Sunday, April 28, 2013

Picking Winners

The job of a professional investor is simply to pick winners, or is it? Professional investors focus on avoiding  losses (nominal or “real” )
and not appearing to act imprudently.

As regular readers of these posts already know, my two great learning schools were the race track and the US Marine Corps. The first taught me how to analyze and the second how to act. Allow me to share some of what I learned from going to "the track" in my quest to pick investment winners for clients and my family.

What is winning?

My betting objective for each day at the track and each season of visits was to finish with more money than when I started. As a wager of limited means I had to overcome my costs incurred including transportation, food, admission and the portion of winning tickets that went to the track and state/local taxes. For me these amounts could easily add up to a hurdle rate of 25%. Thus when it came to investing in the stock market or through mutual funds the costs seemed like a bargain particularly at long-term capital gains rates. With my objective of producing the first dollar of net profit after paying all incurred expenses dragging on my returns, certain basic strategies evolved:

          1.      Avoid losing by selecting only a limited number of races. (No multi bets or the equivalent of indexing).

          2.      Arbitrage the difference in potential payoffs between the winning payoff on a highly favorite horse versus half of the net pool for second place, if one of the first two horses is highly favorite.  At times such a bet may lead to a better return with some less risk than on betting on a favorite to win.

          3.      Look at current race conditions compared with the past record of the racers. Most often the odds on the horses that recently did well were less than those of horses whose immediate past results were poor. (For investors this is the difference between momentum investing or extrapolating vs. searching for new opportunities amidst almost always changing conditions.)

Applying winning strategies

Most fund selectors follow a disciplined approach to avoid losers;  they seek to avoid having any performers in the bottom performance quintile. If their remaining choices are averaged, they should have a performance record that is better than the average of the overall universe which is the equivalent of earning the first (small) dollar of profit.

The investment manager of a portfolio of funds, like me, constructs a mix of funds that in many, if not most markets should produce a satisfactory result. The way to do this is to diversify into a group of funds which will by direction and magnitude offset periodic losers with winners. The selection process should be guided by the assessing the chances of success over the chances of permanent loss of capital.

In contrast, the individual security analyst is most oriented toward the future, looking for the odds of meaningful changes that are not appropriately recognized in current prices.

The current picture

Market price correlations are widening; the price performance between the best performer and the worst are no longer parallel. This phenomenon could make the use of ETFs less useful. A number of actively managed portfolios are demonstrating that their selectivity is what produced better than average performance in the first quarter. In many cases the weighting of individual issues combined with good selectivity produced meaningful performance increments.

Dividend paying stocks have been leaders for over a year. But the focus is narrowing away from just yield production. JP Morgan is recommending common stocks of companies with high free cashflow production as companies that could increase their dividends among other uses of their cash generation. A number of mutual funds have either publicly espoused or just followed a strategy of selecting stocks of companies with rising dividends. The focus on dividends is part of what appears to be an almost insatiable drive for income to replace the former sources of reasonable interest on government bonds or bank savings accounts. This drive has caused an enormous flow of money into corporate bond funds. But this is beginning to show early signs of change. In 2010 the average trading turnover (the amount of trading vs. the amount of outstanding bonds) of investment grade bonds was 95% and now has dropped to 75%. This may indicate that the objective of trading to add to yield is declining a bit.


We have done a good job for our accounts, but at this point in the cycle I am worried that on a relative basis my accounts could use more future growth-oriented funds as well as highly selective fixed-income funds. If you have any suggestions in terms of techniques, or perhaps a securities analyst-trained person who should join us, please let me know.

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Sunday, April 21, 2013

Positive Investment Implications...

I wish to bet in favor of an expansion of returns of investors’ capital, even though this time may be different in that we might be entering a long-term phase of flat to down stock markets. At market turning points there is usually not an over-abundance of evidence of a change in sentiment as to the long-term direction. Thus, to find clues of change I scan all information that passes through my desk and memory. The following are items that I think should be weighed and their implications examined.

