Sunday, September 28, 2014

The Bill Gross Effect and the Need for Other Negative Indicators


The huge amount of press covering Bill Gross’s changes of investment house was a wonderful occasion of misdirection. The day of the announcement I reviewed the average performance of ninety-six fund investment objectives for the week. Of the long-term taxable fund investment objective categories, only two were positive. The two that had plus signs in front of their weekly performance were Dedicated Short Bias Funds and Alternative Managed Future Funds. I believe the unanimous performance declines in every single domestic and international equity and bond fund is symptomatic of deep fundamental concerns.

Lessons from NY tracks

One of the personal learning institutions that has impacted my investment analysis career was the New York based horse racing tracks. The percentage of winning favorites was typically about 33%. One should look at the dollar returns from winning favorites after expenses paid in taxes and fees to the track. The winnings would not cover the losses in other races, let alone cover the expenses of getting to and into the track and an occasional hot dog.  From the track math I learned that there is a tendency for those who make mistakes to continue to make mistakes. In other words they could be negative indicators. How could this be?

At that time the New York racing crowd was the savviest in the country, perhaps like those following stocks listed on the New York Stock Exchange. Clearly these bright people were being swayed into making uneconomic bets. They were following the results of past performance races. A horse that had recently won three or four races, regardless of conditions, was expected to repeat. The crowd could have included some member of the SEC staff who then required the phrase “past performance is no guaranty of future performance,” or similar language to be appended to all performance communications with the public. Unlike many politicians that worship at the foot of “Big Mo” or momentum, some regulators were appropriately concerned about momentum investing.

What are the historical odds of winning?

From my experience in looking at investing for more than fifty years, there are two matrixes that answer the question. The much more common one is to measure whether the price of the investment went up or down. For long-term investors, the odds are that 50% of the choices finish at higher prices. Why? The discouraged ones drop out of the class and, at least in the US, the long-term secular trend has been up. You have to live longer to win. Good managers probably win about 60% of the time. The truly great managers win over time probably about 66%. Just as the critical measure of a day at the track should be measured in terms of net dollars won after all expenses, so should performance results be assessed. Even better, if one was foolish enough to think going to the track as a business, one should look at the ratio of winnings to amounts wagered. On this basis I have seen people actually make money only being right some 40% of the time because they handled their money wisely and benefitted from the knowledge that winning positions grow in relative size compared to losing positions.

Lessons from Bill Gross’s departure

First, it is important to acknowledge that he had a very good long-term record that the institutional and individual communities translated into favorable momentum. Second, Bill was the pied piper for fixed-income investing which had some impact on equity investing. Third, none of our managed accounts owned funds that he managed and there was very little owned in some of the over $4 Billion in institutional portfolios of tax-exempt groups that have me on their investment committees.

What should have been included in the press coverage? First, in all likelihood we have seen the end of a thirty year bull market in bonds which began when the late and great Arnold Ganz told me that there was a generational need for bond managers; there were not enough to go around to all the openings he perceived would be coming. Considering that individual investors around the world were rushing into bond funds, the end of the bond bull market could be very destructive to the investment public and could cause interest rates to rise on government debt as there would be fewer buyers. By the way, many institutions with professionals on their investment committees own very little in the way of bonds.

Second, in later years Bill’s success was based in part on a very strong trading facility that he helped build. His great strength was in the timely use of derivatives. Banks are far and away the biggest dealers in derivatives, with PIMCO probably getting their first call and possible price concessions. Due to rapidly changing bank regulations, banks are cutting back on their inventories of derivatives. Thus, in his new home Bill may be offered less support than what he has been used to receiving.

Third, many news articles have been speculating on how much money will leave PIMCO. While this may be harmful to the fund management company’s bottom line, I suspect that it will be good for those investors that remain within a shrunken fund. There is no portfolio that I have observed that couldn’t be improved by judicious selling. A manager may love all of his/her holdings; however redemptions will force a ranking of those holdings that are least loved.

Fourth, Bill’s quick decision to join Janus, apparently his second choice, defies historical analysis. The board at Janus has a long history of making the wrong decisions in terms of senior executives. This could change.

The need for negative indicators

Since great managers in the long run are only right about 2/3 of the time, we would all like to improve our odds. From my experience those people who have been regularly wrong tend to persist in being wrong. My feeling is that these people are wrong about 75% of the time leaving them to be right 25% of the time. What we attempt to do is to take advantage of superior managers to enjoy them being right 2/3 of the time leaving 1/3 when they are wrong combined with the much smaller number of negative indicators that are only correct 1/4th of the time. If we were absolutely successful we might potentially produce a 91% hit record. We don’t believe that we will achieve this result without your help identifying additional negative indicators.

