Wednesday, June 20, 2018

The G7 Meeting in Its Demise as a Policy Making Body Was Useful - Blog # 529



The current focus on worldwide tariffs, particularly those of Chinese and American products, was kicked off by President Trump at the G7 meeting held  in Quebec. 

·       Mohamed El-Erian, formerly head of PIMCO and now chief economic advisor to its owner Allianz, recently stated that “The failed G7 Summit dealt a very public blow to a once powerful grouping that had already been challenged by global economic re-alignment, the emergence of the more representative G20, and new forms of regionalism.”

·       Today the leading German auto manufacturer suggested that there be no tariffs on autos within the market that uses the Euro. This is a reaction to a suggestion that the American President made at the meeting.

My blog post last week, entitled “Learning from the Demise of G7 through the Battle of Cowpens,” is available by subscribing to my blog.  To become a regular reader simply send me an email at AML@Lipperadvising.com .

I read all subscriber correspondence, so please tell me a bit about yourself and the investing goals for you and your heirs.
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Copyright © 2008 - 2018

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

Sunday, June 17, 2018

Learning from the Demise of G7 through the Battle of Cowpens - Weekly Blog # 528


I learn and apply these lessons to our investment tasks, communicating them through these blog posts. Global policy judgments are not a focus of these blogs. One can learn from watching conflict resolutions in military, political, and sports worlds that are useful in thinking about future investment decisions.


The G-7 meeting

The G-7 meeting in Canada was a wonderful display of tactics that may predict future strategic movements. President Trump was widely criticized before the meeting as a protectionist, particularly by European allies and Canada. In a brilliant flanking move, he surprised them at the meeting by suggesting a relationship with no tariffs or other barriers to trade. What it revealed was that each of the other countries involved had higher tariffs and more trade constraints than the US. The reason for the discomfort (or more correctly, horror) was that these were put into place to benefit specific politically powerful interests, which would presumably be hurt in a no-tariff world and would cause most of the governments at the meeting to fall. (The US is very conscious of the tariff wall which was the primary cause of the early conflict between the Northern and Southern states and thus really led to the Civil War.

The future may well depend on how close a parallel this is to the Battle of Cowpens during the Revolutionary War and its aftermath.


The Battle of Cowpens

The Battle of Cowpens, fought in 1781, was an engagement between American Colonial forces under Brigadier General Daniel Morgan and British forces under Sir Banastre Tarleton. Tarleton’s force of 1000 British in the King’s Army went up against the 2000 men under Morgan. Only 200 of the 1000 British troops escaped the battle. The Colonial forces conducted a double envelopment of Tarleton's forces.
From the American side, almost equally as important, they lost two major cannons that could have helped the Colonial forces at Yorktown.

Tarleton was a young and impetuous commander who marched tired troops into battle and fell into a well designed trap of counterattacking by the Americans. The Americans were instructed to fire two rounds and then retreat into the hills, sucking the tired troops into fire from three emplaced positions with their open flank. That is where the American cavalry showed up, having circled the British lines.

The battle was a turning point and coupled with the British defeat at King’s Mountain, compelled Cornwallis to pursue the main southern front of the American Army into North Carolina, leading to Cornwallis’s surrender at Yorktown. Quite possibly, if Cowpens had turned out differently, there might have been a British fleet off Yorktown rather than the French fleet and the US would have remained within the British Empire a little longer. Except, unknown to the participants, a peace treaty had already been signed in London, with considerable help from some members of Parliament.

Clearly the tactics at Cowpens may have had a role in the strategic reorientation of Britain and the United States. Could this also happen to the make-up of the G-7? Was the difficult meeting in Canada a part, perhaps a necessary part, of the pivot to Asia?


Investment Lessons

The following are possible parallels from the G-7/Cowpens actions:
Read more fully about the past and look for less popular, simplistic explanations.
Be careful about following young, impetuous leaders.
Early gains can be a trap.
Rest is an important ingredient for victory.
Don’t leave your flanks unguarded.


Follow-Up Bits

Everyday we are greeted with bits of information, rarely however do we get the complete picture. Often, the bits are in conflict with each other and formerly perceived “truths.” The following are listed in order of their published date.

Money Market deposit account interest rates jumped to 0.52% vs. 0.47% before the Fed raised rates by 25 basis points.

