Sunday, November 25, 2012

Picking Winners and Avoiding Losers: Thanksgiving Lessons

A good analyst and a better investor learn from what they are exposed to in their life experiences. We are all interested in picking winners and particularly in avoiding losers. In the US on Thursday, we celebrated Thanksgiving. This official holiday is similar to other harvest holidays celebrated in many countries that have developed from an agrarian base. Within the US, the holiday is an occasion to watch traditional American football games, either in person, on a television or on a computer screen. Immediately after the holiday is the somewhat official beginning of Christmas and Chanukah shopping season both in stores and Online.

As family and friends gather, often there are opportunities to acknowledge what we are grateful for; forgiving those that have disappointed us, but not forgetting the lessons learned.

Weather impacts

In New Jersey and some parts of New York and other states, one of the things that we are thankful for is that we have begun recovering from the recent visit of the super storm Sandy. Some of us were just inconvenienced by the loss of power for a period of days into weeks. Others have lost their homes in part or in total to the combinations of the hurricane followed by a “nor’easter” snowstorm, and in some cases resultant fires. The physical, emotional and financial damage is starting to be more fully understood. Whatever the immediate size of the financial loss, by current estimate the money spent on rebuilding, and in many cases new construction, will be larger than the financial losses sustained. These expenditures on housing, infrastructure and shoreline development will occur over a couple of years, as much concerted planning is needed to avoid some of the ravages of future storms. My guess is that the infrastructure and the rebuilding spending will initially focus on an attempt to restore what was in the impacted area first. There is likely a second phase that may occur as people start to take a long-term view. Much of New York, Boston, Hong Kong, Singapore and elsewhere are built on reclaimed land from nearby oceans and rivers. There are people who believe that within the next 100-300 years these lands will be subject to waters rising five feet, which would flood LaGuardia Airport in Queens and Logan Airport in Boston for example. If these fears are acted upon, the indirect costs of Sandy will be huge.

The national media has heavily focused on the impact of Sandy and has largely ignored the weather event that will probably create a larger loss, the devastating drought that is affecting all or parts of 17 Midwest and Western states. The drought is expected to intensify through the winter. While the US is probably the most productive country in the world, there is some possibility that we will have food shortages and suffer some inflationary pressure, particularly intense on the less well-off. A related issue to the food shortage potential is the actual substantial curtailment of barge traffic along the Mississippi River. Due to government water conservation policy, the Missouri River, which is fed in part by dams, and in turn feeds the Mississippi, has not be receiving its full bountiful supply of water since last week. The barges with their deep bottoms that won’t be able to go downriver carry some $7 billion worth of commodities, coal and other products, much of which feeds US export markets. 

Two weekend analytical observations

As long time readers of my posts know, I usually comment upon my visits to a nearby high-end shopping mall during the Thanksgiving weekend. This time I visited the shopping center twice; once on so-called Black Friday and again on Sunday. In contrast to years ago, I was able to find parking spaces. On Sunday I parked where we normally park during the week, not a good sign for retail sales. One of the reasons that parking was relatively easy was that there were fewer cars with New York license plates. In the past, the difference between New York and New Jersey sales taxes drove New Yorkers to shop for more expensive items into New Jersey. (A new very large mall has recently opened that is much closer to New York City which could have attracted the tax conscious shopper.)  Walking in the mall was relatively easy with very few crowded locations; the Apple store being one. Judging by what people were carrying, there were more lookers than shoppers. Some high-end stores changed their merchandise mix toward lower price point merchandise, one being Tiffany. This tactic did not seem to attract many of the well-dressed shoppers that had taken great pains to look attractive. The price and tax conscious high-end shoppers were not enthused by what they were being offered. The two walking tours however, don’t tell us how much shopping is being done Online. I will watch whether the regular FedEx and UPS truck deliveries on our block are delayed from their normal delivery times and if they seem to be heavily laden. At this point, if I had to make a judgment, I'd say that this won’t be a great season for high-end retail shops.

