Interaction of My Investment Muses

George Washington, Benjamin Franklin, Ben Graham, Sir John Templeton, Warren Buffett, Jason Zweig

Introduction

Almost every year on the Saturday evening nearest to February 22nd my wife, Ruth and I attend the birthday dinner celebration for George Washington, the first and greatest US president.  At each George Washington's Birthday celebration The Mount Vernon Ladies Association^*  presents a thought-provoking after dinner speaker. This year's speaker was Walter Isaacson, the scholarly author and biographer of great Americans from Benjamin Franklin to Steve Jobs.  He is also the current president of the Aspen Institute, whose summer sessions I have attended.   His talk at Mt. Vernon focused on the comparison, contrast and coordination of George Washington and Ben Franklin.

*Ruth is a long time member of the Life Guards, a support group for Mount Vernon.

We all react to various inputs into our daily lives through many filters, but often through the singular vision which guides our intellectual actions. For my sins, I tend to think about my roles as a fiduciary investment advisor and investor in mutual funds and similar vehicles as well as an investor in selected financial services stocks.  My reactions to the Mt. Vernon dinner speech are within this context.

While Mr. Isaacson's talk was about these two great Americans' political evolution from different starting points, I could not avoid thinking about the inputs these two successful leaders and entrepreneurs would have on my portfolio management and investment challenges of today. Think about the character of George Washington, the military leader and major farm landowner, who was willing to face unknowns against long odds of success in his search for his own and his country's growth. In contrast was Ben Franklin the poor boy who looked for inexpensive strategic investment at bargain prices. While Dr. Franklin's successful commercial ventures focused on his editorial and business skills as a publisher, too little attention is paid to his initiation of a colonial postal system where mail could go from Massachusetts to Virginia directly rather than being routed first through London. In effect this postal system became the glue that allowed the separate and fractious colonies to begin to evolve into a somewhat unified country.

Washington: growth, Franklin: value

Intellectually through my narrow eyes I perceive George Washington as our first growth focused investor leader and Ben Franklin as our first innovative value seeker. These were the progenitors in the more modern world of Warren Buffett and Charlie Munger as future focused "growth" investors (both of whom I am looking forward to hearing at their Berkshire Hathaway^** annual meeting this year)  and Ben Graham and Sir John Templeton as valued-focused investors.

** Securities that I either own or are in the financial services fund that I manage or both.

Picking winners

Long time readers of these posts and my book Money Wise have learned that I was first educated about security analysis by handicapping (analyzing) at the race track. The key to regularly coming away from the track as a winner was first to avoid losers by not having a betting interest in every race and being highly selective in betting on the difference between the probabilities and the odds dictated by the weight of other people's money. I try to apply the same general approaches to selecting funds for portfolios of funds and individual investment management stocks. These processes are very different than reading the standard Request For Proposal (RFP) that is a highly quantitatively driven search filter for institutional management mandates. These documents’ authors believe that they are dealing with commoditized skill sets that can easily be selected quantitatively. Going back to my racetrack education I recognize that this approach leads to backing favorites. A study of past betting results (past performance) reveals that favorites win a minority of the time and when they do the returns are low and usually can not meaningfully offset the losses when the favorites don't win.

To me successful selection is much more an art form than a science. The art form has to do with understanding the way particular people work successfully in competition and combination with other skilled players. Thus to me the key skills of selection are more akin to the brilliant curators of museums than mathematical screeners. The great curators mix some of the talents of George Washington and Warren Buffett looking for growth beyond the present and the two Bens (Franklin and Graham) innovative bargain purchasers.

