2022 Year End Letter to Clients
New Capital’s portfolios performed well with their defensive characteristics, notably their tilts toward value stocks and shorter term bonds, including inflation protected bonds.
Dear Clients:
Happy New Year. Our family ended this year with an extended stay in Breckenridge, Colorado, a wonderful story of American revival.
My parents began to bring us to ski here in the 1980s when it was still a small ski resort town with a few lifts. We now bring our own children to what has become a five-peak mega-mountain owned by Vail Resorts (NYSE:MTN); a wonderful renovated historic Main Street area with shops and restaurants; and a year-round endless selection of outdoor activities.
It was not always so. After the Ute indigenous people were pushed from their homeland in the Blue River valley, 19th-century gold miners swarmed the area. By the 1940’s the Blue River and many of its tributaries had been almost completely destroyed by placer mines, dredge boat mining, and mine shafts. To this day enormous heaps of mining rubble line many of this valley’s river banks.
Breckenridge long ago quit destroying itself for gold; adopted the crazy idea that a left-for-dead mining town could be resuscitated on recreation; and now makes far, far more money from the far healthier and sustainable business of skiing its beautiful mountains. Beginning decades ago with a small townhome, my parents have over the years gradually upgraded the family vacation home and we all now enjoy a home with wonderful views of the Ten Mile Range. My parents never would have had the confidence to make an initial investment here, much less continue to increase their investment here, if the miners were still in operation.
As for the Utes, America’s national reckoning with its treatment of its First Peoples remains ahead, and the first step is acknowledgment:
Our home in Houston was the ancestral home of the Karankawa;
Our home in Colorado county, Texas was the ancestral home of the Tonkawa;
Our home in Massachusetts was the ancestral home of the Mohican;
Our home in Colorado was the ancestral home of the Ute.
May these acknowledgments lead to greater understanding.
I hope that the remainder of this year-end letter is helpful to you, and if I can answer any questions please let me know.
2022
2022 has been an extraordinary year in many ways: the waning but still very present Covid-19 pandemic; the jolt of suddenly much higher inflation and interest rates; tense mid-term elections in which the country clearly (if barely) rejected deniers of valid American elections; and of course, the initial shock and ensuing grind of Russia’s “special operation” in Ukraine - all combined to downwardly re-value almost all assets (oil and related energy company stocks, and ultra short bonds being the notable sole exceptions).
In this treacherous environment, I am pleased to report that New Capital’s portfolios performed well with their defensive characteristics, notably their tilts toward value stocks and shorter-term bonds, including inflation-protected bonds. In most cases, client accounts, while still negative for the year, substantially outperformed their market-based benchmarks. Notably, we avoided direct substantial exposure to the 2022 headline blowups of grossly overpriced growth stocks (e.g., Tesla), longer-term bonds, cryptocurrencies, and of course, investments in Russia.
I’m proud of this year’s record, as it confirms the most fundamental idea in investing: price matters. The implied yield of any investment, which is basically its annual earnings divided by its market price, tells a lot about the prospects for its future returns. Prices for investments in general are now much better than a year ago, and I, therefore, look forward to 2023.
Your comprehensive performance reports for 2022 will be ready around January 9th and deposited into your NCM360 account - please let us know if you need assistance either accessing them or interpreting them, and we will be happy to assist.
Geopolitics
In 2000, a professional liar became the President of the Russian Federation, which had just come into existence as an independent state in 1991 subsequent to the collapse of the Union of Soviet Socialist Republics (USSR).
Trained as a Soviet “intelligence agent” (a spy) and operating in his early years in Soviet-controlled East Germany, Vladimir Putin subscribes to a personal “philosophy”, originated by certain Russian “philosophers” and shared by his cronies, that there is no objective truth, and that anyone (especially he) is free to create their own subjective truths and impose them on others. This philosophy is generally at odds with the Western world’s most foundational thinkers (such as Plato) and the Eastern world’s (such as Siddhartha Buddha), who posit that the search for objective truth, to the extent that we humans are able to do so, is vital. These foundational beliefs about the nature of truth have led directly to scientific method, personal enlightenment, and human freedom, because they set standards that closely approximate the realities of the universe, individual consciousness, and communities of living beings on Earth.
Despite Putin’s odious background and beliefs, in the year 2000, the world at large remained keen to put the five-decade Cold War behind it, and so Putin’s Russia was allowed, and even encouraged, to remain in the company of the world’s nations to trade goods, services, people, capital, ideas, networks, and other key resources. The hope was that Russia would, in time, finally, at long last, after centuries of dark national tragedies, emerge into the light and the truths of modern democratic nation-states.
