Sunday, May 29, 2016

Almost Everyone Is Really Bullish


After listening to amateur and professional investors for a lifetime, I have concluded that I should largely disregard what most people say and write. What matters is what they actually do. 

At the moment, market volumes are low, people are not selling their tangible investments (including their homes and the artwork in their homes or in secure free port locations) en masse.  We are not seeing smart, investor-focused companies liquidating. In other words “TINA” (There Is No Alternative) has been replaced by “FOMO” (Fear Of Missing Out). These are two arguments as to whether or not prices will be higher. There is some stroking of one’s intellectual chin as to when and how big a valley we must ride through to get our rewards.

Two Arguments

The favored ways of reaching these conclusions are (1) reliance on our faith that the cyclical secular bull market that has existed in the US and elsewhere for two generations will continue; or (2) like my fellow numbers oriented addicts, they can pour over the current and future dispatches from the global investment fronts. As is often the case, faith wins out in terms of our emotional and psychological stability. As a continuing student of history, particularly of unfulfilled predictions, I can not say this is a wrong approach. However, in this era of microsecond overload of so-called facts and figures, I can not escape my predilection for gathering and sorting almost every morsel in the hope of finding at least temporary clarity. The rest of this blog post is designed to help my fellow missionaries as they look deeply for investment truth or at least a higher level of certainty.

The US Stock Market

We have now gone through what seems like a lifetime of not achieving a new high. It has only been one year. I remind readers that it took the Dow Jones Industrial Average sixteen years from the first time it hit 1000 until it finally surpassed that number in a meaningful way. Market analysts characterize a long flat period as either one of accumulation or distribution. If there is a sustained price rise going through the old high it is labeled accumulation. Likewise if the range-bound price level is broken on the downside it is labeled as a distribution. 

In an oversimplification, market analysts attempt to characterize the flow of money from strong players to weaker ones. History suggests the weaker ones are largely driven by emotions (as the disappearing individual investors) and the strong players are felt to be the professionals.

The Financial Services Sector

As many know I follow financial services companies intently. Most publicly traded brokerage firms with large retail business are not reporting commission income gains. This is seconded by many mutual fund management companies whose individual equity businesses are not growing. Many institutional investors continue to experience positive net flows from contributions and other sources. However, this is not just a two-sided battle between long-term institutional investors and retail public investors. In addition there is the trading community including hedge funds. As they can be long and short, they tend to magnify the intra-day volatility because of their leverage through margin and the use of derivatives.

My View

As with most who are gathered under the FOMO banner I believe that we will see meaningful new highs. Notice I did not put a time tag on the prediction or indicate how low the market may go before reaching a new high.

Index Funds, Revisited

Some foolish investors believe the way to play this dichotomy is through Index funds. The reason that it is foolish is not that it won’t participate in the move. It is exactly that it will participate, but not optimally.

According to one public survey some 71% of retail Index fund investors believe they are taking less risk than in actively managed funds. They are confusing the somewhat muted daily volatility of a broad based index with a concentrated fund portfolio. I believe this advantage is lost, as over time market emphasis shifts and leadership changes. Further, Index funds do not carry cash and rely solely on “approved participants” to bring in or take out securities.  (In our managed mutual fund portfolios we use both passive Index or like Index funds as well as concentrated funds.)

The Real World

We normally think of snow in terms of the winter. Gamblers often refer to a stream of bad luck as snow.  After recovering late in the first quarter, the global economy hit snow in April. The first confirmation to me was a luxury company that announced April sales were 15% behind a year ago. When the wealthy cut back they are sensing something. Globally, almost every company that we follow experienced what I hope is only a hesitation. This is an April phenomenon as, according to ThomsonReuters, 73% of the 493 reporting companies in the S&P 500 beat earnings estimates. (Normally the beat ratio is 63%.) What is more worrisome to me is that only 52% beat the ratio in terms of revenue estimates, suggesting some financial engineering is at work.

