Sunday, October 25, 2009

When Experience is not the Best Teacher

In my book Money Wise, I began with the desire to explore the principles of investing to find laws of certainty similar to that found in the physical worlds. I have been unable to find these supports in terms of securities selection or in portfolio decisions. Many others, however, have believed that they have found such rules.

One can often learn more from reading the apology letters from poor performing funds than from winning funds. Brandywine Funds is one of the better communicators of this group. Their basic investment approach is to invest in stocks that they believe are selling at a discount to a future price, based on their estimate of future operating earnings. In bemoaning their under-performance, they focus on the “Quality Ranking System” of Standard & Poor’s, an analytical approach that focuses on relative growth of earnings and dividends over time. Using letter grades to signify the best of these measures, S&P assigns “A” to the best and “C” and “D” to the worst. In the first nine months of 2009, the “C” and “D” companies gained on average 134%, while the high quality “A” stocks were up 21%. To add insult to injury to the earnings modelers, the best performing stock in the Russell 3000, Human Genome Science, was up more than 3,300%. The company has not reported an annual profit since 1994, and is expected to have larger losses in 2010 than in the current year.

Another currently poorly performing manager focuses on the fact that the companies reporting earnings gains often are doing so by significantly reducing expenses. In many cases they are also experiencing reduced sales and/or share of market. Yet in the current market, these stocks are substantially outperforming others that are showing revenues gains and increasing or maintaining market share. Consumer stocks are doing well on Wall Street, but not on Main Street, and they have attracted significant short interest.

Under normal conditions, the focus on accelerating earnings produces performance leaders. The apologists for current relative poor performance have, in some ways, been bitten by one or more Black Swans. In the nineteenth century many Europeans believed that all swans were white, thus there was shock and consternation when they were introduced to Black Swans from Australia. This introduction violated their experience. For hundreds of years before the early twentieth century, the world was an orderly place following the rules of science as pronounced by Isaac Newton. Then Albert Einstein’s thoughts changed the way we looked at the world. In these two instances we are confronted with the choice of the experienced and normal, but recognize that under some conditions exceptions will occur.

Our market and economic experience over the last two years does not follow the normal past experiences. We clearly have been in an exceptional time. History suggests that past exceptional periods eventually coalesce into some form of repetitive patterns that become the new normal. I am not sure what these new relationships will be. PIMCO believes that they have found the new normal, which produces more subdued growth. I am not sure. In view of the fact that, in general, equity returns for the last ten years have been flat, I am of the view that over a longer period we will see growth. My feeling is that at least we will see high single digit growth with some years, like 2009, showing double-digit gains. Further, I believe some form of the old “normal” rules will work for investors, perhaps when we least expect it to work. In other words, this is not like saying to hold on to your Confederate Dollars. But rather, it is a recognition that the South did recover eventually, and is now often a growth leader.

Keep an eye on formerly successful managers, for some of them may be future leaders again, particularly if they do not chase the new normal.

Sunday, October 18, 2009

Are We Selling the US Too Short?

Almost everyday the global financial headlines discuss the decline in the value of the US dollar relative to other currencies. Many economists and others talk about a slow recovery here, and faster in Asia. Because of the difficulty in obtaining student visas for university students since 9-11-01, there is wide-spread concern that we are no longer attracting the brightest minds to study and work in the United States.

The fear (and perhaps a distaste) of investing in US stocks has been translated to Main Street. As of September 30th of this year, 53% of all money invested in Stock funds are in US Diversified Equity funds, according to my old firm. Another 6% is invested in Sector funds, some of which have a distinctive global tinge to them. Combined, Global and International funds alone account for 22% of American fund owners’ assets. These numbers understate the total exposure we have to non-US influences on our wealth. A number of analysts have estimated that over 40% of the revenues of companies within the S&P 500 come from overseas. Foreign earnings of these companies are not often disclosed, but I would not be at all surprised to learn that they represent over half of the total earnings of American companies (particularly if we include earnings from exports). I am well aware, and have benefitted from the fact, that investing globally for many years have produced better results than investing primarily in the US. This may not continue forever.

One of the first things I did as a Wall Street bank trainee was to physically account for the foreign shares in our bank’s vault (investors were issued American Depository Receipts or ADRs). Many years later my fellow trainee became one of the leading investors in both domestic and foreign bonds for central banks outside of the US. Almost from the beginning of my personal investing at the odd-lot, below the 100 share size, I invested either directly or indirectly in foreign trends. At times over recent years my foreign exposure in equities was over 40% including funds, individual stocks, currencies and some operating investments. I am no neophyte to investing globally.