That hopeful period came to an end early last year on February 24, 2022, when Vladimir Putin decided that it was not enough for Russia to already be the largest country in the world by area, but that it needed to be even bigger by conquering and absorbing its southern neighbor, Ukraine, which Putin regards to be part of a lost Russian empire.
As we well know by now, Putin’s most basic assumption that his military would quickly conquer Ukraine and that the Western nations would accede to it has been utterly wrong. Instead, Ukraine, at incalculable cost, has fought back bravely and successfully; and Western nations have allied and supplied Ukraine with arms and aid to continue its fight. Every year, just like you, I pay taxes to our federal government. In many years, I wonder and question what my taxes are purchasing. This year, I am delighted to pay for our government to provide unstinting military and humanitarian support to the people of Ukraine in their fight against Russian liars, lies, and violence. Their fight is our fight as well, for our democracy, for our communities, for our families, and for our wealth.
Along the way of the past two decades, Putin’s “philosophy” of malleable truth unfortunately did not remain quarantined in Russia, but was exported to, sadly, find receptive audiences in other places including right here in the United States, where some have adopted them for their own political ends. Putin’s art of lying - to oneself, to one’s friends and loved ones, to one’s customers and clients, and to the public at large - infected the United States of America through unregulated social media channels.
But like all viruses, it is rare that everyone, or even a majority, becomes infected. And as the recent midterm election results indicate, most in America - Republicans, Independents, and Democrats - thankfully remain uninfected by Putin’s virus, and still choose in a free and fair election to, for the most part, support those who are truthful over those who lie.
That result is very, very good news for your wealth. As I have discussed in previous letters, democratic countries, where people generally expect to both tell others and be told by others the truth, enjoy far higher valuations than countries where autocratic leaders propagate lies in order to remain in power and aggrandize national wealth for themselves and their cronies and enforcers. For example, just before Russia’s stock market essentially shut down after the invasion of Ukraine, Russian oil company valuations often traded in the low single digits as multiples of earnings, while Western competitors traded at three or more times those values. Same business, same products - different countries, different valuations.
It’s simple: in countries where liars rule, human relationships and community laws are often perverted and degraded, and valuations for businesses accordingly suffer mightily, as they should.
Lies and New Capital
Lies have no place whatsoever at New Capital Management. At New Capital, we can neither entertain nor tell lies. If we entertain lies, we may believe lies, and if we believe lies, we may repeat lies, and if we repeat lies others who trust us may come to believe them too, and spread them to others they know. We must always seek the truth about how investments are made and managed, and we must tell you the truth about what we learn and do in response. We must learn carefully and in great detail about your personal financial picture and we must tell you the truth about how we objectively view that picture.
We also cannot be hypocritical: we cannot have one rule for how we serve as your financial advisor (truthfully), but another for how we view other important things like our democratic elections or our own lives (untruthfully). If I am willing to entertain lies about our elections, what other lies might I be willing to entertain? What about lies about the best ways to manage your money?
Our firm depends upon dealing with scrupulous people whom we may question directly and work with transparently. We count among our primary business partners Fidelity Investments, Dimensional Fund Advisors, Vanguard, BlackRock, and J.P. Morgan Chase - all successful, massive, cost-effective, and honest caretakers of your money. Anyone seeking to take their own place in our stable must prove themselves as these organizations have done and continue to do.
We are constantly - and I mean constantly, as in every day all day long - contacted by people and companies seeking to introduce and ingratiate themselves with me so that we will invest your money with them so that they may charge fees on your money. We will not put your money with people who don’t check out with us for any number of reasons.
We assume that anyone coming to us may not be telling the whole truth, whether it is a problem with investment philosophy, management, liquidity, portfolio, fees, or some other.
We automatically assume that anyone unfamiliar to us - even someone with a large public reputation - who approaches us for your money may be telling untruths or half-truths and that they must first empirically prove otherwise before we will invest with them. We are not the United States justice system, which presumes innocence unless guilt is proven; instead, we presume guilt (not in the criminal sense, but in the sense that a proposal to invest is likely defective in some way) unless innocence is thoroughly proven.
Our relationship with you is itself based upon facts and information that come directly from you in the earliest days of our relationship. Many, if not most, have an advisor who will accept any client as long as they have money, and hopefully lots of it. We do not behave that way, and we believe (and you always prove us to be correct) that the least interesting thing about you is the amount of money you have.
I always say that if Bill Gates himself called me and said he wanted me to serve as his advisor (that hasn’t happened, by the way), I would tell him that we have an extensive process of first getting to know him before we can agree to enter an advisor/client relationship with him.
Markets and Investments
Here is a table of 2022 returns by asset class:
While the U.S. stock market turned in a negative 19.3% showing, can you guess which country had the best performing stock market for the year?