Are Yields Heading Back Up?

The fixed income marketplace is broad and deep and it is a bit unfair to use only two yields to identify a trend that could be something of the canary in the mine as a warning to equity investors. According to Barron’s the average yield on a group of intermediate quality corporates last week rose to 4.93% from 4.58% the week before, but still a little lower than the 5.09% a year ago. Minor changes in yields for the highest quality corporates perhaps should calm us. Money Market Deposit Accounts also bounced up.  In this case from 0.22% to 0.25%. This may indicate some tightening of the available money for consumer lending.

Two Former Morgan Stanley Thinkers Worth Reading

1.  Byron Wien, now with Blackstone, for years was reporting on his conversations with an unnamed influence he dubbed the “Smartest Man in Europe.” Unfortunately, the investor, Edgar de Picciotto, Chairman of Union Bancaire PrivĂ©e in Geneva, recently died.

Wien recounted Picciotto’s numerous investment successes and his philosophies. He clearly was early onto numerous investors that did very well. I believe he had very concentrated investments. He foresaw opportunities that were considerably less risky than they appeared to others who came in later. He used his mistakes to improve his thinking. Contact Byron for a copy of his latest blog.

2.  Steve Roach for Project Syndicate has once again highlighted the US dependence on China. (He headed Morgan Stanley’s Asian business after a career as its global economist.) His view is that the US is growing by absorbing savings from China. He is concerned that this source of support for the US will not continue. Roach believes that the US needs to be generating sufficient savings to invest in its own growth.

Other Asian Views

Matthews Asia, a Pacific oriented fund group is re-positioning one of its funds. The Asian Science & Technology Fund is broadening out to become the Asian Innovators Fund. Matthews Asia sees this new focus as a much bigger mandate, as not all innovation is produced by technology. Many commercial and financial activities are benefiting from non-tech innovation. (We have been shareholders of the prior fund.)

Much of the flows into and out of Exchange Traded Funds (ETFs) is caused by shorter term traders. For example in the first four months of 2015, $65.4 Billion went into Global/International funds. In the first four months of this year net redemptions were $5.9 Billion.  In only one of the four months was there was a net inflow of $4.2 Billion. Not surprising in the first two months of the year $10 Billion exited. This kind of volatility was magnified by the thinness of most overseas markets and particularly some of the Asian markets. Investors can use this to their advantage if they counter-time their moves to the regional headlines.

Patience will be required as both “TINA” and “FOMO” are functioning, but one needs to be prepared for temporary reverses.

Monday is a Memorial Day holiday in the US, where we recognize all those who have served their country in times of war and other troubles.

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A. Michael Lipper, C.F.A.,
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Sunday, May 22, 2016

Investment Selection: “Horses for Courses”


Each tool has its best single application. Each investment strategy has its best single application. In a similar fashion horse racing professional handicappers have often stated that there are "horses for courses." Meaning certain horses run better at certain race tracks than others. The most productive implementations of these choices are often the function of changed conditions from the immediate past.

As fund performance analysts and investment managers we have been urged to proclaim that past performance does not guarantee future results. Nevertheless all too many institutional and individual investors use past performance and particularly recent past performance as their primary selection screen. Many have taken this to the ultimate decision by investing the bulk of their money in Index funds.

The source of much of my analytical thinking came from handicapping horses races which is what track aficionados call analysis. The daily Bible reading for handicappers is the Daily Racing Form, (in  my day it was the Morning Telegraph.) In these pages the racing record of each horse is shown. From an analytical standpoint what I find of greater value than number of winning races are the conditions of the race to include which track, distance, time of the winner, time of the particular horse, weight carried relative to others, training times and conditions,  plus the names of the sire, dam, and sire of the dam and finally the conditions of the track. Professional analysts and portfolio managers can translate these factors into various selection screens in picking stocks, managers, and funds.

