Sunday, October 28, 2012

Unpopular, Unconventional, Painful and Disruptive

Unpopular, Unconventional, Painful and Disruptive is not the name of the new hot law firm. The title is a summation of some of my "out of the box" thinking flying home from a too-brief visit to an offsite board meeting of the California Institute of Technology and a visit to PIMCO, the world's largest bond manager.

"The New Normal"

One of the reasons bond managers think in terms of secular trends is that at times they invest, rather than trade, bonds with long maturities. While those who buy stocks should be thinking in terms of long to infinite time periods, many of them focus on much shorter periods; e.g., quarters, twelve months, five or ten years - certainly not thirty years. That is why understanding bond managers is important to equity investors.

In meetings held by senior PIMCO investment people with a group of Caltech trustees, PIMCO focused on an expected period of prolonged very low interest rates. They also shared their opinion that the various stimulus moves by leading central banks and governments will not lead to effective de-leveraging. I got the distinct impression that these moves would prolong the valley of low employment and a decline in the developed world's standard of living, while many of the emerging countries enjoy rising standards of living. A further examination for the sluggish response to the various government actions reveals that in the US, 71% of GDP comes from consumer spending with 47% of that total spent on services and only 24% on goods. As services are time perishable, the old pump-priming techniques of the 1930s don't work as well.


If the present generalized approach is only going to prolong the problems, why not stop banging our heads against the stone wall and let the natural correction forces operate? In other words, let rapid de-leveraging happen through a normal bankruptcy cycle. During bankruptcies, various contracts can be abrogated. I would carry the process further by removing various constraints and restrictions in government policies that are no longer valid. What should come out of a bankruptcy is a new beginning with an enthusiastic attitude. Unfortunately, only 42% of the American public believes that hard work leads to success as indicated in a recent Wall Street Journal article. This attitude must change.

The whole idea of re-thinking past dictates of government is accelerating. I recently attended a conference organized by the Museum of American Finance at the New York Stock Exchange. The focus of the conference was how to restore individual investors' confidence in the equity market. For some time I have maintained that the regulatory pressure to lower transaction costs is a significant contributor to the problem. When commissions and spreads were large, retail salespeople sold stocks and provided other investment services to the public. As their remuneration rapidly diminished, salespeople gravitated to higher commission products such as hedge funds and structured securities. The chair of the NYSE recognized that the switch from quoting prices in fractions to decimals, including sub-pennies, has reduced the attractiveness of selling stocks as a business. I find it interesting that there are news accounts that the SEC is considering a test of a return to the use of fractions. If the SEC can see itself reversing some of its past policies, there may be hope that other government bodies can re-examine their past actions to become more pro growth.

One of the most rigid congregations in the world is the scientific community. Scientists regularly make pronouncements of various laws and theories. This weekend my wife Ruth and I listened to leaders that supervised the work at JPL (Jet Propulsion Laboratory, an affiliate of Caltech) of the Mars landing of  "Curiosity." Each manager described some of the various scientific beliefs and budget constraints to carry out the mission. This remarkable success is viewed around the world not just as a success of Caltech/JPL or of the US, but of mankind as part of its conquest of knowledge beyond our earth. I hope this achievement and the continuing reports back from Curiosity will lead to a greater understanding of what we are capable of doing with our collected talents. We can achieve growth by re-thinking our various constraints.

Investment implications

The markets ahead can be painful either on a prolonged basis with current government policies or more painful but of shorter duration if we allow normal "animal instincts" to operate. In terms of investment policies, in most cases I would not want to own government bonds. I believe the risk premium will rise and stocks will do better than bonds in general. In terms of stock selections, I favor disruptive companies that can take advantage of significant structural changes in our various market places.

What disruptive securities do you own?
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Sunday, October 21, 2012

Labels Can Be Dangerous to Your Wealth


In our modern lives we are inundated with information. To avoid chaos we organize information in silos and give each of the silos a label. Unfortunately we (the universities, the governments, media)  rarely ever examine whether we have misfiled the information or whether those informational relationships have changed. If so, the current label on the current fact is often misleading.

One of the few benefits of long plane rides is that I get to read the news of the day more thoroughly and from many different sources. As I read these pieces, different relationships between the elements of information and some important investment implications occasionally come into focus.

How and where do we shop?

