Monday, December 26, 2011

Your Investment Gifts May Contain Good and Bad Surprises


At this season of both sacred holidays and financial year-ends, we receive wrapped packages. Often we can guess what is in the package by its shape and/or wrappings, others are a mystery. When we closely examine the financial packages, some have surprises within them that will affect our portfolios in 2012 and beyond.

Byron Wien, my good friend and former fellow board member of the New York Society of Security Analysts, is world famous for his list of the surprises he sees for the forthcoming year. Over time, he has an above-average record. Often when he is right in some unexpected event, the returns are high; when he is wrong, not much damage is caused because most investors did not have the same expectations. On the basis that imitation is the sincerest form of flattery, I have hereby prepared my list of investment surprises, published a week before Byron’s. My list is more of an evergreen list than his, and I do not expect to have his winning average. The main purpose of my list of surprises is not to demonstrate my predictive talents, but to develop a list of items that sound investors should periodically review with their portfolios and business plans in mind. Because of my responsibilities for fiduciary accounts, the list generated contains more possible negatives than positives. Further, in the current market environment, it is easier to think about what can go wrong than right; which is probably another indicator that we will see the commencement of a significant upward move of global equity prices.

Surprise: The big money bets can go wrong

The history of huge collapses of market bubbles is that over time the remaining intact assets gravitate to new/different asset classes, often seeming to be more secure. In order to constrain the air coming out of the “Dot Com” bubble, the Fed and other government and non-government leaders became advocates and enablers in throwing money into residential real estate. We all know the results of this over-bet. By the middle of the last decade there were all the classic signs of over-investment by governments, financial institutions, and individuals. Five years later we are still dealing with the buried and yet-to-be buried corpses of this over-investment in supposedly “safe” assets. Where did the money that survived the residential housing collapse go?

The flight to perceived “quality” and safety has led to a situation where the only commodity that is now up in price is the US dollar. This is after the one credit rating agency broke its strangle hold on the highest credit rating, AAA. The other credit raters have not yet followed. If one looks carefully at the US, we still have no substantial effort to materially reduce our deficit production policies. At best, there is an attempt to hold the deficits back, but eventual rises in interest rates and almost guaranteed new overseas military-like commitments suggest that the existing budget plans from both sides of the aisle are naïve. A realistic assessment of our willingness to pay down our debts in “real” terms is no better than mid-to-low investment grade, only scoring that high because of a lot of valuable assets that could be sold. Eventually some of the other major countries of the world will make progress at their own deficits and could become “safe haven” currencies to absorb those dollars that need to be diversified, thus resulting in the price of the dollar going down and dollar yields going up. My contrarian conviction in this possibility was recently strengthened when the CEO of an investment bank was quoted as saying that the US Treasuries are the safest investment in the world. Extreme positions seldom work out over time. A number of Asian countries are agreeing with China to settle trade accounts in yuan rather than dollars; five years from now this could be a significant amount. Currently the only too-strong currency is the Japanese yen. At some point, investors may feel the need to view these two Asian currencies as additional “safe havens.”

The analyst’s nightmare surprise: bad numbers

As an analyst I will never be totally satisfied with the amount of numbers that I have. Part of this skepticism is that we must remember no numbers exist in and of itself in nature. Numbers are an abstraction of someone’s perception of reality. More numbers give me different slices of reality, which may reinforce the initial set of numbers or qualify the applications that the numbers can be used. For some, published numbers by governments, corporations, trade associations and even the specialized press are everything. These are the only actors on the stage of security prices. From experience, however, some of us believe that while numbers are important, they are not all important. In the end, qualitative factors can trump numbers at key junctions in terms of profitable decisions. All of these thoughts are based on the general belief that the numbers are being produced honestly.

For those who want to look, any history of mankind has to reveal that intellectual, spiritual and monetary fraud is a common occurrence. Too many people ask me whether Madoff and perhaps MF Global are the last of the frauds. They want to be assured that all the bad actors have been exposed. This is silly. I am afraid that every single day someone someplace is doctoring results to give a good impression. Most of the time these perpetrators are caught, with relatively minimal damage to most people except the historians. The historians suffer because the fudged numbers are not often replaced with the correct numbers. Thus all too often, the so-called “lessons of history” are based on incomplete facts, with potential damage to all of those that extrapolate from the past. All of this is to alert investors that there will be frauds in the future. The painful ones happen when investors have all or most of their money bet on certain numbers by a trend or manager. The only way I know to defend against such risk of loss of capital is to diversify into different investment approaches that don’t intersect through the same general numbers.

The portfolio managers’ nightmare surprise: hedging creates risk

Many investors and their managers wish to avoid volatility, rather than take advantage of it, or perhaps even better, ignoring it. One of the more popular methods of hedging today is through the use of Exchange Traded Funds (ETFs). The more advanced of these strategies is to use sector ETFs to counter-balance either individual securities or portfolio sectors. That would work well if the sector ETF chosen did truly represent the sector. In Saturday’s Barron’s, there was an advertisement for the nine sector ETFs titled SPDRs (Standard & Poor’s Depository Receipts), often called “Spiders” and managed by State Street Global Advisors (SSgA). The ad showed the percent of each Spider invested in each of the ten largest holdings in the sector. ETFs are often compared with actively managed mutual funds. By policy, most mutual funds do not invest 5% or more in any one stock. Applying the same screen to these sectors, one gets very different impressions as to the diversification in the ETF. For example in the Technology Spider, 47.91% was invested in the first six positions. In the materials Spider, 45.71% was invested in the top 5 positions. In the consumer Spider, the top 5 accounted for 45.04%, and in the Energy Spider, the top 3 were 39.71 %. Any one of these concentrated leaders can have specific risks or positives occur that are not representative of its larger sector. Thus, a gap will open up between the base that the portfolio manager was trying to protect and the hedging vehicle. This becomes important when the manager believes that he/she has reduced the total risk of loss, when that might not be the case. All too often we have seen investors unhappily surprised by these so-called safer vehicles, when the results were not what were expected. In general, I prefer to do my attempts at hedging in separate vehicles where I can track and attempt to understand what each side is doing.

The entrepreneur’s bad dream

With regulators regulating through press releases, aided a news media always hungry for bad news, each business person is fearful of reputational risk. A hard-earned reputation that has taken years (and in some cases centuries) to create can be tarnished or destroyed in a matter of a few days or even hours. Can an investor get ahead of this potential train wreck? No, but one can reduce the potential loss. One clue, particularly in a portfolio of “great companies,” is to cover the name and then look where the price/earnings ratio should be, based on the record. Then compare your theoretical P/E with the actual one. The difference is largely the size of the value that the market places on the firm’s reputation. One way to lessen the risk of sudden reputational loss is to have some preset limit in the portfolio of “great (recognized) companies.”

Surprise: Now, some good news

As regular readers of this blog know, I regularly visit The Mall at Short Hills, with its collection of glitzy stores many of which are part of European brands. Ruth and I visited the Mall on “Black Friday,” and were unimpressed at the shopping volume, as we were able to park easily and saw relatively few shoppers, most with only one or two bags. Today, Monday, is a work day for me, writing this blog and preparing for meetings later in the week. In the course of the day, I drove by the mall and had difficulty getting on to the adjacent highway; there were three jammed lanes trying to get into the mall and past the police that were restricting traffic. The lines to enter the mall were at least two miles long. My guess is that the crowd was not primarily returning unwanted presents, but attempting to buy advertised and unadvertised bargains. This certainly proves that at least some Americans will buy when they perceive value. In an article entitled “U.S. Stores Hope ‘Mega Monday’ Led to Brisk Sales,” Reuters reports that December 26 is expected to be the third-busiest sales day of 2011, trailing Black Friday and Friday, December 23, according to ShopperTrak, which measures retail and mall foot traffic.

Technological breakthrough Surprises

As some of you might know, one of my early roles in the investment world was that of an electronics analyst. Building on that experience and my exposure as a Trustee of the California Institute of Technology (Caltech), I always expect some wonderful new products and services will be introduced to our commercial world. I do not believe 2012 and beyond will be an exception. At one end of the extreme, the truly exceptional items will come from small developers, increasingly located outside of the US. They are the equivalent of the garages that spawned Hewlett-Packard and Apple. At the other end of the spectrum, advancements will come from giant companies with established research and development groups and facilities. The surprise coming from these large groups will be products and services that they were not looking to produce. The potential of this accidental re-purposing can be very large and happen at any time.

The new high: certain, but when?

