Sunday, March 30, 2014

Strategic vs. Tactical: Follow the Lines and Spots

Tactical value investing...Was last week a tipping point?...Possible oncoming worries...Mutual funds holders: is your asset allocation correct?...Correction to last week’s post.


Even to this day the academic world presents concepts on a black or white board or perhaps on a flat computer screen. Therefore in our minds’ eyes we tend to translate investment strategies in terms of continuous lines. We know that the objective is to end with more money than we started. Our experience quickly teaches us that there are many lines that can produce the desired result. In an oversimplification we contrast a perfect growth model that starts low and finishes at a peak. The line can be a perfect 45 degree slant or look like a hockey stick, flat to slightly down before an explosive burst that takes the line to its zenith. There are many variations of this plot, but we can label the group as growth oriented.

Tactical value investing

A second set of graphs are designed to produce the same result, but want to avoid the risks of falling off, at least temporarily, the growth curve. In this exercise there is a second discipline beyond finding securities that go up in price and that is the need to buy at a price spot that will rarely lead to a loss. This second approach achieves this goal by buying value at least in current terms and is called value investing. One might call it also tactical in the sense that timing is critical to successful entry points.

One of the advantages I have compared to most managers is that I can invest in what I think are currently the best Growth mutual funds and the best Value focused mutual funds. The key to this decision process for the client/investor is to get the appropriate time horizon correct in mixing the strategic Growth funds with the tactical Value funds. Read further and you will detect the questions that we deal with in attempting not only in getting our fund selection right, but also the right mix of Growth and Value. 

Was last week a possible tipping point?

Short-term performance is normally the equivalent of static on a poor radio device. However, every key turning point starts with a given day or week. Also individual funds can have a somewhat dramatically different short-term performance than their peers which would indicate that the outlier is doing something different. Thus, I am starting to question as to whether we have experienced a turning point. During the week, Value funds were off slightly less than 1%. Most Growth funds were down about 2.5% but Small Company Growth funds were down almost 4%. A couple of our very successful specific Growth fund holdings that were up 40-50% in 2013, declined in the range of 4-5% for the week. There could be individual corporate elements that caused these above-average declines or could it be for some reason certain investors were cashing in pieces of their Growth fund winnings, but leaving their Value focused holdings untouched?

Broadening the question to all equity funds, according to the Investment Company Institute (ICI) the net new cash inflow on a year-to-date basis through February was only $43 billion vs. $52 billion last year. Perhaps, more instructive is the weekly estimate from my old firm which estimates that the weekly net flow into equity mutual funds was $1.7 billion and the weekly outflow from Exchange Traded Fund (ETF) was $2.1 billion. In an oversimplification one might say the mutual fund buyers are long-term oriented riding up the curve of past incredibly good performance and the ETF sellers (often driven by brokers) were reacting to various news items. This dichotomy is also reflected in Friday’s flow of money into rising stock prices on the New York Stock Exchange (NYSE) of $2.2 billion compared to $0.9 billion in declining stock prices; whereas the more dealer oriented NASDAQ market was much more in balance with each side moving $1.3 billion.

If prices become negative this week we may have either seen a tipping point or we have just received some meaningless statistical static.

Oncoming worries

The job of a good analyst is to look beyond the headlines. The market will assess the current headlines, but analysts should look beyond. In brief, I am currently focused on three elements of the food picture. The first is that the preferred inflation statistic the government and the Fed look at strips the price of food and energy out of the consumer price indicator. While these can always be volatile, they usually stay within some bounds. Currently the price of food is skyrocketing, partly due to weather conditions, but I would suggest a continuing conversion of agricultural assets to other purposes. 

The rapidly increasing price of food is putting pressure on all families, but particularly on those with little or no income. Even with the big increase in the numbers of people utilizing food stamps, people are being squeezed. As bad as they are now, they could get worse. Most of us don’t realize where our food comes from and even if it comes from local sources, food prices move on global scales. 

