Sunday, April 25, 2010

Why Some Individual Investors
Produce Better Results
than Investment Committees

This statement seems counter intuitive to the practice followed by most of our great non-profit institutions. I am going to use as my point of departure a talk given by Jeremy Grantham, a very original and thoughtful thinker who is the CEO of GMO, a Boston-based investment management group. Jeremy’s October 7th, 2009 talk was entitled “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” The talk focused on the potential disadvantages of Graham and Dodd-type investing. A little background may well be helpful for the members of this blog community who are not professional investors and/ or securities analysts. Columbia University is extremely proud that both Benjamin (Ben) Graham and David Dodd taught at Columbia and wrote the fundamental bible for analysts, not surprisingly titled “Security Analysis.” I had the great experience of taking the course under Professor Dodd when Ben Graham had fully returned to his investment management activities. The essence to the text and the course was to seek out value as the basis for investing in both bonds and stocks. This task was to be done by professional analysts using financial statements to find stocks and/or bonds selling below their current value. I remember arguing with the good professor, that while finding price disparity was nice, it was likely to produce a lower return than by finding prices that did not adequately reflect future value. While Professor Dodd did not totally disagree with me; he felt that there was less risk of loss by pursuing value than by following a future-focused growth approach. (At the time I was not conscious of the investment career of one of Ben Graham’s students, Warren Buffett. When Buffett looked at an underlying business, he created sensible measures of quality not found in financial statements, thus adding immensely to the valuation equation.)

Grantham's Criticism

Jeremy’s main criticism of the value-oriented investors is that they are not sensitive to the extremes in the marketplace. The value investor conducts his or her investment search the same way in up and down markets, always looking for the cheap jewels in the expensive weeds. This practice can lead to many years of gains which leads to value investors focusing exclusively on the search for value, as defined by low price/book value. Jeremy points out that when cataclysmic changes occur in the market, these investors are not prepared. At the 1932 bottom, 41 years of previous gains were lost. Ben Graham lost 70% in that market collapse, in part because he was on margin (using borrowed money). Among the others who lost a bundle earlier in currency speculation were Lord Keynes, also a user of margin. Some more trading-oriented investors recognized the extremes, like Roy Neuberger, who was short (selling shares that he did not own, but borrowed) going into the crash.

Two Critical Questions

Two critical questions came out of this experience. The first is to question the effectiveness of diversification, an accepted part of investment dogma today. The goal is to hold many assets that don’t go down at the same time, thus preserving capital. The only problem with this principle is 2008, when practically every asset class around the world rolled over into a decline of mammoth proportions. There were some, very few, investors who did not suffer substantially. I personally know of no investment committee-led institution that avoided the decline, but I do know of a few individuals who appeared to have escaped the onslaught. This realization leads us to the second critical question: Why did so many investment committees, made up of honest, hard working, investment professionals (our British friends call them “worthies”) have such bad performances?


There are two parts to the answer. The first is that the legal charge to fiduciaries is to act prudently. The guiding principle comes down from the ruling by Judge Putnam in 1830 in Harvard vs. Amory, where Harvard lost the case because it did not act prudently. “Prudently” was defined as how other men of intelligence and prudence would have acted in their own accounts. In effect this set up peer-focused comparisons. This was the intellectual foundation of the Lipper Mutual Fund Performance Analysis, which made money by creating appropriate fund peer groups and measuring performance for mutual fund directors. Thus, a fiduciary that is doing approximately the same thing as his/her peers, is being prudent whether the account is going up or down in value. While this prudence fulfills the minimum requirements and answers the career-risk issue for trustees and investment managers, it does nothing to fulfill the desires of the client. The non-profit needs to pay operating expenses and occasionally capital expenses, therefore it may not be well-served by “prudently” losing money. Why then are some individuals better able to produce results than the combined brain power of a group of the worthies?

The second answer is best summed up in a quote that Jeremy uses from Warren Buffet. “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.” The very function of an investment committee leads to prudent actions. I am currently chair of three different investment committees. I find that after an informed, polite discussion, a consensus is formed which rarely calls for taking an extreme action. Members of all of my committees are well-meaning people who have volunteered their time (and quite often their capital) to the institution. We almost never have the sharp disagreements that often occur within corporate or family partnerships. I wonder whether the pleasant decisions are of the same quality as the more intense discussions?

