JULY Alternative Investing for the Individual Invseestor

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1 JULY 2009 Alternative Investing for the Individual Invseestor Roger Shaar discussed alternative investments at the July 18 AAII Los Angeles chapter meeting at the Skirball Center. Shaar is a former president and program chair of the Los Angeles chapter and a member of AAII for 28 years. During his career he was in international sales for Lockheed, spending many years in the Middle East, while at the same time he invested in real estate for 42 years. He opened his talk with a quote from the British economist John Maynard Keynes, It is better to be approximately right than precisely wrong. Sage advice for the current turbulent market conditions. Then, he moved on to profiling the typical member of the Los Angeles AAII chapter. Most are between 45 and 75 years old and prefer to make their own investing decisions, investing as a parttime activity. Their average investment portfolio ranges in value from $400,000 to $2 million. Most are college-educated professionals, many with graduate degrees, making them a very elite group. Traditional investments include stocks, bonds, REITs and international investments, often packaged in mutual funds and ETFs. In contrast, Shaar defined alternative investments as everything not regularly covered in AAII presentations, which amounts to hundreds of things. But for the purpose of the talk, the focus had to be on investments of wide interest. Why do investors need alternative investing? The answer is that secular bull markets alternate with secular bear markets. You can t always count on making money investing in the S&P 500. Indeed, you can count on losing money in the S&P during the long periods of secular bear markets. For a few examples, the S&P 500 returned only 1% per year between 1903 and 1921; only returned.5% per year between 1967 and 1982; and returned a negative 5% a year between 2000 and 2009 (the only consistently negative return period). The S&P 500 may only return an average of.5% a year between 2000 and 2016, leaving secular bear claw marks on investors portfolios. Gail Dudack estimated that it could take to 2016 for the S&P 500 to reach its 2000 peak of 1,550. The S&P 500 hit a low of 858 in April, Investors want to take advantage of Wall Street, but it is disconcertingly easy to end up a casualty of the street. Why? Well, there are too many unknown unknowns too many black swans. Or, as, Harold MacMillan phrased it, events, my boy, events. In other words, investors too frequently get blindsided by unexpected events the equivalent of those fancy trading models getting Table of Contents Roger Shaar Alternative Investing p.1 Kieran Osborne Currency Trends p.3 Renaud LaPlanche Lending Club p.4 Don Gimpel Education Nuggets p.6 1

2 whacked by exogenous variables. One investment solution is in fixed income investments. But they are subject to: interest rate changes, credit quality, market valuations, liquidity, prepayments, early redemptions and other factors, such as taxes. Shaar moved on to contrast traditional investments with alternative investments. He characterized traditional investments as being for the masses. Strategies for traditional investments include asset allocation, diversification, market timing and stock and sector picking. Alternative investing is for the willing, according to Shaar. That includes: hybrids, exotic financial assets real assets and combinations of the above. Real assets that have an assured cash flow (examples, a coin-operated laundry business, an apartment house or a gas station) give an investor the advantage that a swimmer has with an oxygen tank on his back. They are comparable to an annuity. Other real assets don t have a cash flow (for example a Ming dynasty Chinese vase, or a painting by Picasso) and depend on asset appreciation, and taste and market makers to bid up their price. The investing advantages of real assets include: leverage, assured cash flow, no management expenses and a post-retirement income stream. Shaar gave an example of investing in an apartment building, in Burbank, with eight onebedroom apartments. Cost of renting an apartment in 1969 was $65 per month, and the building was worth $57,000. In 2009 the same apartment rented for $985 and the building was worth $955,000. Over that 40-year-period the building was refinanced 12 times. The average annual return on equity was approximately 18 percent. The unrealized capital gain was $943,000. Shaar s equity in the building is $267,000, or 28 percent of the price. He cashed $676,000 out of the building, over a 40-year-period. His average leverage (debt to equity ratio) was 2.5 to 1. His average loan to value was 70 percent. Since Shaar has been a landlord, investing in apartment houses for many years, this is an area of his expertise. He can explain the intricacies of financing and of risk factors under various market and time conditions. Audience members would have appreciated more information on the risks and rewards of apartment-building investing. For more information on the topic, Shaar can be reached at rhshaar@yahoo.com Shaar s final topic was total portfolio risk. One of the best approaches is to invest in non-correlated assets. One would like to invest in a variety of investments that are in watertight compartments. A negative example would be Lehman Brothers, which basically had its assets in one big compartment. When Lehman was hit by a typhoon, its one big compartment flooded and the firm sank. On the other hand, Berkshire Hathaway has Los Angeles County Meeting Schedule Westside Computer Group Don Gimpel, 310/ dgimpel@prodigy.net Veterans of Foreign Wars Memorial Bldg. Culver Blvd. & Overland Avenue, Culver City, Date and topic TBA Pasadena Group Meets at 7 p.m., meets at Lamanda Library, 140 S. Altadena Drive, Pasadena. (Meets third Tues. of the month, except for August and December.) Topic TBA Mutual Fund Group Gunter Hagen 310/ , ghagen1@yahoo.com. Date and topic TBA at Fairview Library, 2101 Ocean Park Blvd., Santa Monica. The meeting is free to the public Stock Selection Group Norm Langhout, 310/ , normlang@ca.rr.com. Fourth Wednesday of the month at 7 p.m. Fairview Library, 2101 Ocean Park Blvd., Santa Monica. Topic TBA San Fernando Valley Group Mid Valley Library Community Room, Nordhoff St. North Hills, Date and topic, TBA IBD Meet-Up/AAII CANSLIM Group Fairview Library, 2101 Ocean Park Blvd., Santa Monica. Date and topic TBA Los Angeles Chapter Skirball Center No meeting in August. Roger Stinnet, of City National Bank, on Weathering Volatile Times: Key Tactics for Your Esate and Retirement Planning ; and, Fred Richards, on Stock Selection Strategies. 2

