Alchemy - Modern Portfolio Theory - And A Forecast

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Kendall J. Anderson, CFA                      

October 9, 2009

Lesson from an Adventure 

Recently our oldest daughter, Andrea, strapped our almost four year old granddaughter, Epiphany, into her car seat and they took off to visit the family here in Rock Hill.  The trip from Orlando is about nine hours by car. After nine hours had passed we assumed they would be arriving any minute. Ten hours came and went, and then eleven, and finally they arrived at our doorstep. Of course we immediately asked what had taken so long.  Andrea blamed it on good ole Dad, and said, "I guess I have Dad's disease.  You know... every trip has to be an adventure."   And she's right... I do love adventures. 

For the last fifteen years, I've had more thoughts of adventures than actual adventures.  Although I have been in the investment business for thirty years, during the last fifteen I've been managing portfolios and this leaves very little time for anything else.  Peter Lynch lasted thirteen years as manager of the Fidelity Magellan Fund. In his book Beating the Street, he says this led to the creation of Peter's Principle #1: "When the operas outnumber the football games three to zero, you know there is something wrong with your life."  His replacement only lasted two years.  According to Lipper Analytical Services, at the end of 2006 less than half of all managers had been on the job for 3 years and 20% had been on the job less than 2 years. Only 8% had been on the job 10 years or more.  I guess that puts me into the special class of managers who the average person would describe as "a little off."  After all, the job never ends: even after working ten hour days, you spend hours watching the business news and reading financial releases.  Your reward for all this work is the knowledge that three out of ten decisions you make on behalf of your clients will be wrong, even during the best years.  Add to that the constant public scrutiny of your results, and you can see very easily why so many people never make it to year 10. 

For the last 10 years I've satisfied my craving for adventure by riding a motorcycle and competing against the best motorcycle riders in the world as a member of The Iron Butt Association (IBA).  The IBA has more than 35,000 members throughout the globe who are dedicated to safe, long-distance motorcycle riding.  Membership is earned by completing a documented ride of 1000 miles in 24 hours, affectionately known as a "SaddleSore 1000."  If you are interested, visit the web site at www.ironbutt.com.  Every two years, the IBA hosts the Iron Butt Rally (IBR). This ride covers approximately 11,000 miles in 11 days.  There have been fourteen IBRs since the 80's with fewer than 400 riders completing the marathon.  Those who have completed one relish in the fact that more people have climbed Mt. Everest than have finished an IBR.  The IBR is known worldwide as the "World's Toughest Motorcycle Competition." 

Having completed two of these IBRs, I can attest that the IBA is not boasting by calling it "The World's Toughest."   This year, there were three separate legs, with the final leg beginning from Southern California.  This years' winner, Jim Owen, traveled over 5,000 miles on his third leg, a four day ride.  On this final leg of the event, he left Los Angeles, headed off to stop by Thunder Bay, Gay, Michigan, and Manitowish Waters, Wisconsin before heading to Edmonton, Alberta Canada and ending in Spokane, Washington.  His winning ride covered 12,706 miles while collecting 139,833 total points in 11 days. 

My adventure this year began in Spartanburg, SC but ended abruptly on the second leg. This leg began in Chicago and ended in Southern California, but during this leg the job of portfolio manager took control and required me to scurry back to Rock Hill.  This is indicated in the record books as a DNF (Did Not Finish), which really isn't so bad, but it was my first and only DNF in all of the competitions I have participated in.  

I do have a few good memories from the ride.  For those who visited me before the start, I am forever grateful.  I am also grateful for the Security Personnel at the Orlando International Airport who could have caused me a few problems, but did not, and for the non-English speaking gentlemen in Miami who helped me out. While there was rain in Chicago, flat tires, and a failed GPS, there were also many wonderful people from around the US, including my Moto-Guzzi friends, who were inquisitive and supportive. Finally, I am thankful, of course, for those who understood that the "risk gene" is in my DNA.  

However, it may take some time before the good thoughts and memories replace all of the emotions which immediately took over my mind shortly after returning to Rock Hill. Initially I went through a period of feeling humiliated.  However justified my leaving the competition was, I had failed to complete an event that thousands of people around the world dream of competing in.  I had also let down the Moto-Guzzi fans who have not seen their brand participate in an IBR for over a decade.  I was embarrassed to even bring the event up in conversations with my peers who have finished an IBR. However, after I came to grips with this, a second emotion took over, that of deep regret. Why didn't I try harder to fix the problems while riding the bike? Why didn't I just keep going no matter what problems had occurred? 

