MEMORY TRAPS JUDGEMENT - Weekly Blog # 578

Mike Lipper’s Monday Morning Musings

MEMORY TRAPS JUDGEMENT

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

In the US it is the season to remember and celebrate the past. For more than 150 years we have had Memorial Days to honor those who served and died in the defense of their country. It is also the time for college commencements. (Like many other families we proudly celebrated multiple college and high school graduations this month) Victors write the published history and exploits are summarized and simply told. It is the simplified and often enhanced versions that are remembered in succeeding years.

This habit is harmless unless it becomes the basis of judgement in dealing with the likelihood of future events. I have often said that if one cuts an analyst, a historian will bleed. Caltech(*) professors have determined that the part of the brain that deals with making judgments is the portion that stores memory. I feel that comparisons of the past with the present or perceived future, unadjusted, can lead to significant errors of judgement. Errors of judgement can be costly in all elements of life, but is particularly noticeable with investments, where it can result in both unnecessary losses and forgone gains. A very perceptive reader of these blogs, while discussing the current investment scene, quoted a bunch of statistics to me from the past. I responded that the current picture is different from the past because so much has changed. He then suggested that I blog about the crucial differences, which led to this blog.

Major Changes
One can categorize the major changes in two buckets. The first are the less visible changes that have and are a continuing influence on the markets for investments. The second are the changes that are driving the broader world. While both sets of changes have their origin many years ago, their importance has been accelerating over the last ten years.

Less Visible Changes in Investment Markets Structure
One of the techniques I learned in the Marine Corps was that when planning an attack, start by looking at it from the defender’s perspective and plot your attack from the enemy’s position rather than from your own. I have utilized the same approach of reversing direction to the art of investing. Thus, I start with the profitability of the agents, intermediaries and principals, recognizing that  return on equity, profit margins, and capital turnover have all suffered since 2007, if not earlier. Because of the generational growth of cash capital, revenues have grown. When I was an analyst at a retail-oriented brokerage house trying to build an institutional business, the return on partners capital was about 25% in normal years. Better firms probably did even better. Today, after an extended period of concentration in the industry, many firms utilizing a lot of leverage have return on equity in the single digits. Moreover, that return is earned on selling private equity and debt rather than publicly traded investments. Private sales are growing at twice the pace of publicly traded sales, although the market is much bigger.

From a customers’ vantage point the lower profitability has led to a much smaller cadre of research analysts and less readily available liquidity in stressful situations. Smaller companies have lost analyst coverage, including many stocks that don’t even have an analyst regularly reporting on them. Part of this decline is the result of regulation FD, which curtailed what analysts could learn from private meetings with corporate executives. With less in-depth analysis and increased media attention on reported earnings, published earnings have become a less reliable guide to what is happening. Previously it was a clue to future results.

Due to the competition for effective salespeople, those that are better get a higher percentage of the revenues they generate. This has led to a switch from selling load mutual funds to selling private equity and debt, plus the occasional initial public offering. These were less frequent occurrences in the past, as private firms remained private for longer or were acquired.

In the past some firms would accommodate good customers by absorbing the stress merchandise they held or sold. Any losses sustained were repaid in future transaction business. This kind of facility is not generally available today. Liquidity concerns may be heightened when we move out of the relatively low volatility market we have been enjoying.

Regulations addressing the late 2007 mortgage credit collapse in the US  penalized the participants rather than dealing with the imbalances that were partially created by politically sponsored government subsidies. In Europe, MiFid II is already reducing both research and liquidity support for European investors.

External to the Market Changes
Central Banks have evolved from being the bank of last resort in financial crises, to stimulating economies within the term of the current political leadership. Unfortunately, they rely on government data that does not capture the reality of inflation and does not fully understand the deflationary impact of technology.

The changing structure of the banking world is not fully appreciated, financial tech providers are viewed as an aid to existing institutions. Fintech has morphed into new competition for established banks through items like electronic payment systems, electronic trading of currencies and personal loans.

Demographic changes have been identified for a long time, but not their implications. The developed world needs more workers, productive workers. Our educational system, from pre-school through the granting of Ph Ds, is not producing enough employable workers with the right knowledge and personal attitudes to fill present and future jobs. Combined, these trends along with the advances of expensive medical science and the inadequacies of social security and pension systems, will not be able to support retirement.

We have a transnational problem. Both consumers and producers have become global, but they are dealing with national laws, taxes, and regulations. To an important degree, elements of consumption and production can and will move beyond local political mandates.

