Originally Aired: December 4, 2014
Topic: Active Investing Done Right with Guest, Charlie Smith
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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- Introduction of Charlie Smith of Fort Pitt Capital Group
- Setting Aside Readily Available Cash Will Buffer You from Downturns
- Include Businesses with Greater Margins of Safety in Your Portfolio
- Competent Financial Advisors Protect Investors from Themselves
- Fees Are the Biggest Drag on an Investor’s Portfolio
- Active Strategy Pays Off When Manager Is Knowledgeable, Costs Are Low
- Because Humans Run Scared, Most Investors Don’t Realize Full Returns
- Price Determines When to Buy; Choosing the Right Portfolio Is an Art
- Reduce Oversized Position to Avoid Risking Your Entire Portfolio
10. With Banks Not Lending, the Risk of Short-Term Inflation Is Low
Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
1. Introduction of Charlie Smith of Fort Pitt Capital Group
David Bear: Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks. I’m David Bear, here in the KQV studio with Jim Lange, CPA/attorney and author of two bestselling books, “Retire Secure!” and “The Roth Revolution: Pay Taxes Once and Never Again.” Charting a long-term investment strategy for your retirement portfolio is always a daunting challenge, but it’s even more so in these uncertain economic times as partisan gridlock in Congress has shut down the federal government operations. For insights on money management and long-term investing, we welcome Charlie Smith to today’s edition of The Lange Money Hour. Executive vice-president and chief investment officer of the Fort Pitt Capital Group, Charlie’s perspectives on the economy and markets are well-respected, and he’s been sought out for comments by CNBC, The Wall Street Journal and other financial media. He’s written and lectured on markets and the economy over the course of his career, which began in 1983, and has included leadership roles with several Pittsburgh regional investment firms before becoming a founding partner of Fort Pitt Capital Group in 1995. The conversation between Charlie and Jim Lange will certainly make for a lively and informative hour, and listeners, since the show is live, you can join the conversation by calling the KQV studios at (412) 333-9385. And with that, I’ll say hello to Jim and welcome, Charlie.
Jim Lange: Welcome, Charlie.
Charlie Smith: Thank you, Jim.
Jim Lange: Before we get into the meat of tonight’s show, I do have a disclosure to make. Usually, when I have an expert guest, they’ve often written a book, or they have had some impact in the financial area, and usually, I have no financial interest, direct or indirect, in the guest. So, for example, if I have John Bogle on, or Ed Slott or any of the other guests, I try to provide the best information, but what they say, and whether you buy their book or not, or even use their services or not, has no impact on me, either financially or directly or indirectly. That is not true with Charlie Smith and the Fort Pitt Capital Group, and I feel obligated to disclose that I do have an arrangement with Fort Pitt Capital Group, so I am not independent with them or their chief investment officer, Charlie Smith. The arrangement that we have is if a client or a prospect that comes through my office and is interested in the services that we provide, such as Roth IRA conversion advice, Social Security advice, safe-withdrawal advice, tax planning, estate planning, et cetera, and they are also interested in money management services, since we are not a money manager, Fort Pitt is our primary money manager that we refer clients to. We have an arrangement whereby Fort Pitt actually manages the money, and Charlie is the, let’s call it the … I always call him the Big Cheese at Fort Pitt, and we do the conceptual work that I have just mentioned, and then Fort Pitt and I … we still charge 1 percent or less, depending on how much money is invested, to the client, but Fort Pitt and I do share fees. So I am not independent.
Now, I look at it as a win-win-win, that is, it is a win for us because I get to be the trusted advisor that I like to be in areas that I feel competent. I like to refer people to Fort Pitt Capital Group, who I think is an outstanding investment group, and has a terrific track record, and I think gives very good service, and for them, it’s good because it’s a client that they admittedly don’t get a full fee on, but a client that they would otherwise not have met, and it’s a real win for the client who gets the combination of our Roth IRA … let’s call it conceptual-type advice and excellent money management with Fort Pitt Capital Group. So, I did feel obligated to disclose that I am not independent with Charlie. But with that, if we could get into the meat of the show, and I think that even though I like to do evergreen shows that are classic and can be listened to a month or a year from now and still be important, I think that we still have to talk, because we’re basically two days into the federal shutdown, which is obviously the news of the day. Something that scares me even more than the federal shutdown is the debt-ceiling battle, which is about two weeks a day. So, Charlie, can I ask what do you think is going to happen, and perhaps more importantly, because your answer’s probably going to be ‘I don’t know’ — what is an investor supposed to do?
