Happy New Year!

We wish all of our readers and clients a very happy and prosperous New Year!

2012 is sure to be a very interesting year for investors with much to look forward to and many opportunities for those who stay patient and disciplined and look to take advantage of owning great businesses at values not seen in decades!!
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Seasons Greetings and Warm Wishes

Seasons Greetings and warm holiday wishes from all of us here at Taylor Frigon Capital Management!

Above, a wreath at the General Grant tree in Sequoia and Kings Canyon National Park rests in the snow. The General Grant tree was designated "The Nation's Christmas Tree" by President Calvin Coolidge in 1926, after a little girl visiting the tree was overheard to remark, "What a lovely Christmas tree that would be!" at the sight of the massive sequoia. The story of how that came about is related on the home page of the Sanger, California Chamber of Commerce here.

The tree is also the only living, federally-designated monument to U.S. military men and women who have lost their lives in service to their country.

We wish all our readers a very safe and happy holiday season this year.
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The fantasy world of modern portfolio theory

The calendar year of 2011 will soon come to a close, and active managers will be watching to see how the performance for the year will turn out.

Many who hire active managers will also be watching closely, and will be judging whether or not they should continue to keep their investments with this or that manager based upon the outcome when the market closes on Friday, December 30.

Others, who disavow active management, will be watching in order to see how many managers failed to "beat the market" (or beat their benchmark) so that they can declare that "active management doesn't work" and that everyone should "just index."

While we believe that keeping score is important in investment management, we don't agree that the emphasis placed on a calendar year is the best way to determine whether any particular manager is doing a good job, nor is it the best way to determine the broader question of whether active management is better than (so-called) passive management or vice versa.

For starters, we have argued that investors often have far too short-term of an attention span when it comes to committing capital to businesses, much the way that the Ents in J.R.R. Tolkien's Lord of the Rings criticize hobbits for being too hasty. Would anyone select a money manager based upon whether or not his overall portfolio of investments went up or down on a single day? That would be ridiculous. How about based upon whether or not his portfolio outperformed "the market" or some other benchmark during a single day?

If you had a friend who told you that he moved his life's savings from one manager to another based upon which one did the best the day before, you might (like Treebeard) advise him, "Don't be so hasty."

The same could be said for jumping to conclusions about whether active management is better than passive management. It would be ridiculous for financial commentators to publish reports declaring "Several prominent active managers underperformed the market yesterday, leading to the conclusion that active management may not be the best way to invest."

We would argue that, while better than a single day, a single calendar year is not the most useful time period to select, but that investors should instead focus on longer periods, and should consider start and end points that are less arbitrary than the annual calendar but which correspond instead to major economic events (such as from one recession to another).

More importantly, the broader question of active versus passive management should not be decided based upon arbitrary and short periods of time. If active managers beat the market or their benchmark in one year or even in two or three consecutive years, some critics will always be waiting to pounce on them in a year that they do not, in order to declare that the mathematics are irrefutable and that nobody can beat the market in the long run. More precisely, these critics will often argue that anyone who does beat the market for a few years does so by taking "excessive risk" which could have been avoided by owning more securities. Since no one can really beat the market without undue risk, the passive advocates argue, then it is best to just buy the market -- that way, you will get the best possible return for the amount of risk that you take.

The mistaken idea that passive management is the best way to invest is one outgrowth of a much larger academic theory called "modern portfolio theory" which has slowly expanded its influence in the investment world, beginning in 1974. We have written about its problems numerous times in the past, such as in this previous post. The distinctive concept at the core of this theory is the idea that risk can be captured in mathematical formulas, and that because it asserts that risk is mathematically linked to potential returns, its advocates believe that mathematical analysis and diversification can point investors to the optimal level of risk and return for their investment profile (the so-called "efficient frontier" is an example of this concept).

This seemingly harmless idea manifests itself in many different ways in the investment industry, one of them being the idea that owning indexes with hundreds or even thousands of individual securities provides better "risk-adjusted return" than owning a smaller number of carefully-selected securities. If you think about it carefully, you will be able to see that this idea (which is at the heart of the "just index" or "passive investing" argument) was also behind the construction of the various structured investments and synthetic vehicles full of sub-prime mortgages which banks and other financial institutions bought under the illusion that enough diversification and the right mathematical models would make the analysis of the individual loans unnecessary. This fantasy led directly to the disastrous financial meltdown of 2008 and 2009.

In this regard, modern portfolio theory resembles the kung fu seen in certain martial arts movies like the one above -- it's a nice fantasy, but it is completely divorced from the real world. Thinking that its mystical precepts will keep you from ever getting cut in a real knife-fight could have disastrous consequences.

It is our conviction that in the real world of investing, there will be times when good investments are out of favor and therefore perform "worse than the market," whether for a day, a month, or even a year. The idea that owning a small number of good investments (even if they sometimes go in and out of favor) is "risky" but that owning a huge number of unexamined investments mitigates risk is actually a dangerous fantasy, and one that unfortunately is pumped out to viewers and readers daily by the financial media in video, magazines, and books. Investors who are tempted to buy into this fantasy should be cautioned that modern portfolio theory's vision of investing is as divorced from reality as mystical movie kung fu is from real fighting.

For investors who want to practice real investing, we would advise that finding quality businesses is not as difficult as they might think -- we have discussed criteria for doing this and provided several examples in previous posts (a list of some of them can be found here). They should then plan on owning those companies through the inevitable ups and downs of the market for long periods of years (this does not mean holding them forever -- we discuss sell discipline in other posts such as this one -- but rather owning them until the business signals that it is no longer the kind of business you want to own, instead of relying on the market signals that so many investors and pundits focus on).

