We Are in a Training Exercise - Weekly Blog # 548

Mike Lipper’s Monday Morning Musings

We Are in a Training Exercise

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

         

We are Never too Old or too Rich Not to Learn
After almost ten years of a one-way domestic stock market we are experiencing some discomfort. Fixed income markets have been falling for some time and most commodities and currencies, ex the US dollar, are in bear markets. One might say that many investors in the US stock market over the last ten years have learned little and forgotten much.

Some of the realities we have forgotten:

1. Change is always present, but it becomes noticeable at different rates and times. From a portfolio standpoint, the time of maximum risk is often when each position is profitable.  The current prices of many positions are two to one hundred times their original cost. The danger herein lies in the belief that the size of these gains is permanent. Any detailed study of wealth over the years will show that it fluctuates and the only way to lose a lot money is to make a lot before one loses some or all.

One way to see the power of change is to examine the ten largest market capitalization companies in a series of ten-year intervals,1998-2008-2018. (See the footnote as to why the three periods were selected.) Only Microsoft and Exxon made the list in all three periods. Thus, there was an 80% failure to maintain relative market capitalization. One might say that any long-term investor who does not own these two for the next ten or twenty years is betting that they don’t survive at the top of the relative peak in market cap.

2. Perhaps, the most creative part of human nature is the ability to circumnavigate around an accepted standard. At one point in financial history the most important measure was yield, which was replaced with book value, which gave way to size and then to earnings per share. Now it is non-GAAP earnings. Usually, sellers of securities favor the old popular measure, where buyers prefer a newer version. Because of changes in accounting standards, tax rates, and regulations, private equity participants often use EBITDA (Earnings Before Interest, Depreciation, and Amortization). I prefer operating earnings adjusted for debt service. The one thing I am confident of is that in ten years the transaction price battle between buyers and sellers will utilize other analytical measures. The art of selling well and buying wisely demands nothing less.

3. One of the most valuable lessons that Charlie Munger taught Warren Buffett was that it was better to buy a good company than a good business. With the cycle of disrupting the old and replacing it with the new, there is a risk of buying into a copycat model based on the financial ratios of some currently successful company or venture. At one point there were some 300 US automotive companies, semiconductor manufacturers, restaurants, banks, insurance companies, and universities. According to Mr. Buffett, a good business is one that any fool could run and often does.

Defining a good company is not a mathematical or a historic exercise. The focus of the search is not on the “C” suite exclusively, it’s on the bulk of the people. Can they do the next important job? Do they have the trust of their clients and suppliers? Will they generate many of the new ideas and procedures that make both large and small differences. While too many annual reports state that their employees are their best asset, some do make that condition happen.

4. Market price liquidity is not important until it becomes critical. Most of the time price sensitive buyers and sellers keep prices and the spreads between them in check. During periods of stress the urgent price insensitive buyer or seller dominates the market and is a heavy user of the liquidity pool. As their insistent need to trade uses up much of the present liquidity, it frightens away some potential liquidity providers, leading to both greater than normal dispersion of prices and spreads between bid and offer levels. Often the price insensitive player is motivated by a need to meet an obligation. This could be an Authorized Participant or a Market-Maker keeping his book in balance. The biggest destabilizer is an owner meeting an immediate margin call.

There are some that say the unusually severe drop in the Chinese “A” share market was caused by the government’s concern about the quantity of  debt in China. They put pressure on the four major government-controlled banks to reduce the size of their loans. They in-turn called part or all of the loans to various entrepreneurs who pledged shares in their company. To meet the call they liquidated enough of their holdings to meet the banks’ demands.

Maybe one of the reasons  many NASDAQ stocks with good earnings and prospects fell more than other stocks is that large portions of their shares were owned by hedge funds, private equity funds, and senior employees who were meeting margin calls. This is the kind of market action that has been periodically happening ever since there have been collateralized loans.

At times, the size of the liquidity pool is more sensitive to sudden changes in sentiment than financial and economic numbers. Periodically, changes in political trends can cause driven investors and speculators to become price insensitive, causing liquidity providers to reduce their commitments or retire from the game.

Perhaps investors have learned enough from last week’s training exercise. Enough to know that when the real market reversal comes they will recognize what to do, before, during, and after a future “big one”. I hope so.

Footnote
2018 is ten years from the last major market decline and 31 years from the biggest single day decline, which was much more a market phenomenon than an economic one.

2008 was the first year of the great financial crises. This was the result of excess leverage by the private sector in response to a series of governments attempts to postpone a crisis in the economy, although they made future crises worse.

1998 was the year I sold the operating assets of Lipper Analytical to Reuters Group Ltd. It was a good company because we had good people who were dedicated to helping both our direct and indirect clients. 


