Fourth Quarter 2014
Key Takeaways

• As the year drew to a close, a handful of big-picture issues dominated the investment landscape.

• Large-cap U.S. stocks contin-ued their unusually strong and unbroken stretch of gains.

• Most other major stock mar-kets fared poorly in 2014. De-veloped international stocks lost 5% and emerging-markets stocks dropped 2%.

• Contrary to the consensus, the 10-year Treasury yield de-clined further and bond prices rose.

• While our diversified portfoli-os participated in the strong U.S. stock returns, they faced several headwinds for the year.

• In terms of the investment environment, the U.S. econo-my looks to be in pretty good shape over the near term.

Fourth Quarter 2014 Investment Commentary
As the year drew to a close, a handful of big picture issues dominated the in-vestment landscape: the plunging price of oil, positive economic indicators in the U.S. relative to most of the globe, and the ongoing influence of central banks (a key effect of which has been to bolster stocks and other risk assets). In the financial markets, the year saw strong gains for U.S. large cap stocks and core bonds with lagging performance elsewhere.

Looking first at the investment environment, oil prices hit five and a half-year lows in late December (falling 40% in the fourth quarter alone) as new sources of supply met with potentially slowing global demand. While a decline in oil prices is typically viewed as an unambiguously positive development for the global economy, the result this time around is different because of the rapidity of the plunge and the current fragile global economic environment. With deflation concerns already high in Europe in particular, the oil price decline was seen as intensifying the deflationary risks.

One offsetting factor that helped the markets regain their footing in the fourth quarter (as it has many times in the post financial crisis period) was the ongoing influence of central banks. Even as the Federal Reserve suggests it is on track to begin raising rates in the face of U.S. economic improvement, it once again soothed markets by reaffirming that it would continue to be patient in shifting its stance. Given the poor economic conditions that persist in Europe, the European Central Bank recently announced its biggest push yet to fend off deflation and revive the eurozone economy by unleashing a $1.3 trillion quantitative easing (i.e., purchasing bonds and other assets with the aim of stimulating the economy) program. The details of the plan have to pass the Governing Council and could be changed by the time you read this newsletter. Central banks in Japan and China also expanded their stimulative policy efforts over 2014. The takeaway is that even as the Fed may begin scaling back its support, there appears to be no shortage of supportive monetary policy globally. At the same time, the fact that central banks continue to under-take (or contemplate) aggressive action provides a re-minder of the broader economic risks we continue to navigate.

Against this backdrop, the S&P 500 index gained almost 14% and, for the third year in a row, avoided even a modest 10% “correction.” On the other hand, U.S. small cap stocks dropped more than 13% from their summertime high through mid-October, and ended the year up 5%. Outside the United States, most major stock markets performed poorly. Developed international stocks lost 5% and emerging markets stocks dropped 2% (based on MSCI EAFE and MSCI Emerging Markets indexes, respectively). These returns reflect the significant headwind presented by the strengthening U.S. dollar, which detracted from returns for dollar based investors.

Contrary to the consensus coming into 2014, the 10-year Treasury yield declined and bond prices rose. The core investment grade bond index was up 5.8% for the year and municipal bonds also fared well. Outside of core bonds, sectors such as high yield and floating rate loans lagged, rising 2.5% and 1.6% respectively.

After another year of outperformance for U.S. stocks versus other markets—for the fourth time in the past five years versus developed international stocks, and the third time in the past four years versus emerging markets—we’re starting to hear more people question the benefit of investing outside the United States. This is an important question, and we acknowledge that owning foreign stocks has been an unsatisfying experience over the past couple of years. Moreover, given some of the current economic and geopolitical forces, it can appear likely to continue this way.

