Alternative Investing for the Individual Invseestor

JULY 2009

Why do investors need alternative Alternative Investing for the Individual investing? The answer is that secular bull markets Invseestor alternate with secular bear markets. You can’t always count on making money investing in the By William Parmenter, editor S&P 500. Indeed, you can count on losing money in the S&P during the long periods of secular bear Roger Shaar discussed alternative markets. investments at the July 18 AAII Los Angeles For a few examples, the S&P 500 returned chapter meeting at the Skirball Center. only 1% per year between 1903 and 1921; only Shaar is a former president and program returned .5% per year between 1967 and 1982; chair of the Los Angeles chapter and a member of and returned a negative 5% a year between 2000 AAII for 28 years. During his career he was in and 2009 (the only consistently negative return international sales for Lockheed, spending many period). The S&P 500 may only return an years in the Middle East, while at the same time he average of .5% a year between 2000 and 2016, invested in real estate for 42 years. leaving secular bear claw marks on investors’ He opened his talk with a quote from the portfolios. British economist John Maynard Keynes, “It is Gail Dudack estimated that it could take to better to be approximately right than precisely 2016 for the S&P 500 to reach its 2000 peak of wrong.” Sage advice for the current turbulent 1,550. The S&P 500 hit a low of 858 in April, market conditions. 2009. Then, he moved on to profiling the typical Investors want to take advantage of Wall member of the Los Angeles AAII chapter. Most are Street, but it is disconcertingly easy to end up a between 45 and 75 years old and prefer to make casualty of the street. Why? Well, there are too their own investing decisions, investing as a part- many unknown unknowns…too many black time activity. Their average investment portfolio swans. Or, as, Harold MacMillan phrased it, ranges in value from $400,000 to $2 million. Most “events, my boy, events.” are college-educated professionals, many with In other words, investors too frequently graduate degrees, making them a very elite group. get blindsided by unexpected events—the Traditional investments include stocks, equivalent of those fancy trading models getting bonds, REITs and international investments, often packaged in mutual funds and ETFs. whacked by exogenous variables. In contrast, Shaar defined alternative Table of Contents investments as everything not regularly covered in Roger Shaar Alternative Investing p.1 AAII presentations, which amounts to hundreds of Kieran Osborne Currency Trends p.3 things. But for the purpose of the talk, the focus Renaud LaPlanche Lending Club p.4 had to be on investments of wide interest. Don Gimpel Education Nuggets p.6

