Sunday, June 25, 2017

Beware of Wrong Identities


Identifying items that are identical to each other is at the base as to how we learn in the western world. As children we are asked what images are the same as other images. Later on we learn that the values derived from a particular equation are the same as the values derived from another equation, and labeled an identity. Many of today’s college and graduates students learn about investing in forty or fifty minute classes in an academic institution rather than in the marketplace. Thus, it is no wonder that many professional investors and so-called sophisticated investors use identities or labels in finding investment solutions in marketplaces that are always changing. Therefore, it is not surprising that far too many investors will continue to suffer from simplistic, quick, applications of identity labels.

Historical Precedent

This post is being written on the last weekend in June, 2017. Forty-four years ago I first published the weekly Lipper Mutual Fund Performance Analysis. At the time my brother owned the Databank and had been publishing since 1968. There was a large balloon payment due to my brother for my acquiring the Databank. What does this have to do with today’s misapplication of identities?

Going back to the 1930s there were reports on the performance of mutual funds. (None of those reports that were published in those periods exist today.) The commercial purpose of these were to help salespeople in their marketing efforts to sell funds. In the case of my brother’s firm, it was to find outstanding managers to manage separate accounts.

These efforts created a central identity. However, I saw something quite different. I saw first a need on the part of the independent directors of funds to have an accurate, timely, independent source of fund performance analysis covering multiple time periods from very short-term to quite long-term periods. The second and eventually larger user of these analyses were the senior management of fund groups to help them manage the portfolio managers and funds under their command. 

The reason for highlighting the multiple time periods sprang from my experience as an investor, which was based on the thought that one never really understood an investment until one could observe its performance in both down markets and other periods of sub-par performance. Thus, some forty years ago I took what was a then standard identity set and delved deeper into it to get more useful knowledge and applications.

The Current Picture

The nexus of the academics getting interested in the market, perhaps to augment their own income, and the rapid development of fast computers with prodigious memory, the price actions in many marketplaces were translated into mathematical equations. Just as the written word, a published equation takes on the aura of an absolute truth and a sense of inevitability. Currently there is a great deal of money invested in published index matching vehicles. That none of these measures were ever designed to be prudently managed portfolios (which had various liquidity, payment needs, and regulatory constraints as well as expenses) was ignored. Little to no attention was made to the commercial motivations of the index publisher.

This week, the Fortune 500 double issue was published. In the US, the first index-like investment vehicle which started in the 1930s was based on the forty largest companies by sales on the Fortune list at that time. It was perhaps a coincidence that half of the forty were on the Dow Jones Industrial Average and half in what evolved to be the S&P 500. No one seemed to focus on the need of Time Inc, the publisher of Fortune to sell advertising. It was a given that the larger the company’s sales, the more likely the larger its advertising budget.

The original Dow Jones average was to record the dollar value change of leading stock prices or in today’s lexicon, volatility. Publishing the more volatile prices had the greater the likelihood that their newsletter and eventually their newspaper would get paying readers. The NASDAQ indices was designed to focus some attention on the Over-The-Counter market which was not represented in the DJIA. NASDAQ wanted more listings. 

Except for the sales culture, professional investors increasingly found that the published indices were not as useful in the more recent markets. This has led to the production of passive indices based on market capitalization, products produced (energy), legal domicile, largest stock market activity, earnings, dividends, etc. These are often called smart beta or factor based. From my standpoint they are an improvement, but in many cases these are using the wrong identities at the moment.

Information Technology Sectors

Charles Schwab & Co., has addressed the concerns that the soaring tech sector stock price performance is sending a reminder of the “dot com” peak of 2000 and subsequent collapse. The data that they show is persuasive that while the tech group has done well it is more soundly-based than in 2000. What I found of great investment interest in the data was that the tech companies in the S&P500  had net profit margins of 17.8% and a price to sales ratio of 4.5x. Both the Mid-caps in the S&P 400 and the Small-caps in the S&P 600 tech sectors had margins in the 3% range and price to sales of 1.4x. As an investor the way I look at these data points, I wonder how much of the lager tech companies are benefiting from materially lower tax rates due to their more global activities. If and when net tax realizations become lower, the Mid and Small caps should rise relative to Large caps. Perhaps more significant is the major disparity in the price to sales ratios. With all other things being equal, which they almost never are, the prices of Mid and Small caps are much easier for acquirers.

If one were going to select on the basis of statistical factors alone, I would, at the moment, be more interested at tax rates paid and price to sales ratios than market capitalizations. The Federal Reserve Board  has come up with their own factors to approve the capital spending of large banks which could well lead to useful factor investing which can be summarized as follows:

  • Credit and counterparts risk

  • Liquidity risk

  • Operational risk

  • Information technology risk

  • Trading activities market risk

  • Interest rate risk

  • Strategic risk

  • Model risk

  • Reputational, fiduciary and business conduct risk

As all the banks passed their recent exams, we know it is possible to do so.

