Sunday, October 26, 2014

Bear Market Thinking Prevents Future Gains


Most people react to present investment conditions in terms of the dominant financial conditions when they first became aware of financial markets and influences. Very few young people entered the financial community after WWII until the mid to late 1950s. I was part of the second wave when I became an investment trainee working for supervisors at least thirty years older than myself. These gentlemen were operating under the canopy of their parents’ experience during the Depression. They were not prepared for the growth experienced in the late fifties and most of the 1960s. Thus their investment accounts underperformed and they in turn were easy to be replaced by a group of young, inexperienced analysts and portfolio managers. 

I was somewhat prepared for this turn of events.  In 1957, I had the honor of taking Securities Analysis under Professor David Dodd who co-wrote the book of that title with Ben Graham. The course stressed risk reduction by using financial statements to represent value. I used to argue that expected future growth was important as a way to make money. While I did not know it at the time, Warren Buffett reached a similar conclusion.

Replacing an investment committee member

Recently I had two meetings with some very bright people that were being handcuffed by the current market conditions. The first was with members of an investment committee which had an opening. I suggested that it might be wise to add someone who understood commodities. The idea was rejected as supposedly the commodity thirty year super cycle was over and commodity prices were now tied to China which was slowing. This thinking is focused at the beginning of price trends and not what I think should be the focus, which is the terminal price.

Future investors

Later that day I met with undergraduate and graduate members of a university investment club. Some of these bright people were interested in being employed within the financial community and/or wanted to learn more about investing.  By their questions they were reacting to their media-driven views of what they thought was happening in Wall Street.  I tried to suggest that they focus on the future; e.g., global shortage of retirement capital and the loss of jobs due to changes in minimum wages driving technological replacement of human labor.

Classic bear market thinking

In both cases and along with the majority of those who follow investments they were demonstrating classic bear market thinking.  Reacting to past stresses they focus on the current and look for proven results.  In today’s time that means placing great emphasis on statistical value including looking at average price/earnings ratios for the last ten years, (including C.A.P.E. which was discussed in last week's blog.)  One way I attempt to learn where we are in the cycle of investment thinking is to look at what periods of time investors are using in their price/earnings calculations.  When people are being governed by fear they use the past earnings of the latest quarter, year, or ten years.  We are not today seeing anyone quoting P/Es or yields based on their estimates of future 5 and 10 year results.  Historically when we do see these, the market is much higher than markets priced on current or past results.

Today’s investments for tomorrow’s needs

My professional responsibilities include managing money to pay future tuition and faculty paychecks, new laboratories and building maintenance and replacement.  The money to pay for these things will be needed many years in the future, so I must look at today’s investments as to what they will produce in the future.

I must be doing something right as numerous of the present holdings that I am responsible for today are yielding 5% or 10% on current dividends on initial purchase prices.  Thus the money can fulfill the capital generation needs of the beneficiaries entrusted to me.

Speculation isn’t new

Investing with an eye to the future is not new.  Much of the European investment into the US and elsewhere was based on the belief that in aggregate, the investment would generate future capital.

Another investor who focused in part on future returns was the advisor to a number of US presidents, and a friend as well as a fellow park-bench sitter with my grandfather, Bernard Baruch.  During the congressional committee hearings in the 1930s, certain congressmen felt that the Depression was caused by speculators.  They got Mr. Baruch to identify himself as a speculator, which meant that he was a cause for the collapse.  “To the contrary,” he explained the Latin derivation of the word speculator, “a speculator is one who sees far out (to the future).”

In last week’s post I expressed a view that the problem facing the global and US domestic economy was not primarily the lack of cash or credit which can be seen in surplus, but the lack of perceived long-term opportunity.

Being a bit of a contrarian and a disciple of Baruch and Buffett/Munger, I believe now is the time to be looking for long-term growth opportunities.  I believe this is wise for the beneficiaries of my long-term investment responsibilities even though there are substantial odds of a major market decline over the next several years.  I am much more confident of my long-term views than my ability to retreat from the market and then reengage.  Over the cycle very few have been able to do that and produce better results than those who intelligently invest throughout the cycle.

Additional thought

Each day our personal, family and corporate real and contingent liabilities grow.  The growth in liabilities without an offset will reduce our net worth.

Question of the week

Where are you investing for growth and when will you increase your growth portfolio?
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Sunday, October 19, 2014

The Failure of Investment Failures


This past week I had several opportunities to chat with Tom Rosenbaum, the new president of Caltech; in one session he asked for suggestions as to what additional subjects should be taught. I suggested a course that covered most of the world’s major scientific failures. My thinking was that there may be a common theme to what has gone wrong. I later realized that this was a half-baked idea. On the one hand the very nature of most scientific discoveries is through experimentation. Some scientists however keep changing various elements until they get the result that they want to achieve or recognize that what they did produce is surprising and a good but unintended result. What is often missing from this application of the scientific method is that there is no attempt to learn from what went wrong or at least what did not turn out as expected. 

