summitV I E WThe CosT of opporTunITyby Ian Jameson When you decide to pursue one action over another, the act you didn’t do is referred to as the opportunity cost; what you could have been doing if you weren’t doing what you’re doing. Weighing this cost after a decision has been made can lead to buyers’ remorse, or a validation of your action. summitVIEW An interesting series of questions arise from this line of thinking: How do you know what the opportunity cost is? How do you know what you don’t know? Much of modern financial theory has defined opportunity cost as the return that an investor would receive from investing in a “risk-free” asset versus investing in a different financial asset. Investment professionals have then divided assets into classes such as bonds, stocks, real estate, cash, natural resources, foreign currency, collectibles and insurance products. By this logic, the opportunity cost 1 for an equity investor would be the return that they would receive from holding bonds, real estate, May cash, etc. instead of their equity investment. Defining the relative returns of the various asset classes 2011 has been a bit of an art form as well; services like Standard and Poor’s and others provide indices for a variety of asset classes, the most familiar being the S&P 500, an index based on 500 large companies that trade in the US on the NY stock exchange and the NASDAQ. For many people, the S&P 500 serves as a benchmark for the concept of stock market return. The opportunity cost for holding cash or bonds, for example, would be the return that you could have generated if you’d invested in stocks, approximated by the return of the S&P 500. Stepping back from modern financial theory, the opportunity cost for an equity investor also includes the “return” that could have been achieved by investing in a local charity, re-insulating your home, taking a week-long backcountry trip, or sending your child backpacking around Europe. Quantifying these benefits is not something that modern financial theory, or anyone else, is able to accurately model. However, there are costs and benefits associated with each potential investment. When choosing how we donate, see disclaimer on last page
where we vacation, if we spend now to save on the performance of your Growth-oriented Large- future energy bills, and what we want our children cap mutual fund will yield some similar results, to experience in life, we are looking to the future, but stepping back from America will offer some seeking to improve upon all we’ve experienced until perspective:summitVIEW this point. From Standard and Poor’s: Looking to the future, then, is a very important part of investing, as is incorporating past experience. If The S&P 500® has been widely regarded as the we know the sugar high from a Krispy Kreme donut best single gauge of the large cap U.S. equities is followed by a not-so-great crash, we’ll incorporate market since the index was first published in that knowledge into our future decision making 1957. The index has over US$ 4.83 trillion processes. If we know that financial assets tend to benchmarked, with index assets comprising move in the same direction during periods of market approximately US$ 1.1 trillion of this total.2 turmoil, that too can be incorporated into our future The index includes 500 leading companies decision making process. in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities.May 2011 A Benchmark for Investing? • The current market capitalization of the S&P 500: $12 trillion We are somewhat constrained in our historical knowledge of financial assets. Just as people have • Current market capitalization of stock markets realized that the language we speak shapes the way in the World Federation of Exchanges: $55 we think, the language of investment also shapes trillion our thought process. • World financial assets---including equities, Anyone who has ever invested in a mutual fund has private and public debt, and bank deposits seen a diagram like this: according to McKinsey: $178 trillion in 2008 Value Blend Growth • Size of the global derivatives market, according to Paul Wilmott: $1,200 trillion. Large 1000000 - million 1000000000 - billion 1000000000000 - trillion 1000000000000000 - quadrillion Mid Yeah, that’s $1.2 quadrillion........ So, the S&P 500 represents 22% of the stocks traded in the world, 6% of world financial assets, Small and is 1% the size of the global derivatives market. Now, we are not suggesting that individuals need to participate in some sort of collateralized debt This diagram represents the universe of options obligation investment to gain a broader investable available to a mutual fund investor: style on the universe (if you thought the Krispy Kreme hangover horizontal axis, and market capitalization on the was rough, try unwinding one of those contracts vertical axis. when it goes south). Rather, the point of the Is an investor’s entire universe of possible exercise is to show what else exists in the world of investments contained in a 3x3 box? The answer is financial assets, and how our perspective is shaped Yes, and No. by what we know. As the 2011 Ibbotson SBBI Classic Yearbook points out, “[a]n investor who Is “the market” a proxy for investment performance? chooses to ignore investment opportunities outside The answer is Yes, and No. the United States is missing out on over half of the investable developed stock market opportunities in Watching movement on the S&P 500 and comparing the world.”
