Sunday, June 27, 2010

Is Breaking Even Equal to Breaking Up?

In my continuing search to locate the missing buyers that are needed to put the stock market on a higher plane, I have learned from others the expressed view that it is too painful to buy more when one has not broken even. Emotionally I understand this. One does not want to go through a breakup, either of a personal relationship or a firm, but often that is required before moving on to the next phase or new relationships. One of the reasons to avoid breaking up is the desire not to unduly hurt other parties. Often this means staying in an unhappy relationship too long for all involved. In a somewhat analogous way, holding on to securities or perhaps investable cash can hurt. But in these cases the hurt is to the investor and possibly the beneficiaries.


Whether an investment is to be successful is a function of future prices, either in absolute or relative terms. Unlike human relationships which are based somewhat on the conditions of the participants when they enter a relationship, stock prices don’t remember your entry prices. Only the tax collector primarily cares whether your transactions produce a net profit or a loss and over what length of time between purchase and sale dates. One of the many errors people make is that they carry their investments at current prices. Since we have been told that the only certainties in life are death and taxes, we should carry our assets net of expected income and/or estate taxes. One of the curious things that happens when a purported price rises above our purchase price is that we might consider it goes from a usable tax loss to an incipient tax liability. Neither condition should heavily influence investor actions. In this case, unlike human behavior/memory, the future will not be determined by our past.


Freeing up investment capital for better investment is the essence of sound investment activity. While we are struggling today with the unknowns of future stock prices, we can easily believe that some prices will grow faster than others. In a vast oversimplification, future relative stock prices will be a function of how rapidly corporations will grow their businesses and what relative change the market places on its collective valuation. This philosophy leads one in the direction of selecting improving companies with more modest valuations, a difficult combination to find. (We hope, on balance, the portfolio managers we have selected for clients do a reasonably good job of selections for the various futures.)

At the current levels in the stock market, one would think that many stock prices do not represent a positive future valuation even if they do improve as one might expect. These stock prices compare with some of those that we own that are good companies with not much chance for above-average improvement. Therefore, some switching appears in order for a number of positions.

By the way, if one is to be truly analytical, positions should be viewed in terms of the real dollar level at the time of purchase. Thus many of the gains that we hold are not up as much as we believe. If you believe as I do, that on a long term basis the purchasing power of the dollar will decline, to maintain your standard of living you need to find investments that will grow faster than the dollar’s purchasing power decline.


In the past, mutual fund investors often redeemed their shares when they had broken even. In most cases they defined breaking even as when the net asset value currently quoted to them was higher than their remembered purchase price. Again, from an analytical viewpoint this calculation is misleading. Over time they have received income and hopefully capital gains distributions, plus in some cases return of capital distributions. These should be added back to the initial price if one wants to compare the performance of the fund versus some stock prices. Another add-back should be the sales costs, management costs and administrative expenses paid. That some of these costs did not produce the intended results is immaterial in that they were paid by the fund investor. Thus, often fund investors have done relatively better than they thought.

Bottom line: do not let the fear of the tax collector put your holdings in a “quasi-tax jail.” Be among the early-renewed buyers of potential future winners. When the other buyers catch-up to you, they will probably be paying higher prices.
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Sunday, June 20, 2010

Unpredictability and My Grandfather

Often in these blogs I use inputs from beyond the US, and I will again tonight. My reasoning is that we live in a closed cycle on this singular earth, where important events anyplace can have significant impact on the portfolios that I manage for wealthy people and institutions. I did not realize that some of the members of this blog community tap into us occasionally from the United Kingdom, Hong Kong, Philippines, Australia, Canada, France, Russia, Germany and Denmark. Just as those within the US, people elsewhere invest externally to escape the constraints imposed by their own governments and look for opportunities elsewhere. Further, we have seen that basic investment principles, or if you will wisdom, regularly jumps borders. Hopefully, all of the members of this blog community will perceive some worthwhile insights from these blogs.

In discussing what to write about for this blog during my Father’s Day call with one of my sons, he suggested a good topic might be the wisdom I received from my grandfather. Most of my investment conversations with my grandfather were when I was a couple of years either side of ten. These discussions were many years after he retired as the senior partner of his own brokerage firm that served the “carriage trade.” I am sure that he had many wise things to say, but only two were germane to investments of today.