One of the stories not being told about the situation in Ukraine is the plight of the farmers. Even before the hostilities many farmers there were heavily in debt to their suppliers of feed and other materials. Compounding the current problem is that under current conditions they have lost five different ports for their exports. Ukraine is one of the largest exporters of wheat and the odds are that they won’t be able to make deliveries to the normal customers. English translation: the price of wheat on our tables is likely to rise.

The third food related worry is predictions that there is a 50% chance of a series of repeated storms, some of these are known as “El Nino.” If these were to hit this would disrupt food production in India, China, and Latin America all of whom produce food for American and European tables.

Mutual fund holders: Is your asset allocation correct?

I have an allergic reaction to following the crowd. However, in general the way long-term mutual fund assets are allocated makes sense in terms of balancing growth opportunities and tactical value holdings. They have allocated approximately 69% of their long-term assets to equity funds and 27% of that total in consciously labeled Internationally oriented funds. The 69% is down from greater enthusiasm earlier and the international component is growing. I use the term ‘consciously labeled International’ as many so called domestic funds have up to 30% in non-US domiciled companies and some of the remainder are invested in multinational companies that through their foreign based operations and/or exports are serving non-American markets. I believe on a long-term basis this is wise as the relative future of our standard of living is likely to decline more due to greater education, work productivity, and savings than here. Our UK friends have recognized this for years and there are hardly any significant UK domiciled companies that are not globally focused. We are seeing the same characteristics in many European companies as well.

The 31% of mutual funds invested in fixed-income is a bit of a problem for me. There are two reasons to own fixed-income securities. The first is to generate necessary income that is not available from other investments. The second is as a strategic reserve if the equity portion falls dramatically. My problem is one of timing. At some point in the future the interest rate repression of the major global central banks will ease up and perhaps terminate. Interest rates will then rise to a level that recognizes both the deterioration of purchasing power of current money and appropriate payment from undertaking credit risk. At this point, if not before, bond prices will decline, damaging the strategic reserve value of fixed-income. Some fixed-income holders would be better off converting most if not all of their long-term fixed-income positions to well chosen dividend paying stocks and funds. If the current income is insufficient to meet current prudent expenditures, the law now recognizes that total return, including stock price appreciation is an appropriate source of income. Some bonds and other credit instruments that have equity-like characteristics, including risk of loss of capital, could be substituted for long-term high quality bonds as long as the investors recognize that the central banks have coerced them to take more risk.

Correction to last week’s post

There was an error in some editions of  last week’s post relating to my discussion of applying the “Rule of 72” to how long it would take to reduce by half (instead of all) the spending power of  principal amounts through the application of a 2% inflation rate. The correct answer is 36 years.  I thank the sharp reader in the UK who called this to my attention and I appreciate the notice of where I make a mistake of thought or proof-reading.  

Question of the Week: for you to ask yourself and perhaps share with me, so that we both can learn:

How are your assets allocated and where would you like them allocated at the end of the year and in five years?
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A. Michael Lipper, C.F.A.,
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Sunday, March 23, 2014

Inflation, the Biggest Sin Tax

Highlights: Sin Taxes, Lessons from the Cosmos, The Political Crutch,
The Enemy, How an Award Winning 401-K Invests During Inflation,
Other Currencies

Sin taxes

Governments have many problems but all have two in common. The first is that certain crimes appear to be endemic to their societies and don’t appear to be susceptible to inexpensive eradication. For example we know there are enormous social costs due to chronic losses from gambling, and there are others as well. Many governments take the attitude that they can not stamp out these sins; however they can hurt them by imposing taxes on them. There is a na├»ve belief that if they raise the cost to participate that eventually the public will not indulge. This brings us to the governments’ second need which is a source of growing tax revenue, not to pay for the social costs of the crime, but to meet general government expenditures. Just look at the incredibly sharp increase in taxes on cigarettes and alcohol in our lifetime. The victims of these sins are often labeled addicts. Strange, we do not label governments as addicts, though they are addicted to sin tax revenues. By the way I believe by far the largest sin tax in terms of impacts on our societies is inflation.

