Monday, December 25, 2017

Better Portfolios from 14 Questions - Weekly Blog # 503

Better Portfolios from 14 Questions

The initial fourteen questions are:

1.  When will the money be needed?
2.  How would you rank these portfolio drivers:
      a) Economy
      b) Stock Market
      c) Bond Market
      d) Political Swings
      e) Popularity
3.  What are the triggers of change anticipated?
4.  How do you define a cash conversion timetable?
5.  How would you structure the replenishment of the Short Duration portfolio?
6.  What are the tolerable levels of Absolute and Relative Risk by TIMESPAN Portfolio?
7.  What is the sustainable spending relative to inflation?
8.  What should be the appropriate performance measures for each TIMESPAN Portfolio?
9.  What allocation or weightings should each TIMESPAN Portfolio receive?
10. What is the client's tolerance for known absolute and relative losses?

In addition, the following need to be determined:
11. Governance Procedures
12. Turnover of portfolio 
13. Legacy Requirements
14. Termination Procedures

I would be happy to discuss privately with any of our subscribers if they are having difficulty answering these questions and how the answers might impact their better portfolio construction.


Portfolio construction and management is an art form and at worst an alibi for failed results. The way we practice the art form is to recognize that it is an expression of deeply held personal beliefs as well as reactions to client needs vs. desires and current conditions. Structuring each portfolio is a continuing discussion and can encompass aggressive and conservative tendencies which can be executed through individual securities and/or open end mutual funds as well as diversified holding companies.

Diversification & Weighting

Diversification is a method of risk control.  Component weighting provide brakes and accelerators for portfolios. The more difficult tasks are after the initial portfolio construction is in place as market prices shift the relative contribution of each component.

A key determination is what should trigger purposeful changes to the weighting in the portfolio?

One should review the portfolio weightings of the components. This review can be done at regular calendar intervals or as a reaction to expected or actual market conditions. The portfolio weightings will eventually become distorted by performance. Due to the good performance of some of the components they will rise in importance in the portfolio and by that fact alone reduce the importance of other components. Both should be examined closely. 

If only one-third of the big gains can be attributed to operating earnings gains, not published eps gains, the rise in the market prices will be due to perceived valuation changes. If the valuation measures are close to or exceed past record levels, there is increased risk which should be addressed. Any cutback or elimination does not prevent risks returning in full or partially. The more difficult task is when the defensive positions lose enough relative weight due to the bigger gains of the winners or some temporary price declines. If the weights of the defensive positions drop by more than 50%, they may not have sufficient weight to substantially reduce the fall of the entire portfolio when there are periodic market declines. In these cases moving some money out of the winners to the more defensive positions should be considered.

In addition to the 14 listed above, additional questions need to be answered before the investment structures to be used in each portfolio are determined.

Questions for the Short Duration Portfolio

This portfolio’s payments could include all payments, truly an operating expenditure bank. Or it could be used exclusively for short-term emergencies, as a reserve for the unexpected; e.g., repairs, health emergencies, and other unanticipated costs.

One of the most critical question for the Short Duration Portfolio is: how much of this account should be available to convert to cash within one to three days and how much within thirty days?

Questions for the Replenishment/Feeder Portfolio

What is the likely exhaustion date of the account before replenishment? This can be triggered by the minimum value of the account before replenishment and will impact construction of this portfolio.  Also you will need to decide whether replenishment capital will be partial or complete in one transfer. In addition, you will need to establish the level of inflation risk that can be accepted before adjusting replenishment moves.

Questions for the Endowment or Lifetime Account

1. What are the expected governance procedures as the key investment decision maker ages or is no longer competent or alive? 

2. How should the replenishment and short duration portfolios be refunded and will they change their nature over time? 

3. What will be the risk tolerances of absolute/relative losses, inflation losses, and appropriate benchmark measures? The tolerance for risk assumptions moving through various market cycles will frame part of the equation for the long-term success of this account. 

