Sunday, February 24, 2013

Confessions of a Holder: Be Not a Buyer or Seller Now

I appear to be semi-frozen in my portfolio right now, not wanting to buy or sell significant parts of our investments. I speak not only as a paid investment advisor who wishes to continue to be paid, but also as a steward of my family’s and personal accounts. The continuation of payment from a long-term strategic investor has caused many advisors to make changes to portfolios look as if they are busy earning their fees. While there are almost always chances of significant deterioration of the long-term prospects of an investment as well as newly discovered research/analysis that makes previously bypassed investments attractive, many portfolio changes are disruptive and I suspect are done merely to look busy. In managing my own and family money as well as serving pro bono on investment committees, there is no need for me to appear to be looking as I am in action rather than observing. Thus, these privately focused accounts are a helpful guide to my professional responsibilities.

With those thoughts in mind, I want to explore with you my current thinking about my personal rather than professional investment duties.
Where are we in the current investment cycle?
Any study of history shows that in almost any activity there is a pattern of expansion and contraction. Even in terms of differing philosophies, they move further apart or become more concentrated in some form of a Hegelian synthesis, until there is another period of disruption of central tendencies. Cycles are endemic to human behavior. Thus, we regularly find investment markets moving in a cyclical format.  We clearly had a market peak in 2007 and an economic/financial fall in 2008 and a stock market bottom in March 2009. Numerous commentators will use these dates to chronicle the latest expansion with comments that some stocks and some funds have risen past their 2007 highs. The politically-oriented economists will focus on 2008 as the turning point and surviving market investors will judge performance from March 2009. (I suspect that many advisor “pitch” books and advertisements will start trumpeting five year performance numbers as well as the consultants’ favored three year period to show investment expertise rather than recoveries from depressed levels.)   

In the light of the above thoughts, I look at my own personal accounts which are loaded with stocks of financial services companies with heavy emphasis on investment managers and broker/dealers both in the US and elsewhere.  The recoveries in general have been remarkable. Careful analysis of the names in the portfolio can be grouped into two categories. The first are the leaders in their segments which have recovered the most. The second group were perhaps value traps; companies that were selling way below the cost to recreate them in sectors that traditionally large companies wished to enter to fill out their product offerings. While these have regained some of their lost ground in terms of stock prices, they have underperformed the leaders. This dichotomy between the two groups leaves me in a quandary and as usual I turn to the study of the current market structure for a guide to the future different from the extrapolation of current trends.

What am I seeing?

The leadership group’s stock prices are back into their “normal” levels; thus I continue to hold them in the belief that if the current expansion cycle ends soon, I will want to hold the leaders for the next expansion when we may see a full uplift to the global economy and its needs for viable financial services leadership. Up to this point I have labeled leadership companies without describing the basis of their leadership. Statistically these companies are among the biggest in their defined sectors, but not necessarily the largest. They have grown internally without the benefit of large acquisitions, but with the occasional willingness to bring a few talented outsiders into key decision making roles. Some of their larger competitors were put together through mergers and acquisitions which make their management focus on political decisions within their expanded empire.

Saturday night I was thinking about the nature of great leadership. My wife and I attended a birthday party for George Washington at his Mount Vernon home. (Actually it was to celebrate his 281st birthday.) The speaker was Ron Chernow, the author and historian, who discussed Washington’s leadership in his two terms as president. What struck me was that General Washington, not Congress, created the concept of a cabinet within the US government. His was only three: Hamilton in Treasury, Jefferson in State and Knox in the War Department. He chose men who were better educated and in many ways more intelligent than him. He encouraged vigorous debate and tolerated strident disagreements, particularly between Hamilton and Jefferson. Yet in his two terms as President, including turning down a third term, he established more policies and better practices than any of the presidents that followed him.

In my mind I applied the lessons from Washington to my list of leadership companies’ attributes:

1.    Attract the best available minds, even those that are smarter than the leader (CEO).

2.    Encourage debate within a small select group.

3.    After listening to critical experts, the CEO should thoughtfully make up his/her own mind.

4.    Knowing when to leave, hopefully at the top.

I will continue to look for other companies with similar leadership attributes, hopefully with not too demanding stock prices.