Selecting Investment Strategies for Different Portfolios

When choosing a bet in a race it is wise to start looking at the most popular which is called the favorite. The favorite is based on the most money being bet, not necessarily the horse that has the highest probability of winning. At the track and around the Investment Committee table most decisions are based on avoiding embarrassing losses, not optimizing the chances of large winnings.

The way I handle this challenge is not to bet on each race or every stock that is currently performing well. This tends to produce fairly concentrated portfolios of stocks, managers, and funds. The long-term (but evolving) focus is on a high aggregate dollar win/loss ratio. If you will, I am describing a contrarian bettor. However, as a contrarian, I should not disregard the weight of money bet on the favorite. This is even more true in investing than at the track because by definition popular stocks attract cash flow. In the short-term some investors can make them appear to be right.

Understanding the Investment Favorites

According to Moody’s* “Globally 10% of all public companies account for 80% of all profits.” Therefore these companies have less credit risk for their bonds. Also, almost by definition, they are large capitalization equities. With the goal of reducing the chances of losses, most investors prefer large-cap stocks or funds. This is particularly true for endowments. 

Endowments are one of the four TIMESPAN L PORTFOLIOS®, and depending upon on the needs of the account can be aggressively or conservatively invested.  Many of the standard endowment portfolio managers are getting frustrated as it has been a year on Monday since the S&P500 has hit a new high, and for the last four weeks the DJIA has been declining. (Perhaps there is some validity to the pre-air conditioning ditty of “Sell in May and go away.”)

The frustrated investors, the media pundits, and the various sales forces have not been paying attention to Charlie Munger, Warren Buffett, and their two investment associates. As a group, Berkshire Hathaway* has been selective long-term buyers of stocks and companies. As the oracles of Omaha have often said, they like declining markets for their long-term holdings. Despite what they recommend for others, they are not buying an S&P 500 Index, they are selectively buying a small collection of Large, Mid, and Small-Cap stocks.

I believe that size does not define a stock as a good investment, but due to size many stocks have increasing difficulty making progress. (This does not mean that investors are blind to the attractiveness of some Large-Caps in their recent purchases of Apple*, IBM, and Wells Fargo*.) One of the reasons that they are more active now than when there is more enthusiasm in the market is Charlie Munger’s belief that is wise to buy a good company at a reasonable price rather than a less good company at a good price.

Applying Betting Principles to The Preakness

In a postscript to my blog that commented on The Kentucky Derby,  I urged bettors not to bet on its winner to Win the second race of the Triple Crown for 3 year-olds. I suggested to find a good Place bet. (A Place bet pays off if the horse comes in first or second, a Show bet pays off if the horse comes in first, second or  third. The pool  of money that is used to payoff winning bets is divided into three parts for a Show ticket, two parts for a Place ticket and one part for the Winning ticket.  Thus it is normal that winning tickets pay more than Place tickets and Place tickets pay more than Show tickets.) I felt the dollar odds would be larger if the Derby winner came in first. This was before I knew that the track would be muddy on Saturday, and based on past experience was an advantage to the eventual winner. Racing luck and jockey skill  produced the result. Regardless of the change in track conditions, my suggestion to make a Place bet on a non-favorite was valid.  On a money basis a $2 Place bet paid $3.20 whereas the favorite, which came in third, paid $2.20.

*Stock owned in a managed private financial services fund and/or personally.

Question of the Week: What methods do you use when investing in Large-Caps and Small-Caps?
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Sunday, May 15, 2016

Three Major Sources of Investment Losses


Essentially I am a student of investment performance. For the most part I use the global universe of mutual funds as my laboratory. In addition, I serve on a number of investment committees that employ external managers as well as own individual securities. Recently, I suggested that in addition to looking at the rank of our endowment performance that we isolate five to ten winners and a similar number of losers. I was much more interested in the second group. There were many similar characteristics of the winners however there were fewer in the laggards.

