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To Investors in Horizon Capital Research’s Portfolio
A while ago, copies of Horizon Capital’s portfolio began
circulating; it subsequently became quite popular. We have no advisory relationships
with those who have been following this portfolio, however this is generally
relevant:
11/7/03 -
We will change the venue of this portfolio in the future.
With the exception of CSCO, any sale of a stock may be taken as a sale of the
entire position.
5/19/04 -
We will manage this portfolio at its current venue until further notice. The portfolio is mainly configured for economic growth.
1/1/05 -
Last year Horizon’s portfolio underperformed the S&P 500, returning 9.8%. We invest mainly in large cap growth stocks, which have not been in favor. In 2005, the operating earnings of the S&P are likely to increase moderately; likewise long-term interest rates, due to increasing inflation. The effects of these fundamental changes on the market will probably cancel out.
Changes in the business climate are likely to have a major short-term effect upon the market. The S&P at 1211.9 is trading 44% under fair value, a large negative variance nearly equal to the one on 12/31/77, in the midst of the OPEC oil crisis. Clearly, the stock market has a lot of error correcting to do. Present corporate earnings are at record highs, but an improvement in the market’s valuation will require an improvement in the Iraqi war and in the willingness of business to invest in new ideas and markets to sustain economic growth.
Our next article will discuss the effects of history and politics upon the stock market.
3/28/05 –
We have met many investors in our portfolio, whose risk tolerances vary. The world is really amazing. Our strategy continues to trim back our portfolio stocks when they approach full value. Our strategy, mainly but not totally quantitative, takes into account the fact that the market is cyclical, as Modern Portfolio Theory does not. Neither is it market timing, which involves wholesale and disruptive market moves. We try to be prudent, but definitely encourage you to seek financial advice to discuss whether this is appropriate for you.
5/23/05 –
Some of our investors have evidently taken the above comment to mean that our stock portfolio is appropriate for almost everyone. We meant that it was likely described as such. We would have and do recommend that our investors seek qualified financial advice, to decide whether this strategy is appropriate for you.
The first element is to buy stocks that, we believe, are selling at a discount to likely value. The second element is to then vary the weighting of these stocks according to their valuations and likely economic circumstances. These are some of the risks (to sound like a SEC prospectus): 1) The company’s operations may not proceed as we expect. 2) We could reduce our holding in a stock for value reasons, and it will continue to appreciate due to other factors. 3) We could be fully invested in a stock for value reasons, and the economic cycle might turn due to an event, such as a financial crisis, or due to increases in the price of energy – causing the stock to drop further.
In our opinion, the last risk is presently the greatest one. Since we also credit analyze our companies for long-term soundness, we are comfortable with the above; but again urge you to speak with a qualified advisor.
6/1/05 –
We have described event risk in the language of error correction. Major events matter in an error correcting stock market; the valuation formula then sets a statistical level that the markets will cross from time to time. There are no major unanticipated events in the mean reverting Gaussian distribution that most laboratory scientists and investors prefer.
In the real world, to use the language of statistics, events cause in the stock market infinite variances, clustered volatility, and no mean reversion. As Granger (1987) has shown, dynamic error correction enables the use of parametric methods with this data. These methods measure the effect of the Fed’s countercyclical policy upon the stock market and make a statistical estimate of the S&P 500’s level that divides positive from negative happenings. In this context, equilibrium is a distinct environment when real macro events are not extreme and approximately cancel out.
For the investing environment to be propitious, political events have to restore balance in Washington.
9/19/05 –
We will sell HCR’s stock
portfolio within the next two years.
As we see it, you can sell your stock portfolio now or over a period of time. There are then four choices:
1) Leave the proceeds from stock sales in cash.
2) Invest in fixed income securities.
3) Reinvest the proceeds in a value managed equity mutual fund, with low overall fees.
4) Reinvest the proceeds in index funds that accurately track their indices.
We definitely suggest that you seek qualified and unbiased financial
counsel. We will reserve this space for market comments in the future.
11/4/05 –
We have sold HCR’s portfolio
down to core positions, consisting of companies that we would personally like
to keep for the long-term. Although we will sell the portfolio’s remaining
stocks as appropriate, We will continue to hold these same stocks in our
personal portfolio. Why be a long-term investor, and how to be a long-term
investor in the companies you like? The reason to be a long-term investor is to
take advantage of the long-term earnings growth of companies in excess of the
long-term inflation rate. A friend of J.P. Morgan’s was worried about stock
market gyrations (volatility). Morgan replied, “Sell down to the comfort point.”
The following concerns shorter-term macro events:
At 1220 the S&P 500 is presently 44% undervalued, on an error correcting basis due to events. The stock market reminds us of Boeing in the late 1990s. Business was great, but the company was unable to capitalize upon increased aircraft sales due to operational problems. The unresolved war in Iraq creating instability in the Mideast, large fiscal imbalances, and high oil prices continue to give the market problems by reducing business confidence. This situation is the exact opposite of the mid 1990s, where the dominant themes were globalization, a federal budget coming into balance, and low oil prices. A change in foreign and fiscal policies is needed for the investing environment to become more propitious.
We have met many investors in our portfolio from Westchester County, New York to Kona, Hawaii, with different tolerances for short-term risk. Our decision was to take the least risky course. We truly appreciate your trust.
1/1/06 –
On December 31, 2005 the S&P 500 closed at 1248, resulting in a total return of 4.91% for the year, and undervalued by 46% on an error correcting basis.
