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.,
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