Investing Successfully – Weekly blog # 525

Introduction

Investors often unconsciously think about their assets and investing. Our own actions, as well as those of others, create opportunities to add or subtract from our assets through opportunities or threats. Our sum total of assets in life is a culmination of our experiences, including thought patterns. For most of us, far too little of our time is spent on consciously thinking about how we invest our resources, emotions, energy, and financial assets. The purpose of this blog is to develop our investment thinking.

The first step is to take an inventory of how we spend our careers, emotions, energy and capital to further our goals, as undefined as they are. The second step is to begin the process of deploying our limited financial assets, beginning at its easiest least threatening level. (For almost all of us, our assets are more limited than what we want to accomplish with them.) The third step is to spend some time and energy on what I will label Capital Motivation.

Capital Motivation

Capital motivation, in an imperfect world with imperfect people, is to optimize not maximize how we focus our emotions, energy, and intelligence in deploying our financial and other assets. We need to begin a task that will never end, listing the threats and opportunities that are before us right now. How should we optimize our capital against each of the major opportunities and threats facing us? This sounds like an almost impossible task, but begins first with conversations both with ourselves and others to draw from our experience banks. Even the most financially knowledgeable institutions and individuals do not have all the answers. They are addressing their perceived needs as best they can and in many cases recognize the unanswered threats and opportunities that stretch out before them. In reality we are all sinners in this task.

What is Your Capital?

Those of us that invest in individual securities and funds recognize that fundamentally we invest in people. When analyzing any specific investment the single most important factor is the individual personality driving the investment in terms of the timing of inflows and outflows, as well as goals. Using a concept as old as The Bible, each of us are relatively short-term renters of the assets we currently command. Over time they become the temporary assets of others, known and unknown as well as those of the global society. This is why I believe any investment plan, self generated or produced by an adviser, needs to start with the individual decision maker and perhaps terminate with the welfare of the corporate and/or individual beneficiaries.

Our single biggest asset is our reputation for integrity, not only to others but also to ourselves. Eventually we need to deliver on our promises to ourselves as well as to others. In effect, when we promise we are creating a contract and we will be known for our ability to complete our contracts and in many ways the art of investing is dependent on our ability to live up to our contract. It is in this light we manage the mix of our financial and other assets on the continuum between capital appreciation and capital preservation.

Capital Appreciation 

Through accidents of life and our own hard work we have a pile of assets which most often come with some encumbrances. Part of the strings attached to our assets, plus a desire to grow them to meet future needs, is the continuous need to manage the appreciation of our assets. There is risk of loss in everything we do and the opportunity to appreciate assets itself comes with risk. On the surface, most of the time risks appear to be equal or exceed identified rewards. It is our skills, integrity, and energies, properly committed, that change the ratio of risk to reward. Outside of internally produced risks, there are two others.

As long as society promises to take care of those who don’t take care of themselves there will be taxes and they will be likely to be progressively higher on higher income. Perhaps the biggest reduction to the value of your investments is the inability of governments to compensate you completely for what they spend, as through their control of the creation and supply of money, they induce inflation. Inflation not only increases expenses, it lowers the value of our intellectual and financial assets. Over a family’s lifespan, inflation could be the biggest hurdle to meeting perceived goals.  These two societal payments also influence capital preservation. To overcome drags on our wealth we look to different capital appreciation approaches. While there may be some income element in our choices, the main benefit we are looking for is higher terminal prices than our initial costs.

There are many ways to attempt to achieve gains. In searching for good investments there is a false assumption that looking initially or only at past performance is the best means of accomplishing this goal. This presumes that the future will be very much like the past, which rarely happens. I utilize a holistic approach in examining not only the entire asset base, but also the potential risks to the individual capital owner.

For example, look at a university that is heavily dependent on government grants and contributions from science based workers. Working with the investment committee, they could decide that tech spending is cyclical and their capital should be invested contra-cyclically away from technology. With the very same set of conditions the investment committee, because of their own experiences, could decide that they are well versed in the issues and in the long run can tolerate this kind of volatility.

At this very moment, most stock and bond prices are flat to down this year, with principal gains in a handful of global tech stocks and their satellites. In these circumstances, a family with a combination of aging seniors and grandchildren entering college years could choose to optimize cash generation rather than aggressive capital appreciation, as they might have done in the past. Again, this is a particularly difficult time to make this judgement. Interest rates on high quality paper, while rising a bit recently, is absolutely lowering the value of fixed income because of the threat of rising global inflation. In addition, reinvestment risk on maturing investments is cyclically raised. The implementers of these decisions could benefit from discussions with their investment advisors, tax preparers, legal advisors, and family.       

