Sunday, December 26, 2010

Perspectives Change With Your Viewpoint

Inside Out

I am writing this blog in the midst of the Blizzard of 2010. There is something almost universal in the northern climes of the Northern Hemisphere this year, as snow is disrupting travel plans and family functions in many parts of the US and Europe. At the moment, we are lucky, as all of our loved ones are with us or are snug in the homes of the family. Looking out the window from our well prepared homes, the falling snow has a pleasant and mystical glow about it. Our California grandchildren are visiting us and are thrilled, as this is quite a wondrous sight for them.

The very same gentle snow being whipped around by a significant wind is treacherous to travelers and unfortunately there will be many accidents, perhaps some loss of life. At best, the travelers and the various service people will be delayed and made uncomfortable. Looking at the falling snow, their perspective is very different than that from our comfortable place. Just as the difference from being snug at home versus being out in a blizzard changes one’s perspective of snow, an individual’s investment positions also change one’s view on the various markets being tossed around by the elements of supply and demand.

Which Direction is the Wind Blowing?

As the regular members of this blog community know, I am on record believing that the stock markets will challenge and probably exceed their old highs reached in 2007. I learned a long time ago one should never predict both the magnitude and the timing of a price move at the same time. Further, my initial prediction stated clearly that it is unlikely that the first assault on the old highs will be successful. Just as the size of the snow flakes and the speed and direction of the wind are important nuances in understanding the ultimate size of the snowfall and when it is likely to end, there are now nuances that are affecting my earlier market prediction.

The first concern is directed at the likelihood of a strong, sustained surge in the various stock markets. With each new bullish pronouncement by various pundits, the odds decrease on a quick 20%+ move. In the weather sense, all of these talking head comments create a vortex; they are chasing their own tails without providing much in the way of forward movement. They are successful in moving the snow from one snow bank to another, but not moving the storm out of the vicinity.

My second concern is continuing to follow the Barron’s Confidence Index. The index measures the ratio of the yields of high quality bonds to those of intermediate quality. When the index rises it is predicting with some degree of accuracy a rising stock market. Most of the time the index is flat with movement limited to a portion of a single basis point. While any week (and particularly a holiday-shortened week) can be an aberration, the recent decline of 1.4 makes me question the likely near term upward move of the market.

Are New Snow Plows Needed?

The final successful assault on an old high is often led by fresh troops, or if you will, leaders. As portfolios now contain domestic stocks that are not found within the lists of 30 (DJIA), 500 (S&P500) or 3000 (Russell), I tend to use the widest available list encapsulated in the Vanguard Total Stock Market Index fund. A large number of funds are beating this indicator as we are coming to the close of 2010, according to my old firm, now known as Lipper, Inc. According to its December 23d report, and focusing on each of the 20 US Diversified Equity fund averages, eight groups were superior to the higher standard of the total stock market index. (Ten investment objective fund averages gained more than that of the narrower S&P 500. The average Diversified Equity fund also beat the 500.) Perhaps more significantly, of the 20 sector categories, half were better. Normally new index highs are led by an over-weighted concentration of investments in the index. We may be slowly marshalling the strength of the leadership needed to breach the resistance likely to be found at the old high points.

Each week we look at the performance of the 25 largest SEC registered mutual funds. Using the same benchmark as we did above, only SPDR Gold fund gained more this year. As these 25 funds were the largest, they were the leaders of the fund business. Over the last five years 15 out of the 25 produced better results than the broadest measure. Following military tactics as I learned them, the final assault will rely on the big guns.

Currently, Small Capitalization Beats Large Capitalization

In looking at this year’s performance, it was the relative size of the market capitalization in the portfolios that led to the better performers. The best performers were the small caps, closely followed by the mid-caps and further down the line the multi-caps. On average, all three of the large cap categories, (growth, core and value) underperformed. The chances of a successful breach of the resistance at the former highs will, in my opinion, rest on large cap performance. In particular, leadership by large cap growth funds would set the tone for the sustained optimism required to bring most investors out of their snug homes.

In the Meantime

During market declines investors often make lists of stocks with attractive buy prices. My guess is that seldom do these lists get fully utilized. However, the technique can be applied now, probably with good effect. Many of us have portfolios embedded with significant unrealized capital gains. As mine do, these portfolios have a few or more holdings that are currently being held at a loss relative to purchase price. In general, I believe one’s entry level into a position is a historic accident when viewing future transactions. However, if you choose to continue to hold a losing position after a year of generally rising stock prices, you must believe that the loser will morph into a butterfly and fly up to the sky. If that is your view (or your handcuff), before year-end you should buy more of the loser. Next year you can choose to reduce your position after 31 days and lower your entry cost. I suspect that as we mount our move to higher levels, the sustained loss will have value to offset new gains. If you are not willing to buy more of an investment, particularly a losing one, shouldn’t you free up your capital for better uses?

These are my thoughts during the Blizzard of 2010.

May 2011 bring to you every bit of happiness you desire.
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Sunday, December 19, 2010

Immediate Reactions + Investment Implications of Tax Changes and Spending Surges

Tax Fight Bruises and Long Term Wounds

Most of the financially literate world has heard the news of the hard fought battle to temporarily maintain the current level of US income and estate taxes. The legislative battle itself has had two long term drawbacks. The first is the emphasis on planning instability. People’s plans for housing, school expenditures, charitable gifts, estate planning and most important of all, business investments, are potentially going to be changed. The memories of the this battle will be refreshed next year on some individual wage earners and business spending decisions. There is no reason to believe that we will quickly get more permanent tax resolutions in two years, in the midst of a presidential campaign. The lack of clear, understandable conditions is likely to retard some long term spending decisions, including job creation.

The second drawback is the absence of dynamic budgeting which would include factoring changes in people’s actions in light of the revisions of taxes.

Fixed Income Investors Discount Their Future

I have tremendous respect for the bond market though I am primary an equity-focused manager of long term accounts. In general, high quality fixed income securities have less normal upside than stocks and other forms of equity and downsides that can approach normal, but not crisis stock declines. The leading bond market players have a much more acute sense of timing and direction than those of us that follow the dreams embedded in many stocks. This week I noticed that the spread between the ten year Treasuries and the ten year TIPS (Treasury Inflation Protected Securities) has widened to over 2.3%, which is significantly higher than the readings this summer before the mid-August announcement of QE2, (the Federal Reserve’s second round of Quantitative Easing). Further, over the last several weeks the Barron’s Confidence Index has been rising close to one basis point each week. This indicator is the ratio of the yields of high grade bonds divided by intermediate bond yields. Normally, a rise in the ratio is viewed as positive for stocks. I interpret the reason a rising index is favorable for stocks over bonds is that inflation is rising, which hurts the purchasing power of bond interest and maturity payments versus the possibility of dividend increases for stocks. Bond investors translating this data see rising inflation.

ETF Flows also an Indicator

Exchange traded funds (ETFs) have attracted a much more active investor than mutual funds and most stocks. The table below shows the dramatic change of the flows from October to November, 2010:

Invest. Objective Nov. Flows Oct. Flows
in US$ billions
Dedicated Short Biased - 0.83 +0.26
S&P 500 - 2.09 -0.83
Emerging Markets +1.40 +6.46
Latin American +0.18 +1.62
Commodities +0.89 -0.36

Source: Lipper, Inc.

To me these flows indicate that the fast (and perhaps smart) money is betting on material changes in the stock market’s leadership and is expecting more speculative behavior.

The High End Consumer is Reacting

Long term members of this blog community know that I often use my observations of shoppers at The Mall of Short Hills as a clue to consumer behavior. Today, Sunday there was a considerable line to get into the large parking structures at the Mall. While initially slow to react the first level of discounts, my sense is that the high end buyer is now in a rush to spend money.

There is Too Much Evidence

Last week’s blog , “Market Highs Coming?” advanced the view that at some point we could challenge and eventually surpass the old stock market highs. Since penning those thoughts the combination of various market pundits’ views, seeing the shopping lines and hearing of the more impressive cyber shopping is making me a bit uncomfortable. I do not like to spend too much time with the majority of other people’s thoughts. However, I am a bit relieved that the relatively low volume of market activity indicates that while the talk is bullish, the actions are slower.

