E7: Basepoint Wealth's Timeless Investment Principles

Our Chief Investment Officer kicks off episode 7 with the Most Important Thing, the Federal Reserve followed by our listener question, "What is Basepoint Wealth's investment strategy and how does it relate to the current market environment?"

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Transcript

[00:00:00] Welcome to The Point Podcast. We have informed intelligent conversations about today's financial topics submitted by viewers like you. Let's go ahead and get started here. Your hosts, Landis Wiley and Allen Wallace. Welcome

to today's episode of The Point. I'm your host, Landis Wiley sitting here with Basepoint Chief Investment Officer, Allen Wallace. Thanks for taking time out of your busy day to join us. For those tuning in for the first time, The Point is just an opportunity to join in a conversation about finance, something Allen and I love to do.

The twist here on our show is we have no idea what we're going to talk about. , we have a hat full of topics that have been submitted by you, the viewer and the folks here at Basepoint Wealth. And in a few minutes, we'll reach in, pick something out and run with it. So always fun or terrifying or a little bit of both.

So, before we get [00:01:00] into that though, we like to take a few minutes and kick off with a short segment called the most important thing. And as the title suggests, the most important thing, It's something going on that's impacting your pocketbook, the economy, the markets, your portfolio, or all the above. , and so without further ado, Allen, I'm going to kick it over to you for today's most important thing.

Thank you. The most important thing right now is the Federal Reserve. While short term factors will not change our positioning or strategy, it is still important to identify potential areas of volatility, especially for our retired clients. Unemployment unexpectedly ticked lower in August at 4.2%, and core CPI was a little higher than expected compared to forecasts.

Unemployment and inflation are the Fed's dual mandates, and these simultaneous surprises will put a lot of pressure on the Fed to be more judicious with rate cuts. Until recently, many market participants were expecting a 50 basis point cut from the Fed in September, and this new information makes that very unlikely.

It is now much more likely that we see a 25 basis point cut. Once the Fed starts cutting rates, we will most likely see a more normalized yield curve. [00:02:00] And the first cut of the cycle has not historically been a great sign for the stock market. In addition, there still may be some lingering problems in the carry trade markets if the yen strengthens on our rate cuts.

A carry trade is when an investor borrows in one currency with low rates and then buys investments in another currency with higher rates, taking advantage of the difference. When the Bank of Japan raised rates last month, there was a short, swift dislocation as traders scrambled to cover these positions.

There is no way to estimate how large the carry trade is and U.S. rates declining could further push carry traders out of the market. Keep your eye on the Fed and whether or not the rate cut cycle has begun. 

What does your ideal retirement sound like? Travel and adventure? Indulging in your hobbies? More quality time with the people you love? Or maybe, all of the above? Let the experienced advisors of Basepoint Wealth help you create your ideal retirement roadmap. Our fee-only advisors provide independent and transparent wealth management advice to clients throughout Iowa and beyond. Ready to see what your retirement can be. Visit basepointwealth.com to book your consultation with a Basepoint Wealth advisor because from here you can go anywhere. Basepoint Wealth is a [00:03:00] registered investment advisor. Visit Basepoint wealth.com for important disclosures. 

Welcome back to The Point again, Landis Wiley, Basepoint Officer Allen Wallace sitting here as we get into the meat and potatoes of today's episode. For those of you tuning in for the first time, we're going to reach in a hat here and draw out a topic.

Something related to finance, and just have a conversation and hopefully along the way it'll help maybe demystify something that you've been seeing on the news or reading about online or talking about with coworkers or family or friends, and so we hope you enjoy this. Let's see what we got today.

All right. What do we got? What is Basepoint Wealth's investment strategy and how does it relate to the current market environment? Okay. All right. So this one a little specific for us. Boy, investment environment today. It's been fun. Fun couple of years. So, you know, our goal obviously is working with people to help them [00:04:00] solve financial problems, try to set them up for future financial success.

That's the whole point of Basepoint. Right, you know, we do that in lots of ways. We do that with financial planning, we do that with tax planning, we do that with business planning. We work with businesses, we work with individuals, we help people with their portfolios. and I think, you know, when most people think about wealth management or think about companies like ours, what they probably think of first is, well, how the heck do you manage money?

Right? And the last two years have been pretty eventful, really the last three years. Right. If you go back to, you know, that time span of February and March of 2020, you know, those were some scary times for a lot of folks out there. Since then, it's sort of been a roller coaster that has gone up and down, but mostly sideways.

Right. So, you know, you're the Basepoint Chief Investment Officer. So nobody knows the philosophies that drive Basepoint and what we're trying to do for the clients better than you. So. What's our philosophy? Well, I mean, we're principles based, and we follow the CFA Institute [00:05:00] guidebook process for investment management.

