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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