VALUE INVESTING WILL BE SUPERIOR BUT IT MAY HAPPEN AFTER THE RECESSION - Weekly Blog # 574

Mike Lipper’s Monday Morning Musings

VALUE INVESTING WILL BE SUPERIOR

BUT IT MAY HAPPEN AFTER THE RECESSION

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

Current Inputs
A few weeks ago, one of our perceptive readers asked what advice I had for his good friends that were managers of value stock portfolios. My unexplained response may have seemed nonsensical in the face of relatively poor performance compared to market. I should have explained my thinking. My reply was focused on the business of providing investment advice. I saw a short-term continuation of poor relative performance leading to less money going into these portfolios and a significant number of the managers withdrawing from the business. Lower prices often result from fewer value buyers participating in the market. Without new performance seeking money in the markets the remaining portfolio managers will need to liquidate some or eventually all their holdings. Typically, they will sell their most liquid holdings first and be forced to sell their less-liquid positions when that is all they have left. These sales will be at bargain prices for those that have the cash to take advantage, but there will be few with the cash, courage, and foresight to take advantage of these great bargains. These insightful managers will have less competition and thus they can earn premium level fees.

Recently I reviewed the performance of a large Planned-Giving Fund run by a well-known and respected manager with a recognized value bias. In looking over their performance record, it was superior for ten years, but not for shorter time periods. Just this week we were informed that a” deep-value” manager was closing his shop, as he was no longer able to produce the good returns he had generated in the past.

These inputs led me to explore the structural reason why this group of intelligent, formerly good performers, were not doing better in a market that was performing extremely well. Like many analysts who are closet history students, my search for an explanation focused on recent US financial history and recorded history from Biblical and Ancient societies.

Last Ten Years
 Because government promoted home ownership, various government subsidies and tax credits led to excessive ownership of homes by those stretched in their ability to support mortgages and the reasonable upkeep on home purchases. In some cases the buyers lied on their applications, but much more significantly lied to themselves and their families as to the predictability of their income and wealth.

In the aftermath of the mortgage crisis the government focused on the mis-selling and mis-labeling of tranches and ended up penalizing the financial industry with burdensome regulation and capital requirements. Further, Central Banks pumped money into the market in what came to be known as “quantitative easing”. This has led to a ten-year period where interest rates have been kept artificially low, depriving savers of the rates that paid them not to spend, leading to a global shortage of savings. More importantly, low rates and the availability of capital has led both commercial banks and non-bank financials to make commercial loans at interest rates which encouraged undisciplined credit extensions. Much of this money went to marginal firms for capacity expansions. This has hurt the value investor, as demonstrated by their poor investment performance compared to other investors.

Companies that value investors favor have the following characteristics:

• Strong balance sheets (under-utilized borrowing power)
• Physical assets where the current market value is larger than the depreciated book value
• Close to impregnable market penetration of good customers
• Unique and highly prized intellectual property
• Respected in-depth management
• Stable shareholder base

It takes many years if not generations to build these. The field of competition changes when marginal companies with a poor financial record and large debt can acquire even more debt at low cost. Often, when marginal companies build excess capacity they fight for market share. They do this by lowering prices, which in turn devalues the more sound companies. With a more leveraged balance sheet the marginal company can report faster earnings growth than the value focused company, at least for a while. Thus, in a period where growth is most valued, the marginals will be the more productive investments, until the next recession.

Ancient History + Human Nature
The Bible and archaeology have recorded various agricultural cycles, often tied to weather but also the expansion of crop or grazing land. Humans are driven by fear and greed. When they are in rough balance, humans tend to be both disciplined and careful. However, when either side is predominant humans tend to do extreme things and concentrate all their resources to gain more wealth/power or horde them to avoid current or future crises. When a mass of people do the same thing, like all going to one side of a boat, they can capsize the boat. That is why we have always needed recessions to correct the excesses of a prior period. I see nothing that has repealed this need and thus I expect we will have a recession at some point.

