Sunday, January 31, 2016

Seven Critical Questions


There were many times in history when a war council was assembled to determine military strategy. For many profit-driven and non-profit groups the modern equivalent is the formal, or in some cases the informal, investment committee.  I sit on a number of these as well as chair others either for compensation or as my contribution to a worthy cause. If properly structured with bright successful investors these can be rewarding experiences. I urge my fellow professional investors to participate in these activities.

General Agreement Can Be Problematic

If there is unanimous decision as to a cause of immediate action, without substantial discussion, then there is no need for a decision making group. In effect, that is a single decision-maker with only a “Greek chorus” of ratifiers.   On the other hand, after substantive exchange of contrary views, there is nothing wrong with unanimous decisions by those that actually participate.

For future actions there may be more benefits from the discussions than from the initial decision.

Critical Topics for Future Decisions

Currently unresolved topics include the following:

1.  Can the large amount of global government debt be slowly and carefully liquidated?  Or will it, based on history, only be solved by a harsh and climatic panic-type contraction?
Which is more likely?

2.  While not likely near-term, what are the odds of a meaningful recession during the next President's term, no matter who is sitting in the White House? 

3.  How useful is our professional experience in light of rapid change in market structure with increased central bank manipulation worsened by conflicting regulations and court cases?

4.  In view of the above questions along with the large number of players, high relative fees, and low general market returns on the upside, have the chances of successful hedge fund investing materially changed?  
Are there any good consistent short sellers?

5.  Is there above market risk in the private equity funds that have recently become so popular with institutions? Do these instruments add any more value over the market (S&P500 or NASDAQ* stock/index) when multiplied by their leverage?

6.  Are there too many venture capital pools?

7.  What are the appropriate time horizons for various portfolio investments?  (Have you considered the principles of my Timespan L Portfolios®?)

Investing in Services

According to published economic data, the two largest global economies in terms of number of labor and possibly revenues, the US and China, have both become service economies. The challenge for us as individual stock and fund buyers is to find future successful service companies. I would avoid one definition that a well-known consulting firm used:  “asset light” which propelled them to be a bull on Enron. Utilizing the correlation indicators I discussed in my last two blog  posts, January 24, "Usual Models Force Investment Errors" and January 17, "Statistical Correlations are Costly, " I would be guided by companies that could be considered talent rich; e.g., Goldman Sachs* and Apple*. Both have a high level of customer/client orientation. They seek long-term, if not lifetime relationships. To some degree they focus as much on the after-sale as the initial transaction.

*Securities that are owned either in my private financial services fund or personally that may or may not be appropriate for others.

In the pitches of advertising agencies and other marketing companies the costs of marketing campaigns are justified in terms of the lifetime benefits of securing a customer. This attitude is certainly true for a number of mutual fund management companies that we currently own. This mindset may be less true today than in the past or in the future.  The potential turnover of clients makes investing in service companies a challenge, but in many cases worthwhile.

Present Portfolio Hurdles

Reliance on the wrong statistical tools can lead to faulty results. As this blog is being written on the eve of the Iowa caucuses, there is something that can be learned from the past wrong calls of polling pundits in the UK and Canada that used a technique called a probability sample, which projects the accuracy of polls from a limited number of observations of an incomplete sample of participants. I believe there is a similar risk if one follows many of the comments of stock market pundits opining on the current market. 

Unappreciated facts that are hiding in clear sight:

Despite the fact that the popular stock market indices posted minor total return gains in 2015, the average stock declined. The entire reported gain was due to a couple handful of stocks. Some stocks in 2015 lost two years of prior gains. Does this mean that we have already been going down since the second quarter of last year?

Asset allocation or equity hedging has become much more difficult and may not be as worthwhile as many were taught to believe. Two examples: 

(A) The Economist magazine each week tracks 44 country or regional markets; for the week ending January 27th only 3 were up and for the period since 12/31/2014 there were only two positive with no overlap among the gainers.

(B) Looking through the SEC registered mutual fund lens at 95 separate mutual investment objective performance averages for 2016 through last Thursday, (before the sharp gains on Friday), there were 12 groups of funds that fell more than 10% and only one that gained 10%. The sole gainer was the average Dedicated Short Biased fund which over the last five years had an average loss of 18.46%, according to my old firm, now known as Lipper, Inc., a ThomsonReuters company.

