Sunday, February 26, 2017

Critical Lessons from Two of the Smartest Investors


Trying to escape reliance solely on experience, I rely on my student skills for this post. I have indicated numerous times that the Neuro-economics professors/scientists at Caltech have shown most people use their cumulative experience as the main or sole basis for making judgments. I try to study current and past history as an important source of additional experiences.

This week I have turned to two of what many have called in their time the smartest men around, Sir Isaac Newton and Warren Buffett. The latter's annual letter came out Saturday morning and I read it before we drove to Mount Vernon to celebrate General George Washington's 285th birthday. While the letter was signed by Warren, it clearly contained some of Charlie Munger's insightful views and was probably edited by the incomparable Carol Loomis.

Sir Isaac Newton

Sir Isaac is acclaimed as  the identifier of the laws of gravity. For many of us market followers this is often translated to what goes up, comes down. We always hope that our particular investment will either continuously rise or we get off the back of the market tiger successfully before he runs in the other direction.

At this particular point I have been focusing on Sir Isaac's investment activities to guide my clients' and family's investment accounts. For almost any gathering of people who are involved with the market the question comes up, “Should we sell after this remarkable rise we have had in many stock markets around the world?” I should not claim forecasting skills, but I can serve up lessons from history.

The South Sea Company was what we would call today an unusually clever public-private partnership that was founded in 1711. The company was awarded a commercial trading monopoly with the lands in the South Seas (South America) and for this the company would assume the war debt coming out of the War of Spanish Succession which ended with the Peace Treaty of Utrecht in 1713. Originally the promise of the company was a 6% yield, but as the government offloaded more of its debt on the company, the promised yield was dropped first to 5% and then 4%. In the Peace Treaty the monopoly was translated to mean one ship a year and there were some restrictions as to the commodities to be traded, but with the fabled gold and silver production in South America the ownership of this team of wealth was deemed to be very valuable. In January of 1720, not quite 400 years ago, the stock was trading at £128, in February £175, March £330 and £550 in May. Somewhere in this parabolic price rise, Sir Isaac (being well trained in mathematics) sold out. Well and good for our hero.

The only problem was that on the way to its ultimate peak of 1000, Sir Isaac got sucked back in, and when it collapsed to 100, he had lost £20,000. According to one account that the loss would be worth £268 million today.

(For those who are interested I would be happy to discuss this bit of history and the roles of the government, the main bank, and other bubbles.)

One of the risks of using the past as a measuring device is that occasionally one can be premature and in some cases quite premature. It is not too bad missing the last opportunity at or near the top. The real penalty is borne by those who get sacked back in by envy and the belief that they can identify the top and go back in and stay in during an unconscionable decline.  I guess the best defense system is the willingness to accept both the loss of presumably large opportunity and actual realized losses during one's hasty parachute exits. 

With the lesson from Sir Isaac Newton's experience in my mind I am paying increasing attention  to expressed sentiments triggering actions. For example, according to one report, Renminbi transactions accounted for over 95% of total Bitcoin exchanges. I am seeing what I believe to be similar activities in some commodities as many Chinese are desperate to get some of their wealth out of their own currency. Further, I see some signs of potential large disruptions in  currencies and treasuries. My concerns are based on the fact that these markets are bigger than the stock markets and through margin and derivatives  heavily committed traders could quickly come into insolvency. This would be too bad for them and their investors. However, it could be very unfortunate to their counter-parties. Often these very same organizations supply credit and facilities to other market participants which could cause a disruption in the stock markets no matter what their level, but particularly if stock prices reflect an increase in speculation.

The Buffett Letter

I suspect that the lead item in Monday's financial press will be about his shareholder's letter released early Saturday morning.  Most of the focus will be about  the value of Berkshire Hathaway shares. As usual I will not compete, but focus as to broader implications on the report as if both Warren and I were back at Columbia.

