The Fallacy of Investment Certainties

Premise

In the worlds of politics, economics, and investing there are no real certainties. By definition a certainty is guaranteed to happen. The guaranty makes it inevitable now and in the various, undefined, futures. We are not equipped to define all the possible futures. Events as presented, particularly unpredicted events, shape reactions often differently than expected.

Introduction

I am incredibly lucky as to the people and situations that I have been exposed to over many years. Perhaps, the other side of that lucky coin is rarely can I be exposed to someone or an event that my mind does not search for an investment meaning. My two great educational experiences, the US Marine Corps and the racetrack have shaped a good bit of my thoughts. The Marines have taught me how very ordinary men and women can do extraordinary things with the proper leadership and training. Further, the USMC taught me that the single best defense is an offense, which tends to drive my impatience into action. The racetrack where I really learned the process of analyzing people and events introduced the concept of the odds of comparing potential payoffs versus a range of probabilities. Out of these analytical exposures I became aware of weighting my bets and the elements of diversification.

I am reaching my investment conclusions by analyzing this week's inputs and my investment reactions.

This Week's Inputs

Discussions with fellow Caltech board members, faculty, and senior staff separately focused on how unnerved they were about the future for its lack of certainty in terms the impacts of changes in political and government grants. My reaction was first “Do not confuse votes in favor of a candidate with votes against another one or policy.” On both sides of the Atlantic and the English Channel people were fundamentally voting against the past. These wise people in Pasadena were very much worried as to what the future would bring to Caltech and to the Jet Propulsion Laboratory that it manages. Caltech staff also had many personal concerns. 

While they were worried, I could empathize with them; however I was not sympathetic. I have always grown up in an uncertain world - if you really looked at it carefully. To me it always comes down to understanding the odds on various future results with a keen awareness that events often override plans. When I mention odds I am not looking for mathematical precision but views arrayed in probabilities which at best could be divided into quintiles. Further, I am totally convinced that if some very unfortunate low probabilities occur that the secondary reaction of all these bright people would change some of the negative impact. Further, to some degree for those who choose to survive there is always a Second Act or next race.

I already mentioned how lucky I am by being exposed to a large number of people, many of whom are bright and accomplished if not both. This week a respected good friend sent to me a very small book entitled "The Usefulness of Useless Knowledge" by Abraham Flexner with a companion essay by Robbert Dijkgraaf. Flexner was the founding director of the Institute for Advanced Study at Princeton and Dijkgraaf is its current director. Flexner’s essay was first published in Harper’s in 1939 . In a period of increased applied research, the book is a plea for basic research. I thought the essay was particularly telling and could provide some comfort for my friends at Caltech. Some of the highlights from the book are as follows:

• 30% of US GNP is based on inventions

•  More than half of all economic growth comes from innovation. Einstein said "Imagination is more important than knowledge, but added, "Knowledge is limited and imagination is not."

• Richard Feynman said "Scientific creativity is imagination in a straitjacket."

(Both Einstein and Feynman did some of their best work at Caltech.)

Inputs from Other Reading During the Week

New products, processes, and systems create new solutions to old and new problems and thus create new and different jobs.

There is a new way to measure the industrial growth in China by measuring the night time lights. (This is interesting in that this can be a commercial venture because of the suspicion as to the quality of the government released data. Of course that wouldn't be an issue here in the US! Also this is not dissimilar to the old analyst's technique of measuring a business by counting cars in a movie studio or industrial plant.)

Europeans seem to be more savings-oriented including their use of Money Market funds whereas in the US there is a more investment orientation including the use of Inflation Protected Securities funds (TIPS). Few seem not to share my long-term concern that materially higher inflation will be a concern.

Moody's* view is that credit conditions will improve due to M&A activity. (This is the reverse of historic experience, as M&A activity led to over-leveraged balance sheets which led to some bankruptcies.)

^*Held in the private financial services fund I manage

Daily stock price gaps are most often filled before prices move very far. For the first time in my limited memory in all three US stock price indices (DJIA, S&P500 and NASDAQ) there are recent two price gaps in each.

My Investment Reactions

First the beauty of the TIMESPAN L Portfolio^® approach is that it helps to separate one's thoughts about current actions by likely impacts in future timespans.

1.  Our overweight in the Legacy Portfolio (our longest term portfolio) in disruptive growth remains in place. However, growth is not exclusively technology-oriented. Demographic and political changes can be equally disruptive opportunities globally.

2.  Endowment Portfolios need to be keenly aware of any changes to the range of spending needs and have enough portfolio flexibility to accommodate possible radical changes and opportunities. 

