Introduction
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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Copyright © 2008 - 2016
A. Michael Lipper, CFA,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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