The 52 year record of performance of Berkshire-Hathaway is truly remarkable. What struck me was over this period there were eleven years when the market value of Berkshire's shares went down and eleven years when the S&P 500 went down. What was interesting is that in eight out of eleven they were different years. This suggests to me while both time series produced good results (20.8% for Berkshire and 9.7% for the S&P 500), they are not good tracking devices for each other. Thus they are not well correlated to each other. One of the reasons I suspect that many accounts that are broad market index centered will be underperforming is that the correlations in today's market is widening. This theme was repeated in a couple of examples from the letter.

Every year since 2002 the operating income, including interest and dividends has produced more for the shareholders than capital gains. These results are the product of a relatively low turnover of its securities investments and the increasing shift to buying companies rather than securities.

The preference of Buffett and Munger to buy whole companies is producing better long-term results than buying publicly traded securities.  This is due to trading, when appropriate, the absence of dividend requirement and the ability to leverage. Other corporate investors have seen this as well which in turn has led to an absolute shrinkage in the number of US publicly traded companies. Further, there are fewer mega cap companies that can profitably use the ministrations applied by Berkshire and ValueAct.  Thus, I suspect that there will be more acquisitions made and there will be some medium cap deals that show larger potentials will be acquired. 

Berkshire reports the earnings of Clayton Homes under Financial and Financial Products rather in their manufacturing complex. While the bulk of the revenues for Clayton comes from manufacturing homes the bulk of the earnings comes from its mortgage operations. There are many public companies and their subsidiaries are similarly misclassified  compared to the better security analysis exercised by Berkshire. In a similar vein, many sector and industry index funds  have  been characterized improperly. Again this may come back to haunt certain sector and industry index ETFs.

All investors and their managers should be indebted to Warren Buffett's page 22 where he shows the almost ten year record of Protege Partners choice of five fund of funds,  which include some 100 individual hedge funds' annual performance from 2008 compared with an S&P 500 index fund. For the nine completed years, the S&P fund was the best in five years. The best of the fund of funds beat the Index fund four times and the others one to two times. What I take out of this are the following:

1.  It is difficult to the beat the market .
2.  The market indicator does not win in each year.
3.  In its best year the index was up +32.3% and worst was off -37.0%, both of more are reasonable expectations for some future years.
4.  It is quite possible that the funds suffered from over-diversification and this is true particularly true versus Berkshire itself.        

In Conclusion

One wag has suggested that the only thing the markets are guaranteed to create is humility. Thus, as a never-too-old student I hope to learn from others, so I make fewer investment mistakes and hope you do as well.
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Sunday, February 19, 2017

Five Speculative Selling Solutions


A long-term reader of this blog suggested that I write about selling rather than buying investments. In everything I do I want to measure how close I get to my goals. Out of this measurement need, I require a time period. While it is of future betting interest to have the fastest moving horse or other investment at the end  of a race, the payoff is the best performer for the fixed length of the race. The genesis of the TIMESPAN L Portfolios® was to focus on achieving the ability to meet disbursement goals on a timely basis. 

This requirement is in some conflict with my instinctive ways to invest. Warren Buffett's favorite investment time period to invest is "forever." Mine may be even longer! (Over time some of my long-term investments have tripled to quintupled or more, beyond my exaggerated dreams.) Nevertheless, in focusing on most investors' needs to occasionally sell, I am commenting on five such events. But once again to judge whether selling is propitious or not, some measure of time is needed. Yes, to some extent the seller can celebrate the freeing of cash from investments in other assets. However, in the aftermath of a sale one is often asked whether the timing of the transaction was good. Thus to some extent a successful sale is measured as to how well the exit price compares with future prices. In this light the success of a sale is speculative in terms of comparisons.

The purpose of producing this post is to focus on the various thought processes that lead to successfully evolving solutions for five events when selling occurs.

1.  The Avoid Switch

Rarely people, their companies, their politics, and their investments  behave exactly as we conceived when we entered the transaction. It is difficult to find an investment that does not in some way disappoint, either by its own actions or factors beyond its control. There are times when the results are so good in the eyes of the market that the current price is way ahead of a reasonable long-term projection. Thus, at current prices there is considerable price risk. At times the risk appears to be too large and while an investor has not lost faith in the company, the investor may believe that the current price won't be repeated for an extended length of time. Most of the time the simple solution is to dispose of the holding. At times instead of selling out completely, reducing the size of the position makes more sense if there is not a screaming bargain available.

