Sunday, July 28, 2013

The Real Investment Risk is not Changing Your Thinking

In the US Marine Corps and in the long-term investment portfolios that I manage we never lose sight of our final goals of accomplishing the mission and survival. In the Corps, investment portfolios, school lesson plans, and certain other activities it is desirable to move orderly in one direction and with a single set of instructions. Unfortunately that approach is often called the ‘school’ solution, a theoretical plan that does not represent the reality on the ground or in portfolios that must perform. In the real world more often than not we are confronted with challenges and therefore opportunities that take us off the narrow principles-based trajectory we have been schooled to follow. At every given moment, those of us that invest for others must negotiate the differing challenges of:

·       Selecting among tactical vs. strategic considerations
·       Diversification against a laundry lists of risks
·       Incorporating multiple and changing definitions of risks
·       Managing operational considerations both for the client and our own shop

The future starts with the present

While a long journey begins with the first step, our near-term vision can dictate how we approach our long-term goals. One of the traditional problems in using long-term performance is that the jumping off point may be radically different than the first step that built the enviable record. In almost all cases it is better to start when the market prices reflect past poor performance rather than counting on momentum to continue. Intellectually this may be easy, but emotionally tough to do. Luckily peaks and bottoms are relatively rare in terms of frequency. Most of the time we are zigging and zagging within an unclear trend.

One of the advantages of my practice is that I get the great opportunity to have meaningful discussions with smart managers, (there are very few, if any, dumb portfolio managers in the fund business). I am often struck that in this world of supposedly fair disclosure, that the better managers receive very productive insights from conversations with people not directly connected to the corporate or financials worlds. In addition, the better managers have good powers of detailed observations.

I try to learn from the good and great ones and apply their different approaches when I can.

A breakfast at Caltech

Some time ago I spoke to a group of incredibly intelligent students from the California Institute of Technology about financial community opportunities. I must have made some sense because a few weeks ago one student asked whether we could continue the discussion with a few of his fellow grad students. My time on the Caltech campus is always quite limited, so I challenged him to come to an eight o'clock breakfast. (For many students, 8 AM is the middle of their sleep period!)  Four of them attended as did a fellow trustee with three degrees from Caltech, who is also a successful company founder. We were joined by a professor and research project leader in neuroeconomics.  He is developing an understanding as to how the brain makes investment decisions.

The students appear to want to focus their efforts in biotechnology. While still on campus one of the students has already founded his first company.

I don't know what they received out of our discussion, I got an understanding of what their science (and others) can do for mankind. This discussion was followed by another about the development of a potential home machine that could transmit the nature of ailments through sampling body fluids that could be delivered to doctors before the patient arrives.

What does this mean to me?

One of my antecedents was an Elector for Abraham Lincoln, and even though my brother received an appointment as a page from a Democratic senator, I am a believer in much of Republican philosophy.

I had firmly believed that the so-called Obamacare was a mistake for the country economically and socially. While philosophically I am still opposed to government sponsored healthcare, the discussions on the campus of Caltech and reviewing a fund that has been a successful investor in biotech companies of high promise, I am now contemplating that the government's projections are extremely misleading, not because of their socialistic policies, but because of technology. Relatively low cost and widely spread new families of healthcare instruments or appliances as well as new drug therapies could materially lower the costs of healthcare. My purpose of bringing this subject up is to show that as long-term investors, we need to constantly examine our thought patterns. This is just like the Marine Corps had to develop tactics of moving off of ridge lines and moving down into the valleys or cross-compartments to take the "critical terrain" and accomplish its mission.

Our mission is to invest successfully long-term

The first rule of successful investing is to avoid permanent loss of capital. In this weekend's Wall Street Journal 
the inestimable Jason Zweig discusses a book that focuses on risk. To me risk is the penalty for being wrong to the degree that critical terrain is lost in accomplishing long-term investment goals. Jason makes the distinction between shallow risk which he harks back to Ben Graham as "quotational risk" or somewhat temporary price declines. "Deep Risk" is what we should be focusing on, he believes.  Deep risk is created by four elements; according to the column they are:
·       Inflation
·       Deflation
·       Confiscation
·       Devastation

Though bad for our future capital, the four conditions above could be survivable if expected and anticipated in our portfolios.  If we don’t recognize the potential for each of the listed ‘four horseman’ then we are truly in deep .... risk.

Recognition time

I could be wrong about the overall costs of healthcare; certainly I will consider more evidence that may alter my view. However we could change direction on national inflation and the continued confiscation of private bond holders' rights versus the government’s prerogatives.