All of us have felt these emotions at some point in our lives, and not necessarily during competitive events.  How many people lost money in a Ponzi scheme and failed to report the loss due to a feeling of humiliation?  How many people sold all of their investments in February or March of this year and are now feeling deep regret that they did?  How many people failed to reinvest their funds over the past few months because they were rationalizing their decision to sell?  As we take a brief look at Modern Portfolio Theory, please keep in mind the power that emotions can have over our thought processes.

Alchemy lasted 2500 Years - Will Modern Portfolio Theory Last as Long?

Modern Portfolio Theory is the driving force behind the recommended asset allocation of a large number of advisors and consultants.  Dimensional Fund Advisors is the one of the best known advocates of this approach. They should be, as the force behind the creation of the firm was the work of Eugene Fama.  According to Dimensional Fund Advisors, "There is a model of investing based not on speculation but on the science of capital markets." Do you think we can apply science to the financial markets?  Are the financial engineers, the university professors, and the Nobel Prize winners who have created and worked with the "philosopher's stone" named Modern Portfolio Theory the current generations' Alchemists?  Only you can decide.

Alchemy

When I was first exposed to the folly of Alchemy I wondered how it had managed to control the minds of so many well learned and respected individuals for over 2000 years.  But as the years passed, I realized that thoughts of living forever with unlimited riches have a power which can consume us and take away all rational thought.  The Alchemists' believed and convinced millions of others that they could find the "water of life" which could cure all illness and the "philosopher's stone" which could change all metals to gold.  The current thought leaders in the investment community are also seeking the "philosopher's stone," but one of computer generated riches.  After all, what could be more appealing than to find a system which could be universally applied to turn all investors into "better than average?" 

All is not lost in the pursuit for riches, however, and sometimes good does result from this pursuit.  The search for never ending life and unlimited riches led to the recording of how to produce gunpowder by Roger Bacon.  Van Helmont is considered the founder of pneumatic chemistry, and it is likely that modern chemistry was a direct descendent of the work of Alchemists.  I also think that the search for a "philosopher's stone" financial theory will have long and lasting implications for future investors.  For example, the emphasis on risk and the benefits of diversification is a positive that we can take from Modern Portfolio Theory.                                                                                    

Modern Portfolio Theory

In the year 1900, a young man named Louis Bachelier completed his PhD thesis entitled The Theory of Speculation.  This paper was the first ever to use Brownian motion to evaluate stock options.  He is considered the pioneer in the study of financial mathematics and stochastic processes.  The paper sat dormant for fifty years before Harry Markowitz published his thesis entitled Portfolio Selection.  Another decade passed before the creation of the Sharp's Capital Asset Pricing Model and the publication of Eugene Fama's Efficient Market Hypothesis (EMH).  Most of these works passed through years with only a few advocates until the computer revolution of the 80's opened the flood gates.  To give you an understanding of how important Modern Portfolio Theory became, I will share with you a small part of an article written by John Authers, published in the September 29^th issue of the Financial Times: 

....But to accept [behavior finance] sweeps away assumptions that for half a century formed the foundations of the financial industry.  The reigning theory, often referred to in shorthand as "efficient markets," is deeply embedded in the way that markets operate. The regulations for pension funds and banks both ultimately hinge on these assumptions.  So does much law on securities fraud. 

            It is central to business schools' curriculum and is part of the Chartered Financial Analyst (CFA) qualification that acts as a gateway to the investment profession.  Fund managers run their business by comparing their performance against benchmark indices, another idea from efficient markets.  The products based on derivatives that grew notorious for their role in the market crash all stemmed directly from efficient markets theory... 

The basic tenants of EMH are that market prices at all times attempt rationally to incorporate all known information.  Patterns of returns in financial markets follow the normal "bell curve" distributions observed in natural sciences.  Risk can be defined by the extent that securities' prices vary around their mean. Enough observations of how markets moved in relation to each other in the past allow a precise and measurable method of defining risk.  A final requirement is to accept that all investors make their decisions rationally.  

These tenants as stated may be a little confusing, so here is a different way to think of EMH: In order to believe in EMH, you would have to believe that you can predict the market's future based on how the market acted in the past.  Markets' prices are always correct and people's emotions never affect their decision making.  

Having lived through multiple market panics, I can assure you first hand that people do not always react rationally when it comes to their own money.  The opposite usually seems to be closer to the truth.  Benoit Mandelbrot, a well known mathematician, was one of the earliest critics of MPT. He calculated that a daily change of 7% in the Dow Jones Industrial Average statistically should happen only once every 300,000 years, yet it happened 48 times during the 20^th century.  A day like October 19^th, 1987, where there was a 22% drop in the index, had close to 0% probability under a normal bell curve distribution.   

Individual share prices change radically during the course of a year.  To remind myself of how volatile stock prices are, I occasionally pick up a Value Line Investment Survey and randomly select securities.  At the top of the page, the annual high and low price is provided for a period of twelve years, and with simple math I can easily see the yearly percentage change in price. Annual changes in excess of 30% are more the norm than the exception.  We know that annual fluctuation of the S&P 500 Index exceeds 15%. This price volatility cannot be rational without emotions entering into the equation.