The first discussion referred to the 1930s, when at times one could not borrow money even if you had substantial cash in a safe deposit box. He recognized that the inability to borrow would be crippling to his brokerage firm (that he successfully liquidated) as well as to his wealthy clients who used margin borrowing. The second thing that I took away from his statement was that he did not totally trust banks for all of his deposits. I wish that he would have been around in 2008 so we could have discussed the liquidity crisis that took down two of the brokerage firms he competed with, Bear Stearns and Lehman Brothers.


The second insight that I learned from him was the importance of tax accounting for the oil companies. He felt that the then sizeable depletion allowances gave the oil companies what Warren Buffet would recognize in the insurance business as “float.” Depletion was one way to have the oil companies focus on the replacement cost of the oil they were pumping. Oil company replacement cost accounting, while not generally the focus of stock investors, drives a number of the large oil companies today. This is why a number of the majors spend all of their prodigious cash flow in exploration and borrow outside capital to pay their dividends which are critical to support their stock prices. One can see the implications for the shareholders of BP of this type of analysis, but we would leave that to others for the moment.


The reason to bring up the wisdom of my grandfather is to illustrate that one of the better ways wealthy families survive is not just cash preservation, but by passing on sound principles to their families. Capital can be lost to bad investment decisions or consumed through high expenses. Analytically sound thinking can aid in the family’s recovery of their wealth. We have seen this often when formerly wealthy families are forced to leave their homelands and begin anew in a foreign land. Relying on hard work and passed-on principles, they recover and prosper. One of the jobs of wealth managers and family officers is not just preserving wealth, but helping future generations learn from their parents and grandparents how to make money in the future.


One of the ways to learn about the financial world that is both different, but in many ways similar to my grandfather’s time, is to read important articles and books. For readers, one of the major pluses of Rupert Murdock’s purchase of Dow Jones is that he can introduce us to some of the best thinking in the London press. In Saturday’s Wall Street Journal an article on the unpredictability of the future, entitled “The Benefits of the Bust,” was written by Anatole Kaletsky, editor at large of The Times of London, (click here to read) This article dwells on the fact that once again we were unprepared for the future. The various economic and political models did not contemplate wholesale disruption of what were perceived to be known: housing prices and the failure of very large financial institutions. I recommend that you read this piece and contemplate it in terms of the unpredictability of the future. Yet as people and particularly business people, we must spend money today against some concept of what the future will hold. These are important lessons for those who have the responsibility of investing money today for the future benefit of others.

Perhaps on this Father’s Day we should think carefully about how to apply the lessons of our fathers and grandfathers to today’s problems and opportunities. I, for one, am convinced that my grandfather would have been a success in today’s environment. I only hope to have learned from him and others to do as well.

Happy Father’s Day
To Members of Mike Lipper's Blog Community:

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Sunday, June 13, 2010

Too Much Focus on Short Term Imponderables,
Not Enough on Long Term Challenges and Opportunities

Unfortunately almost all attention is focused on the short to intermediate time horizons during this period when there is no sustained progress investing in large cap domestic stocks. These horizons are set by the patience of the most impatient member of each of our formal or informal investment committees. I noticed how conversations focus on the latest morsel of very current information, as if this will provide the answers to our long term investment needs.


  • Chase is marketing a CMBS structured offering with a bottom traunch that has no credit rating and will be sold to hedge funds or swallowed themselves.

  • CDO spreads show our fear levels, with Citi being at 327 bps, Goldman Sachs at 260, and JP Morgan at 138.

  • Last week the Australian dollar rose vs. the US dollar 3.1%, the Canadian dollar 2.8%, the New Zealand dollar 2.75% and the Swiss franc 1.3%.

  • The Barron’s Confidence Index (mentioned last week as an unusually bullish indicator) dropped some of the way back to its prior level.

  • The Wall Street Journal suggested this is a time to use leverage.

All of the above elements are indicating that we are in a more normal or even a “new normal” period.

For my clients, family and the institutional investment committees that I serve, I try to focus on long term needs. Additional inputs that contribute to my long-term thinking are:


  • The state of Colorado after using a future investment returns assumption of 8.5% has recognized that if they lower their assumption to a somewhat more reasonable 7%, they will run out of money to pay pensions in 30 years.