For the last week the only major asset class to attract net inflows was High Yield funds. Some may call these “stock funds with occasional coupons.” For the longer term investor over the last five years the average High Yield fund produced a compound total return of 3.57% or probably less than half of its current yield at time of purchase. As a fiduciary advisor I have preferred using Equity Income funds. For the same five years Equity Income funds produced an average compound growth rate (assuming total reinvestment) of 8.09%. Taxable investors of the High Yield fund will pay ordinary rates on its income, however well over half of the average Equity Income fund gain will typically be taxed at the capital gains rate.
There are two intriguing market speculations facing the investor who is consciously investing internationally. The first is that knowledgeable Chinese experts believe that within a year most of the provincial leaders will have been newly appointed which will aid the carrying out of the Party's specific dictates as the economy is being shifted away from manufacturing to a services orientation.  The second is that the pound sterling has been very weak recently as the currency market appears to be discounting an exit from the European Union. For a yield-oriented investor, if Britain stays within the Union  this will provide an interesting kicker into a market where there are many sound companies which are sporting current yields of 4%.

The year 2016 should prove out the old Chinese curse "May You Live In Interesting Times," which can prove to also be profitable times for those investors aware of the opportunities and challenges ahead. 

I invite the readers of this post to contribute their views. The breadth of the thoughtful replies is an important indicator of how important these topics are. At this time there are no wrong answers other than unanswered questions.
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Sunday, January 24, 2016

Usual Models Force Investment Errors


In last week’s post I focused on too many investors that are not identifying the correct correlation models. Building on that foundation, this week I will focus on most investors, including professionals making investment decisions on today’s headlines rather than future potential prices.

Correlation Traps

Scientists who study how the brain works and those of us who have developed performance and fee tables recognize the need for comparisons. We are taught that higher ranked items are better than lower. Because rankings are so important, we prefer that the leagues be mathematically constructed, even though our choices of art, music, and significant others are not mathematically based. I will leave it to others to decide which mindset produces better results. Clue: My wife Ruth and I regularly go to concerts performed by the New Jersey Symphony Orchestra.

In the investment arena we measure nanosecond by nanosecond how well a stock or a fund performs versus market indices. (At my old firm, now known as Lipper, Inc., I convinced funds’ independent directors to compare with similar funds.) Because professional investors recognize that there are differences between companies, the popular approach is to measure companies that generally produce the same type of products or services.

This particular matrix approach did not help explain the performance of most security prices in the first three weeks of 2016. On the downward slide at least 80% or more fell, and on the not too inspiring recovery of this last week, a majority of stock prices rose from a Wednesday bottom. (See my friend Jason Zweig’s weekend Wall Street Journal article entitled “Market Capitulation is Nowhere in Sight (So Far).”

As a life-long student of investing and a professional investment manager, I am not satisfied with the comparisons normally produced as a jumping off point for analysis of investment decisions. This bears on fiduciaries and individual investors as well.

Starting from the premise that a stock and a company share the same name, but often not some of the same characteristics, I suggest for stocks (as distinct from whole company buyers) the perceived characteristics of the stock has more to do with its current and near-term performance than those of the operating company. I am suggesting that there are distinguishing characteristics that stock buyers and owners attach to a stock. All of these are far less mathematically defined than price indices, but like identifying the sought after traits of a life-long companion, lead to actionable conclusions. Because there is no easy math to guide us into putting a stock in a particular bucket, investors will reach different decisions at different times as to what is the single most important element.

Improved Correlation Elements

Over time I am sure that we will find other ways to group stocks and corporate bonds. The first four that I use are:


One example of the criticality of Demand was the sharp reversal on Wednesday which seemed to be driven by overturning the depressing view that the decline in the prices for oil and selected other natural resources was a fall in demand. Apparently investors understood that supply was in excess of demand temporarily which many feared was showing signs of a recession. The prices of crude oil and a few minerals jumping higher was a sign of increased demand from the global economy. (That supposed surge in demand could be right, but based upon my over half century of market experience there could be another explanation. Any time after a material decline is experienced in prices and then there is a sudden price spike it may well be caused by the covering of exposed short sellers.)

Too often we think of supply in terms of the items mentioned above, but I am more concerned with the delivery bottlenecks that are developing and are lengthening distribution times of various products and services produced in the US.

Regularly the number one or two major worries of small businesses are their inability to find qualified labor at reasonable wages. As consumers, people are experiencing delays which is annoying and could be a cause for imports remaining strong even with the escalating dollar. In answer to these concerns, there were discussions as to the impact of robots and artificial intelligence at Davos last week. The shares of companies that are seen to be addressing this supply of qualified labor will be in demand.

