Monday, August 31, 2009

Searching for Innovations

My muse was resting over the weekend, thus this blog was a bit delayed.

In last week’s blog I was describing the search for meaningful innovation as one of the approaches to find true “growth stocks.” Luckily for me and my investors, I have the ability to frequently discuss scientific breakthroughs with Dr. Philip Neches and other fellow members of the Caltech Board of Trustees. Application of science is another way to find innovations that will change the commercial balance of power. As with many of my ideas, they are not new and often they have been used before in mutual funds around the world. Years ago there was fund which, in theory, invested exclusively in electricity. Initially they invested in electrical power producers and some utilities. As time went on, many of the electrical power producers merged, and utilities became unattractive investments. The portfolio managers broadened the list of acceptable stocks, eventually reaching the conclusion that any company that used electricity was a candidate. While the managers’ conclusion may have been a too wide an application, the principle is the father of my thought process today.

Before I discuss certain applications of technology to everyday experience, I believe it is important to share my views as to why innovation is so important today. In classical economics, one of the rationales for the cyclical nature of economies’ progress is that the declines were to reduce or eliminate the excesses. Though most attention is being paid to leverage as the cause for the current decline, I suggest there were a number of other excesses. Under the cover of rising revenues, numerous companies over-hired. This was understandable, as hiring is always a gamble as to whether the candidate really fits the critical need of the organization. In addition, employee welfare services expanded. In the subsequent decline, a good number of these jobs were eliminated, yet many of the chastened employers now recognize that while they eliminated the jobs, some of the needs remain. This is exactly the type of environment where innovation can, and often needs, to flourish.

Even during the current period of low interest rates (and therefore low float value), extensive work is being conducted on payment systems. This work is impacting securities markets, commercial markets, international markets and markets that individuals use. The drive for all of these efforts is not primarily to capture float, but to improve the collection of credit. (I am told by one of my sons that the difference between a good small bank and one that gets in trouble is the speed its collection system can identify problems.) Since much of the work done in the payment systems world is machine rather human-based, productivity goes up.

One of the more intriguing insights to the payment system world is being practiced by a very large retailer who was denied a banking license, yet is providing a bill payment service for individuals. Many, but not all of the customers for this service are already customers of the store. The essence of a bill paying system is the optimum timing of paying bills. This concept is very sophisticated for people of all wealth strata, but particularly for those who shop in low-end stores. We have known throughout history that some people of limited means are very good money managers. (Hopefully, they will be the next generations’ bankers.) The intriguing question is: Can we get a larger portion of the people with limited resources to become better money managers? If bill paying services open the way, the impact on this country’s long term financial status will be incredibly improved.

Other examples of innovation are the uses of hand-held devices. On a recent trip to visit the wise people in Boston, the woman boarding the plane ahead of me displayed her Blackberry which had her boarding pass on its screen. The attendant used her optical card reader wand and the woman was processed through the gate faster than those of us with computer printed paper. If more passengers could be processed this way, labor would be saved and boarding time reduced. Imagine the benefit when a flight is cancelled and rapid rebooking becomes necessary.

These are just a few examples of innovative applications. We need to find others that can impact publicly traded stocks and fund portfolios. We will probably find these more in small caps and micro caps than in large caps.

Any thoughts?

Sunday, August 23, 2009


As some of you already know, I count the race track as one of the two leading educational institutions in my life. (The United States Marine Corps is the other.) The essence of successful handicapping at the track rests primarily on integrating two important variables. The first is the selective past performance of races, parts of races, and workouts under similar track conditions for each horse in a race. For younger colts and fillies, breeding plays a role in the absence of sufficient race history. The second statistical measure to be integrated is the odds that are currently being quoted or calculated for Win (first), Place (second), and Show (third). These are compared with the handicapper’s own belief as to what the proper odds should be. This way of thinking and intense studying essentially looks for a return to some past result which we consider to be normal. One could say this approach is an exercise in selective extrapolation. I would suggest that this gambling. Gambling that some part of the past will repeat itself.

Examine most of the “sage” comments on today’s economy and markets. (Very little of what I read these days looks forward to a distant time horizon.) The focus is a return to normal or the "new normal." The essential belief is the past foretells the future. A security may be “cheap” because its valuation is below some other point in its history.

The size of the recent declines and the destruction of numerous market mechanisms are perhaps similar to the period in American history between the 1920s up through WW II. In my opinion, we have closed an era of excessive demand without the ability to pay for it.

There is a difference between gambling and speculating. Gambling, as I indicated, is essentially reworking the past to find a difference between the current compared with a selected past. Speculation is looking forward and trying to predict the future.