Lessons from the cosmos

We may believe that inflation is a relatively new phenomenon from the time of the birth of coins and currencies. Evidence just revealed this week proves that Albert Einstein* was correct in suggesting that it was present in the original Big Bang Theory* at the creation of our universe. This week according to James Bock, a Caltech* physicist along with others using a telescope from the South Pole, found evidence of gravity (waves that Dr. Einstein, a century ago predicted would be found that were the direct result of the Big Bang that created our universe.) I will leave to others, more learned than me to explain the theory. For those of us that live in the world of numbers and taxes, the key to the discovery was the term used for the exponential growth of particles that became planets and other objects. That term was ‘inflation.’ Thus the term from the physical world describes a power that keeps growing.

* When he came to the US Albert Einstein spent some time at the California Institute of Technology (Caltech). I have stayed in the room/suite that was prepared for him to stay in the faculty club on campus. Princeton lured him away to teach in New Jersey, where we now live. His Big Bang Theory is used as a title for a current television comedy about very bright scientists adjusting to functioning in the everyday world. I will admit my good wife is addicted to watching both the original and re-runs of these hilarious shows. Many believe that Caltech graduates are the models for these characters. There is much amusement about the success of the program at Caltech board meetings that I attend.

The political crutch

I have read a number of constitutions from around the world, and in none of them have I found that the sacred duty of the government is to create jobs for the governed. Yet any government that wants to stay in power, whether elected or not, is at risk when people are out of work and there is general lack of sufficient food. The leaders of the government, rather than to solely rely on the underlying economy to produce sufficient income and jobs, believe that they must do it. In general, governments have two sets of financial tools, fiscal and monetary policies. Fiscal policies are those that set the level of taxes raised from the population. As most people do not want to give up some of their hard earned money to the government, raising net effective tax rates is generally not favored.

The second set of policies is monetary policies. These deal with the levels of loans made by the financial community and in its essence the value of money. There is a long history of the latter. A monetarist would point out the Roman Empire, like all great empires, did not fall to the hordes of barbarians. Rome fell because for many years the government was literally shaving some of the metal from its coinage money. In effect it was devaluing. The public was not dumb and realized that the value of the money declined and so they raised the prices for their goods, services, and labor. Rome fell because it could no longer be protected by the best, most expensive, military in the world. In the Middle Ages shaving coins was punishable by death. A government which is not popular, and few are, can either publicly raise taxes or more quietly devalue which creates inflation. All too many of today’s leaders are unwilling to pay for current and future government services through tax revenues and so resort to forms of inflation that the public does not fully comprehend.

Central Banks which are titularly responsible for monetary matters and in theory independent of political forces are in fact beholden to them. Because the political leaders can not obtain sufficient taxes they have the central banks induce inflation into the economy that they hope will stimulate individual and corporate savers to spend and invest that will create new jobs and incidentally lower the value of their debt repayments.

The enemy

In a closed society that is not expanding, the need for increased spending and investment is high. By definition the people that have the necessary money are the savers. These people are those that are choosing not to spend in order to provide for the future spending needs of themselves, their families, and worthwhile charities. By lowering the value of their savings by inflation, central banks are in effect stealing from these savers. Thus, the savers become the target to generate the future growth. If they don’t readily provide the necessary funds they become the enemy. 

The current policies of many central banks including those in US, UK, Europe, and Japan is to raise inflation to 2% or more to drive their economies. The theft comes in by understanding the long-term effects of inflation. The collapse of the Weimar Republic in Germany brought Hitler into power when their money was practically worthless. Many would say that can’t happen here. If successive central banks meet their goals of 2% or more inflation in one or two generations the entire wealth of the savers can be wiped out. (The rule of 72 shows the number of years it takes to double your money by dividing the current or expected interest rate into 72. The same calculation can be used in reverse to see how long it would take to lose half. Two divided into 72 suggests 36 years. For those of us responsible for long-term investing for endowments or multiple generations of families, 36 years is a short term when century-100 year bonds are being eagerly sought.) 

