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.
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.
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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