Investment Success Dependent on Having Goldilocks’ Peers and Avoiding Confirmation Biases

Introduction

Long-term investment success is much more dependent on people than the elements within a portfolio. This is my conclusion after studying both investments and investors. Everyday there are "learning moments" in watching and trying to understand behavior.

“Goldilocks’ peers”

Last week's blog briefly mentioned the running of The Preakness and the focus on the first three horses. I failed to point out the interaction among the first three across the finish line. While there were other horses in the race, the first three were jockeying for position with “Goldilocks' peers” for the winner (from the fairytale “Goldilocks and the Three Bears”).  The winner benefited from this interplay as the two leading horses were expending a great deal of their energy on dueling each other for the lead in the relatively short home stretch. The exertion tired them a bit and allowed the well-positioned horse under an expert jockey in the final steps to rush past the first two that were tiring. I am guessing that the race would have turned out differently if either the stretch battle or the positioning of the eventual winner was further back.

I apply these observations to competitive investing within assigned investment objective leagues. Thus, a good investment analyst of performance should understand each of the likely competitors strengths and tactics. Just focusing only on one's choice is insufficient. The eventual performance winner says as much about the peers as about the winner, but far less noted by the pundits.

Recently my associate Hylton Phillips-Page and I used portfolio structure data on fixed income from our old firm now known as Lipper Inc. In the fixed income world there are fewer investment objective leagues than in the equity universe, so there needs to be deeper analysis. I was interested in understanding why two different short-term funds were not among the leaders. What we quickly found was the league that they were being measured in had a wide assortment of different strategies being used. The maturity and quality constraints on the funds in question were much more severe than the bulk of the competitors. Thus in the current bond market the funds that were allowed to take more maturity and credit risk were producing better near-term results. Thus the owners of these funds were handicapping their choices. However, this could well be appropriate as these funds in the owner's constellation of fund holdings were designed to be reserve elements against a major bond and stock market decline. When we narrowed our view to funds that were similarly constrained, the tactical skill and relative expense ratios were more than appropriate. Thus for the owner's vantage point the key is to examine the constraints applied and not the specific choice of funds.

Confirmation Biases

(With the exceptions of the focus on mutual fund performance and the analysis of five leading securities the following thoughts and quotes are from a recent article of Farnamstreetblog.)

Often what passes for considered judgment is actually a summary of our memory. The problem with that is our memory is selective at what it retains. C.S. Carroll said "We are what we believe we are." From an investment standpoint, Warren Buffett's quote is very insightful: "What the human being is best at doing is interpreting all new information so that prior conclusions remain intact." (Luckily, according to Charlie Munger, Warren is a learning machine.) Through the ages there have been similar quotes from Tolstoy, Francis Bacon and all the way back to the ancient Greeks by Thucydides. As an appropriate warning to today's investors is the latest advice from Charles Schwab & Company:  "Investors  shouldn't get too caught up in the political wranglings with respect to investment decisions....but remain focused on your longer term goals." Perhaps the best way to identify the power of our biases is a poem by Shannon L. Adler which follows;
  
Read it with sorrow and you will feel hate.

Read it with anger and you will feel vengeful.

Read it with paranoia and you will confusion.

Read it with empathy and you will feel compassion.

Read it with love and you will feel flattery.

Read it with hope and you will feel positive.

Read it with humor and you will feel joy.

Read it without bias and you will feel peace.

Do not read it at all and you will not feel a thing.

One of the persistent biases we are subjected to is that Large cap funds under perform "the market." Those that spout this probably have never read a full prospectus. Rarely are funds designed to beat a securities index chosen by a committee to represent the market. From their inception, mutual funds were designed to convert savings into an investment program to meet eventual funding goals. These goals included some attention to periodic declines in the market and the need for daily liquidity and reasonable costs.

What I find of interest is that I have not seen a single media mention of the following:

Through May 25th , 2017, the year to date average of the S&P 500 Index fund is up 8.53%.