3 many compartments of unrelated businesses, for example in furniture, shoes, candy, newspapers, soft drinks, banks and insurance. Berkshire Hathaway s share price will go down in market storms, but the firm will not sink. Shaar concluded his talk with an enigmatic quote from Albert Einstein, Not everything that counts can be counted. Not everything that can be counted counts. Currency Trends and Implications Kieran Osborne, the second speaker at the July 18 AAII Skirball Center meeting spoke on the topic of Currencies: Trends and Implications in a Changing World. Osborne, a native of New Zealand, is the coportfolio manager of Merk Investments. He manages two mutual funds. In his talk, Osborne gave a summary overview of the contemporary market situation, and then discussed investing in currencies. The financial situation in the U.S. was unsustainable. Among the problems were the twin growing deficits, that of the federal budget and the current account. People in the U.S. were too leveraged in cheap credit. In addition, the public was a global over-consumer. In Asia there was an interest in growing employment. Now, though hindered by recent global overproduction, Asia has massive surpluses of foreign reserves. Its cash position is much superior to America s. Corporate America has been faced with margins being squeezed, with accelerated outsourcing and lackluster job and real wage growth. The Fed fostered credit expansion. Now it is less relevant and ineffective. People operated with a false sense of security. People were living beyond their means. Who would have thought that housing prices would decline precipitously? The ensuing credit contraction was related to a rise in volatility and priced risk back into the 3 market. With a paring down of leverage came price deflation. People sank under water on their home mortgages and drowned financially. Regarding the cheerleading about green shoots in the economy, Osborne pointed to a distinction between hard facts and arbitrary forecasting, based on unrepresentative data. Green shoots cheerleading is based on arbitrary projections. Significant economic headwinds remain. The Fed has moved beyond its traditional role in setting fiscal policy and moved on into monetary policy, compromising its own independence. Foreclosures should continue to rise. Mortgage activity could be downgraded by 30 percent, due to interest rates going too high. State economies, particularly California with its IOUs) will put upward pressure on rates, an inflationary effect. Expectations are the key to inflation. Inflation is a bigger risk than deflation. Expectations of inflation will push up prices and wages in a spiral. Osborne was concerned that the federal government s actions may be sowing the seeds for the next crisis. Among his concerns: rewarding bad businesses at the expense of good ones. Also, crowding out effects, as the private sector allocates resources more efficiently than does government. Finally, government debt is overvalued, and foreign demand may well wane. Who would want to buy artificially overpriced government bonds? As it is now, the government s status as a safe haven is dubious. The Fed is hamstrung to rein in inflation. Government Treasuries look increasingly unattractive as investments. Turning to currencies as investment vehicles, Osborne asked rhetorically, why currencies? Some of their attributes are size, liquidity and their low correlation with stocks and bonds. Currencies do not require leverage. Merk s mutual fund has no leverage. Investors can use the basket approach, investing in a variety of currencies.

