Sunday, August 26, 2018

Short & Long-Term Inputs to Successful Investing - Weekly Blog # 539

Mike Lipper’s Monday Morning Musings

Short & Long-Term Inputs to Successful Investing

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Last week may have been important to both time frames below.

Followers of the US stock market should recognize that analytically the most important news of the week was not that the Standard & Poor’s 500 rose slightly to a new peak exceeding its January top, but rather that it finally caught up with record highs for the Dow Jones Industrial Average and the NASDAQ Composite. What could be more important to short-term market performance is how equity mutual fund averages performed. Many institutionally oriented investors believe that the S&P 500 with its higher market capitalization is “the market”. However, during the week ended Thursday, the average S&P 500 Index fund underperformed most actively managed mutual funds (13 out of 20 US Diversified investment objectives, 17 out of 28 sector fund averages, and 23 out of 25 global/international fund groups). This view suggests to me that investors are becoming more selective than the capitalization weighted market. If this continues we could see a frothier market, which is characteristic of a late stage stock market.

Long-Term Better Financial Reporting
The President favors higher stock prices and not downside volatility. To him stock prices going up are an indicator of present and future growth. When prices periodically go down, he views it as short sited and an overreaction to the publication of unfavorable earnings reports. To him, if there were fewer reports there would be fewer declines. This is not supported by a review of traded markets around the world in all kinds of instruments, from real estate, to currencies, bonds, and stocks. I am delighted that most investment professionals disagree with the President’s view. One of the earliest was Lee Cooperman of Omega and like me a former president of the New York Society of Security Analysts. Later in the week my old friend Bob Pozen, a former President of Fidelity and former member of the US Government and a Professor at MIT, wrote an Op-Ed piece in The Wall Street Journal which expressed a similar view. The WSJ, on its editorial page, was also against changing to semi-annual reporting.

Nevertheless, I am pleased that the President may focus more attention on financial reporting and analysis. One of the least read documents is the SEC’s 10-Q report, which displays more complete financial statements than those in written press releases and includes the ever-exciting footnotes. Unfortunately, far too many investors look at whether sales and earnings “beat” corporately generated “guidance” or the average of publishing analysts’ estimates. Using any single standard is often wrong, as it is with one size fitting best for clothes or other decisions. To me, the way one should look at results can be broken down into three categories. What happened during the period both internally and externally that was beyond reasonable expectations? What were the results of management’s key performance indicators (KPI)?  What were the time periods that management was focusing on? And what did the balance sheet reveal about capital risk?

What Unexpectedly Happened?
Most investors are aware of headline events and expect management to be able to conduct their business appropriately. What they may not comprehend is how these events directly impact both current results and changes to internal forecasts. This is particularly important for internal events in terms of people, prices and policy changes. It is unrealistic to expect companies and their leaders to be on auto-pilot. To an important degree the future valuation of a company is tied to how it handles unexpected changes. Smart competitors already sense what the competition will do when things change, so it would not hurt a company to give some clues as to the impacts of unexpected changes to their owners.

Key Performance Indicators
Often when I start looking at a new company I try to find out what the more important KPIs are. Whether I agree as to their importance is not germane, what is important is how management thinks. All to often in a digital world the KPIs are shown as numbers in a dashboard setting. However, some of the most critical needs are qualitative assessment of people, including successors, customer development, and product & service quality. Nevertheless, a dashboard approach is useful if it can be kept to a single well-thought-out page and  should be an abstraction of what the great merchants carried around in their heads. As an example, while I like details more than most, there are a few things that I care about everyday, like the quality of reports, levels of service to clients, development of people, the schedule of new product development, and the operating cash in bank accounts. Notice, for me I was primarily focused on operations rather than the direct value of my ownership. In my analysis of some publicly traded companies, CEOs are much more concerned as to the appropriate value for their ownership and options. There is nothing wrong with that, it just addresses the appropriate time periods for investment analysis.

