Sunday, October 18, 2015

To Win, Escape the Crowd


Big wins are most often surprises. Typically they arise from lonely corners of the investment world. Having known a number of the portfolio managers that have produced surprisingly good investment performances, I have detected a pattern. First, while intelligent, the winners are not measurably smarter than their competitors. Second, they seek information in the nooks and crannies of the world. They look broader and deeper than most. Third, they derive confidence from the realization that few, if any, share their views of what they have discovered

The interesting question is why do the winners succeed and equally bright, if not brighter, managers with larger staffs of competent analysts and in many cases greater commission power do not? I believe I have some clues to this result, and further I have some thoughts about current potential areas of future success.

The Enemy of Wise Selections are Labels

One of the early academic screens for determining intelligence in children is a test that shows a number of objects and the youngster is asked which of these things are like the others. We identify intelligence with the ability to group like things together. Later on we learn to put labels on groups having similarities. Too often children grow up seeing the world as a collection of labels. They become programmed to make judgments by collecting enough from different labeled characteristics to give them a winner. 

Our educational system combined with our fears of making "stupid" (i.e., unpopular) decisions forces people into what quantitative analysts call central tendencies. Thus, people assemble their decision matrix based on labels with investment names like growth, value, quality, size, etc. Luckily for the US Marines, when often facing massive forces on the other side, the opposition leadership relies on labels and equates two units of equal size but of different experience and expertise to be equal. Of the many things we learn as Marine Corps officers are the characteristics of the individual Marine that will govern the likelihood of success.  The same philosophy works in the investment world.

As a junior securities analyst, for a period of time I was assigned to cover the domestic steel industry. At that time they all used the same production process with the same raw materials. When looking at the majors, many in the financial community chose the steel stock that had the lowest price/earnings ratio. I remember coming to my seniors and suggesting that two of the stocks were worth more than the average P/E in the group, because one was more integrated with its own natural resources and the other had mills much closer to its big customers and thus would have lower transportation costs. (Years later I was happy to note that these two were the last to go through major reorganizations.) The important analytical lesson was the willingness to dissect the labeled specimens.

Looking For Needles in a Haystack

Each weekend culminates my week's effort to find investment value. The first screen I use is to determine where the bulk of the investment thinking is on any given subject. The second is to scan widely various statistical arrays to find elements of change that do not appear to be  believed by "The Crowd."

Barron’s  “Big Money Poll”

This week Barron's published an annual article that reviewed results of an extensive list of financial and economic questions answered by a large number of substantial institutional investors. As part of my two step approach for uncovering winning investments I paid particular attention to views shared by 70% of the respondents to this "Big Money Poll." As regular subscribers to these posts perhaps realize, I tend to examine contrary points of view. Certainly not all contrary views will prove to be correct, but when they do turn out to be right the magnitude of future price moves is considerably larger than when the more popular view succeeds.

With that caveat in mind, please look at the following readings from the poll:

  • In terms of the equity market 76% of their clients are neutral. (53% of the managers are bullish.)
  • 75% of the managers do not foresee a 10% or greater decline.
  • Three stocks are expected to rise:  Alphabet 87%, Apple 77%* and Berkshire Hathaway*. 
  • 72% think that IBM will decline.
  • 73% saw no deflation.
* Stocks owned personally or in my managed private financial services fund.
    Three Insights from Mutual Fund Data

    Because of my background and my management responsibilities I also look carefully at mutual fund data to see if any of the data flow is predictive or at least coincident with changes in investment attitudes. Three items worth commenting are shown below:

    1.  While mutual fund investors redeemed $2.2 Billion net from equity funds, $4.7 Billion went into equity Exchange Traded Funds (ETFs). As most of the dollars that go into ETFs are believed to be from institutional type investors, this reinforces the Big Poll finding that the managers are bullish. (Perhaps these largely index fund purchases are being made to hedge individual stock short positions.) I believe the outflows from traditional mutual funds are not a sign of dissatisfaction, but the absence of offsetting fund purchases. The sellers are often in the process of changing their assets around to meet lifestyle needs. The absence of retail sales volume  buttresses this argument.

    2.  Secondly, the average Precious Metals fund gained +8.33% for the week ending Thursday. This gain, driven by the gold price, brings the year to date loss to -7.63%. To me, this gain is indicating that buyers are viewing precious metals in more of a monetary sense than as an inflation hedge. An index of funds investing in Base Metals is off much more, -12.80% which suggests that investors are not currently expecting rising inflations.

    3.  The third item is a comment by an investment manager at Prudential that the widened spread on "junk bonds" versus similar maturity treasuries is getting interesting. I am intrigued with the fact that the average General US Treasury fund over the twelve months is up +5.59% and the average High Yield Mutual Bond fund is off -4.40%. A reversal of performance would be quite a surprise.

    Finally, I scan lots of material and this week found two other items that are worth thinking about. The first is that small/mid sized businesses make the point that their second biggest problem is finding qualified labor. The first is taxes. The other item of interest is a statement in a US government publication that the presence of high frequency traders in the treasury market may be giving the illusion of liquidity.

    Bottom Line

    If you want to make winning investments, look deeper where others don't, and avoid reliance on labels.

    Question of the Week: Do you have some examples of winning investments that you would like to share?

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    A. Michael Lipper, C.F.A.,
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