The second observation is that there is much to learn from watching National Football League* games on Thanksgiving Day. I have long stated that my two great learning experiences were my active duty service in the US Marine Corps and my hours at various New York race tracks, trying to wager successfully and avoid too many losses. The study of past performance and other factors which I followed were called handicapping, which focused on how changing conditions would affect the results of future races. One of the techniques that I used in reviewing past performance was to look for consistent, hopefully improving, patterns. Many times these encouraging patterns were interrupted by inconsistent behavior. If there were only one or very few inconsistent results, I followed the approach of excluding the inconsistent results and believing that if the conditions were similar to the races where the results were consistent, to believe that the next race the horse was more likely than not to return to its trend of consistent results. Long before the leading Football teams acknowledged that they had hired statisticians as revealed in an article by Judy Battista in Sunday’s New York Times, I was applying this technique while enjoying watching various professional football games. On Thanksgiving Thursday, there were two games where this kind of analysis was useful. In the first game, a grudge match between the New York Jets and the New England Patriots, the final score of 49 (New England) to 19 (Jets) was misleading in terms of a comparison of the potential value of the teams in securing future victories. As is often the case, God is in the details. In the first quarter neither team scored. In the second half, the Jets scored 19 points vs. 14 for New England. However, in the second quarter through a series of interceptions and fumbles, New England scored 35 points, including three touchdowns in about one minute! From my handicapping viewpoint, what happened to the Jets is the equivalent of a jockey dropping his whip or a saddle slipping badly, which led me to exclude the second quarter as indicative of future performance. Applying this approach to selecting funds (and to some degree individual securities), I would be more interested at the right price (odds) backing the Jets than the Patriots. When I apply this to funds, I am willing to throw out the results of 2008, particularly if by early 2010 the fund had recovered from its 2008 loss. Thus one might say that I can be forgiving.

The second game put the Texans from Houston against the Detroit Lions. Detroit traditionally has a game on Thanksgiving Day, for in a much earlier time it could not get a local field to play on for a normal weekend game after the holiday; so a tradition began with the Lions playing this game on Thanksgiving. The Lions traditionally have a poor Win-Loss record. This year’s game was against the Texans who had the best record for the season in professional football of 9 wins and 1 loss. Remarkably at the end of regulation period, the two teams were tied at 31 points apiece and so they had to play in an overtime period. At our Thanksgiving dinner there were relatives from Michigan. The Lady of the House, who had suffered through many football games in Michigan, assured us who were watching the game that the Lions would find some way to lose, which they did. She was not forgetting the team’s past problems. In similar fashion, a fund or manager that consistently disappoints is not likely to rise up for a sustained period.
* I have the honor and privilege to work on the National Football League/Players Association defined contribution plans.

Applications for the care and feeding of investment managers

As we are all humans, we should learn to forgive them, as this is good for own mental health.  Even the “programmers” that control the inputs to quantitative funds are human, and therefore one should allow for some mistakes. The key is the duration and explanation for the shortfalls from our expectations. However, I firmly believe that performance results are not the key to future results but rather a starting point to raise our understanding as to the past, current and future conditions when a manager can produce consistent results for a while.    

Now it is your turn to share:
What are you thankful for?
For what are you willing to forgive investment professionals?
What should we forget?
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Sunday, November 18, 2012

After Selling Short-Term, You Should Buy Long-Term

Two weeks ago I suggested that on a trading and cyclical basis one should sell on the Wednesday after the 2012 US election. My thinking was based on the premise that the election would not provide a meaningful answer to the economic future of the US or to the rest of the world. Since the election, on average six out of eight market sessions have recorded losses. This continues the trend for the last four weeks since the probabilities that the president would be elected rose, and the market average declined 5.66%.

What did the US election signify?

As this blog is increasingly being read by those who are not Americans, I should share with you my analysis of the election.  (Readers from over 40 countries have joined our blog community.)  In general, Americans have had a fear of government actions unless they are directly helped, and often vote by selecting the least objectionable candidate. This election was decided upon the basis of perceived personalities. There was no real focus on a perceived future. Despite the victor’s view, there was no policy mandate given, as only a little over half of the potential voters voted and the spread in the popular vote was less than 3%. However, there were at least two clear implications that will affect the next election cycle that began on November 7th. The first is that the Chicago machine is well trained in urban get out the vote campaigns and produced a much better result than the Boston-oriented management consultants who thought they were dealing with a corporate turnaround. The significance of this disparity is that winning politics is not just policy, but performance. The second implication for the Republicans is that they need to select better candidates for the House and Senate. (Interesting enough, the Republicans were more successful in terms of races for governors, other state officers and state legislatures.)