Charlie Smith: Well, that’s pretty perceptive of you, Jim, because if I told you that I did know exactly what’s going to happen, I would be less than fully truthful. Obviously, we’ve seen, since the beginning of the week, that the federal government has been shut down, and we’ve either shut down as sort of the JV game, and the debt ceiling battles as the varsity.
David Bear: Right.
Charlie Smith: The JV game has now gone on for a couple days and probably last another six to eight days. It’s our best guess that the Republicans will fold at some point. The question is: How much media pressure is it going to take for that to happen? Again, we’re guessing like anybody else, but it appears like the Republicans would like to get a material change to the Affordable Care Act, and the Obama administration is obviously completely dead set against that. But the Republicans, if they could get a one-year extension of the individual mandate as part of the ACA in exchange for, basically, increasing the debt ceiling, I think that’d be a good outcome from the Republican perspective, and that may be what they’re really aiming to get here. I think the issues with regard to the federal shutdown are sort of a sideshow, as I said. The debt ceiling is the big one, and the Republicans are aiming to try to get a material change to Obamacare. Whether they’ll be able to get it is probably a 60/40-type proposition, but it’s my best guess that that’s what the Republicans are trying to get, and obviously, we’ll see over the next few weeks. The markets have really been sort of ambivalent. We saw on Monday, markets were down, Tuesday, they were up. They were down a little bit today. But the response from the markets has been tepid.
I think if we are still at stalemate another six to 10 days from now, the markets will begin to focus much more closely on the possibility of a lack of an increase in the debt ceiling. I’m talking along about the 11th or 12th of the month, and that will be at the point where people sort of begin to realize that there is no deal, and we would possibly see a missed interest payment, perhaps. And also, it’s going to matter how the argument is framed in terms of the way Obama talks about priorities in terms of payments. If he continues to emphasize that interest payments will have first priority, I think the markets will be less roiled by that. If it basically is presented that the interest on the debt is just going to not necessarily have first priority, I think markets will be sort of upset by that. So, those are some of the aspects of the controversy that we’re thinking about.
Jim Lange: And do you think the markets will improve if there is some type of settlement, either on the shutdown, or, more importantly, the debt ceiling?
Charlie Smith: I’m not sure that we’ll see a pronounced move in either direction. I think we might see a pronounced move if Obama was able to get the Republicans to agree that this sort of brinksmanship would not happen again. I think that would improve the markets longer-term outlook, because markets are really tired of coming back every couple years to this battle. It wears people out. It takes up a whole lot of airtime and column inches that really are a bit of a waste. So if the Republicans were to agree to not do this sort of brinksmanship again for X number of years, I think that might have a positive effect on the market overall.
Jim Lange: All right. Well, I don’t know if it’s good news or bad news, but probably as good as we could hope. So, if we could go to some more classic issues, and I guess it’s a little bit timely, but it’s also … let’s call it the last couple years, and maybe the next couple years, the stock market obviously has risks, and we saw what happened in 2008, and typically, the way investors would respond is they would have a certain percentage of money in the stock market, and then they would offset the risks of the stock market by having money in fixed income. You know, whether it’s the classic 60/40 percent portfolio, that is 60 percent stock and 40 percent bonds, or, depending on people’s age and risk tolerance, et cetera. But most people would have some balance between equities, that is, owning companies, or fixed income, which is basically lending companies, or even lending government agencies, money.
Charlie Smith: Umm-hmm.
Jim Lange: But with fixed-income rates so low, you know, with CDs and treasuries at 1 or 2 percent, what is a conservative investor to do these days?
2. Setting Aside Readily Available Cash Will Buffer You from Downturns
Charlie Smith: Well, you’re exactly correct. When we had longer-term interest rates in the 6-8-10, even, you know, low teens back in the early ’80s, it was very comforting for an investor to say, “Well, I can put half my money in bonds and I can earn a double digit-type return.” Those days are obviously gone. So, an investor today has to … the way we approach it is, the investor has to say, “OK, what are my absolute cash needs for the next three to four years?” If I’ve got a cash-flow need that … I annualize some number that I’m going to need for each of the next three to four years, that number should be in cash today. So, if your annual withdrawal rate is 3 percent, you need to have 10 percent or 11 percent of your portfolio in ready-available cash so that you can ride out the historic volatility levels within the stock market for at least a three- to four-year period. Your yields on that cash are going to be minimal, but you can be certain that your spending needs are going to be covered for a period which, historically, has outlasted any of the major declines in the U.S. equity markets.