There are other occasions that selling may make sense. Several times I have been a holder of a security that I thought that I reasonably understood when either the company or the market did something that I did not understand. For example years ago a major conglomerate that I followed as an analyst switched from an under-reporting of earnings to including dealing earnings within operating earnings. Thus from my analyst's perspective, the company went from having a hidden kitty available to cover operating earnings shortfalls in some of its cyclical businesses to reporting every possible element of earnings. In other cases some companies made what I considered to be vanity acquisitions or questionable product pricing policies.  In these cases I felt I did not properly understand  these investments and exited them from my long-term holdings. 

In most cases if an investor is not comfortable in his or her understanding of an investment they would be wise to avoid owning it.

2.  The Bargain Switch

Sir John Templeton, my former data and consulting client, often phrased his sales in terms of purchasing better bargains. While occasionally what is better is only a lower valuation. To me these can prove to be "value traps." Normally things are cheaper because they should be - in terms of quality of product or management. However, we may have entered a period when bargain hunting can be productive.   

The rise of exchange traded funds and other passive devices based on industry sector codes (technology) or market capitalization (Large Cap growth) has led to an unusual level of correlation of stock prices within these data sets. With expected changes in currencies, taxes, import/export mixes, etc., I suspect that there will be greater dispersion in stock prices within many data sets. If I am correct, the number of active mutual funds outperforming the various indices should rise which will attract some of the trading money out of passive/ETF vehicles into either selected individual securities or smartly active mutual funds. As the differences in valuations becomes greater I would expect that there will be opportunities to be long or short individual securities that could favor more bargain switching.

3.  To Trim or Not?

As much as we would like to, we don't control the markets or the spending needs for our money. Thus over time we will have our investment wealth at a different balance than our beginning level. In many ways it is much easier to deal with a smaller amount of money than the beginning portfolio. In that case one should definitely trim the cash. The odds are that the decline in general market prices of stocks will eventually be reversed.

Many of those who have seen their income and wealth rise have already found that their gains do not lessen their problems but rather change them as well as their outlook. Once one has a portfolio, even if is limited to the number of holdings, it is an important part as to how one views the future.  For most individual and institutional investors who have not consciously or subconsciously adapted the timespan philosophy,  they will be dealing with a single portfolio that is probably focused on too short a time frame; e.g., one quarter, one year, or a single market cycle. Under these conditions the fear of near term losses becomes paramount. Thus, in a perceived expensive market the natural tendency is to reduce risk exposure. Perhaps the first technique should be to reduce or eliminate small positions on the basis that if they are still small they are not likely to be favored in the short-term.

Those who take a longer than current period view have history on their side for US equities and quite possibly for equities in general. The other historical trend worth recognizing is that great wealth comes from extreme concentration of effort, intelligence, and investment which suggests that concentrated portfolios in knowledgeable investors’ or managers’ accounts can produce great results.

After due consideration, trimming or completely eliminating positions could be the correct decision even if investments under other managers are doing well.  It might be helpful to not let the tax man become the portfolio manager.

The shorter term oriented accounts will tend to be much more market price sensitive than the longer term accounts who are more focused on building absolute capital. I suspect the shorter term accounts have higher portfolio turnover and on average pay more in taxes over time than the longer term accounts.

4.  The Familiarization Trade 

Most of those who read this blog have a substantial portion of their wealth in tradeable securities. Some do not and receive the major portion of their wealth in a concrete package of stock options, private company interests, convertible securities, and various types of trusts. For many, these instruments are difficult to understand even with professional help that may not be specifically knowledgeable on these particulars. As these managers are unfamiliar to the new recipient, there is some substantial fear of making a mistake in the process of converting their new illiquid wealth to easily tradeable securities and/or cash. My suggestion (regardless as to the perceived value of the new investment) is to take the smallest portion of the investment and convert through the many steps to cash. This will equip the new owner with an understanding of how the process of unwinding the concentrated wealth package can be converted, which should help with some understanding of the benefits of not doing anything more than evaluating the next and future steps. As is often the case, selling something can be a valuable learning experience.

