Sunday, March 8, 2015

Investment Successes: Apple in Dow Jones, New Horizons


One of the least favorite tasks of a professional investment manager is to disappoint clients with a report of performance below some benchmark. Contrast this with how we look at our own accounts which we focus on too infrequently and get pleased or less as the account progresses to building one or more nest eggs to meet our or our beneficiaries’ long-term needs. As a profession we continue to do a disservice to our clients by focusing on relative performance when we know that sometimes we will produce above benchmark results and find reasons (excuses) when we don’t.

My wife, Ruth and I have just come back from The Mall at Short Hills, New Jersey, which is very glitzy with parking spaces at a premium like at Christmas. Not one single store was advertising that we could buy their merchandise with the currency of relative performance, though luckily at the moment we have some.

When I look at our own accounts I have two lenses that I use. The first is what appears to be my long-term risk of not producing the capital and therefore the income to meet our collective needs. The second, what do the various future time periods look to me?

Lessons from Dow Jones

In prior posts I have made clear my personal investment and interest in Apple. In the short-term I was pleased in the announcement that the stock will enter the favored thirty components to the oldest of the popular stock indices. I was pleased because, for some of the index investors including many of the closet indexers, they will have to buy a considerable amount of Apple shares.  Supposed gains may prove to be illusory due to either problems in the perception of investors or in the company eventually exhausting almost all the potential buyers for the stock.

Actually I am somewhat more interested as to what the inclusion in the thirty says about the past success of  Apple’s stock and what additional support the inclusion may provide when, not if, the stock price turns down. In prior posts I have briefly discussed “handles,” a trading and media term for a price at or above a round number of headline significance. Often these handles end in double zeroes, like 100. In terms of the Dow Jones Industrial Average there are eleven stocks above the $100 handle. In this segment of stocks priced above $100 Apple will replace a credit card processing company that is splitting 4 for 1.  Almost all of the stocks in the Dow thirty are successful, but this is doubly true of the eleven above one hundred. What this means to me is that when periodic downturns occur that many investors will be more patient with these eleven than most other stocks. After all they have been successful in the past and at lower prices they may be a temporary bargain before an eventual recovery. Thus, I feel more secure now in a long-term holding in Apple than before.

There is another analytical factor which addresses one of my concerns as to the changing structure of the stock market. In prior years there were far fewer stocks with $100 price handles. One could count these well-known companies on one hand. At that time the retail investor was important to corporate management. There was a belief that many retail investors wanted to purchase a round lot of one hundred shares or more to avoid the odd-lot differential. (My first summer job in Wall Street was with one of the two odd-lot houses that executed the below 100 share orders for most brokerage firms for an 1/8th to ¼ price advantage.) Today the small retail investor is largely absent and the odd lot differential has disappeared. Many of these former individual stock buyers now are primary mutual fund investors. While many funds’ initial price is set at $10, many funds are perfectly willing to see their net asset values rise to well above the $100 handle. The brokers and investment advisers who place mutual funds invest in specific dollar terms not a number of shares and this is why we use to calculate fund performance to five decimal places. (Some funds carry out their net asset values to fourteen places.)

The relative absence of the retail investor in individual stocks probably truncates the extremes of price behavior as they go from all out to all in to all out. That perception is why my view of a market movement this year or sometime soon will +20% to -20% in the same twelve month period because there will likely be less all in and all out players. If they suddenly reappear I would open the gates wider to approach swings of plus or minus

from a zero base.

Winning and losing stock performers

One of the many things that I do for clients in our mutual fund managed accounts is to read their funds’ annual and interim reports as well as their competitors. Rarely will I publicly discuss a fund in a client’s account because they have paid for this knowledge. I am making an exception now because the T. Rowe Price New Horizons annual report was particularly thoughtful and it is closed to new money accounts so my clients won’t be disadvantaged by a wall of money trying to enter the confined place of quality small market caps.

The portfolio manager for the past five years, Henry Ellenbogen, introduced two concepts that have much wider applications beyond the New Horizons portfolio.

The first is he attempts to select two different kinds of stocks, emerging growth companies and durable growth companies. The second groups, durable growth companies, are the types of predictable growers that I would populate most of the third L. Time Span Lipper Portfolio ™ or the Endowment Portfolio. While the second portfolio is designed to replenish the first with spendable capital for two or more years, the third portfolio has a time span of five to fifteen years to produce the capital and income needed to realistically meet the beneficiaries’ needs. 
Emerging growth companies are in some respects the most difficult to find and hold on to. Some will be acquired away and others will be either temporary or permanent disappointments. In today’s ultra competitive environment often the best way to start to build a position in these companies is through participating in one of the pre IPO (Initial Public Offering) financing rounds. While they only participate in a limited number of pre IPO rounds for a daily net asset value fund, they are temporarily illiquid. To use the words of Fidelity’s great Peter Lynch,  the portfolio manager is “swinging for ten baggers,” if not more, a difficult task to do well.

While I can understand the product need to combine these two separate types of companies, to help me with filling out the Time Span Portfolios I wish there were two separate funds. The emerging growth company fund would attract more investor interest with our present and expected future book of business; the durable growth companies would get more of our clients’ money because of their needs. I would hope that for my family’s accounts we would over time build up a significant investment in the emerging growth category as long as it was reasonably well managed.

Perhaps Mr. Ellenbogen’s greatest contribution to the art of portfolio management is his analysis of his twenty biggest contributors and detractors over the five years he has managed the fund. What he found was that the 20 biggest winners contributed more than 117% of his overall gain versus market. The negative contribution on the same basis deducted 24%. Thus the combined leaders and laggard produced 93% of the total advantage over their benchmark. In other words the literally hundreds of other stocks owned during the five year period produced an advantage of only 7%. To be fair for many funds and their investors a 7% over the benchmark would be acceptable. My question for the fund’s independent directors and its investors: “Was the fund overly diversified?”

To answer in the affirmative there is a presumption that one could have excluded certain losers or average performers. This is an endless debate which in some cases I was a participant. This is not a simple problem. There are times particularly early in the emerging growth arena when there are multiple companies trying to accomplish the same goal with different approaches and technologies. I can see a prudent investor putting a small bet on each with the hope that when the eventual winner becomes more visible, the other positions can be eliminated and more capital put into the rising star. 

All managers are likely to make some mistakes if they are really trying and some room should be afforded for a good manager. Actually I am more impressed with the smallness of New Horizons' losses. Compared to the Russell 2000 Growth Index, the aggregate of the twenty largest losers was -7.06% and the twenty biggest winners was a +65.9%. The largest single loss was -1.3 % and the smallest of the twenty largest contributors was a + 1.95%. It is just this sort of analysis that we develop when we analyze a fund for purchase. The losers normally tell us more than the winners.

N.B. Both the financial services private fund that I manage and my personal accounts have had a holding in the management company’s stock. My clients are aware of our ownership of T Rowe Price and other publicly traded management companies and other financial services companies which we believe work to the benefit of our investment management clients.

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