Sunday, March 29, 2015

Selling, Risk, and Liquidity


“Drive for show, but putt for dough” is an old expression on how to win at golf. The vast majority of investment advice is about buying securities that are expected to go up in price. However, the terminal value of investing is the final conversion of paper wealth to spendable cash.

While investors in individual securities can benefit from my thoughts, my comments are directed at institutional and high net worth investors that have one or more portfolios of mutual funds. Those that own multiple portfolios of mutual funds should modify these comments due to the different expected timespans for each portfolio. (These can be discussed privately, if you would like.)

Drive for show

When a competitive golfer addresses his or her tee shot at a crowded first tee almost all the comments will be on the distance and direction of the first shot. However, the first shot is only positioning for the follow-on shots and in the end the key is how many shots it takes to complete the hole. Thus to some extent the first shot is like relative performance versus peers or benchmarks. If all you know is how good the drive off the first tee is, you really won’t know about the ultimate success of the player. Therefore, what the investor wants to capture is the cash conversion from the ultimate sale as one can not spend relative performance.

The more professional golf observer would pay attention to the form of the golfer, the particular club that was used, the amount of power the player used in hitting the ball, and the tactical position of where the first shot landed. If I knew these things I would be in a much better position to judge whether I wanted to bet on the success of the player rather than just remark that he/she hit a nice first shot. Applying this to the fund selection puzzle, I am much more interested in the process and procedures followed by the manager of a fund than their current relative performance.

Relative performance is a rearward looking device. We get paid to make future judgments and thus I am much more interested in the way  managers addresses their task, such as:
a)    What tools are likely going to be used?
b)   The time spent on studying the opportunities
c)    What comparisons with other opportunities in the present or past time periods?
d)   Compensation pressures, which might impact decisions?
e)    What does one know about the competitors that are playing in the game?
f)     And finally, what is the pattern of flows going into and out of the fund?

Since our major investments occur after several visits or points of contact, any changes in these processes or procedures need to be understood. We expect there to be changes as we live in a dynamically changing investment world. If there were no changes there is an increase of being blindsided.  Each of the items listed above can have an impact on future performance beyond general changes in the market. Our objective is to use process and procedure changes as early warning signals to begin to exit a meaningful position. To quote Sir John Templeton, “Progress requires change. Focus on where you want to go, instead of where you have been.”

Three reasons to sell

The first reason to sell is an actual or expected change in the nature of the account. This is particularly true if the account requires a higher than expected conversion to cash for operational spending needs.

The second reason to sell is actually to buy; the late Sir John said “the reason to sell is to buy a better bargain.” (We have had the honor and pleasure of supplying special data reports to him and also being called down to Nassau to consult with him and his colleagues.)

The third reason to sell is if some important deterioration in the process being used or fundamental change in the longer-term outlook for the investment occurs.

What to sell

Anytime one needs to add or subtract from a portfolio, the whole account should be reviewed. The change is an opportunity to partially redirect the course of the portfolio. Thus, the first pass should be to see whether the various components of the portfolio are properly balanced in today’s environment and future focus. This could be the ideal time to reduce a position that has gotten to be way out of balance. Depending on the nature of the account the natural barriers might be 10%, 20%, and 25% for an individual sector. In terms of a balanced account, the fixed income range should be between 25% and 60% with equities between 40% and 75% in most cases. If one is not hurried, changes should be averaged in or out over at least three time periods which can be days, weeks, months, or quarters.

The role of risk

If the account is all of the money of an institution or an individual without any expected new money coming into the account, a prudent investor needs to weigh the impact of a loss of capital on future spending needs. In the same light the investor needs to understand that the risk of not growing capital and therefore income can be a bigger risk than some downside diminution particularly after taxes and likely high inflation. While I am very conscious that various studies have shown that individuals feel a loss 2 ½ times more than a similar amount of gain, nevertheless for most tax-exempt institutional accounts whose demands go up on a countercyclical basis when economic times are poor, the risk to the organization of not growing the capital base is worse. A less than optimum capital base puts extreme pressure on earned income and fund raising in difficult times.

The role of liquidity

Another former client, Howard Marks, of Oaktree Capital Management wrote about liquidity in this week’s Barron’s. He said that liquidity is not important until it becomes vitally important. Further he characterizes liquidity as transient and paradoxical. Liquidity is the ability to get the last published price in a transaction, particularly when one is selling in troubled times. Normally mutual fund investors are not concerned about liquidity because when they place their redemption order they know it will be executed at the price (net asset value) calculated for the next close of the market. However, some fund investors may be surprised by the gap between one day’s price and the next one.

