Quarterly Newsletter – December 1996

As you are quite aware, we do not often write letters to send with our quarterly reports. We are not in the “predict the future” business, and we imagine you would get pretty tired of hearing the same old sermon quarter after quarter. However, with the US market, and especially the big liquid stocks (the S&P 500) on an amazing rip, we thought we would drop you a line.

You may be wondering if we have somehow come to doubt ourselves and our method. Not a bit of it. We hold that the future action of financial markets cannot be predicted, and those who claim to be able to do so are blowing smoke. Eighteen months ago, someone (Abby Joseph Cohen of Goldman Sachs comes to mind) was saying, “The US market will be up big.” That someone is now in the paper and on TV. Someone else (perhaps Jim Grant of the Interest Rate Forecaster, poor fellow) was predicting the end of civilized life as we know it. He is now hiding out somewhere. (Actually, he just wrote a new and rather good book. He says his previous prediction was too optimistic.) Could you have predicted which of these two would be right? We sure couldn’t.

And what about now? With the S&P at record heights, how comfortable would you be if we were to recommend selling everything and buying the hot market? Should we “overweight” the S&P 500, with the hope that this rocket might continue? Or, perhaps we should move aggressively out of the U.S. market, or perhaps out of markets world wide, under the argument that all this must eventually end. We don’t think either buying more, or selling out, is a good idea. Again, we don’t know what will happen. Neither does anyone else.

We hold that, over a reasonable period of time, the primary determinant of investment return is asset allocation, the percent of the portfolio in stocks. Which stocks one buys, or when, matters overwhelming less than the total allocation. Portfolio betting is risky. It is not possible to be consistently successful in market prediction, and it is folly to try. Moving money in and out of stocks as whim strikes has the result that, over the life of the portfolio, the total asset allocation to stocks will be lower. Our method, “slow and steady wins the race,” will mean, on average, a higher allocation to stocks, and therefore a higher return.

Our method has two parts. We believe market timing to be impossible. We do not attempt it. We are “buy and hold” managers. For this reason, we can use mutual funds not available to market timers. We hold to the idea that investing in less liquid market sectors (mostly small stocks and value stocks) should, over time, earn the investor an illiquidity premium (payment, in the form of higher returns, for the risk of holding less liquid asset classes) that will be of roughly the same size as successful market timers expect to earn (thought few of them actually do). Market timers and trend followers must use mutual funds which buy liquid stocks (i.e., the S&P 500). Over time, the very liquidity of these stocks reduces their return.

Rather than buying the hot market with the liquid stocks, we buy the cold market with the less liquids. We believe this to be the safest and most prudent way to invest. With this letter we are enclosing a summary article from The Wall Street Journal on the supporting research. We have models comparing our method to a “pick the best performer” method, as well as other academic work on the illiquidity premium. We are always happy to go over the method in detail with you at any time.

We would like to take this opportunity to thank you for the confidence you have shown us in engaging us to manage your financial assets. We are well aware of the responsibility we have to you. We believe our management method is the proper way to discharge this responsibility.

Sincerely,

Jim Pinney Dean Scofield