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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