Second Quarter 2012 Letter to Clients

America will halve its reliance on Middle East oil by the end of this decade and could end it completely by 2035 due to declining demand and the rapid growth of new petroleum sources in the Western Hemisphere, energy analysts now anticipate.

- From a Wall Street Journal email news alert, June 26, 2012

Say, remember “Peak Oil Theory”?

It was, and still is, the theory that global oil production has peaked, and that the world’s oil fields are going to be producing successively less of the black gold in the years to come. Peak Oil was all the rage back in 2007, when oil prices surged to about $150 a barrel and the world seemed to be on an inevitable path to consuming more and more oil until the fields just ran out.

This scenario seemed so clear and irrefutable just a few years ago, and more than a few investors – professionals and amateurs alike – began to make changes to their portfolios to reflect this “new reality”. Assets invested in commodities funds surged. Brokerage firms began rolling out all manner of oil and gas limited partnerships. And the ever-present Prophets of Doom who sell their catastrophist newsletters to gullible investors for hundreds of dollars a year urged their readers to “bulletproof” their portfolios (whatever that meant) before the oil ran out and anarchy swept the streets.

And so, five years later, here we are: A nation up to its elbows in newly tapped stores of oil and natural gas that unforeseen technologies have suddenly unleashed. And now the once-quaint notion of ridding ourselves of foreign oil dependence is suddenly well within the realm of possibility in the next quarter-century.

For those who made changes to their portfolios in anticipation of $500 a barrel oil prices, suffice it to say this is not exactly the state of affairs they expected. What it is, however, is a great example of the futility of trying to position your investment portfolio to capitalize on (or minimize the damage from) assumptions about the future.

There are countless different investment strategies being touted in the marketplace at any given time, but, in a broad sense, the investment world can be cleaved into two camps: Those who advocate for positioning your portfolio based on assumptions about the future, and those who don’t.

By and large, the investment industry is built around the first group. Probably 90% or more of the investment strategies in the marketplace are based on the premise that you should analyze trends, divine the future and build your portfolio to take advantage of it. But the preponderance of these types of strategies is not due to their success – it is due to the fact that they sell. These strategies appeal to the basest of human emotions – fear and greed – and the investing public is an easy target for this sales pitch.

The reality, however, is that such efforts are notoriously unsuccessful. Consider the track record of the actively managed mutual funds, which attempt to beat the market, for the past five years ending 2011:

• 62% of large cap funds underperformed their benchmark
• 80% of midcap funds underperformed their benchmark
• 70% of small cap funds underperformed their benchmark

(Source: S&P “SPIVA” scorecard for 2011)

Keep in mind that the managers of these funds are among the best and brightest minds in the industry. They spend their days poring over reams of economic and industry data, have huge research staffs at their disposal, and are paid seven-figure salaries for their ability to read the tea leaves about the future and make investment decisions accordingly. And yet the vast majority of them are not able to add any value for their investors; to the contrary, most active managers cost their investors huge sums by making poor choices and faulty assumptions about where to be and what to invest in.

Why, then, do the great majority of such funds fail in their mission to get out ahead of the coming trends and profit accordingly? After all, it’s not as if the smart people running these funds suddenly became “un-smart.”

It’s simply this:

No one knows.

No one knows what unforeseen technological advancements will emerge from out of thin air and totally change the world as we know it, because the pace of innovation far exceeds the ability of investors to anticipate it. After all, who thought ten years ago that we would be using our phones to scan barcodes in department stores to tell us where to find the cheapest blender in a 10-mile radius?

So problems we see today that seem obvious and insurmountable often times end up being non-events, or at least very different events, before long. Investment managers who seek to be ahead of trends and be there to capitalize on them instead often find themselves with their assets invested in the wrong things at the wrong times. This is the real risk of active management – the risk of bad guessing. And it is a risk that, year in and year out, costs investors huge sums in lost returns that were otherwise there to be had.

The alternative to this woefully inefficient way to manage money is to embrace a market-based approach such as we employ at Capital Directions. Such an approach does not attempt to outguess the market. Instead, it embraces the ability of the market to assess every new development as it becomes known and factor that into securities prices accordingly.

Above all, such an approach eliminates the unnecessary risk that comes from making faulty investment decisions based on assumptions, hunches and theories about the future.

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Three Things We Learned (Or Were Reminded of) From the Facebook IPO Debacle:
1. Individual investors have short memories: The frenzy associated with the Facebook IPO was eerily reminiscent of the dot-com IPO days, when tech companies that were little more than glorified grad school business plans would hit the market and close the end of their opening day with a $300 share price. Given that all but a handful of those companies wiped out their investors within a year or two, we would have thought investors had plenty of vivid examples ( anyone?) to keep them from succumbing to IPO fever again.

That investors were climbing all over themselves to grab shares of the Facebook IPO was, therefore, a little disheartening. But perhaps there was some divine providence in NASDAQ’s technical glitches that kept many such investors from being able to execute their trades. By the end of the day, many investors were wiping the sweat off their brows, happy to have been prevented from catching a falling knife.

2. The market has a longer memory: The parallels associated with the dot-com days ended in the runup among investors to get in on the pre-market shares of the IPO. Once Facebook went public and shares began trading, the market suddenly revealed itself to be much less “irrationally exuberant” than it was in 1999. Facebook shares opened at $38, but, in a shocking development, the market did not accept the invitation to attend the Facebook block party. Instead, Facebook shares unexpectedly began plummeting on the opening day, despite the frantic efforts of the underwriting banks to prop up the share price. The stock didn’t find a floor for a full two weeks after the IPO, when it bottomed out at around $25 a share – a 34% decline for the hottest anticipated IPO in years. Suffice it to say the market’s appetite for technology stocks with sketchy earnings potential is not as blindly enthusiastic today as it was in the dot-com heyday.

3. It’s Business As Usual on Wall Street: There was a moment there in 2008, after the collapse of Lehman Bros., that we paused to wonder whether the Wall Street investment banks had learned their lesson. Perhaps, we thought, they’ve come to realize that ginning up every kind of deal possible regardless of merit and figuring out ever-more creative ways to “put lipstick on the pig” is ultimately as bad for the banks themselves as it is for the public.

So much for that theory. If nothing else, the Facebook IPO debacle gave full exposure to the fact that it is business as usual on Wall Street. Normally huge institutional investors are given the first pass at snapping up shares of hot IPOs that are about to hit the market, but when the investment banks underwriting the IPO took their roadshow to institutional buyers, they were alarmed at how cool the reception to Facebook stock was. So the word went out at the wirehouses for the broker sales forces to start shoving it out to small investors. They did, and once again small investors were left holding the bag when the shares began plunging. Dozens of lawsuits are now pending as a result.

Some things never change…