Monday, May 31, 2010

On Memorial Day,
and the Future Leaders of the
Investment Community

On this Memorial Day weekend my first thoughts turn to the ordinary people who have been our extraordinary heroes and heroines, who gave their lives and bodies so that we can be free of imposed dictatorships. One of the characteristics of wars and most conflicts is that they are battles between offense and defense. Rarely can one succeed without relying on both sets of skills.


As I write this blog, I am exercising my freedom to think about the war for the survival of our investment capital. Military wars have alternating offensive and defensive phases which often pivot on the success or failure of both new technology and more importantly, new applications of human behavior. Think about the language in the press, quoting many participants throughout 2008 and during this month of May, 2010. Frequently one reads about someone saying that they were “killed” or “mauled” by the fall in the market, and more recently by sharp spikes. The terms of war appear to be appropriate in describing this battle for the survival of our investment capital.


Wars are won and lost by exceptional leaders and by using resources more intelligently than the opposition. Often the battle leaders have something in their background that one can point to as common among them. There have been a couple of graduating classes at West Point "where the stars fell." The leaders (generals) from these classes led us through our bloodiest wars. I had the distinct honor and good luck myself to be the member of an extraordinary class in the US Marine Corps’s Basic Officers Class. Out of a class of six hundred peacetime Marines, we had six members who became general officers, including a future Commandant and another four star general. (I believe that this was the first time the Corps had two four star generals at the same time.) In addition to the military success story, my class also included a number of very successful civilians in many walks of life. With this as a background, the members of this blog community will not be surprised to learn that I have been an analyst of leadership for most of my adult life.


As the background of leaders change, so does the way battles are fought. Until recently, the investment leaders were either solid, surviving investors or were salespeople who could deliver good investments. Since the 1930s the Bible for professional investors has been Graham & Dodd’s Security Analysis. I had the distinct honor to study under Professor David Dodd, and more importantly, Warren Buffet studied with Ben Graham. The original text and the six later editions discussed the various ways to make sound investment decisions. To the best of my recollection there was nothing about how to place or execute securities transactions. For the next couple of generations, equity analysts trained to become portfolio managers, who gave buy and sell orders on the various stock exchanges to “clerks” to execute. Over time these so-called “clerks” became professionals in their own right and some were admitted to ownership of their firms. As is often the case, the bond market was ahead of the stock market. Bond portfolio managers sat on the fixed income trading desks. Bonds trade largely in the over-the-counter market of occasional limited liquidity and discontinuance prices. Bond portfolio managers added or subtracted value due to their trading skills. As a student of fund performance I have seen that the relative performance results of a bond manager has more to do with making correct trading decisions than correctly anticipating interest rate moves.


In response to the growing professionalization of trading beginning in the 1990s, I started to see the hiring of traders as portfolio managers initially by and for hedge funds. These traders were often well trained at various hedge funds and proprietary desks of brokerage firms. In a vast over-simplification, the traders knew what was moving and they believed that a stock was only worth what it was selling for, not a discount from some future value. As these traders became more successful (and for political reasons the community was destroying the quasi-monopolistic power of its center), the skills of traders became more important. Various new market centers were created, both as exchanges and private markets. One of the keys to their success was the speed in which they could trade. The speed of trading depends on the speed of information transfer so trading technology has become critical.


As the equity world woke up to this change (similar to surface ships recognizing the risk from torpedoes and aircraft), the intellectual leadership began to change. Instead of hiring liberal arts majors who could “think” and develop models of future values for companies, they hired PhDs with math and physics backgrounds. These “rocket scientists” from Caltech, MIT and Carnegie Mellon among other schools, became the bonus babies for “The Street.” (Bias is showing in that I am a trustee of Caltech, MIT bought mutual fund data from me years ago, and I have a freshman nephew at Carnegie Mellon.) The tasks of the rocket scientists were to determine the likely trajectory of the missile, (in this case, the next price) and intercept it for a brief moment. They were being wired to make very rapid, small, frequent gains or cutting their losses very quickly. As this kind of thinking became the dominant market leadership mode, I saw major changes in relative fund performance leadership. Due to the intraday induced volatility, trading added more than investing in many instances.


