Portfolio Construction: An Art or Accident?

Introduction

One of the distinguishing characteristics between many individual’s portfolios and those that are professionally managed is whether the individual positions fit together to achieve one or more specific purposes. In my own personal portfolio is a collection of securities that came to my attention from time to time after taking care of my professional responsibilities. As a professional whether building a financial services individual securities portfolio or managing accounts investing in diverse mutual funds, hedge funds, and in some cases separate accounts, I construct individually-focused portfolios.  If investing is as I believe an art form, the professional construction of portfolios is, if anything, a higher art form.

That great philosopher Yogi Berra is reported to have said that “One can see a lot by observing.” In a 12 hour spread I was exposed to two examples of a collection of individual components being selectively put together into a much more impressive and useful result. Saturday night my wife Ruth and I attended a wonderful concert by the New Jersey Symphony Orchestra. For their second number they beautifully played nine selections from Sibelius’s “The Tempest” which were aided by members of The Shakespeare Theater of New Jersey, with speeches and acting from Shakespeare’s “The Tempest.”

The various musicians and actors all contributed their specific talents to a sterling performance. (I am biased as Ruth is the Co-Chair of the NJSO.) While listening to each individually would have been pleasant, the combination of the music and the words produced a unified experience under the skillful direction of conductor Jacques Lacombe.

The next morning in church, the second lesson appointed for this Sunday came from 1 Corinthians, and dealt with God’s assembly of humans and the mutual dependence of our various body parts, e.g., our hands, eyes, ears, etc., needed for us to function as a complete body.  

These two experiences reinforced in me the critical need to construct and keep current portfolios that attempt to fulfill their specific missions. I believe this is particularly important now. This past week the S&P 500 rose to 1500, a level that has not been seen for five years. Luckily for us as investors, the stock markets have marched to a different tune than what was being sung or perhaps wailed by many economists. The tradition in the marketplace is that in general, economists and their kissing cousins central bankers, come to the market late, and eventually exaggerate the good news that is being adequately discounted by the market. I am not too worried about a major decline until they jump on board as the market train pulls out of the station and urge the public to participate in these goodies. At some point in the future this may once again happen. If and when it does, we are likely to go through a spasm of speculation driving first marginal company prices higher which in turn drive sounder company stock prices higher as they would appear to be cheaper than the flying speculative stocks. This in turn is likely to bring on a meaningful decline in stock prices.

While I would like to promise to our accounts that we will recognize the exact peak and pull client money out at that time, unfortunately the only thing that I can promise (like most of the rest of the professional investment community) is I will not identify the peak concurrently. History suggests that the unlucky ones get out of the market early in the decline and count their savings from large losses all the way through the bottom and most of the way back up.

With these cyclical thoughts in mind, my job is to construct portfolios that enjoy a good bit on the way up, not to get too badly hurt on the decline, and reasonably fully participate on the recovery.

How to do it?

There are two general approaches to professionally constructing portfolios. The first is to subscribe to some top-down asset allocation approach. This is usually based on either particular economic views or historical extrapolation of past performance of various published securities indexes. As someone who has built a large number of individual securities and fund indexes, I can tell you they all have built-in biases. These biases have to do with the expected size of an investor’s assets that would be employed in investing into the index. For example, you would construct the index differently for the 100 share buyer than the five million share buyer. One of the biggest challenges in building an index is how and when to update the index. Markets are continually redefining securities. The question as to when you replace or add components can be effectively gamed by traders. Most indexes are built by publishers to define what they believe is the center of a specific market. They are not in the business of designing prudent investment portfolios for various needs. Most equity indexes are based on what the companies make, where they are located, and/or their market capitalization weight.  These slices are not of great value to me as a bottoms-up individual stock picker as well as a selector of funds that are similarly focused.

What do I look for?

The instruments in my orchestra are as varied as those in the NJSO. While I am not about to describe in detail my “secret sauce” of how I assemble portfolios for different needs, I will share a list of attributes that are not part of the normal asset allocation practices:

·       Degree of horizontal/vertically integrated

·       Value Added

·       Size of protected Moat

·       Direction of Operating Margins compared to historic levels

·       Unutilized Debt Capacity

·       Does the current CEO have an expectation of being there in 5 years?

·       Ability to be disruptive

·       Labor relations

·       Percentage of revenues devoted to pure research

·       Percentage of revenues from acquisitions

·       Revenue, operating pre-tax income and compensation per employee

·       Compensation ratio

·       Pricing power

·       Growth in EBITDA

·       Ownership by management and other employees

·       History of beating internal and external estimates

·       Percentage of revenues in net exports

·       Size of overseas cash and balance sheets

·       List of the Top Ten owners of the stock

Each of these items could represent the critical decision tools for the individual securities or funds. The art form is to pick the correct metric, or if you will the music, but not let any one type of instrument play too strongly and remove appropriate balance to the account. Unlike a piece of classical music, portfolios need to be updated and rebalanced periodically. (Newer interpretations of classical music are also useful, but they are not likely to have as radical changes as some portfolios will require.)

