Sunday, September 27, 2015

Value Investing: Yes,
Book Value: No


Two thoughts to begin this post:

1.  Value focused investing has produced good results for hundreds of years.

2.  The use of unadjusted book value found in the modern corporate accounting statements can mislead the value investor.

Investment See-Saw

With our need to label anything that moves, particularly in the stock market, during rising markets we often divide companies, stocks, and fund portfolios into either growth or value. With the power of computers to sort and mislead, many foolishly believe that there are some statistical divining rods that can separate growth from value. In truth almost every entity has alternating periods when it can be recognized as either growth or value.

The Perceived “Two Number” Screens

As a life long student of investing I have noted that growth investing is essentially time-focused arbitrage. The growth investor has reasons to believe that in a particular future the price of the shares of interest will be materially higher than today’s price. Growth investors are essentially forecasters. In a secular rising market (as experienced by US investors) the trend is their friend until it periodically disappoints.

Value investors see the future as a range of outcomes, only some of which are identifiable. Charlie Munger is the epitome of rational investing. He and his partner Warren Buffett have three baskets, In, Out, and Too Tough. Jason Zweig quotes Charlie invoking Confucius, who said that real knowledge is knowing the extent of one’s ignorance.”

Dangers of “Latest Published Book Value”

Far too many professional investors start their search with a screen of current prices compared with the latest published book value. I would suggest they are taking an easy and faulty crutch to find value. One of the many things drummed into me by Professor David Dodd of Graham and Dodd fame was never to accept the validity of a balance sheet as presented. Balance sheets then and now are important initial file instruments for the credit world. The initial bottom line for credit work is book value. This is a calculation derived from taking all the liabilities on the balance sheet from the total of all assets also shown. For investors in stocks and bonds priced way below par or maturity value, Dodd would term book value, unadjusted as “rubbish.” The good professor was not just a learned academic at Columbia University, he was also an investor and partner with Ben Graham* in a very successful investment partnership.

The Lessons Not Learned

On my recent trip to visit investment managers in London I came across at least two instances where they could have profited from Professor Dodd’s classes. In the first case a sizeable, successful group invested in closed-end discounts from the fund’s current net asset value (equivalent to book value for funds), large family dominated non-US financial entities, and other conglomerates. I have been an analyst of bear raids on US closed-end funds selling at significant discounts. These “operations” rarely work out in practice compared to what they should do in theory.

All published net asset values for funds are based on the closing price of the individual holdings on statement date. Market operators are well-conscious of important stated dates and may adjust their closing prices accordingly. If the fund has particular positions in somewhat illiquid stocks the price to liquidate the positions will likely be anything other than the last price in the NAV. Also the unwinding of the raided investment advisor’s management company can prove to be expensive in terms of settling leases and termination payments. Further, to force a liquidation of a closed-end fund an initial investment needs to be taken and it is at risk for the difference between the purchase price and the liquidation proceeds in the future when the market could move materially. At times, hedging this risk can be expensive. As faulty as raiding a closed-end is, the rest of this portfolio is at risk for using book value as an important measure.

I was one of the very few analysts who in the 1960s spent a great deal of time following multi-industry companies. These were soon called conglomerates, somewhat forgetting that General Electric and other industrial companies were producing products for a wide range of business customers. One of the reasons I was attracted to these companies is that there were many fewer analysts following them and thus they were not highly valued.

One of the sales pitches to convince institutional investors to buy these stocks was to show that there was a substantial discount from the value of each of the major parts of the conglomerates. It was a good sales approach, but I can not remember a single conglomerate that liquidated itself by selling off all of its parts. Yet this is the very same approach that was being used by this London manager. Further, as I knew a little bit about some of the financial operating holdings, I questioned whether book value was reflective of a liquidating value.

In one case, the financial operation was one of a handful of major players in a somewhat restricted market. I raised the question as to whether the local government would permit its sale to a foreign entity. Having recently visited this particular headquarters, I asked whether a very extensive art collection was in the book value calculation. (There is at least one important US group with a similar art collection.)  The conversation then pivoted to their treasures, we did not even get into the expected size of retention packages for key personnel or any guess as to the proportion of revenues that could be lost if the founding family was no longer involved.

On a second London visit, to one of the great names in the global financial world, we were going over its balance sheet and other financials. It was pointed out to me that the monetary value of the firm’s great name was not included. I raised the question whether or not they could get an external appraisal as to the value to the name, which my hosts never considered. As someone who has a globally recognized name in various financial communities, I am aware that a well-known name helps in getting the first introduction. But from that point on it is what one is presenting that will determine what is bought. Thus, the value of a name is a bit ephemeral, but I believe it still can be measured.