Some great past performance leaders did not master the new art. I saw a similar thing happen in the market break in the late 1960s, where two performance leaders had similar spectacular performance on the way up and very different on the way down. While they owned similar and perhaps identical positions, the one that lost less sold his most liquid positions first. The lesser performing fund attempted to sell his most illiquid positions first. What is important in this leadership example is that in the subsequent recovery, the loser kept a significant cash reserve for the first time and the winner went back to his old, almost fully invested portfolio. In effect, the loser and his shareholders lost their nerve. In time the loser who still had some good performance retired and was replaced


I believe we have gone through at least one, if not multiple, inflection points and I expect the next new class which will have stars fall on its shoulders has graduated from law schools and is now getting into position to seek fortune. At this present time, we have about half the scenario for the next leadership battle. We already have, (and are getting more) data as to the instability in the marketplace. What is missing is the regulatory response. New national and international rules will be put into place that will attempt to fight the last battle. The rules will have all the benefit of the Pentagon’s past favorite practice: to fight the last war brilliantly on paper. They do not focus enough on how the future will build on the past.


The new rules will attempt to constrain various perceived ills. The constraints will add a level of complexity that will retard many. There will be some that will actually read the various regulations, and some more will understand the reporting technology put in place. By seeing things more bureaucratic minds will miss (the signs of a good lawyer), they will find new ways to make money. This will be not the first time that legal training led to investment success. One example, and there are many others, is “Mr. Johnson.” A Boston-based lawyer in the 1940s, Mr. Johnson had the opportunity to buy the ownership of one of his clients, which he renamed Fidelity Management & Research. Everyone including his son Ned referred to him as “Mr. Johnson.” For approximately thirty years it was his skill in seeing investment and marketing opportunities that others missed, that became the foundation of what Fidelity is today. He encouraged young associates to research stocks with same vigor as an attorney in preparation for an important case. He saw through regulations and practices that others didn’t.

What should we do now? We should be looking for new leadership to be our investment heroes, some will come from an understanding of the law.
To Members of Mike Lipper's Blog Community:

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Sunday, May 23, 2010

Unintended Consequences:
Investors Again Lose to the Politicians

Two quotes came to mind last week, the first was by New York Judge Gideon Tucker (sometimes attributed to Mark Twain): "No man’s life, liberty or property are safe while the Legislature is in session. The second was Will Rogers', “This country has come to feel the same when Congress is in session as when the baby gets hold of a hammer.”

We are about to watch the ultimate sausage manufacture of legislation, which continues a long line of unintended painful consequences to American investors, and much more importantly, to our economy. Soon there will be a conference committee named to resolve differences between the US Senate’s “Restoring American Financial Stability Act” and the House’s “Wall Street Reform and Consumer Protection Act.” As the various lobbyists and their dependent members of Congress write the new legislation (in which almost anything can show up), there is one almost guaranteed certainty. The ultimate result will not provide either meaningful stability or reform. This is not to say that there won’t be change. There are likely to be many changes, some large, drafted in the desire to help us avoid future problems similar to what we have suffered from over the last several years. Almost in a Newtonian fashion, the problem is that any legislative action will produce an opposite reaction by those beyond the Washington Beltway. If history is any guide, the unintended consequences will produce additional serious dislocations and risks to the soundness of investors and their retirement capital.


The legislation is an outgrowth of the clamoring by many “to do something” about the losses of capital, income, and most importantly, jobs. Unfortunately, changes in the rules of the game (like moving the goal posts in football), probably do not significantly alter the actions, ambitions, and the talents of the players for the most part. Throughout history, from Biblical times to the volatile trading of May 6, investors’ “animal instincts” drive people in the market place whether it is in the stock markets or the job markets. In a gross oversimplification, these are often summed up as fear and greed. (For those interested in these drivers, you may wish to read my book, MONEY WISE.) No law or regulation can prevent someone from buying something they shouldn’t own because they either do not understand it or can’t afford it. When there is a rush to leave a sports arena it is difficult not to join the exit rush.


