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A Q UA RT E R LY P U B L I C AT I O N O F I R O N C A P I TA L A D V I S O R S | Fall Issue | October 2007

I N S I D E STO RY

Stop Investing in the Market. Own Companies Instead.

OWNERS MATTER.

WHERE HAVE ALL THE OWNERS GONE? Do youmiss the days when you went to the hardwarestore and the owner was standing behind the

counter? Or what about going out to eat? Certainly there aresome good chain restaurants, but my favorites are still placeswhere the owner is on site and comes by your table to seehow everything is going. Owners make a big difference.

If you don’t believe me look at any franchised business.Let’s take Holiday Inn for example. I travel a lot and havestayed in all sorts of hotels, and I can tell you that someHoliday Inn’s are fantastic, and others are a little scary. It alldepends on the individual owner. Holiday Inn’s corporateoffice knows this. They have found that one of the mainreasons their market share of hotel nights has fallen isbecause the frequent traveler never knows what they aregoing to get from one Holiday Inn to the next. As a result,Holiday Inn is weeding out bad owners from their system.

OWNERS MATTER. So who owns corporate America?Do you know? Do you care? I argue that you should. Beingin this business I always hear about how mad people are aboutCEO compensation, ethical breaches and yes, even six yearslater, I still get an earful about Enron. I usually just listenpolitely and agree with most of what people are saying. ThenI might ask how they invest their money, and I hear thingslike, ‘I have it all in index funds.’ More and more, they tellme about this great hedge fund, or about the virtues of com-modities and of course the new ETF they just bought. WhatI never hear anymore is something like, “I own Coke.”

Somewhere along the line, Wall Street seems to haveconvinced people that they should stop investing in compa-nies and start investing in markets. John Boggle is probablyas responsible for this as anyone else. If you don’t recognizethe name, Mr. Boggle is the founder of Vanguard, the index-ing king of the mutual fund world. He popularized the notionthat most active money managers don’t beat the market andtherefore one should simply invest in the market and not tryto pick companies. In the boom years of the 1990s, thisnotion became conventional wisdom.

Of course, like most conventional wisdom, there is sometruth to what Mr. Boggle suggests. Especially in very efficient

markets and in markets that are being driven by irrationalforces. For example, in the late 1990s when most activemanagers were avoiding technology stocks due to theirvaluations, the S&P 500 looked unbeatable. In July of 1997less than 6% of active managers benchmarked to the S&P 500were outperforming the index for the three year period thathad just ended. Contrast that to January of 1982, when 81%of active managers outperformed the “market.” Thirty-fivepercent of managers beat the S&P 500 over three yearperiods on average. So, like most conventional wisdom, itisn’t completely true.

There is of course one investor who is known for hisability to beat the market. Warren Buffett is not only thesecond wealthiest man in America, but also the most famousof all investors. The annual report of his company, BerkshireHathaway, is a must-read for anyone interested in investing.Buffett made his name by investing in the stocks of publiclytraded companies, and his firm has grown to the point wherehe now mainly buys companies in their entirety. However, hestill runs the stock portfolio, and this is where I think thegreatest lessons lie for average investors who don’t have afew billion dollars at hand. I was reading the 2006 BerkshireHathaway Annual Report earlier this year, and something

Stop Investing in the Market. Own Companies Instead.

“You should know what you ownand know why you own it.”

jumped out at me: Buffett went through the entire discussion of the stock portfoliowithout once mentioning what had happened to the price of any of the individualstocks he owns. He talked about the various companies’ earnings and cash flow, andhe spent the greatest amount of time talking about the CEOs and how talented theywere. Not once did he mention whether the price of the stocks had gone up or down,or by how much.

I don’t know why this jumped out at me this year, because it is nothing new forBuffett. He has many famous quotes about how important it is to ignore the market,but for some reason this year it really struck a chord with me. This man does notinvest in the market, he owns companies. This is at least part of what has made himso successful.

Contrary to his legend, he is not alone either. There are actually several legendaryinvestors who can rival Buffett; they just don’t have his fame or his personal wealthbecause unlike Buffett, they mainly invested other people’s money – people likeBuffett’s mentor, Benjamin Graham; Philip Fisher; Peter Lynch; Bill Miller; RalphWanger; and more. There is actually a long list. Each of these investors is unique.Graham is the father of security analysis and of what we today call value investing.Fisher is the father of what we now call growth investing. Peter Lynch ran portfolioswith hundreds of stocks, while Bill Miller has never owned more than 40 or 50stocks. Ralph Wanger was a small stock specialist.

Very different men with very different approaches, yet they all have two thingsin common. First, they were/are owners of companies. Good companies with solidfundamentals and good managers. Second, they bought these companies at goodprices, then held on to those companies for a long time. It is that simple.

You are probably thinking, “It can’t be that simple.” Well in the words of Buffetthimself, “There seems to be some perverse human characteristic that likes to makeeasy things difficult. It’s likely to continue that way. Ships sail around the world, butthe Flat Earth Society will flourish.”

Michael Mauboussin in his book, More Than You Know, looked at the characteristicsof mutual funds that had beaten the market over the decade that ended in 2004.Those funds had an average portfolio turnover of 27% versus the average equitymutual fund, which had a turnover rate of 112%. That means the average mutualfund manager owned the stocks in his portfolio for less than a year, while the averagemanager who actually outperformed owned his stocks for an average of four years.

Most money managers did not own companies, and instead were simply “renting”the stock. The successful money managers were owners.