Take a look at the kind of returns an investor could have experienced if he had purchased shares in Wal-Mart in 1982 and owned them through 1992*. Look closely at the chart and you will see that there were plenty of ups-and-downs along the way, including some sudden and rather severe drops: what would that investor have missed if he had been listening to what all the pundits were saying or if he had the mistaken idea that owning a tiny piece of a truly great company could be done without ever taking some hits and receiving some bruises?

Understanding this perspective is the first step towards building a strategy that is based on principles that investors should be focused on, instead of building one that is based on the fantasy of modern portfolio theory and its quest for "risk-adjusted return." It will also enable investors to see most of what appears in the financial media for what it really is -- entertainment that might offer an enjoyable escape into a fantasy world, but which should not be confused with reality, and actually isn't even as fun to watch as a good old-fashioned kung fu flick.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Wal-Mart Stores, Inc. (WMT).
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Have you heard of this company? PNRA

While most of the financial world focuses on Europe and waits with bated breath for every new development in Greek parliamentary voting, S&P sovereign-debt rating, or ECB bank-lending stimulus, we would like to point out that economic indicators in the US have been showing modest but real progress.

Without downplaying the importance of the issues that are at stake in Europe (which we believe are extremely important issues, and which we have discussed in this and this recent post), we would suggest that investors might want to pay attention to some of the companies in the US that we think are well-run and positioned in front of what we call "fertile fields for future growth."

One such company is Panera Bread*, which operates a chain of "fast casual" restaurants which they call "bakery-cafes" distinguished by fresh-baked artisan breads, hormone-free chicken, all natural ingredients, and a dining atmosphere that very different from a typical "fast food" establishment.

Panera Bread calls their concept "fast fresh," which points to one of the reasons that we believe the company is operating within a larger paradigm shift that may constitute a "fertile field of growth." The explosion of the fast-food restaurant concept during the 1950s through 1980s corresponded with a paradigm-shift in pace of life in the United States after World War II. The tradeoff consumers made, however, was in the healthiness of the meal -- you don't always feel very good (or very good about yourself) after consuming a fast-food meal.

Fast-fresh seeks to counteract the negative aspect of traditional fast food without sacrificing the main positive aspect of the fast-food concept (the "fast" part). Instead of plastic decor, bright and unnatural colors, and mass-produced bread, Panera features fresh-baked breads (fresh dough is delivered daily from strategically-located fresh-dough facilities that have an optimal distribution radius of 300 miles), a healthy menu, and a natural ambiance emphasizing earthy colors and free wi-fi.

The history of the company provides a clue to another paradigm we believe is important to the investment thesis. In 1976, a French oven manufacturing company created a showcase restaurant in Boston's newly-renovated Faneuil Hall Marketplace, dubbed Au Bon Pain (French for "with good bread"). In 1978, investor Louis Kane bought the restaurant and began expanding in the Boston area. In 1981, he was joined by political consultant and cookie chain regional manager Ronald Shaich, and together the two began pioineering a new concept in fast-food, the bakery-cafe.

At about the same time, in Kirwood, Missouri, a man named Ken Rosenthal was appropached by his brother about starting a business based on the sourdough bakeries popular in San Francisco. Ken and his wife traveled to SF, learned sourdough baking methods, and founded St. Louis Bread. The concept was successful, and they began expanding slowly over the next few years. By 1993, they had grown to twenty cafes. At that time, their business was acquired by Au Bon Pain, which had gone public in 1991. The concepts of the two companies were very similar, serving breakfast and lunch and featuring baked goods, made-to-order sandwiches, soups, salads, and locally-roasted coffee.

Eventually, the Au Bon Pain line was sold to a private equity firm and the remaining St. Louis Bread bakery-cafes were branded as Panera Bread bakery-cafes (except in St. Louis itself). The company has now grown to over 1,400 locations.

The interesting thing to note about this story is that Panera's success appears to be built in part upon the expansion of an urban phenomenon into suburban, "ex-urban," and even "sub-rural" markets. The concept of a "corner bakery" is an urban concept, and the convenience of having fresh-baked bread available in the neighborhood, and the cultural phenomenon of having neighborhood delicatessens and bagel-shops, are primarily an urban phenomenon in the United States. Panera has built a business model based on capturing the benefits of this primarily urban experience and exporting it to non-urban settings (suburban, collegiate, upscale rural, etc).

The company, of course, continues to have a significant presence in cities, but that is not surprising -- by making a successful urban concept repeatable, they can compete in cities as well, gaining economies of scale and using their superior resource base to their advantage.

Finally, the company faces an attractive potential field of growth in the large portions of the country where there are still few or no Panera Bread bakery-cafes. Our internal analysis suggests that, if the saturation level of Missouri can be projected to the rest of the US, the country is still under 50% penetrated in terms of the addressable market for the Panera Bread concept.

This is an example of the type of company that we look for as a potential destination for investment capital, and the kind of growth story which we seek to connect our investors with so that they can participate in the company's future earnings.

To read about other companies which we believe exemplify some of the same criteria, please visit this previous post, which contains a description of a different investment thesis and links to others we have published in the past.

* At the time of publication, the principals of Taylor Frigon Capital Management own securities issued by Panera Bread (PNRA).
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