Sunday, May 31, 2015

Investing in World Equity?


A study of flows within the global mutual fund business shows that money is flowing into investments outside of one’s own country at a faster rate than being invested internally within the home country. This is not a new phenomenon. For probably the first 200 hundred or so years the US was being built with capital from overseas. Even in the 1920s, I am told that my Grandfather’s firm had one or more branch offices or correspondents in Europe to service European investors and traveling Americans who wished access to the US markets.

A lot of money has been made investing outside of the US in 2015. This is particularly true in local currency terms. According to The Economist, eight separate markets have gained more than 20%, compared with 3% in the US.  The reason this is important to US investors is at the bottom of the market, the locals will set the terminal prices.

My early career exposure to overseas investment

As a trust bank trainee, one of my jobs was counting the foreign stock certificates behind each of the American Deposit Receipts (ADRs) that the bank was issuing for foreign corporations to US investors. One of my mates at the counting table said that we were both likely to be involved with international investing later. He became the research partner for a highly respected London headquartered fixed income shop and at an early career opportunity I joined a small splinter analyst group focused on international investing. My next job was with a brokerage firm that among other things was institutionalizing some foreign corporations to the US market. At the time, while I was following what we called electronics companies, I was asked to sit in on the internal discussions on a major European electronics company. One of the things that hit me as odd was that every morning my firm was buying shares in the company’s local market to sell to Americans. I kept on asking if this is such a good deal for American investors why are the locals selling? Initially it turns out that I was correct. The locals were reducing their holdings in a stock that periodically had falling spells. Perhaps with the proceeds of their sales they were buying some shares of the companies that I favored in the US. This particular dichotomy of judgments is driving this post.

My mutual fund lens

Subsequent to my time at the brokerage firm, I spent my career focusing on mutual funds registered with the US Securities & Exchange Commission as well as in other major countries. Initially my focus was as sales targets for my industrial company research. Later on I focused on selling performance, fee and expense data to the funds. This in turn led to a consulting practice largely focused on boards of directors, including CEOs. In order to understand my clients more fully I bought small amounts of the publicly traded shares of mutual fund management companies mostly in the US and in the English speaking world. Many of these shares are in the portfolio of the private financial services fund that I manage. Thus, I study the fund business on a regular basis.

Utilizing data from the Investment Company Institute (ICI), I have seen that the retail fund investor since 2001 through April of this year has multiplied their investments in World Equity funds almost 4X (to $1.54 trillion) compared with an almost double in Total Return equity funds ($ 3.25 trillion) and about 1.5X for Capital Appreciation funds. It is quite possible that some of the more speculative money in the Capital Appreciation funds chose to speculate in World Equity funds. Institutions using institutionally priced mutual funds have built their world equity positions much faster than the retail investor, multiplying their 2001 base 13.56 X to a $ 749 Billion at the end of April 2015. Thus as far as the US fund business is concerned, approximately 1/3 of World Equity funds are owned in institutional funds.

Is institutional ownership good for world equity owners?

That depends on the dichotomy mentioned in my prior research experience. The retail investor has been reducing his/her more speculative exposure by being net redemption for at least 15 years in terms of Capital Appreciation funds. For their retirement and more conservative investing they have been redeeming only since 2007. What is more difficult to fathom is their behavior in World Equity funds. In 2006 they added $121 billion and $115 billion, in the following year only to be followed with a net withdrawal of $85 billion in 2008. This seesaw pattern was repeated in net redemptions in 2011, -$43 billion and $31 billion in 2012 which was followed by net purchases of $56 billion in 2013. These repeated swings could well be tied to dramatic changes in the value of the US dollar and gold. What is more hopeful is that over the entire period institutional World Equity funds had positive net flows.

World Equity
funds Flow
(in $ Billions)
+ $121
+ $115
-  $ 85

- $ 43
- $31

Mutual recognition of mutual funds in China and HK will allow the sale of locally-registered funds in each market.  This may have an impact of bringing more money to be invested in China.

What the gyrations of net flows on the retail side may be focused on are the short-term views of some brokers or registered investment advisors. I believe that the institutions were focusing on both longer term timespans and lower valuations, ex-US. What buttresses this view is when I look at what is happening in the non-US fund business, I see that investors are investing beyond their home markets. Part of this is practicing sound global diversification. Part may be in recognition that in general, the rich in any country tolerate their governments, but it is difficult to find a country that is happy with their present government. The current one is better than alternative for the most part.

What should be done now?