Jim Lange: All right. By the way, in terms of disclosure, I also forgot to give one important disclosure, and that is that a substantial portion of my personal and my wife’s money is managed by Fort Pitt Capital Group, and I remember having a conversation with you where I was a little bit uncomfortable with the percentage of stocks compared to bonds …
Charlie Smith: Umm-hmm.
Jim Lange: … and you said, “Well, gee, Jim, but look at the stocks that we have in your portfolio.” And you showed me some preferred stocks and some other stocks that has less volatility…
Charlie Smith: Right.
Jim Lange: … than, let’s say, a typical large-cap volatile return. Is that one of the ways that you get safety is by choosing a slightly different, and perhaps, more conservative portfolio of stocks that reduces the risk?
3. Include Businesses with Greater Margins of Safety in Your Portfolio
Charlie Smith: Certainly, certainly. You know, besides having a cash cushion, the portfolio businesses that you put in the account should have characteristics that include the following: generally larger market cap, generally less debt on the balance sheet, generally less operating leverage and generally a higher percentage of cash flow relative to the dividend payout. That pretty much covers it. You want to make sure that you’ve got a portfolio of businesses that is generating the cash with a very significant margin of safety to pay the dividends, even if the economy gets into a period like we did see in ’08-’09.
Jim Lange: Well, that sounds like a value-type portfolio with an emphasis on companies that have lower price-earnings ratio.
Charlie Smith: It can be, and generally, when you have a market downturn, it’s the companies with the PE ratios that are below the market mean, market median as well, that are going to see a lesser decline. Again, you want to look for a payout ratio, a company that’s got a very high percentage of the payout in current earnings. You want to look for a low payout ratio, essentially. But again, yeah, you’re correct. That’s generally a portfolio of low-PE multiple, higher market cap, low debt, low operating leverage and high cash flow with a low payout.
Jim Lange: And the other thing that I have noticed, and I always remember this because I was at one of your events, and you were talking about picking good companies and often sticking with them, and you were citing a, what seemed to me to be, relatively low turnover rate of your companies without doing a lot of buying and selling, and somebody from the audience said, “You mean, we pay you 1 percent just to pick some stocks and watch them?”
4. Competent Financial Advisors Protect Investors from Themselves
Charlie Smith: Well, in a sense, we do that so we can protect people from themselves. It’s amazing how many people want to view investing in the stock market as a game where, you know, you’re trying to out-quick the other guy, or you’re trying to basically add a trading component to what should be a fairly straightforward process of finding well-run businesses and purchasing them at reasonable prices and holding on to them. In many ways, our job comes down to protecting people from the siren song of trading. So, our typical holding period for an investment we own is seven to eight years, and that goes back to the core concept of the equity premium, which is that over time, ownership in a business is going to generate you a greater return than lending to that business. The returns from ownership don’t happen in a nice, neat, straight line the way a CD or a bond works. A CD or a bond is a very comforting proposition. You put your money out, and you get your interest payments every quarter or every six months, and then you get your money back in maturity.
With an equity, an ownership position, there are no guarantees, but you can be certain that over time, unless a company earns more on its own equity than it pays on its debt, it’s going to go out of business. So, if you build a diverse portfolio of ownership positions, stocks, you know that over time, your returns have to be greater than the prevailing interest rate in the economy because, literally, that’s the way our society works. The people who take the risk of going into business, over time, receive a premium return to those who lend to business. We also like to frame it in terms of making an end run around the banks. You can go to a bank and get a CD today at, you know, a one-year piece of paper for 1 percent or one-and-a-quarter percent, and then the bank will take those funds and go to corporate America and lend it out at 3 or 4. Why not take your funds and go and buy the equity of a business like a Verizon, which just actually issued some debt at 3 or 4 percent, and buy the stock of Verizon and earn their return on equity, which is in the 9 percent range today? It’s not guaranteed, but you know that in 10 years from now, if Verizon is still in business — and there’s a pretty good chance that they’re going to be — you will earn that return on equity of 9 or 10 percent instead of what you would have earned by giving it to the bank, who, in turn, would have lent it to Verizon.
So that’s what the equity premium’s all about, and our job is to capture that for our customers in such a way that they can sleep at night, and we do that by being patient and waiting for the businesses that we own to sell at prices which make them a good investment for us. The biggest mistake that retail investors make is paying a price for their investments, which basically doesn’t permit them to make money, and the classic case of this was the late 1990s when people were paying 50 and 60 times earnings for what were good businesses, but they were paying prices which basically made it impossible for them to make money. We buy good businesses, but we’re patient enough to buy them at a price which makes them a good investment for us today. The risk is always in the price.