The first key point is to remember that equity markets and asset classes in general go through cycles and it is unwise to extrapolate recent performance trends far into the future (as we see many investors and commentators doing). Furthermore, investors often suffer from extreme overconfidence that they can predict these shifts and correctly time their buys and sells accordingly (data show actual investor returns lag indexes by hundreds of basis points due to timing errors). As an example, we were hearing this same question back in the late 1990s/early 2000s after U.S. stocks had a similar streak of out-performance. As shown in the chart below, in the market cycle that followed from 2002–2007, international stocks trumped U.S. stocks by a wide margin, and emerging markets did even better, outperforming the S&P 500 by more than 20 percentage points annualized. (Of course, toward the end of the latter period people were asking why they didn’t have more exposure to emerging markets only to see emerging markets meaningfully trail the U.S. market since then.)

Because markets move in cycles, there will always be periods when global diversification doesn’t appear to “work.” In our view, as long-term investors, the case for global investing remains compelling and extends beyond the simple matter of capturing returns as market leadership rotates.

The most important reason to hold a globally diversified portfolio is to access a much broader investment opportunity set. In 1970, U.S. GDP accounted for 47% of the world’s total GDP. Today it is closer to 20%, while emerging markets now comprise roughly half the world’s total output. Likewise, in terms of stock market capitalization, in 1970 the U.S. market comprised 66% of the world’s total stock market value. By 2013 it had declined to roughly 49%, with emerging markets comprising 11%, and the remainder in developed international markets. In other words, businesses around the globe are launching, innovating, producing, and growing, and their stocks have the potential to do so as well. If an investor chooses to only invest in U.S. stocks, they are excluding themselves from over half of the world’s total investment opportunity set. Moreover, they are limiting their opportunity to invest in some of the world’s most attractive companies domiciled outside the United States.

A second important reason for owning a global stock portfolio is the benefit of diversification. A diversified global equity allocation should produce better longer-term risk adjusted returns than any single country held in isolation. This has been the case historically as shown in the chart below, which extends back to 1970 when data for the developed international market index begins, and incorporates emerging markets starting in 1988 when their index returns became available. Looking at rolling 10-year periods, the global portfolio (comprised of 60% S&P 500 and 40% non-U.S. stocks) generated an average return of 12.5%, beating the S&P 500’s average return of 11.3%. (The results were simi-lar using rolling five-year periods.) Moreover, the global portfolio beat the S&P 500 in 71% of the rolling 10-year periods (there are 420 such periods going back to 1970).

Countries around the world are in different stages of their economic and market cycles, and at any given time one particular market can and will outperform others. Consistently predicting which market will outperform, and more importantly getting the short-term timing right, is impossible. If you concentrate your exposure in only one market—even if it’s the U.S. market—you run the risk of that market undergoing an extended period of underperformance that could have a lasting negative impact on your portfolio. And human nature is such that most people also won’t be able to stand being heavily invested in an underperforming market for too long. This discomfort may lead them to sell in disgust at low prices and chase the recent country market winners, probably just as those markets approach their highs for the cycle.

That is why diversification—consistently owning a variety of asset classes, strategies, and managers that should perform differently depending on the environment—enables us to create portfolios that should per-form at least reasonably well across a wide range of possible scenarios and outcomes. But it takes discipline to be a long-term diversified investor, because you know you will own some asset classes that are laggards in any given year or even over multiple years, and with 20/20 hindsight it is easy to start questioning why you owned those particular assets in the first place.

In addition to our belief in the long-term benefits of in-vesting globally, we also believe that valuation matters and is a key component of future market returns—after all, future returns are all that matter from this point for-ward. Therefore, there are times when it makes sense to over- or underweight markets or asset classes to tilt the odds of success more in your favor. So today’s popular argument that Europe and Japan are economic basket cases and that emerging markets companies face risks that U.S. companies don’t face, doesn’t necessarily mean there aren’t compelling investment opportunities in those markets. Depending on a company’s stock market valuation relative to its business fundamentals and future earnings potential (i.e., the price you are paying in the stock market to capture the potential value of that particular investment) the expected returns for many companies in those non-U.S. markets may more than compensate you for those types of risks. Whereas even if the United States is the strongest and most stable economy in the world, that doesn’t mean it’s stock market offers the best risk/return profile right now. We’ll talk more about how we view valuations and fundamentals for U.S. versus international markets in the sections below.