1 One investment solution is in fixed income of his expertise. He can explain the intricacies investments. But they are subject to: interest rate of financing and of risk factors under various changes, credit quality, market valuations, market and time conditions. Audience members liquidity, prepayments, early redemptions and would have appreciated more information on the other factors, such as taxes. risks and rewards of apartment-building Shaar moved on to contrast traditional investing. For more information on the topic, investments with alternative investments. He Shaar can be reached at [email protected] characterized traditional investments as being for Shaar’s final topic was total portfolio the masses. Strategies for traditional investments risk. One of the best approaches is to invest in include asset allocation, diversification, market non-correlated assets. One would like to invest timing and stock and sector picking. in a variety of investments that are in watertight Alternative investing is for the willing, compartments. according to Shaar. That includes: hybrids, exotic A negative example would be Lehman financial assets real assets and combinations of Brothers, which basically had its assets in one the above. big compartment. When Lehman was hit by a Real assets that have an assured cash flow typhoon , its one big compartment flooded and (examples, a coin-operated laundry business, an the firm sank. apartment house or a gas station) give an investor On the other hand, Berkshire Hathaway has the advantage that a swimmer has with an oxygen tank on his back. They are comparable to an annuity. Other real assets don’t have a cash flow (for example a Ming dynasty Chinese vase, or a Los Angeles County Meeting Schedule painting by Picasso) and depend on asset appreciation, and taste and market makers to bid Westside Computer Group – Don Gimpel, 310/276-9875 [email protected] Veterans of Foreign Wars Memorial Bldg. up their price. Culver Blvd. & Overland Avenue, Culver City, Date and topic TBA The investing advantages of real assets Pasadena Group – Meets at 7 p.m., meets at Lamanda Library, include: leverage, assured cash flow, no 140 S. Altadena Drive, Pasadena. (Meets third Tues. of the management expenses and a post-retirement month, except for August and December.) Topic TBA income stream. Mutual Fund Group – Gunter Hagen 310/457-7404, Shaar gave an example of investing in an [email protected]. Date and topic TBA at Fairview Library, 2101 Ocean Park Blvd., Santa Monica. The meeting is free to the apartment building, in Burbank, with eight one- public bedroom apartments. Cost of renting an apartment Stock Selection Group —Norm Langhout, 310/391-6430, in 1969 was $65 per month, and the building was [email protected]. Fourth Wednesday of the month at 7 p.m. worth $57,000. In 2009 the same apartment Fairview Library, 2101 Ocean Park Blvd., Santa Monica. Topic TBA rented for $985 and the building was worth $955,000. San Fernando Valley Group – Mid Valley Library Community Room, 16244 Nordhoff St. North Hills, Date and topic, TBA Over that 40-year-period the building was refinanced 12 times. The average annual return IBD Meet-Up/AAII CANSLIM Group –Fairview Library, 2101 Ocean Park Blvd., Santa Monica. Date and topic TBA on equity was approximately 18 percent. The unrealized capital gain was $943,000. Los Angeles Chapter Skirball Center No meeting in August. Roger Stinnet, of City National Bank, on “Weathering Volatile Shaar’s equity in the building is $267,000, Times: Key Tactics for Your Esate and Retirement Planning”; and, or 28 percent of the price. He cashed $676,000 Fred Richards, on “Stock Selection Strategies.” out of the building, over a 40-year-period. His average leverage (debt to equity ratio) was 2.5 to many compartments of unrelated businesses, 1. His average loan to value was 70 percent. for example in furniture, shoes, candy, Since Shaar has been a landlord, investing newspapers, soft drinks, banks and insurance. in apartment houses for many years, this is an area 2 Berkshire Hathaway’s share price will go down in Regarding the cheerleading about green market storms, but the firm will not sink. shoots in the economy, Osborne pointed to a Shaar concluded his talk with an enigmatic distinction between hard facts and arbitrary quote from Albert Einstein, “Not everything that forecasting, based on unrepresentative data. counts can be counted. Not everything that can be Green shoots cheerleading is based on arbitrary counted counts.” projections. Significant economic headwinds remain. The Fed has moved beyond its traditional Currency Trends and Implications role in setting fiscal policy and moved on into monetary policy, compromising its own By William Parmenter, editor independence. Foreclosures should continue to rise. Mortgage activity could be downgraded by Kieran Osborne, the second speaker at the 30 percent, due to interest rates going too high. July 18 AAII Skirball Center meeting spoke on the State economies, particularly California with its topic of “Currencies: Trends and Implications in a IOUs) will put upward pressure on rates, an Changing World.” inflationary effect. Osborne, a native of New Zealand, is the co- Expectations are the key to inflation. portfolio manager of Merk Investments. He Inflation is a bigger risk than deflation. manages two mutual funds. Expectations of inflation will push up prices and In his talk, Osborne gave a summary wages in a spiral. overview of the contemporary market situation, and Osborne was concerned that the federal then discussed investing in currencies. government’s actions may be sowing the seeds for The financial situation in the U.S. was the next crisis. Among his