4. What is the expected longevity of this account? 

5. How should the turnover procedures for the final legacy account be determined?

Questions for the Legacy Account

What will control the duration of this account, the exhaustion of the money or people involved in fulfilling a mission? Is it to be thought of as a perpetual account?

Will the Legacy account also need to setup and manage a separate short-term account with its own replenishment device?

Our Investment Approach

Each of these accounts can be managed aggressively or conservatively. Individual securities, both publicly traded and private assets along with open-end mutual funds can be used. 

Each account should reflect the wishes, beliefs, and focus of the capital owner.

Seasons Greetings

Ruth and I wish you a Merry Christmas, a Happy Boxing Day and a Healthy, Wealthy New Year.

A Note to our Email Subscribers

Last week a small number of email subscribers received a fake email from me offering supposed documents to be downloaded from “The Cloud.”  We are taking the following steps to reduce this type of cyber-risk:

1. We are tracking those email addresses targeted by this fake email and other similar phishing.  Please let me know if you receive this type of fake email, BUT PLEASE DO NOT OPEN IT. 

2. Next month we are changing the email delivery system for subscribers who receive the blog with the subject line: “Mike Lipper’s Blog.”  We seek to reduce cyber-risk and to make the blog more convenient to read. We will give you sufficient notice.  

3. Those who receive my blog post’s title as the subject line of their emails from me (“Single Portfolio Cannot Do Multiple Jobs, Weekly Blog # 502”) will not notice a change.
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Sunday, December 17, 2017

Single Portfolio Cannot Do Multiple Jobs - Weekly Blog # 502


Would you choose to go to a pharmacy that had only one medicine, a plumber who had only a wrench, or an auto repair shop that had only a screwdriver? My guess is no, you would want a reasonably complete set of tools with some being alternatives to a given general solution. Yet most individual investors and many institutional investors gather their securities investments in a single portfolio and report to themselves and others in terms of a single performance result for the most current period. This is similar to going to an inadequately supplied pharmacy, plumber, or auto repair shop! For this very need, I have developed a different way of arranging investments. My preferred structure is based on the timespans that investments specifically need to perform in terms of cash generation and asset price performance. This structure, TIMESPAN L Portfolios®, leads to the way I examine all of the various inputs to making investment decisions including the weighting of buy, sell, and holding choices. Thus, I am continually looking to solve simultaneous equations with multiple unknowns to drive specific solutions.

TIMESPAN L Portfolios

I am using four separate portfolio structures as filters to examine inputs. (I would be happy to discuss with subscribers the various inputs as they may apply to their portfolio structures which are mentioned.)

Current or Operating Portfolio

This is the portfolio that must need current operating payment needs. For far too many this is their only focus. Current price performance becomes paramount to all of their investment thinking. In these nanosecond responses to news/rumors, global marketplaces speed to change directions that may be more important than the depth of thought. For example this weekend there are two inputs that can shape actions. The first is that on Friday, December 15th, the NASDAQ Composite’s price broke out of a month-long constrained price pattern. For some this may be a bullish event. For most of this year the combination of mid and small technology companies plus the well known FAANG companies were driving the major stock market indicators. For the last month while the NASDAQ was flat, the Dow Jones Industrial Average and the S&P 500 were rising. There was a worry that if the performance leader was not moving higher, the followers would eventually stall as well. Thus the Friday breakout could be viewed as important. This is particularly true because in the week that ended Thursday night the only US Diversified Mutual Fund averages to decline were those of the Mid and Small market-caps, excluding the Short Biased funds which also declined.

The second input was the volatile American Association of Individual Investors’ weekly survey showed a major jump of bullish investors to 45% of their sample compared with 37% and 36% the weeks before. The progress of the US tax bill was probably the cause for the surge. I personally find this as extremely premature. As of Sunday I have not seen the conference committee’s full draft. There is still room for some changes as both houses pass a bill. As a practical matter until we see the implementing regulations which are likely to be more complex than the bill itself, we won’t be able to carefully apply the bill to our own taxes. Relatively soon there is likely to be a Tax Corrections Act plus there is a good chance that tax and/or civil courts will modify the regulations.