While I am content with my portfolio’s leadership positions, what concerns me are the holdings in companies that in some respects are worth more dead through acquisition than currently alive. When I carefully analyze my bets in these companies, they are really dependent upon market actions (or to be blunt, waves of speculation). At this time I may have the winds at my back to push these stock prices higher. The winds in my favor are:

1.    A rising tide of merger & acquisitions as commented upon by Moody’s* and others.  The credit rater is worried that these deals will weaken the acquirers’ balance sheets. On the positive side, the stock prices of a number of mid-sized investment banking firms are selling at above market price/earnings ratios which seems to assume that they see their earnings will rise on the basis of the fees they will earn by representing buyers and sellers in these deals.

2.    The market appears to be concerned about the apparent “take-under” of Dell, unless you see it as a discount that the current owners need to pay to get out from under Michael Dell’s leadership. The market responded positively to the surprise announcement of the purchase of Heinz by 3G and Berkshire Hathaway*. Part of the positive reaction to this deal was that it showed Warren Buffett’s technique of negotiating the issuance of a high dividend rate preferred stock (9%) for a larger amount than the purchased equity.

3.    The interest of investors appears to be increasingly speculative. For example, in the five trading days ending Friday, seven of the ten largest stocks in terms of dollars traded were ETFs. These included two investing in the international developed markets, one in emerging markets, one in smaller market caps, and gold as well as the leader, S&P500. The other three stocks were Bank of America**, Citigroup** and JP Morgan**. With the financial stocks as the best single sector last year, some may be speculating that the three large banks will continue to be performance leaders. (Rarely does the same sector lead two years in a row unless it comes from severely depressed prior periods.) 
*        Long positions held in my private financial services fund
**      Held personally

The difference between my leadership group and my potential acquisition targets is that I might add to my leadership holdings if there is a serious market break, but I may even sell if the targets’ prices drop as my patience could be worn out.

Please share with me privately how you look at your portfolio.
Did you miss Mike Lipper’s Blog last week?  Click here to read.
 Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of .
Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.


Sunday, February 17, 2013

Climbing the “Wall of Worries” into Higher Investment Risks

During a stock market phase when stock prices rise and conventional thinking suggests that the economy is in weak shape, pundits may explain that the market is climbing a “Wall of Worries.” Another way to phrase this phenomenon is that market prices are narrowing their discount of future better prices. After all, the market for future dividends and earnings is what today’s prices are meant to be about.

Since the break in 2008, many of the markets around the world have been assessing the chances of further declines due to potentially large financial failures, deep economic recessions (some said depressions) and political turmoil. These are challenges that make governing difficult to impossible and inhibit the ability to address the long-term structural deficits facing many “developed” societies. Five years after the markets’ bottoms, on the surface we have experienced no major financial failures in part due to the shifting of financial leverage from the private and commercial sectors to the government sector. This feat of legerdemain was done by artificially lowering interest rates by ignoring credit concerns. Removing the impact of deleveraged debt from the surface economy reduced the strains on the economy. In addition, a number of the major governments went through an election which did not produce panic selling by disappointed investors.  In the mind of investors, institutions and individuals, if market prices didn’t go down, they should go up. One rationally might disagree with this “logic,” but in truth that is what happened.

Newer risks

If the old worries did not cause a double or triple dip in market prices, then as one comic book character queried years ago, “What me worry?” As a professional investor that is exactly why I am getting a bit concerned. In my most conservative accounts that enjoyed a good 2012 (and 2013 looks positive), I am beginning to address our stock/bond ratios. Stocks have done well and they now account for way above normal asset class guidelines as a percent of the total accounts. The concern is that when the periodic declines hit the stock market, potential gains from fixed income holdings will not be large enough to hold the value of the account to a comfortable level. 

