Peter Flannery and The Auckland Trustee

Investment Perspective – July 2018

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price…the cash up value. What matters more is the economics of the business” 

Peter Flannery

This is a recent (and still ongoing) discourse involving (1) my client, (2) the Auckland Trustee (newly appointed as he is taking over from a previous Trustee – the trust has been running for over ten years) of my client’s family trust and (3) myself.  It follows a “lively discussion” between me and the new Trustee in my Auckland office.

This is a good example of a collision between the widely practiced Modern Portfolio Theory approach to investing and the less well understood Value Investing Method.

WISEplanning have taken our instruction from our client D (a trustee of the family trust) who has been with WISEplanning for over ten years and has been, in her own words, “…very satisfied with WISEplanning and my portfolio”.

The short of it is that M, the Auckland Trustee wants to sign off on all adjustments to the portfolio and is unhappy with the way the portfolio is managed.

The Auckland Trustees comments are bold and my response follows (not bold). 

So, my email to my client starts….

“…we agree that getting ‘the paperwork’ right is appropriate.  How we go about that is proving to be interesting! 

Here is a brief summary of our discussion about his e-mail to you:

• “The portfolio was designed five years ago around a fairly conservative profile, appropriate for preserving capital with little chance of big ups and downs in value”. Value investors like volatility because lower prices mean better buying for us.  We are unconcerned about pricing volatility.  What’s important here D (my client), is that you are comfortable with it as well. 

• “The portfolio has changed slowly into an aggressive portfolio, at 80% of the trust funds invested in the share market and commercial property. Such a portfolio can swing up and down significantly in value and is expected to produce negative returns every four or five years.  If this portfolio had been in place during the market downturns in 2000 and 2008, you could have seen 20% to 30% of your value wiped off.  In addition, it has taken many years in some cases to recover.  I need to know you are aware this sort of loss can occur and seeing as we have been in a bull market for some time now, it could be at any time.  If you are happy with the prospect of such value drops and have got no problem, I personally would not recommend such an exposure”.  M (the Auckland Trustee) is trained in modern portfolio theory.  The purpose of modern portfolio theory is to protect capital and minimise pricing volatility through diversification.  Value investors diversify to capture opportunity.  We manage risk by investing in quality businesses and do not play the share market.  I note the emotive language used in this paragraph and in other areas of this e-mail (eg “… you could have seen 20% to 30% of your value wiped off.”).  Markets oscillate up and down.  That is normal.  Lower prices for us as value investors means better buying.  Value investors are unconcerned about short term price volatility.  Perhaps the one point M made that I agree with, is that it is important that you are aware that this type of volatility happens.  Further though, that volatility is a natural part of the investing process for us as value investors and represents opportunity rather than danger.  M would be unable to recommend such an exposure because his education and experience is limited to modern portfolio theory. 

       “When prices decline, the value emerges.”

                                                             Warren Buffett.

• “The portfolio is very narrowly diversified. Typical trust portfolios would have many times the number of shares and other assets in order to provide the diversification and safety a trust portfolio requires.  All it would take is a couple of shares to languish and it affects your overall performance badly.”  Again, M’s limitation appears to be his training and experience, which is limited to modern portfolio theory only.  At WISEplanning, the Rule of 5 applies (one in five investments may not perform as well as we expect, however one in five performs better than we might expect, making up for the one that does not.  The other three perform as they should).  If the share price languishes for some time, we can be patient, providing the economics and the fundamentals of the underlying business remain sound.  If not, we will recommend selling, which as you know from experience, is rare at WISEplanning.  Our preference is to average down the original buy price, be patient and to repeat the process as required.  This technique is foreign to those who practise modern portfolio theory. 

• “The portfolio resembles nothing like mainstream portfolios normally used for trust investments. The ratios of different assets are very different.  This demonstrates an arrogance which as a professional trustee, responsible for long term interests of beneficiaries, I would like to see removed”.  Value investors take what appear to be strong positions based on a methodology that those who practise modern portfolio theory may not understand.  I am assuming that his reference to arrogance is to those strong and appearing confident investment positions rather than my behaviour(?).  Of course, a portfolio that is built from the ground up so to speak, business by business, will look nothing like mainstream diversified portfolios.  Indeed, that is the way we as value investors prefer it.  In terms of a professional trustee, responsible for the long-term interests of beneficiaries, perhaps a starting point might be for this particular trustee to take some time and to make an effort to understand a different methodology (that might possibly be more advantageous than the one in which he is trained)?