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A. Michael Lipper, CFA
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Committing Reserves - Weekly Blog # 547

Mike Lipper’s Monday Morning Musings

Committing Reserves

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

Any student of military history will be presented with the reasons why important battles were won and lost. Often the critical decision was when and how reserves were committed, both in defensive and offensive phases. The same thing can be said for managing portfolios. The standard battle structure used by the US Marines for maneuver units is, two up and one back, plus support units. On offense, reserves are committed to replace the tiring front line units so that fresh troops can pick up the pace of an attack. On defense, if the front line forces are pushed back, troops held in reserve are committed to stop the breakthrough, where enemy's troops are expected to be tired and somewhat disorganized. The keys to committing reserves are the factors of time, surprise, and location.

Applying these military lessons to portfolio management, the following principles come to mind:

1. Reserves need to be of sufficient size to maintain or regain the momentum. The two up and one back suggests that reserves should be in the range of 1/3 of the active forces.
2. Reserves should not be committed piecemeal, as they lack sufficient force to accomplish the main objective.
3. Reserves should not be committed too early, suggesting a 25% decline from the prior peak might give sufficient space to pick up bargains.
4. After committing reserves, be prepared to assign additional assets in order to preserve critical resources.

Husbanding Reserves
This week both Goldman Sachs and Morgan Stanley reported unexpectedly good earnings, which the market treated positively. In carefully reading their release and listening to their conference calls, there were some cautionary notes. Both are watching very closely for any weakness in their credit extensions.

Awaiting Direction
Along with other money managers, flows were slower than earlier periods. Modest earnings gains are expected by various analysts. The biggest gains are expected for the Russell 2000, which may be influencing the proportion of firms becoming profitable.

The average Large-Cap growth fund is up +9.09% YTD and +12.72% for five years, with both exceeding the average S&P 500 Index Fund performance of +4.78% and +11.52% respectively. The period of superior performance for index funds may be over for a while.

Major Commitment
Finally, on Thursday there was the announcement of Mass Mutual selling Oppenheimer Funds to Invesco for approximately $5.7 Billion, largely in stock.

In looking at the price, there are two interesting points. First, the rumored price was $5 billion in cash. This is roughly equivalent to $5.7 Billion in stock, in my opinion. Second, the seller wanted to stay invested in the mutual fund business. I view both as a vote of confidence in the business. Invesco has good distribution capabilities in Europe and Asia, which may be effective in selling the Oppenheimer Funds.

 Mass Mutual as a knowledgeable seller becomes the largest shareholder in the combined company and obtains a board position. They like the outlook for the business but probably don’t like the outlook for Oppenheimer’s retail fund operation. Mass Mutual has retained their ownership of Barings, an institutional player.

My clients and I own positions in a number of their domestic and international fund management companies.

Prudential Needs Smaller Reserves
Prudential Insurance is no longer labeled as a SIFI (Strategically Important Financial Institution) It did not have to contort itself as Metropolitan Life did to shed the title, it just had to be more patient and work Washington well.

Risk Management, not a Perfect Defense
Risk appears to be singular but in reality it encompasses a number of known and unknown risks. This multiplicity of risks makes it difficult to model as a single risk factor. This is particularly true due to a growing list of unknown risks. Thus, there is no such thing as a riskless investment.

Some Portfolio Managers Reduce Market Risks
The following brief comments are derived from reading the quarterly institutional reports from T. Rowe Price and Wasatch Funds, that we and our clients own. They are derived  from portfolio managers who also look at broader issues that may be of interest to our subscribers.

1. In the third quarter and continuing into the fourth quarter, security valuations didn’t seem to matter much. High Price/Earnings ratio stocks outperformed those with lower Price/Earnings ratios.
2. Investors remain complacent to the potential of future shocks.
3. A number of portfolio managers are pruning their portfolios by selling into strength.
4. At least one perceptive portfolio manager is taking advantage of the fall in Chinese stocks prices by broadening and deepening her commitment to non-tech Chinese stocks.
5. Concern for the housing outlook favors beneficiaries of short-term and longer-term lower commodity-priced inputs.
6. Trimming some Software-as-a-Service stocks.

In our private financial services fund I personally own shares in the publicly traded T. Rowe Price stock.



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Learn from the Blame Game - Weekly Blog # 546

Mike Lipper’s Monday Morning Musings

Learn from the Blame Game

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

As is often the case, media and politicians look to blame "the guilty" for any perceived negative event. Clearly an 1100 point drop in the Dow Jones Industrial Average (DJIA) on Wednesday and Thursday was caused by bad people and their bad actions. Thus, when the bad people are found and punished for their bad actions we will avoid future problems.

Except, that means we have learned nothing from the event that will help us avoid similar problems in the future. Those who believe that only evil forces created the problem forget the only true rule of market places: The production of Humility is the only guaranteed result in the market place.

