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It's About Time January 31, 2004

Ecclesiastes 3:1-10

1 There is an appointed time for everything. And there is a time for every event under
heaven-- 2 A time to give birth and a time to die; A time to plant and a time to uproot what is
planted. 3 A time to kill and a time to heal; A time to tear down and a time to build up. 4 A time
to weep and a time to laugh; A time to mourn and a time to dance. 5 A time to throw stones and
a time to gather stones; A time to embrace and a time to shun embracing. 6 A time to search and
a time to give up as lost; A time to keep and a time to throw away. 7 A time to tear apart and a
time to sew together; A time to be silent and a time to speak. 8 A time to love and a time to
hate; A time for war and a time for peace. 9 What profit is there to the worker from that in which
he toils? 10 I have seen the task which God has given the sons of men with which to occupy

The purpose at hand is capital preservation.

The popular models for understanding the investment world are out of date. Current culture
demands that the most complex situations be reduced to sound bites of a few seconds, and
answers are obvious or they are not answers. It’s easier to shoot the messenger rather than
evaluate the message. This behavior is not conducive to great investment results, and will likely
wreak havoc on the majority of investors.

The situation is worsened by the lack of integrity of our marketplace. Truth has become
irrelevant and values are all relative. The anchor bias of the marketplace begins with the
aphorism “the more things change, the more things stay the same”. It’s a bias rooted in the
natural human error of oversimplification and an innate desire to shun issues of magnitude that
defy quantification. While investment markets have always been full of change, clinging to the
notion that everything is still the same is naïve and dangerous. The correlation of decision
processes within the world’s largest investors (U.S. Pension Funds) has now reached a level
where the market impact can be devastating. Their concurrent grasp for income or growth, for
liquidity or private equity, has become a source of return similar to the baby boomers’ impact on
homes and cars in the 50’s, growth stocks in the 60’s, hard assets in the 70’s, junk bonds in the
80’s, and tech stocks in the 90’s. Correlated behavior not based on rational economics is
essentially momentum investing and drives roller coaster returns.

Long-term investors risk extinction if they don’t apply more attention to the ramifications of
their decisions. Relative value investing could be described as decision by indecision. The majority
of investors accepts market valuation as a democratic process (the infamous Buffet voting
machine) and therefore must be a true indicator of value. A close analysis of the ballot and ballot
box indicates that market values are driven by popularity contests not logical economics.
Popularity is less driven by consistent sequential earnings growth and more by brand recognition
or significant earnings surprises. The overwhelming desire to be “popular” is now systematically
driving decisions to a shorter and shorter investment horizon. “Systematically” includes the
preponderance of CEO compensation based on stock performance with no income statement
consequences. It includes Wall Street’s market cap based allocation of resources so the larger a
stock’s market cap becomes the more investment worthy it is, therefore more analysts can follow
it and recommend it, and more salesmen can sell it, and more advisors can buy it, and this makes
it more “attractive”. This artificial feeding of liquidity desires has created a false sense of
security and debased the integrity of our markets.

Another systematic driver is the abundant reliance on mathematic modeling strategies that
only partially reflect reality. Program trading is one such manifestation of these models and
such programs now provide over 40% of the trading volume in the market. As models beget more
models and robots essentially take over the execution of transactions integral to our economic
lives we enter a spectrum of risk that is not quantifiable. It is the difference between unlimited
downside and unlimited upside. Too big to fail? Tell that to the passengers in the Titanic.

Investment consultants near and far will advise their clients over the next few months and
quarters that they have studied the markets, the sector returns, the investment funds available,
and have decided that the optimal portfolio is X. X is perfect because it offers the best risk
adjusted return of all the portfolio samples in the database. Many rules have been established to
guide this recommendation such as length of track record, requirements for full investment,
adherence to style and market capitalization guidelines, consistent management resources,
position size and liquidity, etc. The notion that perhaps that whole particular universe is
the wrong the place to be cannot be discussed because of other rules, i.e. no market
timing, maintain appropriate (i.e. maximum) diversification, avoid tax erosion, etc.

Careful observers of history recognize that markets based on unfair trading, corrupt
middlemen, or irrational pricing ultimately implode with far reaching consequences.
This may have the greatest impact on the latest darling of Wall Street – Hedge funds and Families
of Hedge Funds.

The tremendous demand for short-term performance has brought intense focus to the hedge fund
industry. This marketplace of investment return is a result more of balancing acts and intellectual
gymnastics, and while often of Olympic quality is still dependent on the quality of the arena. The
arena we now know has a leaky roof, inadequate judges, and so many me-too competitors that
long term results are unreliable for issues of survivor bias (50% of hedge funds started five years
ago are not in business today). If and when this becomes recognized as an overcrowded,
overpriced marketplace, the stampede for the exit may well destroy the whole herd.

We are creatures of habit. We resist change in our homeostasis. This natural tilt affects our ability
to evaluate risk and return, and causes us to look where the light is, instead of where it is not. As
the search lights of the SEC and Elliot Spitzer have shown, Wall Street has dropped guidelines
of protecting the investor in favor of protecting their lucrative middleman turf bringing
to sharp focus the real risks to an individual’s capital.

It’s about time. Keynes said it best, “in the long run, we are all dead”. We must manage our
lives and investments for a reasonable investment horizon. We don’t drive cars focused on
the hood ornament and we shouldn’t manage our capital focused on the next quarter’s results.
The current obsession with short-term results may reflect an overwrought concern for control.
The concern was bred from exercising no control in the last tech bubble, and so market
participants may have jumped from the frying pan into the fire.

As for me, I believe we must return to investments where capital is preserved through growth
that is organic or overwhelmingly obvious. This can be accomplished in various ways, notably in
timber, real estate, and wireless communications among others. Appropriate investment
choices will generate cash flow, protection from inflation, and value within a deflation.
As U.S. based investors we are entering a period of significant uncertainty where investment
errors are magnified, and investment successes much more difficult to predict.