Excessive Security Risks - Weekly Blog # 561

Mike Lipper’s Monday Morning Musings

Excessive Security Risks

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

                                                               

This last week may possibly have been part of a third correction. After 2017 where there was not a single trading day the market moved 3% either way, 2018 had fifteen such days and finished slightly down. The first correction experienced frequent and rapid sentiment change. The second started after the bottom reached on Christmas Eve and finished after the first full trading week in January, with equity gains in the middle single digits recovering a third to half of the 2018 losses. The third correction was a materially smaller gain last week. For the week ended Thursday, the average US Diversified Equity Fund gained 6.5% for the year to date period.

Investors and particularly investment managers, should always be learning from the present to aid in their thinking regarding their long-term responsibilities to their beneficiaries. (We are all temporary renters of our talents and other assets.) One way to look at the current level of the market is to assume a lower rate of return on risk, be it an investment in stocks, bonds, commodities, and real estate. This somewhat pessimistic view suggests that for retirement and other long-term future payments, the old assumption that equities will continue to appreciate at 9%-10%, as they have since 1926, may not continue. This belief has led to an institutional stock/bond ratio of 60% in stocks and 40% in fixed income. Actuaries in turn assumed a combined return of 7-8% for pension funds, led by the gains in stocks. During this lengthy period, we experienced several deep market declines, wars, and periods of high interest rates, all of which may have been necessary to set-up the subsequent gains that propelled the overall stock gains into the 9-10% range. Although I do not rule out these kinds of wide swings, I do not feel justified in including them into a planning norm. I am considering a different model that looks to the last five years as a better representation of the next five years. In the five years through last Thursday, the average US Diversified Equity (Mutual) Fund gained +6.16%. Future fixed income returns are expected to be lower because we have lower interest rates than in the historic past. Credit losses could drive rates materially higher, which would not be good for stocks.

A Bigger Risk: Seeking Security
For a professional investor, I have often felt that their stomach was a better guide to turning points than their brains! First, it is important to understand how the brain works. Based on conversations with the neuro-economics professors at Caltech, our memory system works on chains. We attach a single thought to an existing chain if it is important to be remembered. We need to find patterns, even in a pattern less world, in order to reduce anxiety. Most of the time, what we believe to be judgement is pattern recognition. Second, the mark of a professional is the willingness to doubt and make mistakes. After all, the experienced investor and hiker know that “no man steps into the same river twice”.

The messages from a professional’s stomach are involuntary. They come from self-experience or observation of others. They send a message of caution not to be greedy when prices are going well, contrary to the brain’s enjoyment of compounding winnings. The other life-long message is the disbelief in absolutes. After the emotional rollercoaster ride of the last eighteen months they instinctively don’t believe in absolute security. They have seen unfortunate surprise endings to securities, firms, jobs, marriages, and lives. Retreating to cash or cash equivalents can be subject to both regulatory changes and inflation. After eight years of gaining assets, an ETF closed due to redemptions (96 months of net sales vs. 1 month of net redemptions.)

What to Do?
Risk was one of the lessons I tried to impart to a board of a liberal arts college attempting to aid enrollment by adding business courses. The presenting professor said he was going to teach about risk avoidance. I suggested he got it all wrong and pointed out that we cannot avoid risk. He should instead focus on risk assumption, with a focus on unintended and unavoidable risks. For our clients we try to move from risk avoidance to recognizing the risks assumed. Taking appropriate measures to reduce the overall risks is an art form, not a science. The single most important risk management goal is to protect future payments on specific future dates.

The second tool in risk management is to understand the leverage that is already being applied to your investments, directly or indirectly. Stock, bond and commodity prices are leveraged by some investors with margin loans. These currently total $554 Billion according to FINRA. This does not include “non-purpose” loans used to support non-securities purchases, which are often used as a cheaper substitute for mortgages. Also not included are corporate loans to employees for the purchase of their own stock, or in some cases relocation benefits. Most of these could be called instantly, forcing the liquidation of all or part of the stock position. We have reason to believe that many Chinese CEOs have had their loans liquidated by selling out their position. In addition, there is operating leverage when operating earnings move more than operating revenues, due in part to corporate borrowing.

One new point of leverage is the delay of deliveries caused by bottlenecks both in the US and China, which stretch critical supply chains and lead to squeezed profit margins.