Some SEC commissioners and certain members of the US Congress are concerned about the potential evaporating liquidity in the bond market including US government issued debt. The professional investors (hedge funds) invested in various debt and equity Exchange Traded Funds (ETFs) could overwhelm the marketplace with a wall of redemptions, which will probably be met by the market makers immediately selling the heavily weighted securities in the ETFs which will put more price pressure on the final net asset value for the ETF and the companion mutual fund.

As a student of the market for over fifty years I would urge fund holders not to panic during troubled periods and add to the forced sales. Well designed investment portfolios of mutual funds should survive the decline and could be very well positioned for a subsequent rise.

Question of the week: For your accounts is there more risk on the upside of not generating enough future capital than on the downside of avoiding forced losses?  
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Sunday, March 22, 2015

Nervous Investment Instincts and Cures


One of the basics in US Marine Corps training is to develop survival instincts which should kick in during battlefield conditions. These are meant to save the lives of individual Marines, but more importantly for the other Marines he/she are responsible. As Ben Graham wrote in The Intelligent Investor, “We are in the battle for investment survival every day.” (Warren Buffett, wrote a subsequent Preface, and called the work 
By far the best book on investing ever written.” Jason Zweig added commentaries and additional documentation to the latest edition of this landmark title.)

An early warning

One of the frustrating emotions that comes from any long-term intensive study of stock markets around the world is that markets move differently than current economic trends and are not particularly good forecasters of economic movements. What appears to me a better forecasting device is extreme indications of sentiments. Remember that large drops in stock prices occur after large rises. Thus, an increasing level of enthusiasm may be interpreted as an early warning sign that some Marines would sense as a possible ambush.  

Bailouts not the answer

While I was preparing to give a US stock market view to a very experienced group of former stock exchange leaders, the Institute of Stock Exchange Executives Emeriti (ISEE), I was approached by a somewhat  sophisticated investor wanting reassurance that the market is safer now since the financial crisis. The mere question instinctively put me on my guard. (Perhaps I was reacting to my Grandfather's instinct. He had a high carriage trade NYSE brokerage firm that according to family folklore, got all of the his clients’ investment accounts out of the stock market before the 1929 crash.)

Since the 2007-09 "crash," various governments have been trying to build a defensive doctrine against "Too Big to Fail" bailouts. If anything these moves have increased the risk to long-term investors. The real purpose of the Too Big to Fail doctrine was to protect the politicians from their own folly. The
public was incensed by the use of taxpayers' money to bail out commercial activities that created their own problems over many years if not decades. In the US the federal government bailed out Chrysler twice, one of the biggest commercial employers in the important electoral college state of Michigan and bailed out General Motors once. (DuPont bailed GM out of its over-leveraged position a long time ago.) In all cases a weaker company evolved while maintaining high relative prices for their merchandise. But the labor unions delivered the votes to elect Democratic presidents.

Mortgage underwriting debacle

When the financial community expanded the mortgage base as directed by Congress through the loosening of the underwriting standards of the federal mortgage companies, the somewhat expected financial crisis occurred. Instead of letting the private sector rescue the borrowers and some of the better servicers, the government elected to bail out the existing financial service companies. If they had not, following the tradition of financial bankruptcies, almost immediately new banks and mortgage companies would have been established taking over the loan books. They would have been populated by experienced middle managers from existing shops. Most of the equity owners would have lost almost all of their risk capital and some of the fixed income holders would have had meaningful haircuts. For the most part the depositors would have come out either whole or almost whole. Since this series of bailouts was directed to the hated Wall Street, the populists were particularly upset. They wanted to ensure that never again would there be a bailout of a large financial institution.

None of these bailouts added any value to existing or future stockholders. As a matter of fact because of their restrictions on some money making activities; (e.g., trading) and the requirement to have large amounts of underutilized capital, the big banks operating under the new rules became less attractive as investments. Large money center banks currently have lower price/earnings ratios than mid size or smaller banks.

As there are bound to be future crises, the existing big banks or insurance companies are likely to have sizeable excess capital available to buy a large worthwhile financial in trouble. Thus future prospects around the world are less safe for equity investors than prior to 2007.

Additional signals

Recently at an institutional investment committee meeting, the main point of discussion was a hedge fund that was making unexpected moves partly due to their success but beyond the expected portfolio discipline. Overwhelming the professional members of the Investment Committee,  the meeting was concentrating on the expected further capital appreciation. There was only one member who was concerned about the risk that was generated by exposures beyond the expected.