  • Jason Zweig in his always important but often controversial column in the Weekend edition of the WSJ (click here to read) compares the current difficulty of the DJIA to sustain a reading over 10,000 over the last ten years to the sixteen year period it took the index to sustainably rise over the 1000 level.

  • Last year for the first time in perhaps thirty years, investors bought more gold than the jewelry trade. I have read that one gold ETF owns more gold in one London vault than all but a few central banks. Diamonds are also in significant demand. A high end Jeweler told me that he is having difficulty in obtaining serious diamonds caused in part by De Beers' control of the market. I also learned that in the US the retail price per carat is about $200, and in China over $1000.

  • There is a new study that that suggests after a 10 year bull market in commodities, a 20 year bear market follows. (This makes sense to me in that higher prices bring into productions new mines and a major rise in capital expenditures, which we are seeing now.)

I maintain all of the above items are tactically important and are descriptive of the present moods. I would daresay that a consensus has been formed that the current markets do not offer any major opportunities to meet long term needs through investment gains.


My training at handicapping thoroughbred race horses holds that favorites, by definition consensus chosen, may win about a third of the time. When they do, the rewards are not enough to pay for the other losing tickets and their imbedded fees and taxes. The only to win money on balance is to selectively pick non-favorites. Almost by definition this process works on a different set of conditions occurring than those that have bet on the favorites.


I believe that future conditions which could start at any time will be viewed differently than those of today. As usual in these tautologies my beliefs are based on three growing forces. The first is innovation and technology. My Caltech bias may be showing, but long before joining their board I was a reasonably good electronics analyst. The second force is demographics as the growth both in numbers and drive for higher standards of living will raise the aggregate level of demand and to some degree where the supply will originate. (For the most part the countries in the northern hemisphere are facing a demographic time bomb of having too few workers to pay for those who are retired. The US is on the cusp of such dilemma. Our way out is to encourage the right sort of immigration and education.) The third force is very difficult: discipline. I have little faith in so-called reform measures imposed by governments without getting their own houses in order. I do believe that many people including business people, investors and loan officers have recognized some of their prior enthusiasm has led to bad decisions. Similarly, some of the losing teams in the World Cup will go home with an understanding that good intentions are not enough without the proper training and on-field discipline.


The question before the formal and informal investment committees is how to structure for this expected change in conditions. Recently, I have advocated for a significant non-profit that the endowment be divided into three unequal parts. The first is to fund the current year’s needs as well as the next years’. (In other words, if the investment world collapses you have at least two years to live.) The second and the largest piece is to invest to meet the identified needs; which could be new facilities or sending Johnny to college. The third piece is to invest the needs beyond the identified horizon. We all have experience in our lives, both challenges and opportunities, that we did not expect. With the correct mind-set and a little bit of capital, these challenges can be opportunities. I will be the first to admit this three element strategy is easier to manage through the use of mutual funds or specifically designed separate accounts, than by choosing individual securities.

I am curious as to the reactions, comments and criticisms from the members of this Blog’s community, please let me know your thoughts.
To Members of Mike Lipper's Blog Community:

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Sunday, June 6, 2010

The Buyers’ Strike May Continue;
Was Friday a Clue?

On Friday, June 4, the Dow Jones Industrial Average declined 323.31 points or 3.15%, with most of the damage occurring early in the day. The volume of reported transactions was only marginally above what is now passing for normal. In the past, major declines brought out “buy on the dips” volume, however not this time. Was this a sign that something fundamental was happening that had longer term implications? Let’s look at three news items that came out on Friday (or after the close on Thursday) and their possible implications.


The new government of Hungary let it be known that the prior government’s statistics were so faulty that the country’s debt probably can not be supported without a devaluation of its currency, and therefore an induced inflation. The significance to investors in euros and US dollars was that this announcement might prompt us to raise a mirror to our own growth of government debt and a constrained economy. Hungary’s way out is its own currency. In effect Hungary, like Lehman and Bear Stearns, has access to capital markets. The countries collectively known as the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) do not have that option, at least for the moment they are trapped along with their richer neighbors in the single currency. The way out for the US (as the de facto world reserve currency) is induced inflation. Was this a wake-up call challenging those who feel that the problems in Greece, Portugal and Spain were being attended to, and the US would grow its way out of problems?