Where are We Today?
While I can’t give a date for the top of the market prior to the beginning of the next recession, nor the percent of the market gain, I can make the following observations:

1. Currently, the US stock market is being led by the NASDAQ composite, made up mostly of tech and services providers. However, this past week the stocks listed on the New York Sock Exchange had a higher percentage of gainers 77%vs. 69%. Perhaps the valuation gaps are too great - NYSE p/e 18.47x vs NASDAQ p/e 23.67x. If the rate of gain slows, perhaps yields will be more important - NYSE 2.16% vs. NASDAQ 0.99%.
2. Despite the strength of the equity market NYSE volume is flat compared to a year ago. The absence of speculative enthusiasm for listed stocks suggests there is more upside ahead.
3. While it is broadly proclaimed that the Federal Reserve won’t raise interest rates this year, this week the average interest rate offered by savings institutions rose 5 basis points to 0.65 bps. I interpret this as savings banks encouraging more deposits for them to loan out. This may support the surprise 3.1% first quarter GDP announcement. I have always believed that the Fed is a follower and not a leader on setting interest rates.
4. Each week the WSJ tracks the prices of 72 securities, currencies, and commodities. Until this week, gainers outnumbered the losers, this week they are exactly even.
5. The bond market is often more attuned to changing financial conditions. In the latest week yields on high quality bonds rose 14 bps, while the yield on intermediate credits declined 4 bps. [Prices move inversely to yields.] This suggests that bond investors are concerned about the future value of the highest quality bonds.

What to Do with Value Funds/ Managers
As a portfolio manager of portfolios of mutual funds, we invest globally in both growth and value focused funds. I expect the more growth-oriented funds to provide both more appreciation and volatility. The value-focused funds will probably go down less in poor markets. However, when interest rates go up, as I expect them to do before the next presidential inaugural, the value merchandise should do better and will receive a reasonable amount of M&A activity.

What Do You Think?  


Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html

https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html



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Copyright © 2008 - 2018
A. Michael Lipper, CFA

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Contrarian Observations, Not Predictions, But Concerns - Weekly Blog # 573

Mike Lipper’s Monday Morning Musings

Contrarian Observations, Not Predictions, But Concerns

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

Contrarians look at the world differently, searching for misleading, generally accepted view-points. My purpose is to not to be contrary, but to look for opportunities to reduce risk and make an unexpected profit. While one of the maximums of trading is that “the trend is your friend”, the contrarian believes that all trends eventually end. After the trend ends there is a shift in direction, often a dramatic one. This week’s blog looks at several current observations that could be sign-posts for a change in direction. The prudent investor should consider these to be possible early warnings signs.

Long-Term Observations
Through the 18th of April the average US Diversified Equity fund gained +15.86%. This rise is significantly higher than the 2019 earnings per share projection for the underlying stocks in the portfolios. If there were no further performance gains by the end of the year, the performance comparison versus the historic gains of the S&P 500 since 1926 raises some questions. Of the 92 completed years, only 42 or 45.6% were better than the 4 ½ months of this year. An actuary would question further progress in 2019.

In reading “The Unlikely Reformer”, a book by my friend Matt Fink. In the book he discusses the history of Carter Glass (Glass-Steagall, Federal Reserve Act, Securities & Exchange Act of 1934). The book makes much of his deep concern for the amount of bank issued credit used for speculation by Wall Street. Today there are some that are similarly concerned, but not about the retail credit used in buying stocks. The concern is about the build-up of corporate credit, which has been issued under very liberal terms for acquisitions and buy-backs of common shares. One of the multiple causes of the Great Depression was the explosion of credit. Some see a similar pattern regarding the explosion of credit issued largely outside of the banking system. 

Intermediate-Term Concerns
Two mouthpieces are telling us not to worry about inflation.

• Robert Kaplan, the president of the Dallas Federal Reserve Bank, ex Goldman Sachs partner and Harvard Business School Professor stated, “No Threat of Inflation”. 

• Bloomberg Business Week’s cover asks, “Is Inflation Dead?”. 

There is an old Biblical Expression “Man plans, and God Laughs”. One of the things I learned from the racetrack is that occasionally a long-shot wins. Surprises are normal in the history of economics, business, politics, and markets. Though the rate of inflation has been low for many years, I suspect it may not continue.

There has been wide dispersion in the performance of equity mutual funds for the five years ended April 18th. The average S&P 500 index fund gained +11.31% annualized, while the average Financial Services Fund gained +8.37% and the average International fund gained +3.33%. Looking to the future, the odds of a similar performance spread and rates of gain are at best questionable.

