Introduction
The essential question
facing investors this Monday morning is whether this just a rally in a
trading/bear market or possibly the beginnings of a new bull market. Only time will tell, but having the right
skill sets and time frame focus will improve your odds. This is similar to the
race track when a knowledge of various jockeys' preferred race tactics, the
training and pedigree of the horse, the conditions of the race and those of the
competitors’ may improve, but do not guaranty the gambler’s chance of
success.
The Conditions of
Today’s Race
We have had six years
of generally rising US stock markets followed by six weeks of falling prices
through mid February and four weeks of rising prices. Different patterns are affecting
different major markets. Europeans seem to translate the latest multiple moves
by the ECB as a reaction to a fear of a business slowdown. China is being
pumped up by various governmental moves. Many emerging markets have suffered by
negative currency comparisons and a sharp drop off of their exports to China
and a cut back in the funding of various projects by the Chinese. Japan’s
negative interest rate policy has hurt the value of the yen, but has not
released constrained consumer and corporate spending. Clearly the almost 50%
recovery in the posted price for crude oil is being treated as a symbol of
recovering global demand in contrast to some beliefs that we are heading into a
recession, forgetting that there is only a tangential connection between
economic cycles and market cycles.
Misreading the Evidence
Many investors and
traders are being pitched so-called value stocks. Others are being reassured
that disruptive corporate and consumer spending will only be felt in a limited
number of industrial sectors. Finally others are relying on flows into Exchange
Traded Funds (ETFs) representing long-term bullish investment demand. All three of these beliefs should be
challenged and some or all will be found to be wanting.
Value is not a Trap,
but some Value Stocks are a Trap
True value is defined
when a knowledgeable unconstrained buyer meets a knowledgeable troubled seller and
can agree on terms and price. One should be wary of pitches by a sales force that
is part of an investment banking chain that focuses on book value or tangible
book value. I have been a buyer, a
seller, and an adviser to buyers and sellers of transactions that produced
values to all or almost all involved. In my blog discussion of Warren Buffett’s
annual letter I agreed with him in terms of the validity
of book value as a measure of investment value.
As someone who is long
financial services securities both personally and in my private financial
services fund, I do not start my investment process with the financial data. I
start with an understanding of the relationships with clients, employees,
regulators, and media. I attempt to calculate the cost and the time involved
to reproduce the target under investigation. I then look at what would be a
reasonable estimate of the costs involved of exiting various elements of real
estate and other leases. Severance costs need to be determined as well as
crystallizing all of the expected contingent liabilities. A good example of
this I heard about recently is a financial operator taking over an upscale
supermarket chain and before the deal even closed, selling a meaningful number
of stores in a geographical region to a national company who was not really
into the same local markets. This buyer was valuing the locations, management
and shoppers and not the financials of the stores, assuming that the purchase
of these supermarkets would be close to the dollar for dollar shown on its internal
statements.
When I sold my data-based
operations, I was transferring respected customer relationships with numerous major
financial institutions. My people, most of whom had worked for our clients,
were a particularly prized asset in my opinion. At the time we were able to
expense practically all of our software development thus these assets were not
represented on our balance sheet in a transfer of operating assets. I bought a
number of modest US and non-US acquisitions, in each case acquiring management
was the real goal. I couldn’t have hired them without buying their operations.
While the investing public, be they institutions or individuals, may buy on
book value-related trades, the professionals don’t.
Most Opportunities are
“Disruptable”
A major investment
banking organization recently published a well written thirty page report
entitled “The Age of Disruption” which did a good job of describing the ongoing
process of many companies and sectors that have been or are being disrupted.
What caught my eye was that the report listed five sectors that have been the
least disrupted with the presumption that they will continue to be protected
from disruption. Two of those sectors were business services and real estate. I
believe well within a generation if not well before that many of these sectors’
ways of doing business will be distorted if not totally eliminated. One of the
major concerns for the taxing authorities in New York State and to a lesser
degree in New Jersey and Illinois is that many organizations within the
financial trading communities are reporting record revenues with decreasing
profit margins. The number of employees is dropping due to technological
replacement and greater concentration. I suspect that these trends are
happening throughout the business service sector.
