Sunday, April 1, 2018

“The Risk to Worry About” - Weekly Blog # 517.


Introduction

Recently I ran into an old friend at a cocktail party who is retired from being the managing editor of a trade newspaper. He expressed concern as to his own investments with the current volatility. I suggested that the time he should have been worrying about risk was during the fourteen months ending in January, after nine years of rising markets! He was much more comfortable with gradual gains and no declines greater than 3%. I said he should have been worried about risk when others were not, which is perhaps the best measure of the reciprocal level of certainty that a large number of pundits proclaim.

You never know about the future, but one can guess what you don’t know. While in the US Marines as an officer, we were instructed when planning for an operation to identify the essential elements of information (EEI). We quickly learned that it was rare to have as much as 70% of the EEI. Applying the same approach to handicapping at the racetrack, I was pleased to find 60% of the EEI. I feel the same today when selecting individual stocks and funds.

I suggest that in each of our attempts to measure risk, the largest single risk is the unknown and it rises when the pundits are more certain.

Is the Public Smarter?

“Americans Hold Off on Spending Extra Tax Dollars” was a page 2 headline in The Wall Street Journal on Friday. In addition, February was the third month that overall retail sales were slightly off from prior months. Consumer spending was up +0.2% compared to a rise in wages of +0.4%. This was not what was expected. I cheered this announcement as it demonstrates consumers are acting rationally. In the end, the article did point out that a number of consumers were using their tax benefit dollars to reduce their high interest loans. (Economists would label this as savings or deferred spending.) 

Consumers should be fearful of increased state and local taxes as well as increased fees paid to government agencies, and for business sales/use taxes. They should be saving and investing to reduce their growing retirement capital deficit. I don’t know whether it has yet entered into the public’s psyche that there is a chance that the purchase prices of their items will bear the costs mentioned and possibly the impact of tariffs.

A Second Example of Consumer Smarts

For the last several years American investors have been net buyers of “non-domestic equity funds.” I am guessing that these buyers are not largely the same fund investors that have been redeeming older domestic equity funds. I believe the redeemers are completing their expected retirement, estate building, and large purchase needs. To the extent that older fund investors are adding foreign stock investments, they are hedging their domestic equity funds. For a number of years the US dollar has been weak compared with other currencies and deservedly so. Despite foreign investors buying US securities for refuge, it makes sense for US investors to invest overseas. Often there are lower valuations in local markets, which makes sense when considering they are also in less liquid markets. They are also unique investments not found within US borders.

Traders are also buying more overseas investments while redeeming domestic ones. Each week my old firm, now a part of Thomson Reuters, measures the net flows of both conventional mutual funds and Exchange Traded Funds and Exchange Traded Notes. For the last week, ending on Wednesday, ETFs had net redemptions of $11.5 Billion in domestic equity vehicles while conventional mutual funds had $2.5 Billion. (Remember the assets of ETFs are much smaller than conventional mutual funds.) It is worth noting that just two ETFs had combined net redemptions of $10.6 Billion in S&P 500 invested portfolios. This suggests to me that the redemptions came from a small group of trading desks and not the general public.

The fallacy of the “risk on/risk off” approach

The financial media has gotten into the habit of describing market movements as either “risk on” or “risk off.” This is simplistic but can be a binary switch for a quantitative portfolio. It assumes that the investor has identified the risks. Perhaps, this in and of itself is a big risk.  Many can produce a roster of risks. Few can weight them. Fewer still can set the time when their impact will be felt.

The fallacy of the “risk on/ risk off” approach is that it is one directional. At all times we should be looking at both the opportunity for risk and reward. In this case those that invest in mutual funds have an advantage over those that use only individual securities. Mutual funds have flows that many individual investments don’t have. Flows drive buy and sell reactions which cause the portfolio to change. (Often a fund in net redemption benefits from pruning the least attractive current holdings and has an additional opportunity to switch into new investments.) 
Regardless of how one’s portfolio is structured, you should always be looking to add opportunity.

Quotes from Berkshire Hathaway’s Annual Report*

While Warren Buffet lays out their thinking about acquisitions of companies, the principles can be applied to selected individual stocks.

  •     good returns on net tangible assets and a sensible price
  •   “We evaluate acquisitions on an all-equity basis.”
  •  “Betting on people can sometimes be more certain than betting on       physical assets” (I would include shown financial assets.)
  •  Berkshire’s goal is to substantially increase the earnings of the non-insurance group through a large acquisition.
  •   Berkshire has suffered four short-term price declines of 59.1%, 37.1%, 48.9% and 50.7%.
  •  “An unsettled mind will not make good decisions.”
  • “Charlie and I will focus on investments and capital allocation.”


Perhaps the single most important clue to Berkshire Hathaway’s long-term thinking is the following statement:


  • “The Yahoo broadcast of the meetings and interviews will be translated simultaneously into Mandarin.”


*Held in client and personal portfolios


Question of the Week: What are the risks to your portfolio that others don’t see?
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A. Michael Lipper, CFA
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