Shorter-Term Questions 
The three stock price composite indices around the world currently performing best are Shenzhen +38.8%, Shanghai +30.5%, and NASDAQ +20.6%. All three indices are fueled in part by a combination of technological products and services, easier credit, and IPOs. Are these gains sustainable?

A partial answer to the question above is reflected in the two largest ETF short positions as a percent of the shares outstanding: iShares China Large Cap 17.3% and SPDR Bloomberg Barclays High Yield Bond 17%. I don’t know whether the bulk of these holdings are for hedging purposes or directional bets in a speculative Market.


Question of the Week:
Did anything happen last week that is causing you to change your investment positions or attitudes? 




Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html

https://mikelipper.blogspot.com/2019/03/investment-committee-and-investors-be.html



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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.

Not Yet a Peak & Luck Lessons - Weekly Blog # 572

Mike Lipper’s Monday Morning Musings

Not Yet a Peak & Luck Lessons

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

       

Absolute price tops and bottoms rarely occur. Most of the time market prices fluctuate without creating important turning points. Comments about investment markets are mainly focused on earnings and related valuations and these have not recently been helpful as guides to making investment decisions. In their place some are relying on various statistical measures of investors’ sentiments and the current somewhat bullish indicators are not generating a lot of enthusiasm. There is something absent from the picture. The stock market has been moving up for three and half months, but the volume on the New York Stock Exchange in 2019 is down -4.68%. An even better measure of short-term speculation, the NASDAQ composite, is up + 1.31%. Some short-term traders may be concerned that in March the three major stock indices had a gap in their price charts. Many market analysts believe that gaps need to be filled before a price trend can be relied upon. While no forecasting measure is ever 100% accurate all the time, I believe we have not yet reached a peak level.

Sports World Experience

One should pay attention to the importance of luck, especially in light of Tiger Woods winning “The Masters” golf championship this weekend. A remarkable comeback for him considering his physical and personal problems. Not taking anything away from the winner, but a couple of golfers that were ahead of him ran into some poor luck with a few of their strokes. In my basic investment analysis course at the racetrack I would call this “racing luck”. To me the most useful analytical time at the track is the twenty to thirty-minute period between races. This is the time during which I compare the results of the prior race against those predicted by my handicapping analysis. Most often, with the benefit of hindsight, one can find in the records of past races the reason the results turned out as they did. In the minority of instances, when the results could not have been predicted, it was the result of the record being incomplete or the result of unanticipated “racing luck”.

My Lucky Experiences

I have had two experiences that had nothing to do with my securities analysis training and certainly was not tested in my CFA exams. I would call these examples of racing luck.  

• As a result of following closed-end funds I owned a few shares of an Eaton Vance fund who had a relationship with Winrock, the venture capital arm of the Rockefellers. They had a share interest in some of their holdings and for regulatory reasons needed to terminate it, resulting in the closed-end fund distributing ownership of those shares to its shareholders. Consequently, I own a few shares of Apple at under $1 apiece. (At some point in the distant past I sold half the position because I had enough losses in other securities to offset the large gain in Apple. VERY DUMB MOVE to let taxes dictate an investment decision, an important lesson.)

• Many years ago I took out a life insurance policy and later realized that unless I passed prematurely it was a bad use of money. The rate of return the insurance company needed to meet its obligation was low relative to what it was earning on its investments. Thus, I bought some shares in the insurance company to take advantage of the spread and the float in the investment account. As a result, I would have a sales force working for me to find others that did not fully understand the economics of insurance. This is a lessoned not taught at Columbia. Over the years the insurance company did well but was never a high-flying stock. Recently it was bought out for cash and stock, the cash being many multiplies of my cost. Thus, I am more than satisfied. The stock is CVS Health, which I currently hold. I don’t generally directly invest in the health care industry, but let my choice of specialty and diversified mutual funds give me exposure. Barron’s recently had a cover story titled “CVS This could be the future of healthcare. Time to Buy”.  According to the article it is selling at an 8 P/E and a yield of 3.79%, which is in the range of the insurance stock I bought years ago.

