Monday, June 29, 2009

The Temptation to Go Short

There appears to be general agreement that a bottom in the stock market indexes was achieved on or about March 9, 2009. April was a strong month, and in some cases showed the kind of progress one sees in what we used to think was a “normal" year. May, and the first few weeks in June, showed additional progress, but at a slower rate. The penultimate week in June showed some weakness. Now we have just two days to see whether we will have a trading rally for the late institutions trying to get rid of too much cash, and trading desks attempting to square their positions.

The popular press (if that term is meaningful anymore), is developing an expectation gap. Very few new jobs have been created by the government’s stimulus. Auto sales have not picked up since the intervention. Interest rates are low, which in many respects shows the lack of solid loan demand. Though somewhat counter-intuitive, many would consider moderately rising rates a plus.

Could we see another test of the recent lows? The answer is yes. But that is not the right question. The correct question is, “What are the odds that we have seen the bottom for most stocks in 2009?” My guess is that there is a better than a 75% chance that we have seen the bottom for most stocks. There is a new symbol for this bottom, “VL.” This suggests that we have already seen something of a “V” bottom coming off the March lows, to be followed by dull, relatively flat movements of most prices. (Within the horizontal portion of the “L” there is plenty of opportunity for trading successes.) Some believe this flat, range bound, market could last for a long time. One might say “VL” stands for very long.

In the face of these observations, why do I believe, in general, shorting it is now unwise for most investors? Often, the study of mutual funds provides answers to larger investment questions. The mutual fund industry is competitive always within its own market, but has grown by entering other providers’ markets; money market, tax exempts, and bank loans are just three examples. Many in the fund business feared the “retailization” of hedge funds (the decline of hedge fund minimum investment requirements) might cause mutual funds to lose customers. The counter attack by the fund industry was led by the so-called 130/30 funds. These funds invest 100% of their assets on the long side and with the use of leverage (often margin) allocate 30% on the short side. Other funds, also willing to bet on declines at least of the markets, if not civilizations, are available.

My old firm, once Lipper Analytical Services, now known as Lipper, Inc., created an investment classification called “Dedicated Short Bias Funds” as a peer group for the 130/30 and other funds betting, at least in part, on a decline. Setting up this peer group worked well. In 2008, and again in the first quarter of 2009, Dedicated Short Biased funds were the best performers (and often the only profitable funds on average) in the diversified US equity fund super-group. As I have often stated, fund performance is cyclical, driven by the highest mathematical power, within a large universe, of reversion to the mean. (Both the leaders and the laggards move in the direction of the middle of the array, often way beyond the point of becoming the new leader or laggard).

I doubt that there will be a meaningful reversal of the performance and rank of the average Dedicated Short Biased fund for the first half and second quarter of 2009. In both periods, these funds are the only classification within the U.S. Diversified Fund super group which shows negative results. Their current fund declines of over -20%, is larger than any other fund in the super group on the upside. (A number are getting close to a 20% gain for the first half.) Further, I believe it is too early to see a counter-reversal for the short sellers.

Thus my considered judgment for investors, not traders, is: this is not the time to go short.

Sunday, June 21, 2009

The Aging of the Uncertainty Principle

As a child growing up in one of the small towns, if you will, neighborhoods, pushed together on the island of Manhattan, I collected railroad timetables. Initially it was the maps that attracted me, depicting routes of the railroads often displaying them quite differently than their competitors. Later I became intrigued with the precision of the times of arrival at the various destinations of different trains. I was told that, at some point, I was able to recite to so-called adults, the fact that currently a train was leaving New York and would arrive at a particular destination at a precise time. Perhaps it was the certainty of these predictions that appealed to me during World War II. (I was blissfully unaware of the reality of train delays.) Later in life I remember spending an entire day at both the Detroit and Geneva airports, waiting for the weather to clear so the scheduled flights could take to the sky. I guess it was then that I learned the wisdom in the saying, “If you have time to spare, go by air.” Only reluctantly have I learned that the precision of timetables masks the uncertainty of arrivals and departures.

One of the most common of all beliefs of politicians, marketers, and analysts of all types, is that demographics dictate the future. There is a calming feeling of certainty being able to make mathematically precise predictions of the number of people of various types who will be alive, consuming so much protein, with a specific percentage employed, etc. Actuaries are paid to predict exactly when our poorly designed social security system will reach the single point of no return. That point is the exact date when the inflow from employment taxes will be surpassed by the outflow of benefits. In theory, the importance of this date is to determine how the government will deliver on promised retirement provisions.

