Sunday, June 24, 2012

Losing Short-term Confidence? Selling Out is not the Answer

Every action we take is based on our confidence that the action will produce a result, hopefully the desired result. Often we are not overwhelmed with confidence, but believe that we must do something, remembering that doing nothing is in itself an action.

In last week’s blog about my stock selection training vs. using passive ETFs, I indicated that it was rare that macro considerations impacted my investment selection decisions. Macro elements are what is happening to the world as a whole, whereas micro elements are what is happening to a single or a small group of potential investments. One of the reasons to focus on micro elements is that they have proven to be easier to identify. After any review of what various political, economic and investment gurus prognosticate, one has the feeling that there is a high error rate. Often the more clever pundits get some things right, but not enough to be truly helpful for those of us who have to make investment decisions for others.

While I think throughout the previous week what I am going to say in Monday Morning’s blog, I pay particular attention over the weekend. Often I search for confirmations or challenges of my beliefs online, frequently focusing on what is probably the largest data bank of computerized investment company data in the world as put together by my old firm, Lipper, Inc. This weekend I am coming up empty for relevant micro insights, as the range of potential outcomes on the macro side is too great and my confidence in the short run of the market is waning.  (I do not have to be right, I just need to not be really wrong.)

The Macro Factors that can go either way:
The debate as to the final constellation of the euro

My frustration is that I cannot add anything to the debate. Worse, I do not see any progress to a permanent solution to the deficit production of governments and central banks supported by the general populations who in aggregate want more in government services than they are willing to pay. Having no responsibility to solve the currency problem, I can perhaps too easily come up with a grand solution.  At the currency level, Finland, Denmark, Holland, and possibly Austria should lead Germany to a hard euro with responsible governments. France and Italy should lead the peripheral countries into a softer euro with one or more devaluations and probably some form of centrist government eventually. I hope the solution evolves quickly; then all of Europe as well as Russia and China can turn to a much more serious problem in their midst which is the growing population of Islamists that fundamentally hold different cultural norms, particularly in the rule of law.

China: can the government continue to get it right?

For at least the last decade, which is the Chinese Party’s time frame, no government has done a better job of controlling its economy in both a huge expansion and a slowing contraction. Power has devolved from the central control of a headquarters-based party to lower levels of government, including getting down to the village and city levels. Actually it is at the lowest level where the biggest monetary contribution is made to the general population’s benefit. From the study of large organizations be they political, military, corporate, religious, or sporting activities, we recognize how difficult it is for good orders from the top, (and they are not always good orders), to be carried out effectively at the lowest level. Recently China has experienced a significant problem on the political level and another at the industrial (railway) level. I am sure that there have been other malfunctions. At the speed that the society must find reasonably well-paying jobs for the population, the Party may not have sufficient control factors in place. An uncorrected mistake could spark the feared social tensions that could derail the growth plans. I will not have high confidence in this arena until I see what the new political leaders will do.

The US election may not be decisive

I do not know many potential voters that are happy with their particular favorite for President or for Senator, when one is running in their state. They vociferously favor their choice over the opposition, but are still not totally thrilled with their candidate. Perhaps this is a good thing, for many political leaders that came into office with a large wave of enthusiasm have disappointed. My real concerns are that unless things change dramatically, getting effective fiscal legislation through the Senate will be difficult. Along with the rest of the world there does not appear to be any groundswell in the US to drastically cut the costs of the things it enjoys and little delight in paying more taxes. Perhaps out of this morass some true statesmen or women will arise and lead the US onto a prudent growth path.

US exceptionalism comes with a price that it cannot deny

The exceptional results of the US are not solely, and may not be mainly, due to its population. The two ocean borders and the abundance of arable land and other natural resources should not be dismissed or discounted. At the moment the US has a large number of the leading universities of the world;  I speak with a bias as a trustee of Caltech. In many fields such as software and biotechnology (including the Human Genome Project) the US is the leading developer of technology. With the gifts that have been given to the United States, the country has a responsibility to others less fortunate. If it shirks these responsibilities as it is now doing, other nations will surpass and could even suppress it. My meetings with the brightest young Americans I know does give me confidence, but not when I see many existing political and corporate leaders.

Investment Implications

My short term confidence and those of others may recover very suddenly. Markets can move extremely rapidly from the present level. I would rather be a worried investor reasonably fully invested in equities than trying to time a re-entry move. Where possible I would have a significant investment in technology companies that have a practice of being leaders in disrupting the status quo. The world has progressed to such a point that all of my investments must address a global world to prosper. Sleep may be overrated as a priority in this pursuit.

