Large Opportunities and Risks - Weekly Blog # 626

Mike Lipper’s Monday Morning Musings

Large Opportunities and Risks

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

Current Picture
Normally the US stock market moves at a pedestrian pace, with annual moves of about 10% (7% to 12%). We have just completed a two-month period that by statistical definition includes the fastest “bear market” in history and a recovery that would qualify as a one month “bull market”. There are some signs the recovery has likely ended, with a rounding or flat top for the three major stock indices. Furthermore, the lack of confirmation by the VIX index and the advance/decline line is casting doubt on the direction of the market. Thus, we have probably entered a confusing period, which until it is resolved will lead to lower volume. It offers an opportunity to reposition for a significantly lower market based on deteriorating economics and politics, as well as an  opportunity to buy into stocks that will be viewed as great bargains in the years ahead.

I am a somewhat risk-aware contrarian long-term investor and advisor. Both the Bulls and Bears could be right. For long-term investors, the bulls have an eventual chance to multiply their capital many times over, whereas unleveraged bears could preserve a portion of their capital. Careful bulls amass more capital over time than bears, although some bears have produced exciting short-term returns.

This dichotomy produced the first modern hedge fund, which was housed in the same 74 Trinity Place building in which I spent 25 years. A.W. Jones, a former magazine writer, came up with the concept of always being 50% long and 50% short. This produced good but not spectacular results over the years, often due to declining less in down markets. Unfortunately, he moved out of the building before we established our office there, but I did study his results. From that study and analyzing the success of a number of mutual fund and other managers, I concluded that long-term investing on the long side produced satisfactory returns. My lifetime’s work leads me to briefly outline the case for increasing equity investments now, although I should first clear up the one reason media pundits have led the investing public into a confused state.

What is in a name?
Our ability to name something or someone is critical to organizing our internal filing system, otherwise called memory. But it is also the source of much confusion if the name is not specific enough, such as with a company’s name. A name can mean different things to actual or potential customers, employees, competitors, lenders, and various types of owners. Much like blind people feeling different parts of an elephant.

Some of the abovementioned people are interested in what the company can do for them today and that becomes the company’s image, although it’s quite different for those who own the company’s debt or equity. They are vitally interested in the future securities price of what they own or are contemplating buying and need to guess the price of the securities at future dates of importance to them. The price will be determined by the current owners selling for some unidentified reason, while potential buyers compare similar investment opportunities. Today, most companies are experiencing falling sales and increasing prices, so things look temporarily bad. However, the securities buyer is looking at pent-up demand, which could return to 2019 levels, more or less.

The Optimistic Case
As is often the case, buying largely rests on demand in the short, intermediate and long-term. In the short-term, the $4 trillion in Money Market funds is earning next to nothing relative the real inflation being generated by the COVID-19 stimulus. At Bank of America (Merrill Lynch), 14 % of the average account is allocated to cash. In the intermediate term, when both businesses and other consumers get more comfortable, pent-up demand will generate sales of products and services.

In the long term, the main purpose of most money in institutional and individual accounts is to create future payments for specific retirements and/or legacies. If one amalgamates the retained earnings from 2018 through the present time, my guess is that in general it did not earn an actuarial rate of return sufficient to meet future payout desires. As my Grandfather’s friend Bernard Baruch explained to congress, the Latin derivation of the word speculate is to see into the future. I expect to see changes in how we live and think about the future coming from demographic trends, the march of technology, and the impetus from the current Coronavirus and future COVID plagues. As a global society we will be paying more for longer and more expensive retirements, particularly in the end.

An example of a little noticed change with larger implications is the following small notice on page 2 of The Wall Street Journal. 

“Notice to readers, Wall Street Journal staff members are
   working remotely during the pandemic. For the
   foreseeable future, please send reader comments only by
   email or phone using the contacts below, not U.S. Mail.”   

Considering President Trump wants the Postal Service to charge much more for packages, while rural members of Congress remain unwilling to change the schedule for mail delivery, future communications from various governments are likely to change. We are already seeing a smaller quantity of mail, which is not altogether negative, but is a lost sales opportunity for some.

The biggest long-term change I see is the possible reduction in our real estate footprint. Not only in our homes, but hospitals, schools/universities, and entertainment locations. I became