While our diversified portfolios participated in the strong U.S. stock returns, they faced several headwinds for the year including our investments in foreign stocks and our underweighting of core, investment grade bonds. Another detractor to our portfolios’ overall performance in 2014 was the underperformance of our domestic large cap equity managers. Key among the performance drivers that have broadly affected fund man-agers is the fact that many managers hold some non-U.S.-based multinational companies and some amount of cash (especially true for our value managers).

Finally, when it comes to the financial markets, we think it’s worth putting recent results into the context of history. This has been an unusually long and strong period of positive performance for large cap stocks. Since 1945 there have only been three other periods (out of 51 total) where the S&P 500 has had a longer streak of gains without at least a 10% correction, according to Ned Davis Research. In addition, over the past two years, the S&P 500 has outperformed both developed international and emerging-markets indexes by an unusually large margin relative to history. These observations don’t mean U.S. stocks are necessarily set to tumble in the near term, but we think this data does provide some perspective as an argument for global portfolio diversification and prudent risk management.

Our Asset Class Views Looking Ahead
U.S. Stocks

In terms of the investment environment, the U.S. economy looks to be in pretty good shape for the near term. There are several positives: the labor market continues to strengthen, inflation remains subdued, manufacturing indexes and other leading economic indicators are consistent with solid GDP growth, falling oil prices should boost consumer spending, and government fiscal policy is likely to become more of a growth tailwind than a headwind as the impact of past budget cuts rolls off.

Fed monetary policy remains something of a wild card, but based on the Fed’s words and actions, we would be surprised if it shocks the economy or markets with an unexpectedly strong interest rate hike.

We continue to monitor the valuation of US stocks, which are fairly valued (i.e. not overvalued, not under-valued) in our opinion. We have a full weighting to US stocks across our portfolios.

European Stocks
In contrast to the United States, the eurozone (ex-U.K.) continues to fight deflationary headwinds. The December year over year headline inflation number fell to negative 0.2%, real GDP growth is below 1%, and two-year government bond yields in Germany and France are actually negative, meaning investors are paying the government for the privilege of owning these bonds.

There continue to be risks in Europe and although stock prices look cheaper than the U.S., they are not cheap enough to justify an overweight position. For our balanced portfolio’s, we are slightly underweight Europe.

Emerging Markets Stocks
There is a lot of negative news surrounding emerging market stocks—such as slowing growth in China and other BRICs and the decline in emerging-markets currencies. Nevertheless, we remain optimistic about emerging markets’ long-term fundamentals and believe they are likely to outperform U.S. stocks over our five year investment horizon. However, we are conscious of the shorter term downside risk and volatility they pose. This is one reason why we are underweight emerging markets relative to our neutral allocation.

Investment Grade Bonds
From an asset class perspective, we believe investment grade bonds are likely to generate low single digit annualized returns over our five year investment horizon. Our low return estimates are explained by the very low current yields and our expectations that interest rates will move higher over our time frame, although the timing and magnitude are of course uncertain. As such, about half of our fixed income exposure remains in opportunistic, flexible, and absolute return oriented bond funds that we believe offer superior longer term risk/reward profiles compared to core bonds. Our highest priority research project is to find a replacement for PIMCO Total Return, which we sold when Bill Gross abruptly left the firm. We are using a total US bond ETF until we complete our research on an active core bond manager.

Floating Rate Loans
The environment also continues to be attractive for floating rate loans, as companies have taken advantage of historically low interest rates, locking in attractive levels of fixed rate financing. As a result, there are few loan issuers with significant near term maturities, and as a whole, companies have healthy levels of cash flow and interest coverage. Although there is the potential for short term downside risk, we believe the asset class will generate mid single digit returns over our three to five year investment horizon under a range of economic scenarios.

We currently have an allocation to Floating Rate bonds in our most conservative portfolio.

Alternative Strategies
We have written previously about our alternatives allocation, a position that is held in all of our balanced port-folios. As a reminder, the strategies we own are intend-ed to generate long term returns that are better than core bonds, with much lower downside risk and volatility than stocks and relatively low correlation to stock and bond market indexes. We have a meaningful allocation to alternatives in all our balanced portfolios.