It was Turkey, with the dollar-denominated iShares MSCI Turkey Fund (TUR) up 106%, an astonishing show of strength especially given the recent dizzying ascent of the US dollar versus the Turkish lira (and virtually all other currencies as well). Dollar strength actually diminishes returns to US investors in foreign assets (in local Turkish lira the Turkish stock market performance was even more impressive, up about 200%, as Turkish investors sought relief in their equity market from punishing local inflation).
You might be wondering if your New Capital portfolio participated in the year’s best-performing Turkish stock market, and the answer is a resounding yes. Not only does our favored international stock fund, the Dimensional International Ex-US Core Equity Fund 2 (DFAX), have holdings in Turkey, but it actually has many more Turkish holdings than the iShares Turkey-only fund, as you can see here. Moreover, the management fee cost of DFAX (about 30 basis points) is half the cost of TUR (about 60 basis points).
Now, can you guess which stock was the worst performing stock in the S&P 500 in 2022?
It was Tesla, that darling of growth investors, whose stock fell 69% (and is still falling), cutting $860 billion off of its market value. And, as most people know, Bitcoin and other cryptocurrency assets fell about the same - if not more - in percentage terms.
At the beginning of any year, it is absolutely impossible to know which equity assets will perform well and which will not in the year to come. Investing is always a matter of paying a reasonable price to earn a return. Once an asset becomes popular, hyped, and overbought, it is always just a matter of time before markets adjust its price back to reasonable. Like the year 2000 before it, when tech stocks like Dell and Cisco Systems came back to earth, 2022 will be remembered by a new generation of tech investors for teaching hard and expensive lessons.
It’s important that our retired clients know that their required minimum distributions for 2023 from qualified retirement accounts will likely be lower than the prior year. This is because RMD’s for a given year are set according to the prior year end value of your accounts, and 2022 year end values (which set 2023 RMD’s) are highly likely to be lower than year 2021 year end values (which set 2022 RMD’s).
You are entitled to withdraw whatever amount of money from your qualified IRA’s that you wish, but please be aware that if you wish to “live off” of your RMD’s, then you may need to make some household budget adjustments this year. On the other hand, Social Security payments will be noticeably higher given that they will experience cost of living adjustments upwards for the 2022 high inflation readings.
With the dramatic re-inflation of interest rates in 2022, I feel it is important to review the concept of bonds. Often I find that bonds may be less understood than stocks by clients, but it’s important to understand them especially now that bonds are again providing quite meaningful returns (very short term U.S. Treasury bonds currently yield around 4%).
A bond is a loan, and the bond owner is the lender, while the issuer is the borrower. A US Treasury bond therefore is a borrowing by the US Treasury and a loan made by the bond owner. Bonds are usually (but not always) less risky than stocks because, as loans, they are often accompanied by legal covenants, priorities in creditor claims, and other mechanisms meant to ensure their repayment on time and in full.
Bond valuation is straightforward and mathematical, and there are rarely “deals” in bonds. Future bond cash flows are generally known, whereas future stock cash flows, which are based on a company’s speculative future profits, are generally highly unknown. This difference in cash flow risk is what accounts for the generally higher expected and observed returns of stocks (stocks should yield higher returns than bonds to compensate their holders for taking greater risks in owning them).
Bonds should always be viewed in comparison to a benchmark bond (I recommend the ten year US Treasury), as well as in comparison with other bonds. The yields on other bonds in relation to a benchmark bond tell you a tremendous amount. If a bond has a higher yield than the ten year Treasury benchmark bond, you can almost automatically infer that it is riskier in one of two, or both of the following ways: it may be longer in its maturity, or its borrower may be less creditworthy, than the benchmark. Conversely, if the yield is lower, then it is likely less risky in only one way: its maturity is shorter, because the assumption in finance is that no entity anywhere is more creditworthy than the U.S. government (I understand this can be debated, but in finance it is taken as an article of faith).
Bonds are a vital part of many portfolios. They help reduce portfolio volatility by often (but not always, certainly not in 2022) providing inverse correlations to stocks and lower price volatility, and can provide valuable cash flow income.
Unfortunately, in the past decade it has been difficult to earn reasonable returns from investment grade bonds. That has now changed with the rapid interest rate increases of 2022. You can now look forward to your quarterly portfolio reports showing - at least for the time being - significantly greater dividend interest from the bond funds that we hold for you.
Model Portfolios
New Capital has made enormous enhancements in our portfolio management, trading, and reporting technology over the past two years with our move to Orion systems, and we now possess tremendous capabilities in this area, which I would like to discuss in some detail.
