Sunday, April 24, 2011

“Fundamental Risk,” Relative Return and Both in China

The view from Deutsche Bank

In a well written analysis entitled “US Fiscal Challenge: Another Minsky Moment?” Deutsche Bank describes that after a period of growth, there may be excessive risk in US sovereign debt. In this work the authors show a chart ranking the risks of sovereign debt, based on their perception of each country's fundamentals. The rankings, with #1 most risky, are:

1. Greece
2. Ireland
3. Portugal
5. Italy
6. France
7. Spain
8. Belgium
9. UK
10. Japan
11. Austria
12. Finland
13. Netherlands
14. Germany

Few Americans and many global investors act as if they believe these rankings. Many would accept that the US has fundamental problems as recently captured by Standard & Poor’s, placing a one-in-three bet on a downgrade to the US’s AAA debt rating in a couple of years. But to suggest that the US’s fundamental risk is even worse, is shocking. The American view is that each of these country's governments can fall at almost any time due to parliamentary maneuvering. Further, many of these nations have as bad if not worse, housing conditions. All of these governments spend more on what can be called social welfare than the US does. To this leading German bank, despite the existence of the euro, the old deutsche mark block is considered less risky than most other countries. After more than ten years of a shrinking economy, for Japan to be viewed as significantly less risky than the US, is a wake-up call.

Some have heard the wake-up call

I believe the large investors in exchange traded funds (ETFs) are policy type investors who wish to capture the central tendency of some trend. They are not focused on perceived superior stock picking skills, as many mutual fund investors are attempting to achieve. Many of the ETF investors are also more short-term relative performance oriented than most mutual fund investors. ETF investors are often more volatile with their cash flows. One might take the view that their large scale buying and selling is coincident with market moves. In some cases there is an attempt to be early, but usually some momentum has already started. Because of the characteristics mentioned, I view ETF flow movements to be similar to the proverbial canary in the mine as an early warning device. One of the early and better analysts of ETFs is Deborah Fuhr, now with BlackRock, who had some salient points in an article in a recent edition of the Financial Times. While she did not phrase her analysis as a wake-up call, her focus on first quarter net flows into or out of global ETFs indicates that these more volatile investors have recognized the same risky elements as the analysts from Deutsche Bank. She notes that $6.3 billion in net flows went into commodity funds, which I believe includes $3.6 billion into agricultural commodity funds and $1.3 billion into inflation indexed vehicles. She further noted that $1 billion flowed out from Government Bond ETFs and somewhat surprisingly, $2 billion from Precious Metal ETFs. (The latter may well be a change in the way some investors wish to hold gold, as the bullion based ETFs lost assets, but there are reports that some large gold securities holders are converting their paper gold holdings into physical gold, to be stored outside of the US.) I interpret these moves as a reaction first to the fears of inflation devaluing paper currency. Other factors include weather-related crop failures and capacity-limited mining and refining facilities. Both the Federal Reserve and the rapidly growing Chinese economy are sparking the current inflation globally.

China is both a source of risk and return for the world

China is the fastest growing large economy in the world. I suspect for both political as well as data reasons, the rate of expansion in China is understated, though the trend rate remains in double digits. China is becoming the largest factor in world trade. Natural resources are flowing into China from Africa, the Middle East, Chile, Brazil, Mexico, Canada, and Australia. Due to historically low labor costs, China is an exporter of manufactured products to the US, Europe and elsewhere. Higher valued manufactured products and systems are being imported from Germany, Netherlands, Scandinavia, and the US. That was the world in 2010. The world that is now evolving is one with rising wages in China as a political necessity. (A flash point could very well be the independent truck drivers’ strike in Shanghai, purportedly the world’s largest port. The drivers are being squeezed by rising fuel costs and their contracted delivery rates. How quickly and well managed this dispute is handled will show the political sensitivities of the authorities.) A recent visitor to the internal parts of China told me of the major building efforts in the cities of only a few million people as a way to keep the movement of people from the farms to these cities rather than the larger ones on or near the coast that are suffering from the onslaught of people in search of the “good life.” The Chinese government is the most expert of any other government in controlling or at least manipulating its economy. Whether China can seamlessly manage this greatest migration and at the same time convert its society from export driven to consumer spending is the key question. The entire world is awaiting the answer. There is a substantial chance (risk) that something unexpected will cause at least a hiccup. At this point in time a hiccup in China can cause an extreme stomach ache for the rest of the world and its investors.

