Sunday, November 27, 2016

Short & Long Term Gifts to Investors


Traditionally in many societies there is a festival to give thanks for the harvest. At this Thanksgiving I find a lot to be thankful about as an investor and portfolio manager. While I personally have a lot to be thankful for, I am going to focus on the gifts that we can share with all investors. As regular readers have learned, I tend to look for investment clues to various future timespans. My comments will be arranged with the most current inputs first extending out to longer timespans.

The Richest Market

At the moment the US has the richest and most profitable market in the world for most goods and services, which means we can benefit not only from what we produce, but also what was produced elsewhere at relatively reasonable competitive prices. Thus, the celebration of "Black Friday," a market shopping holiday, but not an official government holiday, is an important event to be observed, literally. Each year my wife Ruth and I visit The Mall at Short Hills, one of the glitziest malls in the US. For many years we have visited there either on the official Black Friday or the next day if we think we can find a parking place. The following is a brief report on our visit that a number of our long-term readers expect.

We could quickly authenticate the belief that shopping online would seriously eat into the shopping at stores. While considerably more crowded than normal, we were able to find a parking space in six minutes versus under a minute normally. As trained people watchers, we quickly noted that there were more people than shopping bags greeting us in the mall. For the most part shoppers came in pairs or larger groups with one an active shopper and the other either an approver or a payer.  While there were a number of men in the mall the prime shoppers appeared to be women, often in groups that were intergenerational - from pushers of strollers to some using canes along with posses of high school and college age young women. A number of these wore full makeup and were dressed as "fashionistas." The younger women crowded into Aritzia, a shop that my Granddaughter works for as a "style advisor." From an investor’s perspective these purchasers were showing signs of optimism as they are getting ready for a better near-term future. (I don't know whether they have been infected by the Trump Stock Market or this was just youthful exuberance.)  Macy's reported that their website had to shutdown three times during the day due to volume of visits.

We saw no signs of major door breakers of very large discounts, even though we did see signs of 30-50% discounts. With the exception of Apple* cell phones we were not aware of any “must have” products that people, particularly men, must have. The Apple store was extremely crowded but not outside lines. It was well staffed and apparently productive. The Verizon store was less busy but a good crowd. The AT&T store had very few customers in a large store.
* I own shares in Apple.

From an intermediate term investor standpoint, I am wondering whether we should be looking at cell phones as a product or as an entry point to services revenues? In many ways one uses the device to deal with the service sector. (For those who are interested I would be happy to discuss my view that Apple is eventually a service company.)  There may be a much more important clue here.

In reviewing economic statistics from many developed countries, service revenues and the number of employees are growing faster than those involved with manufacturing. I wonder whether we have entered a post manufacturing world, where manufacturing's function is to produce entry points to services; e.g., cars will be needed for Uber drivers and users not for personal ownership. If this is half right, the political implications are mammoth. The out of work workers and miners may not get their old jobs back regardless of long-term trade deals, unless we enter into large scale military wars. In the absence of manufacturing and mining jobs; infrastructure, education, and healthcare will need qualified labor. This will be difficult but not impossible to achieve. (If domestic labor does not fill these needs, immigrants will.) A lot will depend on the individual, some will see themselves as individually empowered and will create their own opportunities. Others will hope that as a group there will be a solution to their problems and may be disappointed.

Other Thanksgiving Gifts

The next thing most likely will be seen as a threat, but I view as a potential opportunity. We have been indoctrinated to believe China has replaced Japan as the second largest economy. On a purchasing power basis it is actually bigger than the US. In many ways this is a plus. The US is no longer the main growth engine for the world. Even though it is being guarded as a fortress, the potential Chinese market is large and under-served. The challenge for the new US Administration in the long run is not protecting our domestic market but opening up the Chinese domestic market as it grows. This will not be easy as both of us will be facing financial problems over the next four or five years. The odds favor that we will have our own economic recession, which may be independent of a stock market decline. China is a central command and controlled  economy which is becoming more free with the rising power of local government and the private sector. This transition will be halting and difficult. The true strength of our economies will be measured as we go through the coming problems.