I recently visited Sacramento’s “Old Town” with my youngest grandsons and their parents. My son pointed to the highest structure, a platform over a merchant’s store, and commented that it was a good example of successful speculation. From his high perch, this enterprising merchant was the first to see the oncoming arrival of a ship coming up the river. My son guessed that the vessel carried merchandise for the town, probably items in short supply. Upon the ship’s arrival, the prices for these items would drop. With this sole knowledge, the merchant could immediately lower the prices of his current merchandise, saving his business from the significantly lower price realizations expected to occur as a result of the ship’s deliveries.

Curiously, I did not see similar viewing platforms in the town. Thus, I concluded the speculation worked more than once. This merchant was following the literal definition of the word’s Latin roots: to look ahead.

While speculating is much more difficult than gambling on various elements of history to repeat itself, the returns on successful speculating are likely to be much greater.

Successful speculation can be a result of the following elements:

  • Changes in demographics in any large consumer market.

  • Major discoveries in the fields of energy or curative medicine.

  • Significant productivity advances in the production, delivery and consumption of goods and services.

  • Technological break-throughs.

  • More effective advertising through old and new media.

Many of these searches/speculations are being carried out by large companies who will benefit from being early. However, the big winners are likely to be smaller, or mid-sized companies.

Unfortunately, I am not seeing portfolios being built on these types of speculations. As analysts, perhaps we need to be spending more time with directors of research, marketing planning staff, and purchasing agents rather than just the financial and investor relations people. In many ways, this was how I used to follow companies. The rewards to investing in these speculations are greater than investing in the general economy.

If any of you see a future trend that is radically different from those of the past, please share them with me. I always appreciate sound examples of fresh thinking for the investment accounts for which I am responsible.

Sunday, August 16, 2009

Possible Implications of Statistical Traps

Many years ago, as junior analyst at a brokerage house, I was assigned the role of writing the firm’s daily market letter. I was determined that I would avoid the tired clichés found in other letters; I would have something valuable to say. My recollection is that my spark of originality was extinguished in ten or less days. In a similar fashion, this Blog challenges me each week to develop some independent thinking that will raise questions as you reach your own thoughts and occasional actions. In preparations for my Sunday afternoon blank page, I read all that I can from various sources. This week I am going to focus on two elements from the Weekly Advisor Alert by US Global Investors of San Antonio, Texas.

One of the preferred ways of analysts and particularly strategists, is to ascertain today’s value, then to determine if today’s prices properly discount future earnings. They use this projection as the denominator of the price/earnings ratio in order to calculate a P/E on future earnings. Once that number is derived it is compared with historic ratios and other current relative choices. The conceit in this calculation is the concept of “normalized” earnings. In this case, normalized earnings are calculated by extrapolating the latest five years of a cyclical expansion and picking the midpoint in the time series, then applying those earnings to today’s prices. On the basis of this analysis, the leading sector within the S&P 500 is Information Technology, with a “normalized P/E of 17.1 times. The second highest is the Materials sector, at 16.8x. The two sectors with lowest aggregate P/Es are Financials, at 11.4x; and Energy at 11.6x. Under this approach, one could argue that those fields where imagination and specific management skills are most valued tend to have higher market valuations than those sectors characterized by cyclical patterns of changing prices (interest rate spreads) where management plays a less determinate role.

The trap in this approach is that it marches forward by looking backwards.

While markets will continue their time series into the future, I believe these series will be marked with footnotes about the severe differences from the past. In many respects, I believe we are passing through dramatic turning points as significant as those experienced in the late 1920s, the 1930s all the way up to1942. The turning points will be found in technology, demographics, psychographics, politics, financial technology and market structure around the world. (Wendell Willkie was correct about global inter-dependencies in his book One World). Disclosure: Mr. Willkie once employed my mother in his political activities.)

Some strategists are raising appropriate questions as to what the “new normal” is. I would like to contribute to their thinking, but my guess is that the best I can do is to sport mutual fund and hedge fund portfolios that look quite different than those of the past, and to position them to creatively participate in the future. Bottom line, Dorothy: We are not back in Kansas.

The second trap is the use of so-called industries in the S&P 500 to make discreet judgments. There are at least four remaining single-stock industries, Heath Care Facilities (Tenet Healthcare), Commercial Printing (RR Donnelly), Building Products (Masco), and Forest Products (Weyerhaeuser). The first two have higher price/earnings ratios than the last two. Most investors would say the rank order of their P/Es is a function of their chosen products, thus if one can find similar companies (either smaller or overseas), these similar companies should have similar P/Es. I would argue that the nature of both their managements and balance sheets may have much to do with their relative ranking. In all four cases, the spreads between the selling prices and the cost of materials these companies buy are large determinants of what they earn. If we go into a period of the “new normal,” the favorable price trends could reverse, with the lower P/E stocks doing materially better than the high ones.

