Sunday, June 5, 2016

Pivoting Season: Be Careful


We are entering the Pivoting Season. Some investors will succeed and others won’t. One needs to understand both the successful and unsuccessful pivots in history and at present to be able to pivot successfully in the future.

Current Pivot Attempts

For some time the “Jarrett Administration,” otherwise known as the Obama Government, has been attempting to execute a Pacific Pivot without meaningful success.

Another pivot is the coming “Brexit” referendum with the base arguments shifting away from London-oriented economics toward social and defense concerns. The continent can not progress economically without Britain, but Britain can survive and even progress without Europe, albeit with some near-term difficulty. In my humble opinion, the momentum will be for the UK to leave.

In the run-up to the US Presidential elections we traditionally enter the period of pivoting to the center and escaping from the strident extremes. This year, due to the length of the primary season and the shift away from network news to the Internet, the movement toward the center is going to be much more difficult unless there are surprises.

With this focus on pivoting it is natural for investors to also think deeply about pivoting their portfolio into more winning structures. Based on my study of history and racehorses, my instinct is not to try it unless you use appropriate, professional talent and then restrict the pivoting to only sections of the portfolio. Our goal is to execute a pivot if certain conditions are met (such as those passed on from Lincoln to Generals Grant and Sherman) as described further below.

The Most Successful Pivot

When President Abraham Lincoln changed focus from defeating the Confederate armies in battle to winning the war, he picked different leaders and different battles. He shifted from primarily fighting in Virginia and Pennsylvania to Missouri and Tennessee. His leadership changed from generals who graduated at the top of West Point to those at the bottom of the Class; from officers that were accustomed to riding horses to ones who in Grant’s case, only made a modest living driving mule chains.

Ulysses S. Grant built his campaign from the shores of the Mississippi River down through the tough terrain of Missouri through to the western side of Tennessee. The Confederate high command took this as a continuation of the North pushing southerly with the ultimate political goal of seizing the political center in Alabama.

At this point Grant ordered General Sherman to execute the pivot. Instead of a north to south-oriented drive, Sherman executed from the west in his ‘March to the Sea’ (Atlantic Ocean).  His target was to knock out the logistic center of the Atlanta rail head. The battle shifted from political targets to a war-making capability. 

Because of the speed of execution and the destruction of property along the way, Sherman was able to survive a two front exposure (from the north and the south) when the Confederates reacted with underwhelming force. In the end the pivot brought the US Civil War to an end many years before the old, politically-oriented strategy would have.  In terms of the conditions for a successful pivot, Lincoln had chosen the right leaders, the right time, and the right place.

Both Napoleon and Hitler also made pivots from the west to the east into Russia and failed miserably because they did not have the same right leaders, time, and space.

Is this the Right Time to Pivot?

Are we at a similar point as was Mr. Lincoln, when the top strategists are wrong? Let’s look at the results this year from the standpoint of large stock and bond portfolio investors.

High Quality Corporate Bonds and US Treasuries are meant to be risk absorbers as they no longer can produce income above actuarial assumptions. They are not meant to be performance vehicles. The S&P500 has a Corporate Bond index that seeks to replicate components of the S&P500. Through the first five months of 2016 this bond-only index was up +4.99%, after being the only major asset class to show positive results earlier in the year.  The problem for most investors is they didn’t own enough of this dull instrument during this period because they were not being advocated by the ‘top of the class strategists.’

What is even worse is that most large investors owned the wrong stock sectors. In the five month period ending May 31st, the S&P 500 stock index gained 2.59%. During the same time period the healthcare sector was down -0.3% and the financials -0.74% of the stocks within the index. These two sectors were heavily owned within institutional portfolios and favored by most strategists. What really hurt the pride of portfolio managers and the pocketbook of investors is that there were three large sectors producing double digit returns: Utilities +12.80%, Telecommunication Services +11.45% and Energy + 10.73%. My guess is that the first two sectors were only slightly owned  by institutional accounts (with the exception of  Verizon and AT&T which was held for yield). The third was shorted by the hedge fund community.

After a period of disappointment with market and performance leadership, performance-addicted investors are ready to switch horses. Should they? Do they currently have the right generals and right locations?

The Lessons from the Track

As my regular readers may know, I have learned many analytical approaches in attempting to analyze the past performance at racetracks. I have previously written that there are “Horses for Courses and more importantly that the changing conditions of each race should impact the probabilities as to the ultimate results.

There are other factors that should also be considered. These start with the racing history of the particular horse and those of its family, including the sire, the dam, and their families. Plus a similar review is required of the past success of the jockeys, trainers, and stables. The challenge for both the track and security investor is that there are very few winning teams that have a good record under all conditions. Under the pressure of the laws of economics, most of the better teams are under contract to rich players. In our investment account world, this often means high-fee hedge or private funds.

While we look to find consistently superior teams and horses, they are hard to find. Thus, we tend to match the available talent to the expected conditions.

Right Battlefield Locations

One the first major distinctions a good handicapper or track analyst focuses on is the length of the race. The length often determines the racing strategy and betting (or if you prefer, allocation strategy). In short races opening speed is very important as there is little opportunity to recover from a slow start. In longer races there is both the opportunity and risk of recovery. Stamina and the ability to handle change in leadership becomes important.

It was the thinking expressed above that was a critical element in our development of the TIMESPAN L PORTFOLIOS®. In this structure we divide the portfolio responsibility into at least four different timespans.

The first or Operational Portfolio is to fund the cash needs for the next two years. From a manager, fund, or security selection standpoint, capital risk is paramount.

The next three of the portfolios should have different representations of investment styles (growth, GARP and value) and talents (technological, turnaround and management assessment). This is a real mix and match effort, which is based on the individual needs of the account.

The second or Replenishment Portfolio is designed to recapitalize the Operational Portfolio. Often the duration of this portfolio is five years or a capital cycle. From a selector’s viewpoint the cycle is presumed to have at least one down year and some recovery.  In the first two portfolios liquidity is very important and expensive however is less important in the final two portfolios.

The third portfolio (Endowment Portfolio) is designed to meet the longer term funding needs often tied to the expected length of service of the CEO, Investment Committee Chair or Chief Investment Officer. This portfolio is expected to last through a few cycles and can accept some risk of loss capital if it has a positive cash flow.

The final portfolio or Legacy Portfolio is the funding vehicle meant to endure beyond the current sets of management and is designed to successfully tolerate a number of disruptions while still provide funding to meet very long-term needs.

Where Are The Generals?

In the US Marines I attained the rank of Captain, however I have devoted my adult life to studying various generals, both investment as well as military.

As a General, U.S. Grant handled numerous setbacks just as a competent securities selector is able to survive the unexpected and not lock into positions where there is little prospect of recovery.

Question of the Month:

Do you have or want the right generals?
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