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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