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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