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