Individual vs. Group Decisions

I believe that Warren Buffet would suggest that at critical turning points, an individual’s decision-making is better than even an intelligent group decision process. Buffett might even favor a strong personality over an agreeable one. I know that trustees that do not ask the tough questions are not acting in the long term best interest of their institutions. They should find their friends elsewhere.

One of my sons and I will see whether Warren comments on this topic while we attend his annual meeting next Saturday. Stay tuned.

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Sunday, April 18, 2010

Too Much Reliance on FICC Can Be Dangerous

FICC is the abbreviation various banks, usually investment banks, use for their activities in fixed income, commodities and currencies. These activities have a common trait in that they derive most of these earnings from market making functions which often include proprietary positions. For sometime FICC earnings have driven the aggregate earnings (or at the least the incremental earnings) of such firms as Goldman Sachs*, Morgan Stanley*, Merrill Lynch/ Bank of America** and JP Morgan Chase**. I was recently asked what I thought about the published first quarter earnings of these banks. My almost immediate reaction was not to rely heavily on these results for future projections. In the first quarter we had volatile markets in each of these sectors, with particularly favorable price trends in currencies and commodities. There was lots of room for dealing profits.


In looking at the results from FICC activities, one should remember that these activities are governed only by the obligations of a market maker to state the terms of the trade honestly. There is no obligation or expectation to identify who is the party on the other side of the transaction, if known. These obligations are different from other parts of these investment banks. When they underwrite an issue, there are some well-defined disclosure liabilities for the underwriter. Each of these groups is also in the money management business. In these money management subsidiaries or divisions, the banks bear fiduciary responsibilities to place the interest of their clients ahead of those of the advisor. (Disclosure: I am a Registered Investment Advisor). When dealing with these complex organizations, one should recognize the differences of the cultures between their dealing, underwriting, and money management arms. These differences should be paramount in viewing the civil suit brought on Friday by the SEC against Goldman Sachs.


The focus of the suit is whether Goldman disclosed the names of all the parties that shaped the portfolio of a synthetic CDO that it sold in a private placement to a limited number of knowledgeable, sophisticated financial institutions. If the SEC is correct that there was a violation, it is immaterial whether the buyers made or lost money. Where the size of the loss and the almost equal and opposite gain could be significant to Goldman is in assessing fines and damages. In the context of Goldman’s balance sheet, the immediate potential size of the fines and damages is relatively small. What is of significance is the reputational loss to Goldman and its shareholders. But perhaps even more important is the coincidental impact of bringing this case on Friday before the week that the Congress is scheduled to take up the Administration’s proposed financial reform legislation. (The SEC has been investigating this particular single trade since 2008.)


In my opinion, few of the news articles about this suit give sufficient background as to what allegedly happened. Due to buyers’ thirst for income, there was not enough in the way of originated mortgage paper to go around, particularly in a structured format with different risk and income tranches. To fulfill the need for more paper, synthetic mortgage paper was created. These instruments did not actually own any of the mortgages but took their prices by reference to actual mortgages, usually in a structured format. (These and other techniques were so popular that there was more mortgage-related paper in the hands of investors around the world than the actual size of the originated mortgage market.) As almost all the participants in the market for synthetic paper appreciated the fact that the reference prices could go up as they did in the past or could go down (either because interest rates went up or because some portion could default). Wall Street, with its traditional role of finding an answer to investors’ needs, further developed their credit default obligations: if a credit event occurred, the risk would be paid for, in effect, by the party guarantying the instrument. CDOs were not traded on a listed market place as the number of investors was limited and each document could be quite different. These securities were traded in the over-the-counter market, usually with a single market maker who helped in the origination of the instrument.


Because market makers are not fiduciaries, in these instances sophisticated investors wanted a separate third party to select which mortgage securities were to be included. In this particular case, ACA Management was selected to be, in effect, the third party manager. There were a number of other candidates which included GSC Partners, Putnam Advisory, State Street Global Advisors. Also investors could have gone to other investment banks (Citigroup**, Merrill Lynch and UBS**) to secure similar investments.