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Sunday, December 12, 2010

Market Highs Coming?

I will probably regret posting this blog, like the baseball pitcher who serves up the winning fat pitch to the home run slugger. I should explain to the increasing number of international members of this blog community my theory that most sports victory is achieved at least in part by the mistakes of the loser.

In the future I can envision that the US stock market rises to at least the level of the former highs in 2007. The first assault on these former peak prices will probably not succeed and could cause casualties in a subsequent push back. Nevertheless, I have confidence that the task will be accomplished. (Perhaps I am too heavily influenced by my US Marine Corp focus on achieving victory.)


Most investors generally accept that on balance the bottom of the US stock market was hit in the first quarter of 2009. Many date the bottom as of March 9, 2009. For the next twelve months we had a substantial recovery, with some portfolios gaining 100% in a year. From April to mid-August there was a period of indigestion until a rather slow rise got underway. Today most observers have a feel that the gains in 2010 are about 9%. Many casual observers do not recognize that through December 9th, the S&P 500 is up about 12.7% and a broader measure, the Vanguard Total Stock Market Index fund, has a 14.6% gain.

Actually there are many investment objective fund classifications that are demonstrating way above average results according to data from old firm now known as Lipper, Inc. As a matter of fact, the average US Diversified Equity fund is showing gains of 15.1%. Within this group there are two different types of funds that somewhat mirror the activities of hedge funds. The leaders of the approximately 8000 US Diversified Equity group are the Diversified Leveraged funds with a gain of 30.8% on average. The laggard and the only group to show negative results were the Dedicated Short Biased funds which sank -28.4%. Within the diversified equity league there were six separate groups which on average were up more than 20%. There were an additional six fund classifications gaining more than 20%, led by the Precious Metal funds’ average gain of 40.9%. (The results above are for the period December 31, 2009 through December 9, 2010.)

I am not predicting that these gains will be sustained in the remaining weeks of this year or repeat in similar fashion next year. What I am highlighting is that in a period of dour economic and political headlines, with two wars underway deploying US troops plus other high level geo-political tensions, funds can gain 15-20%. I wonder what kind of gains we might see in a year when the news is viewed as favorable?

The Artillery

Recently the big guns in the brokerage business have started pounding away with their increasingly bullish pronouncements. Three of the biggest on the institutional side, Goldman Sachs, JP Morgan (who is acting more and more like a broker), and Barclays (exorcising Lehman’s ghost) are seeing positives for the year ahead. Interestingly, at this point the firms that are heavily focused on retail customers have not been leaders in the bombardment.

The Troops

According to one survey, well over half of the investment advisers are bullish. The best single stock market technician that I know personally is very bullish for the next six months or so and his accounts are positioned accordingly.

The Timing

Often, but not always, the US market does pay attention to the so called “presidential cycle.” According to many market adherents, the best markets often occur in the third year of a president’s term. There is less power if the president is in his (and some day her) second term.


We manage a number of different accounts, with each one having its own policy. Considering my generally bullish attitude, I am in the rather embarrassing situation of redeeming fund shares in two retirement accounts under management. At equity commitments of 77%, these accounts were above their equity allocation policy levels due to good performance, thus had to be reduced.

Caveat of All Caveats

I can not successfully predict the future. Certainly we are prone to unscripted surprises; just think about the known and the unknown geo-political risks. Therefore, please be particularly prudent when swinging at my fat pitch of an undated new high on the US market.
To Members of Mike Lipper's Blog Community:

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Sunday, December 5, 2010

Black Friday Buys and Bond Fund Sells

A number of members of this blog community were disappointed that I did not comment on this year’s “Black Friday” shopping. Worse, they felt that this absence was an economic indicator of a decline in my family’s gift trove. I plead guilty to disappointing some of our blog community. Perhaps more importantly, I plead guilty of observing without analyzing. What I saw on Black Friday and reinforced again on visits later that weekend, were unimpressive crowds carrying fairly few shopping bags, mostly from a promotionally-oriented department store. The only two stores that had crowd control lines were Apple, which was jammed and GameStop, an electronic game shop. I found these observations unremarkable and so, dear reader, I did not comment on them. Your concern forced me to dig deeper for my observations and to come up with useful analytical comments.


What I should have focused on was the large number of people who were clearly looking, but not buying. But they did buy on Monday over the Internet, as online shopping on “Cyber Monday” was a record. Evidently some of the lookers returned this weekend, as there were lines at various cash registers. As shopping has become a varsity sport, I should have focused on how the playing strategies of the buyers and the stores would engage. The shoppers were determining the beginning price levels and the availability of merchandise. The merchants were timing their price discount moves. Evidently on the second major shopping weekend, to use a securities market term, clearing prices were reached before last minute frenzy price activity, which comes later. (We know a number of executives that run into their friends on December 24th each year when they are attempting to fill the fondest merchandise desires of their spouses or significant others.) Some of the stores were up to their game mode, but others discouragingly were not. At a visit to a downscale mall’s old chain store in search of a particular home tool, one had to search for a sales person (who turned out to be an order clerk rather than a sales communicator) and the experience proved to be disappointing. Later, the particular item was found in stock in a more exurban location.

The Analytical Summary

Under current tense economic conditions the terms of trade-price, availability and service are critically important to making a sale. In their own way buyers are every bit as knowledgeable as the sellers. True merchants are in shorter supply than in the past as many family-owned stores have disappeared. These are the lessons to be learned from looking deeper as to actions and more importantly, the lack of actions.

Carrying Over the Lessons to the Investment World:
Bond Fund Buyers are A.W.O.L

AWOL is a military term meaning absent without leave, which covers the situation when a serviceman or woman is absent without permission or explanation. Over the last several weeks the prodigious flow of money into bond mutual funds has slowed materially and perhaps in some cases reversed. This phenomenon extends beyond the tax exempt funds which could be attributed to the finally recognized deterioration of the status of some government bodies’ ability to meet future payments. The slowdown is occurring in the larger taxable side even though its small yields are still higher than yields on cash instruments, which suggests a structural change is likely occurring. What is happening, I believe, is the recognition that inflation is being built into the after-tax spendable returns.

The Clue

As essentially an equity-oriented asset manager, I have learned to have great respect for the bond market. Often it is more sensitive to underlying economic changes. For a number of our accounts we have used Treasury Inflation Protected Securities (TIPS) to identify an inflation risk. One of the factors that I use to reach these conclusions is the spread between the yields on the ten year US Treasury and the ten year TIPS issues. For some time this spread has been below 2.2%. This week the spread widened to 2.24%, the highest it has been in awhile.(Historically the spread has been above 3%.) The spread widened, not primarily because the Treasury yield went up, but because the yield on the TIPS issue declined to 0.77%. While this has been good for my accounts because a decline in bond yields means that bond prices rose, this increasing recognition of rising inflation is troubling. The rise in inflationary expectations is being manipulated by the Federal Reserve and confirmed by many commodity prices, e.g. oil at $89.

Portfolio Implications

Buyers will buy at attractive prices and are focused on their after tax spending power. Thus, get out of all of your “high quality” long term bonds and bond funds. One may choose equities and equity funds focused on natural resources and unit growth with favorable pricing capabilities. However, harking back to last week’s blog, be aware we are at risk to unhedged problems from China.

One should always observe what is going on, but should also analyze the implications and quickly recognize and accept occasional wrong guesses.

To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, November 28, 2010

Can China Be Hedged?

There is a difference between people and markets. While both have histories, they are portrayed differently. The experience of people is recorded with lots of emotions, thought processes and personalities. We record market movements whether they are for securities, commodities, real estate or objets d’art in two dimensions, up or down. I believe the study of both are essential for any successful investor. However, the study of people should serve as alerts to those who focus on the history of markets.