Fiscal cliff or barrier mountains?

Those who want short and complete answers to complex problems speak in terms of a single fiscal cliff.  I see the challenge as a series of difficult to solve barriers to a free floating economy. The basic problem (which is not being discussed in the US and most other major countries) is that the governments are providing services to a population that is unwilling to commit to pay the bill. This is not a new phenomenon in the US. Alexander Hamilton, the first Secretary of the Treasury bemoaned this very same condition. In Hamilton’s 1795 report to the Congress, he described the public’s desire for services, and their unwillingness to pay for them through higher taxes. The answer was to borrow the shortfall. However, as much as he tried, at the time Congress was unwilling to establish a specific plan to extinguish the debt. Today we have the same problem. We are facing the threat of sequestration, which will automatically raise tax rates and cut both military and discretionary spending. In addition to sequestration there is the self-imposed debt limit, which will likely result in a credit rating drop. On Friday there was a happy talk session at the White House where the congressional leadership appeared in public to accept some broad but not defined principles of cooperation.  Believing that “God is in the details,” I have my doubts that we will see any meaningful solutions until we get a final House-Senate conference committee proposal. The earliest that I expect any sort of practical compromise will be in March and maybe not even then. The timing may be ironic, as in March the new leadership of China will be in command to somewhat more aggressively manage the world’s second largest economy.
Disclosure:  Not only did Hamilton and I graduate from the same college, he founded the bank where I gained my first fulltime employment on Wall Street.

As much as the politicians might want to be able to act in their own time, there may well be external pressures that will change the picture of cooperation substantially. The first pressure will be the probable need to restock the Cabinet with replacements that will have to go through what could be rough interrogations from the Senate minority party. The second force, dear readers are you, the investors. The bond market can no longer play its traditional role as bond vigilantes because of the manipulation of the credit markets by various governments. Replacing the bond market in its role as protector will be the stock market. If both individual and corporate leaders sell because they feel that their taxes will go up too much for them, there will be a negative “wealth effect.” If the general population feels that they will be poorer due to higher taxes, they may seriously restrict their spending. This could deepen the recession that the Congressional Budget Office (CBO) expects in the first half of 2013. International actions and other surprises could also change the arduous progress to various agreements. Moody’s is predicting that corporate default rates will rise from their abnormally low levels, moving back to their historically more normal ranges. Let us hope that a relatively minor increase in defaults won’t lead to a rise in unemployment, which could impact any congressional compromise.

Secular bulls:  your time is coming

As an optimist, (as is everyone who gets out of bed in the morning), I am concerned about the relative lack of other optimists; as a contrarian this absence makes me bullish. If one believes in secular trends as I do, you may see that we are setting up one of the great bull markets of our lifetimes, not in magnitude, but in length. PIMCO, the world’s largest bond manager believes that stocks will outperform bonds in the future, but the average rate of gain will be more like 5% than the historic 10%. While they may be correct in terms of the aggregate growth of operating earnings, I see a good chance that stock prices will be higher than earnings projections due to valuation adjustments. Beyond that, I believe that there are a number of opportunities to do materially better than the market. There are two very different examples as to how this can happen.