(I have learned about these other investment banks and CDO managers from a well researched piece published in ProPublica, headed by my good friend Paul Steiger, (the former editor of The Wall Street Journal). The piece was on Magnetar, a hedge fund that also profited greatly from the collapse of the synthetic CDO mortgage market. From what was said in this article and in the rebuttal release from Goldman Sachs, it was somewhat common for the selector to receive suggestions from the market maker as well as potential investors, who could eventually take long or short positions. Based on the two sources mentioned, the identification of those who provided inputs were not included in the sales literature. In the Goldman case both the long side investor and the one shorting made suggestions to ACA. ACA itself became the largest buyer of this particular CDO. Unlike corporate investing where there is a fair amount of undisclosed company information, in this case a lot was known (e.g. location, loan to value, arm mortgages with resets and income documentation). If real estate prices went up the buyers would have made money; if prices dropped the shorts would make money. This fact was known day one.


From my vantage point, I do not see what Goldman Sachs* did wrong, but I do see that the reputational risk brought to the surface by this suit could be material. We may not have long to wait for an answer. Early Tuesday morning, Goldman will announce its first quarter earnings and my guess make a further statement on the suit. My bottom line for all investors: Know what you are doing when dealing with firms that make a lot of money from trading (with you).

* These are securities that my financial services hedge fund owns
** These are securities that I own personally

One should not treat these comments as recommendations, but they may be useful in putting this blog into proper perspective.

To Members of Mike Lipper's Blog Community:

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Sunday, April 11, 2010

“The People” vs.
the Economies and the Markets

We live in a dynamic world with nothing more dynamic than the markets. At almost all times there are pulls and pushes in many different directions. Each participant hears and sees different aspects as to what is important and how it affects his or her feelings and actions. The various forces keep the markets in some form of equilibrium at any moment in time. Slight changes in supply and demand cause movements up or down whose impact is multiplied by differences in volume of transactions. Sometimes there can be what my friends in the NFL Players Association call a “head feint.” That is a sudden move of the head to get the opposing player to commit to wrong action. We may have had one Friday afternoon, April 9. Very late in the trading day, the Dow Jones Industrial Average (DJIA) peaked its head over the psychologically important 11,000 mark, only to finish at 10,997. Some may take this as an important sign of a positive change in demand. A more careful examination of the trading patterns suggests an example of what we used to call “painting the tape.” In the last half hour, four individual stocks belonging in the DJIA moved serially on relatively little volume. In Chicago there was a surge of volume in the mini S&P contract. Thus, I would disregard the late move in terms of significance. The current picture is sufficiently murky, with numerous negatives and positives present. Nevertheless, there are sufficient concerns in people’s minds to give an appropriate level of friction that would allow a gradual push to higher level to the markets.


When one speaks to people who are not intimately focused on the markets, they distrust the sharpest rises they have experienced in their lives. Whether there will be another major decline allowing distrustful investors to commit their cash at lower levels may be wishful thinking.

In a front page article in the New York Times on April 9 (click here) the renowned columnist Floyd Norris explores this dichotomy between the way Americans feel and the rise in the market. He focuses on the politicians. Neither political party in the US wants to celebrate the turnaround. On the one hand the opposition does not want to credit the current administration for doing anything right and the party in power wants more power through the passage of still another stimulus bill that might create more union jobs. (My concern is that when it becomes politically correct to acknowledge the turnaround, there will be more risks in the marketplace.) As I mentioned in my book, MONEY WISE, it may now be appropriate to invest against the headlines. Further evidence of this distrust comes from a survey by Bloomberg, which found that only 31% of investors were better than they were a year ago, (at the bottom). Perhaps what they heard as the question was whether their investments had regained their peak level, but that was not the question that was asked. Others see vacant stores and factories indicating substantial excess capacity. To these skeptics, not until all of these facilities are filled with workers will we have executed a turnaround. Unfortunately, a number of these facilities are not going to come back. For the better part of twenty years, I made a practice of furnishing my New York office with high priced furniture from various brokerage firms that went out of business. Many of the employees of these failed firms learned new skills and adopted to changes in the economics of Wall Street with some success.

In the early 1970's on the Manhattan block that begins with 48 Wall Street, there were five small office buildings that were vacant. My first employer after the US Marine Corps was Bank of New York, then headquartered at 48 Wall (now housing the Museum of American Finance). In time the five small vacant structures were replaced by the very large and magnificent global headquarters of Morgan Guaranty. The headquarters personnel were later shifted to midtown as JP Morgan Chase was formed. My point in retelling this history is that idled capacity does not have to come back in its original form for there to be a successful turnaround, and then expansion.