Calamities Travel

Once in a while the single tree falling in a forest or an insect flapping her wings could be the start of a world-wide calamity. There are two relatively recent examples that I saw early, but did not fully comprehend until much later, to my accounts’ disadvantage. The first was the collapse of a Greenwich, Connecticut based hedge fund firm called Long Term Capital Management (LTCM). Actually before the founding of LTCM, I was exposed to one of its widely proclaimed “geniuses.” This learned academic gentleman believed that market-based statistics could be used to predict future market prices. He was correct in many instances, but not in each and every instance. He and his associates applied their mathematical skills to foreign treasury instruments with considerable leverage. They were totally “blindsided” when the Russians defaulted on their treasury issues. My mistake was I did not fully understand the implications of this collapse, after all none of my accounts were exposed to Russian paper. Initially I missed two knock on relationships. The first was the contagion effect. LTCM and other leveraged players (more on this shortly) needed to quickly restore their capital base. They quickly sold their other emerging market positions. (I did not foresee how a Russian default would be the cause of Mexican market decline.)

The second relationship, or if you prefer the second order problem that I missed, was the nature of the trading community. LTCM was one of the largest customers of many fixed income trading desks on “The Street.” Initially these desks merely filled the order of their customer rapidly, perhaps in some cases they sold short the securities as part of filling the order. Soon they saw how successful LTCM was and they followed its trading patterns and in some cases put money into LTCM’s funds. The size of these actual or potential losses would have been very large for the trading community if all of The Street’s trading positions had to be liquidated quickly when LTCM problems became known. Unlike the more recent cases of Bear Stearns and Merrill Lynch, the government recognized the problem early, but the Fed did not ride to the rescue of LTCM with saddle bags full of money. The Federal Reserve Bank of New York convened a meeting of all the principal players including a very reluctant Bear Stearns and would not let the participants out of the meeting until they agreed to loan enough money to LTCM so it could be prudently liquidated. Thus Wall Street was saved from its own potential collapse. (In this instance the FRB of New York played the role of J.P. Morgan when he helped end the “Money Panic of 1907,” before the Federal Reserve was created.) Thus, the tree falling in Moscow almost took down the entire trading market in the US and probably elsewhere as well.

The Sub Prime Calamity

While I recognized that far too many people were speculating in real estate and that amateurs often lose to professionals in the market place, I did not appreciate who the real losers would be. (The providers of credit all the way along the line were the losers.) Initially, people began writing about the ballooning sub prime and the “Alt A” mortgages and that they would lead to bankruptcies and a slowdown on the building of new homes. While this was serious, at the time it was not of monumental importance, as new house construction is a small part of our expanding economy. Once again I was not sufficiently conscious of significant changes and how the market place was operating. I did not fully comprehend that the major investment banking houses had become the center of the mortgage origination casino to feed their securitization sales forces. This process was replicated in the UK, Australia, and elsewhere and the resulting production of mortgage slices were owned throughout the world, including places as distant as Norway and China. While in the case of LTCM the infusion of leverage was at the so-called professional level, at almost every stage of the housing chain leverage was induced so there were many more losers, including those living on fixed income from these mortgage tranches. When the various governments started to get inklings as to the size of the looming debt on the way to non-payment status, the governments rode to the rescue to save at least their financial communities, if not their economies. (We can debate whether the rescue attempt was ham-handed and whether the private sector should have been let to sort out the problem, as Mr. Morgan forced in 1907.)

Is China A Potential Calamity?

Recently I spent time thinking about conventional asset allocation strategies. In almost all cases, institutions are attempting to broadly diversify their assets. Often the categories they use are as follows:

  • emerging market equity and debt
  • developed market equity and debt
  • domestic equity and debt
  • commodities including timber
  • domestic and foreign real estate

My unanswered concern is that these diversification attempts are making a common bet and therefore do not have the diversification against a major risk, which suggests there exists a potential for a major dislocation. All of these classes are exposed to China in one way or another. Most emerging markets are increasing their trade with China. General Motors sells more cars in China than the US. Proctor & Gamble, Coca Cola, Microsoft and soon Apple, have important sales and/or facilities in China. “The Middle Kingdom” is the swing buyer or seller of most non-agricultural commodities in the world. Almost all bonds are priced in relationship to US Treasury issues of similar maturities. The Chinese convert much of their trade surplus with the US into the purchase of US bonds, which helps to absorb our increasing deficits. A significant slowdown in China’s purchases, let alone its absence from the market, could send most bond prices down around the world.

I am not an expert on China. I have a great deal of respect for its economic leadership so far. Perhaps these “experts” will continue to manage the population’s needs and desires as they have done in the past, but each year it becomes more difficult. China has replaced the US as the locomotive for global growth. This is not a prediction but an observation that at some point it is conceivable that the engine will perceptively slow down or even temporarily go off its planned track. With so much of the world dependent on the continued growth of the Chinese economy, a slight flicker or a rumor of an unexpected result could cause all markets to react.

How Does One Hedge The Chinese Risk?

Granted we don’t know for sure that there is such a risk, but we should have learned from the LTCM and sub prime examples that calamities can happen. As a professional investor I would like to identify a satisfactory hedge against the possibility of a Chinese calamity. I would like to do this on two counts. First, I am in the market for some insurance. Second, if there was a recognized hedge, its price action could be a clue to a the current market’s perception of the risk.

I have reviewed all of the current asset allocation categories and have found to varying degrees each is dependent on developments within China. At the moment I can not find an independent hedge. Perhaps you will share your thoughts with me on such a hedge or at least your leading indicator of Chinese problems.

To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, November 21, 2010

Have We Created New Fiduciary Standards?

I am fortunate to be a member of various non-profit investment committees along with a number of very keen investors. In these settings we are able to share our experiences and relevant readings. I hope that this blog community benefits from these associations. An off-setting disadvantage is that perhaps I read too much.

This week I read an excellent review by the renowned law firm Milbank, Tweed, Hadley & McCloy on the enactment by the State of New York of the “Prudent Management of Institutional Funds Act.” All too often laws and regulations have the impact of lowering the investment returns of sophisticated investment institutions. This is not the case this time, at least through my interpretation of the fine Milbank Tweed article.


Diversification or “diworsification” as it is known in some circles, is addressed intelligently in the new regulation. The law appears to require a written investment policy statement to demonstrate compliance with the diversification directive unless the institution determines that it would be better served without diversification. If the institution deems that it would be better served without diversification, that policy needs to be affirmed each year. Mathematically oriented investors might point to the anomaly that if one could find the single best investment, adding a second investment (which by definition would not be as good as the first) would lower the average investment return.

The uncertainty of determining the best possible return suggests that a number of alternatives could improve the potential return over a single investment. For some institutions a thorny issue may be encountered when an over-sized position occurs due to an extra large gift of a security or perhaps more intriguing, a stock position that disrupts diversification due to its way above average performance and expected future growth. Thus, there may be a conflict between diversification and expected benefit to the institution. As an investment advisor as well as a member of various investment committees, I believe the mere fact that the issue of diversification should be regularly reviewed is a breath of fresh air.

The act, and there are similar acts in most states, does not define diversification. In the past, the laws governing investment relied on the 1830 dictate of Judge Putnam, deciding against Harvard College as to what was required to be considered prudent. In effect, he created the whole performance measurement sub-industry that clearly benefited me and perhaps investors, by requiring the prudent investor do those things that other intelligent and prudent investors do with their own money. The recently enacted New York State law appears to define “prudent” as actions that consider eight factors without specific reliance on what others are doing. Thus, trustees need to make their own decisions as to what prudence requires without necessarily being led by others. In many ways this may liberate investors from slavishly following the current popular policies, e.g. emerging markets, private placements or ETFs. At the same time, this freedom is frightening to the less-knowledgeable investment committees. In determining the prudence required, some institutions may want to review the makeup of their investment committees and/or consider the addition of one or more external investment advisors.

The role of each investment

The act, or at least Milbank Tweed’s interpretation, appears to drill down to the individual security position. Apparently each position has to be an integral part of the portfolio. Portfolios can no longer be a mere collection of assets without relation to one another. From my viewpoint, this focus can be extremely useful in the long run. All too often a security that is down in price significantly is an immediate candidate for sale for many investment committees. I believe that all positions should be reviewed for their potential to add, or in the case of down markets, stabilize the future value of the portfolio. One of the ways I and others build portfolios is to include investments that are likely to do well under a certain investment climate. Almost by definition some or all of these “hedges” will do poorly under other market phases. When they do poorly I am reluctant to remove them if I still consider that there is a reasonable chance that the investment wind will shift in their direction. I get extremely nervous when all the securities in appropriately balanced portfolios are going in one direction. At a recent client meeting, I commented that all of our fund investments were producing positive returns for the first ten months of the year, and that I was nervous as there were no losers. In the future this would unlikely be the case.