Active? Passive? We Say Both
The current, hot topic de jour for investors is whether or not active stock picking is dead. Over the 17 years of our history, we have seen this topic rise and fall in popularity, mostly when active stock picking is performing at its worst. While many managers do underperform the S&P 500 (to pick an index) even over the last five years, which has been a bad period for active, about 20% or so of active managers outperformed. With the many thousands of investment choices (we have lost count of the actual number) available and because we only need 20-30 managers or so for our clients, we have and continue to find active managers who have excel-lent long term performance records.

The reason that this period hasn’t been good for active stock picking is because active managers are holding some level of cash and also cost more than passive in-vestments (however, as we like to say, it is not what you pay the active manager, it is about what the active manager pays you). Our active managers will tend to in-crease cash as markets go up in price. As we are in the later years of a multiyear bull market this cash level has tended to increase. This cash will help active managers when the markets reverse at some point. As passive strategies have been winning for a number of years we would expect a reversal to happen sooner rather than later, as usually the strategy that has been working the best for the previous five years is not the strategy that works the best for the next five years. Other reasons for the recent underperformance are: 1) our active managers generally look for undervalued companies with strong balance sheets and sustainable free cash flow. The recent market increase has rewarded riskier and lower quality stocks; 2) QE across the globe has generally lifted or depressed stocks as a whole, making it difficult for active stock pickers; 3) the money coming into passive strategies recently may, inadvertently, support less liquid stocks and as discussed in more detail below, benefited larger stocks of the benchmark because of how indexes are constructed; 4) the last time we experienced this level of active management underperformance was the late 1990’s (tech bubble). We are not saying that we are in a bubble but the environment to-day echo’s that time period.

Taking a closer look at the S&P 500 Index, many investors do not know that this popular index is not a passive, unmanaged or fixed list of 500 companies. Rather, the index is actively managed, regularly updated and modified based on the recommendations of a committee at McGraw Hill Financial. Over the last 20 years, the turn-over has averaged 5% a year. For example, 18 new companies were added in 2013 and 18 were removed from the index. Companies tend to be added to the S&P 500 Index after they have appreciated (we like to buy assets before they appreciate) a great deal and generally when the stock is popular. Conversely, companies tend to be deleted from the Index after they have already declined in value (resulting in selling low). Chris Davis, of Selected American, has done work in this area and he cites a 2005 report by William Hester (Hussman funds) who attempted to quantify this buy high/sell low effect. The study looked at 1998-2005 and the study noted that average annualized returns for the deleted companies was 11.4%, while those added to the Index had a return of just 0.4%. Lastly, for the S&P 500 Index, it is capitalization weighted, which means it automatically owns more of the stocks that have gone up in price.

John Osterweis, Osterweis Capital Management, recently issued a white paper on the active vs. passive debate. The study notes the positives of passive investing: low fees, liquidity, low tracking error, and participatory re-turns during strong equity markets. They also note that passive investments could also provide market like re-turns when the market is trading more on macro (or headlines) information than on the fundamentals of companies. The cons of passive investing do not seem to get as much press but it is important to note these include lack of protection in down markets (this is a big issue for us, as we want to protect capital on the down-side). Because of the capitalization weighted structure, investors can have greater exposure to overvalued stocks (technology in 2000-2003, financials in 2008-2009) and less exposure to undervalued stocks.

There are certain characteristics that we think our “guru”, active investment managers have that make long term outperformance more likely. Although not an all inclusive list, the managers we work with have an alignment of interests with their fund shareholders (investing material amounts of their own net worth in their fund – in short, eating their own cooking), passion for what they do, significant experience, courage or a willingness to look different than a benchmark (which is how you outperform – the manager needs to invest differently than the benchmark, which means they will be out of step over shorter term time periods), run concentrated portfolios with their highest conviction ideas, a long term time horizon and a consistent, disciplined investment process. David Swensen, Chris Davis and John Osterweis, investment managers we admire, have talked about these attributes in their writings and books.