3.  Replenishment Portfolios need to watch likely swings from excessive enthusiasm and fears as we negotiate the next markets on the way to a recession. 

4.  Operational Portfolios should be concerned with interest rate reversal patterns to ensure that it can fund short-term expenditure plans.

Bottom line: as long as there is little enthusiasm, the odds seem to me to range relatively small on the downside (less than 25% ) and materially higher blow-off of 100% or higher.

Questions to Ponder: What are the likely ranges for your portfolios for the next five and fifteen years? 

__________

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A. Michael Lipper, CFA

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Hints on Building Diverse Portfolios

Introduction

As we don't know either the future or all the possible uses of our portfolios, we need to construct them to fulfill numerous functions. This is the main reason that we invented the TIMESPAN L Portfolios^®. But even within this construction there are needs for some diversification as to asset types and strategies. Further, the portfolio managers selected should be diverse in terms of investment thought process. Otherwise one could have a portfolio of managers that have similar levels of aggressiveness based on reactions to current sentiments.

As a portfolio manager of separate accounts invested in mutual funds, I have become aware of having too much similarity of characteristics in clients' portfolios. Thus as essentially a student of financial and investment history, I look broadly as to what I can learn beyond a sole focus on performance. The following discussion of what I am looking at may be in whole, or more likely in parts, useful to our subscribers. 

Searching For The Best CEOs

One can learn from sources in spite of the source's politics. The Washington Post wrote an intriguing summary of an article in the Harvard Business Review by a leadership consulting firm about selecting the most successful CEOs. I suspect that if we followed some of their findings they would apply quite well in the selection of funds' portfolio managers. Over a ten year study they concluded that the school of "higher learning" the candidate went to was not particularly useful in selecting the most successful portfolio managers. In the 1960s my brother and I came up with the idea that we should send a programmer to "The B School" and then we could predict the likely choices of the bulk of mutual fund managers’ actions. While we might well have been correct in terms of pinpointing financial advisory, investment banking, and institutional sales successes, we probably would have been off the mark in terms of successful portfolio managers. Similarly we probably would be wrong in filtering using the CFA^® charter-holder designation, even though I have one.

The study found that 45% of the CEO candidates have had a career "blowup" and that of these 78% went on to become a successful CEO. This suggests that 35% of candidates which experienced a "blowup" were eventually successful. This finding is parallel to one of my approaches in fund selection. Luckily for selection purposes, fund performance histories are replete with down periods. (Possibly we may have entered into one after the March 1st highs.) I pay particular attention as to whether the manager stayed the course or changed the portfolio structure during the decline. (It may be too much to expect them to anticipate the declines. A few do, but many of these are late in getting in on the recovery.) What may be more career shaping is what happened to the portfolio manager within the political structure of his/her shop, which include leaving due to performance and/or economic reasons. I do not focus on the decline, but rather what, if anything, was learned and what actions were taken. Jeff Bezos who is the owner of the Washington Post as well as the CEO of Amazon made the following points in his shareholders' letter:

• Most decisions should probably be made with somewhere around 70% of the information you wish you had. In most cases, if you wait for 90%, you're probably slow.
• Being wrong isn't always so bad.
• If you're good at course correcting, being wrong may be less costly than you think; whereas being slow is going to be expensive.

My personal experience from the US Marines, the racetrack, and investing parallels Bezos’ thinking,  except most of the time the best I can do is to gather about two-thirds of the desired information. This is acceptable because I am usually making an incremental decision in terms of a portfolio or selection of a manager.

Bottom line:  I look for managers that make mistakes quickly and learn from most of them.

Can Managers Adopt to Change?

The  Archstone Partnerships has decided to terminate after 27 years as a successful hedge fund investing in other hedge funds. As a Marine Officer, I am conscious of the mixed emotions of giving up a good command. I do not know Fred Schuman the leader of the fund and certainly don't know of his personal or firm concerns and thus have to take his announcement letter at face value. However some of the points he made have broader implications for other investment managers as follows:

1.  In each decade since the 1950s there has been at least one "confiscatory" event. We have not had one for eight years.

2.  The supposed riskless rate of return as captured by the 3-month T-Bill has dropped from 5% to virtually zero. (I would suggest that today there is more reason to question the rate of inflation and how it impacts the riskless rate.)

3.  Rapid trading has overwhelmed the marketplace with 50-75% of a day's trading accomplished in one minute. (I am not sure that we are capturing all of the trading conducted.)

Perhaps the biggest changes in market structure have occurred in fixed income, commodities, and currencies which in sum total are profitable for market participants. If one isolates equity trading from underwriting and margin, my sense is that equity agency trading is not profitable. These structural changes plus consolidation and the fact that former service providers are increasingly competitors mean that today's successful portfolio management organizations have had to learn new skills that were not used a quarter of century ago.