Understanding the development process

In general, most equity portfolio managers start as security analysts, as I did. Many fixed income managers start off on a trading desk. Why is it that there are considerably more analysts and traders than institutional portfolio managers? Is it the normal pyramid of responsibilities and related compensation within institutional management organizations? Yes, that is one factor, but not the only one. Good analysts and traders, those with winning records of selections are absorbed in their focus on essential details of particular investments in the current time frame. But this kind of highly competitive knowledge is not enough to make good  portfolio managers. The big hurdle that these bright people need to get over is similar to the selectors using RFPs to pick managers. A collection of securities having very similar characteristics is like a symphony orchestra that can all hit the equivalent of high Cs, or a museum that shows only all the artwork of an artist produced in a single year of his or her development. The risk in such a collection is the likely homogeneity of results when impacted by the unknowns that occur.

George Washington thrived on dealing with the unknowns that others did not perceive. A sound portfolio can survive and prosper often under a number of different conditions including the unexpected. This requires moving away from the comfort zone of intense knowledge into the spheres of the less known. Many analysts and traders can't comfortably make the jump. Just combining securities of different natures is not good enough, portfolio managers need to have an effective knowledge of  trading desks. They need to understand what kind of trading orders their traders can execute well, including the difficult trades. Often the trading desk is the first source of the recognition that something is happening in a particular security, sector, or market. I view traders as an important source of market intelligence. Apparently false rumors which could be true are often as important to the future as facts that turn out to be true.

Additional concerns of portfolio managers

A working knowledge of compliance is a necessary set of skills for today’s portfolio manager. Many smart and essentially honest analysts, traders and portfolio managers stray over the somewhat indistinct lines of their actions. Often in their mind obligations to clients lead them to inadvertently breech a compliance barrier which can prove to be expensive for all concerned. Another skill in the real world is to manage the portfolio to fulfill its marketing position. This is what the customer expects. Often part of the commercial responsibilities of a successful portfolio manager is to become a spokesperson for the particular product or the firm.  Some senior portfolio managers move up their corporate ladders and become a managing executive with responsibility for managing people, including difficult people like themselves. Most are unprepared for this by their formal education or by the Chartered Financial Analyst (CFA) readings and exams. Every now and then former analysts that I have known move up through their organizations and become CEOs of their firms, including some which are publicly traded. As one moves up in this world the track record becomes muddied by other people's actions and so selection of which firm to invest with does not lend itself to statistical sorting.

Selection by DNA

My friend Jason Zweig has a thought-provoking piece in Saturday's Wall Street Journal, questioning how DNA or more accurately, the critical life experiences of our parents, shape our investment thinking. He points out that Ben Graham’s mother was "wiped out" by unwise speculation in 1907, and a somewhat similar experience by John Templeton's father shaped both of their investment practices. Graham and Templeton first looked at the downsides and then for bargains. Sir John carried his management process by wide diversification across national borders.

What did I learn about myself from this article? I am driven to attempt to protect my family, including future generations, from an historical pattern where eventually the spenders in the family overcome the earners and investments suffer. I am not just thinking in terms of securities investments, but also life investments of time, money, and a lot of effort into life activities that are neither personally rewarding nor benefit a larger group. This has lead me into attempting to set up some controls to protect members of my family from wasting their opportunities.  

Please share with me confidentially what investment DNA you think is driving your current investments.

_____________________     

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Next Rise Needed for Peak

Introduction

Last week's post hinted that this week I would discuss where are we on the track to a major peak, an issue that I have been concerned about for some time. History suggests that those who use a crystal ball to predict the future are often forced to eat crushed glass. I certainly doubt most people's ability to predict the future with any accuracy. I do not claim any special powers or intelligence. What I do believe is useful is to cogitate about what can happen in the future that is not a mere extrapolation of a current trend.

Fear of loss of opportunity

The way people write about the large losses suffered from major declines is wrong or at best incomplete. There are two missing pieces. The first is what families talk about in terms of foreclosed leveraged loans which transfers property; i.e., the family farm or business. For me the second loss (which is both more difficult to measure and much more important in the end) is the loss of opportunity to make very cheap purchases of property, businesses, and securities. Based on the past, purchases made in distressed periods have yielded capital appreciation of three to one hundred times original capital. Throughout recorded history, burnt investors, often hurt by intellectual or legal frauds swear “never again.” They won't believe in any positive view of the future. We are already seeing investors, particularly younger investors, pulling back.  With this so-called risk revulsion as a prospect, I am focused on a track to be wary of the next market peak.


