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summitV I E W The Cost of Opportunity

by Ian Jameson

An interesting series of questions arise from this line of thinking: How do you know what the opportunity cost is? How do you know what you don’t know?

Much of modern financial theory has defined opportunity cost as the return that an investor would receive from investing in a “risk-free” asset versus investing in a different financial asset. Investment professionals have then divided assets into classes such as bonds, stocks, real estate, cash, natural resources, foreign currency, collectibles and insurance products.

May 2011

see disclaimer on last page

Stepping back from modern financial theory, the opportunity cost for an equity investor also includes the “return” that could have been achieved by investing in a local charity, re-insulating your home, taking a week-long backcountry trip, or sending your child backpacking around Europe.

Quantifying these benefits is not something that modern financial theory, or anyone else, is able to accurately model. However, there are costs and benefits associated with each potential investment.

When choosing how we donate,

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By this logic, the opportunity cost for an equity investor would be the return that they would receive from holding bonds, real estate, cash, etc. instead of their equity investment. Defining the relative returns of the various asset classes has been a bit of an art form as well; services like Standard and Poor’s and others provide indices for a variety of asset classes, the most familiar being the S&P 500, an index based on 500 large companies that trade in the US on the NY stock exchange and the NASDAQ. For many people, the S&P 500 serves as a benchmark for the concept of stock market return.

The opportunity cost for holding cash or bonds, for example, would be the return that you could have generated if you’d invested in stocks, approximated by the return of the S&P 500.

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When you decide to pursue one action over another, the act you didn’t do is referred to as the opportunity cost; what you could have been doing if you weren’t doing what you’re doing. Weighing this cost after a decision has been made can lead to buyers’ remorse, or a validation of your action.

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where we vacation, if we spend now to save on future energy bills, and what we want our children to experience in life, we are looking to the future, seeking to improve upon all we’ve experienced until this point.

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Looking to the future, then, is a very important part of investing, as is incorporating past experience. If we know the sugar high from a Krispy Kreme donut is followed by a not-so-great crash, we’ll incorporate that knowledge into our future decision making processes. If we know that financial assets tend to move in the same direction during periods of market turmoil, that too can be incorporated into our future decision making process.

May 2011

A Benchmark for Investing?

We are somewhat constrained in our historical knowledge of financial assets. Just as people have realized that the language we speak shapes the way we think, the language of investment also shapes our thought process.

Anyone who has ever invested in a mutual fund has seen a diagram like this: Value

Blend

Growth

Large

Mid

the performance of your Growth-oriented Largecap mutual fund will yield some similar results, but stepping back from America will offer some perspective:

From Standard and Poor’s: The S&P 500® has been widely regarded as the best single gauge of the large cap U.S. equities market since the index was first published in 1957. The index has over US$ 4.83 trillion benchmarked, with index assets comprising approximately US$ 1.1 trillion of this total.

The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities.

• The current market capitalization of the S&P 500: $12 trillion • Current market capitalization of stock markets in the World Federation of Exchanges: $55 trillion • World financial assets---including equities, private and public debt, and bank deposits according to McKinsey: $178 trillion in 2008 • Size of the global derivatives market, according to Paul Wilmott: $1,200 trillion.

1000000 - million 1000000000 - billion 1000000000000 - trillion 1000000000000000 - quadrillion Yeah, that’s $1.2 quadrillion........

Small

This diagram represents the universe of options available to a mutual fund investor: style on the horizontal axis, and market capitalization on the vertical axis.

Is an investor’s entire universe of possible investments contained in a 3x3 box? The answer is Yes, and No. Is “the market” a proxy for investment performance?

The answer is Yes, and No. Watching movement on the S&P 500 and comparing

So, the S&P 500 represents 22% of the stocks traded in the world, 6% of world financial assets, and is 1% the size of the global derivatives market.

Now, we are not suggesting that individuals need to participate in some sort of collateralized debt obligation investment to gain a broader investable universe (if you thought the Krispy Kreme hangover was rough, try unwinding one of those contracts when it goes south). Rather, the point of the exercise is to show what else exists in the world of financial assets, and how our perspective is shaped by what we know. As the 2011 Ibbotson SBBI Classic Yearbook points out, “[a]n investor who chooses to ignore investment opportunities outside the United States is missing out on over half of the investable developed stock market opportunities in the world.”

Historically, investors have been taught that there is one “market portfolio,” which serves as the benchmark for investing. Many have used the S&P 500 as the proxy for the “market portfolio.” The percentage of one’s assets allocated to the “market portfolio” is determined by an individual’s risk tolerance. We believe that no two investors, who differ in either risk tolerance or in their forecasts for returns, will have the same investment strategy.