One of the many lessons that I have learned from a number of older and wiser investors is to tend to invest against the headlines. The current pessimism about the long term future of the US is just such a time. For the accounts that I am responsible for (including my own), I seriously doubt that I will be adding to the international allocation in the near term.

Why do I take this point of view? Is it just to be contrary? No, while I am professionally trained to look at the other side (or sides) to any investment before making purchases, my optimism is based elsewhere.

We are incredibly fortunate to have three of our family beginning studies this year at William and Mary, Georgetown, and Carnegie Mellon. Not only are we listening to them discussing their courses, but also hearing about what their friends are doing at other leading universities here and abroad. They all appear to be working long and hard, and their courses are subjects that their parents and grandparents would like to take now. Our young will be much better prepared for the globally competitive world that they are inheriting. Their youthful enthusiasm, with some idealism thrown in, has a much more practical base to them than when I was in college. We are producing great raw material for the future.

While waiting for our young to earn their commanding positions, the current pace of technological development in many fields appears to be on the verge of major improvements for mankind. The discussions from graduates, professors and current students that I hear from my exposure to Caltech, suggest that we do not live in a static world. There will be breakthroughs in energy, medicine and their underlying physics, chemistry and biology. Big problems will be addressed and solutions identified. In the scientific fields, most of the awards are going to people who teach or were educated in the US. In science we have been punching way over our population weight class for some time and this is likely to continue at least for a few more years.

Focusing briefly on the price of the dollar, I would rather be a buyer than a seller. At some point, perhaps right now, our trading partners will want to prevent a further decline in the dollar. They will become buyers rather than sellers to protect their own export books and internal currencies.

My bottom line is I believe that one should not now be increasingly short of US dollar investments.

Sunday, October 11, 2009

On Building Effective
Investment Committees

Investment committees are the heart and soul of many non-profit organizations. The deliberations of these groups determine the near term and perhaps the long term ability of the organizations to accomplish their missions. Combined with the organizations’ Development (fund-raising) efforts, the scope of near term activities is determined. In an ideal world, investment should focus on the long term. In the real world, from a pure investment viewpoint, the pressure of near term funding needs often get more attention than warranted.

Currently, I have multi-faceted relations with several investment committees. I chair two very different investment committees, act as a consultant to some and an investment manager to others. Thus, I read with great interest an excellent seventeen page piece on investment committees by Michael Mauboussin of Legg Mason Capital Management. In his summary, he highlights twenty-one thoughts broken down into general findings, advice for committee members, and advice for committee chairs. With due regard for the patience of blog readers I will not discuss each of his excellent points, but will focus only on a handful.

The best committees are made up of members who bring different points of view from their varied experiences and thought patterns. In effect, intense discussions are the mother’s milk of a successful committee. As distinct from a reporting function which dwells on the past that can not be changed, the committee should focus on the future. Important in the deliberations should be the recognition that after exceptional performance, good or bad, the odds favor a reversal of relative, if not absolute performance. Along this line of thinking, the committee should challenge the obvious. One way to do this is for each member of the group to come to the meeting with thoughts that they share about what could go wrong. Before one can properly come to an assessment of investment risk, one should identify what could go wrong. Up to two years ago, there was no discussion of “hundred year storms,” which actually happen much more frequently. ( For those who are interested, I would be happy to discuss the similarities between the market collapse of 1987 and the defeat of the Spanish Armada.)

Perhaps the biggest contribution to increasing the success of investment committees is to record the essence of the discussions that lead to decisions. Subtly, these records can lead to a shift from an exclusive focus on outcomes to lessons gained from the process. We need to recognize that many outcomes are more a function of luck than skilled judgments. However, if our process allows for luck, or if you prefer the unexpected, we are more likely to be the beneficiary of change than those that have a high degree of certainty.

In applying the last thoughts, maybe we should spend time looking at funds that are currently performing badly, particularly those with managers that have been successful a number of times in the past. Will their successes be repeated?

What do you think?

Sunday, October 4, 2009

Old Money vs. New Money Mistakes

One of the truths about investing is that to invest is to make mistakes. I am not suggesting that investing is an avoidable mistake. We have no choice but to invest our time, talents, and capital. The reason we have no choice is that these resources already exist in some form and if we do not change them, we are reinvesting them in their present forms. Innately, humans and animals instinctively know that our resources will deteriorate and perhaps disappear over time. Thus, we choose to do something with our resources. For most of us, we have no choice but to invest or attempt to improve our condition.