Water as a Gift

Over the lives of our children and certainly our grandchildren it is quite possible that quantities of potable water will be more valuable than oil as our world evolves. Unless we change our dietary patterns our growing populations will consume more and more waters through the food we consume. At some point oil for transportation will be less important as we are going to be living closer together and will be using more fuel efficient vehicles. In a geopolitical sense we used to think that we in the US were blessed by having only two land borders, even though we have gone to war with those to our north and south. In the world that is evolving, our actual benefit is that we are abounded by the Atlantic, and Pacific Oceans and the Caribbean. Through the technology developed by a company now part of GE, we have developed the ability to desalinate large quantities of salt water if we can get enough electrical power. I am convinced that both the cost of electricity will decline and the price of water will rise so the North American countries will be well supplied with water.

Question of the week: Can you employ any of these ideas from this Thanksgiving message to your portfolio, life, or political beliefs?

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Sunday, November 20, 2016

The Longer the TIMESPAN, the More Bullish


Too bad more investors, particularly institutional investors, don't have the same clock in their heads as many successful entrepreneurs. As many of you already know that I believe one of my two great learning experiences was learning to handicap thoroughbred horses at the racetrack. One of the greatest jockeys of all time was Eddie Arcaro. He was said to have a very accurate clock is in his head. That is why he could win with different race strategies with different horses. For each horse he knew how fast the horse had to run in each portion of the race in order to win. Thus he was able to win with early sprinters as well as late come-from-behind racers. Many successful entrepreneurs have a similar clock in their heads. They know how much they need to accomplish in each period in terms of development of people, product, service levels, and key customers. In contrast, far too many portfolio managers only focus on the current performance period.

My evolving investment process is similar to the clock in the head approach. I learned as an entrepreneur that I could only accomplish a limited number of things in each month, quarter, year, five to twenty years. Thus, when I look at investing for clients and my family, I mentally assign investments to various future timespans in my life and beyond. This is why I developed TIMESPAN L Portfolios®.

This filtering system helps me address all of the myriad of inputs that besiege me every waking moment of everyday. I mentally assign various inputs to various timespans as to when they are most likely have the biggest impact on winning. I have often said that if you scratch a true analyst a historian will bleed. As a student of history I am well aware of the cyclical nature of price and value metrics. I am also aware that there is a general long-term trend of secular growth, thus far. The following is how I am viewing the various inputs that I am focusing on this weekend with both cyclical and secular patterns in mind.

The Immediate Term

This is the period that answers "what have you done for me lately" that various pundits in and out of the media chatter about. Any glance of price charts will count more reversals of direction in the daily versus five to twenty year charts. Thus the shorter period the more likely that it will contain more cyclicality. There are five particular inputs that I believe are worth thinking about.

1.  The media is broadcasting that equity mutual fund net sales has turned positive with the third highest dollar inflow in recently recorded history. Only the more observant reader will pick up that the entire positive inflow is coming in aggregate from Exchange Traded Funds (ETFs). Longer term mutual funds are still suffering from the aging demographics of their holders and a relative change in their distribution profitability and thus are still in net redemption. I believe the bulk of the ETF flows are from trading entities like hedge funds and do not represent a long-term commitment to the equity market. For example, on Friday after the Exchanges closed the two largest volume producers in the after-hours markets were the Financial Select Services SPDR and the S&P 500. Neither of these had much or any price movement. I believe the reasons for these trades is that there were some unfinished business in complex trading tactics of being short individual securities in these two good performing groups of stocks and the purchases of the ETFs was a hedging technique to protect the short seller from a group move upward rather than an individual stock from going down.

2.  Apparently the derivative traders en masse expect little chance of a major decline. The VIX contract's price has collapsed well below the average price paid over the years. As a contrarian, this makes me nervous in view of the recent sharp rise we have seen in the popular stock price indices at the same time as the sharp decline in high quality bond prices.