Despite various twists and turns, any study of history and particularly of human development, leads one to expect progress to benefit many. When will this be translated into tradable market prices? I don’t know. We have been told history does not repeat itself exactly, but it does rhyme. The last reference is to indicate that there will be some similarity of the past stanzas to the new ones. From my technical analysis days of reading price and volume charts, I believe that we are in a long trading market that will unexpectedly either have an explosive rally or a sharp collapse. (These moves are often presaged by false moves, sometimes in the wrong ultimate direction.) From the time the Dow Jones Industrial Average hit one thousand points until it finally surpassed it in a meaningful way, it took sixteen years including a nasty bear market with periods of high inflation and deteriorating economics. Currently we are in the thirteenth year of another long, arduous trading market of reduced volume. As I am breathing optimist, I believe that when we do breakout we could see a substantial upside. If we measure the movement from 1983 to the current high, one can make the case of a 13-14 times gain with rising volume. With my financial services individual securities fund and my portfolios of other funds, I certainly hope this is the case.

What are the surprises you expect, both on the up and down-sides?
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Sunday, December 18, 2011

Using News for Investment Gain

Investors get the bulk of their actionable investment news from paper or electronic means, either with the volume on or off. Because of the squeeze on both the profits of agency brokerage and to some extent hedge fund net compensation, less and less original long-term research is being conducted. Thus many investors are reduced to reacting to various elements of so-called news from media sources. If one learns to search the news for longer-term investing implications, often written between the lines, this limitation might not be so bad. This week’s blog is devoted to several thoughts that I have had from my reading and in one case from an out of town investment committee meeting.

The bulk of our management responsibilities is investing in portfolios of funds; in addition we manage a financial services fund. Please keep that last responsibility in mind when reading this blog post.

Research & Development spending

The Wall Street Journal (subscription required) this week previewed an annual review by the Battelle Memorial Institute. There is some good news and some less happy news which was reported. The headline trumpeted that R&D spending was continuing to grow. A couple of disturbing elements were buried within the article. First, the rate of R&D growth will be less than what was achieved in prior periods, in part due to lower government spending, which might be partially caused by planned lower military spending. Second, if one adjusts the growth figures for inflation, R&D spending is essentially flat. While the US remains by far the global leader in R&D, its share is slipping from 32.8% to 31.1%. Of a global total of $1.4 trillion in 2012, China’s share is estimated to rise to 14.2% from 12%. The smaller Asian countries of Korea, Taiwan, and Singapore are increasing their R&D spending, and are attracting (or re-attracting) many of our better scientific graduates who are being forced to leave the US due to visa issues.

The investment implication from this WSJ article is how one can translate news into potential investment gains. For example, R&D is usually focused on personnel spending. Also, a significant portion of R&D will not produce products that can be produced in large scale production. However, some R&D spending will cause substantial investing in new plant and equipment. Counting competitive reactions, it is my guess that the $1.4 trillion in R&D spending will create several multiples of that amount, and most of it will have to be financed. Thus, in the long run, R&D spending will be good for the financial community that will gather the funding for these projects. The interesting question is, where will this spending take place? I am increasingly of the belief that a good bit of the plant and equipment spending will take place where there is a large population base, educated young workers, and already-established scientific communities with their own fine universities. This thinking is leading me to increase the Asian exposure of many of our portfolios, with a focus on the production and consumption of technology.

MF Global

Though Jon Corzine used to live only two streets away from me, I do not have any special insight as to what happened at MF Global. However, I can focus on the long-term implications of this tragedy. The news is somewhat similar to the ongoing saga of the Lehman Brothers and Madoff bankruptcies, both in terms of the ways that the firms conducted their customers’ business, and the fact that ultimately the costs to the customers will rise. The apparent heart of the MF Global set of problems was the normal hypothecation and re-hypothecation of client funds and securities. As I understand it, the bulk of the clients of the firm borrowed money (margin) against the assets of their accounts. Securities firms loan money at very low interest rates to their clients individually because they can pledge the clients’ accounts against the loans provided by financial institutions, normally banks. In opening a margin account, clients sign a hypothecation agreement that permits this. Also, the agreement permits the institutional lender to itself borrow against the client money and so on without limit. This is called re-hypothecation. What may have happened in this case is that the trail locating the original clients’ securities and money was lost. Just as the aftermath of the Madoff bankruptcy caused business practices and regulations to change, I suspect that in the wake of MF Global they will be “reformed” again, in at least the futures markets, if not the broader securities markets. These changes, which are yet to be worked out, will probably raise the interest costs on margin accounts and reduce the amount that can be borrowed. As a result, firms will be required to have more compliance, risk management, and administrative personnel. All of these changes will cost money that the client will pay, and in a dynamic, integrated economy, pass on these costs to the ultimate consumer. Thus, in some sense we are building additional inflation into our future.

Reverse what forecasters say

In the latest edition of Barron’s (subscription required) magazine, ten stock forecasters were asked what sectors they would invest in and which they would avoid. Please remember my previously-stated bias. I was delighted to see that six out of the ten would avoid financials, and only one would buy them. As an identified contrarian, a six to one bet is a bookmaker’s dream. Clearly the negatives are well known: low short-term interest rates, some exposure to Europe, slow domestic economy, and adverse changes in regulations, etc.

The smartest man

Earlier in the week I was out of town visiting an institutional client we have had the privilege of serving since 1981. I was reminded that Byron Wien occasionally writes about his conversation with a long-term fiend who he has named the “World’s Smartest Man.” My equivalent of Byron’s friend is the chair of this investment committee, who has spent a lifetime being a successful investment leader. Toward the end of our meeting, he intoned that he could not see the stock markets around the world going up without the banks participating, if not leading. As many of the regular readers of this blog know, I credit my securities analysis skills to what I learned handicapping race horses and being a US Marine. With my background, and adding the wise words of my “smartest man,” or put another way, an experienced trainer and six-to-one odds, a bet on the recovery of the financials seems warranted.

Please share with me how you extract investment intelligence from the news media and/or whether you agree about the potential of rising costs for those who utilize futures.

My wife Ruth and our family join me in wishing all a very happy and healthy holiday celebration. This is the time of year when we are most thankful for each other.
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Sunday, December 11, 2011

Is the Eurozone the New Korean DMZ?

Capital cities around the world issued a sigh of relief on Friday, a reaction that the commercial cities ignored or feared. The eurozone compact, or more correctly, the belief that seventeen nations can quickly agree and execute the identical fiscal treaty, is highly questionable. If there is any real value to the agreement, hopefully it will make it easier for politicians to cudgel their people into agreeing to spending cutbacks. Only by cutting government spending and at the same time raising tax revenues can the deficits be brought down to one half of one percent of GDP.

While it may be a stretch to compare the eurozone of 17 nations to the narrow Demilitarized Zone between South and North Korea, there is much to be learned from a comparative analysis of their effectiveness. Both separations were to protect all parties from the dangers of war. In the case of the EZ, the war is fought with currencies which are based on purchasing power parity, determining the ability to export goods and services. The alternative is being forced to continue to export good jobs. Both zones have worked well for one group but not for the others. The balance is maintained by the apparent winners taking on significant defense expenditures. In the case of the EZ, the defenses will be in the form of subsidies to the slow-growing members and currency manipulation to keep the export costs low. On the one hand the EZ has the benefit of the European Central Bank (ECB), but in the end the ECB’s size could be destructive to the long-term ability to borrow money cheaply. The ECB appears to be the one organization that can issue unlimited amounts of euros. While that may help on the subsidy side, flooding the market with euros is likely to drive relative interest rates higher. Perhaps the best summary of the deal that has apparently been struck comes from Mohammed El-Erian of PIMCO Investments who wrote: “What came out is necessary, but not sufficient.” Thus the currency, bond, commodity, and stock markets are not likely to be calm.

Superior economics didn’t help

As regular readers of this weekly blog and my managed accounts have learned, I have been an advocate of increasing one’s investment in Asia. The thought process behind this move is that most of the countries in the region have young populations that want to work, are increasingly well-educated and have family savings orientations. While my thinking is long-term, some may say too long-term even for endowments, poor short-term performance is a bit upsetting. In a period of four months, a number of these good long-term investments declined some 20%, all the while growing earnings. What did I miss? I missed the inter-connected, “One World” nature of investing these days. For many Asian countries, their biggest export market is Europe, and Europe appears to be entering into a recession which may become worse under various mandated austerity programs. I understood and was somewhat prepared for this linkage. What I should have picked up was the proportion of Asian debt owned by European banks, as pointed out by a recent Matthews Asia Insight report entitled “Capital Flows: Asia’s Quiet Revolution.” European Banks own over 20% of the debt of Malaysia and Taiwan, as well as over 15% of South Korean debt. The US bank share is about 10% in South Korea and below that in all other countries in the region. Over 30% of Indonesian, and more than 20% of Malaysian debt are owned by combined foreign banks in local currency government bonds. One can assume under current conditions it is unlikely that the Europeans will be rolling over their Asian debt. Higher interest rates (lower bond prices) will be needed to attract US investors who are pouring money into the region.

