Sunday, October 23, 2016

My Investment Views in 3 Periods


As part of my work in designing specific portfolio elements for our Timespan L Portfolios® , I have begun to separate my thoughts about future inputs into specific time horizons. Please let me know what you think about this approach.

Limited Term Horizon

I have little to add to the vast majority of investment chatter other than a few facts and beliefs:

1.  With the bulk of the purchasers of ETFs being investment advisors, hedge funds and other traders there is a belief the average holding period for them is two years or less as compared with between four and five years for equity mutual funds. This leads me to believe that these are more price rather than investment merit-oriented and are short-term focused. In the latest week the two ETFs that had the biggest inflows were invested in the Russell 2000 and the S&P500. My guess is that these were not sole positions, but were probably hedging concentrated short positions.

2.  Alluding to short positions at least for one stock, it is said every available security that could be loaned out has been. This could be just a prelude to a short squeeze which could spike the stock. It could also lead to a corner being declared. This translates to many transactions being cancelled. Is this an indication of our speculative times?

3.  I believe there is a major misconception that the money being redeemed from mutual funds is going into ETFs or passive funds. The two actions are in my opinion not completely related. My guess is that a large portion of mutual fund redemptions are in effect "completions." That is, they were purchased to fund a particular need and the time has come to meet that need. Many redemptions of funds are investor initiated whereas ETF purchases are coming from investment advisors or trading type organizations.

4.  There are three indicators that make me worried about high quality fixed income investing now. First, in the latest week only fixed income funds, including ETFs  saw inflows and all other asset classes saw outflows. As mentioned in last week's post, my early analytical training was at the racetrack where favorites win only about a third of the time.   

More importantly the size of the winnings for the bettor is insufficient to cover losses on other races. One of the reasons for that is the difference between mathematical probabilities and track odds.  The first is the calculated chances of winning based on lots of conditions. The second is calculated on the amount of money relative to all the money bet less payments to the tracks and state/local taxes. Probabilities are based on judgments whereas odds are based on the needs of the track and governments plus the distribution of opinions, some better than others.

There are two other interest rates concerns which are present. Short-term rates with maturities five years and under are higher now than a year ago, but not so for longer maturities, which is often a sign of instability. In addition, published money market accounts at banks have been moving up and are near the high point for the year. Banks raise deposit rates to attract new money or when they need to retain existing deposits. As usual it appears that the Fed is behind the real market.

5.  Over the next fifteen months there are a number of national elections. Some entrepreneurs and other investors will be disappointed in the results. This may lead to an increase in the number of private businesses and other assets being offered for sale. Often the buyers will be publicly owned companies. This is worrisome. The sellers appreciate the complexity of operating their assets on a daily basis. The buyers believe that they can produce better results than the prior owners because the new managers can put into place uniform principles and more complete solutions. Thus we could be entering another period where the buyers will disappoint their investors.

Intermediate Influences

1.  For years the front cover picture of a couple of magazines were wonderfully negative indicators. They were actually correct at the time the accompanying article was produced, they were just wrong as a predictive device. A Wall Street Journal article entitled “The Dying Business of Picking Stocks” could be a good example. The first line in the article went further and said, "Investors are giving up on stock picking." Other articles seem to be in support of that contention showing in the Large Cap mutual fund arena, that over ten years the percentage of actively managed funds dropped from 84% to 66%. 

I have mixed feelings about these views. As a contrarian I am delighted that there will be fewer competitors when I am trying to buy a bargain. Further, when I choose to sell a position I am pleased that a more supposedly successful stock will have more buyers at higher prices than passive funds. On the other hand fewer people adding significantly to their retirement capital means that my tax burden will go up. My guess is that when the equity market produces 2-3 times what the ten year current interest rate will, then be there will be a rush into the market and many people will become stock pickers for the ride as long as it lasts.

2.  One current market observer has commented that almost everything is going up a bit; in my mind this lack of successful selection skills will be only a temporary phenomenon.

3.  One of the current fads is factor investing where a single investment is used as a singular screen. In many ways the first factor was bonds and the second was stocks. These were combined into a balanced account for trusts. Thus the very first mutual funds in the US were Balanced funds. I have been exposed to balanced accounts and Balanced funds since the 1950s. Over time I have noticed that some performed better than others. Several managers, actually economists in training, varied the ratio of stocks to bonds. This explained a number of the differences in performance but not enough. When I looked into the portfolio at first I saw that perceived quality made a significant contribution to both the stock and bond returns. But that did not explain enough. Clearly the prices paid for the securities made a big difference. Trading competence and clout, particularly on the bond side was important. Some funds were close to frozen and others had high turnover of their portfolio. On the equity side whether they were growth, GARP (growth at a reasonable price), value or dividend-oriented also made a difference. Further, whether there was there just one portfolio manager or multiple managers eventually also produced different results. Over time Balanced funds became less attractive to investors as many wanted more distinct performance compared with a more level result when stocks and bonds were going in different directions (which was the original intent).

To the extent that the more modern factor funds can learn from the analysis of Balanced funds would be useful. Further the sooner they move away from analyzing only the published financials the better. This week Goldman Sachs* reported its third quarter results. Going back to my early experience of taking Securities Analysis under Professor David Dodd of Graham and Dodd fame, I reconstructed elements of the balance sheet and income statement. While the reported results were significantly better than the "street" expectation, the stock rose only slightly. In my analysis I noted the shift in the investment banking line to more advisory and a smaller amount of underwriting. In addition, I was conscious that non-compensation expenses were sharply curtailed, plus I saw a shift in the number of employees involved in investment banking and technology (investment banking was reduced, IT was increased). All of these observations added up to the conclusion that the firm is changing and the past record and ratios are of less value today than in the past. Yet many algorithms based on the pure reported results would not have picked up these changes as used by factor funds.

*Held in the private financial services fund I manage.

Longer Term Observations

The number of US publicly traded companies has declined by half over the last 20 years, but the average size of companies is now six times larger. To some degree this means there is less of a need for a large corps of analysts, particularly covering small companies. But this may well be a chicken and egg argument, for over time the level of commissions has shrunk as has spreads between the bid and asked. I suspect that many of the small company analysts that I grew up with are still delving into small companies for their own account, but are not sharing their work with clients. This could work out well for those of us who do not like crowds.

One of the reasons that there are fewer companies could be that the global development cycle has been shortened. Thus lower cost entrepreneurs with reasonable to better technology can quickly enter a market for new products and can rapidly capture market share that would not have been possible twenty years ago. So our protective umbrella has been pulled down.

Perhaps linked to this thought is that, according to recent surveys, 82% of parents in China today believe that their children will be better off in the future than the parents are now. In the US only 32% of the parents felt the same way. My guess is that these expectations will narrow, in part because the US will continue to disproportionately attract some of the best and brightest.

Question for the week: Do you separate your investment views by time periods?         
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