Drystone Communications

The following are excerpts from Christopher Jackson’s letters to pre-Drystone clients.

September 26, 2005

An economic slowdown and accelerating inflation can occur simultaneously, as with the stagflation that blighted the suffering 70’s. Global supply has clearly limited pricing power in many industries, from consumer electronics and textiles to autos and now telecommunication-based services – but globalization also ratchets up the demand for and prices of many inputs to production. Witness China’s appetite for oil and other bulk commodities.

There are no easy total portfolio answers to purchasing-power erosion, and portfolio tweaking of any kind always carries unintended consequences, a.k.a. no free lunch. Other than Treasury inflation-protected bonds (TIPS) and certain annuities, no investments offer explicit, uncomplicated insurance. As for stocks, portfolio managers can adapt portfolios to weather inflation, but please ignore anyone who says “Equities are a hedge against inflation.” This is a facile and widely repeated misstatement.

Far from behaving like a true hedge, the broad stock market has limped the worst precisely during past periods of high and rising inflation. Yes, stocks have historically achieved the generous price appreciation necessary to build up an inflation-cushioning base of wealth, and thus stocks deserve a significant and permanent allocation in most portfolios. A sustained equity cushion builds up only over long periods of time, though, and inconveniently it tends to build up far less during inflationary spells.

March 31, 2005

Regardless of modern portfolio theory, many investors with long time horizons face other risks that are as or more dangerous than short-term price volatility, e.g., inflation, asset-liability mismatching, illiquidity, or big bad bets that don’t come back.

November 26, 2004

Top-down and bottom-up may sound like recipes for brewing ale versus lager, but these labels can actually explain the order taken in any series of investment decisions. Each approach has its strengths and weaknesses, and I would argue that the best path for most investors incorporates a healthy balance of top-down and bottom-up work. A pure top-down portfolio may hew to a prescient overall compass and yet still founder on the specific risk of lousy, under-researched individual investments or waste brainpower on grand, sweeping panoramas which don't translate into real results. A pure bottom-up approach can yield a wealth of intrinsically strong individual holdings but still result in a portfolio plagued by incoherence and whipsawed by unforeseen trends. Better to build a portfolio from both directions.

July 7, 2004

S&P 500 Stock Index Average Annual Rates 1926-2003:

Total Return of 10.4 % = Price Change of 5.9 % + Dividend Yield of 4.3 %

Current dividend yield on the S&P 500 index: 1.7 %

What level of annual price change do you expect, mindful that the long-term average is only 6%? How generous a dividend yield can you expect, mindful that the current level is less than 2%?

My personal attitude is that after-tax total return is after-tax total return – as a portfolio manager and shareholder, I want return any way I can get it within an appropriate tolerance for risk. If it's capital gains, fine. If it's dividends, fine.

I will venture, though, that dividends are a somewhat more reliable source of return, because they depend only on business success and management's willingness to pay out a portion of that success – unlike stock price appreciation which depends on business success and market favor. Business success (earnings) and payout ratios (dividends as a percentage of earnings) are tough enough to sustain, but market favor (the price-earnings ratio) is even further beyond the control of corporate management and hostage to an even vaster array of unpredictable variables.

Note: original idea prompted in part by Financial Analysts Journal articles of R.D. Arnott and P.L. Bernstein, 2002.

March 2, 2004

An investor cannot attempt any calculation of an investment's intrinsic value without first making an assumption about the growth of future cash flows, even if the assumption is that growth will be zero or negative. What, then, are some clues to the future growth of a company?

Past growth in distinctly different economic environments. In most industries, sensitivity to the economic cycle is unavoidable, but I would prefer to avoid a portfolio heavy in companies that experienced steep drops or net losses during past cycle troughs.

Revenue growth versus earnings growth. I prefer to see past revenue growth that does not lag too far behind the growth in net income. I applaud companies able to expand profit margins over long periods, but eventually margin expansion can exhaust itself.

Internal growth versus growth by acquisition. Smaller acquisitions seem to be a more sustainable strategy than mega-mergers justified by dubious "synergies;" acquisitions within related industries traditionally succeed better than lumping together disparate businesses; acquisition prices tend to get less heated and antitrust scrutiny less onerous in fragmented industries with many small to medium-sized companies.

Dividend policy. Dividends have not contributed significantly to total return for years but can still provide signals to corporate health.

November 5, 2003

I believe inflation to be the single most important macroeconomic variable for any portfolio of financial assets. All investing is predicated on expectations of money to be received in the future (from business capital investment to personal financial investment to paying business school tuition) discounted to a present value. Investors can debate what the precise components of an appropriate discount rate are for a particular investment, but expected inflation should clearly be the first, most fundamental component. A rising and/or more variable rate of inflation complicates the calculation of present value and stultifies business and personal planning. Very real and lamentable entropy and deer-in-the-headlights paralysis result – witness the U.S. stagflation of the dreaded 1970's.