Shrinking Number of Small Caps

I was delighted to see that my old friend Jason Zweig had a front page column in the weekend edition of The Wall Street Journal on the shrinking number of publicly traded Small-caps. He felt that with an aggregate universe that is half what it was in the past that it would be difficult to beat the index by active Small-cap managers. I don’t like to disagree with someone as well read and knowledgeable as Jason, but I do and it ties into my concerns about identity or label investing.

First, I am under the impression that about one quarter of the stocks in the Russell 2000 are not currently making money. Over time some of these will disappear. Next the job of an active portfolio manager is not to use a pre-determined list with given weights. One of the key tools of an active manager is weighting. In some cases the heavier weights in a portfolio are caused by better than average performance of individual issues, but in some cases it is the manager not the market that makes the weighting decisions. Timing of purchases and sales can make a big difference. The best way to beat an index is to get out of the index. This can be done by owning issues before they go into an index either in their pre-IPO life or at the instance of a successful underwriting. Finally what particularly appeals to me is if the organization is appropriately knowledgeable is to judiciously add some right-sized international issues.

Is Indexing Peaking?

The problem with sticking to an identity is that we live and invest in a dynamic world. For an extended period of time the individual security price trends were closely correlated. As with any universe there comes a “Minsky Moment” when greater dispersion takes place. One then wants to be long the winners, some of the Large-cap tech stocks, and short the energy stocks at the moment. I find it of interest that the leading performance of the average Large-cap Growth fund on a year to date basis is so great that now for the first time in five years Large Cap Growth funds are beating the S&P500 index funds for five years. I don’t know how long this will last or it will be led by the best performing sector as of now, Science and Tech. What I do know is that all performance is cyclical.  

Looking for the next Winners

Going back to the rationale I used while publishing the Lipper Mutual Fund Performance Analysis, my recommendation is to focus some of your research time on those managers and funds that are clearly out of step. Understand which tunes they are marching to and be prepared to change your attitude when the big band starts to follow their lead. Remember the identity or label that you wish, first a survivor and second an occasional winner.
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Sunday, June 18, 2017

People Decide, Numbers Report Investment Success


The actions of people drive investment results. Numbers are an abstraction of the various realities that people produce. Quantification is useful in reporting history, not motivation. As a long-term student of investing and the investment business, I have seen repeated failures of extrapolating a given set of numbers that produce very different results. At best past numbers are useful as to what has happened in the past of repeated results.

Why Repeated Numbers Won’t be Predictive

People are not machines. Most of us live, think, and emote in the current time period. While our memories do produce faulty or incomplete renditions of the past that we often use as judgments, we don’t always. We don’t follow the old paths, all the time because of change elements perceived or real.

Change Agents

I believe that the presence of change agents occasionally lead to change in behavior. Some but not all change agents are physical, emotional, political, and may be a result of new personalities entering the decision process; e.g., the titular or actual investment committee. Thus I believe it is useful to apply more weight to the study of people than numbers. (This is quite an admission for a green eye-shaded CFA® charter-holder.)

Investment Personalities

I suggest that it is worthwhile to practice the art form, not the science, of people watching with open eyes and empathy. The three useful areas of the study of investors are:

    • The specific investor
    • The collection of investors
    • Speculators called “the market” and financial intermediaries
    Each is quite different, intermittently changing, making false starts and reversals and are sometimes unwilling or unable to state clearly their intentions and motivations. Our good friends the technical market analysts and other quant type analysts and managers believe that their recorded actions are sufficient for predictive purposes. They will be right some of the time but often miss a major change in the mood.

    The Decision-Making Investment Committee

    As a practical matter for some individuals and institutions there is a singular decider who makes final decisions without benefit of external counsel. In addition they are legally empowered to make investment decisions,  consult with others and/or are heavily influenced by external sources. Having chaired, sat on, or served various investment committees, I have learned some investment committees, in truth,  make all the decisions. Others are essentially ratifiers of outsourced chief investment officers (OCIOs) or are driven by the chair or other dominant personality. What I have experienced even with a number of people on the formal or informal committee is: change one person, and the direction of the committee may change. The new person may be the change agent for a reluctant prior group, a dynamic leader, one with a different set of investment or management experiences. The informal committee may include a personal lawyer, tax accountant, neighbor, spouse, significant other or a friend of your golf buddy.

    “Time to Judgment”

    There are two interrelated statistical periods which could be the current quarter, year, length of term expected on the committee, lives of beneficiaries or eternity. (We have suggested that the portfolios be sub-divided in terms of payment streams into timespan portfolios from short operational needs all the way out to legacy considerations.)