New Capital began to implement model portfolios several years ago, and over time we have been gradually transitioning client portfolios in our models. Model portfolios have become the industry-standard way for advisors to manage the portfolios and accounts of a sizable and growing clientele. Model portfolios are also best for clients because your portfolio gets our best thinking and almost immediate implementation of changes based on that thinking. Here is an “overview” of how our current models look:
Click on the table to open a larger view
In the past year we have spent a great deal of time honing our re-balancing software, which is what we use almost daily to implement model trading, and I am delighted to report that it is now running like a top. Jaycee and I, who together manage New Capital’s portfolios and trading, have made several model changes and trades this year in reaction to changes in interest rates. In early 2023, we will continue to transition all remaining clients who qualify (some client accounts do not “fit”) into model portfolios.
There are, however, several issues associated with model portfolios:
Which model do your accounts belong in (different accounts might call for different models)? For many years, we have used an industry-leading product called Riskalyze to test your risk tolerance and help us match you with a model number and benchmark. We are currently exploring and testing alternatives to Riskalyze (for various reasons) and may make a change in the coming months. In 2023, please also expect that we will issue an Investment Policy Statement (IPS) to you for your approval. An IPS is a formal document that discusses your portfolio needs and goals, and our assignment of portfolio management protocols for you.
Do we have the legal discretion in our Investment Management Agreement to trade your accounts without needing your prior authorization to trade? With the ongoing growth in our portfolio modeling and rebalancing projects, we are generating more trades than we have in the past (note that trading costs have plummeted in recent years). If we have a discretionary relationship with you (as the vast majority of our clients do), then we do not have to seek prior permission for our trades - and that is our preference, because we cannot take the time and effort to seek the permission of many clients prior to trading our models. We are happy to ensure that you receive immediate trade notifications from Fidelity, and you are welcome to question our trades upon receipt. There are only a few clients at New Capital who have not yet granted us discretion, and soon there will be none: after almost twenty years in business with an excellent investment record, New Capital, a full fiduciary advisory firm, has earned the right to manage its clients’ accounts in the manner that we believe is in your very best interests.
Are your accounts properly configured for model management? Our software works best when the only holdings in a particular model-managed account are our model components, with no “contamination” from non-model securities. We are therefore in the process of separating accounts that have non-model holdings in them. Often, such holdings are the result of inherited securities that are highly appreciated; highly appreciated securities that came with you when we began working together; or securities that you purchased yourself as investments. In such cases, over the next year we will ask you to create a duplicate Fidelity account with identical title into which we will move the non-model holdings. Splitting the accounts will have two main benefits: (1) we will be able to more efficiently manage your model-based account; and (2) we will be able to report account performances to you more accurately, so you can see how our model has performed in comparison with your non-model holdings, and so that we can clearly explain the invariable differences in performance of the accounts to you.
Other Items
Our 2022 client conference was held this past October 27 and was truly a great success. Approximately 50 New Capital clients, both in person and online, benefited from remarks from our guest experts from Fidelity, BlackRock, and Dimensional. You can watch replays here, and here are my own remarks. A tremendous amount of work goes into our annual conference, and we hope that you will consider making time each year to attend this important event.
We want our clients to be informed and knowledgeable. Every single week, Catherine Bahr and I meet for an editorial meeting in which we review all of the latest financial-related content from our major business partners and other content providers in order to bring you The New Capital Journal. It is tempting to think that the Journal is just another newsletter email in your inbox. But the Journal is the result of what we think is the best of the best from ourselves and our partners. In other words, the Journal brings you information directly from inside the world's largest asset management firms and from ourselves, rather than from advertising-supported media organizations. I encourage you to open and read the Journal, and make it a regular part of your weekly reading.
Since 2016, all new New Capital clients receive a mandatory training session with me that I call Investments 101. This session covers the performance of stock and bond markets since the 1920s, illuminates the stable and consistent sources of market returns, and positions clients for properly and prudently expecting returns from their investments and weathering downturns. On February 9th we will provide this vital training to all pre-2016 clients, and to any clients who wish to have a refresher. Please register as soon as possible so that we can forward to you the training guide that accompanies this session.
As most clients know, NCM360, our convenient, comprehensive, collaborative, and secure client information organizer, has been in use for several years and we are ready to help our clients load their data. Casey Moss is spearheading that effort, and you can elect to load your data with her full assistance, sharing those duties with you, or on your own. No other financial services firm in the world has anything like NCM360, so to sign up to get your life organized click here.
In closing this year-end letter, I want to especially recognize New Capital’s team: Jaycee Smalley, Catherine Bahr, and Casey Moss (who joined us in January 2022) all do wonderful work for our clients on a daily basis, helping with competence and diligence on a wide array of matters in many different ways. Coming to work with this team is a pleasure.
On behalf of all of us at New Capital, I wish you a happy, healthy, and prosperous 2023. If there is anything at all that we can do to make your experience with us better, please do not hesitate to let me know. And as always, I truly thank you for your trust and confidence.
Sincerely,
Leonard M. Golub, CFA