5.  Quitting 

Recently those who have robust national or global political views in light of the strong to very strong stock markets are pondering whether they should quit the game and sell all their exposed equity positions. In terms of recorded history there have been a very limited number of times this has been a correct decision. Those instances have been very rare. But no one can be certain that at any given point stock price declines of more than half are not possible.

My own views are based on the beliefs that we have entered a different market phase. For at least the last ten years and perhaps longer we have been a world of single digits in terms of almost all main statistics of market prices, earnings, revenues, demographics, etc. I believe that starting with last summer we are accelerating into a double digit world, both up and down. In this new world sound investment principles will continue to work, but for some time the numerical bands won't. May this lead to an eventual market, if not economic collapse? Yes, it might, but not necessarily so. Rather than focusing on only the historic ratios, like Liz Ann Sonders of Charles Schwab, I am focusing on sentiment and currently the general lack of wild enthusiasm which is positive in my judgment that there is more time in this expansion.

As a contrarian and as a manager of portfolios owning mutual funds, I am often premature in my market judgments and actions. I am not yet ready to hit the quit button and retreat to cash, which is losing value regularly. Perhaps this time I will accept the downside volatility as the sign to exit.

Even if we do have a top and a subsequent fall, I hope I will not forget my responsibilities to future generations and totally "go to ground" in a foxhole. 


There are times and conditions when selling is wise. However, these decisions should be made carefully without too much attention to the current and a reasonable review of the longer term future. The sellers historically have the burden of history against them, but they can win.

Question for all time:

Have you successfully sold an important part of your wealth and re-entered the market? Was it at a lower or higher price?   

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A. Michael Lipper, C.F.A.,
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Sunday, February 12, 2017

Can You Blame Your Investment Model?


Every moment of every trading day we are confronted with the question, “Do we buy, or sell, or just rearrange?” While one does not know exactly when the next major investment peak or bottom will be, almost all of my time should be spent on how to function between these extremes. Nonetheless, since the actual future turning points are not known, I probably should not expend a great deal of intellectual energy or emotion focusing on the search. If I have this discipline it puts me in a minority of those who make statements about the market. Perhaps my investment accounts and I are benefiting from this redirection of my emotion and mindset. Nevertheless, most of us operate in a relative performance world, my performance will be judged as how it compares with how others perform. Thus, I need to grasp how other investors, particularly institutional investors, view the market. As Hylton Phillips-Page, our firm’s VP of fund selection and I have frequent discussions with both mutual fund portfolio managers and some of their investors, I am struck that most of these chats revolve around  “the market” in general, or the price of a particular stock is expressed as a ratio of the current price to some other variable. Most of the time the managers believe they are buying and owning at some attractive discount to the larger variable. In other words they have a model which is generating a distinct benefit for their investors.

Experience as The Model

What I have learned from the Neuro-economics professors at Caltech, (where I serve as a senior trustee) is that when most are forced to make a judgment, the brain reviews its experiences. If the experiences generated pleasure it was good and thus similar situations will also be judged as good. Having been essentially a student of investing not only through my life but also of others over history where I can get some historical insight, I see a particular pattern emerging.

Most of the time prices move gradually. Often at the final run up or collapse one can divide professional investors/traders in general by age categories. Whatever driving enthusiasm is largely supported by the young, who view the then current offering as new, different, and wonderful will be the opposite of their older brethren that distrust the surge as it looks suspiciously like past problem-producing situations. Thus the more experienced players don’t participate until the parabolic price move that comes just before the turning point. Some of the more experienced players can’t stand missing out these “goodies” and need to defend themselves against the arrogance of the newly rich. (The same pattern occurs on accelerating declines to a bottom when the twin views that the world is coming to an end and/or prices fail to reflect the survival realities.)

