Introduction
All too often we unconsciously use arbitrage selection. We compare a
given result against a perceived standard. This often leads to ranking against
the standard. A classic old gag is an example of comparison. A man is asked how
his wife is, he replies, “Compared to what?” In the same light I would suggest
that it is equally wrong to confuse performance ranking with successful
investing. One should invest as a process to produce income and capital to meet
a spending goal. However, the real measure of successful investing is how the
investor feels about the result. Feeling good about the result is an unwritten,
but very important, psychological goal.
Switching the measurement device
In the United States this week the College Board announced that is making
substantial changes to its Scholastic Aptitude Test (SAT) used by increasingly
fewer colleges in their admittance process.
There were spoken, and I believe unspoken, reasons for the change. The
most obvious reason is that the SAT exam is losing market share to a more knowledge-focused
ACT exam (a competitor to the College Board). To some extent these exams are
used, I believe, incorrectly in making selections. Having sat on two university
Boards of Trustees I am under the impression that high school grades modified
by a view on the academic rigor of the secondary school is a much better
predictor of a student’s ability to handle college level work. A similar level
of higher analysis is more useful in making decisions as to selection of
investment managers or funds.
Finding the correct context for successful selection
Investing is both an art form and a competitive sport. The art form
attempts to use, within constraints, creativity to produce periodic investment
results. Too often these are expressed in terms of the latest quarter, latest 12
months, five years, ten years in addition to "since inception." (Please note that I
excluded 3 years, which statistically is the single worst period for future
extrapolation, but loved by consultants who can earn their fees by replacing a
manager on the basis of poor three year performance just before the market
changes and the manager looks much better.) The competitive sport comes in to
see how well a fund does versus others which are operating under the same or
similar constraints.
The misunderstood constraints
Often liquidity management is the most severe constraint. Some of the
elements of the constraint matrix are possible abrupt changes in cash flows.
The impact of these changes can determine the need to maintain a
minimum cash balance at all times, to size positions relative to their average (or extreme)
market volume, and minimum number of holdings.
Another set of constraints has to do with the quality of the
management, market share, and balance sheet strength. Some managers can use
IPOs, even if they own them for a very few days. Other managers can use private
placements. None of these constraints apply to the popular stock and bond
averages. Thus they are inappropriate as investment measurement devices even
though they are used by their publishers and others in the media business. The
Exchange Traded Funds (ETF) who try to mirror the indices are also not an
appropriate investment vehicle because they lack the flexibility and fiduciary
responsibility that are imposed on active managers.
Two filters for successful investing
The
first filter has to do with a non-profit institution, a personal fiduciary, or
an individual when it comes time to authorize spending to meet the goals of the
account. Clearly any time one withdraws money from an account one is reducing
the capital to make more money in the future. As the exchequer, you should
psychologically feel positive about the goals of the money. If the withdrawal
is less than the total, one should feel good about the ability with the
remaining money to meet future planned goals and recognize the courage of
spending over investing when warranted.
Before you feel too good about yourself, I was struck by a quote in the weekend edition of The Wall Street Journal. The quote was, “The first principle is that you must not fool yourself…and you are the easiest person to fool.” The source of this quote was Richard Feynman, a Nobel Prize winner, and a famed professor at Caltech who provided critical work for the Manhattan Project (Atomic Bomb). I appreciate his wisdom for itself and because of an affiliation to Caltech where I am a current Trustee and as graduate of Columbia University where the initial work on the Manhattan project was conducted. The purpose of utilizing the quote is a warning that it is easy to fool ourselves, particularly in the roles of a fiduciary. This thought came to mind this week when I had to terminate a manager over the firm's surprise because it was celebrating that it was number one over five years in a particular category. My point was that is exactly when, as a fiduciary, one should leave the party. They can only go down on a relative basis from here.
Before you feel too good about yourself, I was struck by a quote in the weekend edition of The Wall Street Journal. The quote was, “The first principle is that you must not fool yourself…and you are the easiest person to fool.” The source of this quote was Richard Feynman, a Nobel Prize winner, and a famed professor at Caltech who provided critical work for the Manhattan Project (Atomic Bomb). I appreciate his wisdom for itself and because of an affiliation to Caltech where I am a current Trustee and as graduate of Columbia University where the initial work on the Manhattan project was conducted. The purpose of utilizing the quote is a warning that it is easy to fool ourselves, particularly in the roles of a fiduciary. This thought came to mind this week when I had to terminate a manager over the firm's surprise because it was celebrating that it was number one over five years in a particular category. My point was that is exactly when, as a fiduciary, one should leave the party. They can only go down on a relative basis from here.
Where are we now?
As regular readers of these posts know, I am wary of a forthcoming
major peak. Thus each day I scan for data points that would indicate that I am
premature in my concerns or add to my concerns. This week the roster of
insiders, mostly corporate officials and directors were heavy sellers of their
own stocks. The leading sellers came from the Health industries with sales of
$1,945, 467 and only $185,247 buys, or more 10 times greater sales than buys.
This was the case in all sectors.
Clearly many executives were selling their newly acquired shares received through stock options and had taxes to be paid. Nevertheless inside selling of significant size is not often viewed as a positive. This was happening with both the S&P 500 and the MSCI World indexes posting new highs. These new highs were driven by large capitalization stocks trying to catch up with the valuations afforded to the mid-cap and small-cap stocks. According to Standard & Poor’s, the average price/earnings ratio on large caps is 15.4 times, 18.55 x for mid caps, and 19.32 x for small caps. The lower P/E on large caps is mirrored by only a 12.76% gain expected in their operating earnings vs. 22.26% and 35.15% for the mid and smaller capitalization stocks.
Clearly many executives were selling their newly acquired shares received through stock options and had taxes to be paid. Nevertheless inside selling of significant size is not often viewed as a positive. This was happening with both the S&P 500 and the MSCI World indexes posting new highs. These new highs were driven by large capitalization stocks trying to catch up with the valuations afforded to the mid-cap and small-cap stocks. According to Standard & Poor’s, the average price/earnings ratio on large caps is 15.4 times, 18.55 x for mid caps, and 19.32 x for small caps. The lower P/E on large caps is mirrored by only a 12.76% gain expected in their operating earnings vs. 22.26% and 35.15% for the mid and smaller capitalization stocks.
Putting it all together
Others are sensing that at some future point we will see a major peak and a
subsequent decline, but not now. Speculation is growing using the surge in IPOs
as one gauge, but it has not gotten to the fever pitch which describes a top.
Nevertheless there is growing attraction into investing into large
capitalization stocks, not because they will grow faster than their smaller
compatriots, but because of the need for liquidity. We used to call some of
these stocks "warehouse" positions that would go up reasonably well with the
market, but provided large exits when needed. (That worked when there were
large amounts of capital on trading desks which could be compensated through
wide spreads and/or commissions. This is not the case today.)
Please tell me, how are you protecting your investments?
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A. Michael Lipper, C.F.A.,
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