Intellectual property and unfunded pension liabilities to be calculated in GDP

In July of this year the US GDP will grow by 3% due to the inclusion of intellectual property in its calculation, recognizing intellectual property as a produced asset rather than an expense-only generator. According to a Financial Times story released on Sunday, this adjustment will be carried back to the initiation of the calculation of national accounts at the Bureau of Economic Analysis in 1929. The size of this addition is roughly equivalent to the size of Belgium’s GDP and the biggest increase since the 1999 addition of software. This change is in response to the international accountants recognizing intangible assets such as research and development expenditures, and royalties on creative works (movies, television shows, books, music and theater). If these are the results of current spending to produce long lasting assets, they need to be identified on accounting statements including the national income accounts that produce our Gross Domestic Product. At the same time the revision will recognize the unfunded liabilities of public and corporate pension plans. There are many investment implications to these changes. The first is that the US economy with its large scale production of intellectual property will widen the gap from most other countries, which may play a role in the on-going deficit production and austerity discussions in the US. Second, intelligent investors have already priced these benefits into some of their judgments regarding the production of intellectual property in the biotech sector (including drug companies), as well as others. If recognized this shift, in addition to published book value, will lower the price/book value ratios that many so-called value investors favor. Also some states like New Mexico will get greater recognition for the large amount of R&D conducted there. Larger in dollar value, but smaller as percentage of total state product, my home state of New Jersey could also benefit. However the various states as well as the nation’s GDP numbers will be marked down due to the size of the underfunding of their pension funds. In most cases knowledgeable investors have understood these conditions and market prices may already be reflective.

Portfolio liquidity

Many institutional investors have been willing to accept in the case of their purchase of “lock-ups” through private equity and many hedge funds that there is a penalty on early redemptions. Recent discussions with investment committees (who are focused on providing operating funds to their institutions) have indicated a stronger than normal push to insure the liquidity of their portfolio.  They are willing to pay a liquidity premium beyond the current year’s needs to feel comfortable in meeting the requirements of their organizations, particularly if business and donor support slows down in the year ahead. At the moment there is less competition for long-term investment opportunities which in turn may lead to better entry prices or terms for lower fees or less onerous exit terms. Thus, now may be a particularly favorable time to be a long-term investor with cash to spend.

Four letter words

From a young age we have been instructed to avoid the use of certain four letter words. In this prohibition, we tend to forget two additional very important words; Love and Like. The world would be a far less attractive place without these words in practice. But there are two other four letter words that now need to be understood. The first is “real.” This term is used in reporting the impact of inflation on income and price performance recognizing that published nominal rates don’t measure the “real” cost or benefit received from a number. My problem with the designation of real is that the number for inflation is increasingly recognized as questionable. There are growing questions as to the price inputs, methodologies applied and the accuracy of each procedure. In my talks with various institutional and individual investor audiences I have yet to find people that perceive the published consumer price index is representative of their experience. I would suggest that it would be prudent to use “real” rates of return as estimated and not certain in the specific situation of the investor or citizen. The second four letter word that should be handled with care is “copy.” Something that bears no resemblance to an original will rarely be compared as a copy. The art and the investment worlds know that a well done copy is not only difficult to spot but also has many similarities to the original and in some aspects could even be better than the original. Copying is the sincerest form of flattery it is said. At the right price a copy could be a useful bargain. In the investment world which follows and mimics performance leaders, I would not necessarily shy away from good followers as long as one identifies that they are followers who could produce better, often more leveraged vehicles, than the original leaders. As long as one recognizes that those who follow are unlikely to either spot the turning points when the period of advantage is over or to be an original leader in subsequent phases. Thus, I would not reject a copy out of hand, but understand as to what one is dealing with and do so at the right price.

Investor confidence

As mentioned a number of times I follow the weekly publication of the Barron’s Confidence Indicator of the ratio of yields of intermediate quality bonds to high grade corporate bonds. When the ratio declines it is meant to be positive for stocks in the future. Most weeks the change is below 1% (100 basis points) which I consider a weekly trading differential. In the past week the decline in the ratio was 1.6% or from 67.9 to 66.3 which is encouraging to those of us that have long positions in stocks.

Markets speak to non-profits and governmental services

One of the hard realities for many non-profit institutions that are serving the public through admissions to various locations is that they are suffering from a falloff in both attendance and donor support. Very harshly, I am increasingly taking the point of view that if these non-profits were commercial businesses with the same secular, not cyclical decline in support, my attitude would be that ‘the market has spoken” and now is the time to consider basic model changes or closing down. Applying the same thinking to the deficit production machine being run by most Western governments, I believe that the situation calls for a significant model change as the public does not wish to pay in full for all of the omnibus services that it receives. The current debate is, “do we want European level of services or Asian types of government spending?” Analytically I reject that simplistic equation. I believe the tool that is called for is the surgeon’s knife not an axe. I believe that if the potential audience for a museum or concert or a government service believed that it wanted the service that was proffered they would show up one way or another in sufficient quantities to effect a re-pricing of the services. We should not close support institutions and governments entirely, but just rescale them to fit today’s demand levels. The investment implication is that there is a third way out of our box, which is to find the level of demand for services that people will fund for themselves in monetary or work terms. If we see more of this new thinking,  the future will be positive for our children and grandchildren.