July 30, 2003

During recessions many companies ratchet up their search for greater efficiencies and productivity, i.e., cost controls. This is natural – even in the best of times, any company's management can better influence money-out (costs) than money in (revenue). In an economic recovery – even a modest, fitful one – though, investors should expect corporate management to re-focus on revenue growth, even if it is a more difficult beast to lasso than costs. In judging prospects for revenue growth, the profile of a company's customer base often offers the most significant clues.

Breadth/dispersion of customer base. I get uncomfortable if I read in a company's 10-K annual report that any one customer accounts for more than 5-10% of the company's sales or that a handful of customers represent the majority of sales.

Importance/non-discretionary nature of product. Obviously, if a company's customers cannot function without the type of products or services being sold, that sort of demand can sustain revenue very nicely. One caveat, though, is political risk or regulation…an item being non-discretionary can tilt into it becoming a government-given right.

Percentage of customers' budgets. Low-ticket items can actually offer a more defensible revenue base, especially if they're still important or non-discretionary purchases for customers.

Lack of substitutes. If customers can switch to a different product or service, that renders any predictions of revenue growth shakier.

Financial health of customers. When you buy a company's stock, you buy the company's customers too.

January 31, 2003

Skepticism should be inherent in active investment management, but it's just one step in the process. No alchemist has yet successfully conjured a grand autopilot solution to all investment challenges. The search for investments to preserve and grow a portfolio over long periods of time requires instead a continuous adaptive filtering of available opportunities matched against specific portfolio needs. Better to buy a mule with an attention span than a one-trick portfolio pony. A portfolio manager should strive to perform at least two functions:

  1. assist clients in articulating and adhering to their portfolios' investment objectives;
  2. deliver good long-term results in the asset classes called for by those objectives.
All clients should expect involvement from their portfolio manager in defining and applying their investment guidelines. A manager’s elegant investment theories don’t amount to much without a frame of reference grounded in a client’s reality.

November 11, 2002

A portfolio manager can chase down many character witnesses: tenure or turnover of the chief executive officer; a company’s history of developing managers internally or resorting to executive searches; restraint or hype in annual letters to shareholders; rationales for acquisitions; explanation of pay in the proxy; beneficial interests in outside businesses. Investors should strive to discern patterns and clues to management’s good faith in upholding shareholder interests and generally steer investments away from companies flashing multiple warning signs. And, on the other hand, they should be realistic about the limitations facing any management – even a choir of archangels in the executive suite cannot save shareholders of a company stuck in a declining or mercilessly competitive industry.

July 30, 2002

Now, what adroit financial term would a learned practitioner like me apply to the pattern of the last two years and especially the panic selling of July 2002? I call it a hangover. All of us who invested in U.S. and foreign stock markets from 1982 to 2000 enjoyed an increase in stock prices and price-earnings (P/E) ratios that for most of the two decades owed to some very legitimate, fundamentally sound trends – global economic growth, increasing corporate efficiency, declining inflation. A nice, polite social affair. Then, sometime between 1996 and 2000, the party got out of control. And it wasn't just those kids who used fake ID's (i.e., dot-com stock prices) to fund underage businesses and who were the first to get their ID's confiscated in 2000.

For one thing, peer pressure increased to dangerous levels even among people who thought they were adults. This was/is true in the boardroom, where corporate executives cajoled or cowed company directors into granting outlandish stock options packages. Also true among those investors (professional and otherwise) who above all else did not want to get caught not owning enough stocks, regardless of price. All of this was natural, but not necessarily rational – not for any shareholder who wants to preserve and accumulate wealth over a time horizon longer than the next three months or shorter than the next thirty years.

Peer pressure also manifested itself in so-called "closet indexing." Some professional money managers, desperate not to underperform a powerful S&P 500 index, began seeking to minimize their deviation from the holdings and price movement of the index ("tracking error" in industry parlance) even while continuing to call themselves active managers. OK, so long as the S&P 500 goes up by 20%+ year after year. The S&P 500 is capitalization-weighted, not equal-weighted, though; the more an individual company's stock market value, or capitalization, grows, the greater a percentage of the index it becomes. Closet indexing and a capitalization-weighted index make for a volatile mixture – managers, wittingly or not, become momentum players, i.e., the more a stock climbs in price and popularity, the more likely the managers are to feel compelled to purchase it. Until the trend reverses. With a vengeance.