What to do now

Long-term investors should continue to add selectively to their Asian holdings of companies meeting their own domestic demand. For more immediate performance-oriented accounts, try to pick up the eventual rise in Asian stocks when European banks have stopped liquidating their loans. One of the turning points to watch for is when the banks will be released from their requirements to own “riskless” government bonds. Hopefully this will be soon, but based on the agreements announced, we should not hold our breath.

Do you agree? Please let me know.
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Sunday, December 4, 2011

Growth & Value: Buyers and Sellers Disagree

In my periodic conversations with formerly successful fund managers, I am struck with a comparison to that wonderfully broad comic television program from the 1970s,“Fawlty Towers.” The essence of the program was a depiction of the “Peter Principle” at work in a small seaside hotel. The somewhat disdainful employees who filled the roles of hotel manager, desk manager, and chef all graduated, perhaps too quickly, from entry level jobs. In their roles they assumed the attitudes of what they perceived to be the deportment of professional hotel personnel, with some very humorous (but sad) results.

The formerly successful portfolio managers that I speak with mouth the same platitudes that they attribute to Warren Buffett and others, as well as their own statements of years ago. While these antics are amusing on the screen, they are tragic for the investors in the formerly successful funds.

Repetition doesn’t make it true today

Almost all of these managers vehemently proclaim that they are growth or value or somewhere in-between investors. These are wonderful banners that masses of investors march under, but have little practical meaning today. While all investors want to grow their capital, particularly after inflation and taxes, the original concept of growth investing as articulated by Thomas Rowe Price, Jr., and others in the 1930s was to invest in companies which produced earnings that grew faster than the economy (market). As no one wants to invest in securities that have questionable worth, value investing is buying something at a discount to a readily identifiable value. Contemporaries with Mr. Price, Ben Graham and Dave Dodd (my old Security Analysis professor) focused on securities with large discounts from current values. At its base level, they were speaking of liquidating value, which is why their initial focus was on buying bonds priced way below their value in liquidation. Warren Buffett, a student of Ben Graham, evolved these two approaches to look for investments that were selling well below their future or intrinsic value.

The apparent message from “The Market”

These formerly successful managers are trumpeting how “cheap” current prices are. The principal suppliers of this ammunition come from the sell-side brokers, academics trapped in the past, and talking heads desperate to find encouragement in an effort to hold on to their shrinking audiences. Why don’t the dumb investors and professional buy-side institutional investors accept the “cheap” argument and commit to current prices? As usual the answer is reflected in the numbers. Buyers are not accepting that stocks have as low price/earnings ratios and price/book values as the sales-side trumpets.

Why not?

There are two main reasons for this buyers’ strike. The first is faulty math. One of the very first things that Professor Dodd taught was not to accept published financial statements as a sole basis for making judgments. We spent hours on reconstructing these statements before applying any valuation issues. First, we focused on removing from the balance sheet any asset that was not readily saleable at the stated value. These would include inventories, real estate, goodwill, and intellectual property. In addition, we learned that liabilities are often understated, particularly in what could go wrong. Warren Buffett would add to the balance sheet the brand name value and the deepness of “the moat” that protects the proprietary value. (While these are not easy to calculate, some attempt is needed. Often this is called acquisition analysis which sub-divides into two categories; one for financial buyers and one for operating buyers.) The whole area of real estate utilization requires careful analysis. One needs to look at not only the current value reflected on the books, but also to ask, “are there any sweetheart arrangements with controlling interests that are giving the company a break on costs; or the other way around, with the company in effect paying a selective dividend by overpaying for the use of some property owned by insiders?” In addition, for many organizations with a large number of branches or offices, some of their leases are a competitive advantage in terms of key locations; some were signed during higher rent periods. In many companies this is too important an area not to be carefully examined.

One of the repeated fallacies that I hear from formerly successful managers and pitching analysts, is that if one deducts the cash on the balance sheet, the stock is selling at a very low ratio to its historic price/earnings ratio. This is doubly naïve. First, in many cases 80% of the cash is overseas and there could be lots of taxes to be paid on repatriation. In addition, a good bit of the cash hoard is a requirement of various lenders, buyers, and suppliers. The second naïveté is that when the cash is brought back to the home country, there would be a measurable benefit to the common shareholder. Unfortunately this is not always the case. The current fad with managements is to use the cash to buy back their own stock, disagreeing about the value of their stock with the market. The big advantages of the buyback are to help the management. First, it reduces the float of somewhat disgruntled shareholders, making a raid on the company more difficult. Second, by reducing the balance sheet equity, the management’s ‘incentive’ contracts, (based on return on equity) become easier to achieve. The third “tout” point is that the money could be used for acquisitions. Because so many acquisitions fail, both entrepreneurs and investor should ask, “will the deal ultimately build or destroy value?"

After unfortunately determining that they can not use all their excess cash, the more responsible managements increase their cash dividends, which often are tax effective and useful for the endowment-type shareholders who have grant responsibilities. (We manage the investments of several grant-making foundations where dividends are important.)

Turning to the income statement, a lot more work is needed before one should accept the bottom line net income number. Starting with the revenue components, it is important to understand how and when revenues are recognized. (There is a lot more leeway than many investors realize and there are differences in how competitors report.) Often the next quarter after the annual statement is full of changes from the last annual report, particularly on revenue recognition and the use and value of inventories. The whole topic of “other income” requires study as to the changing nature of its components, particularly if a portion of this revenue comes from lending money to clients either directly or through leases. The value of other income revenue may be different than the value that careful analysts put on sales. On the expense side, the largest single element is often compensation. Is compensation reflected correctly, i.e., what does it really cost to get these people to work for the shareholders? Balance sheet footnotes and proxy statements often give a different or at least an expanded picture on compensation. In my experience as CEO, the cost to continue or terminate employment is often very much higher than the last year’s compensation line on the income statement. Other expenses also need to be reviewed as to their reasonableness from an owners’ point of view.

After all of this work one can get a good approximation of current realistic book value and current earnings power. This is another place where the bulls get it wrong.

The future is not the past retold

Your past travels are not a sound predictor of all of your future travels. The same can be said as to the value of a stock, a portfolio of stocks, and the gauge of a manager’s skills. I manage a separate account investing in financial services stocks for my family and a few selected other clients; in doing so I look at the world through the eyes of the interaction between the financial services segments and the “real world.” The financial service sectors are the roads where capital changes hands and through very careful use of operating and financial leverage, that capital should grow. One of the problems facing investors in general is that the financial sector is shrinking. Due to the combination of operating losses from the use of unwise leverage and increased rearward-looking regulations, the earnings power of the sector has been reduced. This translates to fewer salespeople raising capital for new needs or capital transfers. Until the financial sector leaders figure out new ways to grow, one would expect that the general level of market valuation may well suffer. Further, bank leaders must deal with the realization that the many former ways they earned significant returns are no longer possible. Outside of the financials, other sectors have also changed dramatically, e.g., book publishing and selling.

What does this all mean?

One should not expect to find good investments by applying unexamined financial ratios to historical data.

What I am looking for in managers?

The first thing that I am looking for in a manager is a discipline of detailed, current security analysis, not a record of parroting the past. Normally too much turnover of stock positions leads to poor long-term performance, particularly on an after-tax basis. Today however, I would favor managers that increased turnover to repopulate their portfolios. I would like to see new names, with new stories based on new field work. Like other investors, I want to see new, sound merchandise.

Note: I would also like to replace “growth” and “value” with more accurate terms.
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Sunday, November 27, 2011

Turning Disappointments into Long-Term Gains

One of my sons has called me a dedicated contrarian, and he is right. I try to look at the whole of a situation rather than accepting the popularly described middle description. Focusing on elements that others do not has yielded unusual profits in the past; and more importantly, avoided significant losses. Thus, one should treat various contrarian views with interest. I believe most deliberative bodies, particularly boards of directors and investment committees should have at least one contrarian to more fully examine decisions, rather than always expecting unanimous votes with limited discussions.

As a self-proclaimed contrarian I will focus on two initial disappointments that lead me to the opportunities to profit as others catch up with their thinking. I will start with the smaller in terms of importance of the two.

Bleak Friday

Many of the longer-term readers of these posts know that each Friday after Thanksgiving I visit the Mall at Short Hills, New Jersey. For those who have not experienced such a visit, the two level mall (which is approaching one mile in circuit), is full of high-end brand names. The appropriate term for most of the stores is “glitzy.” My visit is true market research, in that I study the difficulty in finding an unoccupied parking space, the number of shopping bags being carried and the labels on those bags. The survey is not meant to be representative of the American public, but of a sliver of the population who can afford to own common stocks outside of their tax deferred accounts. In other words, I am looking at the shopping patterns of the rich or those that are called ultra high net worth (UHNW).