The main messages from today’s blog are:

  • First, understand how data is put together to support any financial discussion.

  • Second, be aware that extrapolation may lose to a “new normal” definition when it appears.

  • Third, recognize that those who have publishing deadlines have their limits; in terms of imagination, willingness to have different views, and the pure inability to predict the future accurately or even interestingly.
  • Sunday, August 9, 2009

    Setting Investment Goals Properly
    Through the Use of Science and Art

    When developing optimum investment plans for individual families, non-profit organizations, retirement plans and similar clients, one must recognize the murky junction of mathematics and art, or if you will, comfort.

    The key to properly setting realistic investment goals is coming to grips with the uncertain future. Gains from most investment portfolios are not the sole goal of the portfolio, but rather as a source of future spending. At the end of the primary investment period, which could be as short as a month or as long as a grantors’ life, there is a desired minimum spending plan. To fund the spending, a minimum capital level needs to be in place. To reach the capital goal compared with today’s resources and future net contributions, if any, a calculation to the rate of capital growth is needed. For example, take the selection of a desired minimum annual return, 4%, 8%, 12%, 16%., etc. The critical question that remains is, how quickly can the capital base for the spending be put into place? There is a helpful tool available. An old arithmetic “rule” holds that the number of years needed to double your money is to divide the rate into 72. Thus at a 4% rate, it would take 18 years (which might be acceptable for an early college savings plan or a conservative after-tax and inflation retirement plan). An 8% return (a rate many retirement plans used prior to 2008) would produce the capital required in only 9 years. In the past, after prolonged market declines, 12%-16% gains have been achieved, reaching their mathematical goals unadjusted for taxes and most importantly, inflation, in 6 and 4 ½ years respectively.

    I have set a trap for the naïve investor and/or administrator who focus only on the rates of return as shown above. There are at least two other factors that need to be considered. The first is an understanding of the importance of the impacts of terminal dates. In the examples briefly described above, one can see that to some degree, the rate of return is heavily influenced by the starting point. In a market that has a long-term secular upward bias (as has been the case for all of our lives), the lower the market level for stocks and higher the level for interest rates, the more likely investment performance will be good.

    Relatively little has been written about the nature of the investment markets at the end of a particular period. I have not seen anything on the probability that, after a period of achieved good performance, poorer performance should be expected from the same portfolio. No one has suggested that if you get 16% over a five or ten year period, go to cash. I do remember one sagacious pension plan that immediately went to 100% cash when they were up 20% in any single year. While the fund had a good year-by-year record, if the 20% gain was achieved early in a year of spectacular gains, it missed out in getting the balance of the gains sufficient to provide a good record in the long run. Considering the operational and financial leverage that is built into the system, a double digit investment record in a period of single digit economic growth will lead to an over-valuation; one should expect periodic declines after periods of large gains.

    One can not express often enough that following a high performance period, one is likely to see a market decline or give-back. As if awareness of future declines is not difficult enough, remember that most investment pools are not entirely or even mostly, date dependent. In rare cases, capital pools are used only to meet a specific date obligation, e.g. pay off a bond/mortgage or pay for a new building all at once. When obligations are specific and/or date-defined, a separate portfolio with its own portfolio and investment strategy may be advisable. (See my blog for August 2, 2009).

    For the moment go to other extreme and think about the spending rates needed to support an entire family on a multiple generation basis, or an endowment to provide meaningful scholarships and fellowships. There is no terminal date for this portfolio until the money runs out. In this case, relative performance may become important. One investment strategy would be to attempt to keep performance rankings in the middle three quintiles, avoiding too heavy a weight in the lower of the three.

    In addition to terminal dates, the second factor that needs to be considered is comfort. The biggest single comfort factor for many is to stay within the bounds of prudence as established by others. This is a concept of being outwardly directed. (Better to go down with others than to rise individually.) Going down is the in the domain of comfort, or more specifically, discomfort. In using an absolute performance filter, the bounces taken along the trajectory of success become very important regardless of expected terminal results. Academics and consultants have developed the use of “Beta” which is a measure of volatility, but has also become critical in providing comfort to nervous investors. There are lots of things wrong with this concept, particularly issues regarding its predictability, the differences between upside and downside beta, and most importantly the choice of the optimum investment vehicle. A valid concern of relying on Beta is that investors will be shepherded into making choices with fewer recorded bounces, reducing the odds of participating with successful managers who make frequent right choices.