4 Osborne made a fast trip through the currency investment prospects of the currencies of various countries. Of the U.S. he said the pendulum has swung away to other currencies. Concerning the European Central Bank Osborne noted that it is conservative, that consumers are less leveraged and Europe has lower inflationary pressures than the U.S. Norway Osborne called the new Switzerland. At the heart of the Swiss economy is its troubled banking system. Norway is more of a safe haven, where the government was very conservative in terms of intervention. Australia and New Zealand are commodity dependent, have trade deficits and are subject to carry trade. Canada is mainly notable for commodities, and, while fiscally sound, has considerable exposure to the U.S. Gold, Osborne termed sound money, citing inflation concerns, but noted it holds its value better than many currencies. The yen he called a panic currency, commenting on the carry trade breakdown. A financial services expansion is under way in Asia. China has a big hard currency surplus, and relies too much on exports. However, China is using the surplus to build infrastructure in huge projects. One of them is the nationwide bullet train network, which is employing 110,000 workers and will cost $50 billion in By the time the project is completed in 2020 bullet trains will be flying through the countryside at speeds up to 220 mph, and China will have spent $300 billion, according to an Aug. 17 Fortune magazine article. India has a narrow band of highly skilled and educated workers and mass poverty of at least 300 million people on the brink of starvation. The country is also involved in infrastructure build-out, including a massive, partially completed project to build an interstate highway that circles the subcontinent. According to an article in the June 22 Forbes magazine India is projected to grow at five percent and it now ranks as the twelfth-largest economy with GDP topping $1 trillion. In the question and answer session concluding his talk, Osborne commented that the U.S. can no longer rely on the consumer to pull the economy forward. Currently the economy is experiencing deflation as debt comes due. After that there may be inflation. China s products are inflating the economy and expectations of inflation are important in forecasting inflation. Lending Club : A Novel Approach to Fixed-Income Investments Renaud Laplanche explained how the Lending Club could help investors earn monthly income by investing in consumer notes. He spoke at the July 18 AAII meeting at Skirball Center. Laplanche is the CEO and founder of Lending Club, overseeing all aspects of its operations. Previously he founded a software company that was sold to Oracle, and before that was a lawyer with a New York law firm. He won an entrepreneur-of-the-year award in Consumer notes are registered securities that give individual investors access to a new asset class that combines high returns, low volatility and no correlation to the stock market. In getting under way, Laplanche commented that California was a haven for immigrants seeking the American dream, due to the wide availability of credit, allowing people to start businesses. Laplanche s market niche is the underserved market of the prime credit consumer. Why would the consumer want to pay 24 percent interest on his credit card debt? That is what even the top borrower, who is the most credit-worthy, has to pay. Such usurious rates imbalanced the market, creating an entrepreneurial opportunity. Lending Club s rates are better than the credit card companies affiliated with banks. 4