From a portfolio of funds viewpoint I am looking at some funds differently. We’ve always looked for funds which gained more than the market and average competition on the upside and lost less on the downside. Often that meant we wound up with more volatile funds than some of our clients would like. Recently, I have been paying more attention to funds that go up and down less than peers. What attracts me is higher capture of the up markets than down markets. In one case the fund’s upside capture rate was 72% and downside 62%. This could be a good lower risk addition to a pension type account that is looking at a minimum five-year time span for the portfolio. If the next five years is close to normal and has only one or two down years, this fund will meet their reasonable actuarial standard.

Question of the week: 
Can you meet your obligations over the next five years with a 6% equity return? 
     

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html


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Copyright © 2008 - 2018
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Completion Analysis: Fuller Picture - Weekly Blog # 560

Mike Lipper’s Monday Morning Musings

Completion Analysis: Fuller Picture 

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

                                                 

One of the first things I learned as an analyst selling sell-side research conclusions to a skeptical institutional audience were the negatives to my view point, or at least the contrary facts. Often when I thought I had a sound point of view I would arrange a week of visiting mutual funds and other institutions in Boston. In many respects this was an intensive course in the analysis of both more facts to consider, including the points of view of more knowledgeable analysts from the vantage points of their portfolios. By the end of the week I had a much fuller understanding of my own views. Further, I made up my mind that I should not consider a sales pitch until I was familiar with the opposite point of view. Thus, for me and those who eventually worked with me I insisted on learning and using a more complete picture, or as complete an analysis as possible.

With that as an introduction, this blog will discuss the other side of two very popular items in the popular and professional press, Saint Jack Bogle and the celebration of high return on equity and operating profit margin.

“Saint Jack”

Jack’s high intelligence and high intensity appealed to the CEO of Wellington Management, then located in Philadelphia. At that time Wellington was a load fund group relying on good wholesalers to convince retail brokers to sell the Wellington Fund and its new and much smaller, all equity and value focused, Windsor Fund (managed by the great John Neff). Walter Morgan decided it was politically smarter to name Jack president, rather than one of the competing sales people. At that time fund buyers were more interested in investment performance than the relative safety of the Wellington balanced fund, which was losing market share in the fund business. Jack trusted numbers more than people. He was taken in by the advocates of Modern Portfolio Theory (MPT), which in truth was not modern, not a portfolio theory. Nevertheless, Jack had urged the SEC to require alpha and beta numbers to be required in fund prospectuses. Luckily, even with the endorsement of the CFA Institute, the SEC, some recognized that these numbers were history and might be used to make poor decisions. Jack was determined to get Wellington moving again.

Accelerating growth was the rage at the time and Jack engineered a deal with a Boston manager of growth funds. The deal gave the acquired control of the merged company in a ten-year voting trust. I was visiting Jack either on the day the announcement was published or very soon thereafter. He was pleased with the deal. I cautioned that he might have lost his company. Thus, I was not surprised when he was removed. (By the way, this follows a long tradition of an antipathy between Boston and Philadelphia, since the American Revolution.)

Jack was always resourceful, from his scholarship days at Blair Academy through Princeton. He recognized that while he had lost control of the investment advisor, the independent directors of the mutual funds remained his friends. He convinced them they should internalize the operation, like many closed end funds in the US and Investment Trusts in the UK. The idea of investing in a passive market vehicle was not new. Since at least the 1940s, the Founders Mutual Depositors Fund had been a UIT invested in the 40 largest companies in the Fortune 500. I believe there were several UK Investment Trusts that had similar strategies.

What particularly appealed to Jack was that by going no-load he was materially reducing the power and presence of the sales people. He had the view that they were just a bothersome expense. There was never a study done as to the value of the sales people. (Having known many of them over the years, I suspect some were good and provided both good advice and service to investors.) Jack was a very good student of the mutual fund industry and what he saw as a benefit for Vanguard was the difference in Total Expense Ratio (TER) between an index fund and an actively managed fund. While a lower fee was a plus, what probably aided performance more was that index funds were fully invested in the market and did not have a built-in redemption reserve. Most active funds have up to 5% in cash to meet redemptions and opportunities. By getting these reserves committed, all of the investment was working for them in rising markets. When markets went down, which happens a minority of the time, active managers holding cash can outperform. This advantage also persists in the early phase of recoveries. For example, the average S&P 500 index fund was up +5.22% in the first 17 days of 2019, compared to the average US Diversified Equity fund which gained +6.22%. There were other advantages for index funds, the first is that when dealing in size active funds may have knowledge of something of upcoming importance. To protect themselves the dealers who were providing liquidity to these funds, wanted a wider spread in their favor. Index funds convinced the marketplace that their trades were without information value and that there was no need for a wider spread. There were also administrative expense savings possible.