And that's a really boring discussion, but at a high level, it's a three-stage process. You've got planning, execution, and monitoring. The planning phase is when you work with your advisor to determine your goals and your constraints. Each plan is customized to the individual and then in the execution phase, we determine an asset allocation and select securities.

And then in the monitoring phase, we determine whether or not what we're doing is getting you the results that you need to be successful. So, if I had to break it all down into a one-minute description of the process, that's what it is. The investment principles, we have seven investment principles, and we utilize those to determine our asset management process and really it focuses on things like not speculating with your money, making sure that you have a margin of safety, thinking long term.

Diversifying, watching costs, those type of things, very common sense type, thoughts to help you manage your money. None of them are numbers based because [00:06:00] those things change over time. Principles are sort of the bedrock of our ideas. They're things that are true no matter what the climate we're in. And so we've been in this climate of higher volatility after A 10 or a 15 year period of very low volatility or volatility only on the upside.

And our principles have held true through this entire period of time. And, and they're especially important right now when there's a lot of confusion when prices are dislocated, when interest rates are rising, when inflation is picking up for the first time in 40 or 50 years.

We're not trying to shoot out the lights and crush the S&P 500. As a matter of fact, it would be almost impossible for us to do that in a positive market environment because we hold cash, we hold bonds, we hold alternative investments. What differentiates us from just an investment manager is that most people have substantially all their assets with us, and we can't just throw all of someone's money into the stock market.

That would be that would be highly inappropriate. So we have to, we have to [00:07:00] determine how much money you need to survive. How much money do you need for a cash reserve? What are your specific goals? We may want to allocate certain assets to different goals to make sure that each. of your, each of your dreams can be met at the highest level of certainty.

So a lot of times we'll segregate a retirement portfolio and that'll be managed in a certain way. We may have opportunity portfolios that can be a little bit more aggressive or have less cash and fixed, fixed income type investments in them. So one question I know I've gotten from, from people is, you know, you guys manage money.

How do you compare against the S&P 500? And I don't know that, you know, my view on it is necessarily the right way to think about it, but I think you hit on something really key there, which is there's a difference between what we do in working with a, with a client's entire portfolio versus what a fund manager is doing where they're, they're not, number one, they're not managing for any individual, right?

You [00:08:00] know, I think it's important to distinguish that a fund manager's job is to manage a pool of money for sort of a faceless purpose. Well, their client is the fund, correct? Their client isn't the shareholder, it's the actual fund. And so they're not taking your individual goals into consideration.

And at the end of the day, they're managing a sliver of something that ultimately goes into a bigger portfolio for what we do for folks, right? So if your job as a fund manager is to manage a large cap value fund. Okay. It's probably appropriate to judge your performance against a benchmark of all the large cap value stocks.

Whereas what we're doing is that large cap value fund that we may use or select to fill a role in a client's portfolio ultimately is just one little piece of it. Right. So, you know, when, when people try to you know, ask wealth managers or, or advisors, how [00:09:00] do you perform against a benchmark? Is that the right way to sort of distinguish that of why you shouldn't compare a comprehensive portfolio against just a single index?

Well, indexing or benchmarking can be highly misleading. First of all, there's just how, how is the benchmark even calculated? You know, our system calculates daily returns and then you know reweights the portfolio every morning. So our class blended benchmark performance has a high skew towards the upside because you're always putting more money in after stocks go down.

And so it's even difficult to beat the benchmark under some circumstances just based on how the weighting schemes are taken into consideration. It also depends on whether you're using time. time weighted performance versus money weighted performance. So I think each of those is its own discussion for another day.

So someone write that topic in, you know what's the difference between time weighted and, and money weighted performance [00:10:00] calculations. But you know, at the end of the day, what a client should be focused on is how much return do they need to meet their goals. And that's the whole reason that we do the planning phase of the wealth management process is to determine how much return you need.

It would be silly to just take indiscriminate risk because you know when the market has been going up for several years, people have a tendency to forget what it's like when stocks go down. But as human beings, we're, we're loss averse, which means that our losses hurt twice as much as our gains deliver pleasure.

And so, I don't see the need to take risk that's unnecessary. Most of our clients need somewhere between a four and an eight percent rate of return. And so that's really what I try to use to determine whether or not I'm successful, is are my clients getting closer to reaching their goals? And typically, we say that that goal is for your money to last the rest of your life and then maybe a little longer.

Well, and you know, one thing in there that people forget what it, what it's like when the stock market goes down, but stocks aren't the only thing that can go [00:11:00] down. Right. Right. We're currently in the midst of, if I'm not mistaken, historically, the worst bond market returns that have ever been experienced.