Time Periods for Judgment
While we all dwell on multiple time periods, we tend to manage mostly to a single time-period. There are two lists shown blow to highlight the most logical time periods to make judgements. The first is for companies and the second is for individuals. Reporting should focus on the most important time period that management is using to make their decisions:

Type of Activity              Period                                   Comments
Business Enterprise      Each Day                              # days/size of losses
Fashion Firm Season    More than one a year
Financial Groups           Economic or Market Cycle
Cycle Developers           Maturity or Final Payment

Type of Activity              Period                                     Comments
Politician                         Next election
Statesman                       Next Two Generations
CEO                                  Planned Retirement             Voluntary
Parent                               Children off family payroll

Risks to Capital
Almost all press releases exclusively discuss revenues and reported earnings, with some attention given to earnings under GAAP. Apart from very occasionally listing book value, there is no identification of capital risk. It is this very concern that the founders of modern security analysis, Graham and Dodd, were most concerned with in security selection. Today’s book value incorporates many of the items that had questionable liquidation value during the depression years. These include raw materials and work in process inventory, goodwill, and intangible assets. If one eliminates these, over values real estate at historic prices, and under depreciates capital equipment, the stated value of equity is in many cases materially reduced. These are not generally a concern in periods of expansion, which likely won’t last forever. I believe we may enter a period where costs will be driven up by cost-push inflation, with slower demand-pull price increases. Thus, margins will be under pressure and balance sheet values may be questioned. At this point in time I can not with certainty predict such a period or the diminution of balance sheet values. However, out of a concern for prudence one should be aware of that possibility. Hopefully future reporting will recognize this need and make us aware of these issues in their quarterly reports.

Questions for the week:
What periods are important to you in your investment decisions?
Do you spend any time looking at the balance sheet and cash flow statements of your investments?

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

Sunday, August 19, 2018

People Make the Difference – Weekly Blog # 538

Mike Lipper’s Monday Morning Musings

People Make the Difference – Weekly Blog # 538

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page  2018 -

Factor Investing
I have often been told that given an earnings growth rate a bright investor can tell the appropriate price/earnings ratio, leading to a prediction of the right future price of a stock. In only a slightly more complex approach there are a number of investment products or funds being offered that are driven by an identified factor or a collection of factors. As these are new vehicles they are being pitched as something brand new and superior to the traditional methods of security analysis. Investors have for a number of generations used various statistical measures as a filter to determine better than average choices for additional investment analysis.

Modern Portfolio Theory (MPT)
There is very little that is brand-new in investment analysis. Nevertheless, we periodically receive marketing messages that extoll these new methods as a better way to make money. This reminds me that a number of years ago, based on now recognized faulty academic research, we learned about Modern Portfolio Theory (MPT), which actually was not modern in identifying different rates of change in stock price momentum. MPT was identified hundreds of years ago and had very little to do with portfolio construction and management, other than stock selection. The theory before and after its publication did not regularly produce investment success, but did generate marketing success.

Better Tools for Investment Success
What then are better tools for investment success?  A continuing study of successful investors suggests that the biggest help is the analysis of people at three or more very different levels. Behavior of market participants, buyers and sellers of specific products and services, and finally important portfolio managers, which can improve investment success. In each case the study of these areas has been helpful in the past and I suspect will be so in the future.

Market Transactions
There are a group of market analysts and their followers that focus intently on stock transactions to identify recognized patterns of past movements being repeated currently. For these so-called technical analysts the key to success is the improved chance of being right. They are not interested in the known or unknown motivations of the buyers and sellers, just that their actions follow past trends. This type of analysis is more popular when there are fewer new factors or information introduced.

Looking back to Friday August 10th, the three major stock price indices - the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 and the NASDAQ Composite, all opened below the last price of the previous day and over at least the next four trading days did not bridge the price gap. Most of the time a price gap needs to be closed before the dominant trend can continue. Some of the price gap of the DJIA was probably filled last Friday, but the gaps in the S&P 500 and the NASDAQ Composite remain open. The continued existence of gaps suggests that the forward price movement for the bulk of the US stock market will be limited and will only rise through their past peak at some point in the future. 