Either inflow has to be raised by one means or another or outflows must be modified. Within the Beltway of Washington, tinkering with social security is considered touching the third rail. (Interesting that this is an illusion going back to the electrification of railroads as well as to present day subways.) The date of this presumed point of no return occurs in 2016. This date was partly determined on the projected proportion of people aged 55 who would continue to work. The last estimate was that only 40% would continue to work. Currently the number is about 55% and expected to go higher due to the decline in retirement savings assets caused by the market and economic declines. This is where my sense in traveling by train or by air is alerted; I believe it is wise to presume some margin of safety regarding expected arrival times. My own estimate is that 75% of Americans will continue to work, and most importantly, pay payroll taxes beyond age 55. In some ways this is an extremely bullish view, for it rests on the assumption that members of the 55 and older set are able to find jobs.

Notice that most headlines or declarative statements at social gatherings are begun with a specific prediction as to a future event, be it sporting, political, or market-related. As we are all just large children, we love the certainty of a prediction delivered with the force of a strong personality. Most investment portfolios, particularly those managed by financial institutions, can be summed up as predictions of a specific future. These predictions provide us assurance that we are acting prudently, and that planned expenditures (or outflow) demands can be met. In many ways this is just as childish as having total faith in timetables. To put it bluntly, we don’t have the certainty of a financial statement when it comes to the future, and what it will hold for any of us. What makes the certainty of this belief somewhat incredulous is that this goes against our “bible.” Most securities analysts trained in the black art of the market have read, or at least have been taught from Securities Analysis, originally written by Graham and Dodd. I remember quite vividly taking Professor David Dodd’s course, and listening to his intoning on the need for a margin of safety. Dodd’s margin of safety was defined as an additional discount from current price, after all other discounts were taken for various financial calculations, i.e. inventories, pensions, etc. This margin of safety (in Warren Buffet’s terms, “the moat”), around the future value of a security, is needed to cover for the unknown. While many investment professionals claim they adhere to these principles in terms of individual security selections, their portfolios do not.

Most of today’s portfolios are based solely on the most probable future that is expected. Often this perceived future starts with precise measurements of economic growth, inflation, value of the currencies etc. From these projections (timetables), various expenditure patterns become acceptable or not. I suggest that this approach is not wise and belies the history of human experience. Long-term portfolios, which are not under intensive daily management, should be able to deliver under most conditions (even some extreme ones). This may mean holding, within a portfolio, securities that are cyclically oriented, growth oriented or trading in different currencies.

A more realistic approach is not to plan to spend future income to meet needs, but rather to wait until income is achieved and appropriate reserves are taken for future valuation changes. The approach of earning before spending is often the base of conflicts between the generators of wealth and their families and key charitable interests. A compromise should be possible in the diversified portfolios of both ultra high net worth families and those of more modest size. The compromise should be to “agree to disagree,” that each perceived need requires its own specific portfolio, with its own operating procedures. Some might even follow timetables, while others will keep refreshing their “moats.”

Sunday, June 14, 2009

The Scots May Understand the Current Rally

Regularly I spend both formal and informal time with portfolio managers and other types of investment professionals, as well as talented amateurs. These conversations are part of my professional work as an investment manager and are also as a part of my volunteer activities for various non profit organizations.

This June, I am hearing two very different themes. The first theme, from successful managers, is that we are experiencing a “Beta or Junk” rally. Beta is that part of a securities performance that is market dependent, as distinct from independent. Stock managers are indicating that the stocks that are going up the most are being driven by improving margins due to cost cutting, with little (if any) sales growth. Inventory is being re-ordered after being allowed to fall to the point where it was hurting customer production. Few analysts however, are predicting long-term growth in demand, and many see the current enthusiasm waning in the near-term future. What appears to be happening on the bond side is that investors see a much wider spread between the interest rates of corporate bonds of all types compared to US Treasuries. However, this spread is currently narrowing. Unfortunately the yield spread, and therefore the price spread, is narrowing because the yields on treasuries are rising. This rise has more to do with the fears on the part of some buyers that treasury yields are not compensating their owners for the prospect of inflation, combined with the need of the US government to fund the rapidly increasing deficit.