There are other benefits to owning companies as well. When you own stock in acompany, you have a vote – a voice in what direction the company decides to go.Granted, for the average investor your voice may be one of the quieter voices in theroom, but it still exists. If you don’t like how the current management is running thecompany you can voice that opposition, and if there are enough other investors outthere who share your concerns, you can effect change. If that change doesn’t occuryou can sell your shares before the consequences of management’s actions come toroost. For example, many investors get upset when companies fire their CEO andpay them millions in severance. However, the owner who is actively paying attentionknows that the real mistakes happen when that severance is promised upon hiringthe CEO, not when it is paid out.

IN CASE YOU HAVE NOT HEARD,there seems to be some trouble inthe housing market. In fact if you listen to the news you would thinkhousing is the only factor that drivesthe entire economy. That isn’t entirelyaccurate. GDP growth for the 3rdquarter isexpected tocome in at a veryrespectable3.2%. Jobgrowth slowedbut was positive. The initial report ofjob declines in August was revisedupward to a gain of 89,000 and theeconomy added 110,000 jobs inSeptember. The overall unemploymentrate rose to 4.7% from 4.6%.

The Fed lowered the fed funds rate by0.50% to 4.75%, as the credit crunchin the financial markets overshadowedthe risk of inflation. The problemsthat started in sub-prime home loansspread throughout the credit marketand created a true panic.

Housing remains the biggest negativeon the economy. Housing starts are atthe lowest level in 14 years. TheMortgage Bankers Association is pre-dicting a 22% drop in new home salesand a 12% drop in existing home salesthis year and a further 10% drop inboth categories in 2008. The housingmarket has not bottomed yet.

In 1940, 44% of households ownedtheir house, by 2006 nearly 69% ofhouseholds owned their house. In the middle you had a major moveto suburbia and a something calledthe baby boom. Boomers have boughttheir last house, and when they go to sell it to Gen-X guess what theyare going to find. Gen-X is one smallgeneration of home buyers. Of coursethere is the so called echo-boom, butthis is most likely the first generationin American history which will be leftworst off financially by their parents(who after all were the “me” genera-tion). Housing is going to take a whileto recover. +

R EVI EW of

E C O N O MY

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At the end of all the noise in the market, our forecast continuesto be right on the mark. The S&P 500 is up 9.13% year to date and we still believe itwill finish the year up 10-12%. The volatility we predicted has done anything butdisappoint. Unfortunately we think it is here to stay for a while longer.

Large cap stocks remain far more attractive than small cap stocks. As predictedlarge cap growth stocks have faired much better this year and small cap stocks havesuffered. We believe this trend will continue.

We have also been right about international markets which we continue to like. Theonly flaw in our forecast so far this year is that we did not expect the amazing runin emerging markets. The MSCI Emerging Market index is up 34.85% year to date.We do not expect that kind of pace to continue.

We continue to expect modest returns from bonds. The yield curve has started toright itself with short rates dropping and long rates rising. This is painful for themoment but it is a necessary correction in our opinion. The outlook for bonds willimprove, but we remain cautious in the short-term. +

THE 3RD QUARTER WAS BORING –as always – with the S&P going up2.03% for the quarter. Yeah right, ifyou were asleep. Three brutal days inAugust put several hedge funds outof business. The credit market cameto a screeching halt, and mortgagelenders took it on the chin with onlythe strongest surviving.

What happened?Greed! A fewyears ago somesmart people atvarious financialinstitutions fig-ured out that they could bundletogether a bunch of home loans andsell them in the securities market asmortgaged backed bonds. Alwaysexcited about anything new, the hedgefund community started buying thesebonds which they considered to bealmost as safe as treasury bonds.They thought they were so safe thatthey could borrow money themselvesto invest more in these instrumentsin order to achieve as high a returnas you could want, with “no risk.”

At least that is what they thoughtuntil investors started to get worriedabout people paying their mortgages.Fear quickly replaced greed and thevalue of mortgaged back securitiesdropped forcing brokerage firms tocall back the money they had lent tohedge funds causing a fire sale in thestock market and crippling the creditmarket. These “no risk” strategieswere in reality extremely risky andthis realization panicked the marketwhich is still trying to figure out howto price credit and how much risk isactually there.

In the end, the S&P500 was up 2.03%and the Bond market was up 2.85%as the Fed jumped to the rescue bylowering both the discount rate andthe fed fund rate. The moral is, don’tget greedy and then you can justsleep through another boring quarterof ho hum returns. +

REVIEW of

M A R K E T

M A R K E T fo re ca s t

Chuck Osborne, CFA, Managing Director

» Continued – Own Campanies Instead.

Ownership also tends to settle the nerves in the face of market turmoil. Whenstock prices drop, traders tend to panic, while owners ask themselves, “Has some-thing really changed with this business, or is this just short-term market silliness?”Most of the time it is just silliness. To a large extent, this explains why owners dobetter in the long run.

I hear lots of stories about exciting investment products like hedge funds thatpromise huge returns with little risk. However, I have never met anyone who hasgotten rich by investing in a hedge fund. If you have, please ask them to give me acall – I would like to meet that person, but I won’t be holding my breath. On theother hand, I have met lots of people who have come to me for advice in how tomanage the large sums of money they have made from companies they invested in20, 30 or even 50 years ago. Ownership works.

At Iron Capital, we believe in ownership. We agree with Peter Lynch when hesaid, “You should know what you own and know why you own it.” We use thatphilosophy not only in the equities our clients own directly, but also when pickingmutual fund managers. We like managers who own companies, who understand thelong-term strategy of a business, and who are not just guessing about what thestock will do over the next few months. This strategy doesn’t always outperform inevery short-term interval, but it does in the long run, and in the end that is the onlyrun that really matters.