As our knowledge increases, so too does ourunderstanding of the opportunity costs that we face asinvestors. In that regard, our investments will changeto reflect what we’ve learned over time. WhenAmerica experienced an oil price shock in the 70s, We have historical data that shows what risk/investment decisions incorporated the threat of higher reward relationships have looked like for afuel prices, auto makers produced vehicles that got variety of asset classes in the past, but what will the opportunity cost be of holding these summitVIEW40+ mpg, and consumers invested in them. As fuelprices declined and vehicles got larger and consumed asset classes in the future? For example, whatmore fuel, we re-learned (or un-learned) some of the is the likelihood that large company stockslessons from the past and when fuel prices spiked will exceed their historical average returnsagain, revisited a similar cycle. in the next five years? We consider the use of historical data important in forecastingIncorporating the longer term trends (i.e., oil as expected returns. However, we also believea finite quantity) with the shorter term cycles (fuel deviations from historical returns are likelyefficiency in vehicles) is a necessary part of an in any given long term period of time.investment analysis. Defining an investable universe Forecasting asset class returns is just as much 3means defining long term trends and cycles within art as science. Consideration of pertinentthose trends, then choosing assets that reflect socio-economic matters helps us to adjusteverything we’ve learned up until today, and putting historical returns to reflect our beliefs. May 2011resources towards assets that we believe will prosperin the future. What will be the structural changes to the economy as a result of these socio-economic trends? How will the structural trends affectWhat is your Benchmark? market performance over the long term?Historically, investors have been taught that there Once again, a multitude of variables are inis one “market portfolio,” which serves as the play, and any one person’s interpretationbenchmark for investing. Many have used the S&P of these variables will differ from another’s,500 as the proxy for the “market portfolio.” The sometimes dramatically. As we wade throughpercentage of one’s assets allocated to the “market data and interpret opinions on what trends areportfolio” is determined by an individual’s risk being played out in the world, we will begin totolerance. We believe that no two investors, who determine the returns that we expect for eachdiffer in either risk tolerance or in their forecasts for asset class in our investable universe, and thereturns, will have the same investment strategy. level of uncertainty surrounding those returns.Defining your risk tolerance is equally as important Once we’ve established our ideas aboutas defining your investable universe, and has strong returns and the uncertainty of those returns, wesimilarities: both will change over time given new can determine how much of each asset classknowledge, understanding, global trends, and an investor should hold.evolving investor circumstances. In determining if By assessing one’s risk tolerance and futureyou’re a conservative or aggressive investor, you are financial needs, investors can constructdetermining which aspects of the investable universe appropriate benchmarks for investmentwill be larger parts of your portfolio. Determining performance. Once suitable benchmarkyour asset allocation hinges on an interpretation of allocations have been determined, assets canthe risks and rewards associated with each asset class be allocated to reflect individual risk tolerancein your investable universe. and return forecasts. some perTInenT soCIo-eConomIC vArIABles: - growth of global middle class and global markets - ageing population demand for entitlements - political will to adjust governmental entitlement obligations - debt levels in the public and private sectors - deficit spending by local, state, and federal governments www.summitcreekcapital.com
ConsCIenTIousinvestingby penny mandell starting to embrace impact investing At Summit Creek Capital we focus is that traditionally they invested on returns in the broadest sense,For many investors, if you discuss purely to optimize risk based returns that means both bottom line and“Socially Responsible Investing” with no thought to social factors, social impact are important to us.the immediate assumption is that and on the philanthropy side they Rather than viewing impact investingthis is synonymous with sub par are used to investing to maximize as a restrictive process we view it asprofitability and that it is the bastion social impact with no expectation of a proactive portfolio choice.of tree huggers and nuns. It also financial return.conjures up a process of creatingexclusionary screens designed toweed out morally reprehensible The glow of doing a social goodpractices like drinking, gambling, mixed with high returns wouldweapons manufacture and child seem attractive to high-net-worthlabor. These perceptions may have individuals. But impact investingbeen true at one time but there is is still in its infancy. The Global Impact Investing Network, aa big change underway and this nonprofit group, said that currentchange offers exciting opportunity. impact investments amounted to about $50 billion. It projectsThere is an increasing investor this area to grow to $500 billionawareness that you can actually do by 2014, putting it at roughly 1well while doing good. percent of all managed assets.Impact investing is the term “I think the tipping point is now,”given to the practice of directing said Camilla Seth, director ofinvestment portfolios to solve social programs and operations for Theand environmental problems as Global Impact Investing Network.well as generating a return on the “This activity has been happeninginvestment. for 10 years but investors have been insulated.”True impact investing is reallymore about effecting positivechange through investment and Combining philanthropic ideology We too feel that we are at a tippingcreating positive results beyond with investment savoir-faire, impact point here. The $500 billion [seethe financials. Impact investing investing — actually the intersection box above] estimate clearly indicatescan be a powerful complement to of these two concepts — creates a that there is potential for largephilanthropic and governmental very powerful engine for change. amounts of capital movement, andspending. The reason a lot of The philanthropist is targeting right now there is a lot of innovativeinstitutional investors are just now money at specific needs with no thinking about how to best achieve expectation of profit; this. We have been actively it is money that is working with various experts in this given away. The burgeoning space and are excited 3 T his is noT your investor is targeting about the ongoing opportunities. ’ . investments for moTher s book club maximal profits with Education is a critical part of this no goal to alleviate process for both individuals and broader social institutions. It’s exciting to show problems. Impact that the impact investors can have Penny Mandell has created a fun and investing allows for extends far beyond the bottom line provocative environment for becoming targeting specific and will be the catalyst for solutions financially fluent. solutions while still to many of our planets most generating a profit. pressing problems. This is an exciting 3 concept for many What issues are you most individuals who fluent females focused on flourishing fiscally typically keep their passionate about? philanthropic funds segregated from their visit www.f3blog.com to learn more investment funds.