Get ready for a contrarian bet

A contrarian is always on the lookout for when emotions carry an investment trend too far. The global press will focus on problems within the US. At some point this pessimism will go too far. I suspect sometime over the next five years or so, there will be a major rally in the US dollar. To hedge the dollar now may still be prudent, but to be net short the greenback seems to me to be risky except for those who can be fast, successful traders.

What do you think ?

There is a very good chance that next week’s blog will be delayed by a day. My wife and one of my sons are going with me to the annual meeting, actually a rally, of Berkshire Hathaway. This event will be somewhat exhaustively covered in the press but could be of value in the sense that the various portfolio managers may have a different insight than what is reported. I will share my observations with you the next time.

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Sunday, April 17, 2011

Identify Your Strategic Risk Points

  • The ease of Momentum Investing
  • Patience rewarded
  • The lessons from sports
  • Managing the strategic risk in the portfolio

The ease of Momentum Investing

The great investment counselor Will Rogers told us to invest in stocks that went up and not the ones that went down. In essence he captured the kernel of momentum investing. Find a series of numbers that go up with each reading, higher than the prior one. When the string is broken get out. Simple enough to say, but more difficult to put into practice - nevertheless many try. Below are some of the time series that investors have used:

  • Daily, weekly, monthly, last 50 or 200 trading days’ stock prices: the longer the period the more volatile the average change.

  • Sales: currently this is in vogue, coming off a cyclical recovery that has not yet entered into full bloom.

  • Announced earnings per share: favored by both the press and the data base providers, like the certainty of a number without any adjustment for its composition.

  • Operating earnings: an initial attempt by the accountants to remove non-recurring earnings. These are not the same items that an analyst might adjust for an early or late Easter, price changes, new product launches, etc.

  • Pre-tax margins (sometimes known as returns on sales): a measure of how much of the sales dollar comes down to the bottom line before paying income taxes without any adjustment for changes in selling prices, costs, or quality of product and services.

  • Net income rank within a sector presumes that each corporation is attempting to maximize the results during the period.

  • Return on capital (or return on capital employed, which deducts from capital any identified excess capital): a measure that does not differentiate between the sources of capital, e.g. short and long-term borrowing, temporary capital or float, preferred shares and common equity.

  • Return on invested capital: usually calculated to include long-term debt and equity.

  • Return on equity: usually calculated to include all forms of equity compared with net income.

  • Return on tangible capital which removes goodwill (goodwill is particularly useful in comparing acquirers of intellectual property producers).

  • Return on gross assets or ROGA was a measure I learned analyzing defense companies, comparing corporations that had a mix of government owned and privately owned facilities.

The above is not an exhaustive list. The way the momentum game is played is that one holds or buys the security as long as the current reading is higher than the last one. As soon as the number is less than its predecessor, one sells. Many of the followers of these techniques describe themselves as growth stock (fund) investors. Over the years General Motors, IBM and airlines have been labeled as growth stocks. Not only are there risks to this kind of investing (the potential of a lower reading), but there is a bias in the numbers that changes.

Patience rewarded

In the eyes of too many quasi-sophisticated investors and much of the financial press, the opposite of growth-oriented investing is value focused investing, which at its essential is a view that the current price does not represent the current value. (There is a half way house of "growth at a reasonable price" or GARP which requires both the expectation of growth-momentum and a less enthusiastic price.) Often the key to value investing is the belief that the current price only reflects the immediate past. The value investor has patience and expects that better results, using many of the same measures of the growth investor, will occur soon. In an engineering sense they have built some “fault tolerant” elements into their analysis. We all recognize that too much patience can lead to low returns or losses, even when ultimately successful. To avoid exercising too much patience, the value investor identifies where the prospect security is, relative to its past cyclical behavior. Other approaches average the results over distinct periods of perhaps five or even ten years, with the thought that over time the results will return at least to average.