Jobs, Jobs, and Jobs

The “popular media” and the politicians are focused on the creation of jobs as the only measure of a turnaround. While on a human scale this is very important for our society, it should not block out the other signs of a limited recovery. I wish the focus was on the numbers in the “U6” category that includes the discouraged workers. Adding the discouraged workers and those who involuntarily are working part time to those registered as unemployed raises the total to 16.7% of the work force. One sixth of those who are not producing or under-producing is a very heavy load for our society to carry. The answer to the problem is what has worked for us in the past. In the twenty-five years from 1980 through 2005, almost all of the new jobs created in the economy came from start-ups under five years old, not from government stimulus. These are the employers and employees that we should be stimulating with less bureaucracy and lower taxes. If we don’t others will. In the month of March, evidently we created some 162,000 jobs of which approximately 40,000 were short term census takers. In the same month, Mexico added 125,000 jobs. There are many messages here for a free enterprise economy if we are going to bring the U6 number down to where it would be healthy for us, in my guess about 5%.

Shop, Shop and more Shopping

Actually the economy is getting better. This week the market pundits and certain economists were surprised by the increase in the dollar level of inventories at the wholesale level. The gain was twice what they expected. Perhaps they shouldn’t have been surprised, as March was the eleventh month in a row that wholesale sales gained. I suggest that this was not all restocking rundown inventories. Look at the retail side: In the month of March, 23 of the 25 leading retailers that the market analysts track had better than expected results.

US Inflation is Not a Worry

The inestimable Byron Wien of Blackstone, while favorably attracted to gold is not worried about inflation for the next two years. Interestingly enough, other observers believe that commodity prices are peaking for this year as they see smaller demands in the near future. The much more sensitive market for US treasury paper agrees with Byron. The spread between the yield on the ten year US Treasury and the ten year TIPS is 2.34% compared with a long-term average of inflation since 1926 of 3.01%. Putting their money where their mouth is, the bids for the latest $21Billion auction for US Treasuries received 3.72 times the amount offered. This cover is the largest at least since 1994.

Lessons from Mutual Fund Performance Analysis

My old firm, now known as Lipper, Inc, groups twenty different types of domestically focused diversified equity funds into a grouping called US Diversified Equity funds. In looking through the first quarter data this weekend I was struck by a number of observations:

1. Ten of the twenty more narrowly defined investment objectives, on average, performed better than the average S&P 500 Index fund, as did the whole twenty as a group (7.57% vs. 6.95%). The better performing groups invested, in general, in mid and smaller capitalization securities.

2. The best performing objective in the US Diversified group was the Leverage Diversified Equity funds +16.37% or just about ten percentage point better than the index funds. These funds are designed to use equity derivatives and the strategy is working for them at the moment. (Caution when the market declines these funds often fall the most.)

3. Small Cap Value funds were the leaders compared to the other diversified stock funds gaining + 12.89%. These managers' selection skills seem to be working as their results are better than the performance of similar indexes of small cap stocks.

4. Micro cap-oriented funds did not do as well as small caps which suggests to me that the wave of Merger& Acquisition activity has not reached into their bin yet.

5. In some respects, at this point in this recovery, leadership is being taken by domestic rather than international stocks. The average financial services fund is up + 15.47%, the average global financial services fund is up 7.27%

What me Worry?

One of the measures that market analysts use to determine whether investors, (read: institutions and sophisticated individual traders) are fearful is the expected volatility in the S&P500 index, or the VIX. The reading on the index is now below 17 compared to 40 at the year end of 2009 and a peak in the range of 80. The followers of this index would say that market participants are not worried. (This complacency needs to be watched as one of the precursors to many tops is a general feeling of complacency.)

Yogi Berra Got it Right!

I believe the great Yankee baseball star said “You can see a lot just by observing.” My training as a security analyst and a business entrepreneur taught me that I could learn a lot by just walking around and observing. Last Tuesday evening I dropped my wife Ruth and a friend at the opening of a photographic exhibit at the Museum of Modern Art. As I walked by several office buildings on my way through Times Square to the subway, I saw something that I had not noticed for sometime. There were fleets of black cars waiting until at least 8 PM for the various people at the M&A investment banks and law firms. Some firms were apparently letting a number of their people leave “early.” Living in a community (or more precisely next to a community) that has many of these Type “A” personalities, I was not used to seeing them return home until after 11 PM. The number of the cars would indicate that many are working on forthcoming M&A activities, which echoes Bryon Wien’s views. I take from this observation that some of the stocks in my financial services hedge fund could benefit from substantial M&A fees. More importantly M&A activities mobilize capital and eventually raise the valuation levels in the market.