From my vantage point, the predictability of gap filling is measured by the quality of the analysis of the market technicians.

Customer Analysis
Successful investors often place their bets on their perception of future changes. My wife and I had the pleasure of spending time this week with Ralph Wanger and his wife Monique. Ralph for many years was the portfolio manager of the very successful Acorn Fund. The fund initially invested in smaller companies that in numerous cases became mid-cap leaders. In discussing a number of his very successful investments it became clear that in addition to studying a great amount of relevant financial data, Ralph had a deep understanding of the people at various companies.

In one example, he noticed that a company’s logo had become a body tattoo, establishing a body of trust with its customers that might give the company enough time to execute a well-founded turnaround plan coming out of bankruptcy. Many sound turnaround plans take too long to reach fruition as existing and potential customers’ patience is worn out waiting for the new and improved products. In this particular case with the tattooed bodies, the present customers and the potential customers waited for a couple of years for Harley Davidson’s new and significantly improved motorcycles. Ralph recognized the potential power of the relationship that the tattoo created,  buying the needed time for recovery. He also had a similar population of patient investors in his Acorn Fund, I was one of them. A number or factor driven investors would not have participated in the stock rise, which multiplied its worth many times over.

Earlier in the week I met with the CEO of a statistically driven company experiencing some disappointing results. While not close to bankruptcy, it is in a multiple year plan to evolve with its big company clients into an enhanced relationship. They perceive, along with a number of their leading manufacturing clients, that many of them are becoming service companies. An auto manufacturer is in the after-sale service business as well as in the financial services businesses.  It is their successes in these businesses that is becoming equal to or more important than the success of their new exciting models coming off the production line. These are some of the required elements being implement in order to increase customer loyalty and market share. They are mission critical for both the manufacturer and its statistically driven suppler, for both the auto company and other companies too. I am withholding my investment judgement as to whether they will succeed in a major way, but I am looking for changes rather than extrapolations.

Need for Tolerance
At any given time the investment process produces winners and losers. I am comfortable with this result from learning basic securities analysis at the racetrack. There I learned that if you bet prudently you can walk away at the end of the day by properly selecting only a few races, varying betting procedures so that you can afford to lose more races than you win. You walk away a winner overall because the money won was larger than the money lost. I apply the same philosophy to investing, particularly with the use of mutual funds. But perhaps more important than the money earned was the knowledge acquired. When something turned out differently than expected, the key knowledge gained was the analysis of what happened. There was a growing recognition that all the actors, either on two legs or four are not perfect and can make mistakes, some surprising on the upside. The key to future racing and investment success is to learn what happens unexpectedly. This allows us to tolerate the unexpected and most importantly to tolerate our own and others’ mistakes while learning to manage our expectations.

I would be happy to discuss your expectations and suggest some things that you may wish to consider. Please contact me, as we both might gain from this learning experience. We would be glad to help with the selection and management of funds to fulfill your needs.

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

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Copyright © 2008 - 2018

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

Saturday, August 11, 2018

Get Ready for: Declines, Recoveries, and Growth – Blog # 537

Mike Lipper’s Monday Morning Musings

Get Ready for: Declines, Recoveries, and Growth – Blog # 537

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page  2018 -

One of the prior major stock market declines was signaled when the O’Hare airport authorities would not let United Airlines sell its gate positions to reduce its debt. We may be approaching a similar signal. Media reports that after 31 years of owning the management company for Oppenheimer Funds, Mass Mutual Insurance is considering putting it up for sale at around 2% of assets under management. While this may be a fair price, many professionals would treat this result as negative because it is below full bull market valuation. At the same time the much respected T. Rowe Price (*) is reducing its commitment to large-cap in favor of small caps and international on the basis of valuations. Both of these elements are good reasons to prepare for future declines, recoveries, and growth as discussed in this blog.