The American Association of Individual Investors (AAII) weekly survey turned roughly 5 percentage points more bullish, dropping 5 percentage points from the bearish category. [At this level, rising short-term interest rates are apparently viewed as bullish.]

Mutual fund investors around the world are primarily investing for long-tem needs, largely retirement. At the end of 2017, US investors owned 44.8% of the $49.3 trillion invested in Funds, with only 31% in equity funds. Of American households, 45% own Funds, with 61% owned in tax deferred accounts. Thus, conventional mutual funds are unlikely to be the leaders in the next speculative surge in the market.
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Copyright © 2008 - 2018

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

Sunday, June 10, 2018

When, Not If - Weekly Blog # 527

The Next Recession

Recently, two very senior operating officers of significant organizations asked for my outlook on the next recession. I am very sympathetic to their quest for guidance, as it will immediately impact their day to day decisions which are trending quite positive. Taking the advantage of being an interested observer without operating responsibilities, I replied with some certainty that a recession was on the way.

The real question was when, not if. To be honest, I don’t know. Predicting the timing of a recession with operating precision is similar to the task of identifying when a volcano on the Big Island in Hawaii will erupt, or when “The Big One” (massive earthquake) will hit. One of the techniques in the USMC is to identify the potential for trouble rather than exercise the arrogance of solely predicting.

Why am I confident that there will be a recession? Because throughout the history of humans there have been cycles of alternating relative calm and crises, with some of these being caused by changes in weather. In the world of markets and economies the main stimuli for cycles are human behavior. The causes usually start with the word “over”: Over-building, over-capacity, over-borrowing, over-hiring and other terms for over expansion, or if you will over-expansion.

In explaining the falling apple, Sir Isaac Newton identified the physical laws of gravity. He believed they and other physical phenomena were put in place by “The Watchmaker in the Sky,” or God.  Perhaps there is a similar force that periodically corrects for errors in human risk management behavior. Having established, at least for me, the certainty of periodic recessions, the more difficult task is predicting the timing. I must admit that I fall back to the lessons of both the race track and highly valued stock prices, plus the power of envy.

Most people individually are quite bright and make reasonable decisions. However, when we enter “the crowd” our innate insecurity draws us to popular views which become ours. These are then reinforced by something psychologists call “confirmation bias.” Substituting Newton’s watchmaker with an eternal “bookie,” the greater the power of the confirmation bias the greater the odds that it is wrong. Thus, as noted in last week’s blog, with the large, learned, financial institutions’ belief that the next recession is three to five years away, it is an intelligent bet to make against the crowd. (A much more difficult bet to make wisely is which side of the over/under challenge to accept. Right now the odds favor the next recession coming more quickly than in three to five years, but there have been very long streaks in history which could give the “over” bettors some comfort.)


Risks of Fraud and Mistakes

Thus far, I have just focused on the normal tug of war between greed and fear. There are two other indefinite variables. The first is the surfacing of a large fraud from a respected place. A careful study of humans reveals that at almost all times there is a level of fraud. Sometimes the fraud includes intellectual fraud along with criminal fraud. One of the characteristics of the period before a recession is the pace of activity accelerating and the public scramble for attaining wealth being top of mind. Thus, the time spent on careful underwriting risks is shortened and the envy for wealth is heightened.

The second variable is the frequency of mistakes. During these volatile periods small errors occur in transactions more frequently, caused by too little time and too little experience, by both buyers and sellers. This accelerated pace often leads to big mistakes by important people and major organizations. In the post-mortems after failures, the repeated question is often how these very bright, accomplished people could make these mistakes? The answer appears to be the rapidity of the times demanded it. 
 
Economic recessions and market cycles have been necessary to correct for human excesses. Thus, in the long-run they are cyclical in nature, but do not change secular trends.  Long-term portfolios should be diversified across both cyclical and secular patterns. A 50/50 balance between the two is a useful starting point in portfolio construction because it prevents over concentration on the intermediate and long-term investing.


Two Significant Pivots

1.  Tactical Pivot

This week’s fund performance displayed a significant change. Prior to last week there were a limited number of equity gainers concentrated around the production and use of cell phones. Globally, growth-focused funds were just about the only asset class to show gains. In the week ended June 7th there was a dramatic change. Value-oriented funds joined Growth funds in generating positive results year to date. Their gains in the week turned many of these funds to gainers for the year. The bigger turnarounds were experienced by Base Metal Commodity funds +4.85%, Basic Materials funds +3.41% and the already positive for the year Consumer Services funds +3.73%. One could interpret these results as an indication that a further cycle expansion became likelier last week.