Calling for negative indicators

I hesitantly nominate three groups to start your juices going as possible examples of negative indicators. The first is the current keepers of the Dow Jones Industrial Average (DJIA). In the last year according to Barron’s, they added three stocks. Two gained +5% and +1 % with the third declining -5%. They replaced three stocks that gained +47%, +8%, and +26%. These changes demonstrate their concerns for investors that are tied to the DJIA. Further, they have announced that in the future only those companies which are headquartered in the US would be eligible to be included into the World’s most famous stock indicator. They are following the action of the S&P 500 a few years ago. These choices will have an ironic impact. The next most popular index family, the Russell indices, are now owned by the London Stock Exchange, which might have its new owner’s proclivities in mind.

One might speculate that the keepers of the DJIA (which is now managed by a subsidiary largely owned by S&P which in turn is owned by McGraw Hill Financial*) are defending themselves from a lawsuit by the Justice Department which it is alleged has to do with its downgrading of the credit rating of the US. Thus the announced DJIA move could be interpreted as an attempt to back the current Administration’s efforts to curtail tax inversions. Thus, we are seeing political capital topping investor capital. The history in the marketplace is that this is a short-term advantage and will actually just encourage more off-shore deals.
*Owned personally and/or by the private financial services fund I manage.

The second negative indicator nomination is for the California Public Employees' Retirement System (CALPERS). This judgment is based on CALPERS’s decision to redeem some $4 Billion invested in hedge funds because they were too complex and too costly. I wonder what they thought they were investing into in the first place. There is a chance that their timing is exquisite. After far too many years of declining interest rates and generally rising stock prices, we have currently seen the beginnings of rising rates and falling stock prices. As stated above, the only two fund investment objectives that were up this week were Dedicated Short Biased Funds and Alternative Managed Futures Funds. In addition, a closed-end diversified currency fund had a surge in trading volume.

Caveat emptor

My private financial services fund (which is structured as a hedge fund) has not had a short position in many years. In addition I personally own shares in a non-US manager of one of the largest futures funds in the world. Further some of the non-profit investment committees that I sit on have quite successfully used hedge funds in their portfolios. Thus, I believe that CALPERS is a good nominee as a negative indicator.

The third nomination is the previously mentioned Janus Capital Management whose board of directors has consistently chosen the wrong people and the wrong diversification moves at the wrong times.

I am looking into making a fourth nomination, of a  prominent talking head or columnist who is brilliant about extrapolating yesterday’s news.

Please send me privately your nominations of negative indicators. In the meantime, invest well for the long-term and trade well in the short-term.

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Sunday, September 21, 2014

Enjoy Enthusiasm Now, but Not for Too Long


All of us want the stock market to rise, particularly the ones that our clients and we own; that is unless we are net short or have a disproportionate portion in cash. While Mae West, the burlesque queen said too much of a good thing is wonderful, wiser advisers have suggested that people should be careful for what they wish. A number of commentators have said that the current rise in the stock market is the least loved bull market in memory. It is unquestionably lacking enthusiasm.

I agree that on the surface the general public is not enthusiastic about the stock market. Market peaks are characterized by great bouts of market enthusiasm. Previously, I commuted into Manhattan from the suburbs with an individual in a well paying position who one day announced that he quit his job and would be sitting at home and would be day trading one particular dot-com stock which he said would provide him a handsome wage. His financial fate and those of his kind are well known. Others have described similar historical periods as the madness of crowds. I suggest that most important peaks are so characterized.

Up, Up and Away

Regular readers of these posts are aware that while I believe that we are, for the moment, in a melt up, I am concerned that the next eventual decline could be severe if selected market prices rise in the short-term in a parabolic fashion (1>2>4>8>16). Managers of long-term funds producing rates of return 2-3 times the normal (ten year rates of return) will be fired in favor of mysterious managers producing gains, at least in the short term of 5-10 times normal rates. When these “hot hand” managers no longer deliver they and much that they invest in will plummet.

Breakthrough handles

 There is considerable enthusiasm today within the professional and pseudo professional communities as we have pierced various prior statistical barriers. In previous posts I discussed the term “handles” used by the news media to describe various breakthrough price levels expressed in round numbers. The three big handles recently touted and their handles were the S&P500 (2000), Berkshire Hathaway* ($200,000 for the “A” shares), and Apple* ($100 on the 7/1 split shares). A fourth one may well be looming in Alibaba ($100).
*Shares owned by a managed private fund or owned personally


The proper job of a professional investment manager and analyst is to look underneath the enthusiasm. There are elements that need to be understood and may be of concern in each case mentioned below.

