CREATING A PERSONAL MICRO MUTUAL FUND

The key to creating wealth, with the ultimate purpose to live off your investments, is to achieve far better returns from stock than the S&P500 without a corresponding increase in risk. This might seem obvious but we live in culture of extreme risk taking that has blurred the distinction between investment and speculation so much that high risk stock speculations have become the norm for many individual stock investors.

Gambling and speculation are characterized by taking large risks of a total loss in return for the low potential of a very large gain. Investing is really the opposite; it is finding the lowest risk of any loss with the most likely outcome of a modest gain or better. The central focus in investing is finding the lowest risk stocks with the best odds of outperforming the market. It certainly is not as exciting as a night in the casino but it is easy to sleep at night.

Let’s look at two different companies, one that we consider a high risk speculation and another with very low risk of a total loss and a good chance of outperforming the market over the next few years.

The first company, GBRC has a market cap of $105M and share price of $3.05. They have $780,000 in the bank and have never made any revenue or had a sale of any kind. Their return on equity is -744%. They are developing technology to decompose petroleum related products (like used tires). Hopefully they will make the technology work and be a fantastic financial success but the risks of a complete loss look too high for us. I am sure that the person that recommended this stock feels that they have some good insight into the likelihood of the technology working and are expecting a great result for it. But getting an exotic technology to work is only the first step; there must also be an adequate market size and an excellent management team to take advantage of the opportunity.

Contrast this with another company, Range Resources Company (RRC), which has a market cap of $9.81B and a share price of $65.45. They have $4M in the bank, a revenue stream of $868M/year, net profits of $166M/year, and they pay a quarterly dividend of 4 cents a share. Their last quarterly earnings were up 59.50%. RRC is an independent natural gas producer with properties in Appalachia and the Gulf coast with 5100 miles of gas gathering pipe lines that are delivered to interstate pipe lines which deliver the gas to utilities and large industrial consumers. Last year they increased their new reserves of natural gas for future production by 27%. The risk of the company going out of business and our stock becoming worthless are very low and the upside for reasonable profit and growth is high. RRC is an investment that we have included in our portfolio, and we never lose sleep over it. We have no doubt that people will continue to need natural gas for heat and electricity.

As good as RRC looks to us and as good as the natural gas industry as a whole looks, we still put only a small percentage (2%) of our portfolio in this stock and only 6% of our portfolio into the overall natural gas industry. This is our way of reducing the risk of loss of our capitol by having a highly diversified portfolio. We do not invest more than 2% of our portfolio in any given company no matter how compelling the company looks. It is far safer to have 50 very amazing companies across all industries than to have all of our assets in a few companies or in a few sectors of the market. This also allows us to focus on the quality of the company instead of the latest buzz about a particular sector. We find the best companies to invest in are the better run companies in sectors that are out of favor with investors.

I have met with mutual fund managers that strongly object to people like us investing this way. They say that they can invest better than an individual and that the trading fees are prohibitive for the individual to make it work. We feel that mutual funds have proven the value of this method of investing, especially for individual investors with the time, interest and aptitude. We have also found that being able to control the timing of when we take profits and losses to maximize our tax benefit far outweighs the cost of our broker fees, and we use a full service broker! We think that it is far more profitable to run our own micro mutual fund instead of giving up profits to the managers in the form of outrageous salaries and bonuses.

Our investing approach has led us to own a large collection of unexciting stocks of stalwart companies selling products such as soap and toothpaste (CHD), pumps and motors (SHS), aerospace components (PCP, COL), pipes (SYNL), utility poles (VMI), natural gas (RRC, EGN), and welding equipment (LECO) Though the potential for an out of scale return may be very low, our portfolio is stable and growing at a reasonable rate (16% to 32%) every year. Most of our portfolio companies pay a dividend, giving us additional tax advantaged income. We have never lost sleep over any of our stocks nor felt the need to check on them constantly in fear that some catastrophe will occur that will wipe us out. We check on their status once a week to verify that they are on track and no major changes have occurred. If we get really upset at the management team, like we did at MCO last year, we sell them off. If the management team makes a move we like, as did the RRC team with their willingness to step out and acquire more natural gas properties long before the oil crisis came into view, we buy more.

