Sunday, August 25, 2013

Can Credit Ratings Be Sexy?

The Mae West quote that “too much of a good thing is wonderful” reflected her playful method of sexual innuendo and is the way many investors view credit ratings. Upon her other revelations, I do not believe that the burlesque queen, movie star and stripper was conversant on how bond credit ratings affect relative stock price performance. But that is the dilemma that I have been working on this week. I come to view this issue from two divergent vantage points .

My challenge

I manage a number of balanced (bonds and stocks) accounts for institutions as well as wealthy individuals. As part of our responsibility for one client with multiple accounts we have the task of managing an all fixed-income portfolio in separately managed fixed-income securities and fixed-income mutual funds. In connection with this client I am reviewing and updating the account’s investment policies. At the time of the inception of the account in 2007 certain quality and diversification standards (or what now appear to be constraints) were mandated. As mere thoughtful mortals drew up these policies they did not consider the current tiny short-term interest rates and their manipulation by the major central bankers of the so-called developed world.

High quality, poor relative performance

My associates and I have been reviewing various stock investments of certain equity funds to understand their past two years of relative under performance compared to their perceived peers. In these cases the absolute performance of individual stocks and funds has produced positive results. However their relative investment performance was disappointing. The one common characteristic of the portfolio managers of these funds is that they are oriented toward owning high quality investments, a bias that I share. On average many of these relatively underperforming stocks are higher quality than those found in their relatively better performing peers.

These formerly successful funds are believers in investing in quality companies many of which would have sounder balance sheets and higher margins than found in their relatively better performing peers.  The market recovery phase started in 2009, accelerated in 2012 and continued thus far in 2013. During this period of extremely low interest rates the less credit worthy companies were able to borrow money at historically low rates. With new capital they expanded their capacity and were also able to lower their selling prices which put their higher quality companies at a disadvantage, at least in the eyes of the stock market.

The fiduciary’s selection dilemma

On the one hand we need to set the filters so that managed accounts can meet their funding requirements under practically all absolute conditions. And on the other hand we seek to earn relatively good intermediate and long-term investment performance.

One of the characteristics of all professions is to use codes to abbreviate concepts. In the investment world one very important code set is bond credit ratings. These are thoughtfully issued by three major credit ratings groups Moody’s*, Standard & Poor’s*, and Fitch in various stylized alpha numeric abbreviations starting with the most secure, AAA and declining in terms of potential defaults down to D. On average and over time these ratings have done a more than reasonable job of alerting investors as to forthcoming defaults. However, as with all work done by humans, they are not perfect. As a practical matter investors worldwide recognize as far as taxable issuers are concerned that the first four full ratings are so-called “investment grade.” The term investment grade came out of a case in the 1930s that decided that the first four grades  (AAA, AA, A, BBB or their equivalents) were appropriate as high quality investments for fiduciaries. Since then the lower credit ratings were referred to in polite society as non-investment grade or high yield but the in argot of  “the street” as junk. Notice this whole exercise deals with the probability of timely payment of principal and interest, not whether they are good investments particularly in considering current prices.

Funding vs. performance

There is another decision tree axis which is not quite as well known, but in many respects more important. The filter for this matrix is the earliest expected involuntary pay back or maturity date. Once one is assured that the debt will in all likelihood be paid back, the twin questions facing the investor are how long will this stream of income be delivered and (in many ways much more significantly) the interest earned on the reinvestment of the interest received. For long-term bonds, under “normal” conditions, the size of repayments of principal, total interest received and the income earned on reinvestment are listed in reverse order of aggregate size. For instance even a low 3% coupon payment reinvested for 30 years in available, high-quality paper will be significantly greater than just adding up the interest payments paid on the bond, or the return of the original issue price. While this concept of interest on interest is mathematically correct, for many individual and institutional investors it doesn’t work that way. The reason they own fixed-income securities is so that they can consume the interest payments to meet their various funding needs, for example to make grants, pay for maintenance of people and facilities, etc.

Investment Policy Statements

One of the advantages of blogging is that occasionally one can see the discontinuity in one's thinking. Investment Policy Statements (IPS) are legal documents typically imbedded within contracts or board minutes. Often they are drawn up by lawyers or at least blessed by them. As with the U.S. Constitution, essentially they are limiting the powers; in this case the investment manager or investment committee. IPSs do not focus on how to make money for the account, but detail what not to do. This blinding realization came to me as I started to write about credit ratings, recognizing credit ratings can be sexy.

AAA vs. AA

We prize high credit ratings in an IPS, the closer to AAA, the better. In terms of attempting to make money for the account, as an analyst/portfolio manager and investor there are times that I question the cost to the investor of an AAA rating. Let me give an example of two holdings in my private financial services fund. Both Automatic Data Processing* and Berkshire Hathaway* are major beneficiaries of the floats of their clients' money. At one time both companies had AAA ratings. Now ADP has the highest rating, Berkshire does not. (Berkshire was downgraded to AA some time ago.) ADP is one of a handful of large US companies that has an AAA. The reasons given for the downgrade of Berkshire was the increasing risks inherent in its reinsurance activities. Both of these companies have had a practice of acquiring other companies. ADP has slowed down in these activities while Berkshire has not, as it has been buying large and mid-sized companies. While both companies' stocks and bonds have risen in price, the AA has clearly outperformed the AAA. Many analysts believe if ADP could find suitable acquisitions that do not threaten the perceived quality of its large short-term float, the prices of its securities would have done better.

Betting against dropping ratings

Recently Moody's* announced that will be lowering the ratings on four of the leading financial services companies; JP Morgan*, Goldman Sachs*, Morgan Stanley* and Wells Fargo*. For the moment Moody’s is leaving the ratings on Bank of America* and Citigroup* unchanged. Interesting the two unchanged companies have very recently done better shedding their endangered zombie species. The bulls on these two stocks will acknowledge that they are work in progress with the hope that they can approximate the returns of the four leaders.

* Owned in a wide range of sizes by my private financial services fund or by me personally.

The official reason for the downgrade is the belief that if any of the four leaders ran into financial problems the levels of bailout will be less. Quite possibly true, but I wonder how germane? As an investor and entrepreneur addicted to the long-term, I would much rather own the businesses and more importantly the people of the four leaders than the two turnaround candidates. If protecting their credit ratings and other fortress-like characteristics has prevented them from intelligently expanding their activities or handling their leverage better, the lower ratings could help us shareholders.

I could use your help

I am still struggling with what to put into an institutional IPS in terms of its fixed-income investment accounts to meet some specific needs as well as general strategic balancing needs. Please contact me with your views.
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Sunday, August 18, 2013

Stubborn Analysts may Become Stubborn Portfolio Managers

In last week’s post we discussed the questions that arise from examining turnover rates.  Most fund selectors are concerned about too high of a turnover rate. They are worried that these funds basically rent positions in the stock and are only in “the name” for a relatively brief period not for the longer-term profit generation from growth of the underlying issuer. Another consideration is that the costs of transactions including spreads between actual transaction prices and the pre-transaction bids eat into the profits of ownership, particularly when appropriate after-tax costs are considered.

After a series of visits over the last year with managers who have something of a value discipline (even though a few claim to have a growth orientation), it was stated that there was a risk that some turnover rates are too low. Their portfolios go for years with a number of investments that don’t work out. Often these securities do not totally collapse in price and may eventually go up to a perceived value price. What is not taken into consideration is the opportunity cost of not having winners or at least market performance during the elongated holding period.

Warren Buffett’s bad lessons

For many investors, analysts, and portfolio managers we focus on the writings of the two great names in our pantheon of analytical thought, Ben Graham and Warren Buffett. We are guided by their words, and not what they actually did or do. Many believe what Warren Buffett at Berkshire Hathaway* stands for buying good companies at reasonable (not cheap) prices and holding them forever. Remember Buffett closed his successful hedge fund to use his own capital to buy a failing textile business at what he thought was a cheap price. (This flirtation with bankruptcy is similar to the absolute need to fire Steve Jobs from Apple*.) Luckily for Warren soon after that experience of being an operating entrepreneur he got hooked up with Charlie Munger who taught him to buy good companies with good managers and let them manage all of their companies, except capital allocation in which he became expert. The biggest advantage that he had was that he could invest the leveraged float created by his wholly owned insurance companies. These dollars were used to buy other operating companies who had unique and strong competitive positions at currently reasonable prices. With the excess dollars he built a portfolio of investments; some proved to be short-term like airlines or high income investments that took advantage of distressed situations which would be paid back quickly if the companies survived (Goldman Sachs*, General Electric, etc.)  In his large cap portfolio he was able to buy shares of American Express*, Coca Cola, and Moody’s*. He is selling Moody’s after seeing it has become a much stronger company. His relatively new two internal managers have a much more eclectic appetite and are use to higher turnover rates.

Because I don’t have the advantage of a generally growing float, wholly owned companies carried at historically low purchase prices in an investor focused book value measure; I can’t play the same game.

Mutual funds and other performance-oriented accounts are measured differently

While mutual fund marketers and regulators try to focus present and future potential investors on various time periods of 1, 5, 10 years and since inception, the daily prices of funds drive toward different time period considerations. Any given day can be a peak or bottom to an important trend which should be measured. The change of portfolio manager or investment approach could cause a reappraisal as to what are ongoing significant time periods. Most importantly of all is the relative performance of competing funds for investors’ dollars. In each period the relative performance of individual securities takes on different aspects in an overall portfolio’s performance. A stock price that is flat in a downturn is positive to performance; whereas the same flat performance is a negative in a rising market.

The classical way to teach analysts

Analysts trained academically, including through the CFA exams, or by large organizations are taught to find and promote good companies particularly with so-called moats (impenetrable competitive positions). Notice that these “good guys” are preferred regardless of price and without any significant attention to disruptions in the economy, market or sector. As analysts and portfolio managers get older the attraction to these “good guys” become greater as so many lesser lights have failed as stocks. Soon the portfolio is a collection of surviving “good guys” as the other positions have been liquidated. I am sympathetic to this condition as my personal portfolio is disproportionately invested in these collection pieces. Luckily for my clients a price/value discipline keeps both “good guys” and cheaper and hopefully more potentially promising investments in their portfolios (particularly of funds).

Most funds are managed by analysts

Most funds are managed by analysts, though in many cases they still have direct analytical responsibilities. In most cases the portfolio manager views her/himself as a super analyst and spends the bulk of their time going over and sharpening the analytical views expressed. All too often analysts stubbornly believe in their models that produced their list of  “good guys” regardless of what the current market is saying. The super-analyst-portfolio manager having the same training and attitude as his analytical staff goes along with their views and hence the portfolios take on the aspect of a collection not a vehicle addressed to the current market.

The further training of portfolio managers

I maintain that just being a good analyst is not enough to be a good portfolio manager. The PM needs to understand the current and likely future markets; this is learned by spending time with good marketing people as well as good and bad investors. The PM has to learn how to use his trading desks not only to get the correct executions, but a source of market and competitive intelligence.  All PMs should study competitive portfolios and performance, not to copy them because the student will be late. The key is to understand how the competitors reacted to presumably the same information that she/he received; given that perspective what is their likely actions in the future based on different scenarios? PMs as operating officers should be concerned with the development of analysts, traders, and administrative people including the compliance forces. The PMs should start to anticipate changes of direction for her/his own firm. Thus, I believe there is a lot more to being an effective portfolio manager than being a super analyst.

In summation

I believe that stubborn analysts can lead to stubborn portfolio managers who like a stopped clock will only be correct twice a day or once in the military. The portfolios will not be in a winning position most of the time. I worry when I see a poorly performing fund with low turnover rates that we could be experiencing one of the big, untaught, risks in portfolios: stubbornness.

How do you correct for your own stubbornness?
Please share with me for it is an ever present danger in being attracted to “good guys”

*Some shares are owned in our financial services private fund or personal portfolios.
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Sunday, August 11, 2013

The Importance of Turnover in Picking Managers

Most of my posts end with a question to our readers. I ask questions not only to promote a dialog, but more importantly to learn from some pretty smart people who regularly read these posts. Last week one of the long-term members of this community sent me a series of thoughtful questions. One of which was, “When you conduct your analysis of funds and manager(s), how important is portfolio turnover in your calculation?” In effect, he is asking, do turnover rates matter?

When an investment analyst is asked this type of question you should not be surprised that the answer is “yes and no with an explanation.”

 A compliance invention misused

The earliest use of the term turnover rate was by the US Securities and Exchange Commission (SEC) in required prospectus disclosure. (As I hope to be visiting our British friends shortly, I need to distinguish between the US use of the term and UK’s use of turnover as a synonym for sales.) The SEC’s prospectus requirement was not designed as a selection tool to pick funds. The purpose of the calculation was to spot excessive churning of a portfolio to generate, what used to be valuable brokerage commissions. This purpose will become clearer when one knows the methodology of the calculation which is take the smallest of aggregate purchase dollars or sales divided by the monthly average of total net assets. Now you have learned more than you ever wanted to know about turnover rates.

Turnover is a good place to start asking questions

Portfolio turnover is an important place to start, but perhaps more important is personnel turnover which I will discuss further below. In terms of portfolio turnover data, when I talk with portfolio managers the following questions are asked:

1.      On balance are they selling losers or winners?

2.      What is the average length of time before transacting?

3.      Is the average length of time different for the winners and losers?

4.      Do they do any post-transaction analysis to see in the succeeding six or twelve months whether the decision was a good one?

5.      In general, what did the transactions do to the portfolio?

6.      How does the current turnover rate compare with those in the past and does this have any particular significance?

There are other questions that are then asked about the research behind particular positions in the portfolio. However, if the Portfolio Manager (PM) does not have answers to most of the turnover questions above, I find it difficult to have the requisite confidence in the fund for it to be owned by my clients.

There is an important caveat about turnover rates that needs to be recognized. That is they seem to be rising; meaning that the weighted average in the portfolio is being held for a shorter period of time. One of the reasons for this is the consultants'/selectors' “Three Year Fallacy.”  Under normal conditions three years is only a portion of an investment cycle. Four years fits closer to the historical trends and normally contains a US Presidential cycle. Actually the command economies have favored a five year period for their planning. I personally prefer a ten year period which would give ample time for a recovery from a management mistake. Enough of the numerology, the real reason for the intermediaries to focus on three years is that it is the shortest period that they can earn a new fee for a search to replace a poorly performing manager. (Often there is a substantial relative performance recovery after a three year period. This could be caused by redemptions that are forcing the PM to sell and often he/she sells some positions that didn’t do as well as expected in the recovery.)

There is a second and more structurally dangerous factor causing turnover rates to rise. I have been on non-profit investment committees who are doing a good job meeting the twenty or more years need for funding. They invest for the long-term and review their performance intensively once a year and less so quarterly. Because of the long-term nature of their tasks they will put up with a number of underperforming periods before they switch investments. That period of disappointment might last five years or 20 quarters. Today we have the ability to get publicly traded portfolio performance monthly, weekly, daily and perhaps even hourly. If it took 20 observations for the long-term manager to finally terminate a fund, the same number of unhappy reports could occur in a month of twenty trading days or a year and eight months if monthly numbers are the trigger.

Hopefully owners of accounts in funds and/or individual securities will be mature enough not to be solely driven by performance numbers and will pay attention as to what is happening within the portfolio and within the investment organization.

The important turnover report: Personnel

In our meetings with various fund groups we are sensing many more portfolio managers being switched than what we have seen in the past.  The same trend is also being noted by Citywire outside of the US, where at the current rate by year-end over 1000 portfolio managers will be replaced. Several US organizations which have been remarkably stable for years are now experiencing portfolio manager turnover. Some of this may be due to financial or psychic compensation or in a number of instances, performance problems. In some cases these changes are not disclosed. What is definitely not disclosed is the turnover in analysts. Only at a recent face to face meeting with a PM did we learn about a reduction in the number of analysts in the office. (Interesting enough the PM believes that it could help improve the quality of investment research and decisions.) 

The turnover of senior officers in a firm is important to me. Recent turnover of CFOs has caught my attention as these are not just bookkeepers but play critical roles in developing and carrying out corporate strategies. Rarely do we see announcements of critical changes on the trading desks at institutions. For many funds that have a high portfolio turnover and/or invest in small or micro-caps, the traders can add great value. This also true in the fixed income and credit markets. 
Is turnover important?
Yes, the context of the turnover in the portfolio and in the organization is important, but the number itself can be misleading.

How do you view turnover?
Please let me know privately or publicly.

I am looking forward to seeing some of you in London in September.
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