Sunday, August 26, 2012

A Winning Equity Team

There is a basic belief that selecting the right talents over an extended period of time will give you a winning result. Building a sound team of stock managers is a similar exercise.

Understanding “The Game”

Investing for the long-term, as many institutional and wealthy clients do, presumes with a high degree of certainty that there will be a series of rising and falling markets. Some moves will be broadly-based, where almost all investments will participate in a correlated decline. There will be other more narrowly-based movements where different sectors move in opposite directions. As with all games that involve people, individual persons, regulators, and governments will do unpredicted things, frequently against their own best interests. Often the best teams can overcome the unpredictable actions of those pesky humans.

Increasing the odds on winning

As much as we think we believe that we have a high degree of certainty about the near-term future, the truth is that the future will unfold in a random manner and pace. Long-term winners that I have known have an uncanny record of surmounting different near-term unexpected problems. One of the ways that they do this on a repeated basis, but not all the time, is the selection of talents for their own teams. They are selective in the talents they bring on board and practice disciplined diversity in their portfolio outlook.

Building your dream team

In the real world of assembling your long-term equity portfolio you should use both your selection and diversification skills. If you were building a non-US football team, or a US baseball team, you would select some strikers and pitchers, but you would also add players with other talents who might not generate the same level of headlines but would be critical to the final tally. Therefore, the critical question is building the right mix.

Investment objective mix

There are no two mutual funds that are exactly alike in each and every aspect. On a global basis, depending on definitions, the world probably has on the order of 100,000 funded products. To make comparisons easier, years ago we adopted a strategy of grouping funds according to investment objectives as we defined them. These allocations to different investment objectives are far from perfect, but work reasonably well. The dominant factors used in the allocation scheme are: selecting by main type of security used, sector, industry, or geographical focus. In some cases the way the funds invested for capital appreciation or income led to their assignment. Today, one can choose between some 200 equity investment objectives. (The selection process for fixed income funds is quite different.) I suggest that there are only two initial categories of funds when building an appropriate investment objective diversification: narrowly and broadly-based.

Narrowly-based funds

These funds are like a late inning relief pitcher in baseball, that with great regularity gets the final three hitters to strike out and preserve the victory. Without such a relief man, in a close game the team will be reliant on their tiring pitching staff. However using such a player for every single game would exhaust his effectiveness. I am a believer in utilizing a limited number of narrowly-based funds within a diversified portfolio. For me, the successful narrowly-based fund will add a large increase to a larger, but currently tiring portfolio. In other words, I am looking for an extreme result. The problem with extreme result-oriented funds is that they regularly are found in the fifth as well the first quintile in terms of short-term results. Some examples might include small country investing; e.g., Egypt, Indonesia or perhaps Korea. Further examples could be highly-selected commodities like sugar or an industry focus such as semiconductor equipment manufacturing or offshore re-insurance. The use of this high octane strategy needs to be cautiously applied and should only be used by a limited number of sophisticated accounts who can accept above-normal current volatility in search for long-term gain.

Broadly-based funds

We used to live and invest in a nicely defined world where our future results were largely the results of our own or direct competitors’ activity. That is not the case today. I would submit that the distinctions between international, global, and domestic companies and their securities are interesting, particularly historically, but have less relevance today. A small Midwestern bank has direct or indirect loan exposure to currency fluctuations, crop prices, shipping rates, and changes of foreign government regulations. The remaining railroads will prosper or not on the exports they carry. Our local supply of clothes and foodstuffs are not solely determined by our own local demand. In today’s environment, I believe a prudent strategy is to invest with managers that are not focused primarily on generating near-term dividends and significant buy-backs. I want to invest with managers that are selecting companies with relatively high returns on assets. Actually I like those which have high returns on gross assets to reduce the impact of the financial engineering of acquisitions. I perceive that new discoveries around the world are offering us to invest in new products and industries that not only solve people’s problems but also represent proprietary types of profit margins to the early movers. In selecting Broadly-based funds, those that focus exclusively on the numbers, current market conditions, and the inabilities of politicians can be good near-term positions. The lack of forward focusing on the part of managers and their investments means that we have to look elsewhere.

Where are you finding the future? Please share your thoughts with me.

In response to a reader's question

One of our regular and very savvy readers raised the question as to redeeming a fund too quickly after a series of poor results. The fund in question is now up 30%+ on a year-to-date basis. Was it a mistake to redeem too early?

With the kind of recovery experienced by this fund, one needs to act carefully. I am delighted for those who stayed with the fund. They deserve to be paid for their roller coaster ride.

We started today’s blog with a brief discussion as to my bias in favor of narrowly-based funds. While not by prospectus, but by practice, this fund was an extreme practitioner of the art form of managing narrowly-focused portfolios and was successful for a number of years. If all other things remained equal I would have recommended delaying redemptions through a normal recovery period. In this particular case things did not remain the same.

The portfolio manager of the fund publicly supported the CEO and stock of a major financial institution. In a discussion with the portfolio manager,  I took a very different point of view. After publicly supporting the stock in question, the portfolio manager sold his large position in the institution.

The recovery in the fund’s net asset value is now being driven by its remaining single largest holding, a very large position in a stock with a sizeable US government overhang. I agree with this particular holding, as I have been an owner for many years in the mentioned stock. If the portfolio was a frozen fund with its small number of securities it probably would have been wise to scale out of the fund. As a fiduciary, for me the changing attitudes and personnel added too much risk. As is often the case I was premature.

How would have you handled this?   

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Sunday, August 19, 2012

When the Stock Market Sleeps - I Get Nervous

Not only have the popular US stock market averages been flat for a period of twelve years, the recorded volume this summer has been scant. The so-called fear index, the VIX measure, is producing returns significantly below averages. 

In another sign of lack of concern, the decision was made at a recent investment committee I attended that a specific inflation defensive fund was not needed. (If you believe the US government’s statistics, the latest available all items count would be a minus -0.16% for the month of May and a core rate of 0.01%).

Somewhat more ominously there was praise for our committee’s market index fund selection, with the question as to why we should pay the high fees for hedge funds that are not producing better-than-market results. In another investment committee meeting it was suggested that many institutions are buying hedge funds directly and redeeming funds of hedge funds. (If the latter approach gains momentum it can hurt the expansion plans for the number two profit contributor to Legg Mason, a holding in our private financial services fund.)

What makes me nervous is that there are lots of facts and opinions that are crying out for significant changes in portfolios.

Start with the negatives

A recent piece by Moody’s* chief economist, John Lonski entitled “Global Slowdown Menaces Ratings,” focused on the recent plurality of downgrades as opposed to upgrades both for High Yield and Investment Grade bonds. As reported in my previous blogs, the appetite for yield at the moment appears to be insatiable. In the current quarter there have been 43 downgrades and 20 upgrades of high yields, and a 13 to 3 ratio for investment grade paper. Remember that one of the criticisms of the credit rating agencies (for understandable reasons) is that their findings are late relative to the market. The sellers and buyers of bond funds, particularly of high yields, do not appear to be following the changes in ratings. As an equity analyst I have been trained to think that the bond market senses trends before the stock market. The ultimate payoff with bonds is the return of principal with interest, as distinct from the equity market’s hope of future capital appreciation.
*Moody’s is another holding in my private financial services fund.

In one of John Mauldin’s well-written weekly letters he suggests that we may be approaching a Minsky moment. Hyman Minsky, a well-known European economist stated that stability leads to instability. After a period where the normal is flat, there will be a violent change. The key to this thinking is that something will dramatically change people’s views as to when the current supply and demand mix will abruptly change, which is easy to believe in our 24 hour news cycle world.   

In another letter John Mauldin mentions that the real problem for the euro long-term is France, which I have felt to be the case even before the last unfortunate election

One of the advantages to investors of the flat performance of the VIX futures, particularly if we do experience a Minsky moment, is that hopefully both the academics and the marketers will stop using volatility as a measure of risk. To me, risk is the inability to meet future payment goals for an investment or portfolio, not whether the return is calm or fluctuates. This belief can be a problem for the sleep patterns of trustees.

The positives that no one believes

If you ask most people about the progress of the market in 2012, they will say they don’t believe that we are up low double digit returns by mid-August. These returns would more than fulfill the annual requirements of most institutional funds; as a matter of fact the returns are close to double the needed returns for the more sensible institutions.

Richard Bernstein, now independent from a career at Merrill Lynch suggests that Bull Markets begin out of a malaise of fear. Investors are fearful of facing an unpopular election in the US as well other unpopular and unknown changes in governments for over half of the world’s GDP. In addition, the so-called “fiscal cliff” comes due to challenge the US at the end of 2012.

There are no apparent signs of valuations which are historically too high. (I would suggest that the excesses are in the bond market where the manipulating central banks are depressing interest rates. As we know, eventually even the manipulators run out of money.)

One of the more bullish pieces that I have read is by Seth Masters of Alliance Bernstein. In his view of a normal market expansion he sees a Dow Jones Industrial Average of 20,000 in five years. Even on a lower multiple basis, Masters predicts the market will reach this level in ten years. What is significant about this piece is first that it is coming out now in a period of malaise, second it is not from a promoter, or a Dow at 38,000 proponent,  etc., and third, if true a move from here to a 20,000 DJIA would fulfill lots of investment requirements. (As long as inflation remains tame.)