Both of these inputs are speculative but give support to the bulls near-term.

Replenishment or Presidential Cycle Portfolio

This is an unusual portfolio device to replace the funds allocated to the operating portfolio that have been expended to meet the current needs of the account. Its timeframe pivots on probable changes. These changes may be in terms of political or corporate leadership. The second element would be significant if the bulk of the investments are concentrated in companies with critical roles to their success leaders.

At the moment this portfolio has the biggest hurdles to climb. In the normal course of market history it is reasonable to expect to see a stock market price decline and recovery in periods of four to seven years. Currently, it appears we are building toward a peak. The very inputs mentioned for the Current/Operational Portfolio shows signs of providing the missing enthusiasm which is present immediately prior to a peak. One of the ways to get stock buyers to join in on the rise is to suggest that the rise is not a cyclical phenomenon but part of a long-term growth trend. We are already seeing broker’s headlines declaring “Global Economy Stronger for Longer.” We are also seeing earnings estimates going out to 2020-2022.

As a young junior analyst struggling to come up with annual earnings estimates I became apprehensive when I started to see the justification for buying certain stocks on the basis of their purported five year projected price/earnings ratios after a “hockey stick” type of growth pattern. The result did not turn out well. We are now seeing estimates that global stock markets may reach levels of $100 Trillion and at least one company expected to reach the $1 Trillion level.

US investors are not blind to all of the risks in today’s marketplaces. Their aggregate response to these risks is to invest outside of this country. The largest single net flows this year are into International/Global Equity mutual funds and ETFs, with the latter being driven by institutional owners. Perhaps it is warranted as most markets are selling with price/book value prices below those in the US. (There may be less massaging the book values than the reported earnings.)

Endowment or Post-Decline Portfolio

I believe it is reasonable to assume that there will be both a stock market decline and a recovery which eventually will lead to much higher price levels. There are two keys to benefiting from this prediction. The first is the careful management of assets going into the peak and recovery cycle and the second is to benefit from the probable change in market leadership.

The endowment period is probably as long as the youngest decision maker is in that position, but likely more than ten years.

Typically new leadership comes from overlooked companies and sectors that have gone through major structural changes during the peak/decline cycle. This is often the type of period where prior momentum plays lose ground to contrarian plays. I have two examples of this thinking. The first could be Britain. Because of necessity, the UK comes out of BREXIT stronger than when it entered the divorce procedures. As is often the case the winners could be centered in the mid and small-cap domestic oriented companies.

The second good endowment prospects are what we use to call “warehouses.” These were not physical warehouses, but stocks that would not lose much value in a decline and had reasons to have a better than historical experience in the future. Today there are two, somewhat controversial, opportunities of interest. The first is the oldest warehouse for more than a century, AT&T. While in truth it is the recast Southwestern Bell along with a number of acquired former Baby Bells. I am not attempting to guess the final result of the proposed merger with Time Warner. My interest is focused on the likely leader in the Fifth Generation internet which could well be dominated by AT&T as the technological and capital leader. The declining value of their long lines infrastructure could be reversed.

The other warehouse that is even more controversial is General Electric, which was the first large company I analyzed. The slimmed down current company is essentially being rebuilt around its capability with engines. The power business, particularly in the conversion to the use of natural gas, should be a major plus. The aircraft engine business is very attractive in terms of the parts and services involved. What are labeled their healthcare products are in reality supplying the mechanical/electronics patient movement businesses.

I view both of these stocks as substitutes for ten year US Treasury Bonds, which currently yield 2.4% and AT&T yields over 5% and GE 2.7%.  The income from the bonds is fixed. I suspect that the two warehouses will raise their dividends at least equal to published inflation if not higher. Further over time their pension expenses will decline through pension risk transfer contracts with Prudential Financial or other insurance companies. Also I expect that the number of employees and their ages will decline easing their retirement expenses.