As a long term investor in search of other long term investors we are confident that we collectively will experience declines, recoveries and growth. So much for recorded history, but the value of history is primarily the recognition that these types of events happen. Far too many look for history to be repeated exactly, without adjusting for the dynamic changes of the past. My task is not only to understand history, but to also understand the changes that will modify future paths.

We know that declines, recoveries and growth will happen because greed and fear exaggerate the natural cyclicality of nature. Successful predictors can use this for future events or dates, but should never predict both. That is why I can envisage the three events mentioned, but I clearly don’t know when they will occur or their magnitude. However, what I can do is prepare my thinking for each of these inevitabilities.

There is no question that there will be future declines in both the stock market and the global economy, which are often related, but not always.

As with most wars there are underlying causes of critical imbalances which can be readily observed, but there are also unpredictable flash points e.g. the assassination of the Arch Duke. Populations and their governments can manage through declines reasonably safely, or they can overreact and try to correct both the imbalances and the bad actors. Based on the historical record in this country, overreactions can lengthen and deepen declines. Many of those who lost lots of money in the stock market crash” of 1929-1932 and 1937 discounted their prior gains on paper then swore they would never return to investing in stocks. They and their families missed out on participating in the benefits of the long bull markets of the 1960s and post 1980s.

Strategies and Tactics
Essentially there are two  strategic approaches: abandon or ride through. Neither works particularly well if they are followed minimally. The abandon strategy promotes a misplaced sense of safety  because it does not recognize inflation.  As long as governments spend more than they take in we will have inflation eroding currency values.

The ride through the crisis approach assumes more than a full recovery, including perhaps some inherent gains for the loss of income during the period.  Clearly, even under the best of circumstances not all commercial entities will survive, but most will. However, it may take time. One of the high flyers in the excitement of the radio era (read mobile phones or the Cloud) was the old Radio Corporation of America (RCA). The stock price of RCA did not reach its pre-depression price until the 1960s, on the back of the promise of color television. Also, many farmers lost their lands to foreclosure due to leveraged borrowing.

Few investors fully subscribe to the two strategies of abandon or stay put,  utilizing tactics that address some of the concerns and opportunities of each. Some build up cash reserves, but there are two drawbacks to that approach. Firstly, a study of mutual fund portfolios and performance suggests that unless cash reserves exceed 25% of the portfolio near the top, it will only satisfactorily cushion a typical cyclical decline of 25% or less, not a secular decline of 50% or more. The second drawback, which a study of portfolio manager behavior reveals, is that there is too much comfort in cash and these portfolio managers miss out on buying cheap bargains.

There is another approach that probably works better for long-term investors, that is to gradually move equity portfolios into more defensive stocks. These stocks are generally absent in most market commentary and are often found by examining the rosters of relatively underperforming sectors and stocks lagging near the peak of the market. To me, two of the better hunting grounds for these searches are international and dividend paying “value” stocks.

There are two long term reasons to invest internationally. First, it is a hedge against the larger domestically traded stocks/funds in your portfolio. If one looks at our rank in terms of standard of living in the US compared to other countries, we have been slipping for sometime. The main reason for the relative strength in the dollar is that we are living in a period where almost every other country has threatening dissident groups, whereas our currency is perceived as safer than others.

Using mutual fund performance averages based on their investment objectives, of the 18 global and international fund objectives versus their US focused peers, only in real estate is the foreign fund better. I suspect that at least half the performance superiority in the first seven months of 2018 is the direct impact of the strength of the US dollar, which is unlikely to continue forever.

In many ways the more hopeful and sounder reason is that selectively there are many more opportunities outside the US than in it. There are world leading companies beyond our borders in technology and natural resources. Occasionally these stocks are priced more attractively and their younger populations create an attractive market opportunity. Educational standards and wealth are rising both in Asia and Africa, which should be fertile for investments long term. Thus for defensive (hedging) and aggressive (demographic) reasons, investing internationally makes sense, particularly if one uses select funds for administrative and liquidity reasons.