What Do You Think?
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Sunday, April 14, 2013

Current Worries Obscure Long-Term Portfolio Thinking

There is too little enthusiasm about investments these days despite the fact that we have just slightly breached the old highs on the popular US stock market indexes. This weekend I seem to be besieged by too many worries to enjoy either my market price gains or a wonderful concert by the New Jersey Symphony Orchestra playing three Tchaikovsky pieces very well, plus a spirited encore. (As my wife Ruth is Co-Chair of the NJSO, it should have been exhilarating for me.) Somewhat like Tchaikovsky’s tragic to triumphant Fifth Symphony, my investment worries obscure the good results we and our clients have achieved, and what should be an attractive long-term future.

I find it difficult to rank worries as any one of them could be the proverbial canary in the mine shaft. Thus, I am just listing them in the order that they hit me.
1.    The demand for US $100 dollar bills is up, particularly in Europe. I take this to be showing a concern about the value of various European currencies rather than a money transfer tactic of the global underworld.

2.    Most of the financial press is devoted to the problems of Cyprus and some of the other peripheral economies rather than paying attention to the remaining parts of the world. China now has reserves of $3.44 Trillion which is about the same size of the entire economy of Germany. Interesting the last time China published its gold holdings was 2009.

3.    Due to the fact that governments are trying to dictate to their economies through the banking systems, financial transactions including loans are moving out of the depository banks and into “other’ financial institutions, often called the shadow banking sphere. In China for instance the growth in commercial and personal credit is greater than in the regulated banks. In the US a portfolio of bank stocks has been recovering, but is still behind the other financials’ stock price performance.

4.    The current chatter of the talking heads in the financial press is focused almost exclusively on the pace of the expanding economy. People seem to have forgotten that in every decade there is at least one economic recession and often two. Where this plays a role is in the “happy talk” emanating out of Washington about reaching a balanced budget over the next ten years. According to John Mauldin, there is not any suggestion that the period will include one or more recessions which could balloon government social spending.

5.    A recent census report adding all the levels of US government spending per household concluded that the average is approximately $50,000 and the median household income is about $49,000. No wonder that there is not enough consumer saving to pay for the physical infrastructure needs and intellectual infrastructure needs to create the knowledge and work habits to fuel this economy.

6.    The price, volume, and shorting actions in Exchange Traded Funds (ETFs) suggest to me that an important part of the trading in these vehicles is being conducted by short-term traders similar to hedge funds. If more individual investors were using them I would be worried by a recent study by Mark Hulbert as published online in Barron’s on Thursday. Mark compared the performance of a number of ETFs to actively managed funds within the same organization. He found that, on average, the active managers out-performed their less expensive stable mates. This may be particularly important in the next major market decline where the active managers can either raise some cash and/or get out of some of the larger volume stocks that are leading the market down. (Of course when there is a rally, as they say “cash is trash” and can hurt performance.)

7.    This weekend some of us will be watching the Asian markets and later the opening of the European markets to see what the price of gold will be doing after a major fall at the end of last week. As a well-known and respected non-gold bug said to me this weekend, “The reason to own gold, in some form, has to do with fundamental concerns about the continuing value of paper money; it is just as present today as it was last week month or year.”  The purpose of gold is as an insurance policy within a portfolio of other assets. For generations European private bankers have urged their wealthy clients to own 5-10% of their portfolios in some form of gold. Just as I don’t like to drive on the road with drivers that do not have appropriate auto insurance, I hope that a few do not use the drop in the price of gold as an excuse not to pay their “value of money insurance policy.”

Analyzing your long-term investments

As indicated, the list of worries above is obscuring what you and my fellow long-term investors should be focusing. I am an advocate of dividing one’s portfolio into different time horizon and special pocket investments. At the moment I want to focus on the longer-term time horizon bucket. This is the bucket to fund multi-generational needs for both families and charitable institutions. 

One useful exercise is to look at the current market weighting of each of your investments and assign them into these somewhat distinct categories:

Category one: The portion of your portfolio which is the result of the accident of gains. One never expected this to be such a big winner, even if it was the family company. Now one has a very large unrealized capital appreciation = tax and/or disposal issue.

Category two: Holdings that are selling at very deep discounts compared with other market indicators. The future price potential is large and if successful in later years could be moved up into category one.

Category three: Some investments that are selling substantially below what a knowledgeable buyer would pay for the company, particularly if a new management could be installed. Dell?

Category four: There are some very high quality companies whose shares most of the time reflects their quality, but not all the time. This weekend I read the very long proxy and annual report of Goldman Sachs, a stock that is owned in my private financial services fund. For some this may be a controversial firm, but I find in general in most of their varied businesses they do conduct their activities in a high quality fashion according to the ethics of the business. I own other high-quality names but I was using Goldman just as an example.

When you get all through assigning weights to these and/or other categories see whether they are in an appropriate mix for your long-term needs. I would be pleased to discuss this exercise with you if it helps to bring some additional clarity to your investing.
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