Although more news of lousy corporate governance undoubtedly lurks, the greater threat to U.S. capital markets going forward will likely arise not from significant new selfishness on the part of corporate executives, but instead from the bipartisan stampede of politicians upending the medicine cabinet to find a band-aid before November [Sarbanes-Oxley]. Unfortunately, there's more hypocrisy than Hippocrates in the political realm. History is littered with the unintended moral hazards and economic disincentives spawned by knee-jerk Congressional responses. Not to mention the stultifying bureaucratic and legal blizzard which the current corporate oversight legislation will encourage.

April 30, 2002

Corporate executives at Illinois Tool Works Inc. allocate resources according to an "80/20 Rule," i.e., they spend 80% on the most important 20% of their businesses. In a twist on the 80/20 rule, I spend only about 20% of my time thinking about the merits of the companies held in portfolios and the other 80% worrying about what can go wrong.

The risk profile of higher profit margin companies pales in comparison to the near certainty of losing shareholder value over time in industries where the participants desperately pursue market share with a deathwish against sustainable profit margins. Too many industries in recent years have slipped into destructive oligopolies – industries in which a few large global or national competitors wage debilitating price wars in pursuit of customers. Destructive oligopolies are great for consumers, but awful for shareholders. Especially when an overall industry's growth decelerates; long distance or cellular phone service spring to mind. Even when a particular industry still enjoys overall revenue growth, stupid pricing strategies can drag down all players, leaving at best a profitless prosperity.

February 7, 2002

My other purpose in questioning accounting tactics was to stress my responsibility as your portfolio manager to try to avoid lousy companies. That may sound obvious, but too often in the late 1990's (as in the early 1970's and the late 1920's and so on) supposedly inquisitive investment professionals felt compelled to rush into certain stocks and to own so many different stocks unquestioningly just to match a market index or catch a roaring sector or shut that smug dot-com neighbor up – stocks which, in the harsh light of a burst industry bubble or economic recession, look about as attractive as mud. In the long run, being picky about what you do own is far more important than matching an index or playing in the market sector du jour or impressing your neighbors.

October 12, 2001

[a month before Enron and the topic of corporate accounting vaulted into the daily headlines ]

In this letter, the first of my written ruminations to follow September 11, I would like to discuss: the burden of employee stock options on future corporate cash flow! Why, in a time of terrorist attacks a few short blocks from [my office] and an economic recession which weighs on your investments and mine, do I continue to harp on something as mundane and esoteric as corporate financial accounting? Bear with me, because I have good reasons:

  1. There is already a chorus of commentary on post-9/11 markets and economy.
  2. Accounting issues are more important in the long run.

Yes, in the context of portfolios, green eyeshades are more important than jihads. Investors depend upon a company's financial reports to estimate the real underlying economic value of securities - stocks or bonds. Stock market trading patterns, interest-rate cuts, securities analyst cheerleading, cataclysmic events - all can influence a stock's price day to day, but ultimately a company's equity value depends on the present value of all future cash the company is able to earn and keep, per share.

Some companies try to disguise the true cost of total compensation by granting gobs of stock options instead of just paying more in ordinary cash salaries and bonuses. The cost to you and I, the existing shareholders, arises when the company has to come up with the shares when employees exercise their stock options. A company facing employee options exercise has only two choices, neither pleasant:

  1. Issue new shares and accept the resulting dilution of the per share value of the company that comes from spreading the same total net income and shareholders' equity across more and more shares. Also, by selling those shares to employees at the options' exercise price, the company is foregoing the greater amount of cash proceeds it could have reaped by selling them on the open market. or...
  2. Spend enormous sums of cash buying back its shares off the open market, at the market price, just to turn around and sell those same shares to employees at the much lower exercise price specified in the options contract. Even a successful company has a limited amount of debt-bearing capacity or free cash flow from operations to spend each year, and this money could have been spent on advertising, research & development, acquisitions, etc.

April 17, 2001

The 1990's provided a good environment for improving corporate profit margins at the same time revenue growth was strong. That is healthy while it lasts, but many companies have also relied on relentless share buybacks, heavy employee stock option issuance, and aggressive/wishful accounting to report even better earnings per share. Most of this accomplishes little more than borrowing from future shareholder returns to buttress current results.

January 31, 2001

Long-term investment performance and helping clients to set long-term investment expectations and objectives are where I as portfolio manager seek to add value. The beauty of compound return and commitment to a lasting investment strategy becomes most apparent when incremental annual gains add up over time. That accumulation helps to ensure that a portfolio can meet real-world demands facing it now and years into the future. Wall Street's introverted trading tactics and fixation on quarterly numbers can be very self-defeating, especially for taxable investors. Better to filter out the noise and build portfolios with the mindset of a long-term equity owner.

Drystone LLC investment portfolio manager