Investment objectives which doubled the 8.53% above to 17.06%, including funds that did better and worse than average, were as follows:

Global Science & Tech.	+24.73%
India  Region	23.27
Science & Tech	20.56
Pacific (ex-Japan)	20.18
China Region	18.62
Emerging Market	17.16

Quite a number of the much maligned Large-cap funds owned some of the five tech stocks that produced over half of the S&P 500 gain.

More interesting to me is that the longer maturity Mixed Asset funds also beat the market. For example the Target Date 2055 funds averaged +9.65% plus the Mixed Asset Aggressive Growth allocation was up +9.62%. In addition the average of the Target Date funds with maturities between 2035 and 2050 beat the market, Further, the average Emerging Market Local Currency Debt fund was up +8.74%.

I am not suggesting that a bunch of mutual fund portfolio managers suddenly took smart pills. What I am suggesting is that the market is dynamic and there are usually opportunities to wisely invest in funds.

The dominance of global and domestic Science and Tech has been mentioned above.  Also mentioned is confirmation bias. Biases are short cuts to prolonged thinking and occasionally difficult judgments. I am concerned that these two streams of thinking may collide soon. As previously noted five tech companies represented over half of the stock price gains of the S&P500 so far this year. They are Apple, Alphabet (Google), Microsoft, Amazon, and Facebook. Note that three of these were prominent in our discussion last week on Berkshire Hathaway and Sequoia Fund. My concern is that there may well be  confirmation biases at work due to the use of shortcuts to analytical judgments at work here and particularly by the media. Four of the five leaders have over half of the revenues from what is deemed to be a single source. (Facebook 97% from ads, Alphabet 88% ads, Amazon 72% products, and Apple 63% iPhones.) Without any specific knowledge of these companies, just based on my historical memory as an electronics analyst, all of these will eventually see a decline in some of their revenues from these identified sources. When and if this happens perhaps their stock prices will decline. From my viewpoint this could be a good buy point as all five of these companies appear to have promising developments underway. One may have to be patient due to the short cutters’ disappointment  which follows a quote from Robertson Davies "The eyes sees only what the mind is prepared to comprehend."

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A. Michael Lipper, CFA

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Berkshire - Hathaway & Sequoia Fund: As Seen Through Alphabet, Amazon, and Apple

 Introduction

For the week that ended Friday one could focus on short-term price movements or long-term investment thinking. As my week evolved I did both, which produced positive, but disjointed conclusions.

Short-Term Price Actions

On Thursday prices fell supposedly in reaction to political events. As an analyst and portfolio manager trained in the school of contrarianism, I saw the reason for the decline differently. For some time I have been aware and have commented on the price gaps in the performance of the three main individual security price indices; Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite. In each case the index had two days when  prices through the day were measurably higher than the high price achieved the day before. This price gap phenomenon rarely happens and most of the time a subsequent price action fills the gap before the market resumes its prior trend. In earlier blogs I had warned about this probability. Further, I quoted a knowledgeable market analyst who was expecting a 5% correction.

On Thursday the two price gaps in the two senior indices, DJIA and S&P 500 closed both gaps. By far the strongest index this year, the NASDAQ closed one. I would expect in the fullness of time the remaining price gap will be closed. Historically when the bulk of traders focus on the political issues of the day (in contrast to the financial inputs) their emotions are a bad guide to future investment price performance.

A less followed sign is the Confidence Index published by Barron's each week. The index focuses on the difference in yields between the highest corporate bonds and those of intermediate quality. In the week ending Friday, compared to the prior week, high quality bonds yielded 3.22%, down 17 basis points whereas the intermediate credits yielded 4.27%, down only 13 basis points. This suggests that in the week high quality bonds were considered better value than the higher yielding intermediates. Often this is considered a bearish sign for equities as bond buyers are opting for lower risk securities.

