Sunday, March 31, 2013

Leadership Change Late in the Game

Regular readers of these posts already know that I have been prematurely speculating about the risks of a top of the market. Most securities analysts date the last important bottom as of March 9th, 2009. Almost exactly four years later, the Standard & Poor’s 500 Index (S&P500) reached a new high on the last trading day in March, 2013. Market cycles vary in length from bottom to peak, but generally they are in the 40 month range. (One of the sounder investment management organizations uses a rolling four year period as the shortest benchmark for its internal incentive compensation.)  Each market cycle is a bit different than those of the past, but they have many of the same characteristics. Most often on the rise up, the sectors that lead make sense as they come from deeply discounted price levels. In this particular case the second best performing group from the market cycle bottom was the financials, a group that is of particular interest to me. (I believe that a market boom needs to excite the owners of financial shares. With that thought in mind, I manage a private financial services fund that has been enjoying this rise because among the financial leaders within the S&P500 were Discover Financial, McGraw Hill, American Express and AIG. All of these, I have owned for many years.) 

Buyers need a quantity of sellers before they can push stock prices higher. The coming week or weeks will likely supply some sellers and some will say the doubling off the bottom is enough. Others may feel that after low double digit gains in the first quarter, the time would be right to lighten up on their positions. They would be urged to do so by those who insist that there should be a tight correlation between the prices in the market and their generalized view on the domestic and global economy. (As long as there are numerous economic pundits that are somewhere between wary to negative on the market, I can take a relatively relaxed view of the future for long-term investment accounts similar to what we manage.) 

The drivers so far

Arranged by the leading central banks, the best thing driving the stock market higher is the impact of the banks’ experimental policies to force interest rates to confiscatory levels. These efforts have done much to the maligned credit ratings which have proven on balance to be correct in the long run. Recognizing that it is almost impossible for a credit rater to speculatively lower credit ratings, they do provide a useful purpose of confirming current opinions as to the chances of timely payment of principal and interest. At the top of the credit rating pyramid is the Nine-AAA league composed of the sovereign debts rated AAA by S&P, Moody’s, and Fitch. According to the Financial Times the size of this pool has shrunk by 60% from $11 trillion to $4 trillion since the beginning of 2007. (US, UK, and France are no longer AAA rated.) The size of the drop is first a measure of the scale of the combined fiscal and monetary overreach by governments and the sharp reduction of the size of the pool of so called totally risk-free assets from a credit standpoint. The message delivered to investors is that there is relatively little in risk-free assets available, so if you want to earn a somewhat reasonable rate of return you must assume other risks in the bond and stock markets. 

As many of you probably already know, I spend a great amount of time analyzing mutual fund data. I do not pay much attention to the net flow data that combines the dollar totals of sales and redemptions, since I believe that the motivations behind each stem from very different needs. I do pay attention to gross redemptions. According to the Investment Company Institute (ICI), gross redemptions of equity funds in the first two months of 2013 declined $12.7 billion to $224 billion whereas gross redemptions of fixed income funds rose $21.6 billion to $ 141.9 billion. Strategic Income funds rose $12.8 billion in redemptions for the year to $65.7 billion, followed by increased redemptions in high yield and government funds. The Strategic Income fund bucket includes those fixed-income funds that can move from one type of fixed-income market to others. I believe that the shareholders are concerned that they were not exiting governments and high yield fast enough. My guess is that these figures are just showing a bit of nervousness on the part of some mutual fund holders; the largest single category of redeemer was institutional investors who redeemed $158 billion up $29 billion from the first two months of 2012. These numbers do not support the much-heralded great rotation out of bonds into stocks. I believe that thus far the biggest single contributor to the increased gross sales of equity funds is coming from a $121.8 billion increase in money market redemptions to a total of $2.4 trillion. Thus there is a reasonable chance that when individuals and their managers recognize that for the moment they shouldn’t fight the Federal Reserve, they could commit their assets that may well drive the stock market higher. Or they could decide that the risks are too high already in stocks. 