Finding Workers Critical to Survival and Success

China

I must warn our subscribers that it is likely that many of my future weekly posts will have some focus on China. It is already the second largest economy in the world displacing Japan which is why many of our investment accounts have a distinct Asian orientation. Whether one invests actively in China or not, it is difficult to avoid indirectly investing in China. The IMF and others believe it is only a matter of time before China will be the largest economy in the world. Almost assuredly the path to its growth will not be smooth and there will be some reversals. Nevertheless I believe it would be imprudent not to be increasingly aware of China's impact on how we invest and lead our lives.

According to the China Daily News App, the Ministry of Public Security has announced  a plan to upgrade permanent residents' ID cards. Some of the new features for the new card are as follows:

• The card contains a chip connecting with transportation, hotel, banks and insurance companies.
• The approval time is 50 working days.
• Less restrictions on type of work, company, period of residency.
• High-level talents as well as spouses and children automatically qualify.

Compare these attitudes with those of US, Japan, and European countries where achieving residency is much more difficult!

Northern New England

According to The Wall Street Journal the northern tier of the New England states can not find enough workers to fill the existing needs of businesses and services. (I would not be surprised to find similar situations in many other northern tier communities in the US away from the "oil patch," where shortages are present.) Awhile ago economists were concerned by the lack of labor mobility where there areas of large unemployment and others with substantial job vacancies.

From an investment vantage point we need to be conscious of the mix of jobs and the quality and quantity of labor. We could be on the cusp of significant wage inflation which could bring on even more robots. At the very same time the ticking time bomb of the absence of sufficient retirement capital can cause even more economic and securities markets structural changes.

The Wrong Focus on France

By the time we publish this edition of our weekly blog we will have the results of a substantial portion of the preliminary French Presidential election which is of interest but not of paramount importance to those that invest in France and Europe. The French President is by statute essentially "almost" a figurehead with little legislative power though with some key national security responsibilities. The "almost" is the critical key to the government. The elected President appoints the Premier who is the working head of the government. In the past the President was the leader of the largest number of elected members of the legislature and thus could produce coalitions that were able to enact the necessary laws and regulations that govern the country. This time could be very different with at least three of the candidates having limited numbers of likely members in the legislature. Thus, somewhat like the current dysfunctional US situation, the key attribute for a successful President will be the ability to get things done. The big difference this time is that the parties with most of the legislative votes will not be the same party as the next President.

As in the US I suspect that the private sector will be more advanced in its thinking and policies than those sitting in Paris’ halls of government. What is not clear to me tonight is the level of unity there is in the main private sector powers. Nevertheless, solid companies at reasonable prices may be good long-term investments in France. 

Conclusion

In building long-term portfolios one should want a diversity of approaches as well as an awareness of secular trends and current sentiments.

__________

Did you miss my blog last week?  Click here to read.

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Investment Journeys with Worries

Introduction

Investing is similar to a journey or a voyage. We start from a known location usually expressed as a sum of money and we set sail for unknown futures, some short-term and some long-term including possibly some beyond the time we personally are onboard, but our money is. The wise investment traveler before he, she, or they get started consults the known histories or charts and they scan the horizon looking for possible dangers. Only time will tell whether some of the perceived dangers are real. Some will be mirages or just shadows. And some will not be foreseen and surprise us.

If one wants to survive the voyage one should begin to catalog the beginning dangers and add to them as time and travel produce new ones. In many respects this is the job of the investment managers, at least in my opinion. The way I categorize the dangers is by the most likely time frames when they can do the most danger.

Near-Term Worries:  Sudden Sentiment Switches

At this very moment the biggest worry is that many investors have left the comfort of fundamental investing and economics. Notice how much of the punditry is based on the outcome of political analysis. These “authorities”  including many portfolio managers and analysts as well as salespeople are proclaiming their analysis of various political decisions and even more absurdly, their outcomes on security prices. 

Many of these predictions were brilliant, that is they were brilliantly wrong about recent political events, but even more wrong about the significance of their outcomes. It is true we have recognized that the main drivers to securities prices for almost a year have been changes in sentiment, however there have been very few of these pundits who have been correct; to use a betting term, the "daily double" (which is difficult to win) of getting various political decisions right as well as their significance. The risk to market prices is that when the "experts" are proving wrong in one or both directions; for instance large, one- sided positions are quickly reversed creating high intraday volatility and bouts of illiquidity. If against historic odds the overwhelming opinions of the experts prove out, there will likely be far less movement because the more active players are in a favorable position.