3.  Thomson Reuters reports on individual stocks within the S&P500 fourth quarter earnings estimates with 58 companies lowering their guidance and 29 raising them. Is this 2/1 ratio just a sign of traditionally lowering their guidance so they can announce a "beat" or are things not as good as the price trends suggest?

4.  When a former successful bear becomes an overnight bull it is worth recognizing. Stanley Druckenmiller who has a long history of successful management of two hedge funds and a major influence on one of the better university endowments, immediately after the election moved out of his bearish investments into being long the market. He has been a good reader of the market in the past.

The Short-Term

Unfortunately this is the time period that most investors think about. It is usually under three or at the longest, five years. While this period exhibits less cyclicality than the immediate term, based on history it is wise to expect at least one twelve month period of 10-25% decline. The major question to be determined for this group is whether we need a major bottom to occur before a substantial rise can happen. This concern has led too many portfolios to be concentrated in large cap stocks that trade in the US for US investors and multi-nationals for those outside.

Going back to my education at the racetrack when a significant number of jockeys change horses it may signify a common trend of significance. Currently I am conscious of a number of mutual fund portfolio managers leaving their shops often accompanied by closing some of their funds. In addition, there is a musical chairs phenomena of Chief Investment Officers leaving university endowment positions. Some of these moves are likely being caused by immediate poor investment performance, but not all as some are opting for a less tension filled lifestyle. Nevertheless as an old performance score keeper, these changes bring into question the validity of some long-term trends. This in turn may make fund raising somewhat more difficult. There is a deeper question. As many of the replacements will bring a somewhat to radically different investment approach, is this a classic example of shutting the barn door after the horses have left? Is it quite possible that when the liquidations of the old portfolios are complete that the discredited strategies will get their time in the sun?  Could this be another example of some securities moving from weak disheartened investors to stronger more future oriented investors?

Present Long Term Investors

In our lexicon we call these Endowment Portfolios. These accounts are structured to meet payment needs into the somewhat distant future. In a recent column in The Wall Street Journal, Greg Ip noted that the world has a structural savings surplus and a shortage of (worthwhile) investments. China and Japan this year will produce a savings surplus of about $850 billion. At the same time I believe that the world including the US has a retirement capital shortage of large and growing dimensions. As a fundamental believer in the genius of  marketplaces, I perceive the missing element is a traceable price structure. When we finally get high quality savings rates in the 4-5% range, possibly after taxes and inflation for term savings, and in excess of 8% for risk investments (again after tax and inflation) we will start to close the retirement capital underfunding. Whether the new administrations in the US and elsewhere are pro savings and retirement is yet to be seen, but I am convinced that some leaders will recognize the benefit of being an early adopter.

Under these conditions loans will carry sufficient credit buffers  to guide the borrowers to make safer decisions. This in turn will reduce the default risks which will eventually lead to lower interest rates. Both demographics and technology will be aids to finding the right systems solutions.

Legacy Inputs

The Legacy Portfolio investor is looking to create a stream of future benefits beyond the life of an investment committee or an individual. As in all transactions there is a more favorable time to be a buyer or a seller. I believe the current time favors the buyer of Legacy investments. There are fewer buyers so prices may well be more favorable than what they may be in the future. Why? In a very insightful analysis by James Paulson of Wells Capital part of Wells Fargo* entitled "Rising yields and stock market internals," he examines eight valuation factor ranges to determine why the bulk of investors’ money is where it is invested. His conclusion is "most (investors) have been chronically frightened by the future and therefore have opted to stay mainly domestic in large and traditionally more stable companies and in low volatility consumer and bond surrogate stocks." Almost by definition if that is where the heavy bulk of investors are they will get low returns as there will be fewer buyers to bid up their merchandise. I believe their absence, except in the private equity/venture capital arenas, suggests that prices of small innovative companies with strong owner/managements around the world are less bid for and thus are cheaper. In the words of the track they are “under bet.”
*Owned personally and in the private financial services fund I manage, plus the fund owns Berkshire Hathaway that is a 10%+ holder of Wells Fargo.