Spending rate

Perhaps the most significant element in the article is the following quote: “….spending in excess of 7% of the fair market value of a fund (calculated based on quarterly estimates averaged over a five year period) will be presumed imprudent, which presumption may be rebutted.”

There are several important elements to the quote. The first is the identification of an imprudent level. Second, the use of a twenty quarter average return. Third, that the imprudence contention can be rebutted. That the law (or at least Milbank Tweed) is, in effect, rate-setting, goes beyond the normal principles-based regulation. (I find it perhaps ironic that the level chosen is one percent above the old impermissible level of usury at six percent.) The rate chosen is below numerous pension assumptions, thus could be a cause of concern in the business and labor communities.

The suggestion of a five year rolling quarterly measurement device is a step in the right direction. In the institutional community, three years is the most popular measurement period. The cynic in me believes that three years is the shortest period that many consultants use to urge the replacement of a manager and the initiation of another fee generating search. The analyst in me objects to using three years, as often the market can move in one direction for the entire period, which is not representative of longer periods. The SEC appears to agree with me in requiring performance calculations within fund prospectuses to include one, five and ten years along with since-inception reporting. Market historians and at least one major investment management group have found that the best single fit to the statistics is four years. I suspect in part this works because of the US presidential election cycle that some market pundits use.

What is refreshing is while the lawyers have gotten deep into the weeds of setting investment policies, they have accepted that these views can be rebutted successfully.


As investors and investment managers, we must be aware of changes that lawyers and regulators force on the artform of investing. In the case of the Prudent Management of Institutional Funds Act, some of the clarifications are positive and far reaching. As fiduciaries, all involved are going to be held to a higher standard of prudence not just copying what others are doing.

What are your views?
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, November 14, 2010

A More Insightful Way to Characterize Funds

Guilty As Charged

I plead guilty. I plead guilty for the crime of characterizing mutual funds and their kissing cousins, hedge funds by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out. We choose to identify people by what they look like, not what they are, or more significantly how they think. I should have known better. I forgot my race track education of calculating my betting choices after examining the characteristics of the jockey, trainer, and breeding as well as the conditions of the race and the racetrack. Shame on me.

The Talents of the Trade

Each of us has a different collection of talents. I have made a living analyzing a mass of data, organizing the data for decision making, and using that data for making decisions applying the disciplines that I learned from my educational institutions, the US Marine Corps and the aforementioned racetracks. I should have looked at the primary thought patterns of the principal decision maker for each fund. Most of the time this is the portfolio manager, but it can be the most forcible member of the investment committee, a determined marketer, or extremely rarely, the fund’s board of directors. The following are some of the ways that I identify the dominant personality of a fund and how the fund can be used most effectively in a portfolio of funds. (I manage or advise on the use of funds in a multi-fund portfolio where each fund has a separate function in contributing to the whole over the long-term.)

The Discoverer

This portfolio is full of names that are not common to most other portfolios. More often than not these names are of smaller, often newer companies. Sometimes the names are from rarely explored foreign markets. Occasionally the names are different types of securities which more often than not come from the extremes of the fixed income world. All of these securities lack significant research coverage from the usual sources of research. As an analyst I used to delight in finding companies whose president has not talked to an analyst in years. As he or she explained the company to me, I explained how analysts like me operated. Some of the most rewarding investments were in companies that had a policy of not speaking to analysts. In almost all cases the names in a Discoverer’s portfolio are difficult to analyze. When these stocks move, it is usually not due to an asset class’s popularity or the general trend of the market. Most often a Discoverer will have more strike outs than home runs. The investment results will look more like those of a venture capital portfolio, but have the advantage of offering daily liquidity. In the hands of someone with a great deal of industrial experience and a proclivity in recognizing management’s abilities, this kind of investing can be rewarding for the truly long term investor. Wealthy individuals who have a multi-generational outlook or a structured endowment for long term horizons can find a Discoverer a non-political “fellow traveler” and a good strategic fit.

The Anticipator

I use to hear this term used more frequently than now. The term was applied to managers who felt they had well-defined skills at anticipating major interest rate moves. There is still at least one fund that invests either in very short term treasuries or thirty year treasury bonds. The Anticipator has a defined view of the future and is waiting for the rest of the investing community to catch up. The trick for a successful Anticipator is not to be the first Anticipator but near to the last, just before the take off of the expected trend. At times, Bill Gross and others at PIMCO are Anticipators. To some degree this a necessity, due to its size relative to the size of the available merchandise at an inflection point. This may be a requirement for PIMCO as the world’s largest bond fund manager. Some patience is required to be a successful holder of a fund that anticipates. One can appropriately call my faith in the benefits of technology as anticipatory and not often rewarded.

The Immediate Reactor

The financial press believes that the market is full of those traders/investors who immediately react to a bit of news. They are looking for the proverbial one-handed economist who has a singular view on an event. Even the rapid-fire “macro” hedge funds don’t put their money on a single roll of the dice. Most often a substantial buy is offset by a sale or short sale, perhaps through derivatives or ETFs. Nevertheless, the Immediate Reactor does make dramatic moves quickly. The closing of the liquidity pool around a security or currency is viewed as an opportunity to get in before the bulk of the move is underway. Funds that do react well have suburb trading skills and they know how to use their size to get the best advantage. In many ways these are trading artists. Outside of occasional outsized gains, these funds can be used as an early warning device, a canary in a mine if you will.

Trend Identifier

These managers are constantly searching for minor deviations from immediate past experiences; to be one of the earlier identifiers of a change in an investible trend. For example, these trends can focus on elements of consumer spending at various price points, the popularity of products ( e.g. Blackberries and iPads), or the daily movement of a currency. In the fund arena, the rate of inflows and redemptions can be interpreted as meaningful trends. Often large funds use identification of trends to shift a small amount of their portfolio in the direction of the trend on a daily basis and more as the trend becomes more pronounced.

Trend Follower

Some managers, particularly in the commodities world, are Trend Followers. They need to separate market volatility from important market trends. These stock, bond, and commodity managers focus on large aggregates in the market place. A more modern example of this age-old technique is the use of Exchange Traded Funds. Currently there are portfolios that only own ETFs or Exchange Traded Notes (ETNs), a fixed income equivalent. Increasingly these portfolios are being used for commodities like gold and silver. Trend Followers have more faith that the trend will continue for some period of time than recent history suggests. Also aggregate trends do not allow for the investment opportunity differences among various industries, sectors and other components of the aggregates. If one does not have much faith in individual selection skills and the direction of “the market” becomes all important, Trend Following is an attractive approach.

The Resurrection Believers in Recovering Prices

As all life seems to be cyclical in terms of up and down phases, hopefully around a recognizable trend, some managers look at investments that are currently priced well below their peak levels. Excluding from this universe those stocks that were substantially over-priced given their best expectations, the resulting list of large discounts from peak can be a happy hunting ground for some investors. These investors are different from value investors who believe that today’s price represents a good value relative to today’s reality. Those that believe in recoveries believe that conditions will change. Whatever caused the unfavorable conditions, e.g. commodity prices, unpopular styles or product failures, will change. The argument goes something like this: if oil was priced at either $150 or $36 a barrel, certain properties would be perceived to be more valuable. Another variant of this strategy is when the new production comes on line, such and such will happen that will significantly change the valuation of a security. This may be considered as betting on the return of the Black Swan from Australia. History is on the side of those who believe in cycles of prices and other forms of human behavior. What is more difficult is identifying which particular cycle will change the soonest. To some degree distressed securities buyers believe in a form of financial resurrection.

Final Note

To be a good investor, one needs to know more about the intellectual motivations behind various portfolios.