Also late on Thursday there were two unrelated news elements that brought additional concerns about the global financial community. The first was the rumor that Société Générale had suffered large derivative-related losses, which on Friday they denied. The key to the market was not that the French bank suffered trading losses, but rather that it and other banks could lose big. After the close in the US, it was announced that the president of Wilmington Trust unexpectedly announced his retirement. He is to be replaced as president by an internal candidate with corporate experience who has headed up Wilmington’s non-lending activities. Once again a bank is being led by a non-banker, similar to CEOs at JPMorgan Chase (a stockbroker), Bank of America (a lawyer) and Citigroup (a hedge fund manager). Tying these two elements together, are we projecting that banks will not make deposit gathering and lending their main source of future profits, but instead will rely on trading and other forms of investing to generate dividends for their various shareholders? Is this alternative being severely curtailed by the so-called reform measures in the conference committee of the US Congress which will put US financial institutions behind the less capitalized foreign universal banks? At this point in the cycle commercial banks and retail brokerage firms should be in a market leadership position and they are not today.


The third bit of bad news that hit on Friday was the extremely weak private sector jobs report. One could chalk the disappointment off to the “abysmal science” of the economists. Economists’ US estimates were way high and they were low in Canada, where job growth was twice what was expected and its unemployment rate dropped to 8.1%. There is a suspicion on my part that the economists and some analysts are not mall walkers, having under-estimated the Canadian market and over-estimated the US retail sector. The lack of confidence on the part of stores hiring retail sales people is palpable. There are still too many empty store fronts to support a growing economy. Part of the issue is that now with the bulk of the aggregate stimulus packages spent, our money supply is contracting. This is not a surprise to our government. Treasury Secretary Geithner has warned the other members of the G-20 that the “US can no longer absorb the world’s exports.”


How is all of this being translated into investment policies? There are additional inputs that might be useful in your own investment thinking,

The first is volatility. Notice that the press is full of stories about volatility primarily on down days. Few seem to worry about volatility on the upside. Part of this may be due to the harm that many financial academics have done to investing by equating volatility with risk. This is discussed more fully in my book Money Wise. The CBOE Volatility Index (VIX) is a popular measure of volatility (that few people really understand) which tracks the “bets” on the S&P500 contracts. When the number is high the “fear” indicator is high. The historic high on the index was approximately 80 and the low achieved a few months ago was about 15. On Friday the index rose 6.02 to 35.48, a one day gain of 20.43%. I believe that on May 6th the index was over 45. I would suggest in recognition of the fact that so many of the market participants are trading oriented that one needs to be prepared for volatility in today’s ranges. This translates that on most days we could see moves of 100-200 Dow Jones points. Expect this level of volatility as you manage your transactions.

As is often the case, the US bond market often is more sensitive to future trends than the stock market. Each week Barron’s publishes its confidence index which measures an index of high grade bonds divided by an index of intermediate grade bonds. A decline in the latter vs. the former generally points to higher stocks. In other words, as the yields on intermediate credit declines relative to high grade, their prices go up (which is often paralleled by more confidence in stocks). As an observer of this index for more than 40 years, I am used to seeing weekly moves of 1 point or less. For the week that just ended the reading was 79.0 up from the prior week reading of 75.2. A year ago the number was 68.7. While this indicator is far from infallible, it has produced winning judgments more often than not. I choose to be encouraged by this particular confidence indicator.


One has to have a strong contrarian point of view and a belief in institutional fallibility. The trend of leading pension plans to invest into commodities is growing. CALSTRS is joining CALPERS and the teacher plans in Texas and Illinois, as well BT from Britain and two Dutch pension plans in making specific allocations to commodities. I interpret these as long term bets on increased inflation caused by the deterioration of the value of money’s purchasing power. If these are more than a simple hedge, but a bet on institutionalized inflation, then one wonders whether long term bonds have any place in one’s investment portfolio. Stocks may not do well under these circumstances, but are clearly better than bonds. Many corporate pension plans are very much betting the other way, significantly switching equity money into corporate bonds. Both the government and corporate plans are reacting to their fears not to opportunities, which in the long run makes me bullish for our long horizon investment accounts.


To Members of Mike Lipper's Blog Community:

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