In assessing the value of these two observations it is important to understand that the judgments expressed are based on a feeling for the historical odds and not certainties. As noted in my earlier blog posts there are no pure laws of economics that guaranty the same level of certainty as found in physics. One should assign perhaps a 90% certainty to your favorite economic laws. Most so called "investment laws" would be considered successful if they were correct 70% of the time. Using a technique I learned at the racetrack, I multiply these ratios (0.9 x 0.7 = 0.63). This suggests to me that I would be happy if my analysis was correct 63% of the time. I can improve my dollar return by weighting some decisions compared to others.

General Sun Tzu

Other than the Bible no other text has been used more to teach the military than Sun Tzu's "The Art of War. Considering the importance that we are putting on the rapid progress of China it is very wise for us to remain conversant with China's greatest military scholar. Friday I was refreshed in my knowledge of the general's thoughts when good friends of mine who are life long investment experts on Asian investing gave me a book by Jessica Hagy, The Art of War Visualized: The Sun Tzu Classic in Charts and Graphs.

Since in many ways competitive investing follows the equivalent precepts as successful military warriors, I am going to apply the same principles to investing. There are five particular strategies that the General recommended.

1.  Victory can be achieved through measurement, estimation, calculation  and balancing chances. (In investing it is important to measure accurately what is there and even more important what is not there; e.g., BREXIT and the Republican swing, as well as incomplete financial statements.) These are some of the times when good estimates are critical which makes it essential to know how much reliance to place on calculations of the future. In discussing the short-term data above I showed one possible way to calculate different levels of uncertainties. All of these and other factors need to be weighed in conjunction to determine whether the odds of success are sufficiently high to undertake the risk to achieve victory.)

2.  Always be prepared to attack and always be prepared to defend. (Opportunities will always occur without warning.) A good investor must be able to quickly shift to an aggressive mode and just as quickly shift into defense. Most investors have too little in the way of reserves to dramatically "juice" returns, particularly if they are reluctant to sell or reduce less favorable positions in the new opportunity context. In terms of defense we all need to part with some of our least loved positions regardless of tax implications.

3.  There are dangers to be avoided: recklessness, cowardice, hasty temper, and rich appetites. (Many will find it difficult to react wisely to the opportunities due the dangers listed. As is often the case we can be our own worst enemy. The General called for sound discipline at all times.)

4.  Do not feel safe and be a good generalist full of caution.  (Quite possibly the biggest risk to our wealth is a feeling that we are safe. We are not on the outlook for possible problems, most of which won't materialize, but some or one can be like a hole below our boat's waterline. This can be caused by our bad navigation or an enemy torpedo, Perhaps at least mentally we should practice fire drills as well as abandon ship actions.

5.  An experienced General is never bewildered. Once some level of activity is commenced it is easier to accelerate or decelerate than to start to move from a standing stop. I am a believer, at times, of making partial commitments and at other times full actions. Often the key to an investment decision is not the action itself but how it positions a person or portfolio for subsequent steps.

How Sun Tzu Might Have Viewed the Actions of Berkshire Hathaway and Sequoia Fund Through Alphabet, Amazon and Apple

One is always at risk of misinterpreting or over simplifying by abbreviating some of  The General's thinking. For this exercise I am only going to focus on his first step to victory through calculation and his fourth, balancing chances. Almost all of the named securities (Alphabet, Amazon, and Apple) are owned by me or close relatives. However, the purpose of the ensuing observations are not meant to be taken as any form of recommendation. For those who are interested in converting the observations into actions, I will be happy to discuss my views tied to your specific needs, “off line.”

Berkshire and Sequoia share the same source of inspiration, Warren Buffett. Not surprising over the years they have owned some of the same stocks derived from their own work. The three highlighted stocks were recently discussed in investor meetings. The reason to focus on these three specific stocks is that it revealed their thinking.