In utilizing value for diversification purposes I am excluding “deep value”, which requires corporate actions, mostly mergers or acquisitions (M&A) to work out. Most M&A occurs during expansionist periods, not declines, so it may not provide much downside protection. For diversification purposes, the ideal value stock must have a history of paying dividends with an average payout ratio of about 50%- 75%, with a history of raising the dividend rate at least as much as recognized inflation. “Trust quality” or above BBB credit rating would also be good. Some strong institutional ownership would be a plus, as would a reasonably liquid stock. Some and all of these characteristics are found in average in some mutual fund portfolios.

Recovery Candidates
Product or service providers that are likely to be considered essential in the future include those that have sufficient management depth beyond the CEO to be the next generation of sound leadership. Also attractive are those companies that have surplus borrowing power to take advantage of product and corporate opportunities which may occur in troubled times.

Growth Candidates
Growing target markets rather than growth in market share is an important growth criteria. A multi-generational attitude also helps in the selection for legacy investment accounts. Sufficient internal research & development open to external sources would be best.

Fund/Manager Selection Tips
If the bulk of one’s assets and dreams are tied up in one asset, diversification should lean toward a couple of portfolios with a reasonably large number of securities, with the portfolios different in investment style. For the asset owner that is more liquid,  a portfolio of concentrated funds that complement each other rather than compete for attention is preferable.

We would be glad to help with the selection and management of funds to fulfill your needs.

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

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Copyright © 2008 - 2018

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

Sunday, August 5, 2018

Apple’s $1 Trillion Lesson and Benefits - Weekly Blog # 536

Mike Lipper’s Monday Morning Musings Blog

Editors:Frank Harrison,1997-2018,Hylton Phillips-Page, 2018

Lesson for All Investors
The biggest benefit to all stock investors is what the piercing of the $1 trillion level didn’t do! Often such a press event generates a follow through.  That the Apple $1 trillion event did not immediately trigger a speculative surge probably means that there is more time until the top, which is often the result of a great amount of speculation.

In a speculative surge one can imagine commentary on the next one to five companies reaching that level, or when Apple (*) reaches $2 Trillion. These types of comments generally lead to a speculative surge, causing the next stock market decline. The absence of large scale speculation suggests that the next decline will likely be one that’s more cyclical in nature, about 25%. If on the other hand we are cursed with a speculative surge sucking in more of the public as well as undisciplined institutions, it may lead to losses of half the invested capital. As bad as that would be, what would be worse for the economy and society would be a wave of punishing regulation and legislation, because that would curtail the eventual recovery and the return to a growing economy. Thus, the biggest benefit is that with less than a catastrophic decline, we can hold for the longer term and subsequent market recoveries.

(*) I have been a long-term investor in Apple for personal accounts

Investment Executive Wake-Up Call
Contrary to what many believe, Apple is not primarily a cell phone company. It is a champion supply chain manager. Also, it is a marketing channel leader, a capital-lite massive capital generator, and a post-integrator. Post-integrator refers to organizing activities that are not primarily integrated along horizontal or vertical business lines. Other companies have done one or more of these things, but Apple has become the poster case for doing these things differently in the new world of stock investing and political management.

In the 1950s we learned in college about integration, not so much racial integration, but business structure integration. Corporate leaders were vertically integrated by building all the critical inputs to their product lines or horizontally integrated by selling everything essential to the customer. I remember being a guest in a few corporate dining rooms where my hosts were very proud of their internally produced ice cream (an insurance company), or a prized omelet chef (a brokerage house). The executive dinning rooms were believed to be a source of competitive strength.