The truly successful long-term investors don't lock themselves into a strategy. Each day if not each hour represents an opportunity to change.

An effective time horizon strategy

Rarely market prices, yields, and other investment ratios reach long-term peaks or bottoms. Most of the time we are zigging or zagging from a past major top or bottom. We just don't know which is the terminal point of a trend. Therefore a mechanical process of adding to or subtracting cash to an investment portfolio makes sense. The trick to do this effectively is to keep the time horizon in mind for each portion of the portfolio. 

Current needs

For the portion of the portfolio that needs to provide current levels of money to meet operating needs, US law has changed. Under modern law the distinction between income and capital has been removed. Thus the general level of acceptable current yield is augmented by trading results. In today's markets, I suggest that trading of stocks and bonds will be a greater source of cash needs than yields. The ability to convert principal to meet needs suggests that current requirements will be met by what we used to call "wasting assets" similar to investing in a mine with a known life. Eventually the funds will be needed to support current cash needs.


The next time horizon bucket is the intermediate bucket or perhaps buckets. The purpose of this intermediate portfolio is to regenerate enough cash in a timely fashion to provide for current needs when the first portfolio is exhausted. This portfolio requires less trading skills and in today's environment more equity type risk taking which can include some so-called high yield product.


The four "horsemen" of deep risk should be the main focus of the long-term portfolio with sufficient upside potential to offset the pains delivered by the deep risk elements. Based on my own recognition from this last week, I will look as to what makes sense in biotech investing either in the public market or through intelligent and not too greedy private equity vehicles.

Questions for today

1. Share with me privately what were the "aha moments" in your portfolios.

2. How are you positioning your portfolio responsibilities for this dynamic world?
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, July 21, 2013

Government Debt vs. Tough Love


Introspection is forcing many managers and investors to privately reconsider the basic premises of their long-term investment strategies. With the popular US stock indexes at or near all time highs, why don't they feel better?  The relative investment performance of many high quality value-focused managers is lackluster. The companies they own are doing well and for the most part they are sitting on lots of cash earned overseas from faster growing markets than their own home market.

One of the sectors which is doing very well for many portfolios is financial services securities. In terms of market value this sector is the second largest in the S&P 500. Further, in most other markets, the financials are the largest high quality names. Our own private financial services fund is having a good year producing returns at least twice a "normal" year would produce. And that dear reader may be a symptom of the deep problem.

The two drunks structure

When two people who have had too much to drink and are marching down the street supporting each other, there is a symbiotic mutual support system at work. In most countries, governments are thought to be the guarantors of at least the banks’ depositors, if not the majority of its creditors. In most societies, the largest owners of the governments' debts (those that are not a government entity like social security)
are the banks. The drunks are into each of their pockets in a major way.

The reason and the costs of financial dependence

We all know the historic reasons for these relationships. In the past each side was feared to be in danger of failing. Under these circumstances heads, some of them innocent, would roll. There would be disruption of “normal” activities and many things would grind to a halt. That is until replacements came into being with new leadership and fresh capital. Order would be restored with the absence of some wonderfully historic nameplates such as
Bear Stearns, Lehman, Washington Mutual, Countrywide and Merrill Lynch; as well as, at least initially, more assorted spending and investing. In a parallel example, think about some function or people who were let go and not replaced. In all likelihood they were not earning their cost of capital and in the past were a drag on all who were.

No bailouts plus “tough love”

In a somewhat simplistic view the bottom line of corporate, bank, and government failures is that they run out of money. This was probably due to the fact that they did not earn enough to pay their debts (including to their own people), and because their clients and citizens did not value their services highly enough to meet their obligations. As an independent investment advisor and private citizen, no one is holding a safety net beneath me to meet my obligations. Recognizing that I am not likely to get some form of bailout, and that with the specter of tough love, I have to manage my affairs to pay off my legal and more importantly for me, my family and charitable obligations.

What would the world look like under tough love?

Governments would rely on their taxing authority to meet much more limited needs. Some of present expenditures would be taken over by the private sector; this would include the postal system, Medicare, Social Security, Patent Office, Library of Congress, mortgage companies, student and farm loans, many government facilities and more.  At the same time the private marketplace would determine what would be the minimum level of capital required for a bank to be considered sound and safe. This probably would mean that banks would keep very little of their capital in medium to long-term bonds.

Do I expect this to actually happen?

No, but I think there is some chance that we will haltingly move in this direction.

If there is any chance, how should this be played?

In a conceptual sense we are already seeing replacements for traditional banks. You can't tell this from midtown Manhattan or in many wealthy suburban communities, but the number of bank branches is dropping. The financial agents for college age kids are credit cards, student loans and the “Bank of Mom” or other relatives. In some respects Google, Alibaba, Amazon and undoubtedly others including financial services web-based brokers, large family offices, gatherers and distributors such as BlackRock, Blackstone, KKR and T Rowe Price* will play roles that banks have played in the past. Not all of these stocks will be successful, but some exposure in portfolios will be warranted
          *Held by my private financial services fund.

A question

Who is providing financial services for your children and how will this impact your plans in the future?
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, July 14, 2013

Does Money Make the World Go Around?

Many of us are familiar with the song that begins “Money makes the world go round.” As a card carrying CFA® charterholder and a recovering numbers cruncher, I will warrant that is how all too many measure the rotations of an individual’s, a business’s or a nation’s rise and fall through periods of net accumulations and net spending. However, strange for a numbers addict to say, I believe it is an incomplete and in many ways a faulty measure, particularly when considering investments.


Money is an instrument of exchange used in buying and selling. In the modern world, money is expressed in terms of different currencies that can be transmitted physically over a sales counter or electronically through a banking system. As these exchanges are most often impersonal and rapid, we use numerical shorthand to represent the terms of exchange.

Money buys goods, services, and the time of others + what?

When we make purchases of physical goods most of us think in terms of the item; e.g., an auto or laptop. We do not consciously think of the hours and talents that went into producing it. We are somewhat more conscious of the hours and the credentialed talents when we purchase services from doctors, lawyers, accountants and perhaps paid speakers. We need to include into that list paid workers such as plumbers, electricians, and landscapers. One can easily put an immediate numerical value on a number of goods and services, particularly if there are competitors. However, most of what we buy today is not only for immediate consumption. Thus, there is an implied belief that the buyer is purchasing the goodwill of the vendor, but not in an accounting sense. The value of this goodwill is not just after warranties but entails the quality and quantity of thinking and effort that can make us better users of our purchases. The advertising industry has taught us that various purchases have an emotional benefit, like making us feel good about ourselves. This combination of goodwill purchased and the benefit of us feeling better are difficult to measure and can in the long-run be more important to us than initial price paid. I would suggest that these considerations make the valuation of cash more difficult than a bookkeeping exercise.

Cash/currency in your investment portfolio

I have just completed a couple days of visiting Portfolio Managers of different funds in accounts that we manage for both institutional and wealthy individual investors. In some respects the most revealing parts of these discussions were about the smallest part of their portfolios, the cash on their balance sheets. The different comments are as follows:

  • “Cash is a residual after I make all the investments that should be made.”
  • “Cash is awaiting a few more investments that are out of price range or are not fully identified or more analytical work is needed.”
  • “Cash is a way to express a view as to the level of the market.”
  • “Cash is flow management device.”
  • “Foreign cash is a hedge against home currency.”
  • “Cash is awaiting a planned sizeable redemption.”
  • “Substantial cash holdings allow for riskier other holdings.”
I am sure as I talk with other portfolio managers I will learn of other points of view.

How do I use cash?

As indicated in earlier posts, I view my portfolio construction skills as more of an artist than a mechanical contractor. Carrying the analogy further I hope to be building estates, academic facilities, research labs, performance venues, medical facilities among other worthwhile activities. As each account is managed to meet different needs, my use of cash is far from uniform. The rhythm and timing of the account as well as the feelings about money are taken into consideration.

I use cash in a similar fashion as those that are listed above. Additionally, in risk adverse smaller balanced accounts I have used Treasury money market funds to avoid any principal loss. Currently, I am reducing this element in favor of ultra-short (duration) government funds and some short-term TIPS. My general attitude is that my clients should take their risk in the large equity portions of their portfolios not in fixed income.

If cash is trash as bulls believe, try ETFs

If I am a portfolio construction artist, the ultimate mechanically constructed investment product is the Exchange Traded Fund (ETF). One of the many reasons I believe actively managed portfolios should be compared only with other actively managed portfolios doing the same thing is as seen from the discussion above; i.e., active managers have varying amounts of cash in their portfolios. ETFs are designed to replicate the performance of a fixed list of securities. The list does not include any cash. Thus in a rising market all of the securities within an ETF portfolio could be rising in price. In an actively managed portfolio only the actively traded securities have the opportunity to rise (and fall), the cash is only a very small amount of income. Thus there is a tactical advantage in favor of ETFs. My clients believe that well-chosen selected investments will produce better strategic results.

What does your use of cash say about you?
Please share with me privately or publicly.

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.