Capital Preservation

Capital preservation is not the opposite of capital appreciation, but more like the other side of the coin. We all start with a bundle of talents, energy, and some money. We, over the lifetime of an individual, family, and institution, convert capital appreciation to beneficiary spending and interim investing. What is interesting is that during the investing period we are judged by investment performance, including the generation of cash. However, at the end of the period, and all periods end, we are judged by the aggregate size of the capital. All too often this is translated only as a sum of money. What should be included in this final assessment is what the expended capital has done in known and unknown people’s lives. (Read Andrew Carnegie’s views not necessarily his actions.)

What should we do now?

Any morning is a good time to change our future by making changes to our investment portfolio. I ask myself this question every weekend when I analyze the average investment performance of mutual funds as produced by my old firm, now part of Thomson Reuters. My conclusion is that at most one should consider tinkering with the mix of funds in specific portfolios, but not implement wholesale dramatic changes. The inputs to my thinking can be summarized as follows:

Year to date Average Investment Objective Performance
• No matter what size, growth funds are up 2X value funds
• World stock and bond funds are flat to down
• High Quality Bond Funds are down more than their coupon
• From David Rosenberg, at Gluskin Sheff since 2009, 13 million people are new to finance careers
• The last bond bull market began 35 years ago

“You can see a lot by observing”  

A wonderful quote from Yogi Berra and something we attempt to think about when making only minor modifications to our various investment portfolios. My wife and I just returned from, in many ways our graduate school, The Mall at Short Hills on a drab and occasionally rainy Sunday of the Memorial Day weekend. This is a very upscale market place which had a good size crowd, but they carried relatively few shopping bags and were there with one or more other people. It seemed to me that in terms of their wardrobe and other shopping needs, they were tinkering at the periphery of their sartorial assets. If something at Amazon was priced right or had particular appeal they would buy and perhaps more than just one. (As usual, the Apple* store had the most people and a longer than usual line for specific appointments.) Many of these people are either direct investors or participants in salary savings plans, 401(K), 403 (b) and 457 plans.  Their shopping ode suggests to me that in terms of their financial assets, while they make tinker at the edges of their portfolio, they are not currently driven to make radical changes.
*Personally held in investment portfolios

The tinkering that I am suggesting to various portfolios is as follows:
• In longer term equity portfolios look to good managers out of phase.
• Longer term international funds and quite possibly selected emerging markets should be reviewed.
• Sacrifice fixed income yield for shortened durations.
• Plan for a busy fall and a difficult 2019-2020.

__________
Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email buttons in the left margin of Mikelipper.Blogspot.com or by emailing me directly at Mikelipper@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

Chinese Disruption Around the World - Weekly Blog # 524

Introduction

Most of those who think about the future of the Global economy believe that China at some point will probably replace the US as the global leader, until perhaps after a generation it is replaced with India. Based on current population trends,  Nigeria will have more mouths to feed in the future than India.

China Influences all Markets

Size, in and of itself does not guarantee a good place to invest. At this point investors, no matter what they invest in or where they invest, need to understand the ability of China to heavily influence, if not disrupt, almost all investing in stocks, bonds, commodities, real estate, art, and racehorses. While I intuitively agree with Charlie Munger that there are more investment opportunities in China than in the US, I lack sufficient confidence in my understanding as to how the winning game is played.  Nevertheless, I feel compelled to invest in China and Asia. The way I do it for my clients and myself is through selected Asian specialty funds.

The inclusion of some of the “A” shares in the MSCI indices is in response to demand from institutional investors to put money to work into China very quickly. There is more than the normal amount of risk being created, for the list of included stocks is based on size, not quality or other investment factors. This is particularly significant to what is likely to be a rash of China ETFs. When the financial reports become available there could be a positive fleshing out of how business is done in China.

Racetrack Influences

On Saturday the South China Morning Post, which is now essentially a vehicle for the Mainland government, published an entire section devoted to Horse Racing, with the kind of statistics we used to see in the US in the popular press and specific publications for racing fans. What is impressive to me is that the paper had extensive records of the leading jockeys and trainers. What is notable is that neither the leading jockeys nor trainers win over 20% of the time. This highlights my reluctance to embrace the most popular stocks most of the time.

The Chinese interest in both racing and more important breeding future champions, was again highlighted on a sloppy track Saturday afternoon when Justify won The Preakness. This is the second title to the Triple Crown after Justify won The Kentucky Derby for its largely Chinese syndicate owners. Competitors are labeling Justify as a “super horse.”