Jim Lange: Well, speaking of risk, sometimes, I don’t hear very much about the risk of owning bonds, and I was actually just at a workshop in Las Vegas, an interesting place to have a workshop regarding risk.
Charlie Smith: The capital of risk!
Jim Lange: But anyway, they were talking about the risk of inflation reducing the purchasing power of fixed income.
Charlie Smith: Umm-hmm.
Jim Lange: So, they were saying that these “conservative” investors, with the vast majority of their money in some type of fixed income or CD or bonds, were actually exposed to an inflation risk, and that they didn’t think that that was a very safe position. Do you think that that has some validity?
Charlie Smith: It does, although we would be less concerned about a rip-roaring inflation returning to the U.S. anytime in the near future, that is, in the next two to three years, and the reason that we say that, the reason we’re not particularly concerned about a hyper-inflation environment is because the credit engine is really not running in the economy. As you know, the Fed has cranked several trillion dollars in reserves into the banking system over the last five years, and those reserves have generally stayed on the balance sheets of the banks. So as long as the banks aren’t lending and the credit engine is not running, we don’t expect that we’ll see inflation. Now, we’re monitoring those bank-lending levels quarter by quarter to see if lending does pick up and see if we will see potential inflation, but right now, we just don’t see it. We don’t see inflation as a big risk today.
David Bear: Well, let’s take this moment and have a quick break, and if you have questions or comments for Charlie Smith or Jim Lange, call the KQV studios at (412) 333-9385.
David Bear: And welcome back to The Lange Money Hour, with Jim Lange and Charlie Smith. Let’s start now with a question that was emailed in from Jerry, and for Charlie, he asks, “How do you justify active investing versus passive investing? Most of the academic literature supports passive investing for the long term. What are the technical and philosophical differentiators which would support an active choice over a passive one?”
5. Fees Are the Biggest Drag on an Investor’s Portfolio
Charlie Smith: Terrific question, and it’s a question which should on the mind of just about every investor. Let’s first of all define passive versus active. A passive strategy involves owning a portfolio which mimics the broad markets, and you want to do that in the most cost-efficient method possible. That’s really the advantage of a passive investing approach, is all about cost because active investors would add costs in terms of the fee for the manager, as well as the trading costs. So, passive, generally, is a much lower-cost strategy, and costs have been proven to be the biggest drag on investor’s portfolios, who are able to keep their portfolios fully invested over time. I’ll get to sort of another key difference between the two here in a minute involving the ability to stick with your portfolio, and how an active advisor can help you in the toughest times, but the key advantage to passive investing comes from cost, and as you know, over the very long-term, if you’re able to save 30, 40, 50 basis points in fees, that can compound to a very serious number if your portfolio is worth more than a couple hundred thousand dollars. On a couple hundred thousand dollar portfolio, over a 20-year period, saving 30 or 40 basis points is going to save you $60,000, $80,000, $100,000.
David Bear: It’s like compound interest, but in reverse.
Charlie Smith: Yeah, that’s exactly what it is. It’s the power of compounding. So the cost advantages that come from a passive strategy are undeniable. Now, relative to the active strategy, there are various gradations of active investing. There are some people that trade their portfolios to the tune of turnover 100 percent, 200 percent per year. In fact, a typical mutual fund, a typical domestic U.S. equity fund turns its portfolio about 75 percent per year.
David Bear: Umm-hmm.
Charlie Smith: So if you’ve got, you know, just for example’s sake, you’ve got 10 positions in your portfolio, seven or eight of those portfolios, over the course of a year, are going to change. We wouldn’t define that as investing. We would define that as more like gambling.
David Bear: Speculation …
Charlie Smith: As I said before, our turnover tends to be in the 10 percent range. So, if you had 10 stocks in your portfolio, one of them might change in a given year. And some portfolios have hundreds of stocks in them, so the managers that are particularly active that are turning their portfolios 100 percent, say, if they’ve got a hundred stocks, they’ve got to come up with a hundred new investments every single year. We barely can find the time in the day to find eight or 10 good new investments in a given year. So you need to define active investing. If it’s trading your portfolio to the tune of 100 percent to 200 percent per year, that’s not even investing …
David Bear: Umm-hmm.