There are many trails of unintended negative consequences created by various actions of governments. I could not list all of these, but let me start with one example and trace out some of the implications. Perhaps as a way to control compensation for executives, the IRS limited the tax deductibility of compensation expenses over $1 million dollars, unless the compensation was tied to performance. Within a year after the passage of this diktat, companies found ways to measure performance. Often these were earnings and revenues among other statistical measures. (Note that there were no restrictions on how these success ratios were to be achieved.) In some cases, executives could be richly rewarded but the investors suffered as their stock prices declined. In partial answer to these complains, the movements of stock prices were included in the reward criteria. Most often there was a comparison against a general market index as well as a narrow and hopefully more relevant subset. As CEOs were now less likely to be founder/owners, they looked to their compensations as their payoffs for doing a commendable job. Thus these professional managers now had to worry about relative stock price movements.


This change in motivation set off three impulses. First, managers manage against the time period for their assessment, which in many cases led to more short term decisions. Often these short term decisions postponed longer term benefit to the shareholder. Second, my fellow analysts were quick to sense the change in management’s focus and they also became more short term oriented. Further they understood that relative performance ranking became increasingly important. In turn, this could lead to building mathematical models in order to predict stock prices in the short term. (Later on, these and other mathematical models have led to the development of algorithms which some traders now use exclusively.) The third impulse was to view defined benefit pension plans as profit centers to hopefully produce the equivalent of earnings. At all costs, significant pension losses were to be avoided. (Again the long term investment value could be sacrificed for the benefit of this year’s financial statement.)


As the concern to protect the corpus of the pension fund progressed, many institutions were attracted to “portfolio insurance,” which was an approach that in part, used futures to hedge the market. When the market went down, futures were sold, or in effect, “puts” were put on. The more the market declined, the more “insurance” was placed. Thus in the aftermath of the 500 point drop in October 1987, when the market rallied sharply, the results for some funds were disastrous. To avoid a repeat of this type of automatic trading, once the market started to drop midday on May 6th 2010, many statistical traders cancelled their automatic buy programs. This purported action may well have led to the 997 point intraday loss. (Sometimes it takes awhile for unintended actions to explode.)


Last week the news was full of European debt and related problems as well as some disappointing domestic economic news. Not only was the Senate passing a stability act but there was also legislation attacking the capital gains treatment for “carried interest.”

Perhaps investors showed their fear of the unintended consequences of the week that ended on Thursday, May 13th, when we saw a “normal” year’s net asset value moves in only five trading days. There were twelve fixed income funds up 5% or more for the week and eleven down 5% or more. We saw twenty equity funds up 25% or more and ten that were down a similar amount. What is important to note that is all but one of the equity funds that gained were those with a dedicated short bias. The next best performing group was funds that held general US Treasuries, which was up about 3%. To put this calendar week in perspective, one stock, T Rowe Price (NASDAQ: TROW), perhaps the highest quality publicly traded mutual fund management company (and a personal and fund holding) ended the week at $50.99 after hitting a low of $47.32 and a high of $54.01. Another indicator of the fear in the market place is the VIX which measures the fear level surrounding the S&P 500. VIX is now about 45 compared to close 15 a few months ago.


What this means to investors is that we are likely to see more swinging markets for there will be fewer swingers on the dance floor, another unintended consequence of government intervention.

What do you think?

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Sunday, May 16, 2010

The Fork in the Road
to your Investment Policies

The fork to the left is pinpointed by real world observations, the fork to the right deals with possible negatives.

As many of the members of this blog community know, one of my critical investment laboratories is Ruth’s and my walks through The Mall at Short Hills. For those of the community who are not familiar with our annual rite, the day and the weekend after Thanksgiving each year find us at this very upscale mall looking at the size and intensity of the crowd as well as the number of labeled shopping bags they are carrying. Another clue to the robustness of the Holiday sales is how far away we have to park compared to our normal spot.


We have just returned from a visit to the mall on a very pleasant sunny Sunday. We had to go to the less convenient level to find a parking place. There were more than the normal numbers of intense shoppers, not walkers. The Apple store (NASDAQ: AAPL) in particular looked busy and the Verizon store (NYSE: VZ) appeared to have a good crowd within. In the past I have commented on the depressing number of vacant store sites. Today there are fewer vacancies and there are a number of large stores advertising their future openings and upscale merchandise. Bottom line: people were buying, merchants were expanding, and mall operators were showing signs of success in filling their sites (perhaps at discounted leases).