Are Past Lessons Worthless? 
Absolutely not, they just need to be adjusted to fit the current context. We can learn from past motivations and they should be studied, not the various statistical ratios, frequencies and measures. The statement that history doesn’t repeat, but rhymes, is more accurate than a statistical cookbook.

(*) I am a senior trustee of Caltech and a member of its investment committee, among other committees.
 
   
     

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/05/probable-view-of-next-decline-weekly_19.html

https://mikelipper.blogspot.com/2019/05/probable-view-of-next-decline-weekly.html

https://mikelipper.blogspot.com/2019/05/2nd-of-mays-good-lessons-weekly-blog-575.html



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A. Michael Lipper, CFA

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Anticipating Tops - Weekly Blog # 577

Mike Lipper’s Monday Morning Musings

Anticipating Tops

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

Anticipating Tops
As an investor one can react to changes or anticipate them. Most investors tend to react because it is easier to do. The quick reactors tend to move in the direction recommended by their sources, without much in-depth analysis of the “new” information. As a result, market prices often reverse within days, making sentiment measures highly volatile. For example, the American Association of Individual Investors (AAII) polls a sample of its members each week for their market outlook for the next 6 months. In the latest survey only 30% were bullish compared to the prior week’s 43%. The bearish count moved even more, 39% compared to 23% the week before. As a contrarian and a student of history, I will take the bet. (Hopefully I am a better bookmaker than those that set the odds in Australia, U.K. and the U.S.)

With a background of investment analysis at the New York racetracks and a brother who served in Marine Recon in Korea, I attempt to anticipate both tops and bottoms of markets. I am not so bold or foolish as to try and come up with either the numerical top/bottom or the record date. At best I look to get a high profit with lower risk by anticipating the primary direction of the stock market. The remainder of this blog describes some of the elements used to recognize a market top and some attractive places to invest once prices are materially lower.

Top of the Market
Professional historians and particularly military historians believe the beginning of the hostilities in World War I were easily predictable, but not the timing of the movement of European armies. Their certainty was based on the linkage of the two great multi-national alliances and the lack of US participation. What was not known was the flash point. Many believe it was the assignation of the Archduke of Austria by an anarchist, except it took another six months before the battles began.

I am suggesting that we may well be witnessing the equivalent of building alliances, which in due time will lead to the top of the market. Chart analysis of the three Dow Jones averages (Industrials, Transportation, and Utilities) are showing topping formations. The reason to focus on the Dow Jones averages is that until recently they were rising at a slower rate than the NASDAQ Composite, which is dominated by Tech and service providers which had economically been growing faster. However, something has happened to change the sentiment towards the NASDAQ Composite stocks. For example, this past week 40% of the stocks on the NYSE rose vs. 32% on the NASDAQ. More significant is the new high and low lists where there were 319 new highs and 185 new lows on the NYSE, versus 214 new highs and 270 new lows on the NASDAQ.

There are other signs of extrapolation by so-called professional investors. Those signs are like Japanese investors selling yen to buy US dollar assets like golf courses and New York real estate before the “dot com” collapse. Some examples:

1.  The most crowded trades listed in the Bank of America’s Fund Managers Survey were (in order):

• Long US Techs
• Short European stocks
• Long US dollar. 

When a trade is crowded it suggests that those wanting in are paying a premium price to those who are selling. Historically the sellers are more often correct.

2.  This week by far the biggest input to both Exchange Traded Funds and Conventional Mutual Funds were the flows into Money Market funds, especially into institutional funds. (Is this a withdrawal from the equity market and perhaps the high yield bond market?)

3.  Two “name plate” firms are paying large amounts, e.g. $750 million in cash to purchase roll ups of registered investment advisors. (Do they need to do this because their investment records are not attracting enough new customers to meet their aspirations. Golf courses anyone?)

4.  An increasing number of commentators have mentioned the large amount of money being invested by institutions in credit issues that lack the protective covenants of the past.

Looking for Future Winners
As a young junior analyst, I used to look at the list of stocks hitting new lows in order to find companies requiring further examination. A stock on this list, in the collective mind of the market, has a problem. Sometimes it is just sentiment or unpopularity, an actual problem that looks to be permanent, or both. Almost certainly it would have few friends in the investment community. This was hard work because many stocks hit the new low list, although it was occasionally worthwhile. Sometimes the problem was the result of a cyclical phenomenon or management in the process of addressing the problem. I eventually developed a solution to the problem of having too many companies to research and was helped by two realizations.

• There were far fewer names on the new list when the market was flat or rising. 
• Markets recovering from a major break are not often led by the prior market winners, even though they are available at much lower prices. 