Alphabet, the parent company of Google, was well known to both. Mr. Buffett’s view is one that was under its nose as it was extensively used by Berkshire’s subsidiary GEICO. It was just not in its universe, which is strange as GEICO is so advertising-centric (both they and I owned Interpublic one of the largest global advertising complexes recovering from very poor results). As it wasm't looking at Google, it was not in the calculation. This is similar to those who were following the polls prior to the BREXIT and Trump votes in analyzing data, perhaps the most important task is identifying what is not there.

To some degree Sequoia also had a calculation failure. Sequoia quickly grasped the advertising power that the Google search engine produced. However, it needed a "kicker" to be added to its calculation. The kicker was "AI" or artificial intelligence. Sequoia believes that Alphabet is "by far" the leader in AI, which it may be. My problem is that the current level of earnings from AI products or augmented services has not been revealed. In this particular case the lack of numbers on the AI effort was probably a factor in its balancing of chances.

Amazon is another example where the two intrinsic value investors disagreed. Because of Berkshire's operating experience it had some doubts that Jeff Bezos could succeed in the highly competitive distribution business. If he could succeed, it doubted that the same mentality that could build a highly successful distribution business could aptly handle the technologically challenging task of developing a commercial cloud business. I suggest that the financial analysts in Berkshire focused on the financials which showed robust revenue growth and marginal reported profits. Sequoia saw that the financial statement hid the internal process of taking substantial operating profits and reinvesting them into the cloud. Further, Sequoia probably saw that the keys to the success of Amazon's distribution business were based on highly automated warehouses and tightly controlled transportation. However, Sequoia like many of us, were captured by its collective experience. Bill Ruane the founder along with Rick Cunniff often focused on buying stocks "at the right price" and thus they did not buy as much as they should have as the price of Amazon went up.

Apple is another example where these two investment groups came to different conclusions based on their research methodologies. Sequoia in calling on Apple's management, could not get them to speculate what handset sales would be three years in the future, so they passed. Again the words of its founder were a hurdle. Bill said that they understood potato chips not computer chips. Berkshire only recently viewed Apple as a consumer not a technology company. They focused on both the "eco-system " that Apple was growing and the potential use of its technology and related skills in substantially new product categories not yet on the market. Interesting that both Berkshire and Sequoia want to invest in companies that have competitive advantages, which is often translated into unique products or services. Sequoia will sacrifice future growth for competitive advantage. Berkshire under Charlie Munger's prodding is more attracted to growth at a fair price. Apple effectively used the General's formula of balancing chances.

Bottom Line

As with all "school solutions" there is no guaranty of success. While the odds improve with a well thought out plan, nothing beats good execution. Thus, when we pick mutual fund and separate account managers we pay attention to both their investment philosophy and their history of good executions. More often than not good executions are the results of front line troops. That is the lesson that I learned as a US Marine Officer where it was my job to develop a plan of action and inform my senior non-commissioned officers of the plan and the logistics, communication, and heavy arms support, but let them carry out the mission as they saw how to do it. The same principle works at the racetrack. While I did not see the running of the Preakness the two horses that were leading coming into the homestretch had a good plan, but a third horse had a better execution and thus won the race.

As you can see I am always learning and hope to do so all of my intellectual life.

What are the sources of what you have been learning recently?

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Implications of China vs. US Timespans

Introduction

A number of years ago a good friend attended a Chinese Embassy party where a very senior member of the government commented that while the West owned the watches, the Chinese owned the time. This critical distinction has stayed with me in terms of looking at investment horizons.

One Belt One Road

While there has been some US coverage of the “One Belt One Road” meeting in Beijing this Sunday hosted by Xi Jinping with Vladimir Putin in attendance, most of the US attention has been focused on the dismissal of one employee at the discretion of the President. As a long-term investor, I believe this is a misplaced focus. On the Chinese side the implications of the massive One Belt One Road Initiative may have implications into the next century. The US focus appears to be on the electoral contests in 2017-2020.