The global label

Even if the US solves its fiscal problem, the odds are that its standard of living will decline relative to other parts of the world. Work ethic, education and demographics trends are moving against the US. In recognition of this, I believe that US investors need to invest their equity in a portfolio that has at least 50% of its underlying earnings power from non-US sources. This can be accomplished by investing 60% of the equity portfolio in US multinational companies. These companies have at least 40% of their own earnings from overseas sources. They can accomplish this by having overseas production sites selling into local markets; e.g., Coca Cola, Colgate, etc., or by exports (net of imports) like Boeing and Deere or a hybrid like Apple,  whose annuity-like future I believe is in making and selling products in China. (Though I have used large company names, there are any number of mid-sized or smaller companies that would qualify particularly in terms of exports and royalties.)  The multinational portion of the equity portfolio would have foreign earnings of approximately 24% (60% x 40%  = 24%).  In addition to the 60% in US multinationals, an additional 21% of the equity portfolio should be invested in local companies overseas, particularly those that do not have much of their sales in the US.  Thus 60% + 21% = 81%, which will leave 19% for purely domestic investments. I have presumed that you or your adviser has the requisite knowledge not only to do the detailed analysis of foreign vs. US content, but to also pick winning stocks. If your level of comfort in these abilities is not high, then perhaps some or all of this strategy can be well executed through the use of mutual funds or similar vehicles.

Disruptive Opportunities

I search for companies that perceive opportunities differently than others. Everyone’s favorite example of this is Apple, but this was not a good example years ago when I got some shares. Allow me to use a very narrow example from my particular area of focus, the financial services industry. In a private fund that I manage for a few clients and my family, we own 22 financial services company stocks. Since I learned securities analysis initially under Professor David Dodd, of Graham and Dodd fame, I believe that any and all companies can be acquired. Currently the brokerage/investment banking business is having difficulties. In the last couple of weeks KBW (Keefe, Bruyette & Woods), a dominant financial services broker, is being acquired by a larger more diversified firm. This week ICAP, a UK interdealer firm has closed its New York floor operation and announced significantly down earnings. The general perception is that these businesses are having a rough time and could be terminally sick. This week there was the announced disruptive acquisition of Jefferies, a position in our portfolio, by Leucadia National. In the future, the combined company will be managed by the senior people from Jefferies and they will be able to use both Leucadia’s capital and net operating loss carry forward. What is significant to me about this deal is that as a result of this merger, the new company will be managed for the growth in its book value not its quarterly earnings. This approach is similar to two of our other holdings, Berkshire Hathaway and Alleghany Corp. Actually what has me excited is that I perceive this deal as creating the US equivalent of the very successful (for awhile), UK Merchant Banks. While the US rules are now different than the set of rules that operated in the UK, some of the activities could be similar. To the extent that all of the perceived advantages of this combination come to be, it will change the acquisition of turnarounds in terms of competition with private equity groups.

I am reasonably confident that these types of transformational deals will occur in many sectors of the economy and will create highly focused special opportunities.

It’s your turn

Now it’s your turn to share with me how you are structuring your portfolio.
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Sunday, November 11, 2012

Investment Implications of November’s Inflection Points

There is a good chance that when we look back at November 6th to November 14th, 2012, the period that includes the US election and the Communist Party Congress in China, we will recognize an important secular inflection point.

The key was to sell

There are three time scale references that are useful in looking to the future. The first is that the media and other pundits focus primarily on the tactical or temporary time slots; e.g., when in last week’s post I recommended selling on the day after Election Day. I was wrong that there might have been a relief rally on the basis that one unknown was now known. The key to the recommendation was to sell because of the large number of remaining unknowns which were not likely to be decided until the spring of 2013. On a short-term basis the decision to sell last week was correct. Several astute investors have informed me that they reduced their 60% equity allotment to 30% on Wednesday. Another smart investor decided not to take advantage of the drop in stock prices as there were too many unknowns.

Cyclical periods

The second time frame (and the one most used by institutional investors and members of investment committees) are cyclical periods which go on for a few years. Election cycles, crop cycles, fashion cycles, economic cycles and market cycles are examples of outside forces that somewhat predictably influence market prices and portfolio returns. To participate in these cyclical periods, consultants like three years, older CEOs prefer five years and younger CEOs favor ten years as calendar periods to capture most of the other cyclical behaviors.

Always is a long time

For those of us who are managing money for succeeding multiple generations and/or institutions who believe in their eternal lives, secular time periods are more appropriate. The demographic trends, the technological changes and long-term medical developments are some of the factors that impact secular growth rates and the attractiveness of various investments. I have always been more focused on secular changes than shorter term phenomena, particularly today. I am writing the first draft of this post Saturday night, the 10th of November, the 237th  anniversary of the US Marines Corps. Marines believe in lots of practical virtues, but our motto is Semper Fidelis, which is Latin for ‘always faithful.’ Always is a long time and it is from this background that I look to our future, including our financial future.