In the investment world we also examine why something doesn’t work out as expected. As many regular readers of these posts are aware I believe that essentially I learned security analysis at the race track. In some ways my most valuable time (after not cashing a winning ticket) was spent re-examining the prior records of both the winning horse and my losing bet as well the actual racing conditions. I often found that I had overlooked some critical set of facts and my expectations were sadly out of kilter. I humbly suggest that the 2014 investment performance through this week gives scope to look at a number of investment theories that have not produced the expected results. We should not fail to learn from these failures.

Friday's failures

After a week of significant global stock market losses, on Friday the Dow Jones Industrial Average (DJIA) rose +1.63% easily beating gains of +1.29% for the Standard & Poor's 500 and +0.97% for the NASDAQ. I believe the message from this data is that more of the gain was achieved in the indicator with the smaller number of securities which would demonstrate to me some lacking of enthusiasm for most securities. This view is reinforced by looking at one of the DJIA components, JPMorgan Chase*. On Wednesday the stock hit its low for the week at $54.26, on 37.9 million shares. On Friday the stock closed at $56.20 on 19.5 million shares or little more than half of its high volume day.  Don’t look at Friday’s rise as the beginning of a major recovery.
*Owned by me and/or by the financial services fund I manage

A number of my market analyst friends suggested that the pickup on Friday was to correct a significantly oversold condition and represents a sales opportunity rather than a buy opportunity. This pattern is present in numerous countries' stock markets. Those focusing on the US expect another test of the recent Standard & Poor's 500 lows. Nevertheless they perceive a good chance for a substantial rally in the winter; but a failure to go to a new high in late 2014 or early 2015 would suggest the potential for a major decline.

Mis-reading fund flows

Many market participants jump on aggregate net fund flow data to ascribe a level of demand for stocks and bonds without understanding the broader implications. First, the published data is often based in part on the net differences between fund purchases and sales. To me there is an analytical difference between a $10 Billion net inflow made up of gross income of $11 Billion and gross redemptions of $1 billion compared to a situation when $25 Billion is incoming and $15 Billion is leaving.

Further some analysts add the flows of Exchange Traded Funds (ETF) and conventional mutual funds together. There are two problems with their approach; the first is mutual funds are typically owned by individual investors directly or through financial  institutions that are long-term in nature, like the accounts that we manage, whereas many ETFs are owned by hedge funds and other short-term trading accounts. In the week ending October 15th, $17 Billion were invested net into equities by the ETFs. Of this, approximately $12 Billion were invested net in S&P500 ETFs. The analysts at my old firm Lipper, Inc. believe that a good bit of this inflow was created by the authorized participants who are largely brokerage firms and other institutions who offer these shares to short sellers in exchange for the interest earned on the short positions. The net effect of this activity is that a major portion of the supposedly supporting purchases to the broad market are betting on a decline.

US fund investors redeem domestic funds

For the last six months fund investors have been redeeming US oriented funds and buying International funds except those that focus on European investments. I believe that fund investors like much of corporate America are concerned about the near-term future for the country. The failure is to treat fund flows as a single-dimension.

Poor economic analysis

I write this post from Washington, DC, where the US Congress sits in the Capitol, a building whose inhabitants usually do not understand capital and the need to make it.

Some want to stimulate through throwing taxpayer money on infrastructure and other ways to fuel the US and other global economies. What they fail to understand is the only economic quantity that is of commercial concern to many of us is the opportunity to make money for beneficiaries. Both cash and credit are in surplus. If the politicians really want to invigorate the economy they should reduce the burdensome bureaucracy.

What are your investment failures?
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A. Michael Lipper, C.F.A.,
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Sunday, October 12, 2014

Investment Survival Lessons


In an accelerating world, I find it necessary to always be learning. I hope to learn from almost every exposure I have. This week’s post is based on three inputs to my investment survival orientation:
1. Future vs. History
2. Markets vs. Economies/Governments
3. Levels of Patience Required

Future vs. History

In an always insightful column in The Wall Street Journal, Jason Zweig interviewed Professor Robert Shiller, the Nobel laureate in economics and the developer of the “cyclically adjusted price/earnings ratio” or CAPE. In the interview there is a particular bit of wisdom for all of us who are condemned one way or another to predict the future. Professor Shiller stated while the current level of CAPE “might be high relative to history, but how do we know that history hasn’t changed?” Asking the question is the wisdom not my answers. There are at least two reasons to believe the certainty of a top of a market.

The first reason is that we live in a very dynamically changing financial world. This is not the first time that governments and their central bank servants have been manipulating interest rates or modern day money; from the ancient times kings reduced the amount of gold and silver in coinage. Add to this that the trading markets have changed due to the use of capital restrictions, markets fragmentation, increased use of lightly capitalized derivatives and the communication of investment methods.

