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Thursday, July 28, 2011

Sovereign Debt and the Equity Investor

Last week we came across an "Economic and Policy Watch" update prepared by a major investment bank that reviewed recent government proposals to address the nation's funding crisis. Titled "It Just Gets Worse," the report chided policymakers for actions that "look like a poor cover for loose money, rising inflation, and fiscal problems," and warned that "government financing needs are corrupting monetary policy." As a result of these ill-advised tactics, the bank had turned "more negative" on the outlook for financial stability and saw "little hope of improvement in the inflation/currency mix."
Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.

Indonesia's sovereign debt rating at that time placed it firmly in the "junk" (non-investment grade) category: B3 from Moody's and single-B from Standard & Poor's. Although Moody's upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.

What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.

Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.
For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country's troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.

We are not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor are we suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.

Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation's improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. Our point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a "junk" rating is no assurance of failure. A diversified strategy will have exposure to both.

Thursday, July 21, 2011

Will a Messenger Model IPA Work?

I have seen more interest lately in formation of messenger model IPAs.  I've never understood the fascination with these critters. 

I suppose the gentle antitrust treatment leads physicians to believe that they can form a messenger model IPA, enter into contracts as a group, and be left alone by the regulators.  That is largely true.

The reason that regulators tend to let these entities alone is that, if done correctly, they are completely toothless. If your "messenger" is negotiating with the payor, you don't have a messenger model IPA. 

Done correctly, a messenger merely carries the payor offers to the various physicians in the IPA, and then collects contracts from those who sign.  If the payor offers $1 per office visit, that offer should be taken to the physicians.

This system will work once.  The second time the messenger shows up at the office, however, the unfortunate soul may be met with pitchforks. 

It is only natural that the messenger will attempt to "inform" the payor what terms and conditions "may" be favorably received.  The payor just might consider this provision of information to be "negotiating" on behalf of the competing physicians.  A little call to the FTC, and the docs learn the significance of the phrase "making a federal case out it".

I have been involved in a joint federal and state antitrust investigation.  It was an incredible hassle for the physicians, with a huge amount of discovery and legal work.

So, unless you are comfortable with a toothless wonder, I strongly suggest you go the extra mile and develop clinical integration in your network.  You'll find you really can provide better care, and you then can negotiate with payors who are happy (or maybe grudgingly willing) to pay for this increased quality.

For more information about setting up provider networks and negotiating jointly, click here.

Tuesday, July 19, 2011

Will Apple be the World's Largest Stock?

Stock prices slumped around the world yesterday [Monday, July 18], but shares of Apple Inc. shrugged off worries about a Greek government bond default and record gold prices and surged to an all-time high of $373.80. With a market value of over $344 billion, Apple has already shouldered aside Microsoft to become the world's largest technology firm measured by market capitalization and is now second only to energy giant ExxonMobil among US stocks. It has all happened so quickly that despite its heavyweight stature in the US stock market, Apple shares are still conspicuously absent from the Dow Jones Industrial Average.

Apple's innovative products are the gold standard for personal communication and entertainment gadgets, and the company's fresh approach to store design generates sales-per-square-foot numbers other retailers can only dream about. As the company goes from strength to strength and the billions pile up on the balance sheet, it's worth recalling how uninspiring the future for the company looked not so long ago.

Apple historical share price adjusted for splits to faciliate comparison with current $373 price.
  • $39: "Lately hitting a new high above 77, stock in Apple is not just high-priced—37 times this year's estimated profit—but high-fashion. … Apple doesn't tempt me." Robert Barker, "Apple: It May Be Too Late to Take a Bite," BusinessWeek, February 14, 2005.
  • $12: "But behind the hype and buzz surrounding the iPod and Jobs, there are problems stewing at Apple. Its core computer business, which still accounts for 70 percent of the company's sales, is withering. … What's more, despite their soaring sales, iPods are depressing profitability because of their lower profit margin." Stephen Gandel, "Why iPod Can't Save Apple," Money, March 24, 2004.
  • $12: "I give them two years before they're turning out the lights on a very painful and expensive mistake." Quotation attributed to David Goldstein, Channel Marketing Corp. Cliff Edwards, "Sorry, Steve: Here's Why Apple Stores Won't Work," BusinessWeek, May 21, 2001.
  • $11: "Our conclusion is that Apple has started down a path that will lead to its demise as a serious player in the PC market. … Further, we do not believe Apple will survive its next downturn, which will presage the company spiraling into insignificance as it loses any advantage of scale." Excerpt from Dataquest company report. "Dataquest Sounds Death Knell for Apple," Reuters, September 23, 1997.

  • $4 "Apple has attracted a growing crowd of short-sellers, professional speculators who bet against a company by selling borrowed shares they hope to replace later at a profit if the stock falls. The short-sellers, in fact, now hold the equivalent of 10 percent of Apple's shares." Steve Lohr and John Markoff. "The Incredible Shrinking Apple Computer" New York Times, January 26, 1997.

  • $6: "Apple may have few options other than to shrink the company or to eventually sell out to a deep-pocketed partner." E.S Browning and Jim Carlton, "Apple Still Hobbled Despite Write-Down," Wall Street Journal, March 29, 1996.

Over its thirty-plus years as a public company, Apple has turned out to be a very rewarding investment. One hundred shares purchased at the initial offering price of $22 in December 1980 have multiplied to 800 shares after four stock splits with a current market value in excess of $299,000. Over the same period, $2,200 invested in the S&P 500 with dividends reinvested grew to approximately $49,000. But how many investors would have had the patience to wait nearly three decades for their investment to bear such abundant fruit? At year-end 1985, for example, Apple shares were still stuck at $22, and by year-end 2002, they had appreciated at an annual rate of only 4.4%—well below one-month Treasury bills for a twenty-two-year period. How many of us could have stuck it out, especially with industry "experts" telling us at the time that Apple's best days were behind it?

Some will study the ups and downs of Apple over the years and conclude that the roller coaster aspect of its business and its share price illustrates why clever timing is essential to successful investing. Our conclusion is that predicting the future is difficult and forecasting success or failure in the fast-changing world of technology is harder still. A tiny number of stocks available for trading today will produce sensational results in the years ahead. Owning a broadly diversified strategy can provide exposure to the market's most spectacular—and unexpected—winners.

Jerry Useem, "Simply Irresistible: Why Apple Is the Best Retailer in America," Fortune, March 19, 2007.

Past performance is no guarantee of future results

Tuesday, July 12, 2011

Discipline: Your Secret Weapon

Working with markets, understanding risk and return, diversifying and portfolio structure—we've heard the lessons of sound investing over and over. But so often the most important factor between success and failure is ourselves.

The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.

What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.

This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.1

The survey found 40 per cent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.

"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."

This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.

In a speech in Sydney2, Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.

"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."

Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.

These behavioural issues and how they impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.3

Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behaviour has been shown to be more prevalent in men than in women.

A study quoted in The Wall Street Journal4 showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.

The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behaviour by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualised returns of just 3.8 per cent, well below the 9.1 per cent delivered by the market index, the S&P 500.5

What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.

So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.

An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.

Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.



1. 'Risk and Rules: The Role of Control in Financial Decision Making', Barclays Wealth, June 2011
2. 'Far Too Much Economic News for Our Own Good', Ross Gittins, Sydney Morning Herald, June 13, 2011
3. Barberis, Nicholas and Thaler, Richard, 'A Survey of Behavioral Finance', University of Chicago
4. 'For Mother's Day, Give Her the Reins to the Portfolio', Wall Street Journal, May 9, 2009
5. '2011 QAIB', Dalbar Inc, March 2011