The Investment Management & Consultants Association (IMCA) was established in 1985 to deliver premier investment consulting, wealth management credentials, and world-class education offerings to their members.  IMCA is the organization that grants the Certified Investment Management Analyst certification (CIMA). By all accounts IMCA is highly respected in the investment world.  IMCA is a strong proponent of MPT.  In a recent publication they said: "In the long run, the basic tenets of modern portfolio theory will prevail.  That said, we encourage advisors to look hard at their investment philosophies and make sure they are aligned with sound investment principles." 

The IMCA conducted a survey of their members in January of 2009.  80% of the respondents said they were surprised by the magnitude of dislocation they had witnessed in the financial markets. Remember that this was prior to the severe decline in February and March.  Even with this surprise over dislocation, only 51% of the advisors were questioning the principles of MPT while 27% reported that their faith in MPT was unshaken.  

Personally, I believe that advocates of MPT are simply acting human, which is quite ironic considering that they are advocating a theory which requires humans to act with non-human like qualities in order to be true.  Humans, once committed, will often take actions to justify any previous commitment.  We will only see what reinforces our commitment and disregard any action that contradicts our belief.  MPT relies on mathematical formulas and computers, so it is very easy to apply.  There is limited need to think. You just answer some questions, plug in the data, and out comes the correct course of action.  With a computer, a program, and the huge amount of fees generated to the salesmen of MPT, this theory will be here for many years into the future, right or wrong.

Our Forecast

S&P 500

S&P 500 5-Year Estimated Earnings, Dividends and Projected Returns as of 09-30-09

BV = Book Value  P/B = Price to Book  P = Current Price  BVG = Book Value Growth

ROE = Return on Equity  EEPS = Est. Earnings Per Share EBV = Est. Book Value

Prj% = Projected return as %  Div = Dividend Yield

An investor's expected five year compounded return from 09-30-09:     11.65%

S&P 500 Index level ending 09-30-09:                                                         1057.08

S&P 500 Projected Index level ending five years from 09-30-09              1622.99                      

S&P 400

S&P 400 5-Year Estimated Earnings, Dividends and Projected Returns as of 09-30-09

BV = Book Value  P/B = Price to Book  P = Current Price  BVG = Book Value Growth

ROE = Return on Equity  EEPS = Est. Earnings Per Share EBV = Est. Book Value

Prj% = Projected return as %  Div = Dividend Yield 

An investor's expected five year compounded return from 09-30-09:                 9.46%

S&P 400 Index level ending 09-30-09:                                                                     691.02

S&P 400 Projected Index level ending five years from 09-30-09:             994.50            

S&P 600

S&P 600 5-Year Estimated Earnings, Dividends and Projected Returns as of 09-30-09

BV = Book Value  P/B = Price to Book  P = Current Price  BVG = Book Value Growth

ROE = Return on Equity  EEPS = Est. Earnings Per Share EBV = Est. Book Value

Prj% = Projected return as %  Div = Dividend Yield 

An investor's expected five year compounded return from 09-30-09:                 7.78%

S&P 600 Index level ending 09-30-09:                                                                     317.43

S&P 600 Projected Index level ending five years from 09-30-09:             430.22             

For a full explanation of the process and limitation please see our letter dated January 5, 2009. 

A Special Note of Congratulations

I want to personally congratulate all of you for maintaining confidence in the financial markets and in the ability of the citizens of this country to work through the problems we've been facing.  I am certain that there are many of you who had to fight against your own emotions during this years' market panic. You have been rewarded for this. Although we have still not recovered to the point of maximum valuations, we have taken some big steps and have gotten much closer.  Once again, congratulations to you for maintaining your ownership in a few of the greatest businesses in the world. 

Until next time,

Kendall J. Anderson, CFA

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Anderson Griggs & Company, Inc., doing business as Anderson Griggs Portfolio Management, is a registered investment adviser with the US Securities & Exchange Commission.  Pursuant to laws and regulations Anderson Griggs also maintains notice filing with several individual state regulators including North and South Carolina.  Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirement for advisors.  This letter has been sent to you for information purposes only and is not an offer of investment advice.  The purpose of this letter is to provide information about us.  We will only render advice after we deliver our Form ADV Part II to a client in an authorized jurisdiction and receive a properly executed investment Management Agreement.  Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs Investment Objective, individual account, or index.  The authors of publications are expressing general opinions and commentary.  They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation.  Anderson Griggs Portfolio Management's office is located at 113 E. Main St., Suite 310, Rock Hill, SC  29730.  The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.