To some degree any domestic or foreign investment in the summer of 2015 should have a view on Germany, China, and India. On my recent trip to Germany I was impressed with the feeling of orderliness and a very strong desire for control. Many of their businesses have the attitude that they will not put a product on the market unless it is the best that can be produced within a price/quality range. There is not the rush to gain the first movers’ sole position in the race. If they can maintain control, investing in Germany (particularly in its middle market size companies) should be comfortable. The issue of control of Germany’s environment is critical. German investors’ fears are three. The first is to keep the Euro reasonably intact. The absence of a central currency will drive a huge flow into a German currency which will create an unmanageable inflation. The second is to keep Russia and the sanctions directed to it in proportion. A collapse of the Russian economy would hurt German companies as well as raise potential military stress. The third is to continue to keep ethnic unemployment low enough to prevent civil strife. Can they succeed with their three challenges? They have, but that is not a guarantee of the future.

I have said for some time that China is the single biggest economic/financial issue facing the world for the rest of this century. While the US, Japan, and Europe may think they are being bold with their levels of monetary experiments, China has many more moving parts to manage. Some of these are demographics. The one child policy means that their supply of cheap labor has peaked. The rapid urbanization to succeed required large scale infrastructure spending and an increase in the number of jobs with wages appropriate for urban living. The size of the provincial debt along with debts of government controlled banks will take great skill to avoid a financial collapse. The military/naval machine will need to be fed to avoid political problems. Solutions for ethnic and ecological problems can’t wait much longer. The enormous size of China’s internal market and their own trade ambitions are creating substantial opportunities for the world to participate in its growth. Simply put China can not be ignored.

On a gross basis India is growing faster than China. Whether the year-old government can encourage an in increase in productivity is critical. Skipping the landline phase in telecommunications will help as will some technological improvements in terms of electricity and drug production that need to be accelerated. Higher productivity requires lower levels of corruption and governmental controls. India already has the world’s largest middle class and an increasing number of highly educated workers.

Portfolio advice

Each investment activity that I analyze has a global aspect to it. Increasingly I segment portfolios into different risk classes, bearing in mind that risk is the size of the penalty for being wrong which affects future spending plans. If we live in an increasingly dynamic world we should be investing in securities that can manage change. While this favors stocks over bonds, it also introduces a bias in favor of mid to small companies that can make changes more rapidly than large companies that are too risk averse.

Question of the week:

Which are the companies that are likely to handle future change the best?     
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A. Michael Lipper, C.F.A.,
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Sunday, May 24, 2015

Avoid GDP and EPS


When the starting focus is wrong, many investors do not succeed. Though I can not judge the veracity of Socrates’ view that the unexamined life is not worth living, I believe the unexamined investment process is not worth continuing.

Starting with GDP

More supposedly learned people spend their working lives following and projecting the various Gross Domestic Product (GDP) statistics than any other measure. The academic community (within their institutions and within their satellites in business and government) start almost all of their future projections with a GDP growth rate. Yet it is rare for any annual or multi-year projection to prove to be accurate in terms of magnitude and occasionally direction. Thus most top down investment processes that start with GDP projections have not produced competitive results.

GDP traps

The basic fallacy of substantial reliance on GDP numbers is that a single number can represent the entire amount of economic activity within a geographic location. As a junior analyst at a trust bank, each of our company reviews required a comparison of revenues to a relevant generic measure. For many years the senior investment person was a well known and respected economist and the comparison was often with the GDP*.
          *At the time we used Gross National Product (GNP).

As industry analysts we were meant to contribute our estimates of various industry statistics. As a budding technology analyst among other sub-segments followed, I was responsible for estimating the growth in the production of timing devices. While clocks or other timing tools were inherent in the production of numerous technological products, we did not follow a single company that provided any numbers as to their production. Not even output for industrially important punch card clocks to determine employee hours were available. There was no focus on changing specific prices (e.g., as transistors were introduced into timing mechanisms). In addition, I suspect at that point there were more clocks and other timing equipment already being used in our military and thus their production numbers were not known or were classified. Similar detailed projections were required by other analysts.

For central authorities the cost and availability of gathering complete production numbers were, and are, beyond their capability. Due to the nature of governments to tax, I presume there has always been a sizeable unreported level of business which probably changed with the taxing authorities’ levels of competency, authority and integrity. I doubt that it was ever a constant ratio of aggregate economic activity. Further, I am guessing that everyday somewhere within an economy business people, farmers, and others are finding new and different methods to produce similar goods at lower costs and perhaps increased worthiness.

A “Man-made” metric

Today we live in a global and increasingly integrated world. GDP analysts utilize export and import statistics reported to them mostly based on tax and other regulatory data provided. While this may be a good attempt, it is a monastic view of a commercial marketplace where transfer pricing is an art form, some over-invoicing occurs as a way to move currency and there is not cross-border comparison as to how the same transaction is tracked in multiple countries.