Analytically I see at least three potential concerns that could get worse and put sharp pressure on prices. My concerns are for the potential permanent loss of capital which I call risk; which is quite different from the variability of prices or volatility which many consultants and academics mistakenly call risks.  My three areas of concerns which could lead to permanent loss of capital are:
1.    As regular readers of these posts have learned, I believe the fixed income markets with their more limited potential returns than the equity markets can send important early warning messages to stock and equity fund buyers. I particularly pay attention to High Current Yield or if you prefer the more pejorative term, “junk bonds,” which in effect are stocks with coupons and maturities. According to Moody’s,* the yield spread from low grade paper to higher quality bonds is larger than at past bottoms. Mutual fund investors, despite being warned, have been pouring money into High Yield Bond funds. What is of particular concern to me is that a good bit of this money is going into what is called “covenant lite” bonds that don’t have the usual protective covenants. My fear is that the combination of somewhat imprudent investors piling into funds with significant covenant lite bonds could lead to serious disappointment, which in turn could lead to massive redemptions. Often if a corporation’s low quality bonds drop it can hurt the firm’s stock prices as well.

*Disclosure:  My financial services private fund has a long position in Moody’s

2.    There are surface signs of complacency toward the stock market with relatively low volumes of transactions, particularly by public investors. The VIX measure of the presumed fear of option price declines is flat and near its lows for the year. The structure of capital markets around the world has changed over the last couple of decades by removing the shock-absorbing middlemen as well as agency brokers, replacing them with dealers who have little, if any, responsibilities for an orderly market. Thus a sudden surge of market orders could stampede a market in either direction creating a significant impact.

3.    I am increasingly concerned about the spirit of integrity in the marketplaces around the world, but primarily in the US. I have already mentioned the growth of covenant lite bonds that may have been sold to unaware individuals and institutional investors. Another tendency that is bothering me is a practice of taking publicly traded firms private in a management buyout. To me the only justification for the relatively low price being offered for Dell is that is the cost to remove the present management, which has presided over more than a 50% drop in the price of its shares. We must take better care of our investors if we want to have viable markets.     

Please share your thoughts on any of these topics by emailing me.
Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of
Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, February 10, 2013

Investment Dangers from Extrapolating Historical Trends

Last week the expected outgoing US Attorney General began a lawsuit against McGraw-Hill (Standard & Poor’s) for failing to see the future.  S&P is in the somewhat distinguished company of various Presidents, members of Congress, government agencies and Departments; e.g., Treasury, Federal Reserve, SEC, as well as a number of government sponsored mortgage-related companies (GSCs). The private sector has an equally long list of participants which did not see the end of the rising house price trend.

These errors of human judgment are also found in betting that various streaks will continue.

The mortgage mess

The DOJ alleges that the ratings of a small number of credit ratings issued on subprime-related, structured underwritings by S&P were faulty. (Focusing on only the specific issues in question, based on selected internal emails, the fees earned by S&P were on the order of $13 million.)

Disclosure: I have personally owned shares in McGraw-Hill for many years and my fund has a long position in Moody’s. The high price on Moody’s last week was $55.39, and the low $40.67, with a close of $43.37.

US vs. Mc-Graw-Hill

The case against McGraw-Hill has generated heavy news media coverage, which is ironic as the media itself should be considered a contributing factor in this debacle. As Wall Street Journal columnist Holman W. Jenkins, Jr. pointed out on Saturday, “S&P was not responsible for the destruction of underlying housing collateral (caused) by politicians who made it nearly impossible to foreclose on delinquent homeowners.”  Jenkins also reminds us of the Fed chairman’s illuminating quote:  "You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country."

Seven  reasons why I believe the suit is misguided

1.    Within any sizeable organization that deals with opinions such as credit ratings, there is likely to be differing opinions, particularly from those on the lower and middle rungs of the power ladder.

2.    We know that the Federal Reserve Board was not too concerned about housing and subprime loans during the period in question.

3.    There is significant legal risk if a credit rater is early in downgrading ratings without firm facts that seriously contradict past history.