How we choose to invest is primarily a function of our experience. Our experience is not just what we individually have lived through, but also what we have consciously learned through the experiences of others with whom we choose to identify. Whether we like it or not, one of the inputs to our experience is our own DNA. This DNA is composed of elements of human race characteristics and more directly, family background. This is not to say that since there have been four separate (and not connected) Lipper brokerage firms, that for all time members of my family are condemned to be members of the New York Stock Exchange. What it does suggest is that we have a disposition to be attracted to transactions and services for others who transact. These tendencies can be applied to the various worlds of art and computer services among others. Luckily for the world, people are wired differently so we can find essential diversity in what we do. For the most part, our experience, no matter how formed, does not trap us into certain behavior, despite our propensities. Thus, as we enter each new theater of experience, we either treat what we are about to do as something new, or part of a continuum from the past.

Experienced investors, or if you will, old money, invest differently than those with new money. Each of us is human, and therefore makes mistakes; but often the mistakes of old money are different than the mistakes of new money.

Most of the old money that I know did not materially change the disposition of their financial assets after the experience of the last couple of years, even though their money piles are smaller. Their “normal” asset distribution might have been 5% in cash, 35% in bonds, 20% in domestic growth stocks or funds, 20% value stocks or funds and 20% international stocks. At the end of last year they may have had over 60% in cash and fixed income, 15% in value-oriented stocks or funds, 15% in international and 10% invested with a growth objective. An experienced investor believing that almost all relative performance is cyclical, might not change any commitments. For what the market takes away it will return over time. Further, from their experience, they believe after a major decline they should not change most managers or stocks of currently profitable companies. Old money has an affinity to long term records as they have had their money over the long term. They also generally prefer investing with organizations rather than in the success of any particular CEO or money manager. Thus, they chalk up the declines they have experienced as just a “normal’ cyclical decline which will be corrected by a “normal” recovery followed by some secular growth. In many ways this is almost a Newtonian view of a grand watchmaker overseeing our universe.

Owners of new money are full of themselves. They earnestly believe that their investment results are largely, if not totally, dependent upon themselves. They look at the current market always as an opportunity to show how bright they are relative to the mistakes of others. This personality-driven approach often identifies with specific hero CEOs or hot money managers. A somewhat over-simplification of their choices is that they believe in participating, if not leading momentum. Everyone recognizes that at any given time there are numerous unknowns that are likely to dramatically impact security prices and trends. If momentum won’t supply the answer, the new money is more likely to divine the right answers. They have more tools, or if you prefer gadgets, than the old money players and this give them an almost insurmountable advantage.

In these stylized cases, both the old money and the new money are making fundamental investment mistakes that others have committed in the past. Old money is betting on repetition, as in history repeats itself. If that was entirely true there would be no progress, as everything would circle back to our beginning point. In truth, history does show an uneven upward bias to the human condition and valuations. What many do not realize is that the upward bias is caused at least in part by the abandonment of failed, or too weak to survive, elements; as well as the pull of some new potential riches. Further progress is made by recognizing mistakes/opportunities. In the “old money” asset allocation example shown above, some wise investors might reallocate their money back to their “normal” portfolio. (There may be a seldom-declared advantage to this tactic: By increasing one’s commitment to a currently depressed area, if successful, the quicker one will get to the upper limit of the allocation causing a cut-back. One of the reasons for the dramatic declines in numerous portfolios last year was their over-investment in what was “hot” was not automatically corrected.)

New money often does not recognize that what is working so well now is very similar to similar beneficiaries of momentum in past market cycles. One of the many lessons coming out of the Great Depression of the 1930s was the peril of the extreme use of leverage or margin in the 1920’s by various utility holding companies, the great Goldman Sachs Trading Company and individual investors. Applying those lessons from the ancient past might have reduced the 2008 losses in various leveraged vehicles.

Both the stereotypical old money investor and the new money investor do not take into their considerations that they may be wrong. Their “system” like those of many disappointed race track bettors, does not contemplate that judgment mistakes are as normal as other accidents. Both set of investors can reduce their odds on big individual mistakes of judgments by using professionally sound funds. (Caveat Emptor: I manage portfolios of funds for institutions and a very limited number of individuals.) One might combine both the old money and new money approaches (using the asset allocation example above), by reweighting the equity portion of the account in favor of growth stocks or funds as momentum appears to be picking up in that direction. Another example of combining the lessons from these two habit patterns is taking the view that in terms of high-quality fixed income, it appears unlikely that interest rates will drop materially and therefore the capital appreciation potential from this particular segment is limited, and thus the commitment to high quality fixed income should be below “normal.”

Which kind of an investor are you old or new?