I find it is interesting that China is using a staging investment philosophy somewhat similar to our TIMESPAN L Portfolios^®. China announced some of the outlines to this the One Belt One Road Initiative in 2013. From an economic vantage point it was a brilliant way to export its excess steel and cement capacity in building long line railroads and some internal subway systems. It also would reduce shipping costs of Chinese manufactured products that potentially could be exported to 60 countries, part of the land and sea bridges.  This is somewhat like President Eisenhower's US interstate highway building program that required new federal highways to be built with the ability to handle the transportation of heavy tanks.  As the rail and port facilities are built, China (even without moving its military) will have strengthened its ability to influence all of the surrounding countries. Some have called this drive as "Globalization 2.0.” Compared to the Russian leader in attendance, the US is sending a senior director for Asia at the National Security Council. While there is definitely a military threat in this initiative, by far the bigger threats are economic and political.

The One Belt One Road Initiative is not without substantial  risks. The planned funding requires a series of public/private partnerships. Every analyst and most investors should have knowledge and respect for past histories. Around the world in the last half of the 19^th Century, there was a surge of railroad building. The British were particularly active in South America. I suspect that almost every railroad company started during this period eventually went bankrupt. In one case the largest and most powerful UK merchant bank almost went under because of its Latin American exposure. I can not think of a long line US railroad that did not enter or threatened to enter bankruptcy. Some of the same problems exist today. One of the Chinese-backed African rail lines is not expected to reach breakeven for the first eleven years, and we all know how reliable the predictions of breakeven have been. 

If we of short memory fail to remember the global distribution of less-than- healthy US residential mortgages, we could have a replay with global distribution of private partnerships through the growing power of Chinese financial services companies. Thus, for the global investor there is both downside and upside as this initiative grows. I maintain that no matter what you invest in; stocks, bonds, commodities, real estate, currencies, or intellectual property, your returns could pivot on what is happening or rumored to be happening in China.

What are the US Markets Focused On?

Investors into the US market are focused on the very short-term to intermediate future while China is exercising its long-term options.

The following are briefs tidbits that have crossed my computer screens this week:

1.  Dow Jones Industrial Average - A minuscule decline closed on of the two price gaps in its current chart. The other two major stock indices, S&P 500 and NASDAQ, still have price caps. (One wise market analyst suggests that we need a 5% decline before we can resume a meaningful upturn.)

2.  JP Morgan has noted that 37% of NYSE volume is executed in the last half hour of the trading day as Index funds rebalance.

3.  There is some justification in the adage “Sell in May and Go Away.” Since 1950, the period November through April does better than the other six months, 71.64% of the time.

4.  According to its inventor, the CAPE ratio, used as a valuation measure, explained about 1/3 of the variation in the ten year returns. (Surprisingly this is roughly the same chances of a favorite winning in most horse races.)

5.  Ray Dalio, who manages one of the largest hedge funds, sees no major economic risk in the next year or two. (This could be an important cautionary flag.)

6.  The highly respected GMO seven year prediction for real return on stocks is -3.8%

7.  Vanguard believes we are in a period of slow growth; e.g., a 60/40 asset allocation will produce a return between +3% and +4.5%. (If they are correct, which I doubt, the average foundation will be liquidating its base each year if it has a mandated 5% pay out.)

8.  Turning to the increasingly popular European investing, there are two points worth considering: (a) the current price of the Stoxx 600 Index is where past rallies have peaked out, and (b) over half of the ETF flows into non-domestic funds came into three Index funds and these were somewhat smaller than the ETF redemptions in two domestic Index funds. (These suggest to me that main players in the ETF market are trading-oriented, and may not be patient during surprises.)

Investment Conclusions

Despite the reputation of highly speculative retail Chinese investors, the Chinese government is playing a long game.

The US market is increasingly short-term focused. This may, over time, give us longer term investors a bigger barrel to fish in.

As we structure various markets I am wondering whether our assorted valuation measures need to be adjusted due to fundamental changes in supply and demand.

Any thoughts? 

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.