concerns: rewarding unsustainable. Among the problems were the twin bad businesses at the expense of good ones. Also, growing deficits, that of the federal budget and the crowding out effects, as the private sector current account. People in the U.S. were too allocates resources more efficiently than does leveraged in cheap credit. In addition, the public government. Finally, government debt is was a global over-consumer. overvalued, and foreign demand may well wane. In Asia there was an interest in growing Who would want to buy artificially overpriced employment. Now, though hindered by recent government bonds? global overproduction, Asia has massive surpluses As it is now, the government’s status as a of foreign reserves. Its cash position is much safe haven is dubious. The Fed is hamstrung to superior to America’s. rein in inflation. Government Treasuries look Corporate America has been faced with increasingly unattractive as investments. margins being squeezed, with accelerated Turning to currencies as investment outsourcing and lackluster job and real wage vehicles, Osborne asked rhetorically, “why growth. currencies?” Some of their attributes are size, The Fed fostered credit expansion. Now it liquidity and their low correlation with stocks and is less relevant and ineffective. People operated bonds. with a false sense of security. People were living Currencies do not require leverage. beyond their means. Who would have thought that Merk’s mutual fund has no leverage. Investors housing prices would decline precipitously? can use the basket approach, investing in a variety The ensuing credit contraction was related to of currencies. a rise in volatility and priced risk back into the Osborne made a fast trip through the market. With a paring down of leverage came price currency investment prospects of the currencies of deflation. People sank under water on their home various countries. Of the U.S. he said the mortgages and drowned financially. pendulum has swung away to other currencies. 3 Concerning the European Central Bank Currently the economy is experiencing Osborne noted that it is conservative, that deflation as debt comes due. After that there may consumers are less leveraged and Europe has lower be inflation. China’s products are inflating the inflationary pressures than the U.S. economy and expectations of inflation are Norway Osborne called the new important in forecasting inflation. Switzerland. At the heart of the Swiss economy is its troubled banking system. Norway is more of a ‘Lending Club’: A Novel Approach to safe haven, where the government was very Fixed-Income Investments conservative in terms of intervention. Australia and New Zealand are commodity By William Parmenter, editor dependent, have trade deficits and are subject to carry trade. Renaud Laplanche explained how the Canada is mainly notable for commodities, Lending Club could help investors earn monthly and, while fiscally sound, has considerable exposure income by investing in consumer notes. He to the U.S. spoke at the July 18 AAII meeting at Skirball Gold, Osborne termed sound money, citing Center. inflation concerns, but noted it holds its value better Laplanche is the CEO and founder of than many currencies. Lending Club, overseeing all aspects of its The yen he called a “panic currency”, operations. Previously he founded a software commenting on the carry trade breakdown. company that was sold to Oracle, and before A financial services expansion is under way that was a lawyer with a New York law firm. in Asia. China has a big hard currency surplus, and He won an entrepreneur-of-the-year award in relies too much on exports. 2002. However, China is using the surplus to build Consumer notes are registered securities infrastructure in huge projects. One of them is the that give individual investors access to a new nationwide bullet train network, which is employing asset class that combines high returns, low 110,000 workers and will cost $50 billion in 2009. volatility and no correlation to the stock market. By the time the project is completed in 2020 bullet In getting under way, Laplanche trains will be flying through the countryside at commented that California was a haven for speeds up to 220 mph, and China will have spent immigrants seeking the American dream, due to $300 billion, according to an Aug. 17 Fortune the wide availability of credit, allowing people magazine article. to start businesses. India has a narrow band of highly skilled Laplanche’s market niche is the and educated workers and mass poverty of at least underserved market of the prime credit 300 million people on the brink of starvation. The consumer. Why would the consumer want to country is also involved in infrastructure build-out, pay 24 percent interest on his credit card debt? including a massive, partially completed project to That is what even the top borrower, who is the build an interstate highway that circles the most credit-worthy, has to pay. Such usurious subcontinent. According to an article in the June 22 rates imbalanced the market, creating an Forbes magazine India is projected to grow at five entrepreneurial opportunity. percent and it now ranks as the twelfth-largest Lending Club’s rates are better than the economy with GDP topping $1 trillion. credit card companies affiliated with banks. In the question and answer session Banks charge an average 16 percent credit card concluding his talk, Osborne commented that the rate, and pay depositors an average of 1.75 U.S. can no longer rely on the consumer to pull the percent. In contrast, Lending Club charges its economy forward. borrowers an average of 13.5 percent, and pays its investors an average of 9.05 percent, a

