Sunday, January 10, 2016

Cookbook Investing Doesn't Work

This is my 400th weekly published blog post. Many thanks to my readers in the US and around the world, in particular to those who have commented or written to me over the years.

Amidst the global market uncertainty last week, my blog post “Probable Causes of Underperformance” was named one of the five Most Read Fund Manager Comments in London’s Citywire Global.  Click here  to read.


Thus far 2016 looks and feels different than 2015. Our last two posts which were well received in the global investment community highlighted some of the changes. My friend, the Wall Street Journal’s Jason Zweig and Caltech have been researching how our brains are wired to handle the processing of information that ultimately gets translated into fear and greed. Both the financial journalist and the university acknowledge that people have difficulty dealing with uncertainty. This is particularly true when different elements trigger both the fear and opportunity tracks. We may be at such a junction now.

Misreading the Visible

Some of the items that are being misread are as follows:

1.  Size of government debt which does not include quasi-debt; e.g., actual and implied credit in mortgage markets, social security types of retirement plans and critical-to-national-interest large commercial activities, (in China they are known as State Owned Enterprises SOEs).

2.  Fund flows out of US and Japan, out of domestic stocks and corporate bonds and loans as well as Exchange Traded Funds (ETF).

3.  Declining Returns on Invested Capital (ROIC) of money center banks and major brokerage firms.

Investment Implications

1.  Aggregate government debt will rise as governments attempt to solve societal problems directly rather than through personal and corporate channels which will mean that governments will be sponsors of inflation to make fixed repayments easier.

 2.  Foreign investors have been correct about the direction of their flows into and out of Japan. This is the first time in 25 years when they have been wrong when they produced net outflows and the  Japanese market rose in double digits. I suspect the foreigners were expecting greater declines in the value of the yen. In the second half of 2015 foreign investment in US stocks and corporate bonds declined. Also the US mutual fund investor was a net redeemer of domestic portfolio funds while buying foreign portfolio funds. The net redemptions of Fixed Income funds raises the question,  “have bonds lost their place as a balancing instrument in mixed asset portfolios?”

3.  In many ways the biggest implication of 2015 and early 2016 activities of large money center banks and investment banks is the withdrawal of capital and people from the marketplace. In a world where there is probably 100,000 tradable securities, Merrill Lynch claims to follow only 3500 companies. We are already seeing a talent shift out of the large leaders to smaller financial groups including Registered Investment Advisors (RIAs). To the extent that the retail public is buying ETFs, I suspect that the economics work better for a former broker or bank advisor to use ETFs as an RIA. The market seems to recognize the problems that these large organizations are in. Goldman Sachs* is selling at $164 per share which is very close to its tangible book value of $162. Thus the market is paying nothing for the firm’s talent and position in clients’ minds. Morgan Stanley* is selling below tangible book. If these two firms are accurately priced then I have to wonder whether the general stock market is worth owning. If the "house" is not going to be adding to its long-term value, is it reasonable to assume that the bulk of investors will and if they don't, how much longer can the game go on?

*Held either personally or in the private financial services fund I manage                          

What are they Missing?

The desire for hard data is what drives both quantitative and fundamentally-oriented investors  and limits them to the known in building their algorithms or rules. A cookbook solution is usually created to publicize an investment method. There are two problems with this approach. The first is that I am told that the great chefs don't exactly follow a cookbook recipe as they always modify and improve what they do. The second is in the real world uncertainties are often present and could be large.

When I was a securities analyst studying new potential investments, I made a list of the things I wanted to know about an investment. Quickly the list reached on the order of 100 items. After diligent work I could get up to perhaps 50-60% of the items covered before the fear of a price moving away from the most desirous entry price occurred. Thus I had to make a decision and accept a large amount of uncertainty or go find another opportunity.  Based on the luck of time and investing in America, I had a favorable secular trend working for me so a good number of my recommendations performed well. Thus to this day I am willing to accept a level of uncertainty that would not be acceptable to “quants” and other rule book investors.

One of the major fallacies that many investors accept is that they only deal with what they think they know without regard for what they don't know; or in a Mark Twain world, what they know is wrong. Over the last year Money Market funds serving both individuals and institutions gained $16 Billion, the most of any asset class which demonstrates that their shareholders could not find suitable investments. Further, even with significant mutual fund outflows, the vast majority of fund holders continue to hold their assets in funds. To me the big uncertainty is what is on the mind of the fund holders. Why are they not being swept up in the excitement of the market place? I would suggest that there are two reasons for their current attitude. The first is a belief that for the foreseeable future funds in general are meeting their longer term needs. The second is the future is not clear enough to them to make changes.

 Another long-term trend to consider is that selling mutual funds today is far less profitable than other products like IPOs, hedge funds, private equity funds and securities. ETFs can be much more profitable when they are leveraged and frequently traded.

There is lot written about ETFs, but very little about the source of their volume on the market. What looks like general acceptance of the investment value of a particular ETF may be just the opposite. The only ones who can transact with the ETF sponsor is one or more Authorized Participants (APs).  These are market making dealers on the floor of the exchange. Many of their customers are hedge funds or other trading entities who have shorted the ETF as part of a hedged trade in which they are long. Thus they are betting that the value of the ETF will decline more than what they are long.

Bottom Line

With many stocks down over 5% and in some cases more then 10%, we could be half way to a bear market. I believe the real risk for long-term investors is not being in a position to participate in the next major upswing, whenever it appears.

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A. Michael Lipper, CFA,
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