Do you have confidence in your portfolio?  In which securities and why?
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Sunday, June 17, 2012

The Active vs. Passive (ETF) Investment Debate

The differences between watching golf and football are similar to the differences in active vs. passive investing.  Viewing a golf tournament such as the US Open, one focuses on the shots and skills of individual players. Each player addresses each shot and each hole somewhat differently. At the end of the day it is the way the individual utilizes the combination of his/her skills with specific shots that will translate into being a winner. Equally enjoyable is watching intensely fought team sports. In league competition such as American or European football, the different teams develop certain attributes (strong defense, high scoring, deceptive plays, and extraordinary athletic abilities) which make some teams winners over others that have many of the same skills and talents.

Advantages of passive ETFs

As an analytical device the differences between watching team-focused sports vs. individual-focused competitions are useful in the selection of funds and managers in a multi-asset portfolio. Recently I was in a couple of investment meetings with advocates of using, or completely using exchange traded funds (ETFs) as contrasted with selecting individual funds or managers. In the institutional world this issue is an extension of the passive vs. active manager debate.  One reason for the growth in popularity of ETFs over the choice of good managers/funds is that the latter group can and has underperformed the “market” benchmark (a statistical index of individual securities usually selected by a financial publisher such as Dow Jones, S&P, or Russell to describe a group or an absolute numerical goal). As passive vehicles do not utilize investment management, they are able to charge considerably less total expenses. All other things being equal, the lower the fees deducted from the gross returns of an account, the better the performance.

Being the best in a poor league is not good enough

The professional football teams that meet in the Super Bowl have the best records in their leagues and/or their play offs even though at any given game any team can win, occasionally not the expected winner.  One of the reasons that I did not comment on the 2012 running of the Belmont Stakes is that I felt that this year’s crop of three year-old horses were not as good as past classes. On the same basis, some Super Bowl winners are not as good as winners in the past. Nevertheless, on a relative basis they were the best at the time.

Because most of my accounts are directed to the long-term, individual annual winners are not usually helpful to me in building portfolios of funds and managers.  When taking a long-term approach, some individual years and other data points are not very revealing; e.g., extreme performance outliers are less critically important than market cycle turning points.

Over the last couple of years, correlations between various investment classes has narrowed significantly, “bunching” fund performance results on top of each other. Unfortunately this concentration makes it much more difficult for individual managers to assemble distinctively different portfolios that are capable of producing outstanding results.  For example, if you invested in the entire technology sector, you would have significantly under-performed a portfolio investing in only three stocks, Apple (NASDAQ: AAPL), IBM (NYSE: IBM) and Microsoft (NASDAQ: MSFT).  

Active management: picking more winners

Active management, particularly my style of investing, is quite different than passive approaches, particularly those of exchange traded funds (ETFs). All ETFs are built around a single specific metric. Some use market capitalization, sector groupings based on sales, earnings, dividends/yields, book values, growth rates, or other easily determined sorting mechanisms. Some use market capitalization weighted as distinct from others that use equally weighted portfolios.

As an analyst of electronics, broadcasting, aerospace, steel, brokerage firms and financial service companies, I regularly ranked the companies I covered against each other. In order to carry out this exercise I made a good attempt to adjust all of the issuers’ data to the same standard of disclosure. For example:  paid and accrued tax rates, product and customer mixes as well as revenue and income recognition policies. In addition I attempted to array shareholder orientation, tables of organization, motivations, etc. Using these screens I could rank with some difficulty the companies from best to worst. 

That was half the job. Next I turned to stock price. Except in some periods of stress, usually the better companies were more expensive in terms of normal valuation techniques, which rarely led to the identification of bargains. To find bargains I needed to find ignored critical observations, particularly those that were likely overlooking some vital facts. The next task was to analyze the stock price. This entailed examining who owned the most sizeable amounts of shares (insiders and large institutions) and whether they had a history of being good investors. Other factors to be considered included the identity of the floor specialists, when we had them, or other market makers, and the history of transaction volume. While I was conscious of global macro trends, rarely did they fundamentally affect the attractiveness within a sector of stocks in vital companies.  I cannot remember a single time when I recommended buying the entire list or sector. This rather long winded recitation of my analytical approaches is why I have problems buying a pre-fabricated list found in ETFs or other index funds. However, I have used index funds in some portfolios when I was unable to conduct enough research, or when there was a lack of pertinent information to confidently pick winners.