We avoid investing in overseas stocks as they have no SEC oversight and no way for us to validate their accounting. We also feel that foreign based companies have much greater risks than US based companies due to the many uncertainties of foreign governments and currencies. We gain access to the growth in overseas markets through US companies that own operations and sell to customer bases overseas.

We have found that focusing on lowering the risks of our investment portfolio and finding the best values in well managed companies, rather than focusing on the huge potential upside of high risk speculative stocks serves us well. It has allowed us to create a portfolio of stable yet steadily growing stocks at a time when the stock market has had unprecedented instability and many mutual funds are struggling.

By moving to Hilo, Hawaii we have dramatically reduced our cost of living so that we can live without touching our stock portfolio allowing it to maximize its growth. At a rate of 20% a year, we will have more than doubled the portfolio value in 5 years, a reasonable gain for minimal risk, allowing us to stay as long as we want in this wonderful paradise of Hawaii.

THE CHANGING US ECONOMY

The aftermath of the global housing crash and current liquidity crisis will ultimately result in a sharply contracted world economy and staggering deflation. The contraction combined with changing demographics will completely alter the US economy to cash-based as credit becomes unavailable. The driving force of the economy will be access to food, clean water and mild weather instead of access to high paying jobs. Here is what we believe is happening based on our localized view as boomers having lived 10 years in Silicon Valley, now living in Hawaii, studying investments, and reading the views of economists and others to better understand how we will be personally affected.

The internet bubble reset expectations for investment gains and lowered inhibitions to risks. Speculative investment for high reward with high risk became the norm for investors and institutions replacing traditional value based investing for reasonable reward and low risk.
After the internet bubble collapsed, US companies reduced their costs by moving jobs and manufacturing overseas. Wages and salaries in the US went down and housing prices should have dropped along with them, except that the Fed ‘s aggressive lowering of interest rates to keep the economy from going into a recession resulted in easy house refinancing. Refinancing decreased monthly mortgages and provided a surge of tax free spending money (liquidity) to Americans, more than offsetting their drop in salaries.

The internet allowed borrowers to submit mortgage applications simultaneously to many lenders forcing online competition for mortgage loans rather than relying on local banks familiar with the regional area. The increased liquidity in the economy, lower interest rates, and the growing number of mortgage lenders resulted in housing becoming more affordable and available to the average American. This increased demand caused the price of housing to go up allowing lenders to feel comfortable providing more credit. The lending process was sped up by using database generated house appraisals and internet generated instant credit scores for applications. The rapid increase in real estate drew in more speculators looking for the next high return opportunity.

Additional tax free cash was available to Americans from house equity loans and used to purchase large cars, electronics, and vacations. These purchases further accelerated the profits of retailers and American companies that had moved their operations offshore. Traditionally, that much liquidity injected into an economy would have created tremendous inflation, and it largely did for the few remaining domestically created goods like automobiles, housing materials, health care and services. Manufactured goods like electronics would have normally gone up except that they were being produced overseas at a very reduced cost and generated in mass quantities.

All of these loans to Americans for their houses generated IOUs that were sold to banks and individuals all over the world. In many cases these IOUs became a financial instrument separate from what was previously known as a traditional bank mortgage. These instruments were repackaged and bought globally by banks, hedge funds, and organizations that directly or indirectly wanted to gain access to the interest they generated. As traditional inhibitions of investors toward unregulated mortgage backed securities went away well established banks, investment banks, government and public organizations managing the world’s pensions, retirement accounts, corporate assets, and individual investment portfolios heavily invested in these house equity IOUs.

As housing prices drop and the liquidity it created disappears, the economy will sharply contract. All the cash, previously available to Americans from their housing equity, is gone shrinking the economy due to American’s not having cash or credit to spend on new autos, vacations, eating out, clothes, electronics, private schools, etc. In addition to this contraction, there is a secondary contraction caused by all the real estate backed IOUs in various financial instruments worldwide becoming worthless. These IOUs are held directly and indirectly by banks, in portfolios of wealthy individuals, by pension funds around the world, by mutual funds and numerous other financial institutions and corporations that desired their high interest income. Americans are already feeling the crunch of losing their lines of credit, having their credit cards shut down, and dealing with the upset of retirement plans that were based on the sale of their real estate. But those with these IOUs indirectly in their mutual funds, money market accounts, retirements, or investment bank portfolios may not yet know that their investments or pensions are worthless. The banks, particularly in Europe and Asia, are being slow to admit to their losses and unregulated accounts and money markets often only notify of unavailable funds when the money is requested.