Watch for these signs

A sharp, narrowly focused big rally that will dramatically change the individual participation in the market is almost a requirement for a generational peak. Peaks need to suck in all or almost all available capital. They do this on the basis that despite an immediate strong upsurge, that further large price gains are a certainty. We have not yet had this precursor, but we could be setting it up starting with this week.

After 205 trading days without as much as a 5% general correction, we did get one by early February. This last week saw a  relatively low volume rally that regained almost all of the decline. The gain in the week was impressive. Perhaps impressive enough for people to extrapolate that 2014 could produce the kinds of remarkable gains that 2013 did. (Our own private financial services fund, as did some others approximately, produced a 40% gross gain. We have warned our holders that this type of gain is not expected to be repeated again in the near future.)

Volatility and dispersion

How could we put up some spectacular numbers that would excite people to override their natural caution? The answer is in two technical market words, volatility and dispersion. The mathematical definition of volatility deals with the amount of price movement that is different than some trend line. The popular press tends to only refer to volatility on the downside. The kind of exciting upside market price movement that will need to occur to suck lots of money into the market will not be called volatility, but genius. What will cause this kind of movement? That will be dispersion. The market is moving away from the high correlation market that took almost all stock prices down five years ago. What is happening now is that the relatively little volume being transacted today is away from the large secure stocks even though one could make the case that large caps and their supposedly large liquidity is the safest place for institutional investors today who are conscious of the age of the current bull market run. We are seeing most of the volume being done in social media-related securities widely defined. (In some cases these are the re-birthed "TMT" names, technology, media and telecommunications.) Just contemplate that Apple^* has a market capitalization exceeding Exxon. Listen up at your next cocktail party when the conversation moves from "Bridgegate" to the stock market, count the number of times Apple, Google^*, Twitter, and Facebook  are brought up relative to Exxon. Then judge by looking  at the outer ring  around the conversation and guess what they will be buying and selling soon. One of the reasons individual stocks can skyrocket is an increasing number of insistent buyers are overwhelming the market with buy market orders not terribly concerned about their going-in price because the rewards will be so large.

This kind of action can, and to some degree is, happening in selected currency, commodity, and bond markets which are deemed to be professional arenas. These can be reinforcing a bullish stock market. Much has been written about the smaller than normal interest rate spread between high quality and high interest paying paper. One of the reasons Moody's^* went to a new high this week was the increase in high yield offerings expected in both the US and Europe, which will require credit ratings. And this is where the reinforcement to the equity market comes into the picture. Moody's recognizes that historically low expected default rates will make high yield (low quality) bonds more attractive for purchase. Whether these new bonds are part of a refinancing scheme that lowers interest rates and extends maturities or are totally new to the bond market, the mere successful offerings in the bond market tend to make the issuers’ stock price rise. (This kind of reaction has penalized high quality stock funds compared to those which invest in lower quality or marginal companies.)

^*Stocks owned by me personally, by the private financial services fund I manage, or both.

Haywire

Markets collapse not because of immediate economic conditions, but from rumors or news of unexpected occurrences; e.g., the assassination of the Archduke Franz Ferdinand that was the proximate cause of the beginning of World War I. Clearly I do not know what event will stampede the market decline after a meteoric rise. But I have a possible one to think about. The present Chinese dynasty is very conscious of collapses of prior dynasties; they also think in longer terms than most of the world's political leaders and even some far-sighted military leaders. China is building for periods way beyond  the current expected terms of office. They want to restore China's place in the world to be number one. Along the route a lot can go wrong unexpectedly. Some problem dealing with China in rumor or reality could be the equivalent of that relatively minor shot in the decaying days of the Austro-Hungarian Empire.

What are the sorts of unexpected things you think could cause some future collapse or you don't think there will ever again be a major collapse? Please let me know.

_____________________     

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 MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.