While this numbers-oriented pitch would have appealed to Jack, there were some sales aids that were also of great help. The first is that New York State in the 1940s permitted the Teachers Investment Annuity Association (TIAA) to sell the College Retirement Equity Fund (CREF) to college professors. For many years the bulk of CREF was indexed. Many Professors had proven to themselves that they were poor investors and therefore didn’t trust the market. When Vanguard’s group of institutional sales people discovered this, they had found a fertile field of investors at both educational institutions and foundations. The benefits of indexing were taught at lots of schools, without giving a fuller understanding of investing or indexing. Many of today’s media pundits were educated in these incomplete classes.

In summary, I have great respect for Saint Jack, the mutual fund business’s Don Quixote. He brought a number of important issues forward, but his motivation was not as pure as is being memorialized. We do use index funds within our managed accounts when we can not find better actively managed funds at a reasonable cost.

High Number Celebrations

We are probably at the crest of the current economic expansion. As has happened in the past, markets can decline while the general economy remains in expansion. However, one of the functions of a prudent investor and manager is to be on the watch for signs of trouble ahead. During this season of reading annual reports and conference call pep-talks, one should be looking into the celebration of big numbers. As an analyst I pay little attention to reported earnings, as they have been adjusted by favorable accounting moves or management’s focus on what is working now and avoiding what is not, which is more difficult to spot. While I look at many ratios, the three that are the most important to me are return on equity (ROE), operating profit-margin, and net cash generation after debt service.

This season I am seeing record results reported for ROE. In one case, a net interest earner reported average ROE at an annualized 20%. This is being created by shifting client assets into more favorable earnings for the organization and there isn’t a great deal more to go. The 20% number reminded me that before the Bogle impact and other structural changes, members of the NYSE could attract general and limited partners based on a 25% return on partner’s balances. These firms were not particularly special in terms of skills so I declined to join them, which saved me from several failing firms. 

One of the lessons coming from a recent experience with Apple (*) is the danger of showing high profit margins based on high prices. In effect, Apple is holding out an umbrella over competitors in order to use price competition to successfully take market share at lower levels of profitability. Apparently, investors are expecting revenues to grow slower than they were in 2018, but sufficiently enough to be acceptable. I wonder whether a 1% slower revenue growth will lead to a 1% decline in either profit-margin or ROE. Instead of 1%, a 3% or 5% revenue decline will have a more serious impact on the ratios, as operating leverage works both ways.

After four favorable weeks of US stock market performance we could be slowing down in the recovery, even if the three major stock indices appear to have gotten over their 65-day moving average. I continue to wonder, even with bouts of enthusiasm in between, whether 2019’s average performance results will be in single digits, similar to their first full week’s performance. By the way, the AAII sample survey has all three choices in the 30% rage: bullish, neutral, and bearish.

Thoughts?     

*Held in personal accounts

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

T.W.T.W. > Recognizing Capitulation+Risk Growth - Weekly Blog # 559

Mike Lipper’s Monday Morning Musings

T.W.T.W. > Recognizing Capitulation+Risk Growth 

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

                                                                                                                       

The Week

A long time ago on TV, on both sides of the Atlantic, there was a comic review of the current news titled “The Week That Was” or TWTW. Occasionally, news and commentary of significance are bunched into one week, as happened this past week. The items they covered may be of serious significance for 2019 and beyond.