To Members of Mike Lipper's Blog Community:

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Sunday, November 7, 2010

Risk Identification is More Important Than Volatility

Up Markets Cause Change in Sales Pitches

Notice how quickly the commentary from numerous money managers has shifted away from quoting so-called “risk adjusted performance.” This shift is a clear sign of two different stances. The first is after seven or eight weeks of rising stock prices, many are identifying the current surge as a rising market. Because we have not topped the historic highs of 2007, few are calling this a new bull market. But they are directing their attention almost exclusively to rising rather than falling prices for stocks and bonds in most markets around the world. From a market standpoint it is almost like shouting, “The king (of the bear market) is dead. Long live the new king (of not yet the bull market).”

Intellectual Dishonesty or “They Should Have Known Better”

To me, the second stance that becomes evident from the dropping of the risk adjusted handle is intellectual dishonesty. This strong statement indicts not only many managers but also their marketing people and many academics. The fallacy started in academia, as finance and investment teachers with their reliance on mathematical formulas wanted to balance potential rewards with potential risks. The problem is that risk is the uncertainty of loss. In their 50 minute lesson-plan world they latched on to the volatility of price movements over a rolling 36 month period. If a stock or a fund had a wider than “normal” variance to the trend of prices or adjusted net asset values it was deemed to be more risky than one that hugged the central tendency line more closely. Thus, index funds are by nature less risky than actively managed aggressive funds. The practice started of adjusting absolute returns by these volatility factors to develop “risk adjusted returns.” These numbers appealed to various consultants and other gate-keepers because they generated a selection screen that eliminated the wild performers. The problem with these exercises is that they had nothing to do with actual risk. The purveyors of these numbers knew or should have known that risk adjusted results had nothing to do with real world risks.

What is Risk?

From an investor's viewpoint, risk is the penalty for being wrong in the future. To me as an investor, investment advisor, and a member or chair of non-profit investment committees, risk is the inability to pay for planned and vital expenditures. In the real world risk is different for each account. For some Ultra High Net Worth investors, risk is all about running out of funds for the fourth generation or the new wing to the hospital (which is likely to be one’s last used medical facility).

There Are Two Risks

In assessing the elements of risk identified above, there are really two risks. The first (and of paramount importance) is running out of cash to accomplish the critical mission. The fourth generation will have to become working stiffs (which could be a good thing compared to their third generation parents); or the new wing will be delayed until other sources of funding are secured; or the hospital or university will be forced to scale back, merge, or close. (Perhaps if the potential patients or students won’t support the expansion, once again the wisdom of the marketplace could be correct compared with a donor’s wishes.) The second risk is not running out of funding, but the more likely outcome of not earning a high enough rate of return to accomplish the planned goal in a timely fashion.

Managing Both Risks on a Time Horizon

The simplest way to handle the risks is to have the investment side control the granting side. One of the foundations that we have managed money for years has largely limited its grants to other charities to the capital earned by the charity in the prior year. Politically that is not how most pots of money are run. In reality, the operating or granting side determines what it wants and the investment side concurs if the spending rate is reasonable in light of the time horizon of its mandates. Most wealthy families or endowments believe that their responsibilities are never ending thus they see their funds need to remain in place forever. Others actually plan (or would allow themselves) to, in effect, die. This extreme, and perhaps irresponsible attitude can be summed up as “expending the last dollar with the last breath.”

A further constraint on managing the twin risks is the importance of planning the time horizon. Actually the addition of a time horizon can make it easier to manage risks.

My Approaches

With a great deal of conversation and work with clients, and even more with investment committees, I try to attach to each planning goal time to completely identify the goal with the client. Even more difficult is to array the various goals in some sort of priority setting. The next step is to determine whether the client wishes to intellectually fund each goal until the capital runs out. In setting the investment returns for each of the goal-oriented portfolios (assuming that the intention is to have the capital last forever), I use the following rules of thumb:

  • If the account is a tax exempt account, a payout ratio of total return income to capital of 4% is reasonable.

  • For a taxable account, a maximum payout ratio might be 3%. In both cases I would reduce the ratios if long-term inflation is expected to be higher than these ratios.

  • For accounts with a limited life or if the account was a beneficiary of new cash flow, somewhat higher spending ratios would be appropriate as long as the net cash flow continues.

  • For investments in equities, whether in the form of individual stocks, funds, private equity or hedge funds, I would expect over time the returns would be between 50% and 75% of the net cash generated by taxable entities.

  • In terms of fixed income, on the very highest-quality paper, yields to maturity might be appropriate if the account could hold the paper until maturity. More specific fixed income approaches are very much account dependent.

Social Media

I urge the members of this blog community to share with me your use of social media.Would it be helpful to you if I used a particular social media outlet for shorter thoughts, perhaps at different time intervals?

I want to stay current with my grandchildren, grandnieces and grandnephews as eventually they will become the clients that will benefit from my work.

To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, October 31, 2010

Risk Reduction is Risky in the Long-Term

We can and should learn from every day of our lives. For those of us that are addicted to the securities markets, non-holiday weekdays are our primary classes. The markets of 2006 through 2010 were extremely difficult for all of the students and quite a number failed to finish. One might call these years a master class. However, very few of my fellow students could be awarded a Master’s Degree for the investment progress they achieved. The reason for the lack of success was not that the period did not offer ample opportunities to achieve some large gains as well as some startling losses, but it was difficult to link the periods where the net results were positive for those invested in equities.

Shorting successfully is difficult over time

The intellectual foundation of hedging initially is that carefully chosen securities will go down more than equally carefully selected securities would go up, so that the net result should be to preserve the larger gains of one’s purchases. The truth in the matter is that shorting is difficult to do well over long periods of time. An examination of various shorting approaches will identify the problems that might occur.

Sell the Frauds and the Fads

Until tried in a competent court of law, (and perhaps not even then) it is difficult to have absolute certainty from the outside that some action is clearly fraudulent. Even with the best forensic accounting practices applied to public financial statements, one can not be sure that there is a fraudulent intent. As we have seen in the Madoff and other cases, guessing when the various authorities will surface a complaint, let alone a conviction of fraud, is difficult. (Please do not confuse intellectual frauds when someone should know that what they are saying is wrong, with the intent to deceive through the use of fraudulent financial statements. Over time, intellectual frauds are dealt with in the market place and not a court of law.)

Throughout history there have been brief periods when a large portion of a population becomes enticed into certain actions, usually purchasing, some object or service of questionable utility. For the more senior members of this blog community a good example would be Hula Hoops. When rotated around one’s body, these plastic hoops were meant to aid in fat reduction and other health and psychic benefits. As only the young seemed to have hip movements that could keep the hoops from falling to the ground the fad died out quickly, but not before there were a few stocks that successfully touted these wonders. (From a potential short seller’s position, it is important to distinguish the difference between a relatively short period of a fad that has no lasting value from a fashion that may last for awhile. Both Nehru and Mao jackets did provide some continuing clothing benefits.) The most successful managers of short selling funds are expert at these two approaches. However, even with their clear insights they do not produce winning results every year.


As an analyst, I used to recommend to some hedge funds that they invest in pairs of somewhat similar securities, with the strategy to purchase one and to sell the other short.

One example of this was to recommend for purchase an aerospace company who, in my opinion, was most likely to win a multi-billion dollar defense contract and to short the expected loser. The key to this strategy was not to stay too long, actually it worked best on the day of the announcement. By the time the earnings were expected to be generated by the winner, there was likely to be a recognition that the winner bid the contract at too low a price and would only become significantly profitable from change orders and possibly spare parts reorders. The loser was often free to position itself for the next exciting contract. A somewhat similar pair bet was available every autumn, focused on the Nielsen ratings for television programs. As NBC was buried within RCA, the choice was between CBS and ABC. There have been other event-oriented pair bets. More common is to focus on two large companies within an industry and buy the better-quality company and short the lower-quality company. The only problem with this strategy is that since the bottom of the stock market in March of 2009, often the lower quality stock did materially better than the high-quality competitor. (I am not hearing many pair recommendations either as stocks or as fund formats recently.)

Sector ETF bets

According to the Investment Company Institute (ICI), approximately 20% of the dollars in Exchange Traded Funds (ETF) are in sector or industry funds. Making judgments on sectors is very common today as described in the reports issued by mutual funds and other institutional funds. The funds that make sense to me are those that most of the time select individual stocks that do better than their sectors. Taking this approach further, one could suggest shorting the sector ETF. The problem with this approach is that often the ETF has more low quality names in the portfolio than the individual stock selected. As I have commented above, we have been in a period where the low quality stocks, with their bigger perceived potential, have performed better than the perceived higher quality stock chosen. I suspect that an uncomfortable portion of the transactions involved with ETFs are part of short trades or at least leverage transactions. If I am accurate, this may suggest that a new element of volatility has been introduced.

Market Timing/Macro Investing

The only thing more dangerous than guessing which way the market will go correctly one time is guessing correctly twice. By the time one does it three times in a row you convince yourself and others that you are expert. There are a very small number of professional money managers who do have a record of guessing the overall market trends effectively. Some of the best of these run Macro hedge funds which make big bets through derivatives and other forms of leverage on the sequential changes in direction of the major markets around the world. (I wonder if one made an equal size bet on every Macro fund that began each year and compared its average performance over the next ten year period to that of a collection of broad market indices (adjusted for country bets) which would win? This is not to deny that there will likely be a few spectacular winners, but many won’t finish and therefore for this exercise, they would be declared losers.) Those who are even less successful are called market timers. There is a long history, both at the individual and the institutional levels, as to the lack of success of market timing. Long-term faith in the belief that the trend is one’s friend does not have good results in the stock market, but could in the commodity markets.

Owning Winners

As strange as it seems, one of the best risk reduction approaches is to attempt to own only long-term winning stocks and to accept periodic volatility. (I must admit that it is with difficulty that I attempt to follow this precept.) The concept is one of muted optimism; that throughout our lives there will be an upward bias to stock prices. If one takes the absolute opposite point of view, one believes that long-term bouts of sitting with cash and very high-quality short-term instruments with occasional forays into the market is a correct strategy. Using the Dow Jones Industrial Average as an equity market indicator, in the past we have suffered flat periods of sixteen years and we are in an eleven year flat phase now. I believe that we will breakout on the upside eventually, at least in nominal dollars. And that is how I bet. Each year those that attend the annual meeting of the Board of Trustees at the California Institute of Technology (Caltech) participate in a contest to guess what the DJIA will be selling for at the next year’s meeting. I will almost always be betting for a significant advance because it will happen at some point.

The best way to avoid losing is to Win.
To Members of Mike Lipper's Blog Community:

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Sunday, October 24, 2010

Ignore Short-term Headlines,
Invest for the Long-Term

Pundits focusing on the individual investor and the independent voter proclaim the pains of uncertainty. They explain the lack of attention to the shortage of retirement funding throughout the world. Compared with their appetite for stocks over the last generation, individual investors’ purchases of equity mutual funds beyond their tax-sheltered retirement plans is pathetic. Capital growth is not their answer to recognized long-term needs. Capital preservation through the ownership of bonds is where their smaller-than-normal excess investment dollars are going. The low apparent inflation rate is not a concern for them.

Upbeat notes

In contrast, the non-committee focused professional investor is becoming increasingly attracted to equities and equities with coupons known High Current Yield bonds, or if you will junk bonds. Their purchases are providing the upward momentum we have seen since the dog days of August. They are being reinforced by strategic and financial acquirers’ announcements or rumors.

One of our advantages in helping sizeable institutional and substantial net worth investors in mutual funds is that we talk with lots of very smart and aware portfolio managers and analysts. Without exception they expect better revenues and earnings to be generated by their investments than past comparisons. (To be fair, some are moderating their estimates for 2011, but still see them higher than their 2010 estimates.) Occasionally we supplement this research by interviewing operating corporate executives who report that business is better than in the recent past and that their order books are getting fatter. As many members of this blog community know, my wife Ruth and I regularly check-out one particularly glitzy mall and other stores. There is a discernable “buzz” in the air as we see more shopping bags leaving the mall on the arms of many different types of consumers.

Three upcoming events

“Beauty is in the eye of the beholder” is an old expression that the viewer sees what he or she wants to see. There are three opportunities that will give consumers/investors an opportunity to use their dollars to express whether these events are viewed as good or bad for them.

The US elections

The first will be the results of the mid-term US elections, which may lead to significant changes in the critical unelected, but extremely powerful staffs on the various Congressional committees and to some extent the so-called independent agencies. One might suggest that the stock market rise since Labor Day is discounting the favorable change. The second and third events are somewhat interrelated.

Attempts to manipulate Balance of Payments

The second item is the government's attempted manipulation of balance of payments among the countries of the world. If this practice was done in the private sector it would be illegal. The US government wants to create an artificial ceiling to the size of balance of payments surpluses (read: limit the size of the US balance of trade deficit). We know the reality of international trade, that constraints do not work. In the historic example of the Smoot–Hawley Tariff of 1930, enacted by a panicked US Congress, the world was plunged into a depression from a severe recession. The futility of limiting trade is evidenced by the fact that during almost every war in recorded history, the opposing sides traded with each other through third parties.

Gold vs. paper currencies

The third event or events is the pattern of learned experts predicting that the price of gold will rise to $1500, $2200, and $10,000. This is the wrong way to look at the price of gold according to a very smart friend of mine who has headed two major research departments. His contention, along with others, is that the price of gold is a contrary indicator which measures the decline of the value of paper currencies, led by the dollar.

The link between the government attempts to manipulate trade flows and the decline in the value of paper currencies is the governments’ induced inflation. When people trade using currency (as distinct from barter), on one side of an international trade, both the amount and the value of the currency play a role in setting price. The US along with many European governments is trying to answer unemployment problems by the injection of taxpayer funds to support the economy through the expansion of debt.

In November we will learn about the election, the ill-advised quantitative easing by the Fed (discussed in my blog last week), the meeting of the G-20 leaders, and the likelihood of further legislative actions in the “rump’ session of the US Congress. Whatever actually happens, the key to the near-term outlook for the stock market is what beauty will investors, particularly individual investors behold in the post-November world?

What to do?

What should intelligent long-term investors do in the face of the November issues? I would suggest that you ignore all of the headlines and focus on building a portfolio that is appropriate to your needs for at least the next ten years. Over that period we will get one or more major winds to fill our sails. This wind will give us ample opportunities to jettison any poor investments that we have made and to rebuild our reserves for future storms. Sail on...
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, October 17, 2010

Is There Something Happening Beyond the Discounting of Quantitative Easing?

Focus where others aren’t

I am the first to admit that many of my fellow equity securities analysts are not sufficiently aware of the bond, currency and commodities markets, but at the moment I think there is too much attention on the Federal Reserve’s expected significant purchase of US Treasuries. In the Fed’s terminology this strategy is called quantitative easing. The continuous focus on the Fed makes me recall an old baseball saying that advises players to hit the ball where there are not fielders close by. Thus far in October and most of September, the stock market has been in lock-step with the bond market. I would suggest that there are increasing opportunities to hit the ball where the fielders aren’t (buy winning stocks).

Some examples

I am intrigued with new products and businesses that have a potential of being created everyday in America. As a developer of new products myself, I have found that one of the best opportunities is to find large companies that have big problems which a new product or service can help. For the banking business, there will be no bigger public relations problem over the next several (you can supply: weeks, months, or years) than the foreclosure mess that has been created. From the public policy and publicity standpoints, the creators of securitized mortgages, mostly the banks, need to be able to quickly ascertain the legitimate title to properties that are in default and are in the foreclosure process. There have been huge numbers of paperwork errors at best or in too many cases, fraud. Currently the internal systems of banks and mortgage companies are viewed with suspicion. I have learned recently of at least two data processing-oriented companies that are seeing their order books explode. (Two of my relatives hopefully will benefit from this upsurge in their business.)

American entrepreneurs

Regular members of this blog community already know that I was given an iPad and found it so useful and, in time, essential that I bought one for my wife, Ruth. Several years ago who would have known that today we could not contemplate going on a trip without our electronic personal tablets? The genius of Apple and other American entrepreneurs is creating products and services that we did not know we needed and “can’t live without.”

I should not focus on the American entrepreneur without the recognition that it is the American marketplace that can buy new products and services in quantity. In an age where the US is seeing the number of its new car brands shrink, we have at least one new automobile company, Tesla. Though initially these few cars will be produced in the US, much of the capital and technology came from overseas.

Implications for ultra high net worth investors

What does this mean to the ultra high net worth investor?

First, good investors recognize that the import of the headlines, both in print or spoken by the “talking heads,” is already being evaluated or discounted in today’s securities prices.

Second, one should look for investment ideas in the shopping malls and the back pages of focused periodicals. These periodicals can be financial, but more likely are trade or scientific journals.

Third, many of the fortunes of ultra high net worth people came from a single-minded focus on markets and products that others did not see. While I have a bias looking for technological advances, over this weekend I learned of a very successful businessman who made his money in something as prosaic as ironing board covers. To do this he had to solve product, distribution and capital problems. In many ways his “formula” was not a great deal different than that of Apple or Tesla.

Fourth, every day there are opportunities for the intelligent and patient investor to make money.

Please share with me some of your successes.

To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, October 10, 2010

Governments Join the Bond Bashers

(Warning: this blog is both argumentative and complex. You may find little that you will accept)

The Preamble

I challenge you to find the single most powerful political drive in the constitution of the US or any other government. Whether democracies, pseudo-democracies, or controlled states, the governing group is leased the franchise by the governed as long as they put bread on the table. The lesson that has crept out of the years of the welfare state and other socialistic approaches is that the central government is not very good at putting bread on all of the tables. Due to inefficiency and corruption, governments are not good engines of employment. Military contracts, road building and other grants as pump primers haven’t worked effectively for at least ten years. What is a politically savvy government to do in this post-industrial state? In many countries unemployment and under-employment is much too high for those in power. Complicating their problem, the current size of aggregate demand is not sufficient to foster hiring.

The Political Solution

Apparently the governing élites believe that the size of the existing demand in units of work is currently fixed. The way to increase the economic power of the existing demand is to raise prices. They believe higher prices will lead to more jobs rather than higher prices will lead to less demand. Raising taxes has little positive effect for employment. However, if prices go up the unsophisticated businessman and many securities analysts will see nominal profits rising. Rising profits will encourage employment and investment, or so the theory goes. The problem for the political powers is how to get prices up with slack demand. The way to do it is to raise costs, which on the surface level can be accomplished by increases in taxes and user fees. Politically there is a risk in this strategy. There is a better way which apparently has less political risk and is not as obvious.

The Better Way

If the governments, not just the US, can import inflation, costs will rise and nominal profits may as well. Inflation is being imported from that very powerful engine of inflation – China, as well as that sometime inflation factor, energy prices. The mercantilist recipe for a nation in economic difficulties was to devalue the stated value of its currency compared with its trading “partners.” (This is a game many Wall Street Partnerships also learned.) With the creation of both “the single currency” (the euro), and the de facto single reserve currency (the dollar), an exchange rate currency war would be difficult to win. However, if a currency’s value is depressed by the recognition that its purchasing power is declining, currency exchange rates will respond. The impact of lower effective rates is that export prices are lowered and import prices rise, which helps the balance of payments. As the US and now the EU are attempting to push the yuan higher with limited success, the US currency is dropping in value against almost all major currencies.

The Talking Heads

One of the age old beliefs in Wall Street is the odd-lotter’s theory that the public investor is always wrong at turning points. Careful statistical analysis of the data does not support a strong conclusion to this effect. Nevertheless, one of the favorite approaches of market commentators is to divide the world of investors between sophisticated investors and the “hoi polloi,” or the common investor. They view the net outflows from equity funds and net inflows into long term bond funds as a classic odd-lot signal to buy stocks and sell bonds. As with most sound bite views, the background analysis is not so one-sided and therefore is open to further interpretation. While there are a fair number of individual active traders, there are a decreasing number of active individual investors trading these days in their own accounts. Many use their salary savings plans (401k, 403b, and 457 plans) for their structural investing. Mutual funds have become the most visible arena of individual investors and this needs to be studied to understand what people are doing with their money.

Reading the Mutual Fund Tea Leaves

The net flow data on the purchases and sales of mutual fund shares do not tell the mis-asset allocation story that the talking heads believe. I believe that there is a decline in the gross sales of equity funds. Many of the funds’ good to great performance records were destroyed coming out of 2008, and for the most part their recoveries have not reached their 2007 peaks. Thus many minds believe there is no immediate incentive to invest in perceived riskier equity assets now. Further, many of those in the their middle ages who are the traditional fund buyers are worried about their jobs. On the redemption side of the equity funds, I believe that most redemptions are, in effect, completion payments for retirements or to a lesser extent, educational expenses. Retirements for many came earlier than expected and there was a need to husband remaining assets when income disappeared. Perhaps more misleading to some was what was happening on the fixed income side of the flow data. Many observers recognized that the $2 to 3 trillion in money market funds was largely cash reserves that used to sit in bank deposit accounts awaiting future expenditures. They focus on all of the rest of the taxable fixed income funds, which currently total more than US$1.9 trillion.

What really happened was that a significant minority of money market fund holders grew tired of earning practically nothing on their reserves and moved some of their money to Short/Intermediate Bond funds of various credit qualities. These funds now represent over $1 trillion on their own or over half the $1.9 trillion in the non-money market taxable mutual funds. Over the last twelve months they have earned 2.64% to 9.43% on average, depending upon credit and interest risk they have assumed. I believe that at least half of these dollars will return to the equity market when there is forward momentum in stocks.

Another disguised equity component in the fixed income mutual fund field is the group that has the most money in long term bond funds. High Yield funds currently have over $176 billion in assets. When setting up the original Lipper Analytical Services Fixed Income Fund Performance Analysis report as a companion piece to the equity report, I was tempted to put High Yield funds in the equity report. At the time, as a student of Graham and Dodd I viewed them as essentially stocks with coupons. If one traces out the performance history of these funds, one will find they move with the stock market. When the stock market is moving up there is a better chance to refinance expiring low to mid quality bonds. Also more “junk bonds” are created in equity-like deals in a bull market. My friends in the distressed securities funds are salivating at the huge number of low quality bonds that are maturing in the next few years. If we remain in a flat economy with some induced inflation, a number of these issuers will not be able to refinance their debt and will become candidates for the distressed securities buyers.

The Evidence of Inflation

Central governments in conjunction with most central banks appear at the moment to be winning the currency wars through inflation. Clearly the rise in the price of gold is attracting more buyers. But compared with the size of the gold market, the size of the market for US Treasuries is much, much larger. One of the measures that I use in determining the expected magnitude of inflation over the next ten years is the break even ratio between 10 year Treasuries and 10 year TIPS (Treasury Inflation Protected Securities). In August, TIPS were yielding 1.51% less than similar treasuries. Currently the spread is about 1.98%. Knowledgeable buyers are paying an increasing insurance premium on inflation.

What to Do?

For those accounts that must carry reserves, we have been shifting money into Ultra Short obligation funds that invest in very high quality paper with average duration less than a year and a maximum maturity of two years. For some accounts we have added Australian and Canadian dollar short term investments and even some foreign currency Certificates of Deposit.

What are you doing?

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Sunday, October 3, 2010

Manager Selection in a World With Uncertain Forward-Looking Statements

The Sleeping Pill

One potential cure for the sleep deprived and a somewhat required reading for serious analysts is reading the SEC Form 10-Q of companies of interest. This is a disclosure document that details the past quarter and other periods of a publicly traded company. To make the document more useful to shareholders and/or perspective investors, the SEC requires a section called “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” This narrative gives the management a chance to explain in words what the numbers show or do not show. In order to dampen too much reliance on what is printed, there is a required additional (actually very long) statement entitled “Factors which could cause changes in the expectations or assumptions on which forward-looking statements are based include, but are not limited to.” At every investor meeting or analyst conference call reference is made to this disclosure.

Perhaps I read these turgid documents to repent for my sins as an avid follower of the mutual fund industry and a portfolio manager of a small private financial services fund.