6. Active Strategy Pays Off When Manager Is Knowledgeable, Costs Are Low
Charlie Smith: … from our perspective, and the costs therewith can be significant. So we would define active investing as definitely a very low-cost approach, very low turnover. You want to make sure that you’re getting as low a fee as possible. There are some active managers out there charging one-and-a-quarter, one-and-a-half, even 2 percent. There are some hedge funds with not particularly strong long-terms that are able to charge 2 percent, plus 20 percent of the profits. So there are all sorts of active strategies out there where the fees range from 1 percent on up to 2 percent and more, and they haven’t necessarily been able to demonstrate performance that’s even equal to the markets. So we’re going to defend an active strategy if you can get a low-cost manager who’s demonstrated the ability to at least keep up with the marketplace, and with a risk profile that’s at least equal to or below the market.
Now, the other aspect of active-versus-passive I mentioned before is it comes to the emotional side of things. There are a lot of people that can go out there and go buy a Vanguard portfolio, for example, and get good, low-cost, you know, the wholesale rate, can go get a bond fund at 10 basis points or a 10th of a percent, go get an equity fund at 10 or 15 basis points. But when the world goes haywire, unless those folks have the ability to stick to their plan — and this is where the advisor comes in in many cases —unless they have the ability to stick to their plan when the world is failing all around them, even the cheapest, low-cost index-oriented strategy is going to fail you because you need to be able to stick to the plans. So that’s where the advisor earns his or her money. We like to tell our clients that we earned our money in ’08 and ’09. We had to be answering the phones during the period where people were panicked about their money, because that’s when we earned our keep. So that’s where an advisor, and someone who is earning a fee, can help you differentiate between a passive strategy and a successful active strategy. If you feel like you are going to be able to stick to your plan and ride through the slings and arrows that come from the day-to-day economic tumult in the marketplace, go ahead and do it yourself with a low-cost passive strategy, because that’s going to work, but it doesn’t work for everybody.
Jim Lange: I would add that one of the problems is that we are human beings, and we have certain natural instincts. One of our natural instincts when we fear danger is to run. One way of feeling danger is when the markets go down, we want to run. We want to get out of the markets, and likewise, when the markets are doing well, we feel good and we want to get in the markets. So, basically, that is a “sell low, buy high” strategy, and you keep repeating that until you’re broke.
7. Because Humans Run Scared, Most Investors Don’t Realize Full Returns
Charlie Smith: Well, exactly. It’s interesting. The numbers that the various mutual funds report, in terms of their annualized performance, are often so different from the real results which investors get over time. There have been various studies done. I know Fidelity did a big one from the late 1990s. But what it comes down to is the average investor doesn’t even get the results that are published as the annualized returns by most funds, because they do exactly as you just said. People tend to be wanting to buy in when it’s comfortable and sell when things are uncomfortable. Well, investing is not about comfort or discomfort. It’s about understanding what a business is worth, being patient enough to buy it at a price which makes a good investment for you, and then holding on to it. It’s not about paying attention to what your neighbor, or the guy on CNBC, or anybody for that matter, is telling you about the market, or this latest hot stock tip that he’s just heard. That’s a formula for heartbreak.
Jim Lange: Well, and by the way, I lived through 2008 and 2009 with you, and I know you got a lot of telephone calls. I, even not as the investment person, got a lot of telephone calls, and I know that that was a pretty miserable time to go through, but frankly, the vast majority of the clients that we worked with together, you were able to convince to hang on, stay the course, and now they have been richly rewarded.
Charlie Smith: And it’s hard to take your mind back to that period, but if you remember, we had a brand-new president, and there were some conspiracy theorists out there that not only believed that Obama wasn’t necessarily the best president for the U.S., but he was purposely trying to wreck the economy, and there was a paranoia out there, and it was very real to many, many people. And so, we were fighting not only the day-to-day drip of stocks going down day after day, but this paranoia that was out there as well. So it’s hard to take your mind back to that period, but the value that an advisor adds, 99 percent of it comes in those sorts of periods, and they happen when you least expect them. I can remember on September 13th of 2001 writing about a two-thirds page letter to our customers about what had just happened in New York City, and basically laying out a list of very rational reasons why we wouldn’t expect to see an attack on this scale for a long time, and basically laying out the concept that the world has not come to an end, capitalism is going to function, and we will get through this. But when it’s happening, it’s so visceral and so real that people want to act, and those actions, typically, are directly in contradiction to their long-term financial health.
Jim Lange: Yeah, I remember John Bogle sometimes said that when people face danger, or they want to do something, he said the wrong thing is don’t just stand there, do something. It’s when you see this …
David Bear: Do nothing.
Jim Lange: … do nothing.
Charlie Smith: I’ve got a plaque on my desk, and it says “Don’t just do something, stand there.”
David Bear: Yeah.
Jim Lange: Oh, oh, that’s it!
