Introduction
Most individual and institutional
investors are in essence outer directed. Either consciously or not they follow
what others do and have a fundamental belief in “smart money.” For extended
periods of time this philosophy has worked. Perhaps, it was my brother’s
experience in the US Marine Corps Reconnaissance as the leading point for
wartime patrols to avoid walking into an ambush. Or my experiences at the
racetrack where betting favorites won only about one-third of the time. I look
for instances where the “crowd” is wrong. Not to be just a contrarian, but
looking at the profit opportunities when the generally unexpected occurs. Some
of these opportunities are just plain random, others can be perceived ahead of
time. Each of this week’s concerns has some evidence backing up the views as to
future changes. Whether you agree or disagree let me know.
Is EPS our Golden Calf?
Throughout my investment career I have
heard earnings, actually reported earnings per share, drives the market. In the
1960s I was told all one needed to know was the growth rate of earnings to determine
the appropriate price/earnings ratio. Recently I heard a very well known
and respected Portfolio Manager explain in a long cable news interview that
“earnings drive the market.” The first thing he said about each of his five buy
recommendations was their earnings per share. The analyst in me rebels at this
kind of over simplification.
In a period where much of senior
managements’ compensation is based on in order, EPS, sales, and market price -
do you think that they attempt to show the best possible record? I don’t want
to proclaim that they are totally manipulated or are the equivalent of “fake
news” but it makes you wonder whether it is a true reflection of the value and
future potential of the company. One of the first lessons from my Professor
David Dodd, who wrote the five editions of Securities Analysis
with Ben Graham, was to reconstruct the financial statements of the company
under study. We laboriously went through each line in the income statement and
balance sheet adjusting for removal of non-recurring elements and questioned
the accounting techniques that produced each item. We were quickly taught that
in various cases the results in the press release or Management’s letter did
not give a totally accurate picture.
When professionals discuss the valuation
of various Merger & Acquisition deals today, comparing them to others, the
metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization
(what were the write offs?). The drive here is to understand what was the
operating earnings of the company. Net Interest is the result of the financial
condition and policies of the company
and might not be followed by a new owner. One of the simplest techniques that I
learned at a trust bank was to put all the steel companies held in trust
accounts on the same tax rate. This deprived some of the companies of their tax
management skills, which were often transitory, but would be different under
different ownership.
Depreciation charged is a function of the
weighted ages of the plant and equipment with no adjustment for critical future
expenditures. Amortization could be an orderly way to recognize the
deteriorating value of intellectual property purchased and/or other write
downs. To some degree I think all of these items plus debt service obligations
are more important than reported earnings and so do the “M&A” troops.
Notice that a good portion of some
companies “earnings improvement” comes from profit margin expansion. What this
really means is that reported earnings are growing faster than sales. This is
favorable when the company is increasingly earning more over its fixed cost
base. However, it may mean that it is not spending enough on plant and
equipment and/or research and development. These considerations are important
in an increasingly competing world of relatively slow growth.
In history, when the ancient people felt
that the Golden Calf did not answer
their needs, not only did they destroy the statue, there was a period of
turmoil and violence until new, and in some cases, better beliefs were
established.
The Dangers of Buying the Next
Dip
This past week there was an extremely
sharp jump in the portion of the American Association of Individual Investors
views on the market. In one week 41% are bullish, a gain of 12 percentage point
from the week before with a concomitant decline in bearish beliefs and neutral
holding about even. Both the Dow Jones Industrial Average and the S&P 500
went to new highs, not immediately echoed by the NASDAQ Composite. It is quite
possible that the two senior averages need to catch up with the NASDAQ. The
year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88%
and NASDAQ + 22.96%.
Could this be the key missing element to a
race to the top? While a number of highly respected market analysts expect a
minor pull back, as there are a few price gaps that should be filled in before
a major new top is reached. This could be accomplished by a 5 to10% correction.
The Goldman Sachs* view is that there won’t be a dip as
too many people are expecting it. (Remember the humility production function of
the market.) This focus on sentiment over financials is a concern of Professor
Robert Shiller as expressed in The Sunday New York Times
when he refers to John Maynard Keynes’ belief that market participants were not
making their own investment decisions, but were guessing what others were
doing, in other words, trying to follow “smart money.”
*Held in
the private financial services fund I manage
My concern is that this trading attitude
may actually succeed. The risk is that the successful traders and later their acolytes
will have faith that it is a repeatable result, and they are truly skilled. My
concern is that when the next “Big One” occurs it will be quite different than
managing through normal drops and even minor corrections. The difference is the
size of the trading capital in the marketplace having to provide liquidity to
non-price sensitive ETFs and margin-called players. There is little to no
capital on the floor of the exchanges. Dealers have capital constraints and
banks are limited by various regulations in a global marketplace connected in
less than nano-seconds.
I don’t worry about trading losses, they
come within the territory of investing. What I do worry about is the potential
of future revulsions to investing and a generation that will decide “never
again.” This will be tragic for themselves and their families. But also the
rest of us taxpayers who are likely going to have to pick up some of their
missing retirement capital.
More Evidence Indexing is
Faulting
You have to excuse me for looking at the
world with lenses that start with mutual funds which I have been following for
more than fifty years.
Each week I look at the funds’ performance
for varying time periods. For the week ending last Thursday I saw an
interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks
close to 100 different fund peer groups. The largest equity group is the $ 1.2
Trillion S&P 500 Index funds. I compared its results for three periods and
counted the number of peer groups that beat the large Index funds as shown
below:
Type of Fund
|
# of Fund Types Surpassing
Index Funds
|
||
YTD
|
52 Weeks
|
5 Years
|
|
US Diversified funds
|
4
|
3
|
2
|
Sector funds
|
12
|
7
|
5
|
There were four fund types that beat the
index in all three periods, 2 diversified and two sector fund types. The key point is more active
managers are beating the Index. It is not because they switched from dumb pills
to smart pills. It is due to greater variability of performance within the 500.
Mathematically this splitting is called less correlation and greater
dispersion. Within the Index there are some big winners and a few big losers
which is meat to active managers, and in theory to long/short managers (hedge
funds and the like).
__________
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A. Michael Lipper, CFA
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