Right. We're, we're down. Well, probably in modern history. In modern history. Right. I mean. But let's face it. That's what everybody deals with. So, you know, bonds are one piece of a portfolio that generally are viewed as the safe part of a portfolio, right? Right. Our industry in general focuses a lot on asset allocation, believes that it's the primary driver of returns.

I think that experience has maybe, or that expectation has been challenged a little bit with what's happened over the last few years. Well, it's been challenged since it came out. I mean, that's based on a study by Brinson, Hood, and Beebower that was commissioned in the mid 1980s. And, you know, within 10 years, Ibbotson had come along and said, hey, the way that you calculated this isn't really proving what you say it's proving.

I mean they're using cash as their benchmark for performance. And so really what they're calculating is it. that [00:12:00] 91 percent of your performance is determined by whether you're invested or not. And I think that's kind of one of those duh type statements, right? If you're in cash, you know, you're not going to have any volatility.

And if you're invested, you are. So when Ibbotson re-ran the study, he found that it's closer to a third is based on security selection and a third is based on asset allocation. And then there's approximately another third of other things. So security selection is significantly more important, I think that people give credit to, especially if they're basing their philosophy on that Brinson, Hood and Beebower study from the 1980s, which is what everyone always uses when they say, hey, 91 percent of your return is determined by asset allocation. So, that's another one of those examples where if you're going to quote a study, you should probably read it and make sure you understand what it says. But you know I think we have this tendency to not do that.

There, there's a big misconception in that bonds are the conservative investment and stocks are the risky investment. Now, that depends on how you define things. If you define [00:13:00] risk as volatility, in other words, how much can the price fluctuate up or down, bonds have the potential to be more, even more risky than stocks.

And we found that out last year, long dated bonds, if you're holding a 30 year bond that was issued in 2020 when the interest rate was 1.65%, I think you're down about 50 percent right now. That's not a conservative return. But if you measure holding period return, in other words, from the day I buy the bond until the day it matures, you're going to earn exactly what the interest rate was that you bought it at, the yield, yield to maturity that you bought it at.

Assuming that you're able to reinvest the coupons at a similar rate to what, you know, to what your yield to maturity is. So, if you know, so there's a huge difference here between thinking about it in terms of volatility, very volatile versus holding period returns where it's going to be stable and consistent and predictable over time.

And I think, totaling up our returns each year to decide whether or not we were successful last year is a really bad idea. If you think about the dynamics of that, if you get 10 [00:14:00] percent on December 31st and then you lose 10 percent on January 2nd, it's going to look like year one was really good and year two was really bad, but really you broke even over that three day period of time.

And so, I think monitoring the income that we're generating, monitoring the value of our underlying holdings is significantly more important to our success than, you know, what were the total gains and losses of last year? So you, you mentioned something there, which is the difference between asset allocation and security selection.

And you know, when I first started in the industry and you go through your training, Right. Advisor training and your certification and all that. There's a lot of focus on asset allocation and you cited one study that's often cited which is, you know, 90 percent of your return is just based on which assets you have exposure to.

Which has clearly been disproven since you don't follow that philosophy. You put a lot of emphasis on security selection. Right. Talk a little bit about that. Sure, [00:15:00] well, it goes back to our mandate to know what you own. When we're when we're using diversification to lower volatility we're trying to, you know, get some things that are up, some things that are down, so that it sort of averages out to a middling return, right?

So, the more securities we add, the closer to average our return will be. It's just a law of physics, right? If you have a thousand stocks, you're going to be pretty close to the average. If you have twenty stocks, You can be significantly divergent from the average. And that was a study that was done by Travis Sapp at Iowa State.

They found that the optimal number of securities in a portfolio where the reduction in volatility reaches terminal decline is about 20. And so most of the funds that we buy on the investment selection side are going to be somewhere in the 20 to 30 range as far as the number of holdings. The average fund that we see and then, you know, the other advisors are using have 200 holdings in each fund, and they have 10 funds with 200 holdings each.

And then when I run an overlap analysis, they basically all own the same five, [00:16:00] the same five stocks. So that's, it's stress relieving, but not goal achieving when it comes to, you know, to being diversified. And which is a nice one to talk about as well. And assets are a really good way to be able to be more diversified.

And even worse than that, you'll find that the majority of the assets are concentrated in 10 names. You know, if you own the S& P 500 right now, the top two holdings, Microsoft and Apple, are 14 percent of your assets. And by the time you get to 10 holdings, you're at something like 20 percent of the entire portfolio.