I have noticed throughout my career that many formerly successful investors miss out on “the new thing” because the load of their experiences reminds them of past failures from over-excited enthusiasm. One of the advantages of investing through medium to large mutual fund management groups is that they often have bright analysts and portfolio managers, some with a great deal of successful experience and often, younger ones that perceive greater futures. In assembling a portfolio of mutual funds we choose some of each.

Which Past is Relevant?

To choose as the statistical base for a predictive model we have recorded human history, derived history from scientific sources in addition to yesterday’s news. I suspect we could do far worse than being guided by The Bible. It tells of seven fat years followed by seven learn years, currency manipulation by rulers, collectible and uncollectible taxes, famines, wars, disease, population growth and immigration, etc. While no one has proven that these lessons are not still applicable, we have chosen to shift to statistical measures. Most often we rely on government produced statistics. Since I have met some of the tabulators and understand how they gather data,  I have always had a jaundiced eye on their product. That is even before today’s fully expected (by me) article in the New York Times about groups of government employees developing “slow walking” strategies showing their opposition to the new Administration.

We measure our deficit, that will undoubtedly grow, as a % of our GDP which is an output measure not a wealth measure. As a matter of fact the government’s main view of the population is derived largely from aggregating tax returns. I ask how many of our readers attempt to show the largest income and the least expenses?! Further, often as people get older their wealth grows and in retirement it is their wealth not their income that motivates them.

Another source of questionable value is reported earnings of public companies. When evaluating a possible acquisition of a public company the excess assets and the operating business are separately evaluated. (I sold a data business’s operating assets, not the company and its balance sheet.)

One of the more popular valuation metrics is averaging the last ten year’s reported earnings. This is in contrast to my first lesson from Professor David Dodd, of Graham & Dodd, which was to restructure both the balance sheet and income statement to put them on a comparable basis with other companies that could have been investment candidates. Many models are based on industrial sectors as defined by either the government or a major credit rater. Over the years both IBM and Apple* among others have been shifted from sector to sector. I suggest that if one wishes to be long or short either of these securities, it will not be because of different statistical ratios with whatever industrial sector someone places them.
*Held personally.

We are in a New World

I am well aware the typical reason given to buy a security that is historically over-priced is, according to the salesperson, “This time is different.” To some extent that could be right today in that we have entered essentially a new phase. In the past the leading countries were growing in population and wealth. Often they were clearly technological leaders. In the United States, China, Japan, and developed Europe, the size of the work force is declining relative to their total populations and all are experiencing growth in seniors. (This may inhibit the new Administration’s ability to grow the US labor participation.)

Interesting that some have looked askance of my announcing our firm’s smallest new commitment to a fund that invests in the Middle East and Africa, because of favorable demographics, savings rates, and progress in their educational institutions. Based on current trends it is only a matter of time that Africa will house one quarter of the world’s population.

We are now living in a world where farming and manufacturing are becoming smaller relative to the growth of the service sector. (Service sector includes financial services which is experiencing growth from traditional sources but also new entrants and technologies. Unschooled farmers in Africa are daily monitoring the price of their commodities on cell phones. The fastest growth in the financial sector is in mobile finance and banking.)

The world is facing the integration of currencies, taxes, trade and military policies. One should expect that in the future we will understand the difference between schooling and useful education.

Do I Have a Model?

The simple answer is no. But I have a process to benefit and protect my investment responsibilities. First, I attempt to get our accounts to utilize the TIMEPSAN L Portfolio® approach which addresses the importance of getting the future right. The shorter term portfolios live in the world of the present whereas the longer term portfolios are more future oriented. Since we use funds from a number of the leading investment organizations each has their own views of the future, they will change over time.

My model essentially leans on the investment lessons that have been learned over the millennia and watching what smart commercial and investment professionals do with their long-term money.

Question of the Week (or perhaps the year): What Model Drives Your Investments?  

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