What are the metrics that you use in picking funds/securities?

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All Rights Reserved.

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The Art of Investing vs. The Discipline of Hard Science

Ruth and I spent Friday at “The Brain, a TEDx Caltech” event. From 10 am to 6 pm we were mesmerized by talks given by Caltech Professors, Post Docs, graduate  and undergraduate students plus a number of other professors and experts all focusing on the research that they are conducting on the brain. In a number of cases they described remarkable progress that they are making or expect to make on helping people with various maladies which were previously believed to be behavioral or muscular problems that when attacked through the brain will deliver thrilling results. As a carpenter who is only given a nail and a hammer and who thus thinks all problems can be attended to by driving a nail, my mind wandered through the presentations as to their applicability to the process and product of investing. (The Chief Investment Officer of Caltech and the incoming chair of the investment committee were also in the audience. I wonder what their takeaways from the day were? I hope to find out at our next meeting on Thursday.)

Brain Functions

Trial and Error is the way scientists and others learn. If you will, this is the application of the so-called scientific method to our observations.

When something does not work as expected (error) most scientists move on to do something different (trial). This is not the approach of a number of successful investors. They focus on why there was the failure and what could they learn from it; for example never again invest in technology or low price/earnings stocks. But why in this case, in this particular market, did the stock not perform as expected? This ties back to my belief that studying one’s losses is actually more beneficial than studying winners, which is another lesson I learned from handicapping thoroughbred horse races.

A good bit of the research on the brain examines the brain and behaviors of fruit flies and mice. At first there were thoughts that these small animals with simple understandable brains could easily depict how the human brain works. What the scientists discovered was while these animals were small they had complex brains. Though these small brains did not directly provide the medical solutions being sought, they did identify the complexities found within the brain. Whereas it would have been nice to find simple analyses to solve complex problems, that is rarely how things work-out in the real world. 

All too often a one page summary on the attractiveness of a security can be grossly misleading. Analytically, I grew up in a world where a thorough report would run upwards of a hundred pages and could take six-months to a year to produce. As the economics of both the buy-side and sell-side of Wall Street research has changed, the vast bulk of these types of reports are not being produced. Thus all too often an investment idea is not properly vetted. (Recently at both our fee-paying accounts as well as on the pro bono investment committees on which I serve, managers have been terminated not primarily due to performance, but because I believed their research was inadequate.)

In examining any universe for a particular trait or symptom, scientists divide the sample responses as “normal” and “novel.” If the universes are well chosen the normal represent about 95% of the participants and the novel represent 5%. What is significant is that in many characteristics, the 95% are relatively homogenous.  The novel components are often quite different from one another. From an analytical viewpoint the so-called novel components are the most interesting. In an attempt to estimate the loss potential of a collection of portfolios of loans, commodities, bonds, stocks, currencies, and derivatives, the auditors (at the urging of the regulators) have come up with a measure of variability, which is their attempt to quantify risks. From my standpoint, risk is the penalty paid by the beneficiaries of the account for a permanent reduction of meaningful capital, not variability of returns as measured by VAR. Thus you will see in the financial footnotes to various annual reports numbers that represent these calculations’ views as to the dollars that could be lost due to price variability 95% of the time. This is meant to be reassuring; however they are not to me. Ninety-five percent of a trading month is roughly 19 out of 20 trading days. Most of the time markets are reasonably well behaved and major declines do not happen often. I know of various single days that stock prices have declined more than the average down year. Further, just as the scientists are drawn to the novel components, I am concerned that portfolios analyzed in this manner have misunderstood risks imbedded in them. Bottom line: investors should look for the novel elements which may have a disproportionate impact on their result.

The brain is trained, perhaps from birth or womb, to quickly react to a number of stimuli. (Maybe that is what governments and their central bankers were trying to evoke by the use of their various stimuli.) As the brain is capable of learning, other control mechanisms can be added to the coded behaviors. Probably since the beginning of free markets investors have been evolving automatic responses to various market, political, military and economic news or rumors. These automated reactions are what are being used by computer-driven quantitative (“quant”) trading.  On the other side of that trade will be another quant with a different algorithm, an uninformed investor, an investor with a different time horizon or an investor with a different set of instincts. In the US Marine Corps a great deal of effort is expended in trying to develop instincts in young Marines that go beyond mere obedience to orders. Often when Marine point persons are leading their units, they do not know precisely what they are looking for, but instincts are to avoid the unexpected danger. Such was my brother’s task in the Korean War. In the same way some very successful investors see opportunities where others see risks, and much more valuable, see risks where others see opportunities. Both the quant and the instinctive investor are practicing self-control. The difference is when each periodically make mistakes the instinctive investor can use the brain as a learning device. Often the difference between various computer-driven strategies is only the time to make a decision and the time to act.  The quant moves as soon as the condition appears, the instinctive investor is at the same time patient and anticipatory.