While I can not accurately predict the future, my instinct from my handicapping racetrack days is to bet against the favorites. That way I have more upside and less downside than following the crowd.  Thus, I suggest that long-term investors not get shook out by bouts of volatility and perhaps take advantage of them when they occur  - as they surely will. This will be true for just about all asset classes that have substantial followings.

Bonds Can Hurt Stocks

This week in The Wall Street Journal  there was the headline "Bonds Flash Warning Signs." The Journal was reacting to the continued and accelerating purchases of bond funds. We have seen the same pattern in many markets around the world. Both individuals and institutions are desperate to attempt to close the gap in their retirement capital in their chase for yield. 

I have often said that if one cuts the wrist of a security analyst, a historian will bleed. While I try to learn from my and others' historical mistakes, it appears that most investors and markets do not. The postmortems on the last major global financial crisis ending in 2009 blamed the underwriters and credit rating agencies. In many cases they did not cover themselves with glory. But there were two other parties that contributed heavily to the crisis: the political structure including the central banks and the buyers themselves. The buyers bought into varying levels of residential mortgages without an understanding that house prices could decline. Again the buyers did this in many markets. Have we entered a similar situation about ten years later?

The fearsome drive for yield can be seen this week in the 3.28% yield on what Barron's called the best bonds, meaning high quality. This yield is in the same range of a number of sound dividend-paying stocks. Over time many of these stocks have a long history of every year or so raising their dividends. Currently the dividend increases are equal to or exceed the common perception of inflation. Thus, over time the income from owning some stocks will be bigger than from owning high quality bonds. Having mentioned inflation one should look at the probable price movements of bonds and stocks during periods of inflation. (Almost all central banks have been trying to increase the rate of inflation in their countries.) Since bond interest payments are meant to be fixed and dividends on stocks do rise periodically, it stands to reason that bond prices during an inflationary period will decline until maturity and stock prices rise.

I wonder when the media, politicians, and "strike-suit" lawyers will look for culprits to the mis-selling of bonds into unsophisticated senior citizen accounts. These actions can be helpful to the financial community which may be dealing with illiquidity issues that at least by rumor threaten various counter parties.

To the extent that the bond buying phase continues it could lend itself to bigger fraud instances due to the available leverage opportunities.

Long-Term Worries: The Absence of "Middle Men"

In the history of organizational changes we seem to play accordion, going through periods of contraction and expansion. Almost every industry or group of people start with an increasing number of players which reach a phase of competitive destruction which shreds the weaker players. Often the surviving stronger players concentrate their resources on what they do well and outsource small, difficult, and time consuming functions to others. Thus a group of small, agile, and tightly-managed middlemen evolve. At some point, particularly when the majors sense that they are slowing down, they choose to capture or in some cases recapture the functions that have been the job of the middlemen. We have seen this pattern in almost every industry; airlines, autos, chemicals, financial, retail, etc. On the surface the large acquirers reduce their external expenses and secure some skills that weren't within their base. I have personally seen trading, investing, underwriting, research and money management go through these consolidations. 

I suggest that in time this consolidation of the supply chain will work against many of the mammoth players. While there is a good history of large companies in development of major products and services, most of the startling new products and services are incubated in small, agile companies. Many of these are run by entrepreneurs who work many long hours at low current pay. Small companies have less fringe benefits than their acquirers, which is compensated for by sharing in the proceeds of the buyout. Once the entrepreneur and his/her staff are in their big new homes, their lives and incentives become different and often lead to lower productivity and certainly less risk taking. I suspect that this is one of the reasons that US productivity has declined.

Over a twenty year period the number of publicly traded companies is down by about half. While there have been a limited number mega mergers, most acquisitions have been of large companies acquiring  mid and small companies. A number of savvy portfolio managers have recognized these trends and have specialized in mid-cap investing. In the US they may have less luck than in the past because there are fewer publicly traded mid cap companies.

As usual when there is a need, the markets provide  solutions. There are two trends to answer these needs. The first is that more worthwhile companies are staying private avoiding all the hassles of being public. In some cases they go through the intermediate step of working with and through a private equity group to their eventual mega buyout or IPO. 

A second solution is found in the missing creativity of middlemen in the US, which is increasingly being supplied by activities overseas, both in the developed and the developing world.

I view this evolution as somewhat worrisome, events won't be as smooth as they were in the past and it will cause the larger companies to slow down their growth and/or in some cases see a more halting progress pattern. I am also worried about the skill level of the managers in the major corporations to manage all the elements of the previous middlemen successfully. They are different.

Question: What are your systemic worries?

__________

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.