Defining your risk tolerance is equally as important as defining your investable universe, and has strong similarities: both will change over time given new knowledge, understanding, global trends, and evolving investor circumstances. In determining if you’re a conservative or aggressive investor, you are determining which aspects of the investable universe will be larger parts of your portfolio. Determining your asset allocation hinges on an interpretation of the risks and rewards associated with each asset class in your investable universe.

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What is your Benchmark?

What will be the structural changes to the economy as a result of these socio-economic trends? How will the structural trends affect market performance over the long term?

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Incorporating the longer term trends (i.e., oil as a finite quantity) with the shorter term cycles (fuel efficiency in vehicles) is a necessary part of an investment analysis. Defining an investable universe means defining long term trends and cycles within those trends, then choosing assets that reflect everything we’ve learned up until today, and putting resources towards assets that we believe will prosper in the future.

We have historical data that shows what risk/ reward relationships have looked like for a variety of asset classes in the past, but what will the opportunity cost be of holding these asset classes in the future? For example, what is the likelihood that large company stocks will exceed their historical average returns in the next five years? We consider the use of historical data important in forecasting expected returns. However, we also believe deviations from historical returns are likely in any given long term period of time.

Forecasting asset class returns is just as much art as science. Consideration of pertinent socio-economic matters helps us to adjust historical returns to reflect our beliefs.

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As our knowledge increases, so too does our understanding of the opportunity costs that we face as investors. In that regard, our investments will change to reflect what we’ve learned over time. When America experienced an oil price shock in the 70s, investment decisions incorporated the threat of higher fuel prices, auto makers produced vehicles that got 40+ mpg, and consumers invested in them. As fuel prices declined and vehicles got larger and consumed more fuel, we re-learned (or un-learned) some of the lessons from the past and when fuel prices spiked again, revisited a similar cycle.

Once again, a multitude of variables are in play, and any one person’s interpretation of these variables will differ from another’s, sometimes dramatically. As we wade through data and interpret opinions on what trends are being played out in the world, we will begin to determine the returns that we expect for each asset class in our investable universe, and the level of uncertainty surrounding those returns.

Once we’ve established our ideas about returns and the uncertainty of those returns, we can determine how much of each asset class an investor should hold.

By assessing one’s risk tolerance and future financial needs, investors can construct appropriate benchmarks for investment performance. Once suitable benchmark allocations have been determined, assets can be allocated to reflect individual risk tolerance and return forecasts.

Some pertinent socio-economic variables: - growth of global middle class and global markets - ageing population demand for entitlements - political will to adjust governmental entitlement obligations - debt levels in the public and private sectors - deficit spending by local, state, and federal governments www.summitcreekcapital.com

C o n s ci e n ti o u s i n v e s t i n g

by Penny Mandell

For many investors, if you discuss “Socially Responsible Investing” the immediate assumption is that this is synonymous with sub par profitability and that it is the bastion of tree huggers and nuns. It also conjures up a process of creating exclusionary screens designed to weed out morally reprehensible practices like drinking, gambling, weapons manufacture and child labor. These perceptions may have been true at one time but there is a big change underway and this change offers exciting opportunity.

There is an increasing investor awareness that you can actually do well while doing good.

Impact investing is the term given to the practice of directing investment portfolios to solve social and environmental problems as well as generating a return on the investment.

starting to embrace impact investing is that traditionally they invested purely to optimize risk based returns with no thought to social factors, and on the philanthropy side they are used to investing to maximize social impact with no expectation of financial return.

The glow of doing a social good mixed with high returns would seem attractive to high-net-worth individuals. But impact investing is still in its infancy. The Global Impact Investing Network, a nonprofit group, said that current impact investments amounted to about $50 billion. It projects this area to grow to $500 billion by 2014, putting it at roughly 1 percent of all managed assets.

“I think the tipping point is now,” said Camilla Seth, director of programs and operations for The Global Impact Investing Network.

“This activity has been happening for 10 years but investors have been insulated.”

True impact investing is really more about effecting positive change through investment and creating positive results beyond the financials. Impact investing can be a powerful complement to philanthropic and governmental spending. The reason a lot of institutional investors are just now

Combining philanthropic ideology with investment savoir-faire, impact investing — actually the intersection of these two concepts — creates a very powerful engine for change.

The philanthropist is targeting money at specific needs with no expectation of profit; it is money that is given away. The investor is targeting his is noT your investments for maximal profits with moTher s book club no goal to alleviate broader social problems. Impact Penny Mandell has created a fun and investing allows for provocative environment for becoming targeting specific solutions while still financially fluent. generating a profit.