Bottom Line

There is enough worry in the general population, that one can take a positive attitude toward investing, but watch out for our own and others’ complacency. There are “Black Swans” out there in the form of unthinkable things.

Please share your thoughts with me.
To Members of Mike Lipper's Blog Community:

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Sunday, April 4, 2010

Leadership Companies
Are Not Always Leadership Stocks

Spring is not only the season for sports and nature’s renewal, for some of us it is an extended season of poring over annual reports. From this exercise, I seek to get a fuller explanation, from a particular company’s point of view, of what caused the prior year’s financial results. I also scan for possible governance changes that might produce better results in the current year. Obviously the 2009 reports are most often laden with excuses caused by the economy. (When the numbers turn out well, they will be proclaimed the result of the hard working management.) Often I wonder why I feel compelled to spend so much time on the predictable. Occasionally I do get a worthwhile insight.


I suggest that every leader in any field of endeavor (read: service to others), could benefit from JPMorgan Chase’s (NYSE: JPM) thirty-six page Chairman’s letter. In particular, I call your attention to the nine page section entitled “HOW WE MANAGE OUR PEOPLE-JPMORGAN CHASE’S MOST VALUABLE ASSET.” (click here for full letter to shareholders from the JPMorgan Chase Investor Relations Website, or email me and I will send to you my marked up version of the nine pages.) In the letter, JP Morgan Chase CEO Jamie Dimon lays out how he is building a culture of leadership which can work well in any organized activity. Some of his points are:

• Being smart is not enough

• Leadership is an honor, a privilege, and a deep obligation

• Good people want to work for good leaders

• Leadership is like exercise, the exercise has to be sustained for it to do any good

• (Good leaders) Need to have a fierce resolve to act

• Driving change, fighting bureaucracy and politics, taking ownership and responsibility

• Leaders must set high standards of performance

• True leaders must set the highest standards of integrity

• (The) Best leaders kill bureaucracy

• Watch out for sidebar conversations

• Loyalty and respect are two way streets

• There is a lot of luck involved in anyone’s success

• Leaders work hard because they want to, they believe in something larger than themselves

• The CEO does not have to be the highest paid person in the company


As these statements are similar to the principles espoused by the US Marine Corps, I ask, “Where do I sign up?” Jamie has described a culture that I would want to join. He also describes the attitude of service that I would cherish in a critical supplier or partner. Unfortunately, he and his fellow leaders do not produce a winning stock at all times.


The dynamic nature of markets causes various fundamentals to be priced everyday. At times the high quality culture produced by JP Morgan and some others are priced cheaply. One could buy great companies at relatively low valuations a year ago. Such a purchase or a decision to continue to hold JPM should have allowed a prudent investor to sleep a little better. Looking to the future, even at today’s more advanced prices, one could make the case that JPM and similar leaders have a place in a sound, long term portfolio.

The search for quality investments in the first quarter of 2010 has been frustrating. There are a significant number of managers that are addicted to buying quality. Their results in the quarter (and actually for the last twelve months) have been rewarded handsomely in terms of absolute gains. Unfortunately relative returns have been less good. If you will, absolute dollars of gain has been way above normal, but relative ranking has been disappointing. Stocks of companies who were far less focused than JPM on their prime asset of highly trained people, shot up as their layoffs accelerated. (Pundits have called this trend “hyper-efficiency.”) Those companies who barely escaped a near death (bankruptcy) experience, rose many multiplies of their bottom prices. Their cutbacks saved them at the most critical possible opportunity, allowing them to become leaders in their fields or in some cases reassert themselves as leaders. This dichotomy between the quality of leadership of a company and its stock price should remind us that often the only similarity between a company and its stock price is its name.


As an entrepreneur and personal investor, I am more comfortable dealing with quality individuals and quality companies. However, as an investment advisor with some performance-oriented accounts, I also need to produce competitive results and that has not been easy this quarter. However the month of March, 2010 appears to have been an awakening of the animal instincts to search out good investments. Time will tell whether we entered into a new phase.

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.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at