Legacy/ Future Generations’ Portfolio

The nice part of managing money for this portfolio is that I won’t be around to see whether it works or not. I hope it does work because it will be important for my grandchildren, great grandchildren and their beneficiaries. This is the most challenging portfolio. While some of the future winners will be leaders from today, some will be a surprise. It is in the latter group that I am focusing on in the beliefs that there will be some changes which will lead to good investments.

The first idea is that much of what we invest in today is anchored in the so-called permanent or physical world. In future generations I think we will be living in more fluid situations. Even today’s tax bill may be driving to praising liquidity over permanence. Individual ownership of real estate could give way to greater rentals. With the growing retirement capital gap we may need to increase savings and get higher returns on our capital as we live longer and more expensively. My guess is that we will see more century and longer bonds,  possibly perpetuals.

The second idea derived a bit from the first is that business and industry structure can and will likely change. We are already entering a phase of vertical as distinct from integrated mergers. The recently proposed merger of Aetna* into CVS/Caremark is being analyzed as a process to lower the cost of drugs. I see some other, more important long-term advantages. First, as a data-hawk the idea of putting the aggregate data in terms of medicines with health and life insurance statistics could have enormous advantages to the companies and could well provide better healthcare for patients. There is perhaps an even bigger potential advantage to the proposed merger. CVS is used to their customers coming to them. Aetna has to go out to get their insured through direct or agent sales efforts. With the increase in marketing and sales supported technology the dollar levels of future sales could expand materially.

* Shares personally owned 
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Sunday, December 10, 2017

Same Answer to two Questions Disturbing? - Weekly Blog # 501

What drives stock prices? In this sound bite world of media and academic pundits what drives stock prices is earnings per share. The progress of e.p.s. determines the appraised value and therefore the future price.

What is the most massaged number of all that is published? You guessed it, earnings per share. When was the last time that a modern chief financial officer or CEO knew one year in advance the number of shares that will be divided into the reported net income on an average number of shares or year-end number of shares outstanding? To be honest, net income, at best, is a representation of a perceived reality. Revenue recognition is a semantic guess. The value of inventory consumed and the remaining value as to what is left is heavily influenced by current or year-end prices and the recognition of taxes currently owed to various taxing authorities. In truth e.p.s. numbers are not manipulated necessarily with malice.

This reality suggests to me earnings should not be the sole measure of a stock’s value or perhaps not even the leading measure of future prices.

I am led to this view after reviewing Berkshire Hathaway’s* investment experience and looking at a number of 13f reports reviewed by John Vincent as well as my own long-term portfolios. In each there are some losers. In general from the time the losers become big losers they disappear or have a greatly diminished percent of the portfolio due to the rise of the winners.
*Held in the private financial services fund I manage

Warren Buffett claims he does not make future earnings projections. Even if he did I doubt that he would have much confidence in ten and twenty year projections. Then what is the rubric or rubrics he uses? I believe staying within his circle of competence it would be based on his understanding of the nature of the business that the company is considering acquiring. In 2000 he purchased a big position in Moody’s Corp. that was spun out of Dun & Bradstreet. The current price of Moody’s is fifteen times his cost. This is a clear example of thinking long-term, with an understanding of the functions and quality of a potential investment.

Not long after Berkshire’s purchase of Moody’s, I independently bought the stock for the private financial services fund that I manage. When I bought this stock I believed that I understood the nature of the credit rating business and the essential need of the company’s clients for its services. I also knew a little about its management compared to its main competitor. It was the quality choice. Thus, investing in the highest quality of an essential business worked well for me. I did not project earnings, recognizing that most of the analysts reporting on the company regularly underestimated current earnings. As I was a bit late in my purchase, the current price of Moody’s is only eight times our cost.

There is another lesson from this experience. It is not just finding a great investment, but continuing to hold on through both the changes within the investment, the market, and the needs of the account. Both Berkshire and I sold some of the original position along the way for reasons that proved to be wrong. Thus the same level of diligence needs to be practiced as we, in effect, re-purchase our liquid investments everyday.