One Day, One Week, One Month, One Year

Some of the US stock market followers can point to instances where the first day of the year market performance predicts the first week, which predicts January’s results, and in-turn forecasts the calendar year. They have some statistics to support their view. At any rate, both the first trading day of the year and the first full week of the year produced gains for the leading stock market averages. After surviving a year where only cash produced a positive rate of return of the main asset classes, one can hope that 2019’s results will have a plus sign ahead of it. With that thought in mind, the following mutual fund performance table could address the question of magnitude for 2019’s results:

  

     Mutual Fund Major Asset Class Average Performance

                      ---------------Return----------------

Fund Asset Classes    Week Ended 1/10/19  5-Year Annualized

US Diversified Equity        +6.63%             +5.80%

Sector Equity                +5.62%             +3.00%

World Equity                 +5.64%             +2.47%

All Equity                   +4.54%             +4.47%

Mixed Assets                 +3.47%             +3.65%

Domestic Long-Term Fixed Inc +0.53%             +2.11%

World Income                 +1.02%             +1.46%

Remember, the numbers above are not our predictions, they are a look at history. There were much better results over the past ten years because during this period we saw multiple expansion. The only way for the numbers above to be achieved is for further expansion of the market multiple, assuming the optimistic projections coming out of Washington. With the current size of sales forces contracting it will be difficult unless societies (governments and Private Sector) meaningfully address the growing retirement capital deficit, even assuming the optimistic projections coming out of Washington.

I recognize that absolutely none of the readers of this blog are average investors or investment managers, but there is still hope for you and your accounts to do much better. Barrons each week publishes a list of the 25 leading mutual fund performers for the week, sourcing my old firm now housed in REFINITIV. For the week, these 25 funds had gains of 19.45%-12.43%. (In eleven instances the funds had stablemates on the list.)

Attitude Changes Required?

In analyzing the 2018 results, several deeply held attitudes probably contributed to the poor results:

• Only Earnings Per Share growth counts in selection
• TINA=There Is No Alternative to equities for success.
• Demographics is destiny (without population growth no expansion is possible)
• Four interest rates hikes in 2019.
• A bear market is defined as more than 20% from peak. (Bear Markets are a sustained period of selling by Public investors.) AAII bearish sample 29% from 50% in 3 weeks. Never higher than 50%
• Capitulation requires large selling volume followed by large buying.

Three Longer-Term Considerations

1. Ken Rogoff is quoted as saying “Over the course of this year and next, the biggest economic risks will emerge in those areas where investors think recent patterns are unlikely to change.” His lists includes:

• A Growth Recession in China
• Rising Interest Rates
• Populism undermining central banks
• Higher interest rates on “safe” government bonds 

My concern is a data dependent world where the numbers are incomplete and wrong due to disruptive technology, increased under-reported transactions, poor data gathering, data expenses that are too low, “sound bite” analysis, and surprises.

2. The Historically Speaking Column in the Weekend WSJ briefly reviewed several financial panics going back to ancient Rome and government reactions to them. The column concludes “the only thing more frightening than a financial crisis can be its aftermath”. In many cases the crisis was created by leadership trying to extend a tiring expansion beyond its “normal life.” The solutions applied were an unwise attempt to prevent a repeat of the problem without recognizing the series of faulty decisions made by leadership. This included punishment of unpopular sectors and people rather than an attempt to guide better judgement and the rebuilding of appropriate reserve elements, which could have been quickly and expertly mobilized.

3. Gallop regularly measures the public’s view of the honesty and ethical standards of various occupations. Of the 20 occupations reviewed by far the highest esteem goes to Nurses. The following table shows the ranking of the professions we deal with as part of our professional lives:

Profession      %Low/Very Low   Rank out of 20

Accountants           7%               6

Journalists          34%               9

Bankers              21%              11

Lawyers              28%              14

Business Executives  32%              15

Stockbrokers         32%              16

Telemarketers        56%              18

Car salespeople      44%              19

Members of Congress  58%              20

Similar surveys are probably done in most countries. These public attitudes are probably similar worldwide and represent a major constraining force in the development of a modern financial community where we ask people to trust both our integrity and our wisdom. My fear is that during some future economic crisis the unpopularity of government will lead to an upheaval that promises more honesty and efficiency, but in the end doesn’t deliver on those promises. As bad as our current delivery system is, it will produce better results than any other long-term system. What we need to do is make it much better.

Thoughts? 

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Tis the Season to be Mislead - Weekly Blog # 558

Mike Lipper’s Monday Morning Musings

Tis the Season to be Mislead

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

                                                                     

Standard Review and Outlook

I have written and read many reviews and outlooks over my career, both as an investor and a fiduciary manager. These documents are interesting and represent the most positive thinking of the writer, editor, supervisor, key sales people and compliance officials. Most spend a good amount of space describing the immediate past, with a slight alibi for under performance. For the most part the outlook is an extension of current conditions, likely to turn out to be benign. Those who know me would expect a contrary point of view. I hope not to disappoint. Even if I am wrong, some of these views will give depth to the more popularly expressed views.