On October 18 in the London edition of the Financial Times there was a front page article headlined “Retailers Shut 20 Stores Each Day.” The article was based on research conducted by the accounting firm PricewaterhouseCoopers. In a study of 500 UK cities/towns, PwC found that in the first half of the current year some 953 stores were closed, compared to 174 in a similar period in 2011. (While I don’t have data on the US and other countries, I suspect that the trends are roughly parallel.)  Computer game stores, toy shops, clothes shops, gift shops, jewelers, card/poster shops and furniture stores were hit the hardest. Places offering check-cashing, pawnbrokers, discount and convenience stores, coffee shops, currency changers (and wire sites) and charity shops were far less effected. After reading the article, the analyst in me had three different thoughts that bumped heads with the traditionally-labeled silos.

First, did the UK statistical offices note the change in the mix of retail activity? Second, the realization that we are seeing marked changes in behavior. Trading down from higher-priced merchandise and conversion of assets to various forms of money, replacing merchandise spending for service spending are all important changes. Third, the data is incomplete, I am guessing a good bit of the store traffic has been lost to the Internet.

In my recent discussions with UK portfolio managers, no one directly discussed these changes, however many held Internet-oriented stocks as long as they were moving higher in price. National governments do not seem to be aware of these changes. Local governments around the world are very conscious of disappearing storefronts and therefore employment, but seem powerless to stimulate sales on their High (Main) Streets.

Does the US have the same labeling problem?

The labeling of various stocks as consumer staples or consumer discretionary is misleading.  These are terms from outmoded economists based on the goods and services once sold, not how they are bought today. Amazon and similar online merchants have changed the world and both investors and policy makers need to catch up.

Another example of mislabeling

In a recent conversation with a very intelligent mother of children who are now in the workplace, I was told that she educated her children as they were growing up at various ages by the stocks she bought for their accounts. At an early age she bought McDonald’s for them, as it was the place they went to get rewards for good behavior and good marks. I am delighted that it worked out well for the family. She followed that thinking and at some point bought shares in Apple for them. (I suggested that now as they are in the workplace she might look to buying some of the recruiting firms. In the past they have not been big winners as stocks but are very much leveraged to mid to high-income employment growth.)

All of the stocks mentioned appealed to her and her lucky children because they knew of the companies and their products. But in each case these are globally-oriented companies. It would probably surprise her and many Americans to learn that McDonald’s has more sales in Europe than it does in the US. (Interestingly there are more Burger Kings in Barcelona than McDonald’s even though McDonald’s has the Airport location beyond security.) In a similar fashion, Apple’s future is very dependent upon both production in China and whether the iPhone 5 will increase the potential market from 17 million users to 200 million users.

The fastest growth for many recruiters is their foreign placements. Not only are local offices around the world filling local needs with local talent, they are searching for qualified US talent to work overseas. These are examples of stocks that are labeled as US domestic because they are legally domiciled here. Most portfolios owned by US institutions and individuals need to recognize the global nature of their holdings and adjust to the world not as it is, but how it is likely to be.

Fidelity has come up with some very important numbers

Following the trail of the now grown up children mentioned above, they and their cohorts need to start to think about their retirement capital needs NOW!  In an article  in the October Financial Advisor magazine, Fidelity Investments has laid out the math for meeting a working person’s retirement needs which I have outlined below. (Bear in mind that Fidelity is the largest factor in the 401(k) market.)    

1.     To reach 85% of final salary level at age 67 retirement, including social security, one needs retirement capital of eight times the ending salary. They assume the age at death is 92.
2.     To reach this goal one needs to enroll in a 401(k) at age 25 and make continuous contributions beginning at 6% and raise it 1% each year until it reaches 12%. (This plan presumes an employer contribution of 3% p.a.)
3.     The intermediate benchmarks would be an account equal to one year’s income by age 35, three times by age 45, and five times by age 55.
4.     The underlying investment assumptions are a 5.5% rate of return, the employee’s income grows by 1.5% p.a. more than inflation and no breaks in employment or savings.

There are very few people that I know that are on this track (excluding those who have access to outside capital) and most workers won’t get to these numbers. Thus, we need to come up with a new label for the period of our lives beyond our primary employment.

