First Quarter 2015 Letter to Clients

We have made the point in this space before about the pace of innovation and its incalculable impact on the value of companies and, by association, stocks. It is an esoteric point to be sure. And yet it is very real. To see its impact, look no further than the headline below.

Apple to Replace AT&T In Dow Jones Industrial Average
Forbes, March 6, 2015

It wasn’t so very long ago that the shine on Apple, Inc. had faded to a dull gray. The company’s signature MacIntosh line of computers had been relegated to a cult following among graphic designers. Serious business users almost all defaulted to Microsoft’s PC platform and its market-dominating Windows software program. For much of the late 1980s and early 1990s, Apple was notable primarily as a grad school case study on the dangers of failing to properly leverage your technology.

Bill Gates had won. Steve Jobs had lost. End of story.

Or not.

In June 2007, Apple unveiled the first iPhone. A mere eight years later, the company has transformed the way the world works, lives and communicates. Desktop computers are now principally tools for drafting long documents and creating spreadsheets. If you asked most folks if they’d rather go a week without their desktop or their smart phone, well…we all know the answer, don’t we?

The culmination of Apple’s resurgence came this past March, when the company supplanted the venerable AT&T in the Dow Jones Industrial Average. Apple’s market capitalization today stands at around $735 billion – more than twice that of Microsoft – and it has a staggering $180 billion in cash reserves. (By comparison, the U.S. Treasury has $46 billion.) Its stock price has risen about 10,000 percent in the past ten years.

We point all this out not as a valentine to Apple, but as an example of how insufficient it is to analyze current known innovations when trying to assess future unknown innovations and, by extension future stock prices. In the early 2000s, when most analysts were encouraging investors to dump Apple stock, they were assessing what was known about Apple at the time. They were looking at the present and the recent past. Who among them could have predicted the iPhone’s impact in the coming decade, not just on the fortunes of Apple, but on the productivity of mankind? The answer, of course, is no one – because the iPhone at that time was just a distant glimmer in Steve Jobs’ eye.

We frequently hear the argument made about valuations being “too high” in the stock market. Earnings, they say, don’t justify present stock valuations.

There is no doubt that the stock market moves in fits and starts, and corrections do occur periodically to curb “irrational exuberance” in the market. But it is also important to remember that future unknown innovations radically alter the fortunes of companies and, by association, their stock prices. And it is this incessant innovation that our free market system encourages that has led the stock market ever higher as time marches on.

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There was an interesting bit of news from retirement industry consulting giant Aon/Hewitt this quarter.

Years ago the company created an index that tracks the stock-to-bond ratio of the millions of 401(k) participants in the plans they consult with.

The interesting news this quarter was that now – just now – the stock allocation percentage among 401(k) participants in their index is back to their pre-2008 levels.

The discouraging thing about this tidbit is that 401(k) participants have, in whole or in part, missed the huge market recovery that commenced in March 2009, when the Dow bottomed at 6,443. Only in the past couple of years, with the Dow now north of 15,000, are they getting back to having the majority of their assets in stocks. 

This is hardly the exception to the rule. Looking at the last fifteen years of the Aon/Hewitt 401(k) participant index, we see a long history of buying high and selling low:

Note the two low points of 401(k) participants’ stock allocation – the bottom of the bear markets in 2003 and 2009. Instead of rebalancing their portfolios back to their long-term allocations – which would have had the effect of buying stocks at lower share prices – participants sold stocks instead.

Ideally, a graph like this should look perfectly flat. A participant’s 401(k) allocation between stocks and bonds should remain constant over time, changing only when he or she moves into new phases of life that require a more conservative long-term strategy.

This is a perfect example of the dangers of managing one’s own money. As we have said many times, the first job of a good wealth manager is to be the barrier between the client’s money and their emotions, because it is in the times of emotional extremes – both up and down – that the real damage is done to a portfolio.

Sadly, we need only look at the zig-zag disaster that is the Aon/Hewitt 401(k) index to know that it is true.

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This year marks a milestone for Capital Directions – our 30th anniversary as an independent firm.

From our humble beginnings in 1985, when founder Jack Calhoun Sr., left the brokerage industry with a handful of clients to establish a fee-only, independent firm – Capital Directions today manages more than $1.4 billion in assets.

While we are certainly gratified with the success our firm has attained, we are, more than anything, grateful for the trust and confidence our clients have placed in us over the years. Suffice it to say the past thirty years – and especially the past fifteen – have seen an incredible number of market extremes, both high and low. Most investors have bounced from one advisor, broker or agent to another, seeking to find some sort of magic formula to avoid the downturns and participate in the upturns. Wall Street is only too happy to sell them on this myth, and investors have been burned as a result.

We made a decision as a firm long ago to tell investors what we believe, not what they (necessarily) want to hear, and let the investor make an informed decision as to whether our approach to managing money is right for them. It’s clear now that our approach has resonated with many people. 

Above all, when we consider the growth we have enjoyed as a firm over the years, we are most especially aware that our success is really just a reflection of our clients’ success. For your trust in our firm, we are sincerely grateful.