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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A. Michael Lipper, CFA
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