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.
Short-Term
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:
Business
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
Personal
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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