    When using relative performance and performance ranking within in a universe of peers, the selection of the appropriate peers becomes critical. This task requires a continuous effort to ensure that similar strategies, commitments, fees/expenses and other vital requirements are sufficiently similar. The “comfort factor” also includes numerous soft items, including name recognition and reputation of the manager, availability of the portfolio manager for in-depth conversations, ease of administration among others.

    Investors spend too little time thinking about their investment objective settings. For most, there is attention focused on these issues at the beginning of the account and/or a significant change in advisor, consultant or important members of an investment committee. When conditions change, a review is often conducted. Under these circumstances, changes that are made are often reactive, based on extrapolation of the existing conditions rather than forward looking.

    Please feel free to comment or to ask me a question on investment goal setting. Click “comments” below this entry, or send me an email reply.

    Sunday, August 2, 2009

    The Art Form of Selection
    for a Portfolio of Funds

    As has been noted on this blog and my book, MONEY WISE, which is about to go into paperback, I believe that each major investment need should have a separate set of investments. The end game for all investing is to produce capital for eventual spending. In many cases, the time frame for charitable institutions and wealthy families is infinite. Investing through mutual funds and hedge funds is not necessarily the best single way to invest, but it is far from the worst. Due to my background of studying funds for the last 50 years or so, funds are the first choice in my investment tool set.

    To accomplish the goal of providing for future spending needs, one is essentially dependent on the current spending rate and the growth of capital as they pass through the filters of inflation and taxes. Like most all other investors, I am predisposed to the term “growth.” One of the ways to grow capital is to invest in growth stocks, often found in growth funds.

    As someone who has probably created more fund classifications than any other individual, I recognize that turning fund classifications into investment objectives was never designed primarily to help in fund selection. The beneficiaries of classifying funds into peer groups include fund portfolio managers, independent directors of fund groups, owners of fund management organizations and the fund marketing systems. In essence, fund classification produces bragging rights. Particularly in the developed world’s competitive focus, ranking against peers becomes the title requirement for ownership of bragging rights. This is exactly where a dichotomy lies between the needs of a fund investor and the above-mentioned beneficiaries of fund classifications’ bragging rights.

    To keep the reward game honest, a set of rules are needed which should be based on empirical evidence. For example, my old organization, now known as Lipper, Inc., defines a growth fund as a fund that has a price/earnings ratio greater than the S&P 500, and a three year average growth rate of sales per share that is above the same broad market indicator. Others use some variation of high price sensitivity and historic trend analysis. Note that all of these measures are backward looking because they are known and are usually not adjusted for post-period recognitions of material differences.

    One of the sound arguments against using any broad market securities index is that you are paying for past successes. Remember the SEC requirement that is meant to go with any performance advertising: that past performance is no guaranty of future performance. As a matter of fact, after prolonged periods of specific progress, the mathematical pull of regression to the mean becomes overpowering. Leaders give up the performance leadership and often become laggards, while laggards become leaders. Usually at some point in a sales pitch for a fund, reliance is placed on the fund classification bragging rights mentioned above.

    Extrapolation is easy, particularly if one sees no imminent signs of major reversals. Instead, I am addicted to anticipation. I think about the uncertain future. I have a preference for managers who are also searching the future to find stocks that do not represent an extrapolation of the past. This is much more difficult. In the mid- 1960’s a very good analyst caught the shift from a cyclical valuation to an expected growth valuation for a, now much smaller, company named General Motors. His market call worked for a while until it became accepted word near its cyclical peak. Think about IBM, which started life with more water in its balance sheet than assets. For many years, IBM was considered a growth company; then it became an income stock and now is a consulting services company. Imagine the problems of keeping IBM within any giving index as a predictor of future price behavior.

    After a long period of declining prices, the best relative performances are held by those funds that exert a tight price discipline and/or have used cash as a significant investment. Many of the best, well known, investors have used this type of “value” oriented approach. For investment needs where the spending rate is high relative to the earnings rate, these price disciplined investments should play a major role. However for some needs (particularly in the early stages of many portfolios), the growth of the long term capital is of greater importance than the annual total return generation. Growth of capital is also a primary driver for many wealthy families, who believe the current level of capital is insufficient to meet future generational and /or philanthropical needs.

    By dividing one’s resources into need-focused portfolios, one may have the best of both worlds (value + growth). Periodic rebalancing between the portfolios should be driven by the changing levels of needs. As the late Sir John Templeton would direct, changes to the individual portfolios should be made on the basis of focusing on better bargains. These bargains can be in future growth stocks or funds.

    The successful selection of future growers is difficult, at best. In my case it is achieved by listening to smart managers that have different points of view based on their own research methods. As noted previously, I am willing to own funds that have different, and in some cases conflicting points of view.

    Do you agree?