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.
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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...
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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.

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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:

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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