Are you an active, passive or hybrid investor?

Let me know which and why.
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Sunday, June 10, 2012

Winning Life with Your Retirement Capital

The greatest American horse race for three-year olds was run this past weekend, the Belmont Stakes.  As many of you may already know, I count my “misspent” youth learning to handicap (analyze) races; Belmont Park in suburban New York was one of my centers of learning. Shortly after the famed Secretariat won the race by 31 lengths and the Triple Crown in 1973, I started my firm, Lipper Analytical Services to apply some of the analytical lessons to the study of mutual funds. I was addicted to analyzing criteria to find winners.

A winning life

Some 39 years later, I realize that the process of developing a person’s retirement capital in part defines for an individual and his/her beneficiaries, whether or not one had a winning life. The accumulated retirement income in the senior portion of life will determine whether one is independent, a burden to family, a ward of the state or some combination of the three. Thus, I believe the production of retirement capital from which retirement income will flow is of critical importance to all individuals and to the society in which we live.

The defined benefit dilemma

Pension plans benefits are  obligations of the pension sponsor or employer. Obligations are treated as liabilities that are part of what the various credit rating agencies evaluate in making their credit ratings judgments. Lenders often use credit ratings to confirm their risk judgments. The level of risk is an important component in assigning an interest rate on current and future loans to the employer. Often the smaller the pension liability the lower the interest rate. Currently, employers with debt on their balance sheets may want to reduce the risks in their pension plans by favoring high quality fixed income with relatively short maturities as likely to decline the least of other investments in a down market. This judgment is based on the past and could very well be in complete opposition to a plan’s investment advisor who may believe this is the exact time to increase the plan's exposure to the risk of market forces. The dilemma for the employer is whether to rely on past history to reduce risk or to look at what appears to be an historic opportunity to buy stocks at what in the future would be recognized as great prices. My instinct is to go with the opportunity. This is not just because of my US Marine Corps training that the best defense is to attack, but also because I am familiar with another mathematically accurate analysis, utilizing "least  squares” procedures. 

"Least squares” analysis

Least squares analysis is a procedure that various analysts use to determine the best fit of a line that will be equidistant from a field of many different observation points. My concern today is that we are in a period of an unprecedented volume of inputs. I am aware that single or multiple extreme observations could for example, radically change the slope of the least squares line and produce a radically different expected growth rate. When we experience the unexpected, we are likely to experience even more unexpected results. For instance, older employees can, perhaps, take comfort from a conservative pension plan as the chances of getting the "promised" benefit is relatively good. Younger employees however might feel the opposite. Their pension provider may not have bought cheap growth assets when they were available. Thus in later years the employer may have to contribute more than normal amounts of money to offset their lower earlier returns. The question for these now aging employees becomes whether the employer can meet its pension obligations without starving the company’s future growth.

A rough rule of thumb for younger potential employees rating their future employer

I am going to suggest one analytical tool that might be used as a point of departure, though many may disagree with this approach. One of the ratios that is available on most defined benefit pension plans is the funded ratio of plan assets compared with the actuarial calculations as to what is owed over time. Many plan sponsors want to keep this ratio at or slightly below 80%. Above that level they lose some flexibility in meeting payments. A ratio below 70%, could cause credit ratings to drop. In a very simplified calculation, pension funds can show the amount of money invested in equities or other large risk featured investments. Particularly at this point of time when the stock market has been generally flat for more than ten years, sponsors who have an equity ratio approximately the same as their funding ratio are positively future oriented. They believe that they will experience growth. A risk ratio below their funding ratio suggests, perhaps for good reason, they are being cautious. Perhaps the real value of this rule of thumb is that in a second level discussion, it would show a serious interest in the long-term financial health of the prospective employer.

What choices should be included in defined contribution plans?

The various options offered in 401k, 403b, and 457 plans is something of a balancing act between paternalistic fiduciary views and the desire to let the individual saver choose from all available options permitted by various regulations. Most of the options offered come in a mutual fund format with two notable exceptions, directed brokerage accounts and various types of annuities.