4 situation with a much narrower gap between Average monthly returns during the charge and investment return. comparison period from June, 2007 to March, The business model allows investors to 2009 were: loan peer to peer, or P2P, through the Lending Club, .75 percent intermediary of Lending Club. LendingClub.com Bond Market, (BND), .52 percent (to reference the internet site) packages loans and S & P 500, -2.88 percent sells them as notes, eliminating the high cost and Lending Club’s average loan size ranges complexity of banks and credit card companies. from $5,000 to $10,000. It has 180,000 P2P more directly links lenders and members, and is located in Sunnyvale, Cal., borrowers than does a traditional bank. The phone number,1-866-811-9225. media has shown a lot of interest in the business While P2P has a lot to like, there are model, prompting coverage in Reuters, some caveats. P2P is not as regulated as banks, Bloomberg, CBS, Barron’s and others. which provide deposit insurance. Peer-to-peer P2P may grow to more than $100 billion companies must register with the federal in annual loans by 2012 from about $500 million Security and Exchange Commission, because this year, as borrowers seeks ways to reduce their the loans are considered securities, according to costs, according to Ed Kountz, of Forrester SEC spokesman John Nestor. Research Inc., in Cambridge, Mass. P2P lending “Investors have to question whether they offers a way for borrowers to get access to money want to do business with a cottage industry,” for home, auto and student bills as banks scale Carol Kaplan of the American Bankers back lending, during the current severe recession. Association said. “Banks are trying to control “It’s a great opportunity for investors to their risks,” she added, “by not granting credit to compete with banks, which have largely been some people who may have a credit card, but ripping off the public with their high rates,” said are less than desirable borrowers.” Alan Lysaght, author of the book The ABCs of The risks of P2P loans include Making Money. insufficient information to determine whether Lending Club targets only prime borrowers will repay,” said Ken Naehu, a fixed- borrowers, usually young professionals, using income manager for Bel Air Investment rigorous standards to approve less than one in 10 Advisors LLC in Los Angeles. If borrowers do applications. Borrowers have an average 713 not repay, investors could lose all the money in FICO credit score, an average of 10 percent debt their investment. to income, and no current delinquencies. Consumers may refinance as much as Currently Lending Club has issued $45 million in $159 billion by 2012 in credit card-card debt loans against a base of $471 million loan with P2P, according a January study by Javelin applications. Strategy and Research, in Pleasanton, Cal. High standards have led to solid returns. Consumers could also refinance with an on-line The average annualized return as of July 15 this bank, the main rival of P2P lending. year was 9.6 percent. The annual charge off rate Other companies specializing in P2P was 3 percent. And the late payment recovery lending are IOUcentral.com., Zopa.com., rate was 75 percent. Loanio.com. and Prosper.com. Investors receive monthly payments of This is an industry that can get “a principal and interest. The trading platform sizeable percentage” of the almost $3 trillion in provides liquidity and flexibility. This is a new U.S. unsecured debt, said Chris Larsen, a San asset class with a strong track record, said Francisco-based P2p lender. This new asset Leplanche. class is easily diversified,” Larson added. “People are going to be able to find some great returns.” 5 But, what about those incoming alien Education Nuggets missiles? Kirk’s response, “Shields Up.” By William Parmenter, editor Orange County AAII Announcements Dr. Don Gimpel’s five minutes of investor education and announcements took the form of For information about the Orange futuristic, hypothetical situation. Imagine it is County chapter of AAII and their meetings, go 2040 A.D. and Capt. Kirk , on the starship to [email protected]. Enterprise deep in space, is informed that an alien craft is closing fast and is only 10 minutes from Note to Pro Forma Contributors: blasting Enterprise into stardust. That would give the good captain only a Please have your copy emailed to the few minutes to buy and sell stocks before editor by the fifth of the month. Letters and responding to the alien threat, or being vaporized. comments are welcome. If you want to email an Kirk checks his holdings of Microsoft, article about smart financial steps for coping Apple and Google on his hand-held device, and a with widowhood, whether China can spend its comparative analysis comes up in five seconds. way out of recession, impending health care The proper allocation for Kirk to have an reform, the Social Security “timebomb” or some efficient portfolio would be: Apple, 4.5 percent; other financial issue, you will have a chance to Microsoft, 7.13 percent; and Google, 5.24 percent. appear in print and inform Pro Forma readers. Wow. But, hey, just hold on a nanosecond Book reviews are welcome. Mail disks —you do not have to wait 30 years to get this type to: 319 Walnut Ave., Apt. 2, Long Beach, CA. of information. Allocation information to have an 90802, or use email to send copy to the editor at efficient portfolio is already available, today, at [email protected]. wolframalpha.com. My home phone is (562) 437-2412.

6 Pro Forma

Pro Forma Editor William Parmenter Pro Forma Editor, Emeritus Orvis Adams

SIG GROUP CHAIRMEN

IBD Meet-up/ AAII CANSLIM Norman Langhout Mutual Fund Group Gunter Hagen Options Group Robert Morgan Pasadena Group Ivan Wong Palm Springs Group Patti Gammino San Fernando Valley Group Evan Press Westside Computer Group Don Gimpel

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