How an award winning 401(k) invests during inflation

There is no complete answer to creating an investment portfolio that can meet the needs for reasonable returns that is aware of the risks of inflation. We have addressed these needs in a 401(k) that BrightScope labeled as the best in the country in terms of many attributes including low costs  As the participants can not withdraw their money from this plan for ten years, the ten year performance numbers are relevant as a guide for long-term oriented accounts. Below is the annualized performance for ten years through the end of February of the nine options offered to the participants and their rank within the nine alternatives:
Rank/Category=Total Reinvested Return
1.    Small-Cap Core=9.23%
2.    Small-Cap Value=8.23%
3.    Index fund=7.89%
4.    Growth=7.76%
5.    Value=7.07%
6.    Balanced=6.71%
7.    International=6.27%
8.    Bond=4.73%
9.    Stable Value=3.10%

Do not fixate on the actual numbers which were influenced by numerous special circumstances. During this last ten years I have been very concerned that after-inflation returns were going to be important for all of our accounts to meet their spending needs beyond the financial world. To me the best overall way to do this was to assume more volatility and liquidity concerns by investing in smaller companies. In any given ten year period the actual returns will almost certainly be different as will probably those ranked between 3rd and 7th. As the end of this period was February the ranking of International was hurt by currency movements.

Believing that the US will not adequately address its inflation issue, which should be zero based, I believe on a relative basis the long-term value of the dollar will decline upon the leaders. Thus, at this point in time for long-term accounts I would be increasing exposure overseas even with the economic and credit risks in China. The Bond return of 4.73% includes significant investments in TIPS to provide some real return benefits from owning bonds. Because I expect interest rates to rise the total reinvested return in bond funds in a cash flow account will enjoy higher rates that can offset some lower bond prices. Stable value returns over time should equate to the inflation rate.

Are there other long-term oriented 401(k)s with which we should be speaking?

Other currencies

The way we invest into non-US dollar currencies is through funds that have equity and debt positions in selected currencies. With the US dollar being the temporary safe currency it has appreciated against other currencies. This means that the other currencies have lost value relative to the greenback.  Liking to buy when things are down, I am attracted to investments in sound Canadian companies. The relatively newly appointed head of the Indian Reserve bank appears to me he could be making India’s securities more attractive by raising interest rates as some investors may want to diversify out of some of their direct holdings in China. Along the same line of thinking, the Taiwanese dollar could be of interest.

My question for all of us is: How are we going to hedge our inflation risk ahead of inflation manipulation replacing interest rate manipulation?

Please share your thoughts.  
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Sunday, March 16, 2014

Opportunities Gained Through Losses for Some

I.            The Best 401(k) and New Opportunities 
II.          Seth Klarman’s Warning and Permanent Losses  
III.       ISEEE White Paper on Emerging Companies


This last week a number of things have occurred that will intrude on my work in the next several weeks.

Regular readers of these posts have learned that there are two related themes to my investment thinking. I am very wary of a future peak leading to a major stock price decline and I am impressed with the value of time horizon portfolios.  

One rarely appreciates the advantages or disadvantages that accrue to individuals based on the time they enter their first professional jobs. I began my first professional investment job in 1960 as a junior analyst/trainee. I was part of the second wave of young people to enter the business in a long time. Some others entered Wall Street about 1955. Each of the phalanxes moved up the ladders very quickly to replace the managers that were scarred by the tales of the Great Depression. Many of these managers (and more importantly, their clients) were extremely afraid that the post-World War II boom was about to end and therefore were reluctant to buy stocks in the early 1960s. Their clients found them to be wrong by 1968 if not earlier, and allowed us relatively unseasoned analysts and portfolio managers an opportunity to make important investment decisions. Out of these experiences I became conscious that the larger losses suffered because of the collapse of stock prices in the 1929-1932 market were not the dollar losses sustained. A much larger loss that many investors and their heirs suffered was caused by former investors or their friends and relatives neglecting to reinvest into the stock market. They lost huge opportunities to make a great deal of money.

Ever since that recognition I have been focused on not making that mistake for myself and clients. This is exactly why I believe in creating investment portfolios structured to meet needs for different times. I have little confidence in my and most others ability to make correct risk on/risk off decisions.

The #1 401(k)  - Our client 

For many Americans a large part of retirement savings is in their 401(k) salary savings plans sponsored by their employers. From my point of view as a manager and consultant to a number of these plans they should be invested for the long-term, utilizing my time horizon approach.