Where We’ve Been, summitVIEW Where We’re Going by matt mcneal With the shutdown of the second round of without wage growth?). Quantitative Easing (QE2) looming at quarter’s Banks have received large amounts of cash, though 5 end, investors are wondering what the equity it isn’t totally clear what they have done with it. We markets will look like when the Federal Reserve don’t attempt to answer that question, instead we halts the massive liquidity program. As a brief offer our observations of what happened when May 2011 refresher, Quantitative Easing is when the Federal round 1 of QE ended and what might happen Reserve Bank prints money (just creates it out of when QE2 closes. It sounds cliche, but before thin air), and uses the newly minted dollars to buy we look at what might happen in the future, it is assets from banks (mostly Treasury bonds).Where useful to take a look at the past - in this case the the bank used to be sitting on a pile of Treasury first round of Quantitative Easing - how the market bonds, they are now sitting on a pile of cash. The reacted when that program ended, and how the theory is that banks will push this new money out market responded to the possibility of QE2. In their doors as loans, circulating it into the economy, the green box below is a short piece we wrote in thus jumpstarting a sustainable recovery. Well December 2010 taking a look at the effects both - some things have jumpstarted (stock market, QE programs have had on the market. Note that we’re lookin’ at you), while other things remain we did not perform any correlation calculations stubbornly stagnant (unemployment) and others or higher math of any sort - just pinpointed some defy explanation (consumer spending expansion dates on a chart of the S&P 500 index.That was then... the Federal Reserve will do anything The first round of Quantitative Easing The economy seems to have subtly to keep the stock markets propped (now known as QE1) essentially ran turned a corner heading into the last up. It is telling to look at a chart of from late 2008 until the end of the weeks of 2010. Consumer and Business the S & P 500 over the last year, and 1st Quarter in 2010. Clearly, the Leader Sentiments are up, the major pick out a few important dates on the market did not appreciate the program indexes have surpassed the highs Quantitative Easing timeline to review. ending. After a steep selloff and a reached over the summer, and have achieved levels not seen since the days before Lehman Brothers went down in QE2 Officially Announced flames. Has the US finally shrugged off the anchor of the Great Recession and returned to sustainable long term growth? We remain skeptics, but some of the recent global improvements have kept us from turning into outright cynics (well, some of us anyway). Certainly there are areas in the global economy that will provide attractive opportunities, and it is these areas where we focus our Bernake’s Speech efforts. QE1 Ends However, if there is one thing that we have learned (because it has been hammered into our skulls) it is that www.summitcreekcapital.com
summitVIEW6 summer of rangebound returns, budging the stubbornly high to argue with. Again, pleaseMay 2011 Ben Bernanke made a speech in unemployment, but as the chart reference the above chart. Jackson Hole, WY in which he above shows the old adage The unemployment rate may hinted that if necessary, the Fed “Don’t Fight the Fed” clearly still be stuck near 9%, consumer would not hesitate to engage in applies in the equity markets. sentiment may be stuck well another round of Quantitative below the levels associated with Easing. In the speech he tried Way back in January 2010, any previous recovery in recent to stress that the Federal the Economist Magazine history, and any other of a Reserve believed the economy featured a cover story accusing number of economic indicators was strongly recovering and central bankers of pumping may be pointing to prolonged probably would not need the up asset bubbles through pain, but clearly the stock additional stimulus. The two monetary stimulus. Europe market responded well to the months that followed that seems to be chastised (through Federal Reserve’s programs over speech were a bizzaro world for necessity) into taking the the past two years. equities (not that it hasn’t been austerity approach - tax hikes bizarre for longer than that). and spending cuts on the On top of the monetary stimulus Headlines that suggested the fiscal side, and the discipline provided by Quantitative economy was not improving of the common currency on Easing, the President recently were greeted with strong run- the monetary side (though signed fiscal stimulus into law in ups in market indexes, as Great Britain maintains an the form of tax cut extensions. investors believed that the poor independent currency it is also Worth $858 billion, will these news reflected a greater chance choosing the austerity path). tax cuts also help to prop up for QE2, thus a greater chance The United States has chosen to equity markets? Once again, the of a Federal Reserve driven bull punt these difficult decisions to government is pushing serious market. Good economic news future generations, and decided reform down the road in order (admittedly sparse) was seen as the best way to get out of a to maintain the status quo. a sign QE2 would not happen, debt induced economic crisis and paradoxically reduced is to borrow and spend more. At this point, the best course of investors’ enthusiasm for risk While the long term wisdom of action may be to drink the Kool- assets, sending markets down. this strategy is rightly questioned Aid and enjoy the ride up. by responsible thinkers, the The Federal Reserve may not short term effects of the fiscal have had much success in and monetary steroids are hard
