Questions and Answers

Q: There a a number of stocks in my portfolio that have lost money or have hardly moved in price. Do you think you should get rid of those stocks?

A: First, I think it's important to remember the context of the overall market (January 2006). Stock prices in general haven't increased that much in the last year and a half. And particular sectors of the market, such as energy and metals, have increased dramatically, while most other sectors, including health care and financial stocks, haven't done as well. So I'm not surprised by the performance of the stocks you mentioned.

Second, the past price performance of a stock is a factor in determining whether to hold onto a stock, but I think it's a minor factor. The more important factor is expected return -- where you expect the price of that stock to be in the future. All the stocks you mentioned have decent expected returns. That's based on the company's business and management, and on broader factors, such as the health of the economy. Take Pfizer as an example. The price of the stock has fallen. The company has run into problems such as liability and patent expiration, so some of the fall in price is probably justified. But look at the company's earnings and the PE ratio that people have been willing to pay in order to own the stock. In 1998, people were willing to pay 50 times earnings because they expected that Pfizer would grow like gangbusters forever. Obviously, they were overly exuberant. Today, they are willing to pay only 12 times earnings. I think very little has changed about the drug industry. Earnings have been flat between this year and last, but I don't expect that to continue. At some point, and it could be a matter of months or it could be a couple of years (if I knew the exact time, I would wait until then), earnings will rise again, investors will realize it, and the stock price will rise.

I could be wrong about all that. Maybe the drug industry has changed and I just can't see it yet. But I don't think so. And that gets to the third point, about the nature of managing a portfolio. I'm always making judgments. Sometimes I'm right; sometimes I'm wrong. What I've noticed is that there are millions of words spoken and written about what you should do with your portfolio. A lot of it sounds reasonable. But in the end, reasonable or not, what matters is how your portfolio does. There will be times when the portfolio does better than the benchmark, and times when it does worse. But over time, if my judgments are correct more often than not, you should do better than the benchmark.

Q: I know you have low turnover, but don't you see new opportunities arise all the time?

A: You're right that I make few changes (have low turnover). That's part of my philosophy. I think that prices are generally accurate, so there's often little to gain from making changes. I will make adjustments to keep the portfolio diversified, or to take advantage of taxable losses. And sometimes, investors mis-price a stock or an industry to a dramatic degree, and I try to take advantage of that. But otherwise, I think lots of changes just result in more trading costs without better performance.

Q: If you don't make very many trades, why do I pay an annual management fee? It seems that you do a lot when you set up the portfolio, but you don't do much after that.

A: As an investor, you face a choice of how you'd like to pay for investment advice. You could pay by the transaction, which is how many stock brokers get paid. Instead of paying $17.95 per trade, you'd pay some higher rate. So-called full-service brokers charge hundreds of dollars per trade. Or you could pay some percentage of assets under management, which is how I do it. Most mutual funds are set up this way, too, even index funds, which charge anywhere from 0.1% per year to more than 1% per year. You could also pay for advice by the hour. Typically, those people use mutual funds to structure a portfolio for you. You could also buy an investment newsletter that tells you what and when to buy and sell. And finally, these days, you could invest in a hedge fund. They charge an annual management fee of 1-2%, and they take 20% of returns. They justify these fees by seeking high returns, although they don't always get them. So those are some of the choices, if you are willing to pay for advice.

I've chosen the percentage of assets under management approach because I think our interests are then aligned. If your assets increase, I get paid more; if your assets fall, I get paid less. We both want your assets to get bigger. But your assets could get bigger just because the stock market as a whole is going up, not because I'm doing anything special. So that you can determine whether my fee is worth it, I compare your portfolio's performance, including the cost of my fee, with the performance of the S&P500. I use the S&P500 because it's an easy-to-invest-in, diversified alternative to having a portfolio managed by me.

I don't measure my usefulness to each client by how much activity I generate -- by how often I buy and sell stocks. In fact, I think if I started buying and selling stocks just so you'd think I was busy, you should start to get very worried. Instead, I measure it by how their portfolios perform relative to the S&P500. I give an update of that information to each client every three months, so they know how their portfolio compares for that quarter, for that year, and since they started investing with me. I also make myself available to answer other questions, such as tax-related questions or questions regarding financial assets that I don't manage. Some clients make use of that, some don't. But with the information about the performance of their portfolios, I figure each client can make the determination about whether my services are worth it to them.

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