In this part of the country, dinners and cocktail parties' participants spend some time on our “local sport.” To my grandson’s dismay, this is not soccer but residential real estate. Increasingly we are hearing about bids being hit or exceeded, but with contingencies for mortgages or prior sale of the buyers’ current homes. Months ago there were little or no such conversations.


The investment implications of this left fork are that the economy is in a state of uneven recovery and some hope has returned. From a portfolio standpoint, investment in depressed consumer discretionary items as well as some ties to home improvements appears to make sense. These moves are based on the return some form of normality, even if it’s the “new normal” of lower returns.


The right fork is more difficult to elucidate. Last week one of the questions that my blog dealt with was, "Why didn’t a number of investors jump in at what appeared to be bargain prices?" As mentioned, sharp market movements in retrospect often are found to be inflection points, marking changes of direction in investment thinking. The immediate concern in the first week of May was the clumsy way the European Community was dealing with the Greek problems. The bounce-back sustained in this past week focused on multi-tiered funding approaches by the EC and the IMF. There were some austerity measures announced for Greece, Portugal, Spain and Ireland. I suspect that these will not be sufficient in the long run. At this point a much bigger potential funding deficit in Italy is not being publicly addressed. A number of commentators have compared the deficit tracks of Greece and the US, which is sobering. What has one concerned is the pattern of governments to socialize, if not nationalize, what in the past has been private responsibilities. As families became clans, then tribes and morphed into nations, the primary need assigned to government was defense from without.


To pay for services by government, taxes were introduced which led to government sponsored coinage and building roads. Over time, provisions for education and retirement became government obligation in some societies. In Europe and now in the US, the provision of health care is being socialized. What is not written in our, or other countries’ constitutions, is the creation and preservation of jobs.

Almost inevitably when a service that has been or could be provided by the private sector is turned over to the government, inefficiency and corruption occur at some levels. These are additional transfers from the private sector to the public sector, not dissimilar to declared taxes. There are differences caused by these inefficiencies and corruptions which build rigidities into the economic systems. Over time these elements act as an additional tax on the provision of these services to the community. Countries, states and cities with higher net effective tax will inevitably lose economic opportunities and therefore jobs to more efficient locations.


Are the problems of just about every country which borders the Mediterranean akin to a flock of canaries in the mine? Did some investors perceive the problem without seeing any significant attempt to structurally reform our own economy? If that is their growing perception, they should start to discount more heavily what they expect to be normalized or peak recovery earnings. In other words, do stocks in the future, not have the same potential capital appreciation that they delivered to us in the past century? (Not counting the last ten years of little to no real growth.)


For those that are looking down the right fork, they should consider using significant recovery rallies, including new highs, as selling opportunities. As long term bonds are already unattractive in terms of income and inflation, they are unlikely to be a long term attractive alternative for equity money freed from the domestic market. What is worthwhile, starting today, is the search for governments that are being more responsible to their citizens and investors. Those that are doing so today are more likely to continue to do so rather than the countries that recover from too much government spending.

The choice of which fork is up to you and for awhile one could attempt to do both, but that will require an alert investment manager. Keep us informed.


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Monday, May 10, 2010

Why Didn’t We Buy?
Did the Game Change?

As by now, you and practically every other stock market oriented person on the face of the earth knows, that after a significant market decline earlier in the day last Thursday, starting a little after 2:30 in the afternoon and lasting for about for 43 minutes, stock prices collapsed with 997 points on the Dow Jones Industrial Average disappearing.

A Strategic Question

What caused this calamity? At this point, no one has produced conclusive evidence as to the specific cause or causes. My concern is much more strategic than what was the immediate cause of the decline, (which to me is similar to focusing on the assassination of the Archduke that started World War I, rather than the irreconcilable differences between Germany and its neighbors). My concern is why I and others did not buy at the depressed stock levels. While I won’t be able to be definitive for some time or perhaps ever, I do have some thoughts to share with this blog community.