Can we discuss your retirement planning?
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Sunday, October 14, 2012

London Likes the US


I have been visiting very intelligent investment people in London for over thirty years. One of the reasons I enjoy my discussions is that many of the instruments and trends that we Americans take pride in were actually started in London (and in some cases further east). I have spent a good bit of time with portfolio managers, CEOs of smart asset managers, and very knowledgeable sell-side types. While I was particularly focused on what the retail distribution of funds is likely to be starting next year under draconian new retail distribution regulations, the people I met with quizzed me on the US market and political situations. A number of people wanted to continue discussions on their next visit to the US, or on my return to London. The following are some of my initial reactions to our meetings.

Much more global

To the unaided eye it looks like investors are investing heavily in the UK, however that is not the case. I believe some 70% of the revenues from the 100 largest market cap stocks come from outside of the British Isles. Using the same type of analysis (focusing on the location of sales and profits rather than legal domiciles) leads a number of investors to buy and own so-called European equities. (This is not true for European debt, which for the most part are government bonds.)

US is more attractive

A number of globally-oriented portfolios have more than 40% invested in US names which does not count the US revenues and earnings from UK, European, and Japanese multi-nationals. Not that the US is so good, but better than the others. To quote Bill Gross of PIMCO, “we have the cleanest dirty shirt.” (I suspect this is a result of Alexander Hamilton’s influence.) The main focus is now on technology, particularly Internet-related issues which are growing faster stateside than elsewhere and/or have a larger runway to bigger aggregate gains.

The mindset of many UK portfolio managers is different

UK portfolio managers are different from those in the US.  Perhaps it is just my background, but I don’t think so. Often their initial discussion and presentation is focused on relative performance to the managers’ chosen index, with some attention given to peer group rankings. The managers want to beat their index in every single time period, often quarterly. By doing so, they believe that they can get all of a client’s money. This drive is very much evidenced by managers that run both mutual funds and hedge funds.

Is this focus on short-term relative performance short sighted?

Almost all of my accounts and most of the institutions where I sit on the Investment Committee have some, if not all of their money focused on long-term results. Further, they do believe in diversification, which means they should be comfortable with some occasional under-performers. (The experience of 2008 was most upsetting, when correlations narrowed as practically all equities declined in double digit rates.)

While in London, Ruth and I had the pleasure of listening to the London Philharmonic which played very well as each section had its turn of prominence (performance leadership). The result was much better than if all tried to be the biggest sound at all times. Similarly, a multi-fund portfolio should have a rotation of winners and some temporary losers. In the end the music will be much sweeter than if the players were undisciplined, all shouting with their instruments, all the time. 

Many of the great portfolio managers that I have known, Peter Lynch, John Neff, Sir John Templeton to name a few, all had some awful quarters and even some bad years, including Warren Buffett. Often the under-performing periods were caused by a good manager seeing later opportunities that others did not, and were often proven right. My own favorite time period for measurement purposes is ten years, which guarantees at least two or more bad years. This belief is based on the analogy that poor current performance in good investments is like coiling a spring which will rapidly expand with gusto when times are good. Despite the current political chatter around the world, I do think we will have some good times in the future.

What is your current geographic allocation?  Why?


I have accomplished one of my goals for writing a blog every weekend. The goal is to engage with intelligent people around the world in order to learn more.

In response to an element of last week's blog where I cautioned about institutions entering the private equity arena through participation in funds, one of my concerns was the lack of good interim nav (net asset value, or price) performance during the maturing phase of the underlying companies.

A reader from the private equity world reminded me that a new SEC rule requires these funds to make quarterly estimates as to their net asset value. While some indication is better than nothing, this new regulation is not as helpful as it looks on the surface. According to a large sophisticated chief investment officer of an endowment which has numerous investments in venture capital and private equity funds, the auditors to the funds push them to write-up the values if there is any supportable evidence. There is not equal pressure to write down values unless it is quite clear that there has been a permanent loss of capital. Though these quarterly results may be of help in selling new funds, they are not what drive the managers. Unlike mutual funds and hedge funds, the managers only get paid incentives on realized gains, not unrealized. Thus, in my blog post I should have recognized a step in the right direction.
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Sunday, October 7, 2012

Some Endowments are about to Follow the Strategies of the Pentagon and the Old UK War Office to their Detriment

In a recent poll conducted by SEI (NASDAQ:SEIC) of US non-profits and endowments, 46% of responses indicated that volatility has had a high or extremely high impact on their investment strategies. The solution chosen by about half of these groups was to increase their illiquid holdings. Typically these choices were private equities and commodities.

