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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A. Michael Lipper, CFA
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