Need for new leadership

On the rise from the 2009 bottom, the leading large portfolio funds have been managed by value-oriented managers. They have bought and owned stocks of companies that were statistically cheap using the company’s financial statements as a guide. This is one of the reasons that the financials appealed to these portfolio managers globally. Many of these stocks were yielding an above stipulated inflation rate or would if permitted by the central banks. Other stocks that were found in these portfolios had rising operating and before tax margins. This was mostly achieved by capital and labor efficiencies in spite of limited sales growth. Without a global pickup in sales many of these companies will not be able to show earnings growth. This is exactly the problem facing those who need the stock market to move higher between now and the next Congressional elections. 

Possible new leadership

With fewer and fewer high quality bargains available the value-oriented investor is finding it is difficult to identify new large names. At the same time a growth-focused investor is being limited by the expected lack of volume growth. One possible area for future strength is broadening the concept of value beyond statistical value based largely on reported financial statements. I am suggesting an old merger & acquisition gambit of searching for strategic value.  Strategic value rests on a well-researched view of significant change. In an oversimplification, one could look at these opportunities through the eyes on the cash flow statements or a materially different earnings structure.

One of the key questions is: are there significant opportunities for the company and its peers to materially reduce their capital expenditures? As a relatively young analyst I spent time with an older leading analyst of aluminum producers. He became bullish on these stocks when the companies were shutting down the hot lines and factories. His bullishness was based on the idea that with less available competitive capacity, demand would force prices up until the next wave of expansion would take place a few years in the future. Airlines have followed a similar strategy through their mergers to reduce excess capacity. In a minor way we have seen a similar thought pattern in the financials, with the waves of expanding and contracting fixed-income trading and branch building. The final objective of these strategies is to use cash flow to pay off debt, pay dividends and shrink the number of shares outstanding. Some practitioners of these art forms have produced brilliant results. To some degree the asset allocation skills of Warren Buffett and Charlie Munger at Berkshire Hathaway* and those of Leucadia* fit into this model.  

Currently on offer are two very different investments with dramatic change elements. The first, alphabetically, is Dell. The question here is whether a change to a more patient capital structure and/or change in management can produce good long-term results. While it is possible, I personally have my doubts, as the original driver of these discussions was an embarrassed (or should have been embarrassed) shareholder. Those involved are more financial engineers than sustainable company builders. I could be wrong and this type of shareholder action could become a model for the new leadership. There are lots of candidates for this kind of operation, but not without risk.

The other stock on offer and somewhat a competitor to the first is Hewlett Packard which likewise has been gravely wounded by the computer wars and unfortunate acquisitions. The difference is that the current CEO is in an announced five year turnaround plan. She has solid marketing and management experience. I believe that it is clear that the future company will not be producing the same products if at all or in the same way.   

While less attractive to me is what I have called “the three M” Strategy. The three “M”s stand for McKinsey, (a consultant with a dubious track record of success; e.g., Enron), Merrill Lynch and Morgan Stanley*. The two financials have used the consultant to provide cover for what their managements wanted to do and have hired former McKinsey partners. Both of the two operating companies are trying to improve their balance sheet by selling off elements of their empires to improve their balance sheet ratios. They are doing this rather than materially improving their products and delivery systems. Nevertheless, they may well succeed; I hope so, as they have a number of talented people on board.

Each of the three alternatives to build increased strategic value could be part of a new market leadership which I think is needed to go from the newly established highs to materially higher stock prices. 
*Owned in both my financial services fund and personal portfolios

What Do You Think?
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Sunday, March 24, 2013

Are We Entering The Most Risky Phase?

Apparently this quarter’s surge in net flows into equity funds has been identified as sourced from idle cash, not from in my opinion the most risky asset class, bonds.  I would suggest that two other factors need to be considered to get a fuller picture. The first factor was the January surge, led by stock investments from defined contribution plans; i.e., 401(k), 403(b), and 457 plans in addition to bonuses. In some of these cases the employer’s contributions and the bonus money are once a year events. Further, I suspect the level of gross redemptions in 2013 are down somewhat relative to 2012, which would magnify the impact of one of the highest January inflows on record.  
There is no denying that many investors both institutional and individuals have turned more positive to equities, almost on the basis of ‘what doesn’t kill you, makes you stronger.’  With a few exceptions, major stock markets gained in 2012, rather than going down in early 2012 as many had thought. This result is in contrast to 13 years of equities generally going nowhere. Total reinvested return calculations for the last ten years of equity mutual funds does show a 10% compound growth rate mainly through reinvesting distributions into more shares at lower prices. Those that spent their distributions did not get this benefit.