The lessons from sports

As many of our blog community members know, I view handicapping at the race track as one of my two most formative educational institutions. Further, from a professional investor standpoint, I follow the ups and downs of the National Football League teams and players. Both of these experiences teach that while it is exhilarating to cheer or bet on the continuation of a winning record, the odds are that all strings will break sometime. The “normal” is that one’s choices include some victories and some losses. This is by design. At the race track, officials attempt to see all the horses finish exactly the same by setting the conditions for the race, including the level of weights carried. The genius of a number of professional sports leagues is that on any given day any team can win beating a team with a better record. One of the many lessons from watching these results is to occasionally throw out or disregard a specific contest, particularly the last one, on the basis of weather, location, and/or health of a key participant. A second lesson is to adjust one’s thinking due to an expected change in tactics. Perhaps, the most important lesson is to believe in luck. If for no other reason, the randomness of luck suggests that additional bets (or if you will, diversification) are often appropriate.

Managing the specific risks in your investment portfolio

A portfolio that is exclusively built on the belief in momentum, or current price discounts from value, is likely to move largely at the same time. That is why we often hear that “this market” is good for growth or value investors. I suggest that a portfolio that is entirely focused on one or the other is likely to experience the biggest career risk to an institutional investor. If the “market” is going up for some time and your portfolio is not participating, you are likely to be terminated as a manager. Additionally, you will likely experience the further pain that many of your positions suffer from similar investors being forced to dump their holdings as assets are redeployed. In many cases the biggest risk to an institutional portfolio is the co-venture risk, when too many others have the same or similar positions in a market that changes emphasis dramatically. The best way to defend against these risks is to have some balance of growth and value opportunities, as well as not to own institutional favorites. Currently, many of the portfolios that I see are much more value oriented, and where they do have growth investments, they are one way or another related globally to the Internet. Be careful: luck normally falls on a smaller population than a larger one.

What do you think? Please let me know.

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Sunday, April 10, 2011

“The Archduke Lives For Awhile,” As Speculative Excesses Build Up

  • Speculative excesses
  • The gathering evidence
  • More evidence from theWall Street Journal
  • The Enthusiasm is Growing
  • Trying to focus on the longer-term
  • When will the Archduke be shot?

I suspect that in the colleges and universities as well as our “better” high schools there is little or no attention being paid to why the First World War was inevitable. The process started many years before with the disastrous results from the French side of the Franco-Prussian War, where the French lost 25% of their young men to a newly united Germany, inducing fears on the part of the French of German militarism. Queen Victoria's vast family united the crowns of tsarist Russia, Germany (Prussia) and the British Empire during her reign. Her death weakened those ties. The completion of the first phase of the European carve-up of Africa to secure raw materials, added to the wariness. The intensive study by the German general staff of the US Civil War and the development of the war of maneuver laid the foundations to the way the German Army would fight in the next two wars. Poor economic conditions in Russia, in part due to high taxes and lowered farm yields, pushed the government into many unpopular moves. The Russians were recovering from the expenses of their defeat in the Russo-Japanese war with a smaller, but better equipped and led Japanese. Peace between these two combatants was designed conceptually by the US President, Teddy Roosevelt at his home on Long Island. For his efforts he won a Nobel Prize. (As a trustee of Caltech, the home to so many Nobel laureates, I highly value these awards.)

When the Archduke and his wife were assassinated, the Austrians felt that this was the beginning of an attack on their sovereignty by the local Slavs, egged on by the Russians and/or the French. The Austrians cashed-in their guaranty agreement with the Germans to protect their country. Quickly the French felt that they would be under attack by the superior German forces. The Russians were by treaty required to support the French if they were attacked, and in turn this brought the British into the war. All of these actions were predictable and became inevitable once a spark was fired in the tinderbox of Europe. One could see it coming.