Lead-up to May 6, 2010

Recently the bulk of the trading in many institutionally-favored securities has been driven by proprietary trading desks and other professional traders including some hedge funds, not by investors. In response to calls from investors and some dealers, regulators have been determined to reduce the monopolistic power of the New York Stock Exchange and NASDAQ. They permitted, (some may say encouraged) alternative trading sites and procedures to come into being. The institutions now have many places to trade.

This market dispersal in turn creates the problem that traders must find the natural other side of the order they wish to execute. One of the techniques they choose to use is to divide their orders. Prior orders of 10,000 or more shares were given to a single broker or dealer to execute. In traders’ search to find volume on the other side, block trades have been replaced with many multiple 100 share orders, placed rapidly through a number of different market sites. Because of the difficulty involved in executing these trades, some institutions reduced their participation in the visible marketplaces. In the partial vacuum which was created, traders saw an opportunity to get between natural buyers and sellers and earn a spread. To find these partial vacuums they employed statistical techniques using various types of algorithms developed by PhDs from universities like Caltech and others. They were, in effect, mining the flow of information captured in prices. To avoid the “Black Swam” effect of something occurring beyond the expected, with a stroke of a computer key they could cancel all their below-the-market buy orders, which was what I believed happened Thursday afternoon.

An Inflection Point?

More disconcerting was the absence of large value stock buyers on Thursday. In last week’s blog I shared my brief notes from the Berkshire Hathaway annual meeting. I saw a number of well known value fund managers at the meeting and I am sure that there were others there also. In theory, these managers always weigh price and valuation points as well as trends. With stock prices plummeting to levels that had not been seen for many years, why did they not rush in and commit all of their reserves? Tumultuous days in the market are often deemed to be inflection points. Was there some new vital information that caused a change in the valuation system used by these managers?

Market Intelligence

On Wall Street you don’t have to actually have superior information, you just need to act as if you have it. For many years when he was chair of the Federal Reserve Board, the market thought Alan Greenspan had better information than others because of his background as an econometrician. We now know, sadly, that his information, especially on housing, was not particularly accurate. Nevertheless, at that time, market practitioners tried to tease out the implications of his supposedly superior information.

Foreign Exchange Trading on May 6

Early on Thursday there was much concern as to most of the Mediterranean economies and the fate of the euro. There was a euro-yen trade early in the day which some took as significant. Up to that particular time most did not look to the yen as a safe-base investment currency. Did this trade suggest that the Chinese government’s attempt to safely cool-down their economy was working? Or did this mean that the rise of the US dollar against the euro was, in effect, causing the Chinese yuan to appreciate and thus reduce some politically sensitive trade imbalances? Was something else of significance occurring, causing sound, value-oriented investors to withhold their support from previously favored stocks?

A Non-Political Observation

From my standpoint a further complicating event happened this weekend. I am not making a political statement, but an informational belief. The good citizens of Utah chose not to re-nominate Senator Robert Bennett. Losing his knowledge as to how the markets work will be unfortunate for the country and particularly for investors. Next year’s Senate will have a lot to do with major regulatory changes that are likely to come.

Did the Game Change?

How should an investor, particularly a long term investor who uses mutual funds and hedge funds, react to Thursday and its aftermath? I suggest that some wise managers will be searching for the implications of this possible inflection point. If a number of successful managers start to do things differently, then I think that Thursday was important and our strategies should be adjusted. At this point I am weary of managers that think what happened was just an aberration. Be particularly careful until after the election.

What do you think?

To Members of Mike Lipper's Blog Community:

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Sunday, May 9, 2010

Travel Delays

Due to travel, my blog will be delayed by one day.

Sunday, May 2, 2010

Omaha Highlights

There are legions of books written about Warren Buffett, Charlie Munger and their performance at the Berkshire Hathaway* (NYSE:BRK-A) annual meeting. While I have been following them since the early 1980s, and had the distinct honor to introduce Mr. Buffett to the New York Society of Security Analysts, this was my first visit to the annual meeting. (I plan to return again.) There was not much written in the Sunday paper about the meeting except their support for the Goldman Sachs CEO, but I suspect that coverage will be extensive beginning with Monday. As an exercise for myself as well as the members of this blog community, the following 38 briefs come from my five pages of notes, which I hope share some of the wisdom of these two remarkable men.