2.  Strategic Pivot

For a considerable length of time mutual fund investors have been net buyers of non-domestic equity funds. This focus on non-domestic equity funds is clouded by the way the vast majority of international funds display their portfolios. Most funds rely on portfolio statements from their custodians. Where a corporation is legally domiciled is important to a custodian as a source of local law and taxation. This information is much less important to investors than where companies are making their sales and pre-tax operating profits. The mismatch is clearly seen when it appears that the majority of US foreign investment is in European entities. While this is legally true, it is not helpful as to where our foreign funds expect to make their money.

Most large companies are multinational in scope. This is particularly true of companies domiciled in the UK, Germany, Sweden, and the Netherlands. To the extent that these companies are showing growth it is coming largely from Asia. This makes sense on both demographic and savings trends. The leading middle class growing countries are China, India, and Indonesia. They have populations that are in the early stages of acquiring the goods and services that more developed countries produce, either at home or in their overseas facilities. This is the reason that we are investing for our clients in Asian-oriented funds for the long run.


Asian Play

This weekend we are seeing American political leadership following investors pivoting toward Asia, which is causing distress for many Europeans, even though they are also significant Asian investors. The Asian play is not geographically limited to the Asian continent. Latin America, Canada, Africa, and the Middle East are junior partners to the growing power bases in Asia.


Belmont Stakes Implications and Lessons

I look for useful implications from everything that happens as I’m always willing to learn, even if at times reluctantly. The running of the 150th Belmont Stakes, which was won by Justify with Gronkowski in second place, was just such a learning experience.

Implications

Did you notice the silks worn by the winning jockey or the crowded picture in the Winners Circle? The winning colors are those of one of the three syndicates that own Justify, the winner. They belong to the China Horse Club, a group of some 200 Chinese investors. I am guessing that an old friend and retired good investment manager was probably not surprised that this group was part of the winning combination. He recently pointed out that after a lifetime of collecting selective Chinese art, the prices for such pieces has skyrocketed as Chinese buyers attempt to repatriate their art by becoming the dominant buyers. I suspect we will see more Chinese money buying into racing and more importantly breeding opportunities to meet both nationalistic and long term investment needs. (One of the real power centers in Hong Kong is the Happy Valley Racetrack.)

The other two owners are equally interesting. WinStar Farms is another syndicate, whose leader has the corporate title of president, suggesting that it is being managed with more of a corporate philosophy than just the skills of a bunch of enthusiasts.

The third owner is perhaps the most interesting of all. It is the family office of the famous, or infamous depending on your political views, George Soros. Disregarding politics, the office’s investment approach is sound. It buys into some of the best thoroughbred breeding stock and regularly sells off many of the resultant yearlings, with advantageous tax benefits. Not surprisingly, the manager of this operation is the tax manager. This is one of the ways the wealthy, who want to remain rich, employ intelligent risk management techniques. In this case it sold off the racing earnings of Justify and retained the breeding rights. At this point the colt’s racing earnings, including the Belmont win, is $3.7 million. However, the ownership has sold off most of the breeding rights for $60 million.

The investment implication highlighted by Justify’s ownership structure is that the world is moving toward more professional management of assets and liabilities and away from pure family control.


The Betting Lesson

A reported 90,000 people were at the track on Saturday and many others bet largely through electronic means. As much as I scanned the entries, I could not find a substantial reason, other than racing luck, that Justify was not clearly the best horse in the race. However, my discipline would not let me make an odds-on bet where the amount won would be less than the amount wagered. (I do this in my investing portfolio when buying good long-term stocks.) The colt did win and paid off $3.60 for a $2.00 Win bet, or after returning the $2.00 bet realized a gain of $1.60. I am reasonably certain that this was not a good return for the risk of being wrong. If one considered the winning position for Justify and then selected the second best colt, one might have bet on Gronkowski for Place. In fact, he came in second from trailing behind until late in the race. One would have won $13.80 or a gain of $11.80 for a $2.00 bet, or over seven times more than the winner.

The critical investment lesson to learn: Picking winners is not as productive as balancing the risks and rewards of investing.
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Sunday, June 3, 2018

Facts Trap Us into Choices - Weekly Blog # 526



Introduction

Why do very bright people make wrong choices? In our highly professional world of investments why do so many financially sophisticated investors choose the wrong investments at the wrong time and in the wrong amount?