Speculative excesses

In a similar fashion the history of stock market collapses rests on the building of speculative excesses. These excesses suck in many people who should not have put their relatively meager life savings into markets that appear to offer great wealth opportunities, but in reality are based on permanently higher prices. In a recent CFA Digest article, as noted by Frank Holmes of US Global Investors, three ingredients of asset bubbles were identified. Financial innovation, investor exuberance and speculative leverage contributed meaningfully to the bubble. I would suggest that we are in the early stages of again building such a bubble. While it may be the early days of the pieces falling into place, one must be aware of the risk from the unexpected (the assassination of the Archduke.)

The gathering evidence

Some of the elements that are visible to me from the financial press this week cause my long term concerns. Alan Abelson, the heart and soul of Barron’s, in this week’s column bemoans the sharp increase in the level of bullishness being expressed by investment market letter writers. He compares the data from Investment Intelligence, which shows that we have not seen this level of optimism since 2007. Many people treat this as a contrary indicator: the greater the optimism the more wary some get. I think there is more room for higher levels of optimism as we are now stacking the cards in favor of speculators.

The next two items are only linked in my mind through excessive leverage, speculation, and resulting fraud. In this week’s Barron’s, there is an article on one of two publicly traded companies that are serving the retail urge to play in the foreign exchange (FX) game. The article points out that over 70% of the accounts lose money; many of those initiated their accounts with a credit card. Some of the regulators are concerned about the leverage used by these retail accounts and have cut the permissible leverage in half to fifty times (50X) in the US and 25X in Japan. Elsewhere there are no limits and some leverage reaches 200X. (A portion of the record breaking first quarter volume on the CME is also likely to be highly leveraged by so-called professional/institutional traders.) When there is that much leverage being used there will be significant losses, which in some cases will be “temporarily” hidden by “borrowing” from accounts to speculate more successfully. To a degree this is the theme of the extensive interview with Bernie Madoff in the weekend edition of the Financial Times. The promises of riches returned becomes the driver that cannot be denied by some.

More Evidence from the Wall Street Journal

In a recent article the WSJ noted that the SEC is considering relaxing the reporting rules on private companies. Currently only those companies with 500 or more shareholders need report. The current restriction caused an investment bank to withdraw an offer of Facebook shares to its selected private clients. Assuming that this change comes to pass, the firms that we used to call bucket shops here and overseas can claim that their market has expanded (to the detriment of the gullible public). I recognize that many regulators are pretty desperate to shrink their responsibilities in an era of tightening budgets. However, over the next several years the number of inexperienced players that regulators will have to review is going to increase. (As a manager of a private financial services fund and a member of a number investment committees, I am offered the chance to be an early investor in lightly regulated banks, trust companies, and real estate-oriented finance companies run by people who have limited experience in this new world.)

And now the herds are building up. In a March 31st article in the WSJ, it was noted that Merrill Lynch (Bank of America) Wells Fargo (A G Edwards) and Edward Jones were dramatically increasing the size of their broker training classes. Some believe that the cost to train these recruits over a two to three year period is on the order of $300,000 per trainee. Only about 1/3 of these rookies are likely to be employed by the house that brought them into the party. Some will be cut because they don’t make the required production levels and others will voluntarily leave for higher payouts or object to the products being sold. One expert believes that from the houses’ standpoint the firms will only earn a 10% return on the capital spent. My concern is almost the opposite. In order to fulfill the capital generation requirements, these relatively inexperienced brokers will sell complex products that have high profits for the firm and/or encourage margin purchases. They are not going to be happy with agency-only trades, e.g. buy 100 shares of Ford every month for three years.