As an investment manager for serious investors my first job is to avoid losing large amounts of money for my clients. With this particular task in mind I have identified three main causes of many large portfolio losses.

Major Source # 1: Gross Domestic Product (GDP)

The academic definition of GDP is the sum of the goods and services produced within a national economy. From that top down level other economic projections are made by economists that in turn produce investment strategies of portfolio managers and strategists. There are numerous problems within this approach. First, much of the data collection going into the aggregate GDP number is flawed. The source is usually government data which can be easily manipulated for political purposes to such a significant degree that the former Premier of China indicated that he did not trust GDP as it was “man made.” He used other data produced by the private sector to help him guide the Chinese economy.

There are substantial portions of the US economy that go largely unreported. Not only is the “informal” or underground economy uncounted, the value produced by the volunteer sector is also unknown as is the work carried on within the home for no direct monetary compensation. Paul Samuelson, the great MIT economist and the author of one of my college economy text books pointed out that if a man married his maid and she continued to clean his home as his wife, the GDP would shrink because the maid’s income would no longer be counted.

In the modern world the production of GDP is done for political leaders to guide their economic policies. Because the politicians have most of their political power within their borders, they are essentially focused on domestic job creation. This is not the way consumers look at their purchases which are focused on quality, price, style, and availability from any acceptable source. Managers must manage both domestically produced products and imports and their relative prices. Investors need to follow their investments in companies that have both domestic and foreign activities as well as follow world trade flows and currency fluctuations.

Thus in the real world GDP is not of much use to us as consumers, managers, and investors. Therefore, be very careful of any manager that starts his/her investment strategy based on changes of the level of the GDP. That is not the real world and only useful in dealing with the politicians and the uninformed media.

Major Source # 2: Reported Earnings Per Share

As soon as earnings per share numbers are published, investors are bombarded with slews of “Non-GAAP” statistics often adjusting most of the operating numbers on the income statements. Managements want investors to focus on these adjusted numbers not the reported numbers and the differences can be meaningful, from a loss to a profit excusing some non-recurring occurrence. Managements are often getting paid through stock price changes, but the statistical services are using the reported numbers. So whether the stock and the market is cheap or expensive relative to earnings is a function of which set-off earnings are being used.

As a professional analyst, I prefer to focus on operating earnings excluding in many cases net interest income, but adding actual and additionally needed capital expenses. In essence I am looking to determine the net cash generation of the business after expenditures and debt service. Thus different investors can come up with different valuations from the same financial report. For the professional investor the published financial statement is the beginning of the analytical discussion not the end. Therefore, a manager that relies exclusively on reported earnings could be misleading both investors and him/herself as to the significance of the report.

Major Source # 3: Investment Predictions

Charlie Munger and Warren Buffett place very little reliance on economic or corporate predictions. This is contrary to most of the financial community which rotates, sometimes violently, on changes in predictions. Many studies of investors' behavior and particularly of their losses show that high levels of confidence as to the future can lead to poor results. If one emotionally needs to make predictions, make them often, but go back to the base case each time to see the nature of the differences and the strength of the prediction. The odds are that we will be wrong much more often in our predictions than in our analysis of the present. Our view of the past will be occasionally wrong as well.     

Applying this Week’s Thoughts

Each week Barron’s publishes a confidence index that compares the yields of the best (high quality) bonds and intermediate (lower investment grade) bonds. Over time if the relation between the yields widens, high quality stocks will rise. For the last several weeks that is exactly what is happening with the yields on the higher qualities being flat and the yields on the intermediates rising. Over the latest 12 months the high quality yields have dropped from 3.64% to 3.23% where as the intermediates’ yields have risen from 4.68% to 4.92%. The way I interpret the data, the intermediate yield gain is showing a measurable increase in an estimate of the default risk which to me is more significant than a somewhat larger decline in the best bonds’ yield. I am a little more confident in the analysis of what the present market is saying than I am in the future prediction.

Question of the week: How do you measure your confidence ?

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