I believe that I should always be learning. Because of my investment performance background I study smart investors who regularly make mistakes. Hopefully, I will learn to my clients and my own benefit. With the above mission in mind I was struck by an article entitled “In Defense of Ignorance” which was published in the Marathon Global Investment Review. Marathon Asset Management is a very thoughtful and successful investment manager based in London. Apparently its skillset is to focus on the supply side of economic equations and limit its input largely to facts about supply. As this focused approach has worked for Marathon and its clients, I considered this thinking in terms of my own intellectual process of transitioning from security analyst through various stages to becoming an entrepreneur and registered investment advisor.

Career Transition


As I was finishing my active duty in the US Marine Corps, my plan of action to feed my young family of three (and more planned) was to become a security analyst, study all there was to know about a leading company in an important industry and be hired by a company’s investor relations area as a person serving financial analysts. My career goal then was to be a junior officer of a large, stable, and hopefully growing company by retirement. Luckily for me it didn’t work out that way.

As an analyst my goal was to gather more facts than anyone else on a targeted company. Interestingly enough, the help of employers and analyst societies did not prepare me for the real commercial world. I had to learn, usually by observing, how to sell investment research, make sensible investment decisions, understand internal politics, seek clients, and learn how to run a business. Thus, I had to move away from the simple task of just gathering facts, as comfortable as that was, to a broader set of skills.

Analyst vs. Entrepreneur

Recently I have become convinced that much of the thinking processes of investment, business, and political leaders has evolved in a similar fashion. For a long time leadership was assigned to those who gathered the most facts. Many of them were like a good litigating attorney that gathers all the known facts about a case. He or she does not want to be surprised by something said by a favorable or opposition witness. After gathering the facts, attorneys are selective as to how they build their persuasive pitches. These types of leaders, often rising through highly structured organizations, are replaced or out-maneuvered by an executive decision-maker.

The rise of the executive decision-maker is changing our world as we know it. The old practice of following a case study of known procedures is giving away to more free-form decision-making. Increasingly, successful nations and business operators have less in common with their perceived competitors. 

It is not this blog’s mission to solve world and macro problems, but rather to focus on investments largely through investment managers and mutual funds. With that thought in mind I am wondering whether our practice of building diversified portfolios based on asset classes, size of companies, locations, and market capitalizations, which worked well in the past, is becoming outmoded. Should we assemble our managers and their funds as a good theatrical producer does with people of different talents? A good producer brings these multi-talented people together in a way that produces good results as a unit. As we move in that direction we will need a different classification system, which may be different for each client portfolio.

The only time I had some limited experience with this was when I was fencing in college. In a very short time I had to make a guess whether my opponent favored offense or defense, how to change the expected flow of events, how to lure an opponent into changing styles, etc. We know that most managers are reactive to prices or announcements, only some attempt to position prematurely. Others march to their own drummer and stay fixed in their actions regardless of other stimulants. As we have very intelligent readership of these blogs, I am wondering whether any have some guidance for me as I struggle to adapt to my perceived view of the new world of investing. Please contact me at AML@Lipperadvising.com.

For the Fact Gatherers

Demand for money is gradually rising. In the daily Wall Street Journal there is a statistical box of ten “Consumer Rates and Returns to Investors.” These indicators go from short-term to 30 year mortgages. Each are shown at their current level and their range for the year. Four of the ten are near their annual highs and none are more than 51 basis points away from their annual high.

Two items:
  •  Merrill Lynch’s technical people view cyclicals as being more attractive than defensive stocks. They do not see a recession near term.
  • PIMCO’s latest view is that the next economic recession is 3-5 years way.

When these two major market movers (along with most others) express their views, as a contrarian I get worried about a surprise that blindsides the majority of the thinking. I would be particularly worried if the stock market goes to another new high this year.

There is likely going to be more excitement about the opening up of the Chinese “A” share market to foreigners. WisdomTree* is warning that many stocks do not have good characteristics as investments, so be careful.
*Personally owned.

All too often professionals utilize a formulaic process rather than adjusting to the changing environment.  This leads in many cases to some bad choices.
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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 by emailing  me at AML@Lipperadvising.com

Copyright © 2008 - 2018

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