Perhaps the single most bullish piece that came out this weekend was the disclosure of the portfolios of Paul Ryan and his wife Janna. I do not know who selected the list of well-known and generally sound mutual funds. What is significant to me is that the potential “second family” of the US has been well advised and has a spread of funds that are appropriate for the current world. If Mr. Ryan becomes the Vice President or stays as chair of the House Budget Committee, we will have someone in a high place that has a sound outlook for his and hopefully the country’s investments.

Sleep well, but not too well.

 In last week’s blog I mentioned a recent study of one account that we manage and said that there was not a single decline in 2012 through July, in the list of 47 funds. The actual number was 37. My apologies for the error. 

Second, for an unexplained reason some of our email readers received a version with the initial letters of some words doubled. If that happens again please let me know and we will send out a corrected copy. 

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Sunday, August 12, 2012

Manipulated Markets Thwart Wise Allocators

One of the insightful columns to read in each Weekend Edition of the Financial Times is written by Henny Sender. Her column is always well written and at times explores extreme positions which should be read to broaden one’s views. This past weekend’s column is entitled “This rapacious appetite for junk could yet result in indigestion.” The article describes the significant sales of below investment-grade bonds. Ms. Sender cites an example of a successful bond underwriting of an American utility whose common stock is viewed by many as worthless. Her view is that with high quality bonds yielding low rates (in most cases significantly below actuarial assumptions for pensions and less than the spending rates of trusts and tax-exempt institutions) investors are forced into extreme investments. At the opposite extreme, there are investors concerned about the value of their currencies; we have at least 15 countries with two-year bonds yielding below zero in terms of “real” rates (adjusted for inflation).

What has caused this behavior by so-called sophisticated institutional investors? This was not taught to them at their schools of supposed high learning. This bizarre condition occurred because at the urging of the politicians, central bankers have attempted to manage the supply of credit to support their faltering economies by making cheap credit available. In other words they have manipulated interest rates lower than they would have been under the present economic conditions. In non-manipulated markets the exact price of an investment is determined by the meeting of buying and selling forces. Normally, the market determines a rate of interest that is a reasonable gauge of the perceived risk of loss of an investment. In an administered market there is little in the way of risk discovery. Thus, all too often allocators will choose high interest rate paper for their portfolios to meet unrealistic demands for current income.

One of the misapplications of Newton’s First Law of Motion, (a body in motion tends to stay in motion) is that current market conditions will remain the same in the future. As is often the case, the best economic text, the Bible, has the early recognition of the seven feast years followed by seven lean years. Further as history shows, wweventually all manipulations become exhausted and then there is a return to freer markets. Currently those that pursue the high yield, or if you prefer junk markets, are not worried. The interest rate spread between their merchandise and US Treasuries of similar maturities is historically tight, showing the market’s acceptance of high-yield paper. I suggest that any appropriate analysis of the US government’s finances would suggest that the interest rate for US paper is too low as reflected in its credit rating downgrade. A more realistic interest rate on US paper should force higher rates on “junk” which will cause lower prices for these bonds.

The above views may appear contrary to the flow of money into high-yield bond funds and the issuance of new high-yield paper. This weekend some were suggesting that one way to take advantage of the current market is the purchase of high-yield municipal bond funds. The author of one article conceded that there could be an increase in defaults, but the current superior yields could absorb the defaults. (I do not believe that is the way the math will work out on the net asset values of these funds.) At this point I am unaware of any tax-exempt entity increasing its ratios of solvency. I am sure that there are some, but not many.

The job of an asset allocator

In my opinion and practice the sum total of a specific client’s assets should be arrayed to meet all the expected needs of the account, present and future. This belief and practice is very different than maximizing the disposition of current assets to meet current needs. Many allocators believe that in their infinite wisdom they will be able to shift allocations as the markets turn. There are a few that have the history of successful shifts to catch the big trends. In a review of mutual fund records I cannot find any significant number that has pulled off this feat three or four times in a row with large pools of capital. Thus, as portfolio allocator for most of our accounts, we rarely are all in or all out. (Or, if you prefer the current lexicon, risk on/risk off.)

The insatiable drive for income

Those allocators who get sucked into providing large amounts of current income are producing better current results than those of us who are using a more balanced approach. However the balanced approach appears to be working.  In a forthcoming review of a major account system for one of our clients, all forty-seven of the funds used are showing a positive result for the first seven months of the year. (A much longer period of perhaps ten or more years would be needed to demonstrate skill. But after some rough months in the second quarter, it is nice to momentarily see progress.) Remember that past performance is no guarantee of future results.

How much are you allocating to high-yield and at what yield will you exit these investments?
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