Whatever the reason, we are being asked to become more aggressive with client portfolios. We manage each account for its own needs. In almost all cases we produced double digit returns for 2012 and in some cases were ahead of the equity averages (even though the accounts had somewhat of a balanced nature). In one case our gross performance was above the 20% level. Nevertheless some accounts are asking for even better returns which we would also like to deliver, but the increase in the potential level of risk is uncomfortable.     

The nature of risk

Risk is not what is taught in various schools by academics which should be more accurately described as the variability of returns. Risk is not the volatility of prices from short-term period to period, which may describe the comfortableness of a ride along a trend line compared with some other price series.  Essentially risk is the penalty for being wrong to the extent that it causes the investor or his/her beneficiary to change permanently one of life’s essential goals. For you or I, risk is a potential loss of serious magnitude. For you as an institutional investor, a million dollar decline in your portfolio is a bit distressing but your beneficiaries are not really hurt until the loss may be in eight or nine figures. For others personally, a loss equal the cost of a new car or one or two annual college tuition bills would be painful.        

When to expect large losses?

In typical capital preservation-oriented accounts that are well diversified in uncorrelated assets, large risk of large capital losses come from two sources.

The first is that there is greater correlation of price movements than expected, which is what happened in 2008 where practically everything except Treasuries and a handful of other assets fell, with many funds dropping  20-40% or more.  The other way is to become unbalanced through the exceptional success of a single investment, think of Apple* or Berkshire Hathaway* for early investors. Instead of representing say 5% of a portfolio and because of relative appreciation, one position now represents over half of the value of the portfolio. Assume that Apple at the top represented 60% of the portfolio and with the current slide of approximately 40% from the top, the portfolio could be down 24% ($60x.40%= 24%). How could this happen?  Allow me to quote from the esteemed Howard Marks, president of Oaktree Capital: “Things get riskier as they become more highly respected (and thus appreciate). There can be more risk in thinking you know something than in accepting that you don’t.” He further states: “the better returns have been, the less likely they are-all other things being equal to be good in the future.” 
* Owned positions in personal or managed accounts

Nevertheless, we have often heard the advice to sell your losers and let your gains run. To do the opposite has been the curse that has fallen on US and UK managers of funds sold into the Japanese retail market where many Japanese measure risk only by seeing how much the price or net asset value has gone up and then they redeem relatively quickly. This view may be aided by their brokers who are interesting in recycling their money into newer investments. In my opinion, both extremes of holding forever (for which I can be accused), or quickly selling after a sharp rise, can be wrong. The key is that every day one should evaluate both the upside potential and the downside risk of permanent loss. 

What are the increased risks today?

If we choose we can buy into the belief that while this year may be economically challenging, like the IMF we can choose to believe that 2014 will be better than 2013 not only for the US but importantly for Europe. This “happy talk” is increasingly being accepted despite the strong odds that France will join the deteriorating countries who won’t come to grips politically with their problems. The potentially sizeable problems of France could well be too much for the German taxpayers’ willingness to carry. Further, I suspect that any significant solutions to the US deficit problems unless solved in the next six months won’t be meaningfully addressed until after the 2014 congressional elections, when the fundamental composition of both houses could change and the White House will completely focus on its legacy.     

