocate just such robotic finance, including many proponents of "black-box" or "quant" strategies, as well as many proponents of indexing (who argue that examination of individual business corporations is a waste of time).

Even further, we believe that Professor Bhide's application of the insights of Friedrich Hayek to this subject is the perfect counter to those who continue to invoke Hayek in support of such robotic approaches. We ourselves have argued against those who misuse Hayek's theories to repudiate what they call "active management" and what we insist is the kind of "boots-on-the ground" examination of the recipients of investment capital to which Professor Bhide believes we need to return.

There are many other important aspects of Professor Bhide's latest essay, and we commend it to all investors -- and in fact, to all who must wrestle with the fundamental issues of decentralization, innovation and human prosperity (which is to say, everyone). Please pass it on to your friends.

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For later posts dealing with this same subject, see also:
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The first monthly decline in medical prices in 35 years!

Investors who watch the traditional financial media shows can be forgiven for not hearing about an amazing statistic that came out of this morning's monthly consumer price index release from the Bureau of Labor and Statistics, because it isn't getting much coverage.

The CPI was up in July, after showing declines for the previous three months. However, looking at the fine print, we see that prices for medical care declined in July by 0.2%. As economist Brian Wesbury points out, this is the first decline for the measure of the cost of medical care in any month for the past 35 years!

The previous month, the medical cost inflation reading was zero.

What's going on here?

It's hard to know for sure, but it could be that participants in the free enterprise system in the United States are attempting to address the need for medical care outside of traditional channels, and that this competition is actually causing a decrease in prices. For example, economist Mark Perry recently highlighted this article entitled "Dr. Wal-Mart" in his excellent Carpe Diem blog, illustrating the impact that Wal-mart's entry into the world of filling prescriptions has had on the cost of prescription drugs*.

The article cites a physician in Columbus, Ohio who says: "Because of their big role in the marketplace, they couldn't be ignored. And it really has affected the way I prescribe medication. That is true, and I'm not alone."

Elsewhere in the article Ron Galloway, a national speaker who specializes in giving talks on the impact of Wal-Mart on the US health system pinpoints what he believes is the cause of this demand for "outside the system" medical solutions: "Obamacare is going to have people looking for getting primary care in other places than hospitals. And Wal-Mart, they can ramp up quickly."

Competition, due to free enterprise, tends to drive prices down wherever government interference does not artificially prop them up. This has been the case in most areas of technology for example (think about the price for DVD players and e-readers), but not for medical care.

Back in July of last year, we pointed to LASIK eye surgery as an example of a procedure that is not covered by Medicare and has seen its prices drop rapidly over the years, as opposed to procedures such as MRIs, where government regulates reimbursement and where prices have not gone down at all over the same period.

While those who believe in central planning think that the government can simply mandate that prices be lower, it is free enterprise and competition that brings prices down, not government mandates. The government's attempt to mandate a 21% reduction in Medicare reimbursement for doctors, initially decreed last year, has been postponed by Congress several times at the last minute (it is currently postponed through November of this year).

If physicians cannot charge enough to make administering care worth their while, very few of them can afford to operate at a loss for all Medicare recipients, and will simply refuse to take patients on Medicare. Cecil B. Wilson, MD, the head of the American Medical Association, says that one in five physicians already limit the number of Medicare patients they will treat, and one in four Medicare patients searching for a new primary care physician are currently unable to find one, due to the fact that physicians cannot run charities at their own expense, regardless of lawmakers who think they can reduce prices by congressional fiat.

However, the free enterprise system motivates people and businesses to look for ways to fill unmet needs, which is exactly what Wal-Mart and other businesses are doing in the face of a "halfway private and halfway public" healthcare system that we have discussed at length in other posts.

We choose to interpret the unprecedented drop in medical costs (at least unprecedented for the last 35 years) as a sign of the often-underestimated strength of the free enterprise system.

In fact, we hope that today's CPI data illustrate that it is already working its magic in the healthcare industry.

* The principals of Taylor Frigon Capital Management do not own securities issued by Wal-Mart (WMT).

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The dance of the hippos

While most of the market players and financial media are focused on the Fed decision and whether it will be good, bad, or indifferent for various slices of the markets, we'd like to take a different tack and focus on our favorite topic, the allocation of capital to well-run and innovative companies.

We believe that one of the major pitfalls for investors of all portfolio sizes is the tendency to focus on "the market" -- the trading price for various items, including equity and debt instruments issued by businesses -- rather than focusing on the underlying businesses themselves.

In the past, we have outlined many of the structural drawbacks to mutual funds -- see for example "Some drawbacks of mutual funds" from May 2008, or "Invest like Mr. Howell" from May 2009. We have always stressed that the biggest problem with the mutual fund structure is its tendency to drive the focus of the investor away from the underlying business and more towards the market.

In fact, the structure of mutual funds can have a tendency to drive the focus of the professional portfolio manager -- the one who is steering the mutual fund -- away from the underlying business and more towards the market as well.