As Americans are forced to downsize their energy and food consumption by replacing or modifying their gas guzzling SUVs, over energy consumptive housing, and reducing their number of vacations, prices will begin to drop. As China, India and the rest of Asia run out of their huge US dollar infusion from sales of electronics, processed foods, and manufactured goods to Americans, energy and food prices will drop even further. It will take time, but eventually the severe global economic contraction will create a strongly deflationary economy in the US and worldwide.

The US economy will fundamentally change from credit and job based to value based. Instead of access to high paying jobs being the driving force of the American economy, it will be access to healthy food, clean water and mild weather. The economy will become cash based as there will be very little access to credit. Any consumer credit based businesses, like internet sales, hotels, rental cars, and eating out, will suffer. Any businesses with inflated priced goods like Starbucks, Coach and Apple that are based on status rather than value will not do well. Any credit intensive companies, like airlines, cruise lines, tech startups, and land developers will struggle to get credit. Any company heavily in debt will struggle to stay alive in a cash based economy. Companies and people with cash and with assets and expertise of real value will do best.

Hawaii will do well in the upcoming economy, though the economic contraction will initially be painful and disruptive due to an end in the Wal-Mart tourist and a drop in real estate properties that were priced far beyond their real value. Many Hawaiian’s have expertise of real value in a cash based economy such as knowledge of how to fish, how to grow fruits and vegetables, and how to set up and live with solar energy systems. Hawaii’s mild weather and access to food and water makes it more sustainable and will draw wealthy tourists from around the world, many which will stay and impact the local economy in a positive way.

MERRIE MONARCH – The Feel of Real Hawaii in Hilo

Merrie Monarch, a week long hula festival and competition, was held in Hilo, Hawaii the first week of April , as it has been for the past 45 years. The festival is dedicated to King David Kalakaua who reigned over the Hawaiian Kingdom until his death in 1891. He was a patron of dance and music and revived hula which had been forbidden by the missionaries. Merrie Monarch was started to promote the Big Island of Hawaii, but has matured into a major event for those dedicated to hula and an avenue for the participation in Hawaiian culture and to engage the next generation.

The hula participants are members of schools or Halau with a teacher or Kumu, usually attained through family succession. Hula is imparted and kept “pure” by the families that have instructed their children and other children often into adulthood in culture, language and dance.

The Kumu instructs the students in the steps and chants or meles and must gain acceptance into the competition for teams organized from their Halau. Halau’s exist all over Hawaii, on the mainland, and in Japan. Except the Miss Aloha competition, which is a young women performing hula alone, the competitions are amongst Halau that enter a group of men (Kane) or women (Wahine) - never mixed - performing ancient (pre 1890) hula (kahiko) or modern hula (‘Auana). The rule book for Merrie Monarch competitions are 20 pages long, to keep the art from departing from tradition. The Halau dancers practice their Hawaiian language, meles and chants, and synchronization intensely and Merrie Monarch is their outlet for showing their expertise, comparing it to other schools, and being exposed to other Kumu approaches and improvements.

For a week, everything in Hilo was all about Hula. During the week, my paltry Hawaiian language doubled and I learned that Hula is much more than dance; it is an expression of beauty, tradition, culture and pride. The Hula dancers drew me into their experience and passion, making me feel a part of it. In a crowded auditorium of family, friends, and hula lovers , the audience is part of the dance, an experience TV can’t replicate. Hula is non-discriminating; it is young and old, heavy and slight, man and woman. It impacts all the senses through music and chant, movement, vivid colors and the scent of flowers adorning the dancers. The intensive week had us attending daily hula demonstrations, the invitational traditional arts and crafts show, the Ho’ike (exhibition) night, watching competitions on TV until late in the evening, taking in the Merrie Monarch Royal parade, and attending the 3rd annual He Launa Aloha No Ka Mo‘i Kalakaua at Kalakaua Park.

They say Hilo is like old Hawaii. Our week of Merrie Monarch in Hilo was a wonderful and deep experience of Hawaii.

To find out more:

Official Merrie Monarch Site

Merrie Monarch 2008 videos on YouTube

Merrie Monarch 2008 event review