The U.S. economy remains unbalanced, and Iraq continues to fissure along religious and ethnic lines. The political risks in the Mideast are very high. Columbia University professor of history, Mark Mazower furthermore writes, “The runup to the Iraq war brought a dramatic transformation of world politics.…As a consequence, the US is now widely seen as one of the main threats to the existing order.…in Washington the legacy and mindset of the ‘war on terror’ will continue to stymie a return to real diplomacy with partners abroad. The militarisation of American diplomacy has gone too far to be reversed without a deliberate effort of will and of this there is no sign. As a result, it will be a very long time before the trust that Ms. Rice asked for from the US’s partners is restored.” After the tragedy of 9/11, Washington overmilitarized the Mideast; a change in attitude would be beneficial.
The conventional wisdom of portfolio management is to diversify among asset classes. This advice is particularly germane in an environment of high system uncertainty. According to modern portfolio theory (assuming a Gaussian stock market), the reason to diversify is to reduce the variance of returns. According to error correction (not assuming a Gaussian stock market), the reason to diversify is to reduce the effects of adverse events, such as a worsening of the situation in the Mideast. We have invested in the preferred stock of good credits, to substitute less risky preferred stocks for some common stocks. An analogous strategy would be to invest in bonds.
These strategies are appropriate only if the Fed continues to restrain inflation. We think that it will continue to do so:
1) The institutional memory of the Fed considers the high inflation of the 1970s a major policy failure. With economic growth sustained and the economy near capacity, we think the Fed will continue some increases in short-term interest rates.
2) The U.S. must fund continued trade deficits in the capital markets.
3) The forces of globalization continue to depress the cost of manufactured tradable goods, thus reducing inflation in the manufacturing sector of the economy.
To measure the ability of producers to raise prices in this important sector, we track a monthly index of manufactured tradable goods. This table illustrates that inflationary pressures continue to be well contained, even with large 2005 increases in the price of energy:
Growth in the
Index of Manufactured Tradable Goods
6/05 7/05
8/05 9/05 10/05 11/05 6mo. annualized -.90%
-1.07% .24% 1.20% .75%
-.15% -.12%
Contained inflation also causes the presently inverted (or at least level) treasury yield curve. We purchased preferred stock to reduce cyclical and political risks.
The Fed’s task has been
likened to driving a car with balky acceleration, loose steering, and intermittent
brakes. Monetary Policy with Imperfect Knowledge discusses the
theoretical reasons why changes in the Fed’s discount rate “…depend
increasingly upon economic developments…,” to quote the 1/31/06 Open Market
Committee statement. As an alternative, the Fed could simply set interest rates
based upon a formula like the Taylor Rule. But with imperfect information, this procedure “…is
insufficient to contain inflation expectations near the policymaker’s
target(s).”
Current data suggest a vigilant attitude towards inflation in order to reduce variances from the Fed’s economic targets. However since this expansion has been largely real estate based, the economy will be very susceptible to increasing interest rates. We do not think that the Fed’s rate hike(s) need to be extreme, if they are preemptive.
7/17/06 –
The G-8 summit declaration in St. Petersburg, Russia contains the two crucial elements that must occur for hostilities to cease in Lebanon. The first element is that Israel must show restraint. The second is that the U.N. should act to implement Security Council Resolution 1559, which calls for the disbanding of all Lebanese militias.
7/19/06 –
On July 19, 2006 the S&P 500 traded at 1257, resulting in a .70% capital appreciation return for the year, and undervalued by 44% on an error correcting basis. We would rank the risks of the present stock market as follows:
1) Another Hurricane Katrina. The hurricane season in the Gulf goes from June to November (hint).
2) Acute political problems in the Mideast.
3) Inflation and the Fed’s monetary policy.
We are very slowly increasing our investment in equities to target asset allocation. This strategy is appropriate given the obviously severe but random nature of the first risk.
We will delay further additions to equities. Events in the Mideast have turned the second risk above into an important random variable, continuing beyond the season of adverse weather. We recently visited Munich, Germany. We went to the lobby of our hotel to read a book about the Arabs and walked straight into an animated discussion in German about Hezbullah in Lebanon. There is a major problem, and its not all on the Arab side. By pursuing and condoning extensive military means in the Mideast, the U.S. has exacerbated the stresses of modernization in Muslim societies throughout the world, and this is truly not a good idea – as Iraq, Palestine, Lebanon, Iran, and the bombing plots developed in Britain, manifest.
There are unique circumstances in each country, crucially requiring a perspicacious and nuanced foreign policy that will benefit the political environment of the Mideast. Hezbullah and Iran now have the potential to adversely consolidate a number of social trends that include problems of economic development and political organization.
At its inception, economics was not a separate discipline divorced from politics. The stock market reacts to both because politics provides the supporting infrastructure of “rules, standards of behavior, and ways of resolving conflicts,” as Robert Samuelson writes in the Washington Post. At this time, the growing political risk in the Mideast counterbalances a slight economic slowdown and a more benign outlook for inflation. When two major stock market forces are of opposite signs (and they often are), the best solution is to make no major changes.
On 9/14/06 the S&P 500 closed at 1316, resulting in a 5.45% capital appreciation for the year, and undervalued by 52% on an error correcting basis.
Geopolitical conditions in the Mideast continue to deteriorate (WSJ 9/13/06), but S&P 500 earnings continue to grow – probably at a slower rate in the future. Although we expect no stock market boom, the present margin of safety between actual and calculated market values is now substantial, justifying an appropriate and prudent allocation to stocks. This in spite of a problematic foreign policy that will keep stock market prices below their calculated values.
11/09/06 -
The Democrats have recaptured control of Congress, restoring an essential balance to the government. It remains to be seen how President Bush and Congress will cooperate to implement an effective strategy, pointing a way out for the United States from Iraq. Our inclination is to maintain an appropriate and cautious allocation to equities. We will make more extensive comments on this in December.