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.
Comment or email me a question at:

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A. Michael Lipper, CFA,
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