David Bear: That’s his quote.
Jim Lange: That’s right. And frankly, if you look at a … and I guess I’m a little bit constrained to talk about performance, but I’ll just say that if you look at some of the down periods, it seems to me that that’s where you guys have actually shined, both in not dipping as low as everybody else, and then also keeping your folks in the market, and then they get the market return in the long run, and if we combine that with what you had just said earlier, which is to have a certain portion of your portfolio, whether it’s one year, three years, depending on if somebody’s working and what other type of income they have, so that they can ride out the downturn, then that sounds like a pretty good strategy.
Charlie Smith: That’s exactly right. You need to have that cushion that allows you to ignore the day-to-day fluctuation.
Jim Lange: Yeah, and when you had referred to some studies, I think that you were talking about the Dalbar studies, and the numbers were just incredible. Things like, you know, funds that were earning 8 percent. The average investor was earning 4 percent, even though that’s what the investor did was invest in those funds, and you could say, “Well, gee, if a particular fund has 8 percent — and that’s after cost — why is the average investor in that fund earning 4 percent?” It’s because they got into the fund when it was probably at its highest point, and then they got out when it was at its lowest point.
Charlie Smith: Exactly, exactly.
David Bear: Well, you know, I mean, a question comes up: Are there circumstances, or what circumstances would you say when it’s right to do something?
8. Price Determines When to Buy; Choosing the Right Portfolio Is an Art
Charlie Smith: Well, price tells you when to buy, and the process of deciding which companies we want to own and what price we’re willing to pay is pretty much a science. The selling side of it is much more of an art. It’s all about deciding what the potential of a business is, and whether the management has the horsepower to realize that potential. A whole lot more variables which are less exact in the selling process than there are in the buying process. But action, as I said, you know, we also have the theory that you measure six times and cut once. Trading costs money. It doesn’t cost as much as it used to, and that’s probably one of the biggest changes in the industry since I got into it. To trade $100,000 worth of stock in 1983 when I first got in the business was a couple-thousand-dollar proposition, $2,500 or $3,000. Today, you can trade a million dollars worth of stock for $10. So the trading friction is much less today, so the costs of a little more activity are not as onerous.
There is a time to act, and as we were just discussing, on the sell side, it’s generally when a position gets to be too great a percentage of your portfolio. Let’s say you buy a business at a 3 percent waiting initially in your portfolio, and it doubles or triples over a three- or four-year period, and all else equal, it’s now 6 percent or 7 percent or 8 percent of your portfolio. Well, if something drastic goes wrong with a position that’s 8 percent of your portfolio, it can have a material effect on your overall portfolio. So portfolio science says we need to scale that back. Business may be continuing to do very well, but it’s become too big a position. So on the sell side, it’s sometimes driven by portfolio considerations. Other times, the business just is not doing what it’s supposed to do. Now, we’ll give managements a lot of rope, so to speak, to hang themselves with. We typically will give, even after a company has a quarter or two of bad results, we’ll give them another six months to a year at least to show that our thesis was off. So, we want to be fundamental sellers when things are going wrong, and we’re sort of portfolio sellers when good things happen and the position grows.
Jim Lange: I wanted to mention actually a personal story, talking about concentration of stock. When I was married … we just recently celebrated our 20th anniversary …
Charlie Smith: Congratulations!
Jim Lange: Thank you. Yeah, life is good. Twentieth anniversary, and we are now empty nesters, also.
Charlie Smith: Nice.
Jim Lange: Erica’s at Pitt majoring in computer science. In the dorms, she likes her roommate, she likes her friends, she has a boyfriend, she’s doing well in school, so …
David Bear: It pays dividends!
Jim Lange: This is a good time for me. But anyway, when we were married, my wife came into the marriage with a portfolio, and relatively early on, after I started working with you, I wanted to have my personal funds and my wife’s personal funds invested by you, and we transferred over the vast majority of the funds, and my wife had a substantial percentage of her portfolio in some regional bank stocks.
Charlie Smith: Yes, I remember.
Jim Lange: And the broker who sold her the bank stocks said, “Never, ever sell these. These stocks will be gold. They will pay wonderful dividends. They’re going to grow.” And, sure enough, that’s what they did, and she was very reluctant to hand them over to manage. And then, you know, I kept saying, “You know, these guys know what they’re doing. They say that there’s too much risk in having so much a percentage of your portfolio in one stock. Why don’t you just listen to them? Let them manage the portfolio the way they see fit, and yeah, maybe we’ll do a little bit worse, but it’ll be a little safer.” Anyway, one year, I finally convinced her to do it, and she did it, and by the way, her dad, who used the same broker, did not. And what happened was, there was a merger with those regional banks with Citibank, and Citibank lost roughly 95 percent of its value, and her dad lost hundreds of thousands, and she had a very small position left. So, you literally saved our you-know-what, and part of, let’s say, the value of having a money manager and an active money manager is actually not necessarily doing anything brilliant, but kind of forcing us to do the appropriate thing.