• The returns have been well below those for other growth investments and this has cost you thousands of dollars. Frankly, this type of rhetoric is borderline unprofessional and unhelpful.  I would need to know more details around this statement and what facts it is based on.  As value investors, we do not diversify in an attempt to protect capital or to dampen down pricing volatility.  Further, we do not play the share market by chasing popular shares, whose prices appear to be rising fast.  There have been many examples over time of investment fads that do not last.  I mentioned TENZ whereby investors were told they could invest in the “top 10 companies” in New Zealand.  What was less obvious is that top 10 was measured by market capitalisation or size, rather than performance.  Very few of those top 10 companies exist anymore.  Another example is, ‘the nifty 50’ in the 1980s.  The idea was that all you needed to do was invest in the fastest growing 50 companies in the world and you will be rich.  I believe only one of those 50 companies still exists.  Value investing is simply fundamental and in my opinion, unarguable.  Comparing the rise or fall in the cash up value of your portfolio with the 90 day cash rate or bank deposits, the New Zealand share market, the Australian share market, the global share market index (the MSCI) or an American share market, such as the Dow Jones or the Nasdaq, has some merit long term but offers little in the way of evidence in the shorter term.  The change in prices are impacted by the movement of funds, the weight of money and in particular, market sentiment. Simply, when markets are happy, prices rise.  When markets are unhappy or unsettled, prices decline. 

EDITORS NOTE

Portfolio Return over the last 12 months

Gross return                              12.93%

Net of tax and Aegis fee          10.89%

Net of WISEplanning fee           9.54%

Portfolio Breakdown of return (gross)

Cash                                              1.29%

Fixed Interest                              5.15%

Australasian Equities               20.60%

International Equities              25.75%

As you can see, D, our client could have achieved an even higher return over the last 12 months if the Fixed Interest investments were instead invested in either Australasian Equites (return 20.60%) and / or International Equities (return 25.75%). 

You can also see this type of breakdown on your portfolio too – let us know if we can help.

• Your portfolio relies purely on the ability of Peter Flannery to “pick winners” (not that he has). The returns have been poor and your risks have been high.  That is not impressive or prudent.  Again, the language is borderline emotive and of questionable professionalism.  This sentence also confirms that M has minimal understanding about value investing … value investors invest in businesses with sound economics – we do not play the markets.  Picking winners is about stock picking, which is about picking companies whose share prices are rising fast because they are popular.  Amazon and Netflix are good examples in the current environment.  They may well go on to be sound businesses long term, however as value investors, we stick to what we understand and minimise risk by not speculating on shares.  Picking winners is the opposite of what a value investor would undertake as an investor.  We look for good businesses with sound economics, whose prices are favourable.  That is usually at a time when they are unpopular – the opposite of picking winners.  With regards to the returns being poor and the risks high, we need a bit more detail around that statement and whether there is any fundamental, factual basis to it.  With regards to the risks being high, I disagree.  Intrinsic value enables value investors to establish a buy price.  Intrinsic value is created by the performance of the business – not the share price rising or falling.  Investing in sound businesses with good economics at favourable prices, I would argue, is no more risky than diversifying across a large number of some good and some not so good investments, the result of which is to slow down long term growth, thus impacting on the protection of capital against rising costs in the future.  I am not particularly interested in impressing M nor XYZ Trustees.  I believe investing in sound businesses with good economics at favourable prices is prudent.  I challenge the notion that wide diversification is in the best interests of all investors, especially those looking to maximise the growth of their capital long term.

• Peter’s investment strategy is, in my opinion, flawed. One or two of his comments worried me. One comment he made was especially problematic.  Peter says that if a share becomes a poor asset, he will not recommend it for new clients but he is quite happy to keep it for you.  That is nonsense and in my opinion, lazy.  If a company does not represent good value for one client, it cannot represent value for others.  You could end up with a load of shares no one else would touch.  I need more clarification about these comments, as I am not sure where he is coming from.  He did mention at one point during our meeting that he assumed our clients would all have the same investments.  I responded by saying that generally, they might but not every client has the same investment as everyone else because their investment risk preferences will be different.  Also the timing of when they invested would be different.  For us, if the price is stretched and expensive, then I would be less inclined to recommend it to an investor, whereas for another person, that same business might be unpopular or out of favour, with the price depressed and therefore in range, in which case, I might then recommend it.  More clarification is required here so that I can properly respond to this statement. 