Contributing Factors 
We should have been more aware of the implications of structural changes in the fixed income, equities, and currency markets. These were regulatory changes designed to prevent the public from a government bailout of collapsing major financial institutions, while also lowering transaction costs.

1. Major Commercial and Investment Banks were required to increase their capital buffers and restrict portions of their trading and market making functions. This had twin impacts. First, liquidity was reduced in all tradeable markets, particularly in the fixed income and currency markets. Second, as this was quite profitable in most periods, it reduced the earnings power of these institutions. Thus, some market risk was shifted from the market making institutions onto the backs of investors, creating more intra-day volatility and price gaps between trades. 
2. One of the big differences between the price patterns of stocks on the listed stock exchanges and those traded over-the-counter on NASDAQ was that on the listed exchanges there was a positive responsibility on the part of the floor specialists to maintain orderly markets (In the 1987 fall at least one specialist took this obligation seriously and went broke trying to maintain an orderly market in a steep decline). As an offset to the risks involved in maintaining an orderly market, the specialist had a material information advantage to keep the book registering incoming orders. Thus, most of the time Specialists were quite profitable. Some viewed these profits as being taken from investors in higher transaction costs. To my mind, the forgone profits were worthwhile as payment for liquidity. The SEC believed this was an unfair advantage and pressured the New York Stock Exchange to effectively eliminate the Specialists. Not surprisingly, investors paid the price for the drastically out of balance pressure on non-price sensitive sales compared to those gotten by reluctant buyers last Wednesday and Thursday. We should have expected this. 
3. Daily transactions in Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) are mostly done institutionally by managed accounts and professional traders. During the trading day these players use ETFs and particularly ETNs as part of complex transactions to offset other securities. At the end of the trading day they need to balance their positions, and with the known end of exchange trading they become even less price sensitive. Thus, the last twenty minutes of trading often encompasses the biggest price swings of the day. 
4. Most of the pundits have focused on the rise of interest rates, which have been telegraphed for some time. I believe that there were two other partially related things happening. First, the rising budget deficits expected in the US, Italy and elsewhere will create more government paper, crowding out some commercial needs and driving interest rates higher. Second, credit conditions could be peaking as the faster than expected economic expansion slows. There are signs of this with Sears and various other companies in Europe. Thus, in my opinion the issue is not primarily interest rates, but the future availability of credit capital. 
5. One of nice things about a command economy is that it may be easier to control than a multi-party led one. The central government of China is concerned about the amount of debt that has been produced in their country. It is well known that they have instructed their government-controlled banks and affiliates to cut back on debt extensions. This is not new. One of the ways the government-controlled banks reacted was to have Asset Management Companies (AMCs) take over their distressed loans. The AMCs raised a lot of capital through the Hong Kong markets and those domiciled in offshore locations. This high rate paper was purchased by what may be called "yield hogs" throughout the world. One suspects that some of these loans won't be paid back on time and in the full amount. 
6. For tax purposes, the US mutual fund year is over in October. Many equity funds in net redemption have sold some of their high-priced holdings to meet cash demands. To reduce their shareholders’ taxes, some are selling their losing positions into a declining market.

Working Conclusions:
We have experienced a somewhat normal cyclical contraction that delays normal secular growth patterns. All of the contributing factors were known for some time and thus if investors were surprised by the recent decline they are the "guilty parties" for lack of sufficient risk awareness.

In the latest American Association of Individual Investors (AAII) weekly sample survey, bullish investors dropped to 30.6% from 45.7% the prior week. One can envision the most volatile group going overboard with concern for the next six months. While no indicator has a perfect score on predictability over time, those that are wrong more often than they are right are more predictable. The AAII summary is a well-established negative (reversed) indicator.

This up and down movement lends itself well to adopting a timespan approach. I would be happy to discuss how to use this approach with a limited number of subscribers, tailored to your own needs.


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Searching for and Suffering Great Funds - Weekly Blog # 545

Mike Lipper’s Monday Morning Musings

Searching for and Suffering Great Funds

Tied to Columbus Day Image Control

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

My Perspective
Commercially for the most part, I manage mutual fund only long-term accounts for both institutions and wealthy individuals. In general, I and my associate Hylton Phillips-Page attempt to construct equity portfolios that contain Good Funds and Great Funds. The dividing line between the two is the long-term fear and greed ratio. In some cases this can be translated into the tolerance for embarrassment. To paraphrase what Warren Buffett has said, he would prefer an investment whose path is an uneven compound growth of 12 % over a more even 10%.

Our Three Bucket Tasks
Exercising experience, judgement, and a lot of performance and portfolio data, we divide the fund universe into three buckets.