9. Reduce Oversized Position to Avoid Risking Entire Portfolio
Charlie Smith: That’s a key aspect of active management, particularly an oversized position and bringing that down to a more manageable size so that you don’t put your whole portfolio at risk.
Jim Lange: And I remember … and David’s yelling, and … but let me just finish this one more and then we’ll do the commercial … I also remember that, in her portfolio, she didn’t have any international exposure, and at first, she was reluctant to hand over the whole thing. She just wanted to do a certain portion, and what you guys did that I thought was very appropriate is you said, “Well, even though we don’t like to have more than X percent in an international position, since you have nothing in money that we’re not managing, we’re going to have an oversize international portfolio,” and by the way, we ended up doing a $250,000 Roth IRA conversion, and that was the source of that, and it did very well, and that also was something that we have to thank you for.
Charlie Smith: I appreciate it.
David Bear: Well, let’s take that break now.
David Bear: And welcome back to The Lange Money Hour, with Jim Lange and Charlie Smith.
Jim Lange: Charlie, you have held two positions that actually, in retrospect, have turned out to be accurate. One, when everybody was yelling about and concerned with inflation, you kept saying, “Well, we don’t really see the signs of a heavy inflation,” and you’ve been saying that since I remember, and since you have been saying that, we haven’t seen that kind of inflation. And the other thing that you have said that wasn’t as big a concern to you as it is to a lot of people is our federal debt.
Charlie Smith: Umm-hmm.
Jim Lange: Can we do this one at a time? Ben Bernanke’s leaving the Fed, and many commentators think that that alone, combined with what else is going on with the economy, combined with our burgeoning national debt, would bring on an inflation.
Charlie Smith: Umm-hmm.
Jim Lange: But you had said earlier that, at least in the next couple years, that wasn’t your worry. Would Bernanke’s leaving have anything to do with what your thinking is, or do you just think that that’s just more noise?
10. With Banks Not Lending, the Risk of Short-Term Inflation Is Low
Charlie Smith: Well, let’s start with the prospect that Janet Yellen is going to be the next Fed chair, and her M.O., so to speak, is quite dovish. If anything, she would perhaps step up the quantitative easing, or the bond buying, the aggressive bond buying, that Bernanke’s instituted. So yes, the prospect of a even more dovish Fed is real, but we don’t particularly expect to see a large inflationary result from that, partly because of the reasons we gave earlier, because the banks, really, the transmission is not functioning. The Fed’s gunning the engine, but the transmission is not engaged and the banks aren’t lending all these reserves that the Fed is creating.
If we began to see that happen, we might become a little less sanguine about prospects for continued low inflation. But right now, we’ve got a banking system which refuses to pass along all this cash that the Fed is creating. We also have a worldwide economy where we have literally billions of people have entered the productive economy in the past 20 years. These folks are aggressive savers, they’re aggressive producers, and we have oversupply of just about anything you could name in the world, in terms of manufactured goods. So, you combine this excessive supply with the unwillingness of the credit engine in the U.S. to function as it has historically, and those two factors, from our perspective, really limit the possibilities for an inflationary outcome. That could change. Obviously, if the banks do begin to lend more aggressively and we watch that like a hawk, we watch the velocity of money, and it continues to decline. So, we watch that very closely and try to decide if we’ve got a potential inflation problem, and we just don’t see it.
Jim Lange: The other area where I think you’re somewhat outspoken and probably have a somewhat controversial view is, I know there are a lot of investment advisors, and probably even more individuals, who are just frightened and petrified by our federal debt, and they have debt counters and clocks, and they just show how, you know, each person, when they’re born, is going to owe thousands and thousands of dollars, and it doesn’t seem to bother you as much. Can you tell us why?