While in this particular instant we were talking about investing domestically in the US, the institutional community appears to be betting on foreign stock prices but not on foreign currencies. In the week that ended Wednesday, March 18, three times the number of net dollars were invested in non-domestic ETFs than domestic ($18.4 Billion vs. $5.4 Billion, according to my old firm, Lipper, Inc.).  Most of the money going into the international ETFs went into two country index funds with their currency hedged by WisdomTree* and one other ETF invested into the MSCI un-hedged. These to me, are short-term trading type of judgments.
*Held by me personally and/or by the private financial services fund I manage

More conservative investors are also showing signs of becoming additionally comfortable with assuming risk. Domestic Health Care funds are up on a year to date basis +15.69 % and Global Health Care funds are up +13.0%, a continuation of last year's performance leadership that has benefited from spectacular M&A prices, though it raises some risk concerns.

Even in the high quality bond market we are seeing yields dropping much more than normal this week and for the latest 12 months. The lower yields translate to higher bond prices which is unsettling given the general view that eventually there will be a significant interest rate rise/bond price decline.


The best cures for nervous investors are:

1.  Understand the hyped enthusiasm
2.  Focus on the more important longer term, and
3.  Remember the implications from history.

One of our readers, Teddy Lamade, a fellow weekly blogger and an investment professional with Brown Advisory suggested reading Michael Mauboussin's More than you know: Finding Financial Wisdoms in Unconventional Places. The thoughtful book is a compilation of unconventional approaches to understanding problems from many walks of life-financial, sports, science, politics, and gambling. Below are thoughts from the first part of the book that I felt were particularly relevant to the nervous concerns expressed above:

You are better off focusing on decision-making than outcomes. (This applies to my concern about judgments of managers and therefore risks of repeated poor judgments as distinct from the potential of capital appreciation.)

Robert Rubin is quoted in a commencement address saying, “The only certainty is that there is no certainty...decisions are a matter of weighing probabilities...despite uncertainty we must act.”

In selecting investment managers it is important to understand both portfolio turnover and concentration. (The numbers themselves are the beginning of the discussion not the answer appearing on a screen.)

What is generally good for investors is not the same as what is good for the owners of the investment management businesses. Investors improve their odds by focusing on long-term horizons, (timespan portfolios should help), low fees and expenses, plus consideration of contrarian views as distinct popular choices.

Mr. Mauboussin also mentions one of my favorite investment anecdotes, that the year Babe Ruth set the home run record he also had a record number of strike outs. This highlights the concept that the frequency of correct decisions is less important than the magnitude of correctness. Warren Buffett and Charlie Munger have translated this into investment decision terms.
The probability of loss times the amount of possible loss vs. the probability of gain multiplied by the amount of possible gain is the way to make a judgment. (This is why in the long run Dedicated Short-biased portfolios underperform Long-only funds.)

Investors feel the impact of a loss 2½ times more than a similar gain. (Destruction of investment capital reduces the capital that can grow.)

One of the key differences between gambling and investing is that the more one wagers the greater the odds of losing; in investing the longer you invest the greater the odds that you will generate positive results. (Two reasons for this: first the more fees and expenses one pays, the smaller the capital in play. The second is that at least in the US equity market there is a long-term secular growth rate, which is why Mr. Buffett urges people not to bet against the US. However, he is increasingly willing to hedge that stake with international investing, a position we should all consider.

More insights

Another Michael, Michael Cembalest of J.P. Morgan Asset Management has written a very useful piece on his ten years of authoring market insights, three items of which are especially instructive.

1.  Mr. Cembalest expects a marked increase in the level of volatility. (We don't hear much about volatility during rising markets. The prevailing wish is that every price increase is fundamentally based and not a reaction to a trading imbalance.)

2.  Sentiment indicators are better forecasting devices than price/earnings ratios. He quotes five separate surveys each currently reporting at 90%+ of past records.   (As regular readers of these posts may remember, I am tracking the levels of market enthusiasm, which eventually builds to a peak prior to a major decline.)

3.  Central banks are determined to re-inflate their economies no matter what the long-term costs to their societies.

Question of the Week: what is your level of enthusiasm?
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Sunday, March 15, 2015

Worry Short-Term, Focus Long-Term


“The world is too much with us” is the title and first line of a famous sonnet by William Wordsworth.  One of the truisms of the media world since the first regular competitive publication is that bad news sells. If one scans the front pages of daily papers as far back as possible, one may see that bad news gets a bigger play than good news and normal news is relegated to the less important sections. Now that we live in a social media/electronic world look at all the bad news that we are bombarded with everyday. Also notice that the world, the country, most businesses and individuals have not come to an end.

