Sunday, December 21, 2014

The Worst Price and Long-Term Bargains

Professional investors and their political economies are very much interested in the price discovery functions of the securities and commodity markets. Prices translate into performance. Unfortunately, past performance leads to future individual investment decisions and asset allocations. In viewing the results for any given year, the last or terminal price plays an important role in the calculation of the resulting performance. Thus the December 31st (and to a much lesser extent June 30th) prices play a disproportionate role in the calculation that produces rankings, bonuses and job longevity. (Our actuarial friends would prefer multiple-date averaging calculations to “Last Trade on Last Day” as a better representative to what was happening.)

For 2014 in particular, I suspect the quality of the last prices will be weak. Due to restrictions as to the size and deployment of capital on various trading desks, the normal capital absorption capacity will be limited. Further, many organizations have already determined the size of gains and losses that they wish to sustain for the year. Thus there will be less buying power available on the last trading day of the year. Remember, the absolute final price on the last increment of trading will determine performance. In some prior years we saw a concerted effort on the part of performance players to ramp up prices of what they held in the last hour of trading. In some extreme cases there were efforts through short sales and other techniques to lower important prices for securities owned by specific competitors.

Ahead to December 31, 2014

At the moment I expect a slow Year-end day, but I am prepared for a spike in either direction on the last day which could be well reversed on the first trading day of 2015. In a relatively dull performance year the level of distortion is likely to be 1% or under.  From a performance analysis viewpoint I will pay more attention to year-to-date performance through November and/or the latest twelve month performance through the end of January, 2015. These mathematical machinations have some value in managing portfolios that have limited duration found in operational and some shorter-term replenishment portfolios. It should have no impact on decisions for endowment and legacy portfolios.  These refer to our Timespan L Portfolios™, which are segmented by investment period focus.

Better performance warnings

After a week when some of our holdings from bottom to top gained 5%+, for example T Rowe Price*, I start to get nervous about rising volume sucking in sidelined cash. (NASDAQ OMX* stock volume almost tripled from 773,829 shares to 2,225,599 shares in two days.)  These reactions need to be put into perspective. My old firm, now known as Lipper Inc., produces a daily index for each of 30 equity investment objectives. The components of these indices in the more numerous groups are the thirty largest funds.  In the smaller groups the number of components can be as small as ten. Examining the performance roster I noticed the Large-caps were up 10%, Multi-caps 9-10%, Mid-caps slightly under 8%, and the Small-caps 1.7%. What this suggests to me is that in a period of declining liquidity, institutional investors continued their Large-cap affection. Small-caps were the best performing investment objective asset based group in 2013, demonstrating their recovery potential.

The first warning in terms of a possible blow off will be when Small-caps become once again performance leaders and the investing public throws an extra $100 billion+ into Small caps which can happen.

The second warning is excessive focus on market capitalization as a screen for choosing investments. I note that on a five year compound annual growth rate basis there is little to separate the different investment objective groups’ performance; the entire range for these indices was a low of 13.92% for Large-cap Value, to a high of 15.77% for Multi-cap Growth funds. This narrow performance spread reminds me of one of the phrases that I learned at New York racetracks: one could throw a blanket over the leading horses at a heated finish line. In other words, even with all the traditional handicapping skills, the results of close races can not be successfully predicted. I would suggest that if in the future we have another five year like the last, investors should be pleased to be under the blanket of a 13.92% to 15.77% performance range, and not try too hard to pick the single best winner.

Target Date funds may not be optimal

There is another factor that may change the level of flows going into equities. The most popular inclusion in many 401(k) and similar plans are Target Date funds. The plans that are adopting these relatively new vehicles would be doing their beneficiaries a favor if they instead had chosen the mutual fund industry’s original product which was the Balanced fund where the managers made investment allocations between stocks, bonds and cash based on their outlook.

Lipper Inc. has 12 indices of Target Date funds broken down largely by maturity or retirement dates with performance on a year-to-date basis of +4 to +5%. None of them has done as well as the Lipper Balanced Fund Index gain of +7.03%. In the right hands, most potential retirees would be better off in a Balanced fund. Often the better performance of a Balanced fund is due to its investment into reasonably high quality equities.

Benefiting from discontinuous forecasting

I have often said that I can and want to learn from smart people, thus I read Howard Marks’s letters. Howard is the very smart Chairman of Oaktree Capital and an old friend. He devoted his latest insightful letter to what can be learned from the current decline in the price of oil. He focuses on the failure of most forecasts of the price of oil. These failures created what Wall Street Journal columnist Jason Zweig has called the “Petro Panic” which dropped stock and bond markets globally. Howard focused on the fact that oil price predictions were extrapolations of the past, adjusted perhaps by plus or minus 20%. This is similar to most predictions coming out of the financial community. I would suggest that these are not really helpful on two grounds. Most often the impact of the forecast is already in the price of the stock or bond in question. In addition, big money is only earned or lost when the old model is disrupted.

Three long-term items on my screen

In our Time Span Portfolios approaches, the final portfolio which is the Legacy Portfolio is expected to include securities from various successful disruptors. While there is a place at the right time and price for investing in secular growers, they are not usually the sources of extraordinary gains. These are what I like to find. I do not have the same scientific background as many of my fellow Caltech Trustees; therefore it is unlikely that I will invest client money on the basis of what is in a laboratory. I need to enter into the process later when my reading and some of my contacts can guide me in the right direction. Let me share three examples that I am looking into:

1.  The first is the global shortage of retirement vehicles. Almost no nation has sufficient retirement capital in private hands to meet the increasing retirement needs of large portions of its population. Europe is particularly troubled or should be with more people going into retirement, living longer, and fewer competent workers. I believe some of these needs can and hopefully will be met by mutual funds sold wisely to the public. Two of the investments in our financial services private fund portfolio address these needs. Both Franklin Resources* and Invesco* have strong retail and institutional distribution in Europe as well as in Asia. Their current stock prices are based on the perceived value of their present business and are paying little to nothing for their potential. At some point I believe either or both will show more earnings power internationally than domestically.
*Securities held personally and/or by the private financial services fund I manage

2.  The second item is one that I have only a tiny direct exposure; it is an expected exponential growth in the service sector within China and some of its neighbors.

3.  The third potential actually ties back to the concerns created by the Petro Panic that is the announced long-term strategy of Toyota to get rid of gasoline cars. I am trying to determine what else will be needed as people change their driving habits.
Question of the Week: Please share how far out are you looking and what are you seeing?
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