Time has two very different buckets. The first has to do with the aging process that can’t be accelerated; nine women can’t have a baby in a month  nor can anyone produce 12 year old Bourbon in a year. Similarly, waiting for the next CEO can require patience. The second bucket is the time proclivities of various shareholder and bond holder groups.

At one point an important group of institutional shareholders were the general accounts of Life Insurance companies who held these securities against the expected maturities of their insurance policies. Often growing defined benefit pension plans had somewhat similar needs. Today hedge funds with currently shaky performance need quarterly successes. Sound defined contribution plans (401k) invested through prudent mutual funds are somewhere in between in terms of time sensitivities or at least the ones we have managed. The nature of the shareholder base for any stock is likely to influence its price behavior.


In many respects the recognized talent in a company is the most difficult and often the single biggest differentiator for many stocks. Currently there are three major US investment banks. Because of regulatory changes and the persistent low interest rates all three are cutting employment. The leader (while perhaps slightly increasing its annual cull rate) is still hiring a significant number of bright accomplished young people. The second, managed by a former consultant, views people as one of the ingredients to making profit goals and is cutting deeply. The third with a slightly different business mix has raised senior executives’ compensation because they executed well. From time to time I have owned all three, though I now only own the first in our private Financial Services fund.  

One of the reasons for this belief in talent is what I have learned about the discovery of the Ninth Planet, one of the only three identified in modern times. The work was done at Caltech and started with a couple of graduate students who found compelling elements in the sky. Their professor of Planetary Astronomy went down the hall to discuss what the students found with an assistant professor of Planetary Science. Thus they combined observation and theoretical science to confirm the existence of the Ninth Planet. It is just this sort of cooperation of in-house experts in a maturing organization that I look forward to in a smart, talent heavy organization.

Interesting enough all three investment banks are now selling below their published book value which does not carry talent as a balance sheet item. Certainly in the case of the first and quite possibly the other two, if I could buy just their talent and none of their other assets and liabilities, I think I would.

Entry Point Microscope vs. Terminal Telescope

For my sins I sit on a number of Investment Committees and chair some. At this point my fellow members are focused on reading the current “tea leaves” about the near-term conditions including the likelihood of further market declines. Considering their brains and experience they are probably right in the short-term. My frustration is that this microscopic focus is preventing them from acting to position some of the money we are responsible for by investing in the future.

There is no question that a microscope will provide much more accurate measurement than even a thirty meter telescope. However, part of every fiduciary’s responsibility is to provide benefits to the last beneficiary. Since these institutions are designed to be eternal and some of the families that we serve expect eternity, we should be looking to the future. We can not be as precise about 10-50 year futures as we can be about tomorrow’s opening price, however that does not relieve us of our responsibilities to future beneficiaries. I am reasonably confident that this is the right time to invest for the future.

As a contrarian, I like that most investment professionals are focusing on current market and economic conditions. Historically, one can age a “bull market” by how far out investors are discounting the future. The focus on this quarter’s earnings or the next rate hike or the number of producing drilling rigs is reassuring to me. I have lived through periods when investors were using five to twenty year projections for their investment decisions.

A study of great investors depicts that many have been lonely in their exposed positions before achieving success. While I recognize that there are numerous flashing caution lights, such as the sudden drop in the confidence index published by Barron’s each week of the spread between high quality and intermediate quality bond yields, I am comfortable with some money for some clients investing for the long-term. You probably should as well.  
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Sunday, January 17, 2016

Statistical Correlations are Costly


Why are most stocks down in the first two weeks of 2016 and far too many down in 2015? I submit that our brains are wired to use statistical comparisons rather than to accept uncertainty. Far too many of us learned about investing through academic institutions or pundits. Rarely do investment discussions go beyond the second sentence without relying on accounting terms and comparisons with popularly available indices or their derivatives. I suggest that we have gotten too far away from the early successful investors of merchants and farmers.

The “Modern” Investment Mind

In the pioneering work done at Caltech and other places on the motivations and actions of brain functions, scientists have discovered that different parts of the brain light up when dealing with fear and greed but essentially brains are memory devices. We store our own experiences and in some cases others. I believe what we store are the differences or deltas between the experiences and expectation.

This factoid is more easily stored than “we did better or worse than the “model” +100% or -50%.” This mechanism explains our need for comparative data. Bear in mind this is where the current state of the art is, but two quotes from Caltech suggests future refinements or changes.  A motto of the Jet Propulsion Laboratory (managed by Caltech) is: “Dare Mighty Things” and a quote from a Life Trustee Charles H. Townes, the only person to win both a Nobel Prize and a Templeton Prize, “The fundamental nature of exploration is that we don’t know what’s there. We can guess and hope and aim to find out certain things, but we have to expect surprises.”

Confession of an Index Maker

As someone who probably created more mutual fund indices than anyone, I know  something of the black art of creating indices for use by others. The critical building blocks were finding statistics already accepted by professionals individually and combine them to find a central tendency with a reasonable level of dispersion. For example, in a recent study to guess at future investment expectations, I was able to look at the various mutual fund sub-indices of funds in a client’s account for the last ten years.  The top two doubled over the 10 year period with annual gains of 7.52% and 7.30%. Perhaps more significantly was that an index of Balanced funds (owning stocks and bonds) gained only 5.43%. The significance of this finding is that as a US foundation with an IRS requirement to distribute at least 5% of its corpus, if inflation exceeded 0.43% a year the purchasing power of the foundation would decline and thus its grant making capability.

In a somewhat similar matter the popular securities indices were put together by publishers or brokers to capture the central tendencies of a market. There was no attempt to assemble a prudent portfolio for an individual or more significantly an institution to own. With that understanding I find that it is unsound to use these vehicles even in their index fund or ETF versions for fiduciary comparisons. With the majority always wanting to take the easiest comparisons not only are these indices being used as comparisons but also as correlation devices.

As bad as the general market indices are, what is worse is the sector/industry indices that are being used. The components of these indices are based on the principal products being sold as found in the US Government’s Standard Industrial Code (SIC). As an old specific industry security analyst, in numerous cases I found much greater differences in companies I covered rather than the products they sold. (Note I said sold rather than produced - either totally, white labeled or just assembled.) No wonder the stocks and bond prices for these entities move differently.

More Difficult to Define But Better

Believing that good analysts and portfolio managers are closer to artists than accountants, I think at any given time the single most critical element in wise selection is one of four attributes. While each of the four are almost always present from an investors’ standpoint, one or possibly two should be identified as the basis for comparison in building a properly diversified portfolio. Some of this thinking is parallel with Howard Marks of Oaktree Capital, whose latest thoughtful letter I will discuss below.

The four critical elements are: Supply, Demand, Time and Talent. The use of a firm’s capital to address the needs for expanded supply or increased demand is of particular interest to Marathon Asset Management in London who in a recent study identifies where in a capital commitment cycle a firm is. In an initial stage often the market will absorb all the supply that is available, be it in raw materials or semiconductors. That is until supply overcomes demand and then the critical focus is generating sufficient demand at reasonable prices. With many new product/services companies their initial focus is creating demand in the first place. Often this is the first business need for intellectual property companies.

The third critical element is Time. This needs to be looked at from both the producer and investor standpoints. From a producer’s position the time to produce and deliver is a competitive challenge. The first to be able to deliver in quantity and appropriate price will command the market as long as this condition lasts. From an investor’s viewpoint time issues involve average expected holding periods, payments to wait, expected terminal prices, and possibly certain critical performance dates.

The fourth critical element is talent management throughout the organization. This is critical regardless of size and it starts with the top but also includes, developers, client-facing staff and appropriate control and regulatory elements. The absence of a working plan to secure all of these creates substantial risk for the investor and in the long run for the employees and customers.

While I have yet to see funds or managers show their portfolios in terms of these four elements, some of the smarter ones can and do discuss their portfolios this way. To me this approach allows me to be a longer term holder of their portfolios.

During the kind of decline we are currently experiencing, I am seeing too much cross correlations with stocks in multiple industries, but very similar investment characteristics. Thus, in effect they have become a singular investment which we can use by providing our own diversification by marrying the questioned portfolio with other managers or funds. However, we would have to reject the singular focused fund as not appropriately diversified for some accounts.

Bullets from Howard Marks' Paraphrased Wisdom

Howard’s latest letter is over twenty pages. Below are brief thoughts from his letter:

1. In order to be a successful investor you need to understand psychology.
2. Strike a balance between offense and defense strategies. (single teams)
3. Too many overlook negatives until they capitulate.
4. Daily markets are a barometer of sentiments.
5. Perceptions swing from flawless to hopeless. (Apple?)
6. Investors know less than they thought.
7. There is false belief in investors’ rationality and objectivity.
8. Expectations should be included in transaction prices.
9. Illiquid assets + capital flight = investment disaster.
10. Markets move from yield focus to recovery potential.

Question of the Week: Would you like to discuss any of the points mentioned?
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A. Michael Lipper, CFA,
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Contact author for limited redistribution permission.