• Peter stated his strategy is to “Train” his clients to accept more risk and use his method of investing. Indeed, there is an educational content in our advice.  That is because the more our clients understand about how their money is invested, the more likely they will engage with it and as a result, they will invest in a more advanced way and improve the long-term returns.  Even 1% per annum difference in return is a significant amount of money even over just 5 years.  My clients have been “Trained” over many years and I know many of them will only ever invest using the value methodology (especially after having experienced the limitations of modern portfolio theory).  Further, once we understand how to invest in good businesses with sound economics, at a favourable price, the usual risks that people talk about, such as prices moving up and down, indeed becomes our opportunity.  Lower prices mean better value.  In addition my clients are mostly long term clients and have, not only the general knowledge of how their capital is invested (the methodology) but also real experience over many market cycles (including the recent Global Financial Crisis).  The markets worried as the credit crunch emerged.  As usual for value investors, lower prices meant better buying opportunity for us.  The point is that defensive investors including those invested via modern portfolio theory were worried or selling out at that time (hence the global share price sell off).  Our clients were buying then because the training and experience enabled them to do so confidently – nothing complicated.

• “He said he only communicated with you by phone but that you are quite happy with the strategy”. He took strong issue with the fact that you and I have not met for some years.  I disagreed with him because the portfolio is managed by WISEplanning, using a methodology that has proven to be effective over several market cycles.  You receive regular reports by way of advice statements and letters.  We have worked together for a number of years, even before this portfolio was set up.  I do not believe that your investing efforts have been compromised by the fact that we have spoken on the phone as opposed to face to face. 

• “I sat with him face to face for an hour and I was still scratching my head a little, hence my e-mail to you. As your co-trustee, I need to know you understand the portfolio fully and that you are happy to take the risks associated with Peter’s strategy.  The reality is, his training is in modern portfolio theory and not value investing.  It is understandable that he might be confused or unable to grasp the methodology we use at WISEplanning.  Indeed, this raises the question around his suitability to act as trustee.  We have a proven methodology that has been in place for the last two decades, throughout the so-called “tech wreck” in 2000 and the global financial crisis in 2008.  His comment about you understanding the risks is a fair enough statement, however I would like to know from M, what he thinks those risks might be?  Certainly, the trading price of any particular business bobbing up and down or the cash up value of the portfolio rising and falling is not one of those risks (for us as value investors).  One risk might be if something happens to Peter Flannery that you would need to then find another adviser who could manage your portfolio using our value investing method, which might be difficult to locate.  However there are options and at WISEplanning, we are working on a succession plan to ensure that the value investing methodology can continue after Peter Flannery is gone.  Perhaps another risk that is never talked about openly is people’s lack of knowledge or ignorance about investing.  For example, those who cling to bank type investments and term deposits usually do so because they are afraid to do anything else.  Then there are those who invest in Kiwisaver schemes or portfolios designed by advisers that have been trained in modern portfolio theory.  They will enjoy some growth longer term, which is useful, however the limitation is the diversification and the whole methodology encompassed by modern portfolio theory.  For our clients, once they understand that we are investing in the underlying business and will limit our buying to when the price is as favourable as possible, it does not take much for them to grasp that their money is secure. Just as importantly, they will also enjoy long-term growth regardless of economic conditions.

And So…

There you have it.  What do you make of it?

It appears that recent changes in trust law mean that this particular trust (and many others around the country I suspect) may need to review and possibly tighten up how the paper trail is administered.

I will be interested to hear in this case why M thinks that my client, also a trustee, cannot continue to sign off on investment portfolio adjustments.  I don’t mind either way, but this raises the awkward issue of M, his limited training and knowledge around Value Investing and therefore his suitability as a trustee.  Interestingly, he said to me at our Auckland meeting that WISEplanning will need to tender for the right to manage this portfolio (!).

One important point that has emerged is that my client who set the trust up initially (D, my client the settlor and trustee) will need to stand firm, least the independent trustee dominates investing strategy in a way that is unfortunate for my client and the beneficiaries long term.  I am of coarse referring to M’s blind adherence to the common investing narrative that is based on Modern Portfolio Theory.

At WISEplanning I have developed the Value Investing method well beyond just buying shares cheap using commonly used financial analysis (more on that in the future).

Hey… I am not judging or pretending that I am some Guru.  No investing method is perfect.  However, Value Investing and the way we deliver it at WISEplanning is difficult is to argue against intelligently.

“Diversification may preserve wealth, but concentration builds wealth”.

                                                                                                        Warren Buffett