The current Federal Reserve Board believes that they are largely in control of the both the level of interest rates and the relative value of the dollar. I believe that the Fed can be surprised by non-monetary events. For example a pandemic of SARS or similar life-threatening waves that can affect the US directly or indirectly. This weekend’s issues around Cyprus could produce symptoms of much bigger problems. For example, if the Cypriot banks can tax depositors on their euro accounts, won’t other governments under pressure to raise tax revenues at least consider doing the same thing? Possibly the regulated banks will be considered less secure than they were a few weeks ago. The skeptic in me always looks for something below the surface to actions of governments. In this case perhaps one should look beneath the surface literally. Off Cyprus to the north there is believed to be a large undersea gas field that Turkey wants to develop. To the south there are possibly two potential offshore oil/gas fields which people from Cyprus and Israel want to develop, and the Russians would like an Eastern Mediterranean port for five of their ships. (Remember this would not be the first time that these types of issues have driven geopolitics both within and beyond the Middle East. The British government sponsored what was, in effect, British Petroleum’s takeover of the Suez Canal from a failing French firm.) Other potential offshore gas and oil deposits could also produce conflicts and disabling price movements in terms of the disputed Chinese/Japanese islands and possibly a significant discovery off Vietnam. One only needs to look at the deep-water find off Brazil and the opening up of Mexican oil exploration as examples of how ‘surprises’ can cause disruption to the Fed’s neat playbook. 

A small but potentially new player is on the scene: Irrevocable Trusts.

In the aftermath of the year-end changes on US estate taxes, I believe a significant number of new irrevocable trusts were created out of former estate plans to lower the size of the estate taxes. Many of these trusts used the maximum allowed of $5 million per grantor. In many cases these trusts are designed for children/grandchildren, personal foundations or other charities. Since these are non-returnable gifts, quite probably their investment character should change. As long as the money was in the planned estate corpus it may have been invested for capital preservation to make sure that the grantor and spouse will have enough capital and income to meet their expressed needs. As the money is permanently set aside and could have a materially longer if not eternal (dynasty) horizon, some or all of this portfolio will be more aggressively invested in a capital generation mode as distinct from the same dollars in the past invested for capital preservations. 

The buyers who could drive the stock market

The following is pure speculation, perhaps informed speculation. As indicated, investment advisors are being asked to produce higher returns particularly at present low interest rates. Money from the sidelines appears to be coming in. The continuing flow from salary reduction savings plans is augmented by employer contributions, particularly as more defined benefit plans are being tapped in favor of new defined contribution plans. Foreign investors who are becoming increasingly nervous about unfriendly home governments may also, at least temporarily, want to shift money into US traded equities, And finally some of the money comes from new irrevocable trusts.         

My dilemma is that I believe we have entered a phase of heightened risk. When these flows do come in, by definition they will have the effect of increasing risk to our markets. Jumping out of the stock market too soon may cause professional managers to lose their jobs. Waiting too long to reduce positions could lead to substantial loss of capital or real risk. Exit timing is the most difficult part of the investment art.   

How are you going to time some of your exits?
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Sunday, March 17, 2013

Governmental ‘Good Efforts’ and their Unintended Consequences

All too often what is intended to be good works by members of government lead to significantly more powerful consequences to the unsuspecting beneficiaries of institutional investment. This reaction holds true for the present day and future implications of actions that took place in 1830 in Massachusetts and this week in Washington.

The “Prudent Man Rule” causing investment mistakes

In 1830 Judge Putnam found against Harvard College in how the college's endowment was invested. He held that a trustee should invest the funds that he is responsible for as other men of intelligence and prudence invest their own funds. In our more politically correct world this precept is now entitled “The Prudent Person Rule” and has been adopted as dictum for institutional investment. This concept has been particularly helpful to me in building my commercial career as it introduced the “need for peer related comparisons.” This was the legal basis for me to begin to sell the Lipper Mutual Fund Performance Analysis which in turn led to further performance, fee and expense, and portfolio analyses.

