Sunday, June 8, 2014

Horses for Courses and Thoughts for Two of Four Time-Span Portfolios


I believe whatever my analytical skills are, they got started at the New York racetracks. Thus for years the first Saturday in June was very important to me, even more important than the Chartered Financial Analyst (CFA) exam usually given on that same day.

The Belmont Stakes day is the single most important US thoroughbred race day in determining the future breeding fees for young stallions and in rare cases, mares. At a mile and half which is the longest race for three year-old horses, the winner is usually accorded the title of Best Three Year-old or even Horse of the Year in America. This year the question for the sports-oriented public was whether we would finally have a new Triple Crown winner after 36 years. The answer was no.

Linking these thoughts to what I currently do for a living which is picking the best fund accounts for my clients and other responsibilities, I have learned that it is wise to diversify my bets. I have never found a portfolio that could be the best in each and every time period and change of market conditions. With good horses and good managers there appears to be a finite season for successes; this is what prompted me to use “Horses for Courses” as the title for this post.

One of the questions facing investors every day is whether we are entering a new season or a new track and whether we can extrapolate from past performance records. The majority of the money bet on the Belmont Stakes was attempting to leverage the previous racing success of California Chrome and willing to accept low financial returns if this remarkable horse won. In this case it was not a wining bet and perhaps not even a smart one. Our job is to make smart bets that occasionally win enough to meet various investment needs.

Time Span Fund Portfolios-a recap
  1. An Operating Portfolio is for immediate needs.
  2. A Replenishment Portfolio is designed to produce the required funding after operational funding has been spent.
  3. A Legacy Portfolio is designed to meet needs for those currently alive and/or beyond current management.
  4. The Endowment Portfolio is for beyond our own lifetime and for future generations.

Replenishment Portfolio concerns

As regular subscribers to these posts have learned I am concerned about a parabolic rise in market prices followed by a major decline. While there are some early signs of a peak, we have not yet experienced the heady experience of excited enthusiasm which characterizes the run-up to an extended peak. However, each week I see some signs that make me nervous. The latest is work done by Morgan Stanley*. In this piece the strategist does not see great parallels with past cycles. He postulates that we have entered a "no cycle" phase. His argument is based on comparisons with general economic data. To me he does not focus on the real causes for cycles which are human behavior that goes to extreme excesses from time to time. I see no evidence that we have changed people's behavior.
*Owned by me personally and/or by the private fund I manage

I am reminded that just before the 1929 crash (the real one) a learned economist and market guru said that we had reached a new plateau and in effect there would be no declines. If the recent Morgan Stanley view gets general acceptance I would be worried.

Lessons from history

One of the ways to study history is to identify the underlying causes from wars and other various tragedies. In the case of the First World War it was the assassination of the Archduke Franz Ferdinand and his wife. If my memory is correct one of the immediate causes of the 1987 market break was the inability of a United Airlines labor/management group to be able to use the airline’s gates at O'Hare Airport as collateral to support a buyout. I wonder if the extra large short positions in US Treasuries, copper, West Texas Intermediate (WTI) crude oil and Canadian dollars are issues of collateral for major traders including some hedge funds? Therefore the rumor or the reality of major bank having a new source of loan problems could prove to be quite disruptive.

The Replenishment Portfolio

For the management of the replenishment portfolio which normally has a five year time horizon perhaps the well known view about a glass that is partially filled could be useful. If the liquid is champagne, in addition to its level there will be bubbles, mostly small. The argument will be whether the glass is half full or half empty and as usual the focus will be immediate. I suggest that over time the level will decline due to evaporation. Over the next five years the odds increase that my concerns about a major market break could occur.  Thus these interim portfolios should be sensitive to any signs of market disruptions.

The Endowment Portfolio

In previous posts I have suggested that an important part of this portfolio class be invested in disruptive companies. A long-term subscriber asked whether this was just a collection of opportunistic investments. Not in my mind; the key to opportunistic investing is entering at a particularly attractive price at a good time. In contrast the investments that I believe should be in these portfolios will be companies that will profitably benefit from important if not major changes to the global economy. These will not be evolutionary or innovative changes. They will introduce radically different ways of thinking similar to the impacts of cell phones, sulphur drugs and steam engines.
In The Wall Street Journal, Jason Zweig discusses James Anderson, a successful portfolio manager for Vanguard and Baillie Gifford. As indicated in the article he is attempting to put together a portfolio, possibly for the next one hundred years, of technologically elite companies and similar leaders which have been recognized and currently sell at high valuations.  Anderson believes great innovative companies will continue to be great and innovative. While some of these well known stocks might be represented in my preferred fund portfolio, there will be other names of smaller, perhaps tiny companies.

Why I disagree

There are three reasons for my departure from the views reported above. The first reason is based on a discussion in Nantucket with Dr. Phil Neches who has three degrees from Caltech and is a fellow Trustee with me. Phil's commercial experience has been in disruptive companies as a founder, chief technical/scientific officer and venture capitalist. In Phil’s opinion, with rare exception disruptive companies can maintain their ability to be disruptive for only two generations. This view makes sense to me as an investor. Thus there will be a need to prune the portfolio of what our British friends call "the worthies."

The second reason is that disruption from start-up to commercial viability usually takes time. During this gestation period the market usually does not put high valuations on these companies, which gives the knowledgeable investor a chance for a relative bargain.

The third reason is that all company investments run the risk that successive managements do what turns out to be dumb things. Thus, even long-term, future-oriented portfolios should not follow a complete buy and hold strategy. I like to see understandable selling.

Which time spans concern you most?


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