In sum total, the reliance on GDP pronouncements by government authorities and media pundits seems to me to be a weak crutch upon which to base investment decisions. They are sound bite size, and excessively simplistic answers to the complex question as to how the economy and business in general are doing. As noted in my earlier posts, some of the Chinese political leadership do not trust GDP figures as they are “man-made” and not a direct extrapolation of economic activity.

Most EPS valuations mislead

Currently it is fashionable to quote Professor Robert Shiller’s Cyclically Adjusted P/E (C.A.P.E.) as a valuation metric to determine how expensive the stock market is. Liz Ann Sonders of Charles Schwab** recently produced a study entitled “Devil Inside: Dissecting the Most Popular Valuation Metrics,” which does a fine job pointing out the problems with this ten year average inflation-adjusted earnings per share of the S&P 500 price/earnings ratio. The problem that I have with relying on this as a tool is though it may make life easy for students and pundits,  the earnings used are only the reported earnings and it is looking backward.
            **Owned personally, and/or by the private financial services fund I manage

Beginning at least some 80 years ago Professors Benjamin Graham and David Dodd taught in their Securities Analysis courses that the first thing the analyst was to do in analyzing an income statement was to reconstitute it, removing all the non-recurring sources of income and expense. Eventually the accounting profession caught up and started to disclose the various reported non-recurring factors; e.g., profit and loss of investment sales by industrial companies.

In addition, to determine fundamental earnings power, one of the tasks that I did some sixty years ago was to “normalize” tax rates and where possible put all competitors on a similar rate which in effect reduced the impact of different balance sheet structures. More difficult was to model all peers on the same inventory accounting system such as LIFO vs. FIFO, etc. Most difficult was adjusting for various unusually large year- end sales and expenses that under other conditions could have appeared in the following years. To me the real benefit of this numbers crunching was to force on me that I was viewing a painting depicting someone else’s view of reality rather than reality itself.

This jaundiced view of reported earnings was reinforced years later when I had to deal with mergers & acquisitions. There were significant differences in the views of the buyers and the sellers of a company which led in part, to a dissimilar valuation that motivated each, and in many cases varied from public perceptions as to the value of the deal. In effect, the beauty of the deal was in the eyes of the beholder.

Having helped some financial organizations make acquisitions, the real focus was identifying the range of likely future earnings. The buyers were buying what they thought about the future, both without major changes and with changes that the acquirer expected to make. In almost all cases this led to a bargain purchase with a valuation below the valuation that the buyer’s stock was selling at for at the time of the purchase. Keeping the point of view of potential acquirers in mind, I estimated what I thought long-term future earnings might be in my purchases of individual securities and various funds. Thus, I am a future oriented investor along with others beyond the halls and bypasses of academia.

Three steps to take

1.  Adopt the appropriate valuation measure for each account. Some investors appear to be more comfortable in the past as they fundamentally believe that the current and future will be an extrapolation of the past. Of course the trick here is to pick which past. You could start with the Eighteenth Century, or perhaps 1926 when the first tracking services became evident, or a rolling ten year C.A.P.E. model. You could use a period since last the major peak or troth, or chart when new leadership of a company or country came to power or use another timespan.

2.  Use selection approaches that are appropriate for the timespan. For example in our four Lipper Timespan Fund PortfoliosTM, we will be much more focused on short-term GDP pronouncements and reported earning valuations in the first two portfolios, Operations and Replenishment. In both cases we recognize that a significant downturn is a matter of major concern. As the timespan lengthens we become more future earnings-focused and more interested in changes of demographics and psychographics than in GDP. Thus within our Timespan Portfolios, the shorter timespans will be much more influenced by cyclical factors,  in the intermediate timespans secular trends and in the Legacy Portfolio likely disruptions to historic extrapolations.

3.  An important advantage of investing through a portfolio of funds is that select smart managers that have well thought-out, but different investment strategies are available. This third step is critical to avoid locking into a single philosophy. The one absolute positive as to the future is that every investor and investment manager will be wrong from time to time (or if you prefer, premature). The risk when this happens to all of us is to overreact with an abrupt reconstruction of investments. By instead using a selection of sound, good managers, most of the time the total portfolio will benefit and move toward its funding responsibilities.

Question of the week:

What are the three most likely future changes that your investments can tolerate and what are the two that would force major changes to your investments?
Did you miss my blog last week?  Click here to read.

Comment or email me a question to .

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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.