Monday, December 26, 2011

Your Investment Gifts May Contain Good and Bad Surprises

Introduction

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 na├»ve. 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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