Scientists say that the brain wants to dampen down uncertainty. The investor selectively wants to take advantage of uncertainty. Uncertainty creates the price amplitude on the charts. If there were no uncertainty there would be very little trading, just those who had current needs for cash or to change the focus of their portfolio.

Consequences of negative results to an experimenter can lead to abandoning a particular approach. To an investor, really bad results mean that the beneficiaries of this diminished portfolio will be forced to change their life’s plans. One might say that a scientist has career risk where for the investor and his/her clients there are risks to an accustomed way of life.

Reactions to weekend reading

The chase for income by investors has overrun caution. A year ago bonds rated CCC were yielding 11.5% and now 8.2%, which is probably the lowest yield for the average of these speculative bonds in many years.  The funds buying this paper are responding to significant in-flows of money by stressed investors hungry for yield. This is a dangerous sign.

We are in a recovery phase and getting close to our old highs. (Actually for a number of our accounts we are at new peak levels.) However, investors should understand the math of recoveries. A price jump of 114.6% for the average of five Asian stock markets excluding Japan sounds great. The price gain was after a fall from prior peak levels of 58.9%. However the recovery is not complete, as the rise brings prices not quite equal to the former peak. Be careful of performance records and advertising, as the poor performance of US markets in 2008 drops off in the five year numbers, the records will look similar to the Asian numbers. We have been urging investors to use ten year performance data as more representative of future results, and even they may not be that good.

Increasingly we are seeing stock prices pop up after layoff announcements. While saving on compensation and related expenses do help the bottom line, there are other effects. As we have seen in both the financial services and media communities, in addition to the planned layoffs some of the most skilled employees reassess their opportunities and loyalties and begin to look around or accept external feelers. As an analyst I prefer to see multi-product and multi-location employers decide to exit certain businesses and locations. They should be focusing on their companies’ strengths.

Does the Fed deserve to be independent?

As reported in several recent news articles, the Federal Reserve Board was not conscious of the seriousness of the sub-prime lending problem in 2007.  According to the Federal Reserve Board Chairman, the Fed did not have the tools to uncover the problem and still does not have the tools to spur the economy beyond what it is currently doing.  As the central bank of the United States, the Fed has moved away from its original 1913 mission, being the “bank of last resort,” focusing on the safety and soundness of the nation’s banks. The Fed has gone beyond its original mandate, (as with other nations’ central banks) to become an instrument of the government. If we are to recognize this new role of the Federal Reserve, then we should hold the government accountable for the economy.

The success rate of guerrilla forces

Often I have said investors should try and find disruptive companies. I should stress successful disruptive companies. Years ago addressing a brokerage industry conference I indicated that many of the larger members of the industry would be hurt by the guerrillas (not as some interpreted as gorillas).  In an article in Saturday’s Wall Street Journal, Max Boot examines the success rate of guerrilla forces against incumbent governments. Since 1775, the guerrilla has succeeded 25.2% of the time, and since 1945, 39.6%. This is not to say that the many of the policies of the guerrillas were not eventually adopted by the incumbent governments. But they did not directly benefit.

What are your reactions to these elements of input? Please let me know.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A. All Rights Reserved. Contact author for limited redistribution permission.

Setting a Big Performance Trap?

All US investment performance advertising is required to contain a caveat that past performance is not a guarantee of future performance. Some substitute the word ‘indicative’ for guarantee. Analysts are not as skilled as actuaries in drawing future trends out of past data, but they, as well as portfolio managers, sales people and investors take comfort in investing in securities and funds that have performed well in the past, particularly the immediate past. Increasingly I have a problem with this somewhat comforting approach.

While cheering for a continuation of a winning streak, those of us who follow various sports know that all streaks get broken. One of the many lessons I paid for at the race track was to avoid odds-on favorites to continue their streaks, and to look for horses which fit the current race conditions better than their last several win and loss records. In the current global investment environment I believe we are currently in a period where simplistic extrapolation of the past may well be counterproductive.