summitVIEWThis is now................................ With the benefit of hindsight, drinking that Kool-aid and going all in was a good idea. Below is an updated version of our original chart, with the market returns extended to the 7 beginning of April 2011. The gains continued from the time of Bernanke’s WY speech until Spring of this year. May 2011 QE2 Officially Announced QE1 Ends Bernake’s Speech Mid-East Uprisings, Nuclear Meltdowns, etc It took radical uprisings in the Middle East and an earthquake, tsunami and nuclear meltdown in Japan to derail the relentless upwards march of the market, and even then it couldn’t knock it down for long. There are US military forces actively fighting in Libya and radioactive water leaking into the Pacific Ocean even as we type, and the market is rallying. That Quantitative Easing is powerful stuff! Not to overstate the importance of QE2, there have been some data prints that point to a strengthening economy. Lower unemployment, a hint of price inflation (which would be a good thing now), increased labor productivity and increasing ISM manufacturing survey numbers have given investors some optimism that the US is edging towards a sustainable recovery. Of course there are two ways to look at each one of these statistics, but that may be the subject of another paper. www.summitcreekcapital.com
We aren’t the only ones thinking about the end of Quantitative Easing. A quick, unscientific internet search turns up scores of articles which, true to form for anything to do withsummitVIEW forecasting, are all over the map. As an example, these two headlines appeared right next to each other on the first page of a Google search (quotes added for flavor): End of QE2? no ProblEm for StockS VS. [bill] GroSS WarnS QE2’S End could Sink markEtS “The economic recovery is much stronger than most give it ”By eliminating QE II, the credit for, and so much of the8 Fed would be ripping a talk about the end of QE2 Band-Aid off a partially is factored in already,” said healed scab,” Gross Ryan Detrick, senior technicalMay 2011 writes. “Ouch!” strategist at Schaeffer’s Investment Research, whose forecasts puts the S&P 500 up another 6% by the end of the year. So which story is more believable? Well, if our Reserve, by keeping the interest rate target pegged past experience with the withdrawal of the Federal at the 0% to 0.25% level, has forced investors into Reserve liquidity program is any sort of guide risk assets in order to realize any sort of return. for the future, we might be in for another rough The reward for holding Treasury bonds is simply summer in the equity markets. Of course, as every too low, even for traditionally risk-averse investors. investment professional knows, past performance Hence they are forced to seek yield in riskier assets is not a guarantee of future results, but in this like common stock and corporate bonds. This, of case it certainly deserves attention. Even if the course, is part of the goal for the Federal Reserve, economy has truly recovered enough to stand on and one of the reasons we ended up with QE2 - to its own two metaphorical feet, quitting the QE drug support the equity market. The major indices (Dow, cold turkey is not going to be easy and perhaps S&P 500, NasDaq) are collectively taken as a withdrawal really is the right word to use in this bellwether for the economy as a whole. When they case. Take Barry Bonds as a comparison - one are plummeting, no one feels confident. year he is pumped up on performance enhancers, breaking records and feeling great, then he quit It might help to take a look at some widely read the juice and the next thing he knows he is in a economic indicators to see how they compare to courtroom listening to humiliating questions about this time last year, when the Fed was on the verge the changing size of parts of his anatomy. He of ending QE1. isn’t dead, but clearly isn’t the star performer he once was. Will the markets behave differently or continue to be a star performer? March 2010 March 2011 Unemployment Rate 9.7 8.8 To be clear, if the market is healthy enough to ISM PMI Index 60.4 61.2 withstand the ending of QE, then the program should end as soon as possible. We are simply Consumer Sentiment 52.3 63.4 questioning what the aftermath of the withdrawal will look like. Ending the program was never going There has been some improvement in each of to be easy, and if anything keeps the Bernank (sic) these metrics over this time last year. It isn’t a rosy up at nights, it is this very problem. The Federal recovery, but its not doom & gloom either. Just sort of...sideways. Disclaimer: All material presented herein is believed to be reliable but we cannot attest to its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities.