Sunday, January 26, 2014

Current Investment Traps


To use a term from tennis, a trap is an unforced error. In our arena of investments a trap is a concept/thought that leads us to significant losses of capital, or worse, opportunities to make sound productive investments.

Last week I had the opportunity to address ASCOSIM, an organization of Italian investment advisors. My talk in Milan included a brief list of ten concepts in structuring portfolios of collections of mutual funds. Email me at, and I will send you a copy of the ten slides which might promote useful conversations with investors.

I mention this journey to highlight one of the advantages of spending sixteen hours in an airplane over the course of two days, the ability to have ample time to read, think and to write.

In the world that I inhabit of professional investors and their competent advisors, there are many opportunities for mistakes of judgment. During my flight home from Milan, I kept wondering why these smart people make dumb, unforced mistakes. In thinking about the mistakes that I and others have made, I realized that we all fell into traps. Most of these traps first started with the principles we utilized. We use tools for the impatient. Instead of celebrating data diversity, we use labels as a way to bunch information so we can quickly narrow our focus to making a selection from a pre-sorted list of alternatives. We believe that we can reasonably predict the relative outcome of the labeled alternatives. For example “growth,” “value,” stocks, bonds, developing markets and a whole bunch of other classifications. Our problem is the comfort brought by these and other navigation skills. One example is the ability to predict with a high degree of certainty our arrival time on an airplane trip covering more than five thousand miles with greater precision than our arrival time in our daily land-based commuting. In math and physics we are taught by problem-solving and experiments that there is only one correct answer, and to get it all one needs is to follow the prescribed formula. 

The focus of this post is the current traps that I see smart and perhaps very smart people falling into. They are examples of using labels that can lead to traps. They are not listed in any particular order. Pick your own trap as we all do.


We all enjoy the warm feeling when we believe that we have bought a bargain. We want to pay a price at a significant discount from its true value. There are two traps here. The first is that we can mathematically determine the exact true value of something, including securities. The second is not being concerned with the seller’s motivations which could well change our evaluations and results.

One of the ideas that I hope to get over to the incredibly smart Caltech students (including Doctoral candidates as well as post-docs) that I will be addressing this week is that the person on the other side of the trade may be even smarter and may have better information.

Successful young investors

Having grown up in the investment business I have experienced and benefited from the battle for investment thinking supremacy between young analysts, portfolio managers, and investors and those who are older. Wisdom is not chronologically based, but the work being done at Caltech and elsewhere indicates that memory plays an important role in judgments. The cyclicality of markets and investment themes over time reinforces the need to avoid obvious risks. It has been many years since the general stock market has risen significantly above previous peak levels, thus many of today’s enthusiastic investors have only had the experience of the decline and recovery phases of the last five and ten years; they think a bull market is a new phenomenon. They don’t see that within every surge of higher prices and volume that there are built in time bombs of future problems. Some of these rises will produce spectacular results. Enjoy them, perhaps participate, but don’t count on today’s gainers getting you out ahead of time of their collapse, it will be new to them. In other words it could be a trap.

Book value’s trap

Many purveyors of investment products use a corporation’s book value as a measure of investment value. People tend to forget the calculation of book value is a balance sheet measure of subtracting the liabilities from the assets found on the balance sheet to get the equity and translating that to a book value of a corporation. This may be like choosing a new friend solely based on their precise phone number. Remember that the assets are shown on the basis of the cost to acquire them if they are demonstrably below their current market value. The liabilities are based on the size of known obligations. People tend to forget that the book value they were taught in college or graduate school as well as the CFA exams is a teaching device not a measure of reality.

A better way

As someone who has both bought and sold intellectual property companies and have advised others to do so, I have found book value is only of use in comparing other transactions when their true value is unknown. When one is privileged, or perhaps burdened, to get into the mind of the driver of the transaction, one sees an entirely different set of algebraic calculations. The first is what would be the cost to recreate that portion of the subject company’s customer relations and sales? This is then compared with the potential buyer’s estimate as to what it would cost to build the desired value itself and how long would it take.

The trap of overlooking human factors

All businesses have inherent problems usually involved with human relations. What will be the costs and bother to deal with these?  Most importantly can the buyer supply the talent needed to solve these issues? With those questions what are the balance sheet assets really worth to a particular buyer? One of the more difficult imponderables in evaluating an acquisition or disposal is the reactions to the announcement. What will the customers think and long-term what will they do?  What will the “good” employees do, what will the various regulators and communities attitudes be, what affect will the acquisition have on the acquiring company, will the combination lead to enhanced talents or to a talent drain? These are just some of the questions that should be determined.

Moving to the liabilities; do they reflect all the reasonable contingent costs including retention bonuses, possible adverse law suits and tax consequences, costs to shut down and move facilities and people, unmet needs for research and development and other elements of essential research? As one can see there are real differences between the real value of a company and stated book value. This is not to say that book value is meaningless.  If one can make the tentative judgment that the sum total of the missing factors are similar to the same or related questions of other transactions, the relative multiple of book value of other transactions is a somewhat useful guide as to the trend of deal pricing. (When I know more I prefer to use the metric of price times sales. Stratifying companies that are worth one half of their sales, or even better one times, two times, three times, and more is a good measure of what buyers believe the future value of an acquisition is.) My bottom line is that present valuation is a good current guess of future valuations, but you should not rely on book value as a sole measure.

Predictability of VIX

S&P Dow Jones Indices publishes monthly comments on various indices. In its latest commentary the first point was as follows:
  “The VIX is down over the past month and the current reading of 12.84 suggests that the potential for significant moves lies only to the upside…..The Australian, Hong Kong, and Canadian VIX equivalents are also down, a pattern repeated elsewhere across developed markets.” 

In its simplest terms the VIX is a measure of the implied volatility of S&P 500 Index options.  Often market professionals view the level of the VIX as a measure of fear operating within the market place. Considering the absolute closing high for the VIX was 80 in late 2008, one can see that currently there is not a great deal of price pessimism in the marketplaces around the world. As a contrarian this is exactly when a negative surprise could be its most potent. The sell off thus far in January, which appears to be worldwide, may be the trap that was sprung on those that use immediate market movements to predict future trends including turning points.

The failure of stock investors to pay attention to bonds

Stocks can surprise both positively and negatively. In most cases the best thing that can happen to owners of bonds is that they receive timely payment of interest and principal. Thus bond prices are more sensitive to potential bad news than the stock market. As a stock investor, I am aware that bond prices can be a useful warning device for me. Changes in credit ratings are often a coincident indicator of bond price movements. Nevertheless, they can be leading indicators for the general stock market prices. Moody’s* has published a schedule of quarterly down grades and upgrades. For the 4th quarter of 2013 there were 78 high yield downgrades (68 upgrades) and 21 downgrades of investment grade issuers (12 upgrades). The extreme downgrade readings were 303 for high yield and 93 for investment grade. 
*Owned by me personally and/or by the private financial services fund I manage.

The current preponderance of downgrades in an economy that is meant to be recovering is a cause for one to be cautious about committing new money to the stock market.

Please share with me the traps that you have avoided and which ones are you wary about now.      
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A. Michael Lipper, C.F.A.,
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Sunday, January 19, 2014

Keep Looking For Growth


I am not always a contrarian, but an opposite view from the crowd often gives an investor a safer perspective. Thus the lackluster performance of the US stock market in the first half of January is a prod to look elsewhere for investment inspiration. This is particularly true in terms of equity fund portfolios whose gains were concentrated in the four main credit card company stocks. Further, re-examining the main US fund investment objective averages for the Fourth Quarter of 2013, one finds that there was a major difference between the results of Large-cap Growth and their Mid and Small cap fund brethren. The Large-cap Growth was clearly the leader of all the main groups and the Mid- and Small-cap Growth were the laggards. The leader benefited from a handful of social media/info tech leaders. One of the lessons that I try to teach other students of the market is to pay more attention to the laggards when searching for future leaders than the current leaders.

‘Time Horizon Portfolio’ focus

If you utilize my time horizon approach when looking at your investments, current momentum is very important for the one year or trading portfolio. The switch in momentum is very important to the cyclical or intermediate length portfolio. This second time horizon portfolio is often what insecure investment committees focus on in making their judgments. There is a little bit of the English expression “penny wise and pound foolish” in their actions. The big money is earned and kept in the longer-term portfolios and this is the hunting arena that I like.

The difference in time horizons between value and growth investing

When applied by disciplined knowledgeable professionals both value investing and growth investing have worked,  however each uses time very differently. Ben Graham and David Dodd taught students at Columbia University and succeeding generations of analysts and investors the utility of value investing. In an oversimplified way they were urging analysts to carefully study financial statements to understand the nature of investments currently on offer. Their studies led to the identification of the gap between the current intrinsic value and the current price. In effect, they (value investors) arbitrage the difference with the belief that the current price will relatively soon reflect the intrinsic value they determined. Their most famous student was Warren Buffett who took value investing one step further by focusing on what the future value and price would be. At approximately the same time a Baltimore-based investment counselor was developing this into his theory of growth stock investing and he was T. Rowe Price.

I have memorable experiences as an student, investor or more to the above. David Dodd was my professor; T. Rowe Price* (the a firm) was a client and subscriber; for many years I have invested with Berkshire Hathaway* and attended its annual meetings. Most recently I was awarded the Ben Graham Award by the New York Society of Security Analysts.

Disclosure:  *Stocks either owned by me personally and/or by the financial services fund I manage.

Growth investing

What value investors are looking to do is to get a bigger piece of the available pie, whereas the growth investor is betting on a growing pie and quite probably one that has a different taste. The growth investor needs to know the current financial statements; the value they bring to the exercise is a well-reasoned view of the future and some luck. (More on that later) As we live in a global space where there are product developers/inventors and markets everywhere, one of the areas for some of our longer-term sophisticated accounts is in funds that invest in Asian science and technology. A recent article by J. Michael Oh, the portfolio manager of the Matthew Asia Science and Technology fund,  makes the point that the rising standard of living in many Asian countries will allow new markets to “leapfrog” over the stages that developed countries had to go through. One example is in many places of the world the population has jumped directly to mobile phone use without first having landlines. My background years ago was as an electronics security analyst, thus my inclination is to think of some electronics developments as enhancements to our present gadgets. Michael Oh would suggest that I might be missing the biggest advances. He is very bullish on the improvements in medical products and their vast Asian market potential.

Is Google nuts?

This is the question that the Financial Times asked in an article after it was announced that it had paid a big price in terms of current valuations for Nest, which is headed by Tony Fadell, a critical developer of the iPod for Apple. The firm produces devices that through iPhones or other hand-held devices can remotely control temperature and other elements in a distant home. His pitch is that he wants to re-imagine and reinvent the unloved products we all have. I have no idea whether his work will ever produce earnings per share for Google, but it is not a dumb company and clearly Google has views about the future. However, they need (to quote a line from “My Fair Lady”) a little bit of luck.

Getting lucky

“Getting Lucky” is the title of Oaktree Capital Chairman Howard Marks’ latest thoughtful letter. In his memo he decries those successful people that do not recognize the elements of luck that contributed to their success. He shares with us the elements of luck that contributed to his and Oaktree’s enormous success in the credit and bond funds. He focuses on the accident of meeting people born in approximately the same year that happen to work in the same large company or become close just because they were in college together. He gives a number of good examples in terms of his life, and those of Bill Gates and Joe Flom.  Howard suggests that successful investors succeed more often than not when their expectations work out or as he says, “performance is what happens when events collide with an existing portfolio.”  Luck has a great deal to do with timing, as Marks quotes an old adage, “being too far ahead of your time is indistinguishable from being wrong.” (I will be happy to send my marked up copy of his letter to any of my subscribers.)

Will either Michael Oh’s fund or Google will produce good future results in a timely fashion? I do not know. What I do know is that they are both looking for a bigger pie that will be different than the present one. I also believe that this kind of thinking is an appropriate part of sound long-term portfolios.

What do you think?

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A. Michael Lipper, C.F.A.,
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Sunday, January 12, 2014

Watch Energy and Guns on the Trip to the Peak


Unlike drones and more like electrocardiogram plots, investments rarely go in straight lines but undulate; frequently reversing directions which is normal.  As has been stated in my past posts, I believe that our current journey will take us to peak equity prices. Unlike Irving Fisher’s comment in 1929, I do not believe that when we reach the peak in the future that we will achieve a permanent price plateau. After the peak, there will be a measurable decline whose fall will in part be a function as to how extended the rise is above a reasonable value base. Beyond the decline we will also have future rises to other peaks.

This seesaw pattern is why I am a firm believer in subdividing one’s portfolio into time horizon and perhaps other components to protect the ability to accomplish the majority of one’s investment goals.


No two market cycles behave exactly alike. Nevertheless, there are a number of indicators that I watch and compare with previous cycles. One of the best contrarian indicators is bond prices. A decline in bond prices is caused by the current owners not wanting to own their existing merchandise and/or refusing to buy newly offered bonds. This will lead to the need for higher yields both for the existing and new offerings. The year 2013 was the first in many that prices of bonds and the performance of bond mutual funds declined, which in turn led to bond fund redemptions. When stock prices drop some of their owners may flee the fall and buy into bonds and bond mutual funds. This is not happening now.

A second important indicator is commodity prices. At any given moment the quantity of a commodity in the hands of buyers and sellers available for immediate shipment including movements from or to warehouses fluctuates. New production from newly planted crops, new mines, and new refinery and smelting capacities will not be available immediately. Rarely will new supply come to market at prices lower than current prices. Thus, falling commodity prices are both a sign of reduced demand and expectations. These lowered expectations, along with regulatory changes, are the reasons why major Wall Street brokerage firms are exiting the commodity brokerage and dealing businesses. (This reduction in commodity capacity at some point will lead to shortages and strong commodity prices but not now.)

A third current indicator and a very volatile one is the level of stock trading. The folk law of “The Street” is that as the first trading week predicts January activity which in turn is a good, but not perfect guide for the year. The thinking behind these views used to be based on when Wall Street bonuses were paid out, but in a more modern era of a shrinking financial community, the new flows are expected to come from defined benefit and defined contribution retirement funds which would have just received their cash contributions. For whatever reason, including weather or market volume, this last week was lackluster and most prices moved very little. Some of this sleepy behavior could be attributed to a strong December and a way-above-expectations 2013. On a purely technical basis the ratio of shares sold short to the average trading volume theoretically generates the number of trading days that would be needed for the shorts to purchase enough stock to cancel out their short position. With the NASDAQ market producing much better returns than the other organized markets, some shorting, hedging, or tax management activities were done in December. This year the short ratio of the number of trading days needed to cover declined approximately 21% from the prior month to 3.79 days. This has the potential impact of fewer shares being needed to cover and therefore less demand.


One of the many blessings I have is that I know a number of very thoughtful and accomplished people. Some of them share their views in writing with others. Two in particular have said or written pieces of particular interest at this time. Jason Zweig in The Wall Street Journal (subscription may be required) suggested that we were not in a bubble. He described a bubble as similar to the South Sea Bubble of 1720 based on the presumed ability to become the principal trading partner between Europe and the New World. This is the bubble that sucked in, as prior posts have mentioned, Sir Isaac Newton. In the bubble some investors temporarily made ten times their initial purchase in the unlikely event that they got in early and sold at the top quickly.  I agree that I do not see a bubble on today’s scene, but this does not reduce the risk of an eventual meaningful decline.

The second sage that I (and a lot of others) pay attention to is Byron Wien. Each year for many years he comes up with a list of ten possible surprises. While these are clearly not meant to be viewed as predictions, he believes that his surprises have better than a 50% chance of occurring while other people would not give them more than a 33% chance. A good example is his prediction that the price of West Texas Intermediate crude would exceed $110 a barrel. He is correct that others would find this to be a surprise. A recent panel of investment “experts” were almost unanimous with predictions of $80-90. All of these people are more expert than I on the price of oil and energy in general. However, in the search to find sources of capital to invest it has occurred to me that large portions of capital invested in energy are good sources for re-circulating capital.

The energy trap

As global GDP grows there is little question that the use of energy will grow with (it if not ahead), as people become greater users of energy as they get wealthier. Therefore I do not doubt the long-term demand side of the equation. What I am doing is to raise the question of excess supply and flat to falling prices. There is no question as to the increase in US production benefiting from horizontal drilling for oil and gas. Hardly a day goes by that the US or other countries’ claims of large reservoirs of gas are being published. The costs to develop all of this production are very large. For political reasons almost every government is adding to the operating costs structure. One of the better global investment managers that I know is a great believer in the capital cycle which in its essence is that building too much capacity too quickly will lead to lower prices. I raise this concern as a potential problem for those with large energy holdings on a longer-term basis.

In my model if you have at least three time horizon components to your portfolio, I would:

  1. Utilize rising prices this year to reduce some of my equity commitment for your shortest-term portfolio.
  2. For the intermediate portfolio I would recognize the cyclical nature of the market and be upgrading the quality of my holdings in both the stock and bond elements. You will suffer less when the decline hits.
  3. For the truly long-term portion I would keep focused on likely future markets when you intend to convert your securities holdings to spending requirements.

Guns can shoot down asset allocation.

The past year has been difficult for many who practice the art of asset allocation. For those who use domestic and international equities and debt, plus commodities, real estate, venture capital and private equity there were too many negative or single digit returns, particularly if these investments were housed in a hedge fund or a fund of hedge funds. Smart asset allocation works well if a patient investor will allow the various cycles to work out to the advantage of a long-term relationship. However, I fear the normal cycles will be interrupted.

President Ronald Reagan noted that every war that the US got into happened when others presumed the US was weak and lacked political will. The black flags flying over Ramadi and Fallujah, two cities in Iraq that US Marines and others fought hard for and managed well for the inhabitants is the latest instance of weak US reaction to a significant threat to the World. Syria and Libya are other elements of concern. As an accidental offset, Iran may become somewhat less of a problem as it may fear that it is being surrounded by battle-trained Sunni warriors. Russia, China, and a good bit of Europe and Africa may become unstable due to these conflicts and our collective lack of response.

Perhaps, some additional reserves are warranted in our investment portfolios. What do you think? 
Did you miss Mike Lipper’s Blog last week?  Click here to read.

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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.