Each year BrightScope creates a list of the best 401(k) plans. This year they named the Second Career Savings Plan of the National Football League (and the NFL Players Association) as the number one in the country. Numerous factors were considered including total fees charged. Because of participant choice they did not measure aggregate performance. I can clearly state that investment performance was good as does the plan sponsor. This has been satisfying to all who have been involved.  I wish them well in the future. After twenty years of working with the plan,  I have elected to pursue other opportunities utilizing our expertise and efforts. They should do well due to the generous employer contribution and the structure and administration of the plan.

Seth Klarman’s warnings and permanent losses

Seth Klarman is a well known hedge fund manager that is used by some of the non-profits whose investment committees I sit. He has sent back cash to investors (rather than investing it), so his latest letter as published by John Mauldin is not a complete surprise. Let me summarize his points as follows:

Most investors are downplaying risk and this never turns out well.
Maybe not today or tomorrow, but someday a collapse may occur.
The pain of investment loss is considerably more unpleasant than the pleasure from any gain.
Correlations will be extremely high.
Investors in bear markets are always tested and retested.

Analytically, I agree with Mr. Klarman’s cautions, but I do want to put them into perspective. For those accounts that have long-term needs beyond ten years, I would be reluctant to place less than 50% of the value of the portfolio in risk-assuming investments. I do recognize that in periodic down markets the major stock market indices can decline 50%. The decline from the peak in 2007 to the bottom in 2009 was 57%, with many good managers losing more. The recovery since the bottom has more than made up from the loss and then some additional gains, often more than 50%, above the former peak.

What to do?

Along with most professional investors, I do not posses the market timing skills of Mr. Klarman and a handful of others. Nevertheless, I am conscious of his warnings. Thus, recently I cut back on two of the largest and quite profitable stocks in my private financial services fund. Also I am reducing some of the positions in Small Cap funds in our managed fund account portfolios after they have performed very well and have no or little cash reserves. These moves will not be sufficient if I am totally surprised when the next major decline happens. I am, perhaps foolishly, expecting a more speculative rise before the peak is reached. There are two clear parameters to my thinking. The first is to get prepared for a decline and the second is not to get too long-term bearish as to flee from taking risks for long-term gains opportunities.

ISEEE white paper and emerging companies

There is a very healthy tendency of people in the global financial community to meet and discuss, often heatedly, their views as to the investment future. I belong to a couple of these and learn to appreciate from other professionals’ experiences. One of the groups I recently joined is the International Stock Exchange Executives Emeriti (ISEEE). This is a group of present and former senior stock exchange officials from around the world that meet periodically. Evidently my term of office as the Chair of one of the advisory committees to the board of the New York Stock Exchange qualifies me for membership. For a number of years the group has been concerned about the general inability of emerging companies to get adequate financing in most of the world’s markets. 

Next month at the ISEEE conference at the Museum of American Finance* in New York (one of their conferences around the world) the topic will again be discussed. I have been asked to prepare a brief white paper on my concerns for losses while investing in emerging companies. There is no doubt that there will be some outstanding successes where capital will be multiplied numerous times. On the other hand, it is almost axiomatic that there will be loses sustained by inexperienced investors.

I don’t know that large losses can be prevented, but there are two concepts I am going to try and develop. The first is that various restrictions  caused by the regulators and case law should be modified to present more information about future plans and greater discussions as to the specific market opportunities and threats the company is likely to be exposed. The UK polices are more helpful than those in the US. A second proposal that also surfaced (to the best of my knowledge in some UK reports) is that each emerging company offering needs to require at least one or more institutional investors, with perhaps a required carve out of 10% of the offering. I have some other ideas that I might include.
I find it a bit ironic that for this conference I will be sitting in the old banking halls at 48 Wall Street, the former home of the Bank of New York, my first professional job after leaving the US Marine Corps.

I solicit the readers of this post to share their thoughts as to how we can protect investors from losses but still encourage them to be lifelong investors.

* I am a trustee of the Museum of American Finance
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.