The second reason to question the utility of C.A.P.E. or any Price/earnings ratio measure is my training at the race track. When asked, the wagers who were putting enough of their money on a particular horse that would make the horse the favorite they would focus on one statistic almost to the exclusion of any others. (Favorites typically win only about 1/3 of the time.) With this as a background, you can sense my apprehension when entering the analytical business where the need was to quickly convey brief reasons to make an investment decision through the use of some term or label with the caveat that people would fully understand the limitations, construction, and the past record of misapplication.

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax “pre-other” income growth. In addition, I look at net cash generation after debt service as comparative measures before focusing on an evaluation of management to handle future opportunities and problems. Further, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different than today’s version. The calculators of C.A.P.E. use reported data for the S&P 500 companies which is just not good enough for me in the fight for investment survival.

Markets vs. Economies/Governments

While I am very sympathetic to Professor Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey and London using individual tools and data that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed a rapid rise led by the late stage large-cap stocks. Nevertheless, one analyst has supplied some S&P500 benchmarks in terms of downside risks as shown:

a) 200 day moving average: 1905, breaking down from this level could bring more selling;

b) Down 10% from recent top: 1810;

c) Down 20% from top similar to 2011 or a cyclical decline: 1610;

d) Down 33% a la 1987 crash: 1350.

As frightening as these numbers are, they do not include a once in a generation decline of 50% which could take us below 1000 as compared with today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets; e.g., German DAX is down -12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the Emperor is marching naked. 

Current moods of business people and investors are much more cautious than national statistics would indicate. One example may be helpful, Large Cap Growth stocks were up +2.21 % in the quarter vs. -6.39% for the much more economically sensitive Small Cap Value stocks. To show the importance of volume, on October 6th the stock of T.Rowe Price* closed at $78.14 on NYSE volume of 872,860 shares. At the end of the week the stock closed at $75.35 on volume of 2,643,245 or close to 3X the earlier day. The interpretation is that the firm’s income will suffer from lower assets under management due to market decline and fewer net sales.

In terms of investment survival I pay attention to the market analysts and have adjusted most portfolios that have a five year or less time horizon to be more cautious. However, each of these bright market analysts see that we are setting up in the long run a major expansion of stock prices and somewhat higher interest rates to which I agree. But this could be delayed by the political forces utilizing inaccurate data trying to create a recovery rather than seeing that they are a main cause of the current malaise. We may need new global leadership.

Levels of Patience

An advantage that I have is owning a large number of stocks of financial services companies either personally or in a private financial services fund that I manage. Thus this week I attended an Investors Day for Jefferies, which is now owned by Leucadia*, and is owned in our fund. In one way this has been a good holding in that it is up 143% since purchase years ago. In another way it has been a disappointing holding for the last 18 months with the merged stock just about where it was on the day of the merger. Luckily other holdings did better. However, in terms of lessons it may be worth a great deal.  My reason to continue to hold the stock is that I saw it as a unique player in a rapidly changing investment banking and institutional brokerage business with a largely attractive merchant banking portfolio, a significant net operating loss carry forward and new capital resources.
*Owned by me personally and/or by the financial services fund I manage

What I was counting on was the continued regulatory pressure on the major banks and their investment banking activities in terms of their use of their capital. I was further counting on a significant a number of successful investment bankers and other highly trained technical people seeking employment with an organization that could materially increase its market share through their efforts. Where my analysis was faulty was that these changes would have effect much more quickly. What I should have recognized is that it often takes two to three years for the investment bankers to bring in more revenues than their cost.

Judging by their underwriting and deals success many of the Jefferies bankers are on the verge of becoming profitable to the firm. I should have been more patient to see the expected improvement. It was easy to recognize the pressures on the majors and the deteriorating service levels throughout many of the organizations. This is why I suggested that currently one might not open new bank relationships due to pressures throughout the organization. I thought these pressures would immediately translate to more and profitable business to the non-bank competitors. It didn’t happen on my schedule thus I am reluctant to suggest purchase at this time. I will have to see not only operating earnings coming through, but also a steady decline in Jefferies compensation ratio.

PS: Last week’s suggestion that some of the money planning to leave PIMCO should consider reducing its allocation to bonds may be happening in that the flows this week into money market funds were unusually high. I would hope as equity ratios decline because of falling prices and other disappointments that new capital can be prudently introduced into expanded equity holdings.

Perhaps, once again I need to be more patient.

PPS:  Bloomberg Television Sunday night is showing a weak opening in Asian markets which followed a report from Business Insider that the Dubai Stock Market index fell 6.5%. Be cautious and do not try to catch a falling knife.

Question of the week: Do you have plans to increase your investments in stocks?
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.