Questions for the week:

1.  Are you changing your investments due to political changes?
2.  How do you handle the inputs that you receive in terms of your investment actions?
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, November 13, 2016

Contrarian Experiences Suggest Worries


As we are in the early stages of an indefinite expansion, the self imposed function of a contrarian is to question the primary trend.  As a contrarian I was not surprised by the Brexit and Trump votes.  If you look carefully at the polling data and understood the customers for the data, you could have joined me in these contrarian views.

My worries can be addressed in the context of the TIMESPAN L Portfolios® by allocating them into several time slots where they may have the most impact. All of the worries question Mae West's statement that "Too Much of Something Can Be Wonderful" as applied to investing, particularly long-term investing.

Operational Portfolio Time Frame

Using The Economist's table of national market stock price indicators for the week ending Wednesday 31 of 44 rose. More significantly 20 out of 23 economic leading country markets rose including US, China, and most of Western Europe. In this type of market environment far too many buy orders are "at the market" or are price insensitive. Thus, to some extent some current market valuations are being driven by an unusual amount of sentiment and are not particularly price sensitive. This surge could be driven more by retail buyers than institutions. On Friday the Dow Jones Industrial Average went to a new closing high of 18,847.66. The more institutionally followed S&P 500 and the NASDAQ did not. There may well be one or a few days of delay before the other two indices confirm the record high of the media's favorite indicator.

Clearly for most, the enthusiasm for stocks was due to the surprising to most sweep of the Republicans in terms of the Presidency, the Senate, the House, and a number of governors and state houses. In theory this means with a single party dominance, legislation action will be quite rapid. Large majorities tend to give some rebellious members license to be obstreperous as party discipline will be less powerful. Our history going back to when the Democrats had a roughly similar condition is that the ruling party can not deliver on all of its main elements, it will be blamed for their lack of control and the long cycle of "throw the rascals out" will begin. As I suggested today to a Democratic friend, (I do have some) if you can't win big the next best thing to do is to lose big, and that could have just happened.

From a short-term standpoint the market could be exposed to some sudden unpleasant surprises. A trading desk mentality is warranted. If you don't have exposure to a powerful trading desk be more price sensitive than normal. Limit orders are useful, the worst that happens is that one does not get an execution. (Which can be more beneficial than filling an order at too high a price.) I suspect many of the buyers are closing out short positions. When they have completed their covering operation that source of demand will have dried up.

Replenishment Portfolio Time Span

This total return portfolio is designed to fund the next edition of the spent out Operational Portfolio. At the moment I have three principal worries over the next five or so years.

1.  A generational long bond bull market is over where astute bond holders may have made more money through price appreciation than through receiving interest payments. The discredited central banks will no longer manipulate low interest rates and expanding economies will be using much more credit than previously. The increase in the demand for money will push its cost up and therefore interest rates will go up. Thus instead of getting capital appreciation for owning bonds they will get capital depreciation absolutely until maturity and real at maturity in terms of spending power.

Most replenishment type portfolios, whether they call them that or not are collections of stocks and bonds. Where bonds were meant to provide both income and capital stability if not appreciation, over the next five years bonds they are likely to be a depressing input. This concern is highlighted this week with US based TIPS funds attracting the second biggest inflow on record at the very same time as High Yield ETFs saw redemptions. The mutual fund business is global. In just about every market bond funds have attracted significant sales whereas equity funds have been in redemptions. I suspect that the intermediaries that sold the bond funds will see an opportunity for another transaction, selling the bond fund and buying the stock fund. If this happened in extraordinary volume the prices of bonds, if they can be traded will drop significantly.