One of the first steps in the Buffett/Munger intuitive capital allocation process is to develop their thinking on the potential and likely return on invested capital generated by the businesses being examined.

At this point for Berkshire, capital-intensive investing is a bigger drive than intrinsic (value) investing.


In terms of the ABACUS-2007 deal, based on the SEC complaint, Goldman Sachs* (NYSE: GS) did nothing wrong. The motivation of the other side is not relevant when trading. Berkshire may even benefit from the complaint, as it will probably delay the calling of Berkshire’s preferred stock, currently earning 10% annually.

A new version of Glass Steagall is likely. If Berkshire was forced to put up collateral for its derivative position, it would probably put up its stock holding of Coke (NYSE: KO). At the same time it would demand some additional payments from its counterparties, as they paid for uncollateralized derivatives.


In terms of currency exposure, they have exposure on both their assets and liabilities sides. They are bearish on all currencies, particularly those who have to borrow using other currencies.

Each July, Warren Buffett will give 1.5% of the stock to five foundations. The current turnover in the stock on the NYSE is over 100%.

Over the next 50 years there is a high risk of a nuclear, chemical, or biological attack on the US. The risk is low in any given year. (This statement which is not new, it may be a plea for some sort of federal guaranty.)

The list of four candidates to replace Buffett on the investment side changes periodically. The directors are familiar with the candidates, They did well in 2009 without leverage.

It is easier to build a new culture than to change an old one. They failed in an attempt to change the culture at Salomon Brothers.

They think that despite the worldwide size of McDonald’s (NYSE: MCD), the company does a better job of educating its employees than universities do their students.

Munger was the one that discovered Chinese auto parts maker BYD and drove the acquisition of its position.

The various CEOs are paid on the basis of the economics of their business. There is not a Berkshire standard and there is no compensation consultant. Managers are paid to widen their “moats.” Headquarter fees for the 21 employees are not charged to the various operations, but there are capital charges.

The major railroads have been rebuilt over the last 30 or 40 years. The big 4 railroads are allowed to earn 10.5% on their invested capital.

In terms of insurance risks, the company will accept volatile returns while others want to have their earnings smoothed.

Read chapter 12 of John Maynard Keynes’s The General Theory of Employment, Interest and Money, written in 1935.

In 1982 Buffett submitted to John Dingell the only letter in opposition to permitting futures on the S&P 500.

Employees should think and act like owners.

Generally they hope a dollar of increase in equity to be equal to more than a dollar increase in market value.

Warren Buffett, Charlie Munger and some of the board members are visiting China in September.

Thomson (NYSE:TRI) always seems to want a 40% return on capital, a habit held over from its newspaper days.

Munger is converting his IRAs to a Roth IRA.

The federal government will have difficulty in not bailing out the failing states. Due to too-low rates, they are no longer writing new municipal bond insurance policies.

For the next 10-20 years one should want to own equity and not bonds and cash.

Moody’s* (NYSE: MCO) is a wonderful business, but they made a bad mistake on residential housing, They, like others (particularly graduates of business schools), relied too much on models.

Berkshire does not have an annual budget for a fear that various managers would “game” the system.

“We can get along without oil if we must.”

“If scared when others are fearful, you won’t make money in securities.”

In practice they are much more comfortable averaging down than up.

Advice to a new investor: “Get your feet wet with a little failure.”

“Solar panels will get cheaper.”

There will be a truly national electrical grid system.

Their portfolio is often undervalued, they do not own any major future winners.

“There is no better way to get happy than to lower expectations.”

They are blessed by not having an investor relations department.

“One should know the perimeter of one’s circle of competence.”

“One should always keep learning as the competitors are surely doing."

“Very few people fail totally.”

“Follow one’s passions.”

Many of these notes might be cryptic. I would be happy to discuss them to the extent of my understanding of what was said and what was meant.

*indicates securities owned by me or by my financial services hedge fund.

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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