I have a belief that for the moment we are in a melt up phase which is short of the type of parabolic explosion that signifies a generational top. Further, I believe that in general we have moved from a fairly valued stock market and are on the way toward a fully valued market. Thus, I have been focusing on reducing the opportunities to take large risks of losing substantial capital. I have not, however, devoted as much space in these posts to all the different types of risks there are out there. The quotable Howard Marks of Oaktree Capital, a long-time user of our performance data, has produced another one of his great letters where he has enumerated 24 risks which show the breadth of ways to lose significant chunks of capital.
Nevertheless, a number of professional investment managers feel compelled to buy some positions now. Some may be sensing a “bandwagon” surge on the part of their clients to more fully participate in the melt up. Others have picked up my view to look for unconventional investments. Still others have devoted too much effort on avoiding losses over the years and now need some new winners. These feelings need to be corralled under a term similar to the one that earlier drove investors into the market which was TINA (“There Is No Alternative”) to assuming risk and enter the market. The new term suggested by Howard Marks is FOMO (“Fear of Missing Out”).
A buy a day
I believe that on any given day that there is a security someplace in this world that represents a real bargain. However, to paraphrase Jason Zweig’s excellent interview with Charlie Munger in this weekend’s The Wall Street Journal, one must recognize the extent of one’s circle of competence and not stray beyond it. Further, Mr. Munger has said that patience is needed. He has gone through a period of years without adding a new name to his roster of investments. Charlie’s innate wisdom may be greater than mine, but I am willing to suggest areas that professional investors should examine as long as they are within their own circle of competence.
Framework for seeking new names
My preferred search procedure rests on my introduced Lipper Time Span Portfolio concept. This concept rests on four independent portfolios which may contain funds or individual securities. The four time spans are the Operational Portfolio to provide the next two years of funding. The Replenishment Portfolio which is designed to renew the funding capability of the Operational Portfolio within five or so years. The Endowment Portfolio is to cover the currently identified longer-term needs of the major beneficiaries. The fourth and ultimate portfolio is the Legacy Portfolio which is to produce capital for spending beyond the grantor or initial investor. Typically the Endowment Portfolio is to cover a time span of more than ten years or beyond the competence of the existing investing decision makers; while the Legacy Portfolio, if desired and well managed could be, in effect, a perpetual portfolio.
With the time spans in mind, I find it useful to make some general predictions of the currently likely investment environments in each of the four time spans recognizing the old quote of “Humans Plan and God Laughs.”
At this point in time I believe that the Operational Portfolio will struggle with below historic interest rates which at very best may reach double current rates.
The Replenishment Portfolio should expect at least one major market melt down of at least of 25% and if the current melt up goes parabolic, 50% or possibly more.
Assuming that the market is in a form of recovery by the time the Replenishment Portfolio has done its job, the Endowment Portfolio should be moving up in a cyclical fashion over its life, averaging an inflation adjusted return on equity for stocks and a “real” rate of return similar to returns on capital employed by the general economy. The Legacy Portfolio will largely be driven by the disruptive forces unleashed by technological and sociological changes.
While I would prefer to focus on the longer-term portfolios, my investment management friends and I need to perform well with the first two portfolios or we won’t be given the opportunity to direct the two other portfolios.
Looking for short-term winners
If we were in “normal” times with interest rates tied to credit concerns and inflation, high quality short-term paper would be earning in the 4-5% range which could easily acquit the funding requirement. The so-called riskless investment in US Treasuries can’t do it. My suggestion is to research within your circle of competence the following unconventional thoughts:
1. In August there were a number of currencies which gained 1% which could be of interest; Norwegian Krone +1.42%, Malaysian Ringget + 1.39%, South Korean Won +1.37%, Brazilian Real +1.24%, and Mexican Peso +1.01%.
2. Very selected Commodities; Cotton +5.89%, Natural Gas +4.75%, and Aluminum +4.74%, all for the month of August. I would not recommend Livestock +11.45% gain year-to-date or shorting its corollary, Grains -11.28% year-to-date.
3. Not immediately but in time, one should also select, high quality municipal bonds which are likely see their interest rates go up when newly issued. The banking authorities have ruled that these issues can no longer be counted as High Quality Liquid Assets (HQLA) for bank reserves' calculations. Combine this news and the fact that banks are being forced to cut back on their trading desk’s Muni positions. This means that there will be fewer buyers of this paper particularly at a time that the US needs to dramatically improve its physical and educational infrastructure. Demand for financing will force interest rates up.
4. Bank loans recently shunned because of fears of a recession may well be priced attractively if we are entering a slow down, not a recession.
Searches for the Replenishment Portfolio
The next five years or so are likely to be difficult for portfolio managers. The melt up momentum will drive a lot of stock prices higher, but one needs to be careful with some biotech and new small companies being priced generously. Focusing on firms which are spending their excess funds wisely to build competitive advantages might be prudent.
Because we believe in the rising capabilities found in many emerging markets we have a number of investments in these kinds of funds for our Endowment and Legacy Portfolios, but I would not be adding them into the Replenishment Portfolio now as these stocks have led in seven of the last ten and half years. Most of the flows into this sector come from institutionally-driven ETFs (Exchange Traded Funds) which added $3.5 billion in August compared to the much larger and more conservative mutual funds which added only $1.8 billion. Our financial services private fund is doing better recently by not being burdened by deposit-oriented banks.
Question of the week
Where are you finding stocks to buy for the short term (five years)?
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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.