The interesting thing coming out of this type of exercise is that for internal purposes the value of the brand would have been added to its assets and perhaps materially. If that was the case, the return on assets and return on investment could well show that the present management was not really earning its keep.

What to do Now?

As we do not know which type of investing will do the best for any particular period, in our portfolio practice we own both growth and value focused mutual funds for our accounts. Over long periods of time the survivors of these two schools of investing produced similar results, but quite different in shorter periods. On a year-to-date basis in each market capitalization size category, value funds have underperformed growth funds. In a somewhat extreme example, through the 24th of September, the average Large-Cap Growth fund is barely down -0.36% as compared with the average Large-Cap Value fund falling -8.57% as measured by my old firm. As a long-term contrarian investor I note that the spread is unusually large and could prove to be attractive in the next cycle. 

* I was very honored when the New York Society of Security Analysts awarded me the Benjamin Graham Award, my old Professor might not have believed it.

Question of the Week: What measures do you use to find value?

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Sunday, September 20, 2015

Hearing and Seeing Different Investment Views


Having just spent the last eleven days in discussions with portfolio managers, CEOs of banks and other investment experts in London plus global stock exchange leaders in meetings in Barcelona, I have been trying to find some common theme among these bright men and women. The single most common theme is the complaint,  “The world is far from perfect and getting worse with almost every bit of news.” This feeling is felt widely, which I attribute to the rise of populism on both the right and left of the political spectrum.

All Cash To Escape the Complaint

In spite of their complaints, almost no one is just sitting in all cash, which is not what I am advocating. But to own anything we must have a belief that on a relative basis at least some assets will hold value and may increase in value. Thus, we must be relatively happy about something or some things. Interestingly we don't often proclaim our happiness. Perhaps, we fear if we brag about what we own, it will be taken away from us. Many in the or around the investment community want to appear to be sophisticated so that they may join in with their lists of complaints. Rarely is any time to devoted to those investments or conditions that make them relatively happy.

There are very few portfolios that have 20% in cash. A holding of 50% in cash within a fiduciary account might be considered imprudent before a probate judge. This is not to say that we should not prepared for periodic drops of equity prices in the range of 25% and once in a twenty five year generation of 50% decline.

Bottoms Good and Bad

The reason we limit our cash accumulation is that we have studied cash hoarding by mutual funds and individuals. In many minds, cash can become too comfortable because there could always be another major drop. Off of some bottoms, the first 10 to 20% is often viewed as a rally in a bear market when it is really the easiest earnings in a bull market. Many are frequently surprised by the strength of the new market leadership. Above all we need to remember that we can and will be wrong from time to time.

Interest Rate Hike to 4%?

My readers will not be surprised that I was disappointed by the Federal Reserve’s inaction last week, including what was said by the Chairwoman. I did not expect what is analytically needed. The best result would be a single immediate jump to 4%. Many will feel my call for 4% is extreme, but they should examine the last two studies of the so-called "dot-plots" by the members of the Federal Reserve's Open Market Committee. In each case the highest rate called for was 4% or even higher in the furthest out period. If some members believe that such a rate will be called for because of economic stresses within the next two years, why not be preemptive now?

By immediately raising interest rates we will probably reduce the intensity of the bad loans being made. We will also make saving attractive to those who need to begin a life long activity of building their capital for emergencies and retirement. A careful observer should note that, as usual, the Fed is late to changes in the market place. I believe one should look at Main Street as well as Wall Street. The average interest rate being offered by a large number of banks has risen from its lowest level of 25 basis points to 30 basis points. This demonstrates to me that local banks want to attract more deposits so they can make money on more loans.

While I believe both our monetary authorities and our courts should be guided by what is appropriate for this country, there are lessons that can be useful in assessing our own problems. Some of the observers of the surge of refugees streaming into Europe are suggesting that a significant number of these people are migrants for economic reasons not for political reasons. Applying that distinction when we look at a substantial number of immigrants to the United States (including some of our original founders) we learn they came to the US for economic opportunity reasons. If we want to see growing economic opportunities in the United States we should be constructing opportunities to save and to invest, activities that the current level of interest rates do not encourage.

Come what may, investment managers will find reasons to complain and keep their investments in equity mutual funds and stocks including those in the financial services arena. Many mutual fund and other portfolios that I examine have as their largest investment sector various financial services stocks. 

Question of the week: Next week I am contemplating addressing value investing. Please let me know what aspects of value investing you would like me to address.

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A. Michael Lipper, C.F.A.,
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Sunday, September 13, 2015

Entrepreneur vs. Investment Thinking

Singular vs. Diversified Investing

Charlie Munger reminds us that the great fortunes that have been made come from entrepreneurs who focus on one product or service and do it very well.