Challenge Ahead

Perhaps too many of the portfolio managers that I speak with, while concerned about the near-term future due to the identified unpredictability of events, are not raising their cash levels. In numerous cases the hesitation to act dynamically is due to career risks. As a contrarian long-term thinker I have already accepted the realization that there will be a stock price decline ahead of us which may be combined with a recession, fixed income collapse or military actions.

There remain two critical questions. First, the size and duration of the decline, and second, should we trade in and out of the decline or do we stay pretty much fully invested to benefit from both the recovery and the expansion beyond?

As usual I look at the current data and the misdirection that most are following. Economists and politicians are being led by the lack of sufficient productivity, actually labor productivity. This is defined as revenues divided by wages. Governments around the world have found within their constitutions a “requirement” to create jobs. In particular they want to create jobs for union workers and other politically active individuals with eyes on the next election.

While these are important, they are not addressing problems that are broader and deeper in scope than unemployment which can be summed up in different measures of productivity.

In all of our societies there are more consumers than workers. What has happened all over the world is that consumers are buying more and better quality products and services due to both technology along the way and world trade. I suggest, unaided by government or perhaps in spite of government, consumers are better off today than ever. Clearly more is desired. If we create jobs that raise prices and/or reduce quality, that is a step backwards.

The second productivity measure which is not highlighted globally is the productivity of capital, particularly retirement capital. I do not know of a large government retirement plan that is fully funded against any standard, let lone the fact that we are all living longer and our last years are very expensive. We must support increased investment into retirement capital vehicles but this will have the effect of lowering current consumption.

Net Flows into Mutual Funds and ETFs

The next set of numbers that is not getting enough attention is the net flows into mutual funds combined with flows into ETFs. Domestic Equity funds particularly Large-cap Growth and Large-cap Core funds have been in net redemption for a considerable length of time. Despite the average performance of Large-cap Growth funds this year is close to a gain of 30%, they are in net redemption. This is largely an aged base, as the fund holders who were sold Growth and Core funds years ago are at the stages of life where they need the money for other purposes. This is not new and has been happening for decades. What is new is that the long- term profitability of selling funds and managing accounts invested in funds has changed.

But there is a more important message from net flows. Global and International funds are adding assets at almost the same rate as the Domestic-oriented funds are being redeemed. What this is saying is that the Domestic funds are suffering from the lack of sufficient retirement capital. Plus today’s active fund buyers are hedging their retirement against a perceived long-term decline in the value of US assets. This is backed up by the current yield on long-term government bonds. There are ten large countries with ten year government bonds. The yield on the US ten year is second highest of the ten. This means that the market participants view that there are eight better places to invest their bond money and will take lower yields to insure their safety on a post-inflation basis.

Equity = Opportunity/Risk

At the current global level of interest rates we will be far short of filling the retirement capital deficit. The best opportunity to fill the gap is equity. Equity has imbedded within it both opportunity and risk of loss. In general the larger, more mature corporations have the least risk but also the least investment returns, as shown below utilizing the three S&P market capitalization indices’ investment performance since 12/31/1999:
S&P “Market Cap” Indices                        
Average %
Range: High to Low %
+  194.89 to (51.36)
+  874.74 to (69.38)
+1198.12 to (95.89)

This table suggests that mid and smaller market cap companies can produce higher returns than the more mature, larger companies in general. The market risks are greater also, but not relative to the size of the gains.

Betting on Change

None of us know for sure what the future may bring, but the wise equity investor hopefully recognizes changes earlier than many others. There are many possible disruptive changes which could impact all of us. I am not sufficiently knowledgeable to have an appropriate view on autonomous driving vehicles but they could change or disrupt almost every element in our societies. It is the marriage of technology and lifestyle changes.

There are a number of other disruptive forces that can change our world, hopefully for the better by addressing the two missing productivity measures.  Because I believe that some of these changes will occur, I will continue to be largely an equity investor.

Question: What are the changes that you are expecting?
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Contact author for limited redistribution permission.