Charlie Smith: Well, in the last six to 10 months, I’ve actually become a lot more positive on this because we have made so much progress on the deficit, and oftentimes, the deficit is a good lead indicator where the debt is going. I’m not going to discount the fact that we do have a significant entitlement problem, and within the next five years, we’re going to have to make a serious long-term directional change in the payout amounts for Social Security and Medicare, in particular. So, that’s a huge potential problem on the horizon. But in the near term, it appears as if, particularly the sequester, has had the effect of really significantly bending the spending curve down here in the U.S. so that the deficit, which is the annual difference between spending and income, has shrunk by about 50 percent in terms of its percentage of the GDP. Two years ago, we had a deficit running at north of 10 percent of our GDP. Today, it’s running in the 5 percent range, and it’s headed downward. So, that means that the debt is going to grow at a slower rate, and it’s our expectation that if we just continue the policies that have been put in place, particularly the sequester, over the past six months to a year, we can continue to bend that spending curve downward, and we will see a deficit much more in line with the historic average of 1 or 2 percent of GDP within the next three years, and that’s bullish.
Jim Lange: And I think one of the differences between what you had said and what I have often heard about the deficit is you’re not putting it in absolute terms, you’re comparing it to GDP.
Charlie Smith: Yes, exactly, and debt is a problem when it becomes too great a percentage of the productive capacity to pay it off. So, if our economy is continuing to grow, our debt can continue to grow. It’s when one outraces the other. It’s when the debt levels are growing at a rate which the mathematics begin to fail, where if, let’s say, your debt’s growing, and your interest on that debt is 5 percent or 6 percent, and your economy is only growing at 3 percent, mathematically, that blows up pretty quickly. You know, you’re borrowing just to pay the interest at that point, and we haven’t reached that point yet, and we haven’t reached the escape velocity for the debt, where the debt just begins to compound exponentially. We were close, but now, we’ve come back from the brink, and if we continue the process of a little bit greater fiscal rectitude and a little more fiscal responsibility and keep that rate of increase bending downward, I think we can be OK, but it’s obviously something we’re watching very closely.
Jim Lange: Is it fair to use an analogy of two people buy a $500,000 house, and they put $100,000 down, and they have a $400,000 mortgage? One of those people is a physician making a million dollars a year, and the other one sweeps the streets, and he makes $10,000 a year. Maybe what you’re saying is for the physician, that debt might not be an enormous problem because, relative to their income, he can handle the debt problem, but somebody with a lower income can’t handle that kind of debt. So, is that why comparing it to GDP is so important?
Charlie Smith: Sure, oh yeah, exactly. You need to have a context in which the debt is offered in. That’s what’s key.
Jim Lange: Alrighty. Well, we only have about three minutes left, and what I usually like to do at the end of the show is to kind of do an open-ended of whatever you happen to think would be important. By the way, I did that to John Bogle, who might be considered the cheapest guy in America …
Charlie Smith: I’m close!
Jim Lange: … and then he said, he just shocked me when he said that a financial advisor adds a lot of value. That just blew me away. So, if I could have a, let’s say, some of your parting thoughts for what is going on and what you’re thinking about, and something that perhaps our listeners should know?
Charlie Smith: Sure. You know, everybody’s wrapped up at the moment in the federal government shutdown and the debt ceiling, and we have this … it seems like an annual problem with Congress’ dysfunctional nature. But I would ask people to recognize that we will get beyond this. Cooler heads will prevail, and, you know, a month from now, perhaps, as soon as a couple weeks from now, we will be beyond this, and the world will be back to focusing on the fundamentals. Unfortunately, one of the key fundamentals today is the Fed, and the fact that the Fed is cranking $85 billion of newly created money into the economy each month, into the financial markets in particular, not necessarily into the economy. So that’s something you need to pay close attention to. But fundamentally, stocks are not overvalued. We’ve got about a 15 P/E multiple for the average company within the S&P 500, which is a large-cap U.S. index. So stocks are neither particularly cheap nor dear. A 15 multiple is just under the long-term average of about 16, 16½ historically in the U.S., and those averages go back to the mid-1920s. So stocks are neither particularly cheap nor dear, earnings are continuing to grow, we expect to see 2 to 3 percent earning growth next year, fair value for the S&P 500 for the end of this year, somewhere in the 1,575 to 1,600 range, which is down slightly from where it is today, fair value next year on the S&P, around 1,700.
David Bear: Well, thanks to Charlie Smith, and you can reach him directly at his firm’s website, www.fortpittcapital.com. Thanks also to Dan Weinberg, our KQV in-studio producer, and Lange Financial Group program coordinator Amanda Cassady-Schweinsberg. You can always hear encore broadcasts of this show at 9:05 this Sunday morning, here on KQV, and access audio archives of past shows, including written transcripts, on the Lange Financial Group website, www.paytaxeslater.com. And finally, please join us on Wednesday, October 2nd at 7:05 for the next edition of The Lange Money Hour.