In maximizing their sound bites or column inches, the talking heads of the news media often focus on a single concept or instrument. While this specific input may be helpful if someone is looking to add to his or her portfolio, following the advice is verging on the irresponsible in terms of how it affects the whole portfolio and the total financial condition of the investor.

Recently I have been researching the impact of ETFs and other pre-packaged instruments and I found that many of the holders of these instruments don't understand the changes in the market mechanisms about trading in and through ETFs. Further they are confusing the difference between individual and team performance.

The Analysis of Picking Winners

As my readers know, I learned much about analysis by handicapping at the racetrack. In order to cash winning tickets it is not enough to find the fastest horse based on its prior races, work outs, breeding, jockey and trainer capabilities. One also needs to guess how the other horses are likely to run in this particular race. If the fastest horse in the race is your choice you would be better off if the horse is not blocked by a crowd of horses running similarly. Some horses with early speed that soon tire could help the ‘come from behind’ horse. Thus, in picking an instrument it is important to have some idea what the other major securities are likely going to be doing. Therefore the length of the race is important. In short races the ability to rapidly accelerate and maintain the acceleration until the finish line is critical to winning. In much longer races stamina is a good deal more important.

Picking Your Measurement Time

When a prospective investor asks me for a recommendation, I ask “What is the period of preferred measurement?” This is like asking the length of the race. To aid the investor, I introduced the concept of the four Timespan L PortfoliosTM, which stretch from the near-term to the long-term. I find this approach useful in contrast to almost all of the popular commentators, who appear to be focused only on periods of under twelve months. To use a military analogy, this is like firing a single rocket compared to a longer range guided missile with bigger and multiple payloads.

Index Funds are Different than Managed Mutual Funds

For long-term accounts, let’s compare an index-tracking ETF with a fully discretionary managed fund. The index tracking portfolio is like a rocket that once fired can not be re-directed to new and better targets of opportunity. The managed account can shift its portfolio composition to address a new or different investment opportunity.  It can change its risks assumptions. As a matter of fact that is one of the reasons managed funds have underperformed since 1987 and particularly since 2008; because of fears that periodic down markets would bring on the need for cash to meet redemptions, which has happened to US domestic-oriented funds for more than a year.

A managed portfolio needs to pass a prudence screen, e.g., avoiding bankruptcies as well as perhaps some social screens, individual stock limits to share of portfolio, shares outstanding and liquidity concerns.

A index tracker does not have similar constraints. Often its portfolio is constructed to represent the central tendency of stock prices along a particular axis such as market capitalization, sales, earnings, etc., that the publisher of the index selects as the single most vital indicator. In the extreme a managed fund manager can face a judge or regulator as to the prudence of the assembled portfolio; the index publisher has no such constraints.*  

*I hold the record for creating the largest number of indices, in this case for mutual funds, which are now published by Lipper, Inc.

Managed Funds Out-performed Indices During Turmoil

Recently S&P/Dow Jones Indices, a subsidiary of McGraw-Hill Financial reported that relatively few mutual funds beat the various indices, regardless of whether that was their goal. In an article in FT Money, Merrryn Somerset Webb of MoneyWeek pointed out that many fund averages lost less than the security averages from April 13th through August 24th. Her astute comment was not that the funds did better, but that the indices did worse. I would suggest that the absence of cash explains much of the sub-par performance of the indices.

Securities indices were never designed to be prudent portfolios and follow normal managed portfolio constraints, therefore it is not really useful to compare managed accounts to indices and ETF tracking vehicles. Each has its place in tool kits of investing.


Some of us like watching individual performers in the sports arena or on the theatrical stage. Others like to view a team of talented individuals working together scoring points or producing great symphonies. We should not confuse the attributes of each to select one over the other.
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Sunday, September 6, 2015

What Have We Learned...if Anything?

Personal Perspective

I see the world somewhat differently than most. Perhaps I was always destined to be a securities analyst. Or learning basic analysis at the race track where betting on favorites for every race was a losing proposition. Or being trained the elements of leadership from the US Marine Corps. Regardless of the source of my learning, I tend to examine popular beliefs with a somewhat jaundiced eye. In reading my posts readers would be wise to remember how my thought process works. 


Too much has been written about the causes of the late August declines in global stock and bond markets. The focus has been  almost exclusively on the various financial instruments and economic data. Almost nothing has been written or spoken about the key determinator of market prices. Did a significant number of people all of a sudden get a new insight as to how they should manage institutional or individual portfolios?  In general, the answer is ‘no’ and more importantly, they did not take away any lessons that they should use in terms of structuring their portfolios to be winners over time.