November Elections

In a period of under 10 days the US and China, the two largest economies of the world conducted elections (albeit differently) that may be viewed as inflection points to the future.  The practice of analysis rests heavily on an examination of past actions. There is a well-documented history of the rise and fall of empires, or if you prefer, dynasties. The characteristics of large empires that go into declines over many years, and in some cases centuries, start with public displays of moral decay, demographic changes that create distrust between elements of the population, excessive spending by central governments, inflation leading to the practical devaluation of the currency and weak political leadership which translates into too cautious military and naval deployments. While empires fall because of their internal problems, they are finally subdued by new empires that are led by hard-working populations that want more. Often the rising empire is to the east of the falling one.

The victors in the US election and the California Proposition 30 referendum ran on the platform of raising taxes on others, temporarily defined as wealthy income generators. Few of those who supported these policies stopped to think that in the long run these impacts will be self-defeating. Ultimately, if the wealthy do not physically move, as from France to Belgium, California to Nevada, US to Singapore, or change their cost structure (employing fewer people), they will raise the prices for their goods and services. Some of the price increases will be disguised as reduced services and support, as well as less quality. This phenomenon is called inflation. We know that the impact of inflation tends to be retrogressive. The poor will suffer more than the wealthy. Central bankers around the world desire inflation which will lead to the practical devaluation of our fiat currency compared with hard assets. We are setting up a weak dollar, which will be dangerous if combined with a less capable US military/naval force.

To the East of the US is China, beginning the installation of the fifth generation of its collective leadership this week. The composition of the Politburo Standing Committee (expected to be seven) was determined by the retiring fourth generation leadership, and to some extent the third generation leaders. On November 9th, China Daily published an advertisement in the Financial Times as to the progress that has been made under the fourth generation. The results compare 2011 data with that of  2002, which can be summarized as follows:
·        Percentage of Urban Population: 51% vs. 39%
·        Private Vehicles: 79 million vs. 10 million
·        Foreign Students: 293 thousand vs. 86 thousand
·        Fortune 500 Chinese Companies: 69 vs. 11
·        Refrigerators per every 100 rural families: 62 vs. 20
·        Cell Phones per every 100 rural families: 180 vs.15
and many other measures of physical and financial progress.

The expected fifth generation leaders have prepared detailed plans which have apparently been approved.

Investment Implications

Near-term (tactical) events move markets; thus volatility will pivot on news from both Washington and Europe. While stock market volume will probably remain relatively mild, there will be an increase in selling by taxable investors trying to avoid higher capital gains taxes. It is possible that the number of insistent sellers could create some bargain prices.

Cyclical investors should recognize that the odds are that an economic cyclical recovery has already started; led by housing, replacement/replenishment cycles, Sandy-induced repair and rebuild needs and perhaps some longer-term attention to prevent severe damage from future natural disasters. Casualty insurance stocks will get a boost when they announce their premium increases.

The secular investor needs to recognize that the next generation is going to hinge on the opportunities and problems emanating from China. Successful investing in China is problematic for us who are used to Western accounting and contract law. However, there are three other alternatives. There are some mutual funds and other institutional investors who may well be able to be successful investors in China. A second alternative would be a handful of US, UK, and European companies that expect a large part of their future growth will come from China. The third alternative would be to invest in those areas that can be critical to Chinese growth, such as Africa, Australia, Brazil and Mexico.

One secular trend identified by Sir John Templeton years ago is the shortage of high quality shares to buy. The combination of cash acquisitions and stock buybacks is reducing the pool of available shares for purchase. To a similar degree, the credit problems facing many bond issuers have reduced the amount of the highest quality paper that is available. As these needs become apparent, I have no doubt that the investment and commercial bankers of the world will try to fill the void; the question will be the quality of the new paper. Under these conditions, and I speak with bias as an owner of shares in a number of investment bankers, I would rather own them than the paper they sell.

It’s your turn

What portion of your investments do you assign to your tactical, cyclical and secular buckets?
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