The US Department of Labor has indicated the minimum of options to be offered to include a high quality, short-term fixed income fund that is often translated to be a money market mutual fund or a stable value fund. The minimum number of funds is four with at least one equity fund. At the other extreme, for awhile a number of plans offered over 200 funds from a number of providers. Studies have shown that too many choices confuse participants. Further, the history of plans is that most of the money is in relatively few funds. (I suggest that any fund that does not garner 5% of the money should be a candidate for being dropped.) Each of my plan clients is different due to the beliefs of the sponsor and the perceived needs and general investment sophistication of the workforce. In a generic sense my approach is to start with the oldest type of fund, a balanced fund, with stocks as the majority asset class and fixed income for the remainder. This fund should be used as the default alternative. Some may suggest to use target date funds for this need. My problem with these vehicles is not with their portfolios, but based on studies too many of target date fund investors don't fully understand them. If there is an effective individual advisory function at work, target date funds could be added to a moderately large list. I would like to have at least two fixed income funds, both high quality and preferably US Treasury-oriented, one short-term and one intermediate.  In addition I would add a TIPS fund. In terms of equity funds I would include a Large cap and a Small cap fund with at least one of them focused on growth. A stocking-picking fund without constraints would be a nice addition. Notice I did not label the choices as domestic or international or manager-selected global funds. These are becoming less distinctive as choices today.

Investors should have their own individual investment accounts

There are two reasons for this belief. First and foremost, the individual account can select when to accept tax consequence transactions and, at least for now, gains will be taxed at the tax advantaged capital gains rate rather than the ordinary rate that will be due when the withdrawal period begins from these savings plans. Second some of the product line extensions that I do not feel are appropriate for these fiduciary savings plans, could well be useful in an individual's own account.

Using leading equity funds

Many individuals avoid funds with large unrealized capital gains for their taxable investment accounts. In my new Reuters column,  I recently asked whether there is a penalty box for funds that have had great long-term investment performance.  The answer may have some relevance for investors and beneficiaries of retirement income.
What are your reactions?

How are you planning to overcome your retirement capital concerns?
Did you miss Mike Lipper’s blog last week?  Click here to read.

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Sunday, June 3, 2012

No Guarantees in Fiat Currencies or Retirement

One of our younger relatives told my wife and me years ago that he couldn’t settle down because he had “too many questions in his head.”  Unknowingly he repeated what market sages for years have stated, that the market needs “certainty.”  Thus both the young and the wise are grappling with an unknown and perhaps more correctly, an unknowable future.

To answer our basic concerns, the strongest human marketing powers in business, government, science, and religion have repeatedly provided generally accepted guarantees that answer our concerns. During the current period of global neurotic economic stress, one wonders whether the title of Andy Grove’s book, “Only the Paranoid Survive”  is relevant. I am suggesting that as with all well-marketed messages, guarantees provide necessary comfort, but they may not be complete in each individual case. Given the uncertainties facing the modern world, the backing behind each guaranty needs to be understood.

Briefly this blog will touch on some of the accepted guarantees involved with retirement income and the value of money. As usual at the end of this blog I will suggest investment implications to these views. (Many of the views expressed will be provocative and will hopefully generate feedback.) 

The Promise

The heart or essence of any guaranty is the promise that under specifically-stated events or occurrences a predetermined reaction will automatically be triggered. In effect, the promise is a contract, often ill-defined or in some cases not even written down. As time passes, what is remembered is what someone believes to be the promise, without any review of the contract. In typical wedding vows, the only exit is by death. There is no mention of actions and attitudes that lead to today’s large number of divorces. In Europe and elsewhere, the fear of either the marriage contract or divorce has led to a large portion of the population living together for extended periods of time rather than marrying.

Retirement Income

Rational people for ages have been saving money, in part to meet a future period where they will no longer be sufficiently economically active to provide for their own needs. For centuries hoarders have converted much of their stash of wealth into savings. In turn some or all of their savings have been entrusted to various financial instruments and institutions. Since the 19th century and that great “humanitarian” Otto van Bismarck, people have increasingly relied on taxing authorities to supply retirement income.  (Bismarck created the first social security system which would pay retirement income starting at age 65. He picked that age because he believed that very few would reach that age.) In a more modern era, recognizing that most employees would not have enough discipline to save for themselves, companies would defer some current compensation to be paid out later in retirement. Unfortunately, these two sources, the government and various employers, represent the bulk of the expected retirement income for those that had a career of working. For the most part these people are not worried now and don’t expect to be worried in the future because they believe that they have been guaranteed these payments.