As a junior securities analyst I was assigned to follow the eight major steel companies using only annual reports and brokerage reports. I found that each of the companies was reporting differently from each other. I also learned the major differences between the largest steel companies and the next tier was their degree of integration. The largest steel producer was also the world's largest cement producer, which had its own transportation system and produced a good bit of the electrical power it consumed. When it needed to get additional capital, the chief financial officer walked across the street from their financial office in Manhattan to a Wall Street investment or commercial bank to get the money. (This was the same pattern for the world's largest auto producer, as well as for the world's leading oil company.)

Contrast this with the $1 Trillion Apple (*) of today. While not completely like Nike, which has no manufacturing efforts, Apple makes very few of the components used in its products in its own factories. Its factories are essentially the final assemblers of the completed products, with sub-assembly work done by others. This is the supply chain task that Steve Jobs assigned to Tim Cook, who built the modern global Apple. In so doing the company transcended governmental and cultural borders. Thus, national political leaders have been out-flanked, and taxes and other trade barriers have become multi-national competitive fields of play.

To some degree the competitive advantage that Apple has developed is channel management, with intense focus on the level of completed product inventory, for what is probably the world’s largest grossing store change. Interestingly, Apple built the stores at the very time that large department store chains were closing unproductive stores. There is a major difference in Apple stores, both from the general department store and the stores of other mobile phone manufacturers. The difference is the sales floor and the sales force. Not only is the sales force knowledgeable and caring, but they reflect similar demographics as their expected customer base. The network of Apple stores in most major cities of the world supports both the local market and travelers with some critical in-person tech support, which is most appreciated by the traveling and spending population.

Apple’s profit margins and their low but growing dividend payout produces a prodigious amount of excess capital, which means that the company is not dependent on Warren Buffett, as he’s mentioned, and most of Wall Street.

The $1 Trillion lesson for the directors of research of investment groups is that they have been assigning the wrong analysts to follow Apple. They have had primarily technology analysts follow the stock. These analysts have focused on the technical specifications of Apple’s products relative to other manufacturers. What they’ve found is that current Apple specifications are not as impressive as others, but they charge more. Thus, they join the large number of professional Apple haters that have been successful in creating periods when Apple’s stock price has declined absolutely and relative to competitors.

What the technology analysts miss is that Apple customers will pay a premium price for products and services that effectively communicate with them. Customers want solutions to their problems. Some of these problems are new to the customers but address important needs. If I were running a major securities research effort I would assign Apple to a team of fashion retail analysts, bank analysts, demographers, and field analysts covering the use of office supplies. This approach would have identified Apple’s strengths sooner than those focusing on technical statistics.

The future is unlikely to be an extrapolation of the past, thus different analytical and investment approaches will be needed to survive and prosper.  In the future we will be presented with various opportunities and risks.

Indirect Apple Winners
The second largest equity owner of Apple shares is Berkshire Hathaway (**), which probably owns close to $50 Billion of the stock. The company announced its second quarter earnings on Saturday. From a long term investor's standpoint, while it was nice that the company’s investments rose, including their derivative positions, it is much more important to investors that the operating earnings rose beyond the lower income taxes paid. Casualty insurance operations recovered largely through an increase in the premiums generated. In addition, the railroad gained as there was more freight moved, and earnings from utilities rose because more capacity was brought on line.  In brief, Berkshire’s results reinforce other data that US business is getting better and the reduction in income taxes at almost all levels helped.

(**) I have been a long-term investor in Berkshire Hathaway for personal accounts

The careful investor should always look at what could go wrong. This could possibly be summed up in one word, CHINA. A good bit of the freight being moved on the railroad is to and from China. If the level of threatened trade with China is not replaced, earnings could fall. The US stock market is beginning to worry about that. Five out of the ten worst performing mutual funds this week, as published in Barron’s, were primarily invested in China.

Investors can learn a lot by studying two of the most successful companies in the world as they focus on the future.

Due to travel schedules during the next two weeks, blogs may be delayed in reaching you

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

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.