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?
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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.