2014 4th Quarter Client Letter

Dear Friends,

worldmapWhile I’ve never captained a sailboat, one of the items on my personal “bucket list” is to island-hop via boat in the Caribbean, taking an extended period of time to experience each island and the beauty of the sea itself. During a recent session of daydreaming about that event and reading some related articles about sailing, it dawned on me that science has played an important role in the evolution of both seafaring and investing

Back in the 1800s, sailing for pleasure or commercial purposes was a risky proposition.  Chronometers (clocks precise enough to determine one’s longitude) were only available on a few ships.  Sailors lacked maps of the oceans’ prevailing currents and winds.  As a result, the forces of nature often threw ships wildly off course, at best causing very expensive delays and at worst increasing the risk of peril.  Having no other viable solution, sailors developed superstitious beliefs and mantras, which some still follow today:

Red sky at night, sailor’s delight, red sky in the morning, sailor take warning” – A red sunset indicates a beautiful day to come, while a red sunrise indicates rain and bad weather.

“No whistling on board” – Mariners have long held the belief that whistling or singing on board will “whistle up a storm.”

“No women on board” – Women were said to bring bad luck on board because they distracted the sailors from their duties, and accordingly, the intemperate seas would take their revenge out on the ship.

In the mid-1800s, a naval officer named Matthew Fontaine Maury changed everything.  Maury had entered the Navy in 1825, but a leg injury rendered him unfit for sea duty, so he turned his attention to studying navigation, winds and currents.  For years, he studied thousands of captains’ logs stored in the U.S. Navy’s Depot of Charts and Instruments, while at the same time developing a reporting system for shipmasters to gather further information about the sea conditions they encountered on each voyage.  After over 20 years of research, he published “The Wind and Current Chart of the North Atlantic” in 1847, and received international acclaim.  Anyone who’s spent time on or near the sea

knows that marine conditions are variable and unpredictable by nature, but Maury’s publication showed sailors how to use the oceans’ prevailing currents and winds to their advantage.  From that point forward, the time required for sea travel was reduced dramatically, efficient trade routes were created and cross-continent commerce and immigration flourished.

In many ways, the world of investing resembles sailing on the high seas.  From a day-to-day perspective, conditions can change rapidly.  Gains made in the markets on one day can be quickly erased the next and seemingly calamitous storms can quickly transform into calmer waters.   Historically, this variability and unpredictability has led investors to practice superstitions akin to those of a 1800s seaman:

The “October Effect” – Followers sell all of their stocks every October because the 1929 and 1987 stock market crashes both occurred in that specific month.

The “Super Bowl Theory” – Followers believe that if the National Football Conference team wins the Super Bowl, the stock market will go up, and vice versa.

The “Hemline Theory” – Followers believe that when higher hemlines are in style amongst women, the stock market will rise, and vice versa.

Fortunately for investors, the 1980s and 1990s brought tremendous academic advances in the world of investing, in 1981, Rolf Banz, then a professor at Northwestern University, published the first research documenting the fact that in general, companies with smaller market capitalizations (“small cap” companies) provided investors with greater returns than large-cap companies over long periods of time.1  His research showed that this “size effect” had been in existence for decades prior, yet like the nautical weather research of Maury described above, no one before him had compiled and presented the evidence to the world.

Over a decade later, professors Eugene Fama and Ken French published a paper that expanded on the work of Banz.  These two professors affirmed a “size effect” similar to the one established by Banz, but also found that stocks trading at low prices relative to value of their assets (“value” stocks) had generally outperformed stocks that were trading at high prices relative to assets (“growth” stocks). 2   By pouring over decades of stock price data,

Fama and French had effectively found two forms of long term “tailwinds” that could inform investors.  Over two decades later, in 2013, Fama won the Nobel Prize in Economics for his life’s work in research of financial markets.

The parallels between Maury’s nautical research and the investment research of Banz, Fama and French don’t end there.  In the sailing world, even captains who precisely followed Maury’s charts inevitably experienced periods of frustration, as his research only identified prevailing winds and currents; it did not forecast day-to-day weather patterns.  There certainly were days at sea where the winds blew contrary to Maury’s research.  During these unusual and unsettling times, ship captains were put into a quandary:  Continue to follow the science-based recommendations of Maury’s charts, or scrap the charts and try to guess

which way the wind and currents might blow tomorrow.   Similarly, investors who allocate their assets based on the evidence presented by Banz, Fama and French undoubtedly experience their own periodic headwinds and are tempted to abandon the scientific approach.

2014 proved to be one of those “headwind” years, as small cap stocks dramatically underperformed large cap stocks, and low-priced “value” stocks ran in roughly a dead heat to higher-priced “growth” stocks:

2014 Returns3

  • U.S. Small Cap Stocks (CRSP 6-10 Index)                                4.0%
  • U.S. Large Cap Stocks (S&P 500 Index)                                 13.7%
  • U.S. Value Stocks (Russell 3000 Value Index)                        12.7%
  • U.S. Growth Stocks (Russell 3000 Growth Index)                  12.4%

The lack of a “size effect” in 2014 will surely lead some shorter-term investors to question its viability as an investment strategy.  Longer-term historical data should give those investors pause before “jumping ship”.  Looking at 12-month periods back to 1926, we note that 45% of the time, small cap stocks underperformed large caps, as they did in 2014.  But, over that period as a whole, small cap stocks materially outperformed larger ones:

Annualized Return from 1926-20143

  • U.S. Small Cap Stocks (CRSP 6-10 Index)                              11.7%
  • U.S. Large Cap Stocks (S&P 500 Index)                                 10.1%

At TFO Phoenix, we believe that it’s prudent to use science in making investment decisions, and to follow the long-term prevailing winds, even when it may seem uncomfortable to do so.  That said, we do recognize that there is no guarantee that the past will repeat over each investor’s time horizon.   As such, we believe it is sensible to diversify across all sizes of stocks, domestically and abroad and overweight small cap and value ones, rather than concentrate exclusively in them.  While this may potentially reduce the long-term returns our clients might achieve relative to a concentrated strategy, it also reduces the adverse impact on the investor if an unusual long-term “headwind” blows against them.

As usual, we’ve attached our Quarterly Market Review to this e-mail.  We welcome your thoughts and questions.


Chuck Carroll, CFA, CAIA

Chief Investment Officer

TFO Phoenix, Inc.

1Banz, Rolf, ”The Relationship Between Returns and Market Value of Common Stocks”, Journal of Finance, 1981.

2Fama, Eugene and French, Kenneth “The Cross-Section of Expected Stock Returns”, Journal of Finance, June, 1992.

3Source:  Dimensional Returns 3.0 Software.

Past performance is not indicative of future results.  Information in this document should not be construed as a recommendation to purchase or sell any security.  All investment strategies have the potential for profit or loss.  Indexes are not available for direct investment.  Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indexes represent the results of actual trading.