The second point brought home the realization that some market reversals are not due to high valuations, but due to something fundamentally changing.

At this stage in my career I use mutual funds as the prime investment vehicle for my clients. Except for financial services companies, which are or could be part of the financial services fund that I manage, I have only a passing interest in individual companies. The exception to this rule are prominent companies in the funds we manage for clients. We will have to see whether “bottom fishing” for future ideas will be as successful using funds as it was employing individual stocks.

There are only six mutual fund investment objective averages showing minuses year-to-date through last Thursday. They are in reverse order:

Dedicated Short Bias         -18.71%
Agricultural Commodities      -6.31% 
Equity Market Neutral         -2.19% 
India Regional                -1.27%
Precious Metals funds         -0.90%
Precious Metals Commodities   -0.39%

Agricultural commodities and India Regional Funds, on a very long-term basis for multi-generational legacy accounts, one would think there are opportunities if the world is to make progress. The other investment objective declines are more the result of political reversals. There are 28 investment objectives, other than money-market and tax-exempt investment funds, that are gaining less than 5% year-to-date. Twenty-three are fixed income and five have an equity-risk component.

Question of the Week:
Do you have an organized way to find new investments?
 
   

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/05/probable-view-of-next-decline-weekly.html

https://mikelipper.blogspot.com/2019/05/2nd-of-mays-good-lessons-weekly-blog-575.html

https://mikelipper.blogspot.com/2019/04/value-investing-will-be-superior-but-it.html



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A. Michael Lipper, CFA

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PROBABLE VIEW OF NEXT DECLINE - Weekly Blog # 576

Mike Lipper’s Monday Morning Musings

PROBABLE VIEW OF NEXT DECLINE

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

Preface
My focus in building portfolios of mutual funds is to meet the needs of multiple generations. Nevertheless, I pay attention to very short-term inputs as well, like last week.

Tariffs Rising, Stock Markets Decline
Global stock markets fell last week after rising for four months and it may suggest the structure of the next major decline. Last week 57 of the 72 price indicators for stocks, ETFs, commodities, and currencies were lower.

Using the performance of mutual funds may show some important lessons about the decline.

1. S&P 500 index funds    -1.56%
2. Large-Cap funds        -1.40% 
3. Mid-Cap funds          -1.34%
4. Small-Cap funds        -0.81%

The performance array suggests that the sellers were seeking to reduce risk were often the same trading-oriented investors who drove up large-caps, particularly tech-oriented stocks. Index funds are required to be fully invested with no cash, whereas the large-cap funds had some cash to meet immediate redemptions, helping to cushion their declines. Investors who prize liquidity were less interested in mid-cap and smaller-cap investments.

We noted a similar pattern with SEC registered global and international funds, where large-caps declined more than mid and smaller-cap funds. The classification scheme for funds registered beyond the SEC is not identical to that used in the US, so it is more difficult to make identical conclusions, but looking at individual funds I think the tendencies tend to be similar. It is worth noting that fixed income appreciated during the week when equity funds declined

The Origin of Value Investing Leads to Confusion
Just as economists wish they had the certainty of the laws of physics, academic courses teaching value investing were an offshoot of accounting courses. Their first illustration was of stocks selling below their “net-net” value, current assets excluding inventories greater than all liabilities. This measure also excluded fixed assets. An investor did not need to know the value of inventory, fixed assets, or non-financial assets like customer lists and intellectual property.

In the days when analysts were labeled statisticians, a net-net situation did appear occasionally, and financial liquidators often swooped in and attempted to conduct a fast liquidation. These are quite rare today. Nevertheless, most value investors believe they are buying shares at a major discount from the net worth of the company. There are a few problems with this approach.

1. It is exceedingly difficult to liquidate a company quickly for tax and other regulatory reasons. Thus, the number of financial buyers has been reduced.
2. To replace financial buyers value investors instead sought out strategic buyers. The strategic buyer was often better able than the current management to see that they could make money out of the target’s assets. Even if this view is not naive, it is not easy to execute quickly. While one can attempt to tie up critical people, they may not work as hard after they become richer or older, particularly for a different generation of management. Customer loyalty will be tested by the competition and may have to be re-marketed to be assured. 
3. In a period of low interest rates and less stringent loan covenants, marginal competitors can enter on a price basis. 
4. Enticing discounts are derived from a reasonably fixed value and most fixed values are directly or indirectly tied to the value of a currency. Currencies fluctuate in value for lots of reasons, including relative inflation and interest rates.