The newspaper has the same type of mutual fund price (NAV) listings one sees in London. These are paid placements which often represent the key profit item for the paper. Recently I co-chaired a panel at the International Stock Exchange Executives Emeritus conference in Hong Kong. In our lead off session with the Chair of Value Partners, I was somewhat surprised to see a good sized list of Value Partners funds and their classes in the newspaper. They even had some funds quoted in New Zealand’s currency. Most of their competitors are UK and Swiss groups. For historic and cultural reasons, only a few funds appear to be offered in the US.

Xi Jinping Cites People’s Liberation Army “Principles”

On Thursday the same paper had a front page article with a headline “President calls for stronger military science studies.” In the article Xi Jinping, as chairman of the Central Military Commission said, “Innovation has to be practical and closely based on warfare and combat issues to create advanced military doctrine suitable for modern warfare and embodying the PLA’s unique characteristics.” (Bear in mind the People’s Liberation Army has not been at war in a generation. During that period the US has almost constantly been in small wars.) Notice there is no particular emphasis on defense, which suggests offense is important and could be in the President’s plans.

The leading economic thinkers viewing China internally as well as externally are very conscious of developing economies running middle income growth to the limit. There is a fear that they become old before they become rich, as on balance China has an aging population. Japan and most of Europe  are laboring under demographics that reduce the proportion of productive human labor and an increase in the portion of the nation’s wealth spent on healthcare. (With US fertility rate at an all time low, we hope that US leaders see a similar long-term risks that needs to be addressed quickly.)

A number of funds investing in China have been shifting their emphasis away from exporters and basic industries, investing instead in consumer-oriented stocks and services. Many global and international portfolios cover their China bet with one or two stocks, such as Alibaba and/or Tencent. From a stock price standpoint, most of the time their prices parallel the so-called “FAANG” stocks, not China-focused developments.

Balance Sheets More Useful than  Income Statements

My old Securities Analysis professor David Dodd might have enjoyed my late conversion to paying initial attention to balance sheets rather than income statements. In the class (taught by the co-author of our text book) we had discussions on the proper methods of security analysis. I had the temerity to argue with him in favor of the primacy of income statement analysis. He shut me off once when we were discussing a specific security, which just happened to be in Graham and Dodd’s portfolios. He ended the discussion by informing the class and this doubter, how much money they had made on that position. Thus, it is ironic that I bring up balance sheet and related cash flow concerns in dealing with Chinese investments.

The very successful export drive that led to China being the fastest growing large economy for a number of years was based on exporting industrial goods and consumer products. On my visit to Hong Kong and Shenzhen* I was very impressed with the new infrastructure that has been put in place in under a generation. At the same time the US and most developed countries experienced deteriorating infrastructure, Hong Kong is expected to require an additional airport in 2019. (Our returning flight was slightly delayed in leaving as it had to coordinate with flights from nearby Chinese airports.)

*I would be happy to share by email the field notes of my visit to the fascinating BYD headquarters in Shenzhen.

China Experiencing Downsides to its Growth

However, there are a couple of downsides to the growth in the Chinese economy. After the farmers flocked to the cities, they used their savings to buy apartments, quickly followed by a cars, resulting in crowing and auto pollution. For this reason, the government is heavily subsidizing the production and sale of electric and hybrid cars. Thus China is the manufacturer of half of the world’s electric vehicles. This led to BYD leveraging its flows and balance sheet to a point where liabilities equaled or exceed assets. BYD is not worried however, as its loans are from state controlled banks.

One Belt, One Road Linkages

A further extension of debt was used to finance infrastructure in Africa and along the promoted “One Belt, One Road” connections from China to neighbors on the way to European markets, which will probably make use of the excess steel and cement capacity that is not being used internally in China. I am not predicting the future but rather asking prudent investors to study the history of debt-driven expansions in railroads in North and South America, and the financial history of the car business.

I will be happy to learn from subscribers about prudent ways to invest in China.

__________

Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email buttons in the left margin of Mikelipper.Blogspot.com or by emailing me directly at Mikelipper@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Critical Decisions: Successors, Appreciation and Preservation - Weekly Blog # 523

Introduction

The combination of long flights and attendance at the Berkshire Hathaway* Revival meeting has led me to think more prominently about the structure of successful investment processes. I have often said that if one slashes the wrist of a securities analyst (even before they become portfolio managers), a historian will bleed.

I have been thinking about the failure of the conqueror of the ancient world Alexander the Great, whose key lieutenants were for the most part bad successors. In contrast, I compared that result with today’s most profitable company, Apple* and the succession of Tim Cook to the product/service genius Steve Jobs. (This not a prediction as to the future of Apple or its shareholders.) Currently we are in the public succession disclosure phase of the distinctive leaders of two companies: JPMorgan Chase* and the aforementioned Berkshire Hathaway. I believe both successful and less successful command changes should be studied in terms of responsibilities for our families and non-profits we care about.
*Held in client and/or personal portfolios

The Wrong Instincts

I have sat on a number of non-profit boards officially or observed them as their external investment manager. I have noted a number of habits that usually led to long-term sub par results. Choices are made by committee which tends to favor the politically skilled candidates. Frequently it is deemed important that the new leader get along well with the existing staff. Often what is needed for optimum survival  is to either seriously remove staff or materially change their way of thinking and executing. This is particularly true for academic groups where the new person is meant to solve the single biggest short-term problem facing the institution without upsetting too many of the existing “warhorses.”

Another road to failure is setting up a competitive horse race. Not to say that the best person not often wins, but all too often some of the better people leave in disappointment, which weakens the firm even if the best person wins. Unfortunately, we have seen this approach in financial organizations. Just think of the number of CEOs that have come out of GE and a number of leading brokerage firms. The same thing happens with both non-profits as well as families.

Successful Patterns

When Steve Jobs recognized that his deteriorating health would lead to the need for a new leader he chose Tim Cook. He was not a “product guy” like Jobs, but was the master of the supply chain manufacturing and selling all the wonderful new products that were dreamed up by Jobs and his tight design crew. Further, Jobs told his appointed successor not to do things they way he (Jobs) would do them, but the way that made sense for Tim Cook. Under the successor, the shareholders (and I presume the Job’s estate) have seen their assets multiply a number of times. I suspect that Steve Jobs’ thinking was in part shaped by having been fired from Apple in 1985 to avoid taking it into bankruptcy. Luckily he learned a lot with new responsibilities and was better prepared to be Apple’s CEO the second time.   

Selecting Two American Generals

We have benefited from two US Presidents making controversial decisions to lead our Army at critical points. President Abraham Lincoln chose a cashiered Ulysses S. Grant to lead the Union forces through a brutal campaign, first in the Midwest and then the South. Grant who graduated from the US Military Academy at the bottom of his class, accepted the surrender of Robert E. Lee who graduated at the top of his West Point class and is generally believed to have been the best general of the Civil War era. Lincoln’s selection of Grant was key to the eventual Union victory.

When it came to choosing the commanding general for the US-led invasion of Europe, President Franklin Roosevelt turned down the highly respected, most senior Army officer General George Marshall

(later a brilliant Secretary of State) in favor a much younger and junior officer, Dwight Eisenhower. I suspect FDR’s thinking was shaped by the fact that for a number of peacetime years Eisenhower was on the staff of the very difficult, but brilliant General Douglas MacArthur, who not only graduated at the top of his West Point class but also returned to the Academy as superintendent.  I believe that the President felt that if Eisenhower could get along with MacArthur he could work with the difficult British Field Marshal Bernard Montgomery. Being a politician himself, Roosevelt recognized the importance and skills of another politician.

People Skills Part of Asset Allocation

Warren Buffett believes his greatest contribution to the success of Berkshire Hathaway is making major asset allocation judgments. Beyond the required investment skill to make these decisions, he has the ability to “sell” his decision both internally within the firm, and also to his outside audience which he does very well. In looking at these decisions, with the help of Charlie Munger, he uses both capital appreciation and capital preservation strategies in building Berkshire Hathaway for the next generations of owners. While Buffett likes to portray Berkshire as a long-term thinker, he can afford to do that as long as he has a bountiful supply of cash or short-term paper.

With Warren Buffett and Charlie Munger as models, the approach that we recommend to prospective clients is based on our Lipper TIMESPAN Portfolios^®. For illustrative purposes only we have divided an institution’s or individual’s portfolio into four unequal timespan sub-portfolios. Each portfolio is assigned a portion of both capital appreciation and capital preservation securities and strategies which can be modified if conditions and specific needs dictate. The following table is illustrative and can be modified when required:

Lipper TIMESPAN Portfolio®	% Capital Appreciation	% Capital Preservation
Operational (Short-term)	25%	75%
Replenishment (Cyclical)	50%	50%
Endowment (Present lives)	60%	40%
Legacy (Future Lives)	80%	20%

Source: Lipper Advisory Services, Inc.

Please let me know how you would allocate resources for which you feel responsible.

N.B. One of our long-term subscribers who is both an accomplished mathematician and a successful money manager properly called to my attention that I gave the late Stephen Hawking a Nobel Prize that was not awarded to him. Further he reminds me that his theories were never confirmed by measurement. I plead guilty of being in awe of him as a person and the work he did at Caltech.

__________

Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email buttons in the left margin of Mikelipper.Blogspot.com or by emailing me directly at Mikelipper@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.