The Investment Gods Are Angry

By Steven Selengut

The Working Capital Model (WCM) is an historically new methodology, but with roots deeply imbedded in the building blocks of capitalism, and financial psychology--- if there actually is such a thing.

The earliest forms of capitalism sprung from ancient Roman mercantilism, which involved the production of goods and their distribution to people or countries around the Mediterranean.

The sole purpose of the exercise was profit and the most successful traders quickly produced more profits than they needed for their own consumption. The excess cash needed a home, and a wide variety of early entrepreneurial types were quick to propose ventures for the rudimentary rich to consider.

There were no income taxes, and governments actually supported commercial activities.

The investment gods saw this developing enterprise and thought it good. They suggested to the early merchants, and governments that they could "spread the wealth around" by: (1) selling ownership interests in their growing enterprises, and (2) by borrowing money to finance expansion.

A financial industry grew up around the early merchants, providing insurances, brokerage, and other banking services. Economic growth created the need for a trained work force, and companies competed for the most skilled. Eventually, even the employees could afford (even demand) a pieceof the action.

Was this the beginning of modern liberalism? Not! The investment gods had created the building blocks of capitalism: stocks and bonds, profits and income. Stockowners participated in the success of growing enterprises; bondholders received interest for the use of their money--- the K.I.S.S. principle was born.

As capitalism took hold, entrepreneurs flourished, ingenuity and creativity were rewarded, jobs were created, civilizations blossomed, and living standards improved throughout the world. Global markets evolved that allowed investors anywhere to provide capital to industrial users everywhere, and to trade their ownership interests electronically.

But on the dark side, without even knowing it, Main Street self-directors participated in a thunderous explosion of new financial products and quasi-legal derivatives that so confused the investment gods that they had to holler "'nuff"! Where are our sacred stocks and bonds? Financial chaos ensued.

The Working Capital Model was developed in the 1970s, at a time when there were no IRA or 401(k) plans, no index or sector funds, no CDOs or credit swaps, and, a whole lot less risky product for investors to untangle. Those who invested knew about stocks and bonds; investment-qualified trustees protected workers pension plans.

The WCM was revolutionary then in its breakaway from the ancient buy-and-hold, in its staunch insistence on QDI selection principles, and in its cost based allocation and diversification disciplines. It is revolutionary still as it butts heads with a Wall Street that has gone madwith product differentiation, value obfuscation, and short-term performance evaluation.

Investing is a long-term process that involves goal setting and portfolio building. It demands patience, and an understanding of the several cycles that both create and confuse the environment in which it takes place.

The WCM thrives upon the cyclical nature of the process while Wall Street ignores it. Working capital numbers are used for short-term controls and directional guidance; peak-to-peak analysis provides longer-term performance analyses.

In the early 70s, investment professionals compared their equity performance cyclically with the DJIA, over the time from one significant market peak to the next--- from the 11,400 achieved in November 1999 to the 13,930 achieved in November 2007, for example. Equity portfolio managers would be expected to do at least as well as the Dow over the same time period, after all expenses.

Another popular hoop for investment managers of that era to jump through was Peak to Trough performance. Managers would be expected to do less poorly than the Dow during corrections, like the 33% drop between November 99 and September 02, or the much steeper 40% variety that we are immersed in today.

Professional income portfolio managers were expected to produce secure and increasing streams of spendable income, regardless. Compounded earnings and/or secure cash flow were all that was required. Apples were not compared with oranges.

Today's obsession with short-term blinks of the investment eye is Wall Street's attempt to take the market cycle out of the performance picture. Similarly, total return hocus-pocus places artificial significance on bond market values while it obscures the importance of the income produced.

WCM users will have none of it; the investment gods are angry. (Google Peak-to-Peak or Trough-to-Trough to see how far a field the financial community has strayed.)

The WCM embraces the fundamental building blocks of capitalism --- individual stocks and bonds and a few managed CEFs in which the actual holdings are clearly visible. Profits and income rule.

Think about it, in a working capital world, there would be no CDOs or multi-level mortgage mystery meat; no hedge funds, naked short sellers, or managed options programs; no mark-to-market lunacy, Bernie Madoffs, or taxes on investment income.

In a working capital portfolio today, lower stock prices are seen as a cyclical fact of life, an opportunity to add to positions at lower prices. There has been no panic selling in equity holdings, and no flight to 1% Treasuries from 6% Munis. In a WCM portfolio today, dividends and income keep rolling, providing income for retirees, college kids, and golf trips.

Capitalism is not broken; it's just been too tinkered with. The financial system is in serious trouble, however, and needs to get back to its roots and to those building blocks that the Wizards have cloaked in obscurity.

Let's stick with stocks and bonds; lets focus on income where the purpose is income; let's analyze performance relative to cycles as opposed to phases of the moon; let's tax consumption instead of income; let's not disrespect the gods.

Amen!