    Measures of Success

    After the targeted investment period(s) are identified, a key question is what measures of success to use. The first duty of a fiduciary (and we are all fiduciaries for ourselves and others)  is to deliver returns sufficient to meet expected spending levels. Thus one of the measures is in real, after-inflation returns. If the beneficiary is tax paying, the payment to the beneficiary should be after taxes.

    That is the easy part. Much more difficult are the appropriate measures of investment success and prudence.

    Indices made up of individual securities were never designed to be prudent portfolios, but rather a measure of perceived central tendencies. To me these are inappropriate measures.

    Usefulness of Mutual Fund Performance Databanks

    I suggest the comparisons should be with other investors which are operating under the same constraints as the account. 

    My experience is that the most transparent Databank on performance is mutual funds. These can be segmented by investment objective, size, expenses, turnover, tax efficiency, consistency of performance and other factors. 

    In most periods the bulk of investment performances will be centered in the middle of the performance array. Thus I suggest to divide performance into quintiles. The beauty is that one can treat those funds in the middle quintile (40-60). Then an interesting analysis would allow one to examine the frequency of quintile performance by quarters over long periods of time or when the portfolio manager or policy changes. This type of analysis will demonstrate the investors patience. (Over an extended period of time a number of different investment philosophies will produce similar results, but quite different interim results.)

    In assessing the investor or investment committee, their actions over time will have a great deal to do with their ultimate success. The best time for them to make changes within their portfolios of securities or managers is when performance is so good that it is likely to be unsustainable. The other criteria for their future success is whether or not they are developing a long-term plan on how their assets will be managed beyond the Principal’s lifetime.

    Measuring “The Markets’” Personality

    A look at history will show that a high percentage of the time markets move within reasonably well defined price and valuation boundaries. Unfortunately, these periods produce pedestrian returns. It is the extreme periods which might be 10-20% of the time that will capture the big gains and losses. These periods are often tied to perceived external changes. Europe enjoyed a long period of economic expansion due to the use of Latin American gold that was brought back which made their currencies stronger and created inflation. Wars can be both good and bad for stock, bond, and commodity prices at different times. Discoveries of natural resources and technology can create important changes and reversals. The very same factors that cause dramatic change in one market will not in others due to the mood of the market. There are times almost every item will be positively at other times the same items will be viewed negatively.

    At this moment the US stock and bond markets are highly priced but showing relatively little momentum except in certain narrowly defined sectors. There are two elements that other times would cause some concerns, but may not presently.

    The first is what economists call a “Minsky Moment” after an economist that many felt should have been awarded a Nobel Prize. His concern was for the unbridled growth of speculative borrowing/lending. This is the type of activity where the borrower expects to roll over the debt and not generate the capital to pay it back. Some are focusing on China’s industrial and real estate debt. I am concerned of the attitude of various governments and non-profit institutions here in the US who intend to cover their fund raising needs through new debt that they expect to be rolled over.

    The second element is an examination of the daily price chart of the NASDAQ Index in the Wall Street Journal. (This is a technology-driven index. Technology prices have now risen to the peak level seen in March of 2000.) If the prices do not fall appreciatively, it could lead to what the technical analysts at Merrill Lynch describe as a failed pattern. These two elements may be “straws in the wind” and blow away, but watching people’s changing moods will have some impact on near-term prices.

    Financial Intermediaries’ Personality

    We used to live in a world of single purpose intermediaries. They were either transaction-oriented, making their money largely through the bid and asked spreads and/or commissions or advisors which earned largely through percent of asset fees. Theses are now being effectively combined into multi-purpose entities. Within the financial community many former service providers are now competitors. Through this homogenization process the prices for services has come down but it is not clear that the quality and integrity of service has improved. Banks have morphed from being financial services department stores to perhaps the full financial services mall. If money is involved, so will be the banks. On a real estate basis we are seeing many of the old temple-like head offices becoming restaurants or event spaces which has happened in New York and Philadelphia. (We had a graduation lunch for a magna cum laude grandson in a space that used to be the main banking hall for the First Pennsylvania Bank, the fist bank in the US until it merged.

    While some of the intermediaries have large amount of capital it will be used primarily for them to make money for themselves rather than for their clients. They are hiring PhDs from Caltech and other leading research schools to convert their processes from seasoned employee functions to automation. There is not the same service attitude from machines and call centers that were previously bestowed on us by the familiar faces of yore.

    The great damage sustained in major declines was suffered by investors who feel abandoned and dumped their good investments. With fewer people who have the investors best interest in mind to consult, there is a probability that a number of investors will believe that they are condemned to live through their own Minsky moment.

    Question of the week: How well do you think your financial service providers really understand your needs and will be there when you need them in a general market meltdown?    
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    Copyright ©  2008 - 2017

    A. Michael Lipper, CFA
    All rights reserved
    Contact author for limited redistribution permission.