Three concerns
I have at least three concerns with the currently preferred solutions for those institutions that are chartered for long-term or eternal uses. The first is that I believe almost all of life is cyclical. Almost every culture recognizes the regular changes of seasons and that good and bad times are occasionally bunched. Considering we have had a twelve year period of flat equity markets combined with perhaps a thirty year period of rising bond values, I believe we are due for a significant change in direction; with the values of stocks rising and those of high quality bonds declining. Because I serve on the boards of several non-profits as well as managing money for a few, I am conscious of the pressure from those board members who are focused on operations and grant-making rather than meeting the long-term needs of the institution. Further along in this post I will offer a strategic answer to these concerns.

My second concern is the current growth in the appeal of private equity investing. Generally this means subscribing to various private equity funds, usually with lengthy periods of lock-ups (no redemptions), and often with the requirement to make additional cash contributions. Historically some of these funds have done brilliantly. They have done so well that not only have they raised new money, but their success has caused others within the winning groups to start new funds and new fund organizations. We are even seeing new funds managed by some of the younger partners from the premier groups. Thus we have a situation today with a number of funds having more cash than they have immediate opportunities. Often this has led to higher entry prices and/or rushed decision-making. These are largely tactical considerations. A more basic strategic hurdle is at variance from the somewhat bearish views of those trustees questioning a long-term rising stock market. Keep in mind that the brilliant record from the past is based on exits from these portfolios, largely through the IPO (Initial Public Offer). What really appeals to certain investment committees of non-profits is the tradition of marking these holdings at their purchase price unless there is a transaction that takes place that causes the manager of the fund to write-off some of the value. This artificial expression of value does not represent the reality that every company gets better or worse on almost a daily basis. However the auditors will not allow the reporting of these changes unless there is a transaction. While this restriction is understandable, it does not truly recognize what is actually happening. For smaller and less experienced institutions, I would not be an advocate of starting into private equity today.

My third concern is with commodities. Often an investment is approached not on the basis of short-term scarcity, but as way to protect the value of the institution’s capital from expected significant inflation. Most responsible investors are concerned that the manipulations of various central banks will kick off several rounds of inflation way beyond what the learned doctors at the central banks can effectively control. The favored commodities are timber, energy-related resources and gold. While each of these have some investment value, most of the time they will not rise in price when stocks go down in value; thus they are not effective as a direct hedge. Somewhat contrary to these cautions, I am trying to find some good managers who know what they are doing in finding partial solutions to what I perceive as very long-term problems: the twin and related shortages of food and water.

The three-part buffer strategy

I believe very few can regularly predict the market. If you can, concentrate on your own account and prevent others from ruining your timing opportunities by not publishing your holdings. As mere mortals, we don’t know the future for our responsibilities. For long-term/eternal money, we need a strategy that can weather most storms. What I recommend is a three unequal-part strategy.

The first is for an institution, or even a family, to have up to two years of expected spending invested in the highest quality short-term paper. (Strange to say, considering my aversion to what governments are doing, I prefer US Treasuries with scattered maturities up to two years.)

The second layer would be a funding vehicle to rebuild the short-term layer as the money is expended. Typically one can start the refunding mechanism at the beginning of the second year. The portfolio for the second level would be publically traded securities of high quality depending on where one is in the investment cycle (inverse to the current enthusiasm). This balanced portfolio might be 75-80% in equities recognizing that the refunding need is paramount and could lead to selling some positions at a loss.

The third layer, the long-term portfolio does not have to have substantial liquidity. Nevertheless, the long-term portfolio has to be carefully invested to derive the optimum, not maximum result.

This three-part strategy is not a ‘Maginot Line’ type of approach.  The strategy is designed to buy time in order to prudently invest the corpus of the institutions.

In the past I have written about the folly of trying to learn from previous wars in preparation of fighting future wars.  Investing is no different. 

The US Pentagon and the old UK War Office used to regularly study past wars in preparation for the next series of wars.  In contrast, I know that the US Marine Corps regularly plans for future wars that are much different than those it has recently won. Perhaps endowments should not follow the patterns of the Pentagon or the old War Office.

In prior posts I have observed that the way the brain is wired is to compare each new decision point to its collected experience. Thus, all of us can understand that we have a tendency to fight the last war brilliantly as we deal with today’s threats.

How do you structure for the future?
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