Sunday, December 13, 2015

Are you an Investment Trend Follower or a Selector?


Are you an investment trend follower or a selector? The answer to the question will determine the result and the comfort level of your volatility.

Many institutional and individual high net worth investors inherently believe in the comfort of being gathered into the current central tendency of the market. They fundamentally believe in the phrase “the trend is your friend.” Others with some exposure to the sports and/or political world are very aware that there is an end to every trend which can be surprising and dramatic. Other investors practice a diversion from the central tendency by being selective.

The “H” and “T” Choices

While each of us think we can easily make rational choices between trend following and selectivity, to go against the trend you may have to identify whether you are more “H” or “T.”  Briefly “H” stands for Herodotus and the “T” for Thucydides. Both were historians  of ancient Greece. The first has been called “The Father of History” and by some “The Father of Lies.” He was among the first to write down the combination of what he saw and what we would call oral history without much authentication. He put these stories into a continuum in order to show a developing trend.

Thucydides  has been called the father of scientific history. Unlike his predecessor he did not often express an opinion and required hard evidence in the experiences beyond his own. In effect, he was a collector of incidents including the motivation and expertise of the main players. I must admit to a leaning in his direction as he was a general in addition to be being a historian. His history is required reading in the US Naval War College.

Why are so Many People Wired to be Trend Followers?

Which way we have been taught may very well have to do with a political decision made by the Communist Party in the US and probably elsewhere in the 1920s. The party saw that it needed to convince people as to the inevitability that communism would triumph eventually. They were clever in getting educators at various universities, high schools and even grammar schools to accept these so-called trends as the way the world will go, thus building the belief in the inevitable march through the left to socialism and then communism after a number of generations. Many, if not most of us have been schooled in trend identification and following. Once this becomes our main thought process toward political history it is difficult not to apply it to our investing.

Trends Don’t Last

A careful study of the history of almost any topic will show that the human genius often comes up with intelligent breaks of emplaced trends, be it fashion, art, music, politics, sports or investing. While there are some risks in being too early in deviating from the existing trends, the loss of capital opportunity of getting on sound future trends is much more expensive than being too early.

The Job of a Professional Analyst

The most important job of professional analysts is to act as Thucydides would to examine what is actually happening and apply the lessons prudently. This is what I attempt to do every day for the benefit of my accounts. I do this with the comfort of knowing that most investors will be trend following. This will help in keeping my losses relatively small when I am too premature and have the pleasure of selling into the crowd when the new trend becomes acceptable.   

This Week’s Historical Implications for Possible Trend Disrupters

Last week the Chief Investment Officer of Matthews Asia with his forty strong investment group had a breakfast meeting at a midtown Manhattan hotel. He is betting on rising wages within Asia led by China and India to create massive consumer spending. (Interesting that the government of China recognizes that its hold on power is dependent upon job creation funding a rising standard of living.) He expects that China’s former role as the driver of demand for many industrial commodities will be filled by India with announced major infrastructure projects. To accomplish these goals India will need (as in China) to pay attention to the level and grasp of corruption. Asian stocks while not relatively cheap in terms of price/earnings ratios, appear to be relatively cheap on a price/sales ratio. I would be focusing on the spread between return on invested capital and return on equity to focus on the risks of over-leverage. As these countries move from low wages to higher, I find operating earnings per person is a trend of particular interest to me.  

Much of my focus on deeper financial ratios comes from almost a year solely devoted to getting my arms around General Electric in the mid 1960s. Interesting from my seat at the breakfast last week I could see across Lexington Avenue to the entrance of what used to be the General Electric headquarters building. One of the reasons I question lots of trends is that while the numbers proceed, the way they have been generated has changed to such a degree that past comparisons are less meaningful. My analysis of GE was that the company was essentially a manufacturer which had various financial and insurance activities to support the manufacture and sale of its products.  That started to change as the CEOs changed. GE moved its headquarters to lower-taxed Connecticut and started to grow GE Capital into an independent, financially aggressive series of unrelated activities. The move to southern Connecticut cut the taxes for the most senior executives living in that state, and detached itself from the New York financial community. Initially this helped GE overcome an aging plant and employment base, but it also fundamentally changed the corporation into a materially slower operating growth company on the industrial side and increasingly dependent on, in my opinion, lower quality earnings from GE Capital. Thus while GE is probably the only stock in the Dow Jones Industrial Average stock for the last 100 years, its long-term trend is not particularly useful in predicting its future stock price.