While a few can make some money with short-term trading approaches, most who attempt to do it on a day in/day out basis contribute to the wealth of various agents until their capital or personality is exhausted. When Bernie Baruch was testifying before the US Congress about the trading that preceded “The Market Crash,” members of the committee were eagerly waiting to pounce on anyone who made money in the market. They were pleased when he announced to them that he was a speculator. Then they were downhearted when he explained the Latin derivation of the word meant to see far ahead. (As I have observed in the past, subsequent to the hearings he chatted with my grandfather on a familiar park bench and also counseled various US Presidents.)

Using the passage of time

Taking a leaf from Speculator Mr. Baruch, I worry about the current conditions, but try to focus on the long-term. One way I do this is with the development of the four Timespan Portfolios* that I am developing for clients. The first or Operational Portfolio is very much currently-oriented, with the need to pay for the next two years of expenses to meet the crucial needs of the account. Any unexpected shortfall will starve some important need. Nevertheless, over a reasonably short period of time the operational capital will be all consumed. To meet the continuing needs of the account it must be replaced. That is the function of the Replenishment Portfolio which over the next five years must replace the Operational Portfolio. While there is nothing magic in five years it does represent a political period from leadership elections, the minimum expected presidency of corporate CEOs, some turnover of critical middle management and certain voting blocks. Some may prefer the four year US presidential cycle up to a Biblical 7 year period. 
* Timespan L PortfoliosTM

In any case, based on past history one should expect a market decline during this period of about 25%. (If one does not see it in that period, be particularly weary because a bigger decline is likely.) During this timespan the markets are likely to be somewhat balanced between cyclical and secular trends with each playing a predominant role for part of the time. During this phase price-disciplined value buyers as well as those market players seeing expanding growth have a place in these portfolios.

Personal and institutional endowments

Even my friends who feel that they are already ancient are likely to need to use a part of the Endowment Portfolio which should have a focus between five and fifteen years. These portfolios ought to be largely invested in reasonably consistent growers of sales, operating earnings and dividends. This period is long enough to recover from periodic declines. Rarely there is an equity portfolio that has produced a negative result over fifteen years.

The Legacy Portfolio

The final Timespan Portfolio is the Legacy Portfolio which should be loaded with lots of emerging growth opportunities, recognizing that a number of these will fail as businesses but the survivors will more than make up for the failures. The focus of this portfolio is beyond the current horizon and will be largely dictated as to how technology acts on our world. Thus smart users of technology as well as their producers should be important investments in this prudent portfolio.


If I am primarily focused on the long-term in selecting investments for the Endowment and Legacy type investors, I cannot avoid occasional short-term losses caused by relative changes of marketplace popularity. What I worry about is too much enthusiasm in an up market. This is not a major concern today in the equity market. Excess enthusiasm however is very prevalent in the fixed income market. The owners of various fixed income instruments have convinced themselves that they know the future levels of interest rates and how they will evolve. This certainty is a worry.

A major decline occurs when there is a sudden shift in sentiment. One of the very reasons some fixed income investors have done very well is that the dealing community has shrunk. With fewer well-capitalized dealers, price trends become exaggerated beyond their appropriate value levels. This has helped on the upside and will hurt materially when the eventual decline hits fixed income.

My first worry is equity market capital will be drawn into the fixed income market to replace the missing levels of liquidity, the withdrawal of capital from the equity market could trigger a stock market sell-off of significant dimensions.

My second worry is in stock markets that are experiencing higher than currently customary volatility. We are seeing the 2015 leadership shift to more growth companies, particularly of smaller market capitalization. Biotech funds are producing year to date performance twice to three times Growth Stock funds and this is a global trend. Part of this excitement is due to very highly valued acquisitions.  A number of these stocks are gyrating well above many consumer and industrial stocks that are suffering from mixed to mediocre sales and limited opportunities for margin improvement. I can not guess how high this move will be, but I remember from years ago that I used to track funds that were up more than 100%.  As a matter of fact I had to explain to a board of directors that the poorest performing Tech fund was doing a good job being only up 100% with others producing almost double those returns.

My real focus is to avoid big declines that are likely to come from very extended stock market prices. I am not sure about that likelihood for fixed income prices.

Question of the week:

What are you worried about long-term?
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.