This is an exciting 3 concept for many individuals who females focused on typically keep their flourishing fiscally philanthropic funds segregated from their visit www.f3blog.com to learn more investment funds.

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At Summit Creek Capital we focus on returns in the broadest sense, that means both bottom line and social impact are important to us.

Rather than viewing impact investing as a restrictive process we view it as a proactive portfolio choice.

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We too feel that we are at a tipping point here. The $500 billion [see box above] estimate clearly indicates that there is potential for large amounts of capital movement, and right now there is a lot of innovative thinking about how to best achieve this. We have been actively working with various experts in this burgeoning space and are excited about the ongoing opportunities.

Education is a critical part of this process for both individuals and institutions. It’s exciting to show that the impact investors can have extends far beyond the bottom line and will be the catalyst for solutions to many of our planets most pressing problems.

What issues are you most passionate about?

by Matt McNeal

The economy seems to have subtly turned a corner heading into the last weeks of 2010. Consumer and Business Leader Sentiments are up, the major indexes have surpassed the highs reached over the summer, and have achieved levels not seen since the days before Lehman Brothers went down in flames. Has the US finally shrugged off the anchor of the Great Recession and returned to sustainable long term growth? We remain skeptics, but some of the recent global improvements have kept us from turning into outright cynics (well, some of us anyway). Certainly there are areas in the global economy that will provide attractive opportunities, and it is these areas where we focus our efforts.

However, if there is one thing that we have learned (because it has been hammered into our skulls) it is that

the Federal Reserve will do anything to keep the stock markets propped up. It is telling to look at a chart of the S & P 500 over the last year, and pick out a few important dates on the Quantitative Easing timeline to review.

The first round of Quantitative Easing (now known as QE1) essentially ran from late 2008 until the end of the 1st Quarter in 2010. Clearly, the market did not appreciate the program ending. After a steep selloff and a

QE2 Officially Announced

Bernake’s Speech QE1 Ends

www.summitcreekcapital.com

May 2011

That was then...

without wage growth?).

Banks have received large amounts of cash, though it isn’t totally clear what they have done with it. We don’t attempt to answer that question, instead we offer our observations of what happened when round 1 of QE ended and what might happen when QE2 closes. It sounds cliche, but before we look at what might happen in the future, it is useful to take a look at the past - in this case the first round of Quantitative Easing - how the market reacted when that program ended, and how the market responded to the possibility of QE2. In the green box below is a short piece we wrote in December 2010 taking a look at the effects both QE programs have had on the market. Note that we did not perform any correlation calculations or higher math of any sort - just pinpointed some dates on a chart of the S&P 500 index.

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With the shutdown of the second round of Quantitative Easing (QE2) looming at quarter’s end, investors are wondering what the equity markets will look like when the Federal Reserve halts the massive liquidity program. As a brief refresher, Quantitative Easing is when the Federal Reserve Bank prints money (just creates it out of thin air), and uses the newly minted dollars to buy assets from banks (mostly Treasury bonds).Where the bank used to be sitting on a pile of Treasury bonds, they are now sitting on a pile of cash. The theory is that banks will push this new money out their doors as loans, circulating it into the economy, thus jumpstarting a sustainable recovery. Well - some things have jumpstarted (stock market, we’re lookin’ at you), while other things remain stubbornly stagnant (unemployment) and others defy explanation (consumer spending expansion

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Where We’ve Been,

Where We’re Going

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summer of rangebound returns, Ben Bernanke made a speech in Jackson Hole, WY in which he hinted that if necessary, the Fed would not hesitate to engage in another round of Quantitative Easing. In the speech he tried to stress that the Federal Reserve believed the economy was strongly recovering and probably would not need the additional stimulus. The two months that followed that speech were a bizzaro world for equities (not that it hasn’t been bizarre for longer than that).

Headlines that suggested the economy was not improving were greeted with strong runups in market indexes, as investors believed that the poor news reflected a greater chance for QE2, thus a greater chance of a Federal Reserve driven bull market. Good economic news (admittedly sparse) was seen as a sign QE2 would not happen, and paradoxically reduced investors’ enthusiasm for risk assets, sending markets down.

The Federal Reserve may not have had much success in

budging the stubbornly high unemployment, but as the chart above shows the old adage “Don’t Fight the Fed” clearly still applies in the equity markets.

Way back in January 2010, the Economist Magazine featured a cover story accusing central bankers of pumping up asset bubbles through monetary stimulus. Europe seems to be chastised (through necessity) into taking the austerity approach - tax hikes and spending cuts on the fiscal side, and the discipline of the common currency on the monetary side (though Great Britain maintains an independent currency it is also choosing the austerity path).

The United States has chosen to punt these difficult decisions to future generations, and decided the best way to get out of a debt induced economic crisis is to borrow and spend more.