The Current Picture

Going from the most negative to the most positive, comments that I have seen are as follows:

1.      JPMorgan's leading mathematically driven analyst believes "half selling is done." Since much of the selling started with various derivatives it is worth noting that in August the CME reported a 60%+ increase in the volume of index trades. Further while the S&P500 market weighted index declined -6.03%, a version  whose components are equally weighted declined -5.39%. This suggests that large sales of market weighted ETFs (Exchange Traded Funds) contributed to the decline. (This in turn leads me to believe that the August market turmoil was a trading event rather than a fundamentally-driven move.) Put volume exceeded call volume which is also a bullish sign.

2.      A market analyst from Morgan Stanley has commented that the size of earnings estimate revisions have been declining for almost fifty years.

3.      At this time of year Byron Wien regularly reports in his series of exclusive lunch meetings for visitors to the Hamptons. His conclusion is that no one is expecting a recession. (Caution: one of his more perceptive guests commented that the consensus is usually wrong.) 

4.      It is worth noting that according to The Economist there are three local markets that have risen in US dollar terms more than ten percent this year: Hungary +18.8%, Denmark +14.7%, and Argentina +14.5%. I don't remember seeing any of these stocks in emerging market stock portfolios which shows that there are still opportunities for hard working analysts. 

Looking Forward

The second largest California State Pension Plan is electing to reduce its stock investments to 43% from 55%. It is somewhat following its larger neighbor which is pulling out of investing in hedge funds. I view both of these as good news. 

We all search for good indicators to follow. After many years of watching the record of the best positive indicators I have concluded that they are correct only 2/3rd of the time. The inverse of some negative indictors has a greater accuracy level. Thus I view the actions of the two California pension plans as positive.

A somewhat more positive view is expressed by actuaries which are recommending to their clients a 6.4% actuarial rate for pension plans. First, one needs to remember how conservative they are. Second the rate is for the entire pension plan. Assuming a "normal 60/40" split between stocks and bonds and a 4% total return on the bond portfolio would suggest an 8% return for the stock portfolio and a so called risk premium of 4%. The risk premium would drop if bonds were assumed to earn 5% and the actuarial rate remained constant.

One of the guests at Byron's lunches was a CEO of a tech company who addressed the concern that the tech world will run out of big new products or services within thirty years. With what he saw on the horizon if anything he thought technology would be accelerating its progress. 

Perhaps the most bullish and soundest piece of analysis was done by the good people at Charles Schwab. They looked at annual returns of the S&P500 from 1926 to last year to determine the performance extremes for one, five, ten, and twenty year periods.  

Time Period
Extreme High
Extreme Low
One year
+54 %
 -43.3 %
Five years
+28.6 %
 -12.5 %
Ten years
+20.1 %
 - 1.4 %
Twenty years
+14.8 %
+ 3.1 %

These periods can be utilized in our Timespan L PortfolioTM construct.

The longer the time period the smaller the extreme loss, with no loss for the twenty year period. These periods would be appropriate for operational, replenishment, endowment, legacy and custom portfolios. In custom making these portfolios one has at least five different attributes for his or her portfolios which include aggressive, conservative, middle of the road, rigid, and idiosyncratic. These attitudes can be exercised by the selection and combination of stocks, bonds, mutual funds, ETFs, and separate accounts.

What should have we learned?

There is a significant difference between our intellectual financial risk tolerance and our emotional risk tolerance. If we are using an operating portfolio and possibly a replenishment portfolio, we should have been reducing our risk in the first and starting to nibble at the second. As a practical matter (as one of our readers indicated) that procrastination was the mode of the day. This means that for most managers of their own or other people's wealth they have not thus far reached their emotional risk tolerance action point.

There is a good reason for this inaction. They do not believe all the focus on interest rate setting by the Fed and or the latest pronouncements of GDP. Without knowing it they may be practicing Goodhart's Law, introduced to me by David Kotok of Cumberland Advisors. The law states "When a measure becomes a target it ceases to be a good measure." In these two cases (over-utilizing GDP and interest rate data) the poor forecasting ability of the Federal Reserve Board and many of its banks makes one wonder why anyone thinks they could get monetary policy right. The calculation of GDP is not only suspect in China but also in the US as reported recently by John Mauldin. I suspect that many of us are giving additional credence to the fact that we are seeing more people being hired and more jobs that are going unfilled.

The current geopolitical picture is also an element of worry with a Chinese Naval fleet operating off shore in US waters near Alaska, the migration from the Mid-East, and the appeal to populism in many countries, including this week in the UK when the new Labor party leader is elected.

Bottom Line

For those who lack sufficient trading skills and are long-term oriented: stay the course.
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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.