These guarantees are increasingly being issued by some  entities  that are having their own financial difficulties. Most federal and some state and municipal governments around the world are operating at a deficit. We, the citizens, consciously or involuntarily are consuming more from the government than is being taxed. Almost all now recognize that this deficit production cannot continue forever. The two standard solutions are to cut expenses or raise taxes. Somewhere in between these two difficult choices there is a stop-gap measure of changing the payment schedule assumed by the government.  Delaying debt repayment to foreign borrowers can lead to materially higher borrowing costs in the future. One can see the possibility that the government could materially change the net effective payment of social security payments. After all, it is difficult or almost impossible to sue the US government without its permission. Most beneficiaries may not realize it, but social security payments are already effectively means tested. The amount of the payment which becomes reportable as taxable income is based on the level of other income received. Remember that half of the benefit received came from your employer or you as self-employed. Changing the date of full retirement is another way of changing the shape of the government debt. For some time I have warned all of my young employees that they should view that FICA (social security) taxes withheld from their pay and matched by their employer are tax payments and they will be unlikely to receive any real retirement income from their tax payments.

What is probably a larger problem for some is the so-called Pension Guaranty Corp, a government body that is meant to guaranty some pension payments for corporate pension plans of bankrupt US corporations. With the government proclivity to bailout pre-packaged bankruptcies of companies with large union member work forces, the guarantor will run out of money and will have to raise fees on those declining number of defined benefit plans or get an infusion from the US Treasury through an act of Congress. Both are uncertain.

Other ways to save are through various financial instruments directly or thru financial institutions. These are only as good as their continuing credit conditions.

Bottom line:  the various sources of retirement income are not perfectly secure under all conditions. The prudent saver needs to be aware that the expressed guarantees have some limits.  

The Value of Money

In the US, much of life’s activities are ultimately measured by colored pieces of paper approximately 6 by 2 ½ inches called the dollar. The pretty paper which circulates around the world in various denominations has little face value, but has substantial spending and trading value based on the belief that there is some almost universally accepted value because of a series of ill-defined guarantees.  Thanks to President Nixon,  the US dollar no longer has direct backing of gold or even now a fixed basket of currencies. As long as others will exchange goods and services for these painted pieces of paper, the dollar and other fiat currencies have value. Around the world the dollar trades against other currencies 24/7. In theory the Federal Reserve currency  has the vastly expanded Fed balance sheet as backing. These are supported by various issues of  US Treasuries that are the debt of the US government. What makes this curious to a financial analyst is that we have never seen a published balance sheet for the US government. We can speculate as to the enormous value of the government’s real and intellectual property. Most of us don’t know the size of the debt against these assets, particularly the future contingent debt. Value-oriented investors regularly arbitrage the difference between a quoted price and its intrinsic value. I cannot perform this equation as I lack any sort of precise knowledge as to the value of the dollar other than what is trading for now versus other currencies, including gold. Thus, I do not recognize fiat currencies such as the dollar have a guaranteed conversion price.

The Terrible Link

Both the value of future retirement income and the value of the dollar are linked to the rate of future inflation, which itself has no guaranty. The value of the current dollar, euro, pound, yen, and Renminbi is exclusively based on what they can buy today in the way of goods and services. If one isn’t going to spend currency today, one must be concerned as to its future value. Often its future value will be dependent on the path of relative prices. This is particularly true for the retired when an expenditure is likely to draw down retirement income or capital. As these are unknown or probably unknowable, I seriously question the certainty of both currencies and retirement capital that people are using.

 Investment Strategies in a World of Questionable Guarantees

First is my guaranty. My guaranty is that I won’t guaranty any specific future scenario or strategy that will produce only winners.

Second, in a period of increasing uncertainty, excessive concentration is dangerous. 
Third, as I believe significant inflation is eventually probable, I believe up to a quarter of one’s portfolio should be in an inflation defensive mode to include TIPS and selected foreign treasuries of up to five year maturities issued by  small population/commodity rich governments with small to no deficits.

Fourth, all equities should have a global orientation. These companies should have some of these characteristics: exporters, foreign operations, net royalty recipients and managements that think beyond their local borders.

Fifth, technology developers and users should play dominant roles.

Sixth, put at least 25% of your or your clients’ portfolio into stocks of companies that are more flexible than their large competitors. This puts one into smaller capitalization securities.

Seventh, as only a few mutual funds are constructed exactly along these lines, a portfolio of funds that appropriately counterbalance their portfolios will be needed and selected carefully.

Feedback Sought

Please share with me your thoughts on the guarantees discussed and or how one should construct a portfolio for such uncertain times.
Did you miss Mike Lipper's Blog last week?  Click here to read. 

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