4.    In my work over the years, I generally felt that credit ratings were a lot like performance statistics; i.e., a backward-looking device with not much predictive value if things change.

5.    While the SEC has been mandated to reduce the power of the credit rating agencies, it has not been able to do so yet, and the SEC has not joined in the suits.

6.    I suspect the states who have joined the suit are trying to aid in the defense of their own pension plans who did not do their own credit research.

7.    In most cases of the so-called AAA paper, it was only the top tranche that had that highest rating, and the lower tranches had lower ratings. It was the lower tranches with higher (leveraged) yields that investors bought, ignoring the lessons of the market that higher yields often show a market judgment of potential risk of loss of capital.

There are no innocents

There are no innocents in this train of unwise and intellectually challenged decisions. The list includes both Congress and the administration, the Fed and the SEC, the builders and real estate agents, the public who lied either to themselves or to the mortgage companies, the investment  and commercial banks who couldn't get rid of the paper off their own books quickly enough, insurance companies and pension funds who let their insatiable need for yield override their own sense of fiduciary controls, the media that stoked the desirableness of owning ones' own home and the ease of getting a mortgage and of course the credit raters who relied completely on history and not a fundamental understanding of supply and demand and the dangers of leverage.

In my opinion, there were NO innocents, all of the parties overlooked one or more important signal.

Lessons to be learned from the mortgage mess

There are a number of great lessons from these tragedies. The first is to be wary of sponsored mass movements in any one direction. (In this case, new home ownership based on very large borrowing.)

Second, one needs to anticipate the possibility of a “black swan” effect, of something happening that is beyond our historical context (house prices dropping materially).

Third, when there are too many middlemen in the process there is little discipline (politicians desire to change voting patterns, new builders starting with little experience and less capital, inexperienced buyers, mortgage brokers and loan officers, etc.).

Fourth, we live both individually and collectively in a cyclical world of ups and downs and the longer we go from a key market turn, the more likely that there will be a major change in direction.

Buy the leader and be wary of number two

One of the characteristics of a bear market and many flat markets is the lack of faith in various companies and types of securities. In times like the present when investors believe that despite the globally troubled economies they must invest, they all too often take a historical approach. They look for the single leading company in a sector that is already expanding. They forget two important lessons.

The first is from the sports world, be it with human athletes or thoroughbred horses, though I prefer the latter group. Unless there is a premature retirement, winning streaks always end. Often they do not immediately resume, at least that is my experience with a number of portfolio managers. 

As with the lessons from the mortgage mess, investors often do not anticipate the arrival of a black swan. These can be unexpected changes in personalities, government regulations, structures of commercial and financial marketplaces, etc. Often once a market surge is underway the number one company’s stock rockets up to a price that is beyond a fair level. In this case there is a tendency to jump on the number two company in the sector, whose price has not appreciated to the same degree. I have studied this phenomena in the financial services area, and I believe that it is also applicable to some other sectors. 

For years whichever retail brokerage firm had the second largest number of salespeople to Merrill Lynch was favored by some investors in the belief that it was selling at too big a discount to Merrill. Going all the way back to Bache, none of these number two companies did as well as the leader. There is a sound reason why the gap did not materially close. When a firm believes it must compete across all product lines with a leader, it will come to the party late in terms of loyal experienced people. 

Today, Morgan Stanley through acquisition of Citigroup’s sales force, is now the firm with the most active employee salespeople. This is somewhat ironic as its CEO came out of McKinsey and Merrill Lynch is now tucked into Bank of America. We will see what it can accomplish as number one. Judging by the large number of experienced brokers who are leaving it won’t be easy. Morgan Stanley is the original major competitor in the investment banking business though Goldman Sachs remains the “go-to” banker on large, difficult deals.

(We own a much larger position in GS than we do in MS which may be an indication of my concern about betting that a number two can become number one.)

Bottom line

One should understand past history, but be aware that the future, at some point in time, will not look like the past.
 Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of
Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.