While the long term wisdom of this strategy is rightly questioned by responsible thinkers, the short term effects of the fiscal and monetary steroids are hard

to argue with. Again, please reference the above chart.

The unemployment rate may be stuck near 9%, consumer sentiment may be stuck well below the levels associated with any previous recovery in recent history, and any other of a number of economic indicators may be pointing to prolonged pain, but clearly the stock market responded well to the Federal Reserve’s programs over the past two years.

On top of the monetary stimulus provided by Quantitative Easing, the President recently signed fiscal stimulus into law in the form of tax cut extensions.

Worth $858 billion, will these tax cuts also help to prop up equity markets? Once again, the government is pushing serious reform down the road in order to maintain the status quo.

At this point, the best course of action may be to drink the KoolAid and enjoy the ride up.

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This is now................................

QE1 Ends

Bernake’s Speech

Mid-East Uprisings, Nuclear Meltdowns, etc

It took radical uprisings in the Middle East and an earthquake, tsunami and nuclear meltdown in Japan to derail the relentless upwards march of the market, and even then it couldn’t knock it down for long. There are US military forces actively fighting in Libya and radioactive water leaking into the Pacific Ocean even as we type, and the market is rallying. That Quantitative Easing is powerful stuff!

Not to overstate the importance of QE2, there have been some data prints that point to a strengthening economy. Lower unemployment, a hint of price inflation (which would be a good thing now), increased labor productivity and increasing ISM manufacturing survey numbers have given investors some optimism that the US is edging towards a sustainable recovery.

Of course there are two ways to look at each one of these statistics, but that may be the subject of another paper. www.summitcreekcapital.com

May 2011

QE2 Officially Announced

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With the benefit of hindsight, drinking that Kool-aid and going all in was a good idea. Below is an updated version of our original chart, with the market returns extended to the beginning of April 2011. The gains continued from the time of Bernanke’s WY speech until Spring of this year.

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We aren’t the only ones thinking about the end of Quantitative Easing. A quick, unscientific internet search turns up scores of articles which, true to form for anything to do with forecasting, are all over the map. As an example, these two headlines appeared right next to each other on the first page of a Google search (quotes added for flavor):

End of QE2? No Problem for Stocks

8 May 2011

VS.

[Bill] Gross Warns QE2’s End Could Sink Markets

“The economic recovery is much stronger than most give it credit for, and so much of the talk about the end of QE2 is factored in already,” said Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research, whose forecasts puts the S&P 500 up another 6% by the end of the year.

So which story is more believable? Well, if our past experience with the withdrawal of the Federal Reserve liquidity program is any sort of guide for the future, we might be in for another rough summer in the equity markets. Of course, as every investment professional knows, past performance is not a guarantee of future results, but in this case it certainly deserves attention. Even if the economy has truly recovered enough to stand on its own two metaphorical feet, quitting the QE drug cold turkey is not going to be easy and perhaps withdrawal really is the right word to use in this case. Take Barry Bonds as a comparison - one year he is pumped up on performance enhancers, breaking records and feeling great, then he quit the juice and the next thing he knows he is in a courtroom listening to humiliating questions about the changing size of parts of his anatomy. He isn’t dead, but clearly isn’t the star performer he once was. Will the markets behave differently or continue to be a star performer?

To be clear, if the market is healthy enough to withstand the ending of QE, then the program should end as soon as possible. We are simply questioning what the aftermath of the withdrawal will look like. Ending the program was never going to be easy, and if anything keeps the Bernank (sic) up at nights, it is this very problem. The Federal

”By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab,” Gross writes. “Ouch!”

Reserve, by keeping the interest rate target pegged at the 0% to 0.25% level, has forced investors into risk assets in order to realize any sort of return.

The reward for holding Treasury bonds is simply too low, even for traditionally risk-averse investors.

Hence they are forced to seek yield in riskier assets like common stock and corporate bonds. This, of course, is part of the goal for the Federal Reserve, and one of the reasons we ended up with QE2 - to support the equity market. The major indices (Dow, S&P 500, NasDaq) are collectively taken as a bellwether for the economy as a whole. When they are plummeting, no one feels confident.

It might help to take a look at some widely read economic indicators to see how they compare to this time last year, when the Fed was on the verge of ending QE1.

March 2010 March 2011

Unemployment Rate ISM PMI Index Consumer Sentiment

9.7 60.4 52.3

8.8 61.2 63.4

There has been some improvement in each of these metrics over this time last year. It isn’t a rosy recovery, but its not doom & gloom either. Just sort of...sideways.

Disclaimer: All material presented herein is believed to be reliable but we cannot attest to its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities.