The First Commandment for all investors is to play to survive.
In my discussion of the Legacy Portfolio part of the Timespan L Portfolios®, I suggest including stocks and funds that focus on being disruptive to the established order. Thinking deeper about the attributes of disruption, I know we have entered a disruptive age.
If you are a keen observer you will see that almost every major activity is experiencing some form of disruption. In virtually all areas we are trained in some classical way of thinking derived from past successes and failures. The neuroeconomists at Caltech assure me that we make important judgments on the basis of our or others’ experiences. We like to follow patterns. The problem with this comfortable approach is that in many spheres there is disruption. Just look at Science (colliding black holes creating time warp evidence), Economics (experimental quantitative easing), Politics (populism usurping establishment roles), and even some money managers. Our instinctive reaction is at first to reject the disrupters and then fight them as they are threatening our classical way of thinking and operating. What we should be doing is examining the facts/data and trying to understand the power of their proponents. Whether the disrupters are right or not they may represent an opportunity. They may not be completely wrong, and without rigorous study we may not recognize when they are more right than our older models.
This is far too big of a series of subjects for me to thoroughly deal with now. Because I feel that I have some responsibility to those that have used various investment performance measures to select mutual funds and other managers based on their past records (which for a period of about a year have been underperforming) this set of disruptions deserves some attention. I am going to briefly review what is in the process of changing which may explain what is now happening and more importantly what may happen.
Look at almost any front page of a newspaper or the first story on a so-called news broadcast. The strong odds are that it will be negative in terms of life, limb, and the pursuit of happiness or gain. We need to understand that the media has discovered that negative sells. The people who believe that principle the most are the politicians. In almost every country they are focusing on the problems as a way to attack the “they” who need to be replaced by a different set of politicians. Interesting that each day many if not most things in this world get a little bit better.
Last week I devoted most of my blog post to the annual letter from Warren Buffett as edited by Carol Loomis. I, and others, found the letter to contain reasons to be bullish in the long-run. In her letter this week to her largely retail audience, Liz Ann Sonders stressed a preference for what Mr. Buffett was saying rather than the politicians and their pleas of misfortunes if they are not elected. The statistical odds favor investing in US equities in the long-run.
The Cost of Regulation
Around the world banks and other members of the financial community were blamed almost exclusively for past financial crises. To prevent repeats without reforming the political leadership, the financial community and particularly the large banks were subjected to intense and costly regulation. Due to this additional regulation banks need to increase their capital at all levels. The higher the value placed by the market, the belief is the better the future results and the lower the cost of raising the required capital.
According to Standard & Poor’s the price/earnings ratio of the banks in its 500 index is 12.38 X where the P/E for the banks in S&P's small cap 600 Index is 18.51 X. Thus the smaller banks have to give up less of their equity to get capital than the larger ones. In a period of manipulated low interest rates banks will have difficulty making enough money to attract more capital to make more loans. One of the disruptive forces being unleashed are non-bank financials that are less regulated and often less transparent. Thus the portions of the economy that need loans will likely get their loans with less regulations but at higher interest rates. In Europe banks are often less well capitalized and in some cases have materially larger non-performing loans relative to their assets.
Most private businesses get their money from local banks. In the US, businesses approaching mid size have the option of publicly issued paper. This would be a new experience for many European companies which they may find disruptive in terms of disclosures, costs, and tax implications. On the other side of the coin, retired individual pensioners are not earning enough on their deposits to meet their living needs. So their senior lives have been disrupted.
Price of Oil Links
Disruption can be positive or negative in terms of direction and whether one is a natural buyer or seller. The more established participants are in the camps of lower prices for longer. Moody’s has just lowered the credit rating of many Gulf and African government bonds. T Rowe Price New Era Fund which maintains half of it portfolio in energy stocks views that the price can descend into the twenties from the current prices in the thirty dollar a barrel range, rebounding for a longer term target of $40-50. Sounds bearish, but in February the leading developed market broad market index performer was Canada +4.27% compared with S&P’s measure for the US of ‑0.28%. (For many years, I have hedged my investments in US domiciled mutual fund management company stocks with some of their cousins above the border.)
Another link to the disruptive changes in oil prices are many securities in the emerging and frontier markets. In general, as a group they have fallen in sympathy with the fall in imports into China. One of the reasons for the decline in energy prices is a cutback in its imports of oil and other raw materials. Based on their valuations close to the lows of the prior cycle, they appear to be “cheap.” They may be cheap, but not a bargain. In revamping the Chinese economy its import needs may be permanently altered which would certainly be disruptive to buyers of these stocks.
How to Invest In a Disruptive Period
During disruption, most of us mere mortals do not know how things will turnout. We do know that we are in a period of rapid change at many levels. While we may return to the pre-disruption stage, it won’t be really the same because in the back of our mind we know that there has been a disruption and others could come.
The standard investment strategy in dealing with risk is to diversify into different instruments. Most investors do that within various individual securities. What we do for clients is to offer a better way to diversify. We assemble a specific portfolio mostly of mutual funds from different managers who think differently about market conditions, risks and opportunities. All too often even those who are early recognizing a problem or opportunity only see a portion. Hopefully we can assemble a task team that can get a fuller picture and thus give us and our clients more confidence in dealing with disruptions.
I would be happy to discuss how to deal with the disruptions that you perceive.
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A. Michael Lipper, C.F.A.,
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All Rights Reserved.
Contact author for limited redistribution permission.