The enthusiasm is growing

My old firm, Lipper Inc., noted in its first quarter report: “Breaking a two-year trend, equity mutual fund investors injected more net new money into equity funds for the quarter than into fixed income funds.” Interestingly the reported volume on the stock exchanges, unlike the commodity exchanges, is not perking up. (With a portfolio heavily weighted toward mutual fund management companies and brokerage firms, these are trends that I follow closely.) However, I am concerned that few of these investors paid attention to another article in the WSJ. This article focused on measurements that mislead. Included is the point of view that the statistics from the recently completed NFL(*) Scouting Combine are not great predictors of the future playing records of the player. However, the stats probably do track the sizes of the initial signing bonuses. This is similar to SAT scores which do not predict college graduation rates, 4 year grades or success after college. They are somewhat useful in guessing freshman year results. In effect, these statistics which drive lots of actions, are not particularly useful in making long term judgments. I feel the same about the use of mutual fund performance numbers. My guess is that the majority of the flows are going into funds that have shown the best near term results which may mean that they have an oversized position in Apple (*).

Trying to focus on the longer-term

At this particular moment one of the keys to the future is guessing as to future inflation expectations. The Federal Reserve, by its actions, is inducing inflation into the global economy and lowering the value of the dollar at a time when many others do see the threat of inflation. John Mauldin and others see capacity utilization rising, which can only lead to higher prices until new fields, mines, and plants come into production. Many other central banks are attuned to this risk, and those in both Europe and Asia are raising interest rates that will slow their economies a bit. Our own bond market senses inflation is real and growing. One measure I use is to compare the ten year yields of US Treasury Bonds with the Treasury Inflation Protected Securities (TIPS) of approximately the same maturity date. Currently the spread is 289 basis points or 2.89%. Thus the market is predicting inflation at the high end of its “normal” range of 2-3%. My fear is that it may go into the 4%+ range if we do not get better control of our deficits.

When will the Archduke be shot?

Not only do I hope it doesn’t happen and if it does that it is long in the future. Nevertheless, I feel we must be prepared for a sharp market break. I do not yet see enough speculative excess to make a premature move to raise cash, but I am watching for it. One of my three sons is an investment professional with a CFA. This weekend he expressed the hope that we have ten years of good markets ahead of us. I hope he is correct, but history suggests to me that the next five years could be difficult for some.

What do you think? Please let me know.

(*) Disclosures:
1. We are lucky enough to manage a number of defined contribution plans for the NFL and the NFL Players Association.

2. For many years I have personally owned shares in Apple that was a spinoff of a closed end fund that I owned many years ago. Foolishly, I sold some years ago in a tax balancing move. One should never make an investment decision based on tax impacts alone.


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Sunday, April 3, 2011

A Thoughtful Response to “Combining Core and Periphery Portfolio”

Dr. Phil Neches sits with me as a trustee of the California Institute of Technology and has been a long-time friend and adviser. He offers a response to my blog of March 28, 2011, titled, “Combining Core and Periphery.” The original blog post made references to markets, portfolios and classical music preferences.

Phil’s email is posted below.

Philip M. Neches received his BS, MS and PhD from Caltech.



One more thing about the periphery versus the core: the "next new thing" almost always comes from the periphery, not the core.
  • Edison's movies versus Broadway
  • Intel's microprocessors versus RCA's vacuum tubes
  • Teradata versus IBM
  • Charles Schwab versus Merrill Lynch
  • First Solar versus Exxon?

If you want superior portfolio performance, particularly over the long haul, you have to identify and include "game changers" from the periphery. The earlier you identify and invest in them, the greater your differentiation from the herd.

Classical music was dominated by Romance language speakers through the Renaissance, but by German speakers from Bach through Brahms (roughly 1725 to 1875). For 150 years, classical music meant German music, and for much of that time, Vienna was the undisputed musical capital of the world.

But then music globalized. French, Russian, Czech, American, Scandinavian and English classical music blossomed. In our lifetimes, we saw that expansion reach Asia and South America. Vienna and German music still hold a key place in the classical music scene, but it has become much bigger, broader, more diverse -- and better.

The same thing is happening in business. Just as anyone who wants to excel at classical music must absorb the work and world view of the great Viennese composers, anyone who wants to excel in business must learn the language and values that we trace from Amsterdam to London to New York.

America will not totally dominate business in the 21st century as we did in the 20th. But ideas Made In America will, just as composers in Stockholm, Caracas, New York, and Beijing build on the heritage of Vienna.


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