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Barton Biggs January 7, 2020 Capitalism works quite well Success attracts competition. Sometimes industry leaders falter or at least their wonderful 'monopoly position' erodes. Sometimes the whole industry largely fails. Often it is because new entrants are able to raise capital to help them introduce new technologies and/or products and other innovations. The list of disruptions is very long and includes things like online delivery vs. shopping malls, cell phones vs. landlines, and cable and streaming vs. traditional local TV broadcasts. It is how the U.S. and global economy makes aggregate progress, but often stalwarts lose ground. If anything, company and industry lifecycles seem to be becoming shorter. Winner takes all is not new, but historically the best, most promising entities and industries mature and others emerge. Equity index solutions ensure that investors own all future winners in that segment of the markets without foreknowledge. Of course, index investors will also own the dogs including those that go from large components to effective failures. That's not ideal, but far less ideal is when you own future laggards in outsized positions today and little if anything in future winners. "There is no asset class that too much capital can't spoil." – Barton Biggs How do favorable stock cycles come to an end? High returns beget lots of capital. Too much capital means valuations get pushed up which lowers future returns. Here is what Barton Biggs observed -- https://www.bloomberg.com/news/articles/2019-12-02/-peak-private-equity-fears-are-spreading-across- pension-world Reflections on my career as an equity analyst The first four years in my career I was a ‘sell side analyst.’ My job entailed screening for companies that seemed to offer a favorable reward-to-risk ratio. In other words, we endeavored to find stocks that we thought were undervalued that if owned by our clients (institutional investment management firms including behemoths like Fidelity) would provide attractive returns. We had databases which enabled us to screen for characteristics that we thought were attractive like growth in sales, earnings and dividends of at least x% and then we also looked for valuation metrics (e.g. price to earnings (PE), price to book ratios) that seemed attractive relative to things like the company’s own history or broad measures like the S&P 500, etc. We then would have calls and in-person meetings with company managements to try to discern if it was likely that the company would be able to continue to generate favorable growth rates, whether it was likely that their profit margins would expand or contract and importantly why, etc. The profile I naturally gravitated to was companies with strong balance sheets (e.g. not a lot of debt), high profit margins, a history of steady sales and earnings growth (as opposed to highly cyclical companies) selling at discounts to historical valuation metrics. This focus is often referred to GARP (growth at a reasonable price). When I reflect back on these companies and their stock, it is impossible not to notice how many of these once well- thought of companies have failed to flourish. That said, some have performed quite well over the past 30 plus years. On the other hand, many of the best performing stocks did not even exist back then. Nearly 20 years ago, I embraced indexes as an effective means to capture long-term growth in the economy and markets. I became acutely aware that it is a relatively small number of upside outliers that drive most gains over time. I also was aware that often, the most dearly beloved companies, industries and segments can become unduly expensive while at the same time other segments can be owned at incredibly attractive valuations. That led to my strong conviction that it is essential to broadly invest one’s capital via ownership of many, if not all, market segments. Our advice and investment approach is different from many other advisers … That begs the question is it prudent, reasonable and effective? We are biased but we are confident it is. I want to share some insights about when and why we have developed confidence and conviction in our approach to manage risk and also earn competitive long term returns. More than 20 years ago, I started actively thinking about the risks associated with concentrating one’s capital including through ownership of even a broad based index like the S&P 500, and also about the stocks below the surface of the ‘mega caps.’ Specifically, I modelled the range of outcomes of large, medium and smaller cap stocks over time and came to the belief that broad ownership helps ensure good outcomes under ‘buy and hold’ conditions. Most industry practitioners believe that small stocks are more risky (e.g. they have a higher error rate) than large caps. While we agree, we also believe that a portfolio that is broadly diversified in small, mid and large stocks is less risky (and often less volatile) than just large caps or large cap indexes like the S&P 500. As history shows, indexes like the S&P 500 or Russell 3000 can decline and fail to make new highs for 10+ years. This can be painful for investors who are largely allocated only in large and mega-caps – especially those who are in ‘distribution mode.’ What is also true is that positive outliers are responsible for nearly all gains in a portfolio. After all, a particular stock can lose 100% of its value while others can increase 5, 10, 20, 50 or 100+ fold. Over the long term, it is those success stories that drive the increase in most portfolios including index funds. Indeed some studies reveal that roughly 70% of stocks ‘underperform’ their relevant index benchmark.i Often these stocks do not perform nearly as well as broad indexes – more like the Titanic. From an individual investor’s standpoint, this begs the following questions, namely 1) Do I have enough in the right sectors? 2) Within the sectors am I in enough of what prove to be stocks that generate handsome future returns? We believe diversified index based portfolios help ensure the right long term result. In my next letter, I plan to revisit an important topic, namely that cap-weighted indexes like the Russell Top 200, Russell 1000 and Russell 3000 produce surprisingly similar results over time and along the way. However, mid and small cap indexes perform quite differently than large cap or large cap dominated indexes like the Russell 3000. Therefore if investors allocate to mid and small caps separately, they can change the return profile and harness diversification benefits. Of course, investors can also allocate to international and/or ‘growth’ and ‘value’ segments. My next letter will show how this can be beneficial in the context of market data for the past 25 years. In sum, we have a healthy appreciation for capitalism and we are acutely focused on what can go wrong when everything seems to be favorable and vice versa. Finally we don’t know of any short-cuts/reliable ways of effectively timing in and out of various market segments. We don’t know when leadership among market segments will occur. We believe there is every likelihood we will continue to experience them in the future. We are prepared for these changes. Our approach remains centered on long-term risk management through deliberate diversification. Wishing you the very best in this New Year and new decade! W. Richard Jones, CFA Senior Vice President, Investments i Source: JPMorgan Private Bank, The Agony and the Ecstasy, September 2, 2014. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of W. Richard Jones, and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation Prior to making an investment decision, please consult with your financial advisor about your individual situation. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Russell 1000 measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 90% of the investible U.S. equity market. The Russell 1000 is highly correlated with the S&P 500 and is reconstituted annually on May 31. 4969 US Highway 42, Suite 1600 // Louisville, KY 40222 D 502.329.2371 // T 844-542-1834 // F 502.329.2072 www.harmonywealthpartners.com Raymond James & Associates, Inc., member New York Stock Exchange/SIPC .
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