• The first bucket are possible candidates for the great fund managers, which is a small group. 

• The second bucket are the good funds that most of the time produce satisfactory results. 

• The third and largest bucket are the other funds, which should be studied to identify characteristics to be avoided. These observations require long records to be reviewed and entail visits to managers, their staff, competitors, and clients.

Numbers Filters
Analyze the fund’s record under the same portfolio manager, pretty much the same staff, senior management, and the same investment and commercial goals. Some minor adjustments can be made, but if there are too many we need to begin the analysis at the point where these inputs are reasonably stable. Thus, a stable universe is created.

The next step is to compare the manager’s relative quarterly performance quintile among the appropriate peer group over 40 quarters. A good manager’s performance will be in the mid quintile and the next highest performance quintile between 24 and 30 times during the 40 quarters. In the remaining quarters the preponderance of the quarters should favor the top quintile over the bottom quintile.

Great managers will spend most of their time in the best quintile. However, the second most likely placement will be in the bottom quintile. Those quarters need to be examined carefully. Great managers are often out of phase with the current market and give up current market opportunity for capital preservation. Thus, the worst quintile performance is often a small absolute gain or loss. Large losses need special explanation. It would help if a bad quarter is followed by a top quintile performance.

The Human Filter
Investments are an art form based on a mix of personalities operating at the same time. Too often investors treat the short hand of numbers as reality. The interaction of the various personalities throughout the ecosystem of the fund drives the results. In discussions with the various participants, total intellectual honesty should not be expected. I have learned to group responses into categories in order to build a more complete picture from the various fragments. The following is an example of this approach:

Good Fund Managers limit their cash to 5-10% of assets and are politically sensitive in their organizations to clients. They try to avoid excess volatility and are often top-down thinkers, motivated by the long-term prospects of promotion translated into money.

Great Managers will use cash as a residual, primarily when they can’t find attractive holdings. Thus, cash holdings in extreme cases could rise to 50%. They are very individualistic in many of the things they do. They will occupy the best and worst quintiles more frequently than the more controlled good managers. Great managers are very bottoms-up and are detail oriented in their thinking. Their preferred time-period is a lifetime, but they will sell when disappointed. These are “rare ducks” who are quite introspective and may not provide the best interviews. Rarely will they enter crowded stocks and are contrarian by nature. They are hard-working and would probably fit in with the current Chinese work effort of 12-hour days, six days a week. When focused, they are good observers of people and consumer trends. They feel deeply when they make mistakes and try to learn from them, even though they often repeat the same types of mistakes. When they are early into a stock they can hold the position for a long period of time. These can produce what Peter Lynch called “ten baggers”, or gains of ten times or more the original investment.

Image Control/ Columbus Day Perspective
Most successful professional investors are by nature private people and don’t like to discuss their current investment thinking. Several r of them overcome their shyness, driven by commercial needs, to bring new money under their management. Often, others have the responsibility to use the successful investor’s record and skills to make them both rich. One of the fears of the successful manager is that the public relations machine will exaggerate the investor’s accomplishment.

Monday in the US we have a national holiday, Columbus Day, to celebrate the popular view of his discovery of America. In truth, he never landed on the North American continent. Prior to his voyage, at least two other explorers landed here. Nevertheless, there are aspects of his life that some of the Great Managers have paralleled in their own careers. These are:

1. A man of great conviction [right in concept and wrong in details]
2. Could not raise the money for the exploration at home and went abroad to Spain.
3. Leveraged the Queens’ jewels to get the needed cash.
4. Diversified risks by having three ships, tow returned.
5. Lost control of the theme upon completion of his successful voyage.
6. His discovery was an excuse for US politicians to grant an important urban political group of union workers a national holiday. No similar holiday exists in either Spain or Italy.

Thus, an investor’s success becomes a commercial vehicle for the greater success of others.

Where to Hunt?
As every single day is a day to think about the search for great managers, what does last week possibly signal?

1. For the week, six of the seven biggest market performance leaders tracked commodities. 
2. Five of the seven worst performers were stock indices.
3. While most funds declined, there were some winners that gained more than 1% for the week - Base Metals Funds, Agricultural Commodity Funds, Precious Metals (Gold) Funds, Natural Resources and Energy Funds. DOES THIS MEAN THAT THE MARKET IS MORE CONCERNED ABOUT INFLATION THAN GROWTH?
4. Longer-term targets of future opportunity: Longevity Care and Management, Food allocations, Disruptions to come from AI/VR, TIPS.

Conclusions:

• The world is changing in both identifiable and unidentifiable ways.

• Good equity managers perform credibly well most of the time.

• The rare great managers will find ways to make a lot of money, but it won’t be a comfortable ride unless one builds that likelihood into ones’ expectations.

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.