Sunday, October 27, 2013

Long Term Investors Are Too Short Term:
The Key Question is ‘How Long is the Race?’


As the readers of my posts already know, I learned critical elements of security analysis and portfolio management by handicapping thoroughbred horses at the New York racetracks. In deciding on which races to wager on as distinct from just observing, the key decision was to guess how fast the race was going to be run. Further, some guesses were helpful in terms of the segments of the race. Through this analysis one could determine the probability of which horses were likely to be in the lead at important times and whether horses that normally run from behind the crowd had enough time to catch up and be a leader at the end.

Do you notice that almost all discussions of supposedly long-term investors are focused on the present or the very immediate future? Can you remember an instance when we have seen the best performing stock in early January be the best for the year, or much more importantly the best stock for ten or more years?

Investing for grandchildren can help the picks of the grandparents

At a recent investment group of semi-retired and fully retired portfolio managers, chief investment officers and senior fundamental and technical analysts almost all of the talk was how these remarkably experienced and smart investors focused on their own accounts as they dwelt on how they saw the current investment picture. The general conclusion was sobering which led  many of the individuals to only a few possible purchase decisions, without much in the way of changes made to their existing personal portfolios.

In an attempt to bring greater value to the discussion, I asked that we focus on investing for our grandchildren. In that line of thinking, I asked the group to show by a raised hand how many thought that in some period at least ten or twenty years in the future would we see US Treasury interest rates above ten percent, the vast majority of hands went up. I suggest that this view is more important in setting policy than whether the esteemed Dan Fuss of Loomis Sayles is right in his intermediate projection for ten year US Treasuries at 4.25%. The key point is that this “horse race,” which is indefinite in length, is likely to be run differently than our memories of past performance.

Change of data has unrecognized impacts

Those who follow the races should take into consideration a change of equipment on the horse. The following changes are probably under appreciated:

  • US Treasuries are already trading on the basis that they are "AA" relative to German Bunds 
  • Observable prices are going up; real estate at the high end, many food items, costs of services. (We don't fully appreciate the impact of the decline in energy prices.)

  • The measures quoted by the various government agencies on inflation do not capture the hollowing out of middle class employment conditions. While there are a large number of highly skilled job openings, the costs of general employment are structurally rising and those positions that can not be replaced by machines are being supplanted by lower cost domestic and foreign contractors.

Society and investment policies do not reflect the changes and the long-term outlook.

Please share with me how your long term outlook is involving.
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Sunday, October 20, 2013

Betting For or Against Nobel Prize Winners


This past week we learned that Gene Fama, Lars Peter Hansen and Bob Shiller  received Nobel Prizes for Economic Sciences. These are relatively new awards starting in 1969 in honor of the founder of the Nobel awards, Alfred Nobel.

Nobel Prizes, except the questionable Peace Prize given by a different committee in Norway, are based on the discoveries and insights developed many years before the award. A relatively small number of the awards given for economics have had their focus on securities selection. There is no substantive record of whether they work in producing winning portfolio performance. A number of past winners became highly paid consultants to investment groups after the award. These have produced nice lunches and wonderful dinners, but little in the way of commercially exploitable performance.

What are the implications of these three awards?

Each recipient was trying to find a systematic way to invest profitably. They should have gone to the racetrack and listened to those in the Grandstand or perhaps better, in the higher priced Clubhouse. After each race people talk about why in the next race their particular choice will win. If someone has a number of winners in succession or at least a preponderance of winners, he or she has a “system.” Having been exposed to these various systems whether they have been mathematically based or dependent upon anecdotal information about the horse, its breeding, its trainer, its jockey, the jockey’s agent, the condition of the track or the colors of either the horse or what the jockey is wearing, I can attest to the fact that none of them work a majority of the time. The key to making intelligent bets at the track and in the market is to be sensitive to changes from the past. Otherwise one can be like some generals/admirals in the Pentagon fighting the last war brilliantly; for after the war they have determined what may have caused the victory or defeat.

Is there is a message in the Nobel Prizes?

By awarding three learned economists this year’s prize where each had a different point of view, methodology, or to use the racetrack term a system, the committee may be saying that there is no uniform selection process that works all the time. This is not to say that their work is worthless. Gene Fama was one of the founders of Dimensional Fund Advisors (DFA) which manages a number of mutual funds, some of which we use for clients. The practitioners have focused their money using other selection and perhaps more importantly, trading techniques. The result is a relatively low cost (not as low as pure index funds) portfolio of a large number of securities which allows them to nibble at bargains when offered. Sometimes they will have above average results and some times not.  As the inventor of segmented performance by quintiles, I can’t remember seeing their performance in the top or bottom one fifth of an array.

The Shiller approach, looking at the last ten years earnings relative to current prices, is a useful beginning to analysis. The analyst in me rejects sole reliance on reported results. I believe that one must first adjust the results for changes in tax rates, mix of business and tactical opportunities, accounting changes, changes in shares outstanding and significant changes of management. While I urge client expectations to focus on performance of at least the last ten years, I do adjust my thinking to recognize cyclical developments.

All of these approaches are useful until they become too popular.  They are not the complete answers to successful investing. In part because the favored investment styles of the economists  (small, value, momentum, and quality) will be redefined by market forces and in all likelihood smart-eyed observers may find other winning groups based on management techniques, technological supply chains, beneficiaries of social media, etc.

Changing conditions

One of the problems when intensely looking at present conditions is that something that appears to portend broader changes may not be very important in the future, and other incidental observations could be the recognition of bigger things to come. Two items caught my eye this weekend. I offer them up for our subscribers to consider or reject in terms of implications and importance.

The first item is that hedge funds reportedly have their biggest short position in gold since January. This may be a sideshow and only important to “gold bugs” or it could be a clue of how some hedge funds are looking to play catch-up from being behind the larger market advances. Undoubtedly at some point various markets will decline, perhaps meaningfully. The risk that all short sellers take is if the items that they are short move up dramatically, they may be forced to buy back the shorted securities at a rapidly advancing price. In other words they could be caught in a short squeeze, particularly those who shorted gold. With announced trading volume quite light, a squeeze could be applied.

The second item is that yields on German Bunds are closing in on the yields on US Treasury Bonds. For some time, global investors have felt more secure with the credit value of the German government paper than that of the US. Thus they were more expensive in price with lower yields. The closing of the yield spread could indicate that global investors are less worried about the credit value of US government paper which could be good for the US stock market from a foreigner’s point of view. At the very same time foreign currencies are appreciating against the dollar. Part of this may well be caused by an increase of US investments into Europe and possibly Japan.

Would you please let me know what you think?

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Sunday, October 13, 2013

Risks Found in this Week’s Readings


Each week I appear to be a one person research or reconnaissance staff looking through the information clutter trying to avoid Improvised Explosive Devices (“IEDs”).  I hope to dance through the minefield that is out there. Like most destructive forces they are initially hidden and like a wary animal I try to sense dangers before they become clear. My search approach is to look for possible analogies that could reveal dangers to all of our portfolios. This week there were four questions that popped up:

  • Possible ties between compulsive gambling and ETFs?
  • Are there parallels between the collapse of the Weimar Republic and the US?
  • Are there amateur real estate winners?
  • Is political arithmetic more important than budget math?

Is using ETFs a form of compulsive gambling?

In The Wall Street Journal’s Review section this weekend, there is an article entitled “The Real Odds On Gambling.” I am pleased that the source of the data for this discouraging article is from scholars in the UK supported by gambling business consultants in the US. The findings showed that the odds on winning big in casinos were stacked against the players 31 to 1, (31 losers to 1 winner).  The scholars also found on average, that gamblers who bet somewhat continuously over a two year period, 31 lost money for every one who made money in casino type games of chance. Poker players playing against other players did better winning about one third of the time. A number of poker players and casino players did win periodically. They kept their winnings by walking away from the tables.   

When I wrote the book Moneywise, I noted that two of my great learning institutions for adult life were the Racetrack and the US Marine Corps. Sorry about that Columbia University, where I joined the professional military through the Naval Reserve Officers Training Corps via a scholarship. Actually a good bit of my racetrack experience was learned while I was enrolled at Columbia full time, with an on campus job and a member of a world famous fencing team. What I learned by doing the math was that it was virtually impossible to walk away a winner for the racing season by betting every race. First there is the issue of racing luck/bad analysis/not picking winners. Second, the state and the track replaced the casino in terms of the take they took out of every bet. Finally, the New York betting crowd (possibly the same Wall Street players or their cousins that I competed with later) were too accurate juggling most of the track odds and the probabilities at winning.

I concluded that I materially improved my chance of walking away a winner by betting few and in some cases no races on a given day. Further I looked for opportunities where most of the attention was focused on predicting the winning horse and the odds on either of the first two or three horses aligned more favorably with my analysis of the probabilities.

What does this have to do with investing in Exchange Trade Funds (ETFs)? I believe a great deal. Over-simplifying, the bettor using ETFs is in for a fast trade, essentially betting against the market’s view of valuation; or else he/she wants to participate for an extended period of time (which is sort of like some of my relatives who wanted to cash a ticket so much that they virtually bet almost every four legged vehicle in the race). Both the short-term and long-term approaches do not have good odds on winning big, particularly when compared with other opportunities.  In truth, I should not be anti ETF as I own shares in publicly traded investment groups that are the sponsors of various ETFs. I have improved my odds by betting on the house rather than with the crowd. I will admit that I have used index funds in various institutional accounts to balance the concentrated investments of some active funds with broader and cheaper passive funds. However, I do not use them personally.

Possible parallels to the Weimar Republic collapse

The inspiration or perhaps more accurately my fear was generated by The Wall Street Journal, in this case a book review of “The Downfall of Money” by Frederick Taylor.  He describes the monetary trap that the German government, the Weimar Republic, found itself in attempting to pay off its high reparations debt calculated in terms of gold. Germany’s answer was to inflate the money supply to such an extent that the internal value of their currency collapsed. (In the week of the French invasion of the Ruhr to seize the coal it was owed, the Germans needed 7,260 deutsche marks for a US dollar. By October the purchase of one US dollar required 65 billion marks and this was not the final quote before the mark became worthless. Under such circumstances one should have seen that a charismatic leader who would fix things and repair the wounded German pride would arise to take over and indeed Hitler did. This part of the story is well known and should be taught in every school in the world.

What is not as nearly well known is the contention of the author that the economic problems actually started in August of 1914. In order to raise the money needed to feed their war machines each of the soon-to-be combatants began to inflate their money supply. By 1920 the purchasing power of the US dollar had declined by 50% since 1914. In reaction to the induced inflation one after another of the major countries returned to a gold standard pushing up the value of gold to offset the purchasing value of the internal currencies, thus wiping out arbitrage opportunities and the competitive advantage of various exporting countries. With this background we can understand the fears of some of the implications of the problems at the periphery of Europe, potential problems in Japan, China and clearly the US with its growing deficit. (At least for now our debt is all dollars based.) We could see at some time in the future a reversal of Franklin Roosevelt’s arbitrarily raising the price of gold behind the US dollar and Richard Nixon’s closing the gold window. (What a strange combination!)

These fears are a good reason that corporations are doing more of their business overseas and in some cases in local currencies. Securities investors should follow remembering that US listed securities represent less than half of the world’s securities.

Investing in residential housing has worked

In an article from the Financial Times it was noted that the UK wealth gap grows as homeowners save more but renters suffer. The article focuses on first time, but well off buyers of residences. They are intelligently reacting to some remaining softness in home prices, low mortgage rates and rising rentals. The same pattern appears to be happening not only in the UK but other countries including the US. There may well be a political as well as economic implications to this as more people begin to think of themselves as a “little bit wealthy” and change their spending, investing, and possibly their political habits.

The real arithmetic of the partial Shut Down

Both the trade press and the general circulation news media are focusing on the size of the current US deficit and the ability to pay the incurred debts. On the surface these are important, but are not the motivating drivers of the politicians leading the battle. For them the key numbers are 17 swing seats in the House of Representatives and 5 seats in the US Senate. If the elections bring additional cover for the Administration more socialistic laws and regulations should be expected. If the reverse happens there will be a stalemate on the legislative side leaving the actions to take place mostly on the regulatory front. The battle is being fought through various press releases and interviews on or off the record to influence the relatively small number of swing voters who will make up their minds in terms of local choices one year from now. Largely the long-term economic impact of what is finally decided in 2013 will have limited dollar impact by October of 2014. Thus the keys to watch are the growing changes of perceptions as to which specific local candidates will be considered less bad than the other person to fight for a better share of rewards for the swing voter. At this point delivery will be more important than wisdom

The Benjamin Graham Award

Earlier this week, I received the Benjamin Graham Award for Distinguished Service to the New York Society of Security Analysts. I have been active in the Society for more than fifty years serving the leadership with energy and advice. In a very brief acceptance speech I stated that I was delighted to get an award named after Ben Graham who was the spiritual godfather of the society. Having taken Security Analysis under his writing partner David Dodd, I was able to say that Ben taught us (including Warren Buffett) that one could lay out various principles but in the heat of the day do something different. (I believe this is an important realization for all who participate in the market at any level.) I also thanked the audience for the ability to give back to a business that has given so much to me.

How are you looking at the investment world now?        

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Sunday, October 6, 2013

Will Fund Classification Hurt Your Fund Selection?


I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases relative performance is very important. My concern is that most benchmarks be they securities or fund indices are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional  “gate keepers” or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the US. According to McGraw-Hill Financial’s survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies’ foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources.  As a matter of fact I found four which had foreign sales of over 75%. Since for many years sales outside of the US have been (in local currency terms) growing faster than in the US, I am willing to bet that a number of funds that are characterized domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher quality small cap funds had a relatively good third quarter performance (see many of the Royce* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important on this Sunday when the Financial Times reported that the Brookings Institution announced that the global economy is coming back, being led by the richer countries. For the moment the classification of small cap appears to be working. Nevertheless, from a selector’s view point it is a flawed classification.
* Owned by some of our accounts

Better Classifications

Originally funds were slotted into classifications solely on what the funds’ marketing people claimed they were. Over time this yielded to the language in the prospectus created by the firms’ lawyers. Increasingly their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards as to earnings growth, price to book value, yield, market capitalizations and other measures. The data sources for these were the unadjusted financial statement statistics.

As both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed.  I have already pointed out that higher quality Small Cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors.  Other such measures might have to do with the difference between turnover in dollars vs. turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float and there are others.  Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

Bottom line: Pure performance ranking numbers in one period are not an important selection device today.

What screening devices do you use?  Please let me know.

Readers’ Service

In last week’s post I mentioned that Colin Camerer, a Caltech professor that we supported with help for his post-doc students, had just won a MacArthur fellowship, often called a Genius Award.  He sent me his collaborative article in the Neuron magazine, entitled, “In the Mind of the Market: Theory of Mind Biases Value Computation During Financial Bubbles.”  The work shows that during a bubble, the “smart guys/gals” get caught up playing what we used to call “the bigger fool theory.”  Please let me know if you would like me to email the article to you.

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Contact author for limited redistribution permission.