And by the time you get to 35 holdings, it's 50% of your entire portfolio in those 35 stocks. That's not really diversification. It's not how you would think that you set out to develop an investment portfolio. So we want security selectors evaluating companies with analysts to make sure that these are companies that we want to hold for a long period of time.

And when we do that, we're reducing our diversification. But that means that we're allowing more volatility. But when we put the time into it, we hope that the volatility is on the upside. We're basically putting the odds in our favor. [00:17:00] So if you're doing adequate analysis, you may want to root for more volatility.

Because volatility is the chance you're going to outperform and the chance that you're going to underperform. And so, if we're making good decisions, when we deviate from average, it should be to the upside. So maybe more risk is better if you're doing the work. So, you know, I think there's a number of people out there that have probably heard Warren Buffett say that the average person would be better off just putting their money in an S&P 500 index fund and letting it go.

What do you, what do you say to that argument? Well, that's directly from Benjamin Graham and I think it's, it's like page 33 of the fourth edition of security analysis. And he says, if you don't know what you're doing, don't try, just buy the, buy the major companies. So, when Buffett says that, he's insulting you.

He's saying that you don't know what you're doing. And, you know, Buffett is in a position to tell us all that I think. But if we follow Graham, if we [00:18:00] follow Buffett, then we should be able to make those decisions to buy, to buy superior companies with able and competent management in good businesses and hold those for long periods of time and outperform.

It doesn't mean we're going to outperform on an annual basis. When the market is screaming higher, we're probably going to underperform. It's when the market goes down significantly that our patience and our care and our diligence, pay off. And so, if you run out a series of returns of 12% a year for nine years with a 50% loss in year 10, and you compare that to 6% a year for 10 years, which one do you think wins?

My guess would be the more consistent. Exactly. Yeah. So, hitting singles scores runs. And so it, it's much more important for us to avoid mistakes than it is for us to, you know, to have flashy results. Well, it's maybe not a coincidence that, you know, in maybe not so much over the past year and a half as markets have generally declined substantially, but it seemed like there for two, three, [00:19:00] four, five, six years.

You know, there were a lot of talking heads out there that wanted to talk about how you know, Buffett's magic had diminished, how he wasn't keeping up with the markets as they were roaring higher and higher. That's always the most dangerous time. Right. And that, that seems to be kind of what you're talking about, which is, you know, if you're, if you're investing in things and you're focused on quality and you're, and you're focused on value, It you may not want to necessarily be keeping up when the markets are, are shooting to the moon irrationally, right?

Yeah. I mean, I think it's dangerous to hold things that are significantly overpriced in relationship to their value. So we're more concerned with our companies becoming more valuable over time than we are with what the price is. The price is just something that tells us what to do. If the price is high, we should sell it.

If the price is low, we should buy it. Right. it all other things being equal. But, too many people let the market tell them what things are worth. If, if your neighbor came over and offered you a million dollars for your house or 2 million for your house, let's say you'd, you'd probably say, sure.[00:20:00] 

I would be out by tomorrow morning. Okay. If the same neighbor came over the next day and offered you 10 grand, would you panic and sell it to him? Because it went down. Okay. We do that with our stocks, right? Stocks are down 50%. Let's panic. You know, it always, it always amuses me that when the price of socks is down 30%, people buy socks.

But when the price of stocks are down 30%, people panic. And it's counterintuitive. If we like the company at a hundred, we should really love it at 70. Now, that doesn't mean that we indiscriminately buy it, but just because it's down, 30 percent off is not really the magic formula for success. We need to be humble. Reevaluate our thesis, make sure that we’re still, you know what we thought was true is still true and if that is the case then it is the time to buy more not panic and sell.

So, I mean, this is covering a lot of ground, which I think, I think is great. You know, what I'm, what I would maybe take out of this as a, you know, back to the question that was asked of, you know, what's Basepoints wealth management or investment philosophy and you know, how do you handle today's [00:21:00] markets?

A couple of things jump out at me. Number one is. We're, we're trying to base a return target based on what a client needs, right? It seems like step one, right? As opposed to just buy a basket of stuff and sort of hope that I average out to some number and hopefully it works. Yeah, I'll never forget early on in my career when I was you know, I was learning how you set up and manage your portfolio It always struck me as interesting that the process with a client generally began with a risk tolerance survey.

Sure. And, you know, the client was asked a series of questions and ultimately it decided, are you conservative to aggressive? And, you know, some things in between. Okay. That, that seems like it makes sense. But as I, as I learn more about the industry and just worked with more clients, I always was kind of taken aback of, okay, I've asked what you're comfortable doing.