This year we were able to find a convenient parking space in less than ten minutes. In past years more than a half an hour was needed, and in some cases I had to park off the property and take a shuttle bus to the stores. The ease of parking should have been a clue. Within the mall, walking was only slightly more crowded than a normal weekend. The big bag carriers were toting merchandise from Macy’s, which appeals to the low-end income buyer as well as some of the more well-heeled. My guess is that the store had advertised significant discounts and an early opening. In contrast, most other stores’ signage indicated a 25-30% mark-down. They were not the kind of discounts that lead to “binge” buying. One indicator that people wanted to buy was that a number were carrying shopping bags from home, without labels and that were mostly empty. In clothing stores, inventory was attractively displayed, but there was little depth.

In-store orders were being taken for merchandise that was going to be shipped to the buyers at home. Clearly, merchants wanted to avoid excessive inventory that would lead to large markdowns before the end of their fiscal years in January. There are three phone stores in the mall. Apple was the most crowded, but still I recognized some sales people that were waiting for new walk-ins. Verizon had normal sized traffic, and as usual, the large AT&T store was practically deserted. My initial reaction to this visit is that the prospects would have to be labeled disappointing.

This is when my contrarian thinking asserted itself. First, it is just possible that the wealthy are spending less to leave room for an eventual binge buying of equities. (After reading this, some may believe that I consumed too much Thanksgiving feast). Second, like some investors, consumers are looking for growth markets and are doing their purchases online. If your responses from office workers Monday is a little slow, it could well be that they are using their employers’ computers to participate in Cyber Monday buying. Third, and much more importantly, it is possible that people of all economic levels are acting prudently by controlling their spending in order to generate money to carry them through an uncertain period. If I am correct, consumer-focused banks will have their loans paid off more quickly and see their deposit balances rising. Possibly one should look closely to savings banks and S&Ls.

The big disappointments: the euro and the deficits

Around the world stock, bond, and commodity markets shudder as values of currencies fall, particularly against the US dollar. (A future blog post will deal with the biggest bubble, the US dollar.) Almost all of the focus is on propping up the euro through various fiat or leverage techniques. The few articles that are coming out about the potential disappearance of the euro are encouraging. As a dedicated contrarian, I am happier when I see someone considering the reverse of the current view. Some articles have made a calculation as to what it would cost in debt repayments if the euro ceased to exist. These are very high, one-sided numbers. One-sided because they do not take into consideration the gains that some companies and families would benefit. One of the more thought provoking columns appeared in the weekend edition of the Financial Times by John Dizard, who pointed out that sovereign debt is governed by each country’s own laws which are relatively difficult to change or abort. Most corporate debt in “Euroland” is governed by English law and courts, which is more difficult to change. Even if a country defaults on its debt, that does not release most of its corporate issuers. Thus in today’s mixed up world, corporate debt could be safer than the debt of various countries. I believe markets on both sides of the Atlantic are recognizing this, with more institutions owning or buying corporate debt than government debt. Perhaps the rating agencies may even change their long-term policy that corporate debt could not be rated higher than that of its own country; the markets would agree with this action.

“With all the discussion about currencies, there has been little if any focus on the root cause of the economic problem,” so says the contrarian. If one looks at currency as a price mechanism, one needs to examine the base cause of the price disequilibrium sparked by almost worldwide deficit spending in Europe, America, Japan, and China. This is not a new problem as pointed out to me by my brother who sent me the following quote:

“The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.”
–Cicero, 55 BC.

There is much controversy on this quote’s accuracy. Many claim that the original quote is: “The arrogance of officialdom should be tempered and controlled, and assistance to foreign lands should be curtailed, lest Rome fall.” Others claim Cicero said nothing on the subject, and source the quote to later accounts. Whatever the case, this is an age-old series of problems.

We all know what eventually happened to Rome through authoritarian governments and the need for booty to sustain them. In the end Rome was not conquered by the barbarians but by its own corruption and inefficiencies. If there is not a willingness of the people all over to world to cut their reliance on government payments and services, then keep your eyes on military spending. Despite the political threats to the defense budget, I believe that a prudent long-term investor needs exposure to defense stocks. I suspect technology will increasingly play a role in protecting us even if we get our spending below our revenues.

All contrarians expect their views will lack popular enthusiasm, but they are willing to learn from others who represent more mainstream thinking. Thus, I ask you to communicate your views.
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Sunday, November 20, 2011

Resentment Math vs. Capital Growth

The supposed causes for the Occupy Wall Street (OWS) events and the inability of political leaders around the world to respond effectively are really very simple concepts that most young children understand. The occupiers want something they do not have and that others possess. The way this should be taught is that the demonstrators see themselves with an abundance of minuses (--) and the other side with an abundance of plusses (++). The political types generalize this perception of young children by seeing a mass of people who they support, with self-perceived (--) and some other group in their country or in another country having the (++). The challenge is to arrange a transfer arrangement. Some believe that it is only "fair" to make this swap. Others harken back to the failed French Revolution’s slogan of “Liberty, Equality, Fraternity” which was the forerunner of the Russian or more correctly, the Communist Revolution. These concepts rest on the belief that equality is a natural occurrence. Any series of observations of nature will see individuals or groups adding or losing assets, but almost never holding at an equal level with another individual or group. While the (++) and the (--) exist in nature, the = does not. As resentment (or if you prefer the Wall Street term, greed), is something that we all have to some degree, the question the occupiers should ask is: “How do we arrange a transfer of a portion of the (++) to us?” The growth of capital can be an answer to both the resenters and the investors.

The solution is in the numbers

Unless there is a perceived advantage, people will not willingly give up their (++), or assets. As all of life is encompassed in a trading world, we need to see some present (perhaps future) advantage for a trade. Multiplication, or if you will, “fast addition,” changes the size of a quantity by some factor, in effect, increasing the size of the pie. Now back to OWS and the political dilemma. All of their focus is on an immediate transfer of assets that are owned by someone else, with nothing offered in return. They are not looking for a multiplication factor, for in their minds, they have nothing of value that anyone else would want.


All too often the term capital brings up the image of monetary capital, e.g., the capital of a given bank is x or y billion or a city or country of z trillion. People think of capital in terms of the present ownership of an asset that can be readily sold. The true nature of capital is the aggregation of human capital. Human capital is the work that can be done by individuals which includes physical and intellectual efforts. Human capital can and is often leveraged to do many worthwhile things. For example, instead of creating garbage, the OWS demonstrators could volunteer to go to many communities that have an excess of trash that is a health hazard to the inhabitants and is beyond the limits of the local waste removal people; offering to quickly remove the danger. In a more global example, educated people all over the world could provide educational assistance to the multitudes of children who are in failing schools or worse, no schools at all. These and similar work efforts can be arranged in ways that would not take away from the gainfully employed. In many parts of the world an organized military force that can effectively separate warring factions could bring peace to areas that desperately need it. While we live in an ultra-modern world, much work can and is paid for in different forms of barter. Thus, the limitations on the recognized cash flow should not limit the work that can be done and paid for in an alternative fashion.

The current investment dilemma

After solving the global problems driven by resentment, we must turn to our day jobs of managing money to pay for goods and services far into the future. Currently the financial press is focused on the inability to close the deficit gaps of both countries and families. The popular solution is to buy bonds, which is in effect, loaning money to the very groups who have proven that they cannot manage to pay off their debts. The current mood is most pessimistic in spite of the reality that bit by small bit, at least in the US, Japan, China, Canada, and perhaps the UK, things are getting better, ever so gradually.

We should be investing for capital growth

Just as the OWS crowd and the stressed governments should be looking to leverage their existing capital bases, we should do so as investors. We should be investing in the creators of future capital. Think for the moment of capital that has been and will be created through cell phones and the Internet. In the US, next Friday is the official opening of the Holiday Season. Traditionally retail stores become profitable for the year on “Black Friday” due to waves of buyers who will shop to take advantage of sales items. I would not be surprised to learn at some point that the Internet sales next weekend will equal or surpass Black Friday’s in-store sales total. This is just an example of the growth capital that is occurring in our society. Similar such examples are being created in the healthcare field and even the ancient and ailing automobile business. If one looks out long enough, the future appears to be bright, at least that is how I am investing for my institutional and high net worth clients, both domestically and beyond the US.

What are you doing?


A number of the members of this blog community tell me that they regularly email copies to a list of friends. We can cut your labor if you send us your list; we will add the names and email addresses to those who automatically get these posts. This will aid us in answering questions, which we love to do, and will also let us know how a questioner saw a particular post.

For those in the US realm, Ruth and I wish you a very Happy Thanksgiving. We hope you are able to celebrate this harvest festival with family and friends.

Did you miss last week’s Blog from Mike Lipper? Click here to read.

