Sunday, September 7, 2014

Six Probable Investment Mistakes


Recently I read a quote which said experience is what others call mistakes. As we are all humans, we make mistakes. Progress is made by learning from mistakes. Often when I meet with another investment manager who has had some completed mistakes I ask what he/she has learned. Some complain that they were lied to by various sources or that some major unforeseen forces occurred. I would invest with these types of managers only if I was convinced that the future would duplicate the past, an unlikely event. I am much more likely to invest with a successful manager that has had some mistakes and who has upgraded his/her processes to avoid similar mistakes in the future.

I believe that the job of good analysts is not to merely be detailed reporters, but to be looking for future changes or more likely, mistakes from which to benefit.

Our job should be to look into the shadows of oncoming events with reference to past shadows. Notice the focus on shadows when there is the absence of hard, clear facts.(Shadows have three elements-a candle or light source, an objective to be projected, and a reflection on one or more surfaces.) The size of the reflection can be measured, but it can not be understood without knowing the length between the light source and the object and the object to the reflection. The key is not to stop there but guess what is not visible in terms of the other sides of the lit up objective.) My self appointed task with this post is to look at what I believe to be the causes of future mistakes by extrapolating what is known.

The six mistakes that I will focus on are: 

1.    The KISS Principle 
2.    Static thinking in a Dynamic World 
3.    Elusive Liquidity 
4.    Masquerading Earnings 
5.    Non cash generated dividends 
6.    Comfort in Conformation

1.      The KISS Principal

Marketing people traditionally look for short “snappy” communications with prospects. These instructions to portfolio managers and analysts can be summed up as KISS – Keep It Simple, Stupid. Others prefer the “elevator pitch” which can encapsulate the salient pluses about a recommendation that takes no longer than the time the elevator travels from the lobby to the prospect’s office or in reverse if the client is going to be entertained outside of the office. While both have the virtue of brevity, they run the chance of failure to communicate the essential risk of disappointment which can come back to haunt the (sales) pitcher in court. Yes, we need to be able to transmit complex topics quickly, but with appropriate balance. All one needs to do is to ask someone or institution about a meaningful loss to learn the failure of a KISS statement or elevator pitch.

2.      “All Other Things Being Equal”

Often the way economics and/or finance are taught is by using a standard XY chart of supply and demand. Where the two slopes meet is the equilibrium price point. In a perfect world this might be accurate. But in a world where there are capable marketers and traders on each side plus other external impacts to a marketplace, transaction prices will be caused to shift. To do away with these unpleasant realities the presenter will state, “All other things being equal,” something explainable will happen. In truth we live in a dynamic world where factors are changing every moment and therefore we rarely get to the condition of all other things being equal. Static thinking rarely works in a dynamic world.  Wise investors today should expect conditions to be in a state of flux. Thus, we attempt to weigh the potential market or price power of buyers, sellers, and main changes of conditions.

3.      Elusive liquidity

Based on the fact that the average sized transaction on the New York Stock Exchange is 250 shares or less the ability to exit a market position at a reasonable price relative to the prior sale can be difficult. The “Silicon Traders,” actually the speedy computers in the hands of high frequency traders and others, have dried up the ability to safely move large blocks during normal markets. In periods of extreme price and volume movements the computers are driven to suspend current trading. To offset some of these risks HFT (High Frequency Traders) use stock futures. In so doing, they have forced the price of futures to rise to such a level that, according to BlackRock, many of the trading institutions are using ETFs (Exchange Traded Funds) as a cheaper substitute with assured execution. Rarely has the imbalance in ETF trading led to the spread between the bid and asked prices to widen so materially or in rare cases, suspend trading.

The bond market is a substantially larger market with many more discrete issues.  It faces a series of challenges to provide liquidity in an over-the-counter market dealing with panicked owners of both highly leveraged positions and stable owners of large bond holdings. With these concerns in mind I urge all investors to be conscious of significant bond market volume disruptions which could cause equity prices to gyrate. Liquidity can always be purchased, sometimes at a very high price.

4.      Masquerading earnings

The soothsayers trying to calm equity investors speak about valuations that are not out of line with their past histories. In the past most companies’ earnings came from domestic operations. Today’s earnings are increasingly being generated overseas and there is no recognition as to the increased taxes that would have to be paid if those corporate activities had to be brought back into the US. In some companies that sell products a good bit of earnings are coming from their net interest income for subsidizing their sales. At any rate these types of earning are not worth the same valuation as those coming from manufacturing and servicing clients. 

Today a measurable portion of earnings per share is a function of stock buybacks which lower the number of shares and therefore raising earnings per share, not a useful measure of growth and valuation on the growth achieved. Of the funds that we invest client money into we ask that they discuss with us the operating earnings production including their source. This leads to a general view on our part that valuations are moving beyond fair price, but not yet at historically full price.

5.      Non cash earnings-generated dividends

As with the rest of the investment world, some of our clients want dividend income even in this 2-3% environment. This is particularly true for our foundation clients who use the generated income to do the good deeds they do for those less fortunate. I have two concerns with this stream of income and its market value.

First, due to our out of touch corporate tax structure many companies are retaining their outside of US earnings overseas and borrowing to be able to pay domestic dividends. Their official payout ratios don’t look out of line on the surface, except if you look at my concerns expressed about reported earnings above. If domestic earnings do not improve and there are no tax changes, the cost of future dividends will become higher and could cause the rate of dividend growth to be curtailed at the very same time that recognized inflation goes up which will put a squeeze on our foundations' ability to deliver those important good deeds.

The second concern can be characterized by the fact that years ago one of the advantages of a good dividend paying stock was that its yield was in the neighborhood of high quality bonds and thus would lose materially less when stock prices went down. I expressed this theory to an elder, more experienced member of my family when a particular stock in question was yielding 5%. He smiled as he said that in all likelihood the 5% yielder could reasonably hold its value for a couple of days at best and after that would fall in line with other stocks of reasonable to high quality. He proved to be correct. Thus, the current 2-3% yielding stocks are not giving the foundations much in the way of downside protection. My current view is that these accounts should be managed on a total return basis and we should supply the needs from an Operating Portfolio (OPERPOR) part of our Lipper Time Span Fund Portfolio concept.

6.      Comfort in conformation

Jason Zweig in an always interesting weekend column in The Wall Street Journal noted that humans tend to be more comfortable conforming to what other humans are doing. This probably comes from our prehistoric needs to gather for self defense. From an investment standpoint the history of attempting to hug the middle of the movement can be less satisfying and at times expensive. As a graduate of a US Marines Corps Basic Officers School I observed that bunched up troops were good targets for the enemy, thus the need often to move in single file as we progressed.

Actually I started adopting this principle when I was one of the worst fencers on the Columbia College championship fencing team. When I had lunch with the current fencing coach last week, I observed that when fencing a better athlete who was classically trained, I could score points with unconventional tactics.  I was pleased to learn that the current coach got a gold metal in the Junior Olympics following a similar pattern. I firmly believe that there are times when it pays to be unconventional. This may be the time for you to be unconventional, as many investments are correlating closely so that they are on parallel courses which do not give investors much in the way of protection against reversals. Bottom line: When too many are participating someone is likely to get hurt. Some well chosen and well timed unconventional moves could be the most prudent of all strategies.

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