In terms of Real Estate
the banks and others in the mortgage business have drastically reduced their
head count through better controls and technology. Good creative real estate
people who can quickly deliver transactions and provide other services should
be in high demand well into the future. However, those that troll for listings
can be easily replaced through technology. There will be increasing pressure on
all costs involved with real estate including title insurance and closing
costs.
Surge in ETF Flows
I believe individuals
and the media misinterpret the flows into and out of ETFs and also mutual funds.
Most of the volume is essentially a beta play for or against an index. It is my
belief that the bulk of the flow comes from traders; e.g., hedge funds and
other fast market participants. Occasionally one sees brokerage firms and
registered investment advisors committing discretionary or near discretionary
money into ETFs. In almost all cases these transactions are part of complex trades
(often carry trades) with the use of ETFs on the short side vs. individual
securities on the long side. We see very few ETF holdings that are meant to be
a permanent holding. Thus their flow data is for trading consumption not investment
attributes.
Most mutual fund
redemptions are, in effect, completions of self-administered investment
programs to meet life’s needs. What gets reported is the net flows out of funds
and into ETFs which are not related. As already indicated the ETF flows are
principally from the trading community. The net redemptions of mutual funds (until
last two weeks) is essentially a function that intermediaries have suitability
and churning constraints with mutual funds they don’t have with ETFs. There are
numerous undisclosed ways that the investment firms are better off dealing with
ETFs than mutual funds. I hope to find out more in a panel that I will chair at
the International Stock Exchange Executives Emeriti summit conference in April.
Investment Timespans
and Skills
As the regular readers
of these blog posts may recall, I have suggested that investments
should be allocated to different time horizons by using the matrix of the
Timespan L Portfolios® to cover various time horizons between the
immediate cash needs all the way out beyond our current lifetimes.
In building these
custom portfolios there are different investment skills required to buy, hold,
and sell securities. A good buyer is a prudent believer, often of changing
conditions both within a particular security and its market environment. A good
holder is someone who diligently follows trends and is quick to determine
whether any variation is acceptable under the conditions. A good seller is
essentially a skeptic that views the present and the future looking for any
sign of contrary elements which should alert a sale process.
Applying Investment Skills
to Timespans
1. The first task is to
identify whether the security, mutual fund, or investment manager is already on
board or just one under consideration. (If you already own it you may have
to do something, if you don’t you have the luxury of not doing anything.) In
the case of the short-term operational portfolio one is very concerned as to
whether on a total return basis the principal will be substantially intact during
the short-term duration of this portfolio. Liquidity becomes very important in
this analysis. One probably should not add to this portfolio unless it makes
this portfolio more liquid and stable.
2. In terms of the
replenishment portfolio which is designed to provide capital to the exhausted
operational portfolio, this portfolio has a limited duration in the four to
seven year range and presumes at least one if not more down years. The critical
skill for this portfolio is the diligent holder who is very alert to any
variation to the outlook for any part of this portfolio. An appropriate risk
balance is necessary to insure that the replenishment portfolio can and does
perform its job well.
3. The third portfolio
type is the endowment which has a timespan from the end of the second portfolio
to the end of the power base of those who are in command at the time and would
be often in the ten to fifteen year range. All three of the investment skills (buy, hold and sell) should work on the third
portfolio.
4. For the fourth portfolio both the buyer and
seller skill sets are important. One wants only those investments in this
portfolio that look in the long-run to perform materially better
than the market and when they don’t they should be replaced.
How Do I Come Out?
Recognizing that t the
only thing I can promise my accounts is that I will be wrong time from to time
and hopefully that I will correct quickly enough so that the client is not
fundamentally hurt. With that as a caveat:
•For
my conservative clients, I would be reducing risk in the operational portfolio
as markets became more enthusiastic.
•For
the replenishment portfolio, I would use periodic dips to raise my
market risk exposure a little bit.
•The
Endowment portfolio should not be particularly market trend oriented, but should
focus its attention on viable quality leaders.
•The
Legacy portfolio should look for the survivability of disruptive companies.
Question of the Week:
How are you addressing the market as a temporary rally, the beginning of a market
upsurge, or a distraction?
Please let me know
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Copyright © 2008 - 2016
A.
Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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