The second theme I hear, is that stocks appear to be cheap, compared to earnings; not current earnings but “normalized” earnings. The concept of normalization of earnings was found in the early editions of Security Analysis by Graham and Dodd, which comes as close to being the analysts’ Bible as anything ever written. The way Professor Dodd taught me at Columbia in the late 1950s, was not to trust any given year’s results, but to average the reported earnings and margins over at least one business cycle. Dodd would also urge us to apply the valuation metrics to the normalized results in terms of both absolute and relative price/earnings ratios and yields. There have been a number of great, value-focused managers that have applied this thinking to their portfolios. One of the greatest was John Neff who purchased Citicorp stock when it collapsed into single digits during another loan crisis. Neff had the pleasure of holding the stock for many subsequent years at multiplies of his purchase price, which aided his Windsor Fund’s performance. An interesting side note is that when John Neff retired, his small retirement dinner in New York included only two non-insiders, John Reed (then the sole CEO of Citi), and me.

This is where the Scots come in; the case for normalization is based on the concept that at some point in the future, things will be like they were in the past. According to a legend turned into the wonderful Broadway musical “Brigadoon,” there was an ancient town in Scotland that would come back to life for one day each 100 years. My concern is that in a much more dynamic market than experienced in the fifties (when I was exposed to both Professor Dodd and Brigadoon), we will pass through the normalization phase very quickly, and be on to new crises and events. One example is the expected decline in the profitability of credit cards due to current legislation in the US and UK (including Scotland). However, the smart guys at card-issuing banks may find new ways to use their credit card relationships to make money, as well as to recoup some of the loans that have been written off. Nevertheless, when it comes, this day will not be an exact revival of Brigadoon.

What do you do with all this input and folklore? My first suggestion is to avoid buying and to perhaps practice some trimming of portfolio positions that have shown unsustainable price gains since March. We could experience a major mark-up of some prices as pension and hedge funds wish to show less cash on their June 30th statements. If this mark-up is extreme, one should react. July and early August, while tricky due to less than normal volume, may well be cautiously good entry points.

While you wait and contemplate, watch out for little signs of change and keep humming.

Sunday, June 7, 2009

Investment Lessons from the Belmont Stakes

Readers of my book, MONEY WISE, (which was published last September) will recall that the race track is one of my two great educational experiences. Thus, I look with great interest at the handicapping, (if you will, the analysis) of picking winners in the Belmont Stakes. This race is like no other race in the country. For most horses, the Belmont is the only time they will be asked to run a mile and a half on dirt. The horse that wins this extreme challenge is often viewed as the three year old horse of the year. Fewer horses enter this race than either of the first two legs of the Triple Crown, the Kentucky Derby and the Preakness. Because of the fewer contestants and the longest race, there is less chance that racing luck will be the determinant of the winner. The whole concept of well-known classic races with large purses is a showcase for the future breeding fees that young stallions can demand before their progeny start to race.

The plan to win the Belmont begins with selecting the correct stallion with the right mare to breed an eventual starter. Usually the selection process is driven by the racing record of the parents and grandparents. Our lesson plan for today is going to focus only on the first three horses to finish in a fairly tight bunch, under 3 (horse) lengths. The third placed horse was the mathematical and sentimental favorite, Mine That Bird. This rather small gelding finished first in the Derby and second in the Preakness under different jockeys, but was ridden by the jockey who won the Derby with him, and was also on the winner of the Preakness. His sire was Birdstone, who won the 2004 Belmont. His pattern of running last and closing very fast seemed ideal for this race. However, both his jockey and a number of handicappers (or if you will, analysts) recognized that if the early pace was too slow, Mine That Bird would not be passing tired horse in his late running charge. The second place winner was Dunkirk who has lots of champions in his pedigree and was bought for $3.7 million compared to the $600,000 purse awarded to the winner of the Belmont. Dunkirk ran a poor race in the Derby and was not raced in the Preakness, but trained very well coming up to Belmont. (These two horses were my picks.) The winner was Summer Bird, who was also sired by Birdstone, and did not have a good race in the Derby but was being trained for longer races.

For the purposes of our investment lessons, I want pull out a couple of facts about the race:

  1. Dunkirk was the lead horse for most of the race and was able to regain the lead after he lost it briefly, but not a second time at the end.