One way that this can happen is by the accumulation of assets under management.

The strength of the mutual fund is that it can give many smaller investors access to a professional manager -- access that they would not otherwise have. It is simply not worthwhile for a professional manager, with all his experience and all the professional research and investing tools at his disposal, to manage a small portfolio of $15,000 or even $45,000. Even if he were to charge a couple thousand dollars a year to do so (which would be a pretty hefty fee in terms of percentage of the assets), he would have to manage an awful lot of them in order to make that pay for itself. Therefore, mutual funds enable the pooling of lots of small portfolios together, into a pool that is large enough to be worthwhile.

However, this strength is also their drawback. As certain mutual funds do better than others, investors seek them out, and today the top ten mutual fund companies manage almost $4 trillion of the total $10.8 trillion invested in mutual funds.

This concentration of assets among the largest fund companies is reflected in the largest mutual funds. In fact, the ten largest mutual funds are all managed by companies in the ten largest fund companies. The assets under management for these largest mutual funds are all in the tens of billions, and this is where the difficulty begins for a mutual fund manager who wants to focus on business fundamentals rather than market factors.

The largest mutual funds (not counting those that are money market mutual funds) currently range in assets from over $239 billion for the largest down to about $54 billion for the tenth largest.

In portfolio management terms, this means that the manager of a fund with $60 billion under management who wants to invest 1% of its funds in a single company is talking about a $600 million allocation of capital (1% of $60 billion). With 1% positions in all of his holdings, this manager could allocate capital to 100 businesses (in reality, portfolio managers hold some percentage in cash, but that is another discussion and for the sake of this example we can ignore the cash position right now). If he wanted to be more concentrated, with 2% positions, he could own 50 companies and allocate $1.2 billion to each one.

Many investors have no idea how few companies exist that can absorb an investment of $1.2 billion or even $600 million. Obviously, a company with a market capitalization of $600 million could be bought outright by an investor with $600 million to invest. This makes it all but impossible for portfolio managers of larger funds to invest in companies of this size (unless they make a tiny investment of a fraction of a percent of their assets, but that is hardly worth while, since even if the company's stock does really well, an investment of such a small percentage of capital will barely move the performance needle at all).

Thus, portfolio managers overseeing large piles of money are forced by necessity to own more and more names, and to own larger and larger companies, simply to find a place to put all those assets. What this means in practice is that these large portfolios typically have more than 100 names, often closer to 200 (and in some cases even more), and each one is typically a company with a market cap of $10 billion or more.

What many investors fail to realize is that there are not that many companies with market capitalizations over $10 billion. The Ford Equity Research database of 4,247 US-listed stocks reveals that, as of the market close yesterday, there were only 356 companies with market caps of $10 billion or more (back in February of this year, when market prices were a bit lower, there were only 299).

If all the large fund managers are owning hundreds of names, and they are forced by necessity to pick from among the same 300 or 350 companies, then they are owning an awful lot of the same companies.

This might not seem like much of a problem, but it does mean that fund managers have a harder time differentiating themselves by selecting superior companies. If you are managing Fund X, and you are competing against your buddy over at Fund Y, you can't say, "Let's each pick different companies, and after five years we'll see who was better at picking innovative, well-run companies." The companies you each select will have a lot of overlap, because you are both forced into the same holdings by the necessity of placing all that capital somewhere.

Therefore, in order to differentiate yourselves, you may say "I will own company Z, and I know my competitors will also own company Z, but during the next 5 years I will own it at the best times to own it, and ditch it at the worst times, and in that way I will beat my competitors."

In other words, your focus may shift from the underlying company itself to the market. You are now interested in owning "slices of time" -- you want to own semiconductors when they are temporarily in the market's favor, and rush out of them the moment they seem to be going out of favor for a few weeks or months.

It should be evident that this type of activity is based more on making market predictions than on trusting in the long-term performance of carefully-selected businesses. We have noted that in his own explanation of his investment philosophy, Thomas Rowe Price rejected the "various systems" for predicting short-term market gyrations and argued for the "simplicity and soundness" of trusting in carefully-selected, well-run businesses.

What should investors do to base their investment discipline on a more business-focused footing? We've argued previously that investors can become their own investment managers, selecting individual stocks and bonds -- see for example here, here and here.

Those who are not inclined or not able to take on investment management duties themselves can search for professional management that can demonstrate a business focus in their investment process. Avoiding mutual funds by no means guarantees one is avoiding the "mass-managed money" problems described above; in fact, many "separately managed accounts" offered by large investment management firms have as many assets under management as mutual funds run by the same firm -- or even more assets than their brother or sister mutual funds. Similarly, some smaller mutual fund companies offer funds that do have a business-focused investment process. We discuss selecting an investment manager in previous blog posts such as this one, this one, this one and this one.

We believe that this is an important and little-understood concept among those not in the portfolio-management business. Please be sure to share it with your friends and family.

