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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