Brokers are Sharing the Disappointment

The pre-Tax Return on Equity in 2014 was 9.2% compared with 25.1 % in 2000 and 40.3% in 2009 for the aggregated NYSE reporting firms according to SIFMA, the industry trade association. Revenues are less than half their peak levels of 2007 and have been essentially flat at $165 Billion between 2008 and 2014. The number of registered representatives for FINRA has not varied much since 2009 and is now 637,000.  The average annual turnover rate of shares traded on the NYSE is the lowest it has been in the last 15 years.

What has gone up and shows the change in the structure of the market is total margin credit (borrowing); in 2014 it reached $456 Billion compared to $187 Billion in 2008. The growth in margin credits is a mirror of the growth in hedge funds and other trading vehicles. Another growth element through 2014 and probably reversed (at least temporarily) is the portion of the Global Equity Market Capitalization that is now 23% which is double its 1995 level of 11%. When Emerging Markets return to favor there is a good chance that the 42% invested in the US will drop. (Any investor that has more than 50% invested in the US is betting against the rising standard of living outside of the US.) This is a major change in the structure for the long-term demand for US stocks.  For those who have a portfolio structure similar to our TIMESPAN L PORTFOLIOS®, I would recommend to have significantly greater international holdings in their Endowment and Legacy Portfolios than their Operating and Replenishment Portfolios. Charles Schwab’s next 12 months earnings growth is 2% higher for the Eurozone at 15%, and 5% higher for Emerging Markets.

Bulls Could be Disappointed

Readers of my blog know that I don’t like being in crowded trades, viewing that often one’s co-venturers in a security are potentially a greater source of price risk than the issuer itself. Further, I have often identified that I manage a private Financial Services fund. In this week’s Barron’s nine investment strategists were asked to pick their favored sectors. Eight had financials in their selections. The saving grace for me is that I believe our stock selection is quite different than the bulk of others, without significant holdings in commercial banks, credit card networks or life insurance companies. Nevertheless, I get concerned when new money is coming into my neighborhood.

All is Not Clear Sailing Ahead

The Third Avenue Focused Credit Fund has had too many redemptions so has suspended the ability to redeem from the fund. This is particularly instructive on a number of levels. For some time the yield spread between high yield paper and US Treasuries has widened considerably. At the same time the credit rating agencies have raised their year ahead estimate of the percentage of high yield paper that is likely to default. The combination of low sales growth, falling energy prices, rising interest rates and maturing debt schedules are some of the market’s apprehensions.

What is fascinating to me is that the management company was founded by Marty Whitman, a 91 year old  very successful distressed securities player who made a lot of money for me. As part of my research on closed end funds that we were tracking I bought some shares in a West Coast fund that was being managed by a trust bank, but was selling at a big discount. Mr. Whitman bought control of the fund and converted its portfolio into a distressed securities portfolio with particular focus on firms that had large tax loss  carry forwards. He then merged operating companies into those with large losses and thus freed them of a tax burden. This was a wonderful investment particularly as it was not an open end fund that had to meet redemptions. To me this is the appropriate place for investing in similar merchandise, not like the Third Avenue open-end fund.

Fund pioneer and value investor Max Heine with his associate Mike Price at Mutual Shares did the same thing on a smaller scale in their open end funds which always carried large cash reserves plus a portfolio of very liquid stocks. There is nothing wrong with selectively owning distressed securities if you know what you are doing and do not need liquidity in a market with shrinking risk-oriented liquidity. (If anyone is interested I will share what I did with cumulative shares in arrears as a another distressed securities play.)

The final possible storm warning is the interest rates that many banks are offering for deposits. Just this week the average dropped to 0.26 basis points from 0.28 the week before and 0.44% earlier in the year. There is a demand for loans, but banks may be so constrained by bank capital requirements they would prefer to keep their money with the Fed or in the highest quality corporate bonds whose yields according to Barron’s are averaging, 3.74% which is more popular this week than last.

Question of the Week: What portion of your portfolio do you consider significantly different than mainstream thinking?
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