Sunday, April 23, 2017

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.

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      A. Michael Lipper, CFA
      All rights reserved
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      Sunday, April 16, 2017

      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.


      Sunday, April 9, 2017

      Asset Allocation - Three Psychological Inputs




      Introduction 

      The psychological need of the investor is a major contributor to the dominant asset allocation chosen. This is a preliminary, hopefully useful insight in a world of over-simplification. Further it can be a useful aid in structuring timespan portfolios. For the moment think of an asset allocation spreadsheet with three psychological columns and four timespan rows.

      The investment account needs to fill in the matrix below:

      TIMESPAN
      Income
      Value
      Growth

      Now
      Operations
      Portfolio



      Intermediate Term
      Replenishment
      Portfolio



      Long-Term
      Endowment
      Portfolio



      Longest Term
      Legacy
      Portfolio



                              TIMESPAN L Portfolios®


      Income

      The oldest investment need is to meet critical expenses. For each investor these may go from the immediate need to put food on the table to obtaining the most expensive item of fashion which can be real estate, life style, breakthrough medical care or the latest gadget. The income need includes the cash generation from capital and capital itself. Enough income is in the end not a statistic but a feeling of well being.

      The need for income may be immediate and/or a stream of cash for different timespans. For example, it may be high immediate expenses or future streams of payments requiring well covered cash generations. To the extent of long-term payments in a world of paper or electronic money, the impact of inflation should be considered as to the value of cash levels.

      Most income driven investors tend to live very much in the present. They view loss of income as much more serious than a missed opportunity to enhance income and capital generation. They believe that they are conservative, but often they are taking into account only what is present and not the value of current and future income.

      At prevailing interest rates on presumed high quality fixed income paper, investors are being pressed to meet perceived payment needs. This is particularly true for US foundations with a tax requirement payout of 5% over time. Currently, in most cases income investors are ignoring the present but low level of inflation. This is reducing the real value of both the spending and capital base.

      Our preferred solution is to invest in established companies that have a long history of growing well protected dividends in good times and bad. Currently there are a number of these in the financial services field which we can discuss offline. In these cases I believe the income is secure and generally grows faster than normal inflation. The risk is in the fluctuation of the price of the shares. In many existing cases they are reasonably priced in terms of their intermediate- term outlook.

      Value

      Value investors really don't like making meaningful mistakes. Perhaps earlier in the investment experience they were exposed to big mistakes made by others or themselves. Their reaction to prevent future mistakes is to accept a well defined price discipline. They will often quote the two big investment rules:  Rule 1: Don't lose money and Rule 2: Don't forget Rule 1. This is the historic coda from my old professor David Dodd of Graham & Dodd fame. This strong survival instinct at times prevents them from buying into big opportunities with substantial risk of loss. They are just the opposite of successful venture capital investors that have more losers than winners but the winners are large enough (and then some) to make up for their losses. Because we live in an uncertain world, most often they own lots of securities to diversify their risks. 

      Most of the time they are attempting to arbitrage the difference between current price and some standard of value. It is in the selection of this standard of value where the value investor tribe breaks into sub smaller units  or families. Many of these families use the various corporate accounting statements to determine their values; e.g., book value, net tangible value, revenues per share/per customer or net liquidation value. It has been my experience that often many stocks sell at a 30% discount to their theoretical value. However, normally this discount is not fully captured quickly without some internal or external activist event.   

      In effect the value investor lives in the current price range and wishes for the market to relatively quickly recognize the present value. These kinds of investments, when they work well, are found in the Replenishment Portfolio which invests through the present cycle. Because of their risk aversion value investors have better than market performance record, but often underperform when the market is looking for dramatic changes in the future.

      Growth

      The growth investor fundamentally believes in dramatic change that most do not fully comprehend. The change could be based on technology, radical price movements because of fundamental and largely permanent supply and demand shifts, as well as substantial and lasting impacts of demographic evolution. The successful growth investor not only believes that he or she can spot future changes but also which company can be the most successful exploiter of these changes. Relative to the value investor they are more tolerant of near-term price risk because they see larger and longer-term price rewards. Except for large funds investing in smaller companies they tend to have more concentrated portfolios. However, they are much more sensitive to changes on the horizon  which makes them less patient than value investors. Thus often they have more concentrated higher turnover rate portfolios.

      Putting Income, Value and Growth to Work

      In each cell of our intellectual investment matrix of the three asset allocation types and the four timespan investment periods, the investor should determine the appropriate mix. Thus one might have 60% in income, 30% in value and 10% in growth for the Operational Portfolio; 60% in value and 40% in growth for the Replenishment Portfolio and the reverse in the Endowment Portfolio. The Legacy Portfolio could have 70% in growth and 30% in value. Please note that I do not divide the world into domestic and international. I believe just about every company and most individuals are increasingly impacted by activities beyond their national borders. As indicated in earlier blogs "We are all Global." The location of incorporation or main securities market is a third level sort for administrators and sales people to worry about.
               
      Rebalancing

      The very next trading day changes the actual allocation from the planned and prior day. Far too many investment organizations rebalance mathematically back to an original allocation. I believe rebalancing is an account-specific responsibility. I am very conscious that most large successful investors/entrepreneurs have made most of their money in a few or even one security. I am also aware that a family's concentrated wealth can be wiped out in a major failure. Thus, I  suggest that rebalancing is a critical decision for the capital owner to make. One can see the degree of concentration will change as investment control shifts from the founder to succeeding generations of family workers and non-workers. Further, to me rebalancing is essentially a market call of quasi permanent market change or a return to some concept of "normal."  The decision may be heavily influenced on payout considerations from how "income" and capital are defined.

      What Not to Invest in the Legacy Portfolio

      The whole concept of the Legacy Portfolio is that since the current generation of investment managers are responsible there are likely to be future periods of disruptive change compared to the present construct of our investment thinking. Often we may want to focus on investments that would benefit from expected changes. It is equally important to focus on what should not be there.

      Two possibly negative trends that should be considered for reduction or elimination in a Legacy Portfolio are:

      1.  JPMorgan Chase

      I have great respect for JPMorgan Chase and its CEO Jamie Dimon. Personally I have owned the stock for many years and it is our main deposit bank. Nevertheless, it should not be considered in a Legacy Portfolio of companies to benefit from disruptions. I commend Dimon’s brilliant 46 page letter to shareholders that describes their success and outlook. It is the bank’s very success under Jamie that makes me question whether at some future point the stock of JPMorgan Chase may not be an investment leader. If one links the performance of JPMorgan Chase from the date of its merger with Bank One  its stock was up 211% compared with a gain for the S&P500 of 154.8% and the S&P Financials 32.3%. For the last ten years the annual compounded growth was +8.6%, vs. +6.9% for the S&P and -0.4% for the financials. JP Morgan Chase has been a great stock. In the same period the large foreign banks have retreated. My fundamental concern is that it is less likely that the bank's relative performance advantage will continue. I expect that at some point the global financial businesses will be restructured to reduce the odds of continued  success for the current bank.

      2.  Urban Real Estate

      The second area to possibly exclude in the Legacy Portfolio is urban real estate. Cities are absorbing rural populations all over the world for sound economic and demographic reasons. At some point there will be intolerable overcrowding and with the advent of the internet and driverless vehicles, some of the people and capital will migrate to exurbia.

      Whether these two thoughts work out, the key message is to look for those investments that will be advantaged and disadvantaged in the future.

      Your Thoughts? 
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      Copyright © 2008 - 2017
      A. Michael Lipper, C.F.A.,
      All Rights Reserved.
      Contact author for limited redistribution permission.