S&P 500

The recent rise may be a function of an extreme amount of money being invested by institutions into ETFs tracking the index. Popularly it is believed that hedge funds and other aggressive investors are the main drivers. In the last week investors only redeemed net $0.6 Billion in domestically focused mutual funds, in the same week ETFs had net equity sales of $6 Billion of which $5.7 Billion went into the largest, S&P 500 ETF.

Berkshire Hathaway - $200,000

Unlike last year it is likely that Berkshire’s published book value and unpublished intrinsic value will rise more than the S&P 500, as it is already doing. Most equity oriented institutions are underweighted in the stock and some feel that they must catch up.

Apple - $100

While the stock is reacting positively to the various new product and service announcements, I believe the gently rising stock price is in part due to a massive buy back program. Ruth and I visited The Mall at Short Hills twice over the weekend to check out the lines not only at a massive Apple Store but also smaller, but still busy Verizon and AT&T stores. What impressed me in all of these stores was very sound and pleasant crowd control. They know what they are doing.

All four of my older personal Apple units have now been upgraded to the new iOS8 software and we are seeing already important improvements. From my particular point of view Apple is not an equipment producer and seller, but a creator of annuities which can probably go on long after the neat new products are no longer annual events.

Alibaba - $100

The high NYSE price on its opening day was $99.70 which could well set up the Alibaba $100 handle. There is enough which is not fully fathomed about the company as well as China that a highly volatile future is likely.

Contrarian Corner: Hedge Funds

There was a negative column on hedge funds in Sunday’s New York Times indicating that a very large California state government pension plan intends to exit some $4 billion dollars they have invested in hedge funds. I suggest that this may well be a clarion call for those sophisticated institutions and some individuals that have not invested in hedge funds to begin their hedge fund research in earnest.

The keys to understanding a hedge fund

Probably there is more misleading information about hedge funds than any other financial community topic. While there are services that track those funds that are willing to be tracked, people do not understand that hedge funds are not an asset class that has well defined rules and regulations. The key documents in the relationship with a hedge fund are the various agreements with the investors which are not necessarily the same for all investors. Because of the perceived profitability to the managers of hedge funds, they have attracted some of the best portfolio managers, analysts, traders, and sales people from both mutual funds and broker/dealers. The attraction has been too great! Thus the ability to distinguish one fund from another has narrowed. We are seeing a number of hedge funds retiring from competition either because they were not successful enough or they made too much money so their principals could retire from client-facing work.

The market environment has not been favorable to many of the past ways some hedge funds have made money. A number of funds in the last couple of years have underperformed, particularly when compared with market indices that were inappropriate measures. Using an average performance measure often gives an inaccurate picture of skills. For example, I was recently made aware of the three year cumulative performance of funds investing in India. Goldman Sachs* came out on top with a gain of +19.1% and worst was -8.4% by a fund managed by Jupiter*, taking a mean of 5.4% tells us nothing about the two extremes and more importantly as to how either will act in the future.

We may well be on the cusp of a new period where the skills of hedge funds could produce good results. First instead of a low interest rate environment, Moody’s* believes that we are coming to an end of the period of cheap credit.  Already one of the measures that I look at daily is the average interest rate paid by banks on deposits which has gone from 0.38% to 0.42%, which indicates that banks are making loans above the rate they can earn leaving their money with the Fed.  This changing environment will introduce opportunities for significant rewards and risks particularly in the intelligent use of leverage. Notice in the discussion above the underlying elements of the market could be significant opportunities through more volatile markets. A retired very successful short seller tells me that profitable short selling is something of a lost art. In the aftermath of greater enthusiasm which will drive prices too high, the art form may resurface.

My thoughts are biased because I serve on a number of investment committees that have used hedge funds successfully in the past. Further, my private fund could be considered a hedge fund, because we can sell short. We haven’t done so in many years as we thought there was, in general, more to gain on the upside than on the downside.

How to play in an enthusiastic arena

As most of you are aware we recommend the use of Time Span Portfolios (Operational, Replenishment, Endowment, and Legacy). The portfolios that have time horizons of five years or less need to be able to use the expected volatility to their advantage or at least to avoid major losses. The longer term portfolios should be conscious that from time to time there may well be attractive bargains available.     
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Sunday, September 14, 2014

The Need to BUY Now


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.