2.  To fill the demand for loans there has been a sharp increase in the number of credit funds and other types of non-bank financial institutions. These are not policed the same way banks are. Years ago I sat through a course for bank examiners. One of the lessons from the course was the examiners were cautioned to look hard at banks growing their loan books too fast, outrunning some of their credit ratios and their staffs of seasoned underwriters. While I have no information as to various non-bank credit granting institutions, I am under the impression that many are growing faster than the banks and the newer ones may be competing for customers with more favorable terms. Most of the time this can be dangerous, but now or soon it could be particularly dangerous as interest rates move up, a lot of unsound loans could be unable to be rolled over during the replenishment portfolio period.

3.  A good bit of the enthusiasm for the new Administration is based on the repatriation of  US companies’ overseas earnings. Based on past experiences this money will be used for increased dividends and buybacks of voting common stock. In the near-term this is positive, but does nothing for longer or even intermediate-term holders. Worse, a management that is focused on its short-term stock price may pass up sound opportunities to invest overseas in markets that in the long run are likely grow faster than the US market.

Endowment Portfolio Time Span Input

Are we currently suffering from a cyclical or structurally slow period is the question for the investors trying to manage future payments for periods that their current investment committee or investment officer is functioning. Clearly most of the developed world including the US is going through a flat or sub-normal growth period. Some of this may be caused by central banks and various government regulations and taxation. Through the political system we can be hopeful that many of these issues will be addressed. Because policies go in cycles I believe these are cyclical factors that suggest that endowment management needs to wisely make changes periodically. However, these switches do not address the current reality of structural problems.

Throughout the developed world labor and therefore capital productivity is low by historical standards. One of the main culprits is demography. Birth rates are low and declining in many societies, but at least in the US people are working longer. Currently the growth rate in the population that is working between the ages of 16 to 55 is equal to the number of people over 55 that is working. As one of those I would say that shows that there is some value to experience and work ethics. I am very conscious of the benefits that my brother and I, depression babies, received when we entered the investment community. Very few young people entered the financial community from the 1940s-1955. When we entered we had a few senior elders in the field who were psychologically recovering from the depression and very little in the way of middle management. Our progress at a relatively young age was rapid and remarkable. Today's youths have too many of us still in the picture and because of the advances of medical science, we are likely to stay involved.

A very important part of the political upheaval caused by Brexit and the Trump victories has to do with immigration. The odds are if the developed world had more good, competent, workers we would see our national productivity numbers rise. The more difficult set of questions revolves around how to pay for their training and placement in productive locations. This is a societal issue that won't be quickly solved, but without it being successfully addressed our long-term rates of return on Endowment assets are likely to be below historic norms at the very same time we are living longer.

Legacy Portfolio Inputs

In some ways this is the easiest as well as the hardest portfolio to manage. It is easy as we won't be around to see whether it works and thus avoid whatever criticism that is directed at it. At the same time it is hardest, for by definition we must deal with the future and that is predictably unpredictable. Nevertheless, for those who take on this responsibility for grandchildren and great grandchildren and beyond, the best thing we can do is to lay out some useful principles.

At the heart of the dilemma is who do we trust to use the right instruments. In some ways it is dealing with the risk and reward questions that we already must deal. Almost all of the advise that is around today assumes an investment in a liquid portfolio which can periodically be readdressed to handle market turmoil. An incomplete study of great wealth indicated that once it is converted into portfolios, short-term and personal concerns reduce the size and power of the family's wealth perhaps over many generations.

Another study of great wealth is based on great entrepreneurs. These ladies and gentlemen typically have a keen understanding of a particular market niche and with high energy plus some inspiration develop a needed product or service. Then comes the much more difficult task of building a sustainable company, very few succeed beyond the third generation.

I believe a wise legacy portfolio should be invested in securities and operating businesses and have different managers for the portfolio investments and the operating business opportunities. Because I can not predict the future I am searching for the right mixture and right managers for some institutional and personal accounts. But times are changing and one should anticipate some of these changes, and that is really our legacy.

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.