Now that I serve on various non-profit investment committees and have some as fee paying clients, I perceive that the prudent person rule can lead to significant losses. Note that the good judge’s words did not define prudence, only how to compare it. The rule suggests that to avoid being found to be imprudent one needs to do what others do with their investment portfolios. In many fields of human endeavor being part of a crowd is comforting. Any serious history of investments (particularly of major declines) will conclude that being with the crowd is to lose substantial amounts of money and perhaps more importantly the confidence to take advantage of rare opportunities that only occur at the emotional bottom of a market. Further, the courage at the top of a market to take different actions than the crowd can be the savior of various non-profit institutions that will leave them with capital when others have to curtail their good works or close their doors. Recently, I have been a witness to situations where well intentioned executive committees made up of people without career knowledge of investments were dictating investment policies to investment committees of professionals. The executive committee or full boards wanted the comfort of “looking like the others” rather than giving the professionals the latitude to be different. For example, following the popular view that diversification is a risk avoidance technique, a certain non-profit board would not approve of allowing its investment committee to have the discretion not to own any of a particular type of asset. I guess the view is that we should have investments in a large number of asset classes even though the professionals believe that there is a substantial risk of loss of capital. (Can you think of situations when you would want to own US Government Bonds with the possible exception of TIPS securities?!)

A more current concern is the inclusion of separate analytic slices for domestic and foreign stocks. As a practical matter many large and small US companies are dependent upon non-US customers for their growth and manage their foreign exchange risks for the most part well. These so-called domestic companies compete with both foreign multinationals as well as local companies and all three groups are subject to the same trends in their business. As an investor for over 30 years in stocks whose main trading markets are outside of the US and as an analyst who has been studying both domestic and foreign multinationals for fifty years, I see less and less distinction between stocks that trade in any of the major marketplaces in the world. In my mind the world is made up of equities for growth of capital and dividend income; and fixed income for interest and capital along with interest on interest. In many ways the main difference between the two is that in theory equities have an indeterminate life and fixed income has stated maturities. There are other legal differences of some importance.

I suggest that the first definition of investment prudence is the avoidance of permanent loss of purchasing power to the extent that the beneficiaries must alter their important plans. The bottom line: one wants to have both the capital and courage to survive and take advantage of investment and other opportunities that occur in periods of stress. To me prudence is all about not taking comfort from seating next to others as a ship is going down.

Senate investigations may lead to unintended structural changes

On Friday the US Senate Permanent Committee on Investigations held forth on three panels involved with the $6 Billion loss of JP Morgan Chase* through the actions of the so-called “whale.” As a practical matter most of the time was taken up by the soon-to-retire chairman of the committee asking pointed questions of people that were in the US that had some involvement with the loss or the intensive internal investigation by uninvolved senior officials of JP Morgan. I listened to most of the ranting questions by the chair and the ranking Republican member. But most of the time the chair was the only questioner in the chamber. As far as I was concerned, I learned nothing particularly new from what I have read in the papers. However, the hearing perhaps did have some effect in the marketplace. The volume of trading of the bank’s stock was 60 million shares on Friday compared with 26 million on Thursday and 16 million on Wednesday all with relatively little final price move. On Friday, in addition to the hearing, there was the announcement of what the Federal Reserve Board (FRB) would permit the bank to do in terms of dividend increases and stock buybacks. The key to me is that there are enough buyers to absorb the sellers’ disappointments emanating from either the hearing or the FRB action. Thus, I would conclude that there was a lot excitement, but no serious damage to the value of the stock. 

However, there may well be a future development coming out of the hearing that could impact depositors in not only this bank, but a number of others as well. To justify the extensive work of the committee staff for three months and the expense of the hearing, the ranking Republican kept referring to the fact that some of the money that was being hedged was depositors’ money that was protected by the taxpayers through the Federal Deposit Insurance Corporation (FDIC).  Perhaps what the ranking member was saying is if there were no direct risk to the US taxpayer that the Congress would not be investigating a loss that was fully absorbed by the shareholders of the bank, including me in a tiny way. At this point JP Morgan is awash with depositors in the US and overseas because of its reputation for possessing a fortress balance sheet. Many other banks including community banks are similarly burdened with deposits that require they pay fees to the FDIC and cannot earn a reasonable return by investing in the government market and/or find relatively safe loans to make. Under these conditions, I wonder whether a number of banks will elect to leave the FDIC system. If some depositors want similar insurance, I am reasonably confident the private sector will provide such services on a risk assumed basis.
*  I have owned shares of JP Morgan for many years.

Tip to the wise

We should all be sensitive to the deeper implications of “good works” that we perform and how they could impact how others will act in the future.

Please share some of your thoughts with me.   
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