Lessons

1. As indicated, don’t let taxes alone drive investment decisions. Sell when there is a better use for the money.
2. One needs to be invested to allow good luck to happen to one’s money. If I had to buy them independently, I probably would not have owned these winners.
3. Over long periods of time, investing in a portfolio of equities works better than trying to time the market
4. Cash reserves are appropriate to meet expected payments and for use as a possible opportunity reserve.

Questions of the Week:

1. What is the range of your opportunity reserve?
2. How long should you keep the reserve if you can’t find a commitment?

  

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

https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html

https://mikelipper.blogspot.com/2019/03/investment-committee-and-investors-be.html

https://mikelipper.blogspot.com/2019/03/the-actively-worrying-classpassively.html

Did someone forward you this blog?

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Investing in Quality for Growth or Value - Weekly Blog # 571

                               

Mike Lipper’s Monday Morning Musings

Investing in Quality for Growth or Value

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

     
                               

Capital Preservation vs. Capital Preservation
Occasionally I assign Capital Appreciation or Capital Preservation labels to each security in my portfolio. These identities may change with each time period examined. The purpose of this exercise is to examine my decision process during the expected top and bottom phases of a cyclical market. (Perhaps a +/- 10% move before or after a recognized turning point has been reached.) For me, this is not an easy exercise and needs to be repeated periodically.

What makes this process particularly difficult for me is dealing with it in my mind, as it’s a small distinctive asset class of high quality companies. My two somewhat contrasting filters are the Charlie Munger type of good companies to own forever and most securities owned by portfolio managers with turnover rates in excess of 20%. (On average they hold their positions for less than five years.) One way to look at the capital preservation companies is that these are the positions I hope to hold for the future generation of the investment committees I serve and for the future generations of my family. On the capital appreciation side I expect market sentiment to become much more favorable to the stock, either because of general changes in attitude or changes specific to that name.

Divining Rods
Old farmers in the search of below surface water used a bent stick to find the critical element necessary for success. Most professional investors use numbers. That is why I was delighted to see Jamie Dimon’s 74-page shareholders’ letter in the JP Morgan Chase annual report, where he made the following statement “earnings is not a perfect measure of performance and economics”. Despite all the billions/trillions of dollars being spent on technology by JP Morgan and many others, as in “the world is going digital”, basic human processing remains an analog art. (I suspect the utility of earnings estimates was downgraded when analysts switched from slide rules to calculators. Slide rules produced good approximations, not precision certainties.) Jamie’s letter is full of what of they are doing for people, including clients, customers, employees, local communities and sovereign nations. This is how he is building what he calls “a financial fortress”. (I wish he would have used another term for such a high-quality organization. A study of military history shows that the strongest fortress falls due to the actions of those within the fortress, causing internal deterioration.)

One fallible measure of effective capital preservation is the company’s lowest stock price relative to tangible common equity. For example, the lowest price for JP Morgan was above its tangible common equity. This is more difficult for a service company and the number of contractual subscribers might be used as a measure in some cases.

Quality Can Be Expensive
Most of the time the US stock market goes up and the market often prices quality at a significant premium to its “bear” market price. Therefore, purchasing a new high-quality name could lead to a significant drop before a new bottom is established. However, if the purchaser is interested in long-term capital preservation, the odds are good that future cycles will give the investor substantial rewards for many years and decades into the future.

Why the Focus on Bear Market Prices?
The job of a prudent manager is to always be aware that markets can surprise on the downside. This is particularly true when sentiment is rising. The following news elements make me cautious:

1. The current low double-digit stock market gains are much larger than current earnings projections for 2019, suggesting the bull market will continue into 2020.
2. Volume is dropping as prices rise. 50 of 72 index prices rose last week and bond prices weakened.
3. Barron’s Cover “Is The Bull Unstoppable”
4. Barron’s article headline “There’s no Expiration Date on this Bull Market”
5. The risk of professional investors actually running companies may be growing, in spite of poor past results.

Question of the Week:
How Do You Identify Quality?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/03/investment-committee-and-investors-be.html

https://mikelipper.blogspot.com/2019/03/the-actively-worrying-classpassively.html

https://mikelipper.blogspot.com/2019/03/long-term-trends-may-not-be-friend.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.