October 2020
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

Jurrasic Park Movie PosterSaving Private Ryan Movie PosterIf someone has been nominated for 8 Academy Awards, won 3 of them, and the list of movies he’s worked on includes: Jurassic Park, Saving Private Ryan, Lincoln, Catch Me If You Can, Ready Player One, and the entire Indiana Jones series, you would expect his to be a household name. The person I am referring to is Michael Kahn. Mr. Kahn is someone with whom I was completely unfamiliar until I heard him mentioned in Greg McKeown’s book “Essentialism”, but he is one of the best Film Editors of all time. The award for Best Film Editing is less hyped than some of the others, but there has been only one instance since 1981 where the film that won “Best Picture” wasn’t also at least nominated for “Best Film Editing.” A good editor will review every clip to make sure that it makes the overall story better while being willing to cut out things that do not serve this greater purpose, no matter how good that clip might be.

I have been empathizing with Mr. Kahn and his fellow editors this summer as we have been monitoring our client’s portfolios. Many contain stocks of great companies that have added value, and, in a vacuum, we would like to continue to hold. But, keeping the greater priority of achieving client goals within their personalized risk/reward parameters, some cuts have had to be made. We decided this was necessary because of 3 themes that have emerged in the past several months:

  • Valuations – We mentioned in our previous newsletter that market valuations had been steadily climbing since the end of March. This trend has continued through August as stock prices improved without a corresponding improvement in company fundamentals. When prices are high, it is better to be a seller than a buyer. September brought the stock market’s first negative month since March and brought down valuations slightly, but they still trade near historical highs.
  • Economics – As the economy recovers from the COVID recession, significant progress has been made, but many hurdles remain. As much as we would like to hope that a switch will get flipped and we will quickly enter a post-COVID world, our expectation is that the virus will be impacting consumer behavior, lifestyle, and the employment situation for some time to come. Just last week we saw new rounds of major layoffs at Disney, Regal Cinemas, and the airlines, reminding us that a true recovery will likely be more gradual and take longer than we wish.
  • Politics - The cloud of uncertainty that includes a presidential election, congressional elections, confirmation of a potential Supreme Court Justice, continued racial tensions, and civil unrest contributes to greater market volatility. We do not see the value in trying to predict either the outcome of these events, or the market’s reaction to them.

The convergence of these themes at this point in time makes us believe that the most prudent course of action is to maintain a reduced market exposure for the near term.

The extremist’s response to this is, then why not sell everything and get out of the market completely? Despite what the risk/reward indicators are telling us, a significant market correction is not a slam dunk. Remaining invested in the market, even sometimes at reduced levels, is a key element to allowing the power of compounding to work for you.

Psychology book image

Morgan Housel recently wrote a book titled “The Psychology of Money.” Here is an excerpt that uses Warren Buffett to illustrate this point.

“As I write this, Warren Buffett’s net worth is $80 billion. Of that…$70 billion came after he qualified for Social Security, in his mid-60s.

Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three-quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him.

Consider a little thought experiment.

Buffett began serious investing when he was 10 years old. By the time he was 30 he had a net worth of $1 million, or $9.3 million adjusted for inflation.

What if he was a more normal person, spending his teens and 20s exploring the world and finding his passion, and by age 30 his net worth was, say, $25,000?

And let’s say he still went on to earn the extraordinary annual investment returns he’s been able to generate (22% annually), but quit investing and retired at age 60 to play golf and spend time with his grandkids.

What would a rough estimate of his net worth be today?

Not $80 billion.

$11.9 million.

99.9% less than his actual net worth.

Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years.

His skill is investing, but his secret is time.

That’s how compounding works.”

He goes on to say,

“There are books on economic cycles, trading strategies, and sector bets. But the most powerful and important book should be called Shut Up And Wait…good investing isn’t necessarily about earning the highest returns... It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.”

We all want Buffett-like results, but our instant gratification culture pushes against this concept of sticking with something for a long period of time and allowing compounding to do its astounding work. We strive to structure and adjust portfolios in such a way that when the down times come, clients don’t get derailed from their long-term plan so that they can reap the rewards of compounding’s benefits.

Switching gears to current events...

We get quite a few questions about the investing impact of various post-election scenarios. I’ve found the chart below to be helpful in gaining perspective. Regardless of which party has held the White House and Congress, the stock market has historically generated solid returns.

Makeup of Congress chartSource: Morningstar/Ibottson. Data shows first year returns of the last 11 presidential terms.

We will certainly be paying attention to things like changes to tax policy, tariffs, the direction of interest rates, and the impact they will have on the investment environment, but history tells us to be careful about predicting market returns based on election results.

Recapping the third quarter, markets continued to advance, but at a significantly slower rate than Q2. The outperformance of large companies over small, and tech-related companies (NASDAQ) over the broad market, and U.S. over international continues to be a trend. In reviewing previous versions of this chart, I noticed that in the summer of 2013, the 3-year return numbers for the S&P 500, NASDAQ Composite, and Russell 2000 were all within 0.2% of each other. Notice the gap in performance numbers that exists between those 3 indexes now and it tells you just how much the market has preferred large cap tech companies in the past few years.

Index     3rd Qtr 2020      
Return
1 Year
      Return        
3 Year
     Annualized      
Return
5 Year
     Annualized      
Return
S&P 500 8.9% 15.1% 12.3% 14.1%
Nasdaq Composite 11.2% 41% 21% 20.6%
Russell 2000 – Smaller Companies 4.9% 0.4% 1.8% 8%
MSCI EAFE – International 4.8% 0.5% 0.6% 5.3%
Barclays US Aggregate Bond 0.6% 6.8% 5.2% 4.2%


In the coming weeks we will be sending you information on how to access and log in to the portal, so if you’ve changed email addresses recently please make sure that the address we have on file for you is correct. We will work hard to make this change as painless as possible and if for some reason you will not be able to access your portal, we will happily make accommodations as needed.The software upgrade that we have been implementing this year will soon allow each of our clients to access more data about their portfolios online via their own client portal. In addition to account information, you will be able to securely send and receive information to and from us. As a result, we would like to transition to electronically sending items like this newsletter and your fee statement, while also including a portfolio review report similar to those we go through in our regular review meetings. These will come in a pdf packet that you can either read online, or print out if you prefer the paper version. We are hoping to roll this out in January 2021.

As we begin the final quarter of 2020, let’s hope we are playing the Falcons (for you non-NFL folks, Atlanta’s team managed to lose 3 games in September despite leading significantly in the 4th quarter in 2 of them). Kidding aside, with all that we’ve been through this year it is easy to dwell on all of the negatives and challenges that we have faced. Sometimes it takes a conscious effort to find some positives and focus on things that are going right.

One of the ways we would like to do this is to compile a list of charities that our clients support and highlight the people and organizations who are making the world a better place. We know that our clients are giving and caring people and a complete list might be overwhelming, but we’d like to give it a shot. So, if sometime in the next month or so, if you would be willing, would you email Kim in our office with a name of a charity to which you have donated either time or money in the past year. It can be one or many, and your contribution can be large or small. We’d like to celebrate these difference makers with you and perhaps inspire others to support a cause that is important to you. We will post this list on our website (donors will be anonymous) and will pick some from the list to support with a donation from our firm. Thanks in advance. Kim’s email is

This quarter’s mailing also includes a copy of our privacy statement. Nothing has changed and no action is required, it is simply available for your review if you wish.

Thanks for reading, here’s to the positive compounding of both our investment portfolios and of kindness in the world around us. Have a great fall.

 DarrenSignature

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.