Monday, July 4, 2016

Lack of Confidence in Brexit Era Could be Costly


I am a student of long-term investment performance for our accounts and my family. Some of the money entrusted to us is designed to make future payments many, many years into the future. Thus, I study which are successful and unsuccessful investors and their strategies over long periods of time. In that light I mentioned at a recent meeting of the New York Society of Securities Analysts celebrating the thinking of Ben Graham, the father of value investing, why I believed that the “experts” were wrong that the British would vote to remain within the European Union. They violated my rules for avoiding large losses that I derived from Ben Graham and my old professor David Dodd. The rules are:

A.  Overconfidence (Almost universal belief in an outcome)
B.  Faulty, incomplete, and poorly timed assumptions (Economic only
arguments) - Lack of non-financial milestones (Confusing money bets with bookies and number of bets + % undecided)

C.  The frequency of massive overconfidence in financial history is relatively rare; e.g., “Tulip Bulb” Sub-prime mortgages with house prices never declining. Avoiding those losses are critical to the number one rule of successful investing which is to avoid (big) losses along with the second rule, which is not to forget the first rule.

The First Two Rules Are Not Enough

One could have avoided losses from overconfidence by just moving into an all cash position and one would have saved all or the bulk of one’s capital. But if you stayed in cash you would have missed out on the compounding growth that investors have experienced over many years. Using a no-brainer approach of investing in a market index since 1926, one could have compounded at about 9% which doubles money every 8 years. (This is not a prediction of future returns.)

Our objective relative to the risks assumed is to do better than a mechanical index strategy. However, to beat the index one should analyze the performance of the index compared with actively managed investment accounts. In the periodic market declines, the index declines more than the accounts because first it does not have any cash and second most indices are heavily weighted in favor of the most liquid stocks which typically drop the most as they are the easiest to sell. The reverse is true on the way up from the bottom. The indices have no cash to reduce their rate of gains and are in the most liquid stocks that late-comers plow into.

As a student of investment performance of successful managers, I have noted that they have more confidence in what they are doing than others. Often they are lonely in adopting a particular stance or set of securities. Typically they are not positioned defensively in early stages of what proves to be a rising market. Many times this lonely confidence (compared to a market of little confidence) produces a superior compound growth rate. The superior managers don’t always do extremely well, which is why our portfolios have a number of funds that have characteristics that suggest in appropriate markets that they will do well.

Is Brexit an Opportunity?

Caveat emptor or buyer beware: we can not predict the future. My training at the race track is such to wish most of the time to avoid the betting favorites (weight of money) as well as my contrarian nature suggests that Brexit could well represent a major long-term opportunity for investors around the world.


There are potential parallels between 2016-17 and 1848 as indicated in last week’s post   There are already eight European elections scheduled plus the re-vote in Austria. Australia finished voting this weekend with the present government weakened. The US will have a new administration and a different makeup of its Senate. There is a likely chance that within Europe there will be Brexit type votes either the in planned elections or in special referenda.

Around the world the existing order is under attack by groups on the right and the left claiming that the politicians and other “experts” have not delivered. Further they claim, governments are too big and therefore expensive and inefficient. Supranational bodies are viewed as even worse, as they are further away from the disgruntled people. In part due to social media, many minorities have expressed unhappiness with majority cultures and are expressing desires for autonomy or even independence. One wonders whether the concept of nationhood will need to change.

The world has changed. Even small companies and to some degree small investors view the world through multinational lenses. In the forthcoming negotiations between the UK and the EC, at the moment the UK has the advantage in that it should not be in any hurry. In the meantime it will be free to develop singular trade deals around the world. At the same time multinational companies and investors will seek out their own best deals. There is a long history of wartime enemies arranging a regular flow of trading between combatants. (I suspect that some in Germany are already at work on this option.) In the eventual final negotiation it would be wise for the UK to have one with the negotiating skills of “The Donald.” This is not a US political judgment, but one that recognizes commercial realities. It would not surprise me if the length of the negotiations is not similar to the twelve-year period between The Declaration of Independence and The Constitution. And that process had the benefit of the Founding Fathers led by Hamilton, Jefferson, Madison, and Monroe.

Perhaps coming out of all this will be a political shift favoring consumption over labor. China is attempting to do this with difficulty. The pro-labor attitude of the existing power structure has not worked. By raising the cost of labor (including benefits), it priced much of labor out of the market to be replaced primarily by automation, if not outsourced production beyond China’s borders. By focusing on consumption the drive will be in terms of price, quality, and safety which can produce a healthier and more satisfied society.

There is Still One Thing Missing.

The two largest economies in the world have been built by risk-takers. In both the US and China, the countries are populated by people who took the risk to move to their present location. Historically in the US, it is important to remember that with the exception of the Native Americans, we all came from someplace else for the past four hundred years. Because we arrived with very little in the way of financial assets, we were, and many of us are still today, risk-takers. This makes us unique among nations at the moment, which will have to be corrected if the Europeans want to catch up to the US.

Pardon a parochial view, but I often view the world through mutual fund glasses. One measure of the risk-taking attitude of investors is the portion of their assets invested in equity funds. On paper, Europe as a whole is the same size as the US economy. As of the end of the first quarter of 2016, the world has invested $16.4 Trillion in equity mutual funds. US registered funds accounted for 60.9%. All of Europe had only 27% in equity funds, including Luxembourg and Ireland which are favored by tax aware global investors outside of the US. Excluding the tax shelter investors, the four European nations with the largest share of the global equity funds were the UK with 4.3%, France 1.9%, Netherlands 1.7% and Germany also 1.7%. The potential of  less expensive and bureaucratic government focus on consumption is great. However, it won’t be achieved if most of the risk-taking comes from US and Chinese sources.

Assets in Equity funds:
as of 3/31/2016
All Equity Mutual funds
US-registered funds
60.9 %
All of Europe?
(including Lux & Ireland)
27.0 %
4.3 %
1.9 %
1.7 %
1.7 %

Source:  ICI

How should one invest in the Brexit Opportunity?

This will undoubtedly be a long and laborious task. In a time-segmented portfolio as in our TIMESPAN L Portfolios®, I would begin with small commitments to International funds which have 40% in Europe and buy more during periodic setbacks. The small fund participation rate in Europe may be an opportunity for financial services investing. I will be happy to discuss privately how we do it in our private financial services fund.    
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A. Michael Lipper, C.F.A.,
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