Sunday, November 13, 2011

Patience Can Be Expensive To Your Portfolio

In a recent blog post, I made the statement that patience can be expensive. This thought became clearer to me after reading a number of third quarter reports that were, in effect, apologies for performing so badly. In essence, the apologists were intoning the message that fund managers buy securities well below their estimated intrinsic value. These so-called “bargain purchases” did not hold up very well in the dramatic decline in the third quarter. They were praying that their investors be patient and it will turn out alright in the end.

Premature purchases

Over the last couple of months, members of this blog community have received my views that we should be investing in Asian equities. Since these calls for action were prior to the very recent bottoms, by necessity I practiced some patience before the recent upturn. This last volatile week I was early once again, purchasing some shares in UK money managers and brokers. Luckily for me, I had only to wait until the end of the week to see positive, albeit slight, gains. I did not have to exercise patience for long. The point here is that it may be okay to be a little premature.

Long suffering patience

In contrast to my brief pain for being premature, one needs to look at the funds that are pleading for investors to be patient. In some cases they have underperformed their own identified targets 1,3,5, and 10 years. The insistence that their performance numbers will come out ahead is based on the fact that over the time since inception, these multi-billion dollar portfolios have very attractive results.

When should impatience take over?

In discussing this briefly with my sage wife Ruth, she warns that impatience can be worse than too much patience. This is all too true; for example if we had dumped our clients’ Asian fund holdings in September, or my personal UK asset management stocks early in the week. What could have compounded either error would have been not investing at all or investing in the wrong vehicles.

If you take the attitude that each day you repurchase your holdings, you should examine the research case for buying your positions today. As we live in a very dynamic world, I am getting increasingly impatient with the same rationale for buying into similar names today as what I heard 1, 3, 5, and 10 years ago. The absence of new fundamental, analytical support other than “price has made something cheaper,” is not reassuring. Some of the relatively poorer performance players have recognized these concerns; they have detailed a portion of their staff to produce the "Bear case" for their holdings. In a number of cases, the more traditional managers are attempting to learn from long-short hedge funds. Another approach is to rotate the analytical coverage of the names in the portfolios. I have yet to see much relative improvement in funds applying these techniques. (I could be too impatient.) Those analysts and portfolio managers trying the new approaches may be too junior in their organizations to have their opinions lead to prompt action.

Trading Markets vs. trading “The Market”

Most long-term investors desire to have quasi permanent holdings of securities or at least similar investment objectives. These people may very well feel that for the past ten years we have been in an essentially flat market as measured by the securities indices, therefore they have been right not to make changes, as “the market” has not spoken with clarity and force. They are going to wait patiently until it does.

At the race track, one of my two learning institutions, horses who come from behind do occasionally win, if they can get to the lead by the known finish line. With our race for acceptable returns, we don’t know where the finish line is. Yes, we do know what various “gate keepers” and fiduciaries want to see in their periodic reports. However, we don’t know when that all important breakout or breakdown reporting will be. That is the time when patience will run out and results without excuses will determine whether the institutional relationship will continue.

Multi fund managers and accounts

For those of us who have the fiduciary responsibility for these accounts, we need to deliver acceptable performance. In the best cases, we need some demonstrable winners and only a relatively few managers that try our patience. Bearing in mind Ruth’s warnings on the natural impatience of those in the market, we should periodically prune those formerly good-to-great funds that beg for our patience. We can hold a few of these if they can supply current reasons to believe that their holdings will work, but each year we should eliminate or rotate out those that do not.

What do you think?
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Sunday, November 6, 2011

Good Investments from Good Companies, Good Prices and Recoverable Mistakes

At times I refer to myself as a registered contrarian, meaning that I get nervous when I find too much agreement on most subjects. As a contrarian today, I look for an end of the dominance of macro trends over micro trends. For the last four years, the rumbling clouds of despair and global problems have largely dictated the investment performance of most investment managers. As all of life, one way or another, is cyclical, I am looking forward to the reemergence of micro influences, breaking the bonds of the tight correlations that we have experienced recently.

In preparation for the day when stock pickers once again become the performance leaders (as distinct from the “risk on” / “risk off” switchers), I have been in contact with various portfolio managers. In looking at these managers’ portfolios, I find a collection of good companies, good prices, and identified and unidentified mistakes.

Good Companies

While I am equity oriented, the same identifiers that apply to good companies can apply to other good issuers, including bonds and to some degree, even currencies. From my viewpoint, a good company is a producer and distributor of an essential product or service, whether or not we knew we needed before it appeared, e.g., iPads. (Or, for that matter, accurate, analytically sound investment performance analysis tools.) A good company depends on the conviction on the part of its clients that the company has exactly what the clients need. In truth, this need is identified and delivered by a good sales and distribution effort. The essence of a good company is a good communicator, to its market place, its employees, and its suppliers. Good companies produce great cultures. As good companies (like old generals and other heroes) fade overtime, the investor needs to be alert to any form of deterioration. Long before strong competitive threats appear, there is risk of internal problems developing. These include arrogance to some clients, employees, suppliers, media, and government officials. In time, any one of these victims of the arrogance can hurt the base of a good company. There are at least two other risks. The first is utilizing the brand’s image equity to expand products or services beyond the company’s basic competence, such as an automotive engine producer entering the appliance, railroad engine, or aircraft businesses. The most dangerous of all threats to a good company is that others recognize what has been built and successfully recruit away senior and particularly middle management. One may go so far as to say that the primary product of a good company is to produce good managers.

The issue for investors is that most of the time the prices of the shares of good companies recognize their superiority over the competition. Today, in this era of very tight correlations, the normal premium that one has to pay for a good company (as distinct from an average company) has shrunk. Thus, today’s investor has a relatively rare buying opportunity. This opportunity may be particularly large for good small and medium size companies. We are currently in a market phase where there is relatively weak mid and small company acquisition activity. One of the frustrating things about investing in small and mid-cap funds is that in the past they all too often lost their good companies through acquisitions. Yes, they benefit from the pop of the premium price paid that helps their near term performance. However, the portfolio manager and analysts have the challenge of finding a good replacement company and prices are likely to begin to reflect the premiums paid for good companies, making those that are left less attractive in terms of future price performance.

Good prices

The basic tenet of looking for value investments is to find a price that is substantially below the stock’s intrinsic value. The higher intrinsic value price is based on past peak prices, relative values compared with other companies, and some significant change in the supply/demand factors controlling the current price. One of the lessons that I learned from taking Security Analysis from Professor David Dodd of Graham and Dodd fame, was that almost any security at a given price is a value. In looking at a large number of value oriented portfolios and talking with their managers, I find lists of stocks, that according to the managers, are currently being priced at discounts of 30-50% below their intrinsic values. In my mind, the immediate problem, for these funds is the tight correlations have priced these stocks too close to the small list of good companies. Thus, “when,” not “if” the next upsurge comes, the early relative performance leaders will be those portfolios which have more good companies than well priced stocks. Once the good companies reach much higher levels, the well priced portfolios will catch up, and in that timeframe will be the relative performance leaders.


Humans make mistakes. I have never seen a portfolio, including my own, that did not contain mistakes. Some of these mistakes have been identified by the portfolio managers, and often they will reveal them privately. There are three common mistakes made by managers. The first is when they continue to hold certain securities because in their mind they are too cheap to sell, or in some cases they do not have qualified replacements. The second type of mistake is where the manager will not admit that at the current prices, a particular stock is a mistake. Some of this is due to arrogance, but some is due to faith in the issuer’s management. They like these corporate executives who they have called on for years. In effect, they share the same dreams of success. The third type of mistake is the failure to rapidly react to a fundamental disappointment when the market recognizes a material change in circumstances. As someone who has interviewed hundreds if not thousands over the years, I often focus on how a particular manager deals with mistakes. As much as this goes against my nature as a long term investor, patience can be expensive. Investors in mutual funds have it easier in this respect compared with those who have separately managed accounts. One of the advantages of investing through mutual funds is that one can redeem without that painful exit interview dispatching a long and valued relationship.

Where are we today?

I am looking forward to a micro driven market as distinct to today’s macro driven market. When we enter that phase, investing in good companies should have the biggest burst of relative performance, as the sidelined money comes into play. After that surge, the intrinsic value players will get their turn, as those who fully missed the initial surge will play catch up. The leaders will tend to have the fewest mistakes.


I have received a number of helpful suggestions as to my initial screens in my search for a portfolio for a cash balance pension plan. Any other suggestions would be helpful as well as any reactions, comments and disagreements with anything that you find in these blogs.

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Sunday, October 30, 2011

Neuroeconomics, Asia, Cash Balance and “Total Return”

This weekend, while the east coast of the US was preparing for the season’s first major snowfall, Ruth and I were at the annual meeting of the Trustees of the California Institute of Technology.