  2. Mine That Bird moved a little prematurely and was not passing tired horses as easily as expected.

  3. Summer Bird not only showed the benefit of his extended distance training, but also could charge up the middle of the track well wide of the leading horses.

  4. Dunkirk paid $5.40 for a $2.00 bet to Place (second).

What are the investment lessons that I draw from this race of all 2 minutes and 27 seconds?

First, as with markets, the defined future is somewhat unpredictable. The earlier than expected move by Mine That Bird changed the expected race pattern. Competitors have a way of doing that by learning new tricks. Think of Apple and the iPhone/AT&T. Second this small gelding, whose only earnings will be from racing, was the sentimental and mathematical favorite of both the bettors and the crowd. The race tracks normally publish the percent of winning favorites; rarely is the number 50% or higher. (In my novice period of handicapping at New York tracks the percentage of winning favorites was more like a third.) Most importantly, when one surrenders a winning ticket to the cashier, he/she pays out in real dollars not sentimental dollars. The lesson here is: generally stay away from where the crowds have gathered for two reasons. The first is that the greater the number of backers for a horse, by definition the odds are smaller. The second reason is that the chances of success are less. The hottest stock at some point peaks out, having sucked in all the bettors that it can and with no other buyers in sight a rapid decline is likely as owners scramble for liquidity. The phenomenon works clearly and often rapidly with individual securities. Much to my chagrin it also works with large mutual funds that become the dominant buy of a small class of securities e.g. “dot-com” stocks.

The owners of Dunkirk (or if you prefer the Damon Runyon term the horse's “connections”) appear to know what they were doing when they paid $3.7 million for this colt. After the running of the Belmont, Dunkirk has proven at equal weights that he can lead at most distances. If after this race they retire the horse to take up stallion duties, the aggregate breeding fees will more than recoup the owners’ initial cost plus operating expenses for at least the first three or four years. If the connections are more ambitious and are willing to assume the inherent risks, there are a number of classic races for three year olds that could add luster to his “Horse of the Year” crown. The title would almost be assured if he won various handicap races in his fourth year where he will be carrying more weight than others. The investment lessons with Dunkirk begin with the fact that there are some smart people with money and vision. This suggests that when looking for investment managers, one should determine whether these managers were trained in successful shops which can handle most of the different investment environments. Further, Dunkirk’s “connections” were willing to pay up for the long term benefit of owning a potential big winner. The attraction of investing in very well paid managers could be, but not completely, parallel here. In this light both winning jockeys and trainers participate in the winnings. The key to these successes is not just spending large sums of money on horses and investment managers. The execution of the day to day process of selection and training along with a clear vision of the future are also vital criteria. The vision should be based on desired competitive strengths, not extrapolations of present conditions.

The winner of the Belmont was Summer Bird. The casual reader of past performance data would have clearly missed this one, who carried 11 to 1 odds. This colt had only won one out of his prior four races. While he was sired by Birdsong, an upset winner of the 2004 Belmont, the other Birdsong sired entry; Mine That Bird had won the Kentucky Derby and a second place in the Preakness. Summer Bird did not run a good race in the Derby in the company of undistinguished rivals. Like others, I missed looking at this colt carefully. What I failed to do was what I require when looking for good managers of mutual funds and hedge funds: get a focus on them as individuals. What I missed was that Summer Bird often keeps running well beyond the finish line. When his trainer recognized this trait, and started to lengthen the distance for his training sessions, the value of the past performance data diminished. Further, I did not contemplate that this colt, in his race with two track turns, would be strong enough to race in the middle of the track and thus in effect sneak up on the then leaders.

All of these lessons are less instructive for portfolio investors than the final factoid. Dunkirk, who was clearly the second best horse in the race both before and after the race, paid $ 5.40 for a $2.00 place bet. (The pay off would have been smaller if the favorite and Dunkirk had finished in the first two.) The lesson here is that one could have a bet on any horse in the race and a place bet on Dunkirk for the same amount of money and come out a $1.40 winner. ($5.40-2.00 -2.00=$1.40) Being a $1.40 winner is not only better than being a loser, but you paid for an opportunity cost which did not work out. The lesson for portfolio investors is that in an appropriately diversified portfolio one can afford some losers and still come out ahead.

As they say at the track, “whaddya think?”