5 Banks charge an average 16 percent credit card rate, and pay depositors an average of 1.75 percent. In contrast, Lending Club charges its borrowers an average of 13.5 percent, and pays its investors an average of 9.05 percent, a situation with a much narrower gap between charge and investment return. The business model allows investors to loan peer to peer, or P2P, through the intermediary of Lending Club. LendingClub.com (to reference the internet site) packages loans and sells them as notes, eliminating the high cost and complexity of banks and credit card companies. P2P more directly links lenders and borrowers than does a traditional bank. The media has shown a lot of interest in the business model, prompting coverage in Reuters, Bloomberg, CBS, Barron s and others. P2P may grow to more than $100 billion in annual loans by 2012 from about $500 million this year, as borrowers seeks ways to reduce their costs, according to Ed Kountz, of Forrester Research Inc., in Cambridge, Mass. P2P lending offers a way for borrowers to get access to money for home, auto and student bills as banks scale back lending, during the current severe recession. It s a great opportunity for investors to compete with banks, which have largely been ripping off the public with their high rates, said Alan Lysaght, author of the book The ABCs of Making Money. Lending Club targets only prime borrowers, usually young professionals, using rigorous standards to approve less than one in 10 applications. Borrowers have an average 713 FICO credit score, an average of 10 percent debt to income, and no current delinquencies. Currently Lending Club has issued $45 million in loans against a base of $471 million loan applications. High standards have led to solid returns. The average annualized return as of July 15 this year was 9.6 percent. The annual charge off rate was 3 percent. And the late payment recovery rate was 75 percent. Investors receive monthly payments of principal and interest. The trading platform provides liquidity and flexibility. This is a new asset class with a strong track record, said Leplanche. Average monthly returns during the comparison period from June, 2007 to March, 2009 were: Lending Club,.75 percent Bond Market, (BND),.52 percent S & P 500, percent Lending Club s average loan size ranges from $5,000 to $10,000. It has 180,000 members, and is located in Sunnyvale, Cal., phone number, While P2P has a lot to like, there are some caveats. P2P is not as regulated as banks, which provide deposit insurance. Peer-to-peer companies must register with the federal Security and Exchange Commission, because the loans are considered securities, according to SEC spokesman John Nestor. Investors have to question whether they want to do business with a cottage industry, Carol Kaplan of the American Bankers Association said. Banks are trying to control their risks, she added, by not granting credit to some people who may have a credit card, but are less than desirable borrowers. The risks of P2P loans include insufficient information to determine whether borrowers will repay, said Ken Naehu, a fixedincome manager for Bel Air Investment Advisors LLC in Los Angeles. If borrowers do not repay, investors could lose all the money in their investment. Consumers may refinance as much as $159 billion by 2012 in credit card-card debt with P2P, according a January study by Javelin Strategy and Research, in Pleasanton, Cal. Consumers could also refinance with an on-line bank, the main rival of P2P lending. Other companies specializing in P2P lending are IOUcentral.com., Zopa.com., Loanio.com. and Prosper.com. This is an industry that can get a sizeable percentage of the almost $3 trillion in 5

6 U.S. unsecured debt, said Chris Larsen, a San Francisco-based P2p lender. This new asset class is easily diversified, Larson added. People are going to be able to find some great returns. Education Nuggets Dr. Don Gimpel s five minutes of investor education and announcements took the form of futuristic, hypothetical situation. Imagine it is 2040 A.D. and Capt. Kirk, on the starship Enterprise deep in space, is informed that an alien craft is closing fast and is only 10 minutes from blasting Enterprise into stardust. That would give the good captain only a few minutes to buy and sell stocks before responding to the alien threat, or being vaporized. Kirk checks his holdings of Microsoft, Apple and Google on his hand-held device, and a comparative analysis comes up in five seconds. The proper allocation for Kirk to have an efficient portfolio would be: Apple, 4.5 percent; Microsoft, 7.13 percent; and Google, 5.24 percent. Wow. But, hey, just hold on a nanosecond you do not have to wait 30 years to get this type of information. Allocation information to have an efficient portfolio is already available, today, at wolframalpha.com. But, what about those incoming alien missiles? Kirk s response, Shields Up. Orange County AAII Announcements For information about the Orange County chapter of AAII and their meetings, go to aaiichapter_orangecounty@yahoo.com. Note to Pro Forma Contributors: Please have your copy ed to the editor by the fifth of the month. Letters and comments are welcome. If you want to an article about smart financial steps for coping with widowhood, whether China can spend its way out of recession, impending health care reform, the Social Security timebomb or some other financial issue, you will have a chance to appear in print and inform Pro Forma readers. Book reviews are welcome. Mail disks to: 319 Walnut Ave., Apt. 2, Long Beach, CA , or use to send copy to the editor at wparme1@lausd.net. My home phone is (562)

7 Pro Forma Pro Forma Editor Pro Forma Editor, Emeritus William Parmenter Orvis Adams SIG GROUP CHAIRMEN IBD Meet-up/ AAII CANSLIM Mutual Fund Group Options Group Pasadena Group Palm Springs Group San Fernando Valley Group Westside Computer Group Norman Langhout Gunter Hagen Robert Morgan Ivan Wong Patti Gammino Evan Press Don Gimpel Pro Forma is offered free of charge exclusively via and is also available for downloading from the Los Angeles Chapter web site at: The American Association of Individual Investors is an independent nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research. Pro Forma is published for advising members of the groups' activities and for sharing information. All material compiled without verification of accuracy to a specific task or computer system. All material provided in the ewsletter is for educational and illustrative purposes only. Comments are the views of their author and no other person or organization. Investing is an inherently risky business. Investors may loose their entire investment or more. Past performance is not a guide to future return. 7