Professor Antonio Rangel

One of the benefits in attending meetings of the Caltech Board of Trustees is to listen to various presentations of very learned professors. Professor Antonio Rangel, whose work we support, discussed the research he is conducting at Caltech’s Rangel Neuroeconomics Laboratory. His work shows that the brain assigns mathematical-like values to various choices, which leads to decisions. The values assigned to gains and losses can be different. (This is the case in selecting appropriate funds for the cash balance pension fund discussed later in this blog post.) According to Professor Rangel, an increasingly rapid serious of decisions leads to mistakes. Patient personalities tend to make better long term decisions. (One would hope those investors who experienced a decade-long trading range will be rewarded by an eventual upside breakout.)

Why Asia?

In response to my comment in last week's blog, "buy Asia," I note the following reasons why Asia should be important to investors:

  • India needs 1000 new universities within ten years. India is likely to lead the world in mathematically based programming, and China may lead in Engineering and Physics; both will need to catch up with Korea, with the most PhDs per capita.

  • Asian assets are expected to reach $4 trillion by 2015, driven in part by local mutual funds and other institutional vehicles.

  • The Korean National Pension Service is growing at $2 billion a month.

  • Thailand and India have government matching, voluntary contributions for non-government workers.

  • Slightly more generous retirement plan contribution limits will be allowed in the US next year. Increasing the limits of 401k and IRA accounts may lead to more flows into the long term portfolios of investors (including the working wealthy), which will enlarge the amounts to be invested internationally.

  • More money is likely to flow into Asian funds and securities. Asian investments will be attractive to US and European investors on a comparative basis, and to Asians themselves with their growing cash piles.

  • Merrill Lynch expects the United States to suffer another credit rating downgrade, a recognition of the long term decline in the quality of our country’s credit.

  • Asian countries are carrying less debt than the US and Europe relative to the size of their economies, and lower levels than in their earlier crisis periods.

  • Chinese stocks have been in a decline at least for one year, while China's economy continues to grow, albeit slowing.

  • Despite the current image, the Japanese market is gently rising.

Cash balance pension fund / absolute return mismatch

I have been asked to create an investment strategy for a new cash balance pension account. This particular account will treat the loss of a dollar more painfully than it would welcome the gain of a dollar. In researching the proper approach, I have identified a conflict in the naming implications between the institutional and mutual fund worlds.

People in the institutional world are comfortable with the term "absolute return," meaning vehicles that are designed to produce a specific numerical return, e.g., 4 percent regardless of what the general market indices return. Some of the smarter institutional investors are dropping the term “absolute return” for various Long-short and derivative-laden investment vehicles. The term is not used by responsible people in the mutual fund business because some might imply a type of guaranty. Thus, I can not turn to an absolute return mutual fund category. As is often the case, I have to devise my own screens to produce a list of candidates. In terms of equity funds, my criteria are:

  • Twelve month fund dividend yields between 3 and 6 percent,

  • Assets above $100 million,

  • Expense ratios below 1.25 percent,

  • Turnover rates below 100 percent, and

  • Active portfolio manager tenure of ten or more years.

One could argue I am being too restrictive. Nevertheless, I am coming up with a list too long to conduct further, in depth research. Please note that for the moment I am not restricting my search to domestic funds, however considering the nature of the cash balance pension plan, we are initially restricting our search to SEC-registered vehicles.

Does anyone in our blog community have some additional or better screens to use? If so please contact me quickly at
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Sunday, October 23, 2011

To Avoid Moral Hazard: Buy Asian Equities, Hold Cash for Redeployment and Sell High Quality Bonds

This week’s blog is based on thinking about the signs shown for “Occupy Wall Street,” seeing the video rendition of “Too Big to Fail,” remembering the insight of a blind leader, looking at extreme numbers and watching the NY Jets beat a better team. Part of the intellectual handicap we all have is that our views of history are shaped by commentators who lack full understanding of what they thought they saw or heard.

D/F + TBTF + OWS = Bigger failures - - bigger opportunities

By now the media savvy recognize "OWS" stands for Occupy Wall Street which has gone global as sites of anger, frustration, and the willingness to break laws. "TBTF" abbreviates the title of the book entitled Too Big to Fail, which was made into a movie which was rebroadcast last night. "D/F" is my symbol for the Dodd Frank law that is being imposed on the US financial and economic community, which has implications to financial communities around the world. This witches’ brew of maladies will, in my opinion, lead to bigger failures and greater disruptions to global progress and at the same time open up new opportunities for the wise to make money.

The complaints

Two of the complaints coming from the inhabitants of the various “rescue encampments” are first, the banks got bailed out of their problems and we “ordinary people” did not; and second, we have selected various financial institutions to receive future bail outs whenever they get into trouble. I do not expect the strident to allow me to share my personal historical perspective from both fifty years of professional investment experience and having listened to other professionals who went through the changes in the financial community for over one hundred years.

Ever since the “Money Panic of 1907,” (if not before), financial people have been concerned about the potential damage that a concerted “run on the banks” could do to individuals, themselves and the community as a whole. In its simplest form, banks collect deposits and loan most of their deposits back out to the community in the form of demand loans or term loans. Banks require interest income from these loans to pay for deposits, other expenses and to build reserves to cover for periodic credit losses. No bank keeps enough cash on hand to meet redemptions of all its deposits. Thus, if there was a “run on the bank,” the bank would attempt to call all its demand loans and as much of its term loans as possible. The news of a run on one bank is likely to cause a run on other banks. This fear is what led to the founding of various government financial agencies like the Federal Deposit Insurance Corporation (FDIC) in the 1930s. Those of us who have spent our lives in the mutual fund world have harbored the same fear about “money funds.” As a matter of fact, Jack Bogel, the first president of the Vanguard Funds, has told of his fear of one day turning on a Philadelphia television news program and seeing a helicopter reporting on a long line of people formed around Vanguard’s Malvern offices who want back the billions in their money market funds. Both the current US administration and its immediate predecessor felt that they had to “do something” to prevent harm to ordinary citizens. In the government’s eyes, it was bailing out individuals and small businesses. One could argue that the government and financial community leaders should have let various banks fail, and individuals lose the value of some of their deposits. Such inaction could well have led to a lack of confidence in the financial community that supports the government’s funding requirements. Bank failures and government defaults have been going on since their creation without total loss of economic progress.

The way the potential run on the banks was headed off was to force Federal government or Federal Reserve Bank loans on the banks, which led to the belief that certain financial institutions were so important that the society could not afford to let them fail financially. In other words, they were too big to be allowed to fail. There is a term for this which is “moral hazard,” which means that the government will permit these groups to make significant financial mistakes and they will still be bailed out. This concept goes directly against the wisdom of a very successful regional brokerage firm. On the occasion of the annual meeting of its partners, I was paid to give a speech on how I saw the brokerage business evolving. This was in the early days of Power Point graphics which I used in my slides to support my conclusions. To my horror, no one told me the chairman of the firm (who was sitting next to me) was totally blind. Trying to recover in my conversation with him, I recognized he did not have to see the charts, he intuitively knew what I was talking about. We then discussed what his firm should do in the face of the increasing market share that larger brokerage firms and banks were taking out of his market. I inquired why his very successful firm had a small capital base, (where the substantial profits were paid out at the end of each year). He replied that he did not want to accumulate firm capital, for he feared that his partners would invest it poorly. Too much capital would lead to putting undue pressure on the firm.
Today, I wonder whether firms that get into financial trouble should be bailed out. The FDIC has a model that a failed bank’s deposits and sound loans get auctioned off to a competent nearby bank, and the losses to be absorbed by the bond and shareholders of the failed bank. In the UK, the banking authorities are trying to “ring fence” or separate the retail deposits and loans from the business loans and investment activities of the bank. (In some ways they are trying to put back in place the Glass–Steagall Act in the United States.) This weekend in Europe, the powerful countries are trying to determine how to help their national banks with faulty sovereign debt and underwater loans, either through a materially stronger bailout fund backed by a central bank, or a facility that would insure some of the value of the loans. To me, the insurance scheme has less moral hazard.

All governments need to be careful about changing established ways of conducting business. In the US, we have merged investment banking with commercial banking rather than keeping them separate and in some cases, competitive. Almost all of the losses suffered by the large investment banks were in their investments, particularly illiquid real estate. Similarly the Savings & Loan scandal of the 1980s was caused by pulling down the interest rate advantage the S&Ls had in attracting deposits for making local home mortgage loans. Once there were level interest rates, many S&Ls went into commercial lending that they were ill-equipped to do, and commercial banks built up their home mortgage business without the requisite local and personal knowledge of hometown people and properties. Further, when the SEC introduced price competition in brokerage commissions (as distinct from service and research competition), it changed the game which led to the need for capital to facilitate trades. The SEC compounded the problem when it encouraged multiple sites for trading, executions, and reporting. To some degree, the fragmentation of the market has led to increased volatility.