Counter-indicators

1.    In the first week of the year the value of the yield on long term US Treasuries was lost in price declines. The stretch for yield has led one bank to recommend 15% of clients’ fixed income to be invested in leveraged loans. As some are predicting no gain in investing in government paper after the impact of inflation this year, the relative risk in the fixed income allocation of portfolios is likely to approach or perhaps exceed the risk in conservative stock portfolios. (Outside of very low yielding cash there are no large places to hide-out.)

2.    At the end of December the short positions in the NASDAQ Capital Markets were on average 4.79 days compared to 5.47 days as of December 14^th. Part of the decline could have been year-end trading influenced by taxes including the expected rise in ordinary rates for some traders and a drop in volume running up to year-end. Nevertheless a 12.5% drop is worth noting. Most NASDAQ stocks are more speculatively priced than those listed on the so-called “Big Board” (the NYSE). They tend to be more volatile. One of the reasons to pay attention to this data point is that every short position eventually needs to have an offsetting purchase. Thus a short position eventually means some buying. With shorts declining there will be less demand for some stocks, not a good sign for a long-only investor.

3.    Large, in theory conservative, banks and other wealth management organizations are recommending hedge funds or worse, funds of hedge funds. One bank has recommended that 20% of clients’ balanced allocations be in alternative investments (largely hedge funds). Even the sage Byron Wien is recommending 15% in hedge funds. Some who are looking for a dull 2013 believe that hedge funds, on average, will earn only mid-single digits. (This pains me as both the manager of a private financial services fund and an investor in some other funds. However, I can understand the warning, as financial services mutual funds on average gained 24.8% and so could give something back, even though there are other investors who believe that the financials will do well.)

4.    With the increasing loss of independence from political control, some fear that central banks will drive monetary policy to greater inflation. The fears are that the money created will flow into asset price inflation; for example in commodities and commodity currencies, emerging market debt and equities. The fear is that after some speculative surges these assets will crash, taking the rest of markets with them due to counterparty risks, which will lead to a significant recession in the 2015/16 time period (or at the end of the current US President’s political power.) What will happen after that will depend to some degree on the 2014 and 2016 elections, which will if anything be more divisive than the past election, particularly as the number of House of Representative seats that are considered safe has declined to 35 from 105 twenty years ago. A number of currency funds are taking the opposite view and are drastically reducing their size in terms of capital and number of employees. (This would not be the first time that the investment community reduced its capacity just before a major change in the nature of the market and then scrambled to rebuild their fortunes.)

5.    All of the above points are relatively short-term oriented and can be classified as cyclical trends. There are at least three more secular trends that will drive investments for the next generation and these are;

a)    Five of seven leading countries in terms of life expectancy at birth are relative hard currency countries. (Switzerland, Australia, Sweden, Canada, and Norway) These are all exporters that have small populations. The US is far down the list. However, the demographics of the US are changing rapidly. Would you believe that California is running out of babies who are needed to fill classrooms with union teachers and for more workers to contribute to the retiring state/city work forces?

b)   In the last year of record, the Chinese filed for some 400,000 patents compared to the approximate US total of 500,000. Contrary to some (and perhaps due to my exposure to Caltech), I believe that we are entering a period of rapid expansion in the use of technology, including biotech, into almost every aspect of our lives. Historically China has been a place of invention and I expect that their commercial and perhaps military interests will drive the US into responding, if not leading in kind.

c)    Two recent studies should be the basis for increased investments by individuals and families. While these surveys are based on US findings, I believe that they may apply to much of the western world.

                                                       i.            A survey of US millionaires showed that 82% believed that their heirs should make their own way financially. Perhaps driving that view, 31% believed that they will pass on to their heirs less than what they received. (The latter finding is particularly relevant to families with multiple generations of wealth that may be drying up.)

                                                    ii.            A survey of workers invested in retirement plans indicated that only about 12% are very confident in their retirement prospects. (One of my fundamental beliefs why the value of equities over time will grow is that both at the societal and individual level we will be investing more into retirement funds. Even if this new money goes only into fixed income, it will in effect leverage risk absorbing equity.)

What am I looking for?

          I long for much,

          I hope for little,

          I ask for nothing.

                -Tasso, 16^th Century Italian poet

Most of the money I am directly or indirectly responsible for is long-term in nature. With appropriate levels of cash available to meet current needs and in some cases strategic reserves, my focus is on investing in good companies that can grow their earnings power over time relatively regardless of the progress of GDP. On a price/value basis most often I find these in small and midcap companies around the world. My preferred vehicle for these investments is in mutual funds and an occasional hedge fund that possess deep analytical skills with particular emphasis on the application of disruptive technology.

What are you looking for? Please share.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A., All Rights Reserved.

Contact author for limited redistribution permission.