Career Risks

This may well be the first outlook to start with this topic, but it hopefully will cause professional investment people and senior politicians to focus their actions on reducing the chances of repeating their 2018 performance, or worse. The best that than can be said about last year is that the results were reasonable considering the prior good times when waves of enthusiasm carried stock prices and political popularity to new highs. In some respect we have come back to earth. The only problem with the small net progress made in 2018 is that it reduced the longer-term growth rate, which is the underpinning of our current position and its remuneration.

Faced with the somewhat disappointing results of 2018 there is a natural drive to do something to improve results. In most cases this translates to committing more assets to short-term solutions, often by reducing reserves. While 60 of the 72 prices representing stock market indices, currencies, commodities, and ETFs rose last week, there may have been an excess investment of reserves, which is often a precondition of both bear markets and recessions. These asset allocation shifts don’t cause bear markets and recessions, they just make them more painful. Let’s place this microscope on three careers to raise some concerns.

Investment Professionals

Over time most professional investment people have delivered good performance relative to client’s actual constraints. In a period when most security prices rose in tandem with market indices or sector indices, passive vehicles looked to be more attractive than active choices. (This view was reinforced as commission brokers became fee charging investment advisors). Recently, instead of a steady increase in the number of new firms, hedge funds and mutual funds, the opposite has been happening. Organizations are merging to get control of assets that are no longer being won through sales efforts. In the merger, one of the back offices is eliminated and the best of the investment and sales people are retained. Even with this group of survivors, once their guaranteed employment period ends there will likely be a second round of layoffs. By the way, there is no evidence that the ultimate client is better off after these mergers. Seeing the prospect of this on the horizon, current employees may elect to push more aggressive strategies, even after a ten-year expansion.

Publicly-Traded Corporate Executives

Many corporate C suites are like the old fighter squadrons where there were bold or old pilots, but no bold old pilots. Often, the executives that rise to the top have more political skills than vision and help select boards of a similar nature. Most of the Fortune 500 CEOs are in their corner chair for five years, which is generally not long enough to go through a recession and a recovery. Thus, they tend to opt for capital preservation rather capital growth. This is not new, which is the reason why wise entrepreneurial companies with much less in assets outgrow their larger competitors. New technology’s disruptive forces wait for no one and some foreign companies may have what it takes to win business away from slower moving behemoths. Often, being a little bit bold is insufficient to hold off competitors. At some point boards, with or without activist sponsorship, demand a bold replacement or sale of the company.

Political Leadership

Both the “Big Two” (US and China) are trying to keep their expansions growing to protect their employment base. Further, in the US the opposition party is led by individuals older than the US President. Both leaders would prefer to focus on the longer term, but they are being forced to prolong and accelerate current growth. This is the trap that will increase the pain when the economic slump occurs, as happened in Ancient Rome, to Louis XIV and to Herbert Hoover/ Franklin Delano Roosevelt. Economic and military wars lead to deficits and tax increases, where opposite measures might cushion the decline and accelerate the speed of the recovery. But this kind or restraint would necessarily need to accept a slowdown, along with the political risk of a rise in unemployment, which would need to be managed.

If !!!

If corporate and political leaders are slow to support a decelerating economy, they might put off the inevitable recession by finding new and younger leadership.

Watch Emerging Market Bond Yields

Franklin Templeton (Franklin Resources*) 2019 outlook was entitled Distortion, divergence, and diversification. This thoughtful piece had three themes and was written by their head of equities, chief investment officer of Templeton Global Macro, and CIO of Multi-Asset Solutions:

• The state of the world which investors have become accustomed to will change, with low correlation and low probability of outcome.
• Local-currency emerging markets are showing the highest level of undervaluation.
• Opportunities exist globally, as disparities narrow between the US and other countries.

I was particularly interested in a chart of two-year bond yields which compared the US yield of 2.8% with Mexico 8.5%, India 7.2%, Indonesia 7.3%, South Africa 6.2%, and others. My interest is that these countries are represented in equity mutual funds we own long-term for clients and personal accounts.

(*) Owned in a financial service fund and personal accounts that I own.

Question of the week: 

What return do you need in 2019 for it to be a considered a good year?

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

https://mikelipper.blogspot.com/2018/12/news-focus-may-drive-investment-success.html

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.