Many investors believe that the increase in volatility is a sign of increased economic risk. I think you have to look at volatility as any time series, and dissect it to derive meaning. In Saturday’s WSJ, which is what they are labeling the Saturday edition of The Wall Street Journal, there were two items that address volatility. “The S&P 500 would be up 16% for 2011 if the three biggest declines were excluded and it would be down 13% if the three biggest daily gains were excluded.” The message that I get from this data is that we have been in trading range markets with periodic extremes. For the technical or chart analysts, this pattern is either of a distribution where stocks move from strong (in theory, “bright”) sellers to weak (presumably dumb) buyers, or it is an accumulation by bright investors picking up bargains from tired or discouraged speculators. Only time will tell which is correct when a significant move breaks out of this trading range. My long term bet is for a breakout on the upside. In a contest, the bright or better team doesn’t always win. We just returned from seeing the New York Jets, with their home in New Jersey, play football against the San Diego Chargers. While I was cheering for the Jets for “hometown” and other reasons, I had to admit that most of the time the Chargers played a better game, except for two pass interceptions which led to a Jets victory. Thus, it is often better to be lucky than smart; and I hope that while I understand the negatives facing us, I hope to be lucky on the upside.

To put my neck out further, I was a member of an investment panel addressing a group of Caltech alumni and scholars. Our final question was what would we buy, hold, and sell. We ran out of time before I could answer, but as some of that audience are also members of this blog community, I thought I should very briefly give my answer which we can discuss in future posts. I would buy Asian equities, hold cash for redeployment, and sell high quality bonds.

What would you do?

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Sunday, October 16, 2011

Frustration is Widespread and Normal


As almost everything in the modern telecommunications world is abbreviated, for those who have just landed on the planet OWS stands for Occupy Wall Street. Similar to the “Arab Spring” or the various color revolutions, OWS activities were spread through social media, in this case to a reported 868 cities around the world. The apparent rationale for crowding a large number of young people and some older into a constrained space easily accessible to the media, is to vent their frustration as to the lack of jobs and other grievances. (This Saturday when we were briefly visiting Carnegie Mellon University, I noticed a sign on a very crowded bulletin board advocating to bring OWS to Pittsburgh to “occupy” Mellon Square in the middle of the financial district. No one appeared to be taking any notice of the signs; this group of very smart students appeared to be focused on their difficult studies and other normal university activities.) From what I read, the crowd which does not appear to have a leader, is frustrated with their joblessness, as we are for them, but also upset about the distribution of wealth in their communities. They seem to believe that the financial services companies have deprived them of what is, in their opinion, their rightful share of the wealth of the community. They may fear that the coming cutback in government spending will reduce their lot in life even further.

At the moment, these masses of people can be properly called a crowd, not a mob. Mobs have leaders, often self-appointed. Mobs led on by their leaders can express their anger in non-violent activities. All too often, non-violent activities in the eyes of some, impinge on the rights/privileges of others. To protect both sides, the forces of “law and order” try to keep each group separated and calm. Unfortunately, all too often one side or the other, often the original protesters, lash out against “the authorities,” creating a series of violent eruptions, which can be taken to its extreme: open rebellion. Historically, some of these rebellions can lead to bloody revolutions, which in the end defeats both sides, for example the French and Russian revolutions. This risk is why it is wise for global investors to keep a wary eye on these crowds.

OWS concerns

Some of us are also frustrated. We are frustrated with the current generation of protesters who in many instances have not prepared themselves to find work in a changing world and often appear so self-centered that they are not helping out with their extended families or charities. Most importantly, they do not recognize that they themselves, their parents, and their grandparents have benefited from a society that has been willing to give us more services than we have been asked to pay for in taxes, fees, or volunteer work. In the US we have allowed a number of our school systems to cease teaching either civics or geography. Civics, properly taught, would have emphasized the individual’s responsibility to the community and the society in general. Geography is essential to economics. One quickly learns that land, water, and other resources are not equitably distributed. Some elements are better than others and are worth more. The fights to gain these basics shape our world’s history. Any reasonable students of geography and therefore economic/military history, would focus on the incipient power of China. They would be able to explain that except for about the last two hundred years, China has been the leading economic (and in some ways, intellectual) power in the world. With this knowledge, one would be wise not to play the “China Card” with the political crowd.

My own frustrations

The people in the milling crowds are frustrated because they do not have the appropriate tools to solve their problems. In a very much less important way, I am frustrated in my inability to answer a mutual fund search question. I was asked by a very savvy investor to come up with one or more “deep value” mutual funds. As with most terms in the world of funds, there are not complete definitions, but a series of concepts. One would think with the ability to tap into my old firm’s ninety-odd fund classifications, I could easily find a couple of “deep value” funds. This is not the case; so I must rely on artistic instincts to complete the search. In the past, poorly performing funds would excuse their poor performance by saying they were holding securities that were priced with big discounts to their intrinsic value or even better future prices. Over long periods of time they never get into a market that recognizes the values they perceive. To avoid waiting for the market to recognize these managers’ brilliance, I am looking for funds which base their choices on three attributes.

The first attribute is a massive change in the supply/demand equation for the products or services of the company. Often this kind of search puts one into commodity types of companies. The risk of getting a massive change on the upside is that it can also go the other way. Further, often changes in government regulations can cause significant alterations in the supply/demand balance. Because of the sources that cause change, the successful investor has to have deep contacts with the users and regulators of these products and services.

The second attribute is simply price changes. Not the kind of changes that emanate from the first attribute, for that is a given. The second attribute focuses on a relative price of a company and/or a sector relative to the larger universe of investments. There are times when the relative value spread gets to be too large between what is considered to be the best investment and second or third or possibly the tenth best investment. The skill required here by the portfolio manager is to pick up the changes in momentum between the current leaders and the others too far behind. Trading skills are very important for this kind of manager, both in stocks and other financial instruments.

The third attribute is usually an abrupt change in management which comes with radical changes in policies and how the company is run. There are activist managers who try to force these kinds of changes. Sometimes they are successful, sometimes not. Change is not always good for the investor. Occasionally a management change in one company makes other stocks more attractive.

All three of these attributes require a great amount of patience on the part of both the fund manager and the fund investor. A successful deep value fund(there have been some) should not be the only fund in one’s portfolio. As a manager of accounts devoted to a portfolio of mutual fund investments, we would normally own funds that have a variety of characteristics.

I am developing my list of “deep value” candidates; I would appreciate suggestions from any member of this blog community.

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Sunday, October 9, 2011

Steve Jobs and Lessons for Fund Owners

We have all benefited from the life and genius of Steve Jobs. One can only speculate whether in our own lifetimes, Apple Computers, “Toy Story,” the iPad and the iPhone would have been produced and at the prices we paid, without the guiding force of Jobs. He married Art with Technology, and came up with magic to give us products that we didn’t know we wanted, but demanded nevertheless. His attention to detail, particularly to the fit and feel of Apple’s products, was amazingly accurate. Part of his genius was organizing the supply chain of essential parts that would be assembled into his finished products. Knowing of his medical condition, Steve Jobs left his company with new products planned out for the next four years. He built a team of successors that he felt would carry on with his goals. Clearly, I am a fan. The smartest thing I ever did outside of marrying Ruth was to give my late, learning-disabled daughter an Apple IIc. Because of its intuitive operating system and keyboard, she was able to communicate with a whole new world of people and learning. Important disclosure: I personally own Apple shares which I received many years ago as a distribution from a closed-end fund. Luckily I kept half the position; since then, I stupidly sold a portion to take an outsized profit to offset some realized losses from other transactions and to free capital for new investments. Like Steve Jobs, I was able to make mistakes and learn from those errors. Jobs certainly did make blunders, several which could have bankrupted Apple if others had not intervened. Despite the very fact that as good as he was, he had a combination of tremendous successes and near-fatal mistakes. These extremes are somewhat similar to many very successful fund portfolio managers.

Lessons from Fidelity Magellan

Chapter 16 of my book Money Wise details some early lessons from the progress of Magellan, from its initial restricted launch through some of the later portfolio managers. This chapter should be required reading for all those interested in the economics and portfolio history of the mutual fund business. While there have been many portfolio managers of the fund, none were better than Ned Johnson and Peter Lynch. Very recently a new portfolio manager has replaced one who produced lackluster results. To some degree, his appointment is recognition of less-than-successful succession planning, which highlights how difficult the task is, particularly for the management and board of Apple. In terms of Magellan, like with Apple, there are two elements that are required to make succession work. The first is the outward results: e.g., will the iPhone 5 and iPhone 5s continue Apple’s astounding growth? To do so, these devices will need to open up new markets as well as to convince owners of Apple’s older versions to crave these new phones. On the fund side, I wonder, will Magellan become a performance leader once again? The other key element to whether a successor works out well is on the business side. Can Apple’s management keep its gross and net margins where they are, through managing both the supply chain and distribution margins up to the current level? For Magellan, the issue is more challenging. The fund is largely a retirement vehicle, as distinct from a performance vehicle; its shareholders are different and getting new flows from retirement plans will take a lot of work. Further, at one point in time Magellan was the flagship and largest fund within Fidelity. It is not today, which raises the question as to whether it will get all of the top attention that may be needed to succeed in a much more competitive world.