And I can kind of derive from that, maybe a return that you're going to get, but nowhere in there, did we ever figure out what you actually need. Right. And so, you know, [00:22:00] inevitably after every major, you know, scary time in the market, most people immediately would respond to a risk tolerance question of, I'm conservative.

Yeah. Everyone's conservative when the market goes down and aggressive when it goes up. Right. And so if all I did was ask you that and then put you in a portfolio that, you know, is okay, you're, you're conservative. Here's a conservative portfolio over time. It's going to average four or 5%. Well, if you need 8%, And I've set you up for four.

All I've done is make you feel really comfortable running out of money. But then the other thing is that you put them in that portfolio and you overweight bonds, and if you did that last year, you actually made them worse off than your aggressive clients because bonds went down so much. You relied overly on the fact that bonds are conservative on a volatility basis which is completely untrue.

So I think, you know, back to it. Number one is understanding what the client needs to be successful. Number two, which you kind of hit on there is going to that next layer, which is within asset allocation, you've got to actually understand what the what the assets are and what they can do under different [00:23:00] types of stress.

Right. And then the third piece is really the the security selection. Right. It's what am I picking? Right. It could be one thing to say, Well, okay, to hit your return target, you need have allocation of 70 percent stock. The piece that seems missing in just a blind adherence to asset allocation is well, what stocks you want to buy.

Sure. Yeah, and academic finance would have you believe that they're all the same, or that, you know, picking them is a futile effort. And I think the reason that they come to that conclusion is because whenever they evaluate it, they look at widely diversified portfolios. And I think they're right, that it's a waste of time to try to pick the best 500 stocks.

If you're going to do that, you're probably better off, you know, I would say the equal weighted S&P 500. I don't really like the market capitalization weighted strategy. It sort of builds momentum into the, into the returns of the product. But you know, S&P 500 equal weighted is probably a good barometer of the United States economy.

If you're going to hold a portfolio of 20 stocks, then I think that your analysis is absolutely [00:24:00] paramount. If you tried to pick 20 stocks at random, you're probably, you're not going to get average results. Sure. So I guess takeaway from this is, you know, our view would be you know, number one, you need to know what you need for return. Number two, you need to have enough knowledge to know how to build out a portfolio that maybe avoids obvious, you know, pitfalls, right?  Such as if you, if you have a firm belief and there's reason to believe interest rates are going to go up, you probably better pay real close attention to how much exposure you have to bonds.

Well, you don't even have to have a belief that interest rates are going to go up. You just need to know what the risks are if they do. And you need to know the historical context of where you are. So, two years ago when 30 year bonds were at 1.665%, we didn't have much reason to believe that there was much downside unless they're going to go significantly negative, in which case, why would we want to owe them anyway? Yeah and so we knew, also knew what the downside risk was if they went up even 1% and they didn't go up one 1%, they went up like 300 basis points. And we see where that, where that leaves us. 

It leaves us with a 50 percent temporary loss in our purchasing power. [00:25:00] So, instead of that, we were sitting in cash and now we're earning 5 percent on that same cash at face value instead of earning 1.665 percent for the next three decades. Right. Well, you said something earlier that maybe is a good way to draw us to a close, which is, you know, we have a responsibility to know what we own and know why we own it.

Right. Right. In a client's portfolio. And I think if you, if you take that at face value, you know, I think it, it really very simply explains what the philosophy is that drives Basepoint. Sure. Right, you know, identify the target, figure out the things that, you know, the makeup of a portfolio to help execute on that target, and then really go out and try to pick the highest quality securities available to to deliver the result.

Right. And then continue to follow our principles and make sure that we don't violate those. Right. Even when things get, especially when they look wrong, that's when they're the most important. Absolutely. Well, great chat. This is always enlightening and refreshing to go through this.

So hope that was informative to you out there a little bit about how Basepoint thinks, how we operate, what we look for is we're constructing portfolios [00:26:00] and working with our clients and helping them with their money. So we appreciate you taking your time to tune in today on The Point, again, Landis Wiley, Allen Wallace here.

If you have a question or a topic that you'd like to hear more about, feel free to visit our website, basepointwealth.com or send us an email, info@ basepointwealth.com. And who knows, maybe your topic will be one that we. Set up here and banter about at some point in the future. So until next time, take care.

Thank you for joining us for this episode of The Point Podcast sponsored by Basepoint Wealth as always you can submit questions or topics You'd like to hear discussed to info@basepointwealth.com.

Be sure to subscribe so you don't miss any future episodes Basepoint Wealth LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.

Investments involve risk and unless otherwise stated are not guaranteed. Be sure to consult with a qualified financial [00:27:00] advisor and or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.