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Have you heard of this company? IIVI

We have noted before that a company does not have to hail from Silicon Valley in order to fit the description of a classic Taylor Frigon growth company (although some Silicon Valley companies do fit that description).

Today, we highlight a long-time portfolio holding based in Saxonburg, Pennsylvania -- advanced materials and laser component manufacturer II-VI, Inc.*

The company takes its name from the Periodic Table of the Elements, specifically in reference to elements found in columns II and VI (see diagram above), a name which stretches back to 1971, when the founders saw an opportunity to build a business around providing the highest-quality cadmium-tellurium material available, a material needed for the optics used to produce high-powered industrial CO2 lasers.

Cadmium (Cd) is found in the II group (atomic number 48) and tellurium (Te) is found in the VI group (atomic number 52).

Today, the company announced earnings of $0.51 per share, versus the consensus Wall Street expectation of $0.38 per share, on year-over-year revenue growth of 71% (also beating expectations on revenues) and earnings growth of 162%.

In his prepared remarks this morning, CEO Francis J. Kramer touched on some of the growth fields in which products manufactured by II-VI are participating.

He stated that "increased demand in the telecom segment is mainly driven by increased bandwidth demands that are resulting from increased Internet traffic worldwide, along with the worldwide deployment of 40G optical networks, and major infrastructure investments in Asia that are scaling in order to support mobile communications and computing applications."

We would note that the demand he is describing matches some of the trends we have tried to explain in numerous previous posts such as this one from February 2008, this one from June 2009, and this one from June 2010. The discussion of infrastructure for mobile communications was also highlighted in conjunction with another Taylor Frigon growth company in this recent post.

The laser components and other advanced materials produced by II-VI are used in many other industries besides networking and telecommunications. In another part of his call, the II-VI CEO described business activity from the most-recent quarter in many other potential fields of growth, including "a large order for UV filter assemblies which go into systems used for missile threat detection on airborne platforms. [. . .] On the commercial market front, VLOC [a II-VI business segment producing components for near-infrared optics, named for a company acquired by II-VI in 1996 that itself was a combination of two companies called Virgo Optics and Lightning Optics, hence the acronym] experienced growth with bookings increasing 20% versus last year. In the U.S. market, the growth is driven by an increase in demand for aesthetic medical application products. In international markets, demand for low-, mid-, and high-power industrial products supporting laser-based marking, welding and cutting applications is growing. [. . .] In China, VLOC is experiencing growth related to laser welding and marking systems being utilized in the industrial arena, as well as for the lasers being used in the manufacture of consumer products such as MP3 devices, iPhones, and batteries."

Did he just say iPhones?

II-VI is another excellent example of the focus that we recommend for investors. While there are aspects of government activity which will restrict the economy from growing as strongly as it could grow (and there always are, to greater or lesser degrees), investors should focus on finding innovative, well-run companies positioned in front of fertile fields for future growth. Doing so is always important, but doing so during more "unfriendly" business climates is even more critical.

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* The principals of Taylor Frigon Capital Management own securities issued by II-VI, Inc. (IIVI).

For later posts on this same subject, see also:
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"Reducing taxes is the best way open to us to increase revenues"

Yesterday in the Wall Street Journal, Art Laffer published an opinion piece entitled "The-Soak-the-Rich Catch-22" which offered evidence from history that increased tax rates have actually led to lower tax revenues as a percentage of GDP. He also demonstrates that higher tax rates have historically led not just to lower revenues as a percentage of GDP but also to lower GDP growth rates and lower overall GDP -- "a double whammy," he calls it.

This is the important distinction we pointed out to readers in our post last week "Lower tax rates stimulate growth."

Art's piece opens with a quotation from President Kennedy's Economic Report of the President from January 1963: "Tax reduction thus sets off a process that can bring gains for everyone, gains won by marshalling resources that would otherwise stand idle—workers without jobs and farm and factory capacity without markets. Yet many taxpayers seemed prepared to deny the nation the fruits of tax reduction because they question the financial soundness of reducing taxes when the federal budget is already in deficit. Let me make clear why, in today's economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarged the federal deficit—why reducing taxes is the best way open to us to increase revenues."

These are important points, because the primary argument from those who want to raise tax rates is that we "can't afford" lower tax rates. The point of Art's article is that tax rates influence behavior, and that higher tax rates lead to lower growth, fewer jobs, and less tax revenue.

We realize that if tax rates were lowered to zero there would be no tax revenues at all, but we wish that all the politicians would similarly realize that keeping tax rates low stimulates the growth that President Kennedy describes as the "best way open to us to increase revenues." Is "taxing the rich" so important that it is worth sacrificing growth, jobs, and revenues? As we have demonstrated in previous blog posts, it is precisely the rate on the highest tax bracket that has the greatest impact on the business and venture investment that drives economic growth.

This is such an important point that it bears repeating.

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