I have a reasonable degree of comfort in the prospects for Apple over the next four or so years; I approach the decision in terms of Fidelity Magellan differently. If one already owns shares in the fund, I would not redeem them until one sees the next portfolio of the fund after the new manager took over. The key that I would be looking at is to see how many of the old holdings are left in the portfolio. In the case of someone contemplating buying into the fund on the basis that the new portfolio manager has a better record than the old one, I would wait until the publication of the second listing of investments in the portfolio. I would be interested in whether the portfolio looks like his old portfolio or whether he is branching out to new names and policies.

Applying successor concerns to Fairholme

As famous as Peter Lynch was during his high performance years, Bruce Berkowitz has been shepherding his Fairholme Fund for the eleven years between 2000 and 2010. In all but two of those years he handily beat his peer group as measured by the Lipper Large Cap Value Fund Index, in most cases by ten percentage points. (For our UK members of this blog community, the name Fairholme may seem to be familiar, it is the name of the street where Bruce lived while he was in the brokerage business when he was in London.) Bruce’s fame was such that Morningstar named him as the best equity manager of the decade. As with Peter’s Magellan fund, the outstanding performance attracted a huge amount of inflows. So much in the way of inflows, that Fairholme was larger than Lynch’s Magellan when Peter was managing it. (Fidelity merchandised Magellan after Peter Lynch stepped down, to a point that it had assets over $100 billion, and for a time was the largest active stock fund.) Unfortunately, we have seen poor performance patterns appear after great performance. For the twelve months ending September 30th, Fairholme was down -22.20%, compared to the minor -3.54% loss of the Lipper Large Cap Value Fund index. All of the decline could be attributed to Fairholme’s poor third quarter of -25.47%, compared to its peers of -16.67%. Bruce’s concentrated portfolio, with heavy emphasis on financial-related stocks, was hurt. Is this poor performance similar to the period when Steve Jobs was producing poor financial results and lost control of his own company? Only the future will tell whether Bruce can snap back, though I hope so. For many years until he moved to Florida, his New Jersey office was about a mile away from my office.

Just as I focused on Magellan in terms of both the investment and business side, I think shareholders need to examine Fairholme. Bruce is managing what he does with a small staff of investment and administrative people. If something unfortunate was to happen to him, I do not see a succession plan in place. Who could run both the portfolio and the business? Unlike the present day Magellan where existing holders may be wise to wait to review the new portfolio manager’s holdings, my fear is that Fairholme’s holders won’t be patient. This does not appear to be a Steve Jobs type of succession in terms of people and products.

Why did I focus on Fairholme and succession issues?

For awhile we did use Fairholme in a number of portfolios that we manage; however we limited the size of the commitment below what we would have done had there been a well thought-out succession plan. Further, we cut back our position, as the fund’s analysis was very different than our views on specific holdings, most particular in the financial sector. (Please bear in mind that I manage a small private financial services fund.) The purpose of sharing my views is to indicate some of the ways I analyze funds and fund managers. Further, as with all good analysts, I could reverse my views on the basis of new information and once again build positions in Fairholme. When Steve jobs returned to Apple, both he and the company were better off than before he left. Both had matured and were ready for exponential new growth. From the time he came back until this last week, the price of the shares of Apple went up 7000%. Thus, there is always hope for a great second act.

Wall Street protesters

I am gathering my thoughts about the significance of these demonstrations. I may devote next week’s blog to thoughts about the meaning of the “occupations” for the rest of us. Please share your thoughts with me on how I should think about these events.
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Sunday, October 2, 2011

London Calling, with Concerns

As regular readers of this blog may know, my wife Ruth and I spent last week in London; several days with temperatures in the 80’s (F). In my many previous visits to London, I have found some of the most sophisticated investors in the world. Topic one for them last week concerned the problems with the Euro and how that would affect other markets. In addition to those concerns, now that I have a Facebook group, I am getting regular inputs from old and new friends who have strong views as to what should be done by various politicians. All of these concerns expressed by many people far beyond the small world of the financial community has led me to think through the large and growing deficits being experienced in Europe, the UK, Japan, and the USA.

There are two causes for this crisis in my opinion. The first is that at least since the great depression of the 1930s, people have believed that they needed help beyond their means and wanted the various governments “to do something.” The second cause is that in our elected societies we are governed by politicians, not statesmen. A statesman has a long term view as to the correct path, often unpopular, and tries to convince people as to the correctness of his/her view. Politicians, always looking toward the next election, try to find an already exiting parade of supporters for a particular policy and place themselves as the leader of the parade. In each of the countries and regions mentioned above, both the governments and their principal oppositions are headed by politicians, as distinct from statesmen. To my analysis, the structural problems facing most of the democratic world is that for about 80 years (or three-plus generations), we have been directly and indirectly spending increasingly more than we have been willing to pay for in taxes as well as fees.

I do not want to appear as an apologist for the current US President, but we need to find a parade of strong volunteers to both cut our spending and to advocate for paying a larger portion for what we receive. As we dug this hole in our national balance sheets over three-plus generations, we should expect the change in our life patterns to take one or more generations. While there are likely to be some “band aid” attempts, progress will be slow until there is general acceptance of shared pain for all. This pain will come in lots of different ways. The deficit problem cannot be solved by simple eliminations, but only by a thorough review of every entitlement and subsidy each of us individually receives; for example, tax deductible mortgage interest and gifts to charity, (which would hurt me). The overall solution will be granular and thus will take lots of time. What I have outlined is not pleasing to anyone, perhaps particularly not to investment market participants.

Portfolio Reactions

The more people contemplate the deficit issues, the more bearish some react. As we know, the third calendar quarter was ugly in terms of performance; and as time passed, market participants became increasingly bearish. One example of these bearish actions is that the short interest ratio rose almost 44%, from 2.92 days to 4.2 days for NASDAQ stocks in just 15 days to September 15th. Over the same period, the short interest ratio of the supposedly higher quality stocks on the NYSE rose to 3.7 days from 3.2 days, a gain of 16%. (This measure is of the number of days volume of transactions that would be needed to cover all of the existing short positions. While the increase in shares sold short is an immediate bearish sign, keep in mind that when the market starts to move up many of these positions have to cover to avoid losses.) One of my personal concerns about the growth in the use of Exchange Traded Funds (ETFs) is their growing short positions. The two largest short positions on the NYSE are two ETFs, as a matter of fact, of the 40 largest short positions, ten are ETFs.

Many of the investment managers that I saw in London use European based ETFs. (Not of minor importance is that apparently the UBS trading fraud was conducted in ETFs, which were meant to be hedged.) I do not believe that there is equivalent public data on European ETFs short positions, but considering there is a smaller retail market in Europe, my guess is some of the short positions could be larger than their equivalent US ETFs.

Is there any good news?

Yes, there are three positive elements that could be of some help. First, the chart pattern on the Dow Jones Industrial Average is displaying something of a bottoming since the August decline. (However, there is not as helpful a sign in the transportation average; this could have some bearing on the Warren Buffett discussion below.) The second positive note is that the Barron’s Confidence Index, comparing high grade bonds with intermediate grade bonds, rose 2.4 points last week to a 70.3 level; most of the time this index moves less than 1.0 point per week. Often when the index moves up it is good for stocks, for it shows that investors are willing to take on more risk (intermediate quality bonds). The third somewhat misplaced positive, in my opinion, is the bullish reaction to Warren Buffett’s decision to buy back Berkshire Hathaway stock. I believe one of the best things about Mr. Buffett is that he corrects some of his mistakes. For many years, he has only bought companies for cash and has not used stock for acquisitions. Because of the large size of the acquisition of Burlington Northern, he had to use stock to supplement his cash to buy the railroad. (I believe despite the uncertain price pattern for the transportation average, over time this will prove to be a very successful investment.) What he is really doing now is buying back at a lower price than what was used for the acquisition, and in effect turning the purchase into close to an all-cash deal after the fact. With the buyback, I believe, he is not making a market call. Buffett and/or his new investment manager is probably buying some “cheap” stock also.

Investment Posture

As indicated, deficit solutions will be a long time coming and there is increasing speculation on the downside; nevertheless I believe that one should view the current market and periodic dips as opportunities to add to sound investments. The next 100% move will be on the upside, even if it takes a long time.

Did you miss Mike Lipper’s blog last week? Click here to read.

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