The Nightmares

State Street Corporation is at the center of the mutual fund universe as the largest fund custodian in the world, the second largest manager of exchange traded funds (ETFs), a major provider of passive portfolio management and other services. With its impressive client base it should have a good view of the future for the investment business as well as itself. However, it lists 22 separate bullet points under its “Cautions as to Forward-Looking Statements.” In my opinion, 15 of these points are importantly under State Street’s control or at least heavily influenced by the bank. The seven that are not under State Street’s control or influence raise concerns as to the predictability of the future. I will briefly summarize them below:

  1. The financial health (viability) of its counterparties as impacted by changes of law or regulation.

  2. Financial market or economic disruption beyond “normal.” (To some this may be the “Black Swan” or “Fat Tail” risks.)

  3. Not only the maintenance of high credit ratings, but also the level of credibility of credit agency ratings. (I believe a world without some informed credit ratings is a scary concern for all. Our fund is a long term holder of Moody’s stock.)

  4. The level of redemptions and withdrawals from State Street’s collateral pools and other collective products.

  5. The potential for new products and services that could cause the bank to be at operational risk and exposed to higher unreimbursed expenses.

  6. Changes in accounting standards and practices. As we attempt to have a single global set of accounting standards, the accommodations to foreign issuers could cause harmful results to domestic issuers.

  7. Changes in tax legislation, the interpretation of existing tax laws and the affect as to when tax payments are due.

The Implications

Perhaps it is very strange for me, who made money by analyzing and selling past fund performance data, to now consider State Street’s precaution that the past is even a worse guide to the future than it was in the past. The conservative management of State Street is suggesting that we should be warned that we are entering a new investment world. What this means to me is that reliance on past historic patterns could be dangerous to our wealth. Carrying this thought out, we should question the utility of various individual securities indexes like the multiple Dow Jones, Russell and Standard & Poor’s benchmarks. By definition many ETFs can become suspect of not capturing the new forces that operate within the markets.

The Exploiters

Many portfolio managers spend their entire investment life investing in the same securities. Some of these have good long term records, but that may not be of much comfort going forward if the pace of disruption accelerates. I would suggest that early general stock market investors who purchased Apple (which I own personally by historic accident) and Google after the flipping of the IPO phase ended, recognized change. Similarly, those global or international funds that were early in China showed the kind of sensitivity needed to ride the future waves.

How do you find these managers? I would suggest that it will be worthwhile to look at the new purchases shown in the interim reports. New names to the portfolio and perhaps new names for you are of great interest. Of course they have to go up in time to be very valuable. However, the willingness to buy into the unfamiliar can be a good trait, if on balance it leads to success.

A Search for New Names

If members of this blog community wish to suggest new names to me, I will be happy to publish a list with or without attribution and further comment in a future issue of this blog.

To Members of Mike Lipper's Blog Community:

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Sunday, September 26, 2010

Emerging Market Warnings,
Crowds Ahead, Smaller Exit Portals

Ever since the dawn of attention to investment performance, the smart guys figured the way to outperform was to invest outside the general experience of others. Often this technique worked initially until too many others copied the strategy. As with life in general, the unexpected happened and the exits became crowded and were blocked for the late movers. This is a repeat performance of a movie I have seen before.

I am a Believer

I am a believer in investing internationally. As a trainee in my first job after my education in the US Marine Corps, I had a tour of duty within a bank’s vault to count the actual foreign stock certificates that backed up the bank’s issuance of American Depositary Receipts (ADRs). More than 15 years later, when I could start to invest for my own account, I began investing outside of the US. Over the years I have invested in Latin American and Asian closed-end funds, individual equities in Canada, Australia, the United Kingdom, Netherlands, Finland and Japan as well as private equities in the UK and France. In addition, at the time of my sale of the operating assets of Lipper Analytical to Reuters PLC, we had foreign clients buying non US-data from our offices in London and Hong Kong. Thus, I believe I have won my stars as an international investor. So why am I raising the yellow flag of caution now? Simply because it is getting crowded out there.


On Thursday of this last week Petr√≥leo Brasileiro S.A. or Petrobras, sold over $70 billion worth of common stock. This was the world’s largest initial public offering (IPO). According to the Wall Street Journal, options will be available which will expand the common stock offering by 25%, including an undisclosed amount of preferred stock. (It is true that some $43 billion was an exchange with the Brazilian government for the drilling privileges to a potentially huge offshore series of sites. Nevertheless, an enormous amount of cash was invested into Petrobras.)

First Warning Flag

The sheer size of the enthusiasm for this transaction should be enough of a warning to a practiced investor, but there are other danger signs. Petrobras has been a favorite of many well-known global investors. A number of them felt that the terms of this offering were not in favor of the existing outside shareholders but were to the benefit of the government. Among those who are rumored to have sold out are George Soros and the good people at Templeton. One of the risks in any investment is that the government may turn less friendly. (This risk is valid in the US as well.) Based on my experience, foreign investors typically don’t really own foreign securities permanently. They rent them.

The Second Warning Flag

One of the better international money managers that I had the pleasure of knowing taught me the importance of the flows of money into a security. In the 1970’s, he focused on foreign money coming into the Japanese markets. He believed that the “weight of money” would lift Japanese stock prices that were clearly not bargains. He focused a good bit of his attention on mutual fund data and that was why he contacted me. His clue to exit an overpriced market was when there was a slow down in the gusher of money coming into the market.

As is commonly acknowledged, mutual fund redemptions have been larger than the rather lackluster sales of US Equity mutual funds. As of the end of August, according to my old firm now called Lipper, total net assets are approximately $4.7 trillion dollars, with only $3 trillion devoted to US diversified investing. The fifth largest collection of assets is in Emerging Market Equity funds ($253 billion). This excludes $112 billion of the more narrowly focused funds that invest outside of the US and Europe. The two collections together have total net assets of $365 billion as of the end of August, which is somewhat larger than the money invested in S&P 500 Index funds. Clearly, emerging markets are not undiscovered territory. The cautionary flags go up with US Diversified Equity funds shedding $ 10 billion in August, with $2.3 billion going in one month to Emerging Market funds. This shows a significant shift in investors’ opinion. A more dramatic indication is that in the same month $3.8 billion went into Emerging Market exchange traded funds (ETFs). I believe this latter inflow is much more speculative in nature. If you will, they are more like daily renters than annual leasers.

The growth in demand of ETFs is particularly ominous. Money can flow in and out of these funds on a daily basis. When the money moves, the managers must transact as nearly as possible to mirror an individual stock’s proportional ownership in the index. If some negative news event causes a redemption run on an ETF, they will have to sell some of each position. The history of international investing, particularly in small markets, is that when we come in we buy from the locals who feel that our valuations are wrong. When we sell under duress they understand that any price is a good price from the pressured seller’s point of view. The losses can be dramatic under those circumstances.

To put the ETF risk in perspective, each week I look at the twenty-five largest SEC registered open-end funds. On that list are five ETFs, two of which invest in emerging markets. On a combined basis these two funds have $70 billion in assets. They promise their large shareholders instant liquidity during US trading hours.

The Third Warning Flag

The next set of concerns is one of personal exposure. Over the last two weeks I have had three discussions about emerging markets. The first was with a marketing executive of a major broad line fund group who was commenting that its International/Emerging Market funds were selling very well. The second conversation was with a retired international investor who was being pitched to go back in business, focusing on the frontier markets which are exciting many people. I am hearing a great deal about investing in Nigeria and Ghana. (Memories of the “South Sea Bubble” of the 18th Century come to mind.) The final conversation was with a fund president who has been away from the market for some time and is being asked to develop a country-specific infrastructure fund as well as other frontier investments. (The Nineteenth and early Twentieth century investments by the Scottish trusts and Barings also come to mind.)


Despite HSBC’s ten point pitch to invest in the emerging markets and Western Asset’s belief in the attractiveness of the debt side of the emerging markets, I would be particularly careful now. If you are lucky enough to have been there already, cap your exposure at sometime. If you are not invested in emerging markets directly, you can gain some exposure through US companies that export or have operations in the area. As a contrarian bet I would look to large US Growth funds, they have lots of attractive companies in their portfolios at reasonable prices. They should do well enough on a relative basis over the next four years.

What do you think?
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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