I still believe in value investing, but it needs to be less of an accounting statistical approach and more in the hands of a proven merger & acquisition group, with excess talent and capital, or cheap financing.

A Place for Value Investing in Diversified Portfolios
Simplifying construction of an equity portfolio into growth and value components is a useful approach. Depending on the various time spans of expected outflows, the portfolio manager should be allocating to some investments that appear to have a reasonable chance of providing an acceptable total return over extended time periods.

The level of predictability will often define a growth company and they will be subjected to many successes and a few failures. Cyclicality will also generate different levels of expectations and enthusiasm. Far too many investors view growth stocks on a short-term basis, making them volatile. While volatility in and of itself has little to do with long-term performance, it can make for some anxious reporting periods.

To dampen reported performance swings value-oriented investments can help, particularly in periods of rising interest rates. Since most investors are less attracted to value-investing, they tend to have less market sensitive volatility and generally have fewer negative surprises leading to price drops. For example, within the same portfolio one can hold stocks that will benefit from the change to electric vehicles, big data, and scientific breakthroughs, along with some financials that are selling below their normal 25% discount to acquisition value.

Hope for All of US
Neuroscientists at Caltech and other places have determined that people, at least short-term, can be trained to learn new things. Evidently, the trick is to attach new thoughts to an existing thread in our minds. As I spend a good bit of my waking life studying markets and people, I hope that I can continue to learn. Hopefully other investors will also learn and that will create better markets.


WHAT DO YOU THINK?   

   

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/05/2nd-of-mays-good-lessons-weekly-blog-575.html

https://mikelipper.blogspot.com/2019/04/value-investing-will-be-superior-but-it.html

https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.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

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2nd of May’s Good Lessons - Weekly Blog # 575

Mike Lipper’s Monday Morning Musings

2nd of May’s Good Lessons

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

The inestimable Charlie Munger has labeled Warren Buffett a learning machine, someone who is always learning from his own and other’s mistakes. This is a good model to follow. The first couple days of May provided some good classrooms, the Berkshire Hathaway annual meeting and The Kentucky Derby, both on Saturday, May 4th.

The Annual Meeting/ Investment School

While many attended the meeting to gather bits of information to help guide their views as to Berkshire’s earnings and/or near-term stock price, I view it as an opportunity to learn about the art of investing. For me this is a linear progression from my Introduction to Securities Analysis course under Professor David Dodd at Columbia University. Dave Dodd was both a teaching and investment partner with Ben Graham, Warren Buffett’s first mentor. The following are the nuggets gathered from the meeting which can be applied to investing in general:

1. Paying too much makes it very tough to make money on an investment. (They did for Kraft.)
2. Intrinsic value is a range not a specific point. This range could be 10% plus or minus. (This is the fulcrum point for their buybacks.)
3. Individual Investors are their preferred owners rather than bureaucratic institutions.
4. They have a desire that their heirs hold onto their shares long after Charlie and Warren are gone. That is why they are developing the next tier of management, which will be different and better.
5. A large opportunity reserve has two values, it cushions periodic declines and creates bargain opportunities.
6. The allocation of resources allows them to shift capital to where it is most productive long-term.

The Kentucky Derby 

I have written about “racing luck” or surprises in the past. At this year’s running of “The Derby” we witnessed a classic example of “racing luck”. With far too many horses on a rain-soaked track there was at least one bumping incident, which the three racing stewards felt impacted the order of the finish. After reviewing many films of the race and a call to the two leading jockeys, they disqualified the winner and gave the victory to the horse that came in second. The level of surprise can be gleaned from the betting odds. The first horse to finish was the second favorite at $9 to $2. The declared winner was a $63 to $1 long-shot. This is the first time in the history of this race that they have disqualified the winner for an on-track violation.

The investment lesson from this experience is to avoid putting too much faith in the “inevitable conclusions”. Surprises do happen, even those that are the first in more than one hundred years.

The Mixed Current Picture

Change Signs?

1. While the NASDAQ composite has gained the most since its January low, +26% compared to +17% for the Dow Jones Industrial Average and +20% for the S&P 500, this past week the 420 new highs on the NYSE exceeded the 305 new highs on the NASDAQ. Have traders shifted their focus to more industrial and  seasoned companies from growth and tech?
2. Of the 72 price indicators tracked by the WSJ covering securities, commodities and currencies, only 30 are rising, Recently, the number of gainers were in the majority.
3. Both High quality bonds and intermediate quality bonds gained in price, showing some shift in demand away from stocks. 

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

https://mikelipper.blogspot.com/2019/04/value-investing-will-be-superior-but-it.html

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

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.