We believe that due to the characteristics mentioned above, bottom up, value style investing (buying assets at a discount to their intrinsic value) provides investors downside protection relative to an index and a “margin of safety”. A margin of safety means that by buying an asset for less than its intrinsic worth, they may not experience a large loss even if the estimate of value is off, since the manager is not overpaying for the asset. Managers can also say “no” and not purchase a stock that is overvalued. Cash can and will accumulate when prices are unattractive, providing “dry powder” for periods of stock price volatility. Mr. Market has a tendency to go through mood swings and our active managers can take advantage of these opportunities to buy companies at attractive prices. Many so called active managers are “closet indexers” – a deep look at their portfolios deter-mines that their portfolio looks very similar to an index but at a higher cost. We prefer active managers who look very different than a benchmark – as noted earlier in this newsletter; the way a manager outperforms is to invest very differently from their benchmark.

We think the active/passive debate is misplaced. Our philosophy in constructing portfolios is that there is a role for both active and passive investments. We have been doing this throughout the history of our firm. For our passive component, we partner with Dimensional Fund Advisors (DFA) – their trading, portfolio construction, low expenses and academic research sets them apart. Their portfolio construction focuses on the dimensions of higher expected returns (vs. traditional passive strategies which are tied to a benchmark, making it less flexible) – the market, size (small, large), profitability and price (value style investing). The DFA approach provides a “passive plus” strategy, which we prefer.

We think that the combination of active managers that exhibit the traits discussed and the passive plus strategy brings the best of both worlds – the building of an asset allocation strategy that has lower costs than an all active portfolio, uses the skills of “guru”, concentrated active managers with long term track records of performance to provide the potential for improving a portfolio’s risk adjusted returns and the diversification and cost benefits of passive plus investments. What is smart early can be dumb late as we approach the end of the latest chapter in this never ending debate.

Tax Time
Tax season will be in full swing in a couple of weeks. Now is a good time for clients to review their financial situation, as well as their income tax situation. We read or heard somewhere that people spend more time planning their vacation than they do on their financial planning! This makes no sense to us. People work hard for their money and in addition to saving as much as they can for as long as they can, we think they need to be reviewing their financial situation at least annually. As practicing CPA’s, tax planning is an important service available to our clients. We will be working with our clients to properly plan and minimize their income tax bill. This includes, where possible, the placement of investments in the right account. For example, when possible, we put fixed income investments in IRA ac-counts. Since all income from an IRA is considered ordinary income (even if generated from capital gains), we prefer when possible to have equities invested out-side the IRA. Currently, dividends and long term capital gains get preferential tax treatment versus ordinary in-come. In addition, capital losses can offset capital gains in a taxable brokerage account but not an in an IRA.

River Capital News
We have updated our Guide to Understanding Your Portfolio Performance Report. The updated booklet dis-cusses how our performance reports handle the rate of return computations for the recently added alternatives position. We have discussed the limitations of our port-folio software with many clients during our planning meetings and have updated the booklet so that the reference guide is current. We welcome any feedback that you have on performance reports and booklet.

For our clients, enclosed is our 2015 Privacy Policy. At River Capital, maintaining confidentiality and protecting your privacy has always been a high priority.

Parting Thoughts
People want certainty, especially when it comes to their money. This is why terrible products like annuities are sold to people every day. People want forecasts – they want to know what 2015 will bring – so do we. However, no one knows the future. The Wall St. Journal recently published an article looking back at the economic forecasts for 2014 and the picture is not pretty. Most economists, according to the article, expected higher oil prices for 2014 (not even close), firmer inflation (nope), a worse jobless rate (wrong again) and higher interest rates (everyone knew rates would be higher in 2014 and they ended materially lower. 30 year bonds were one of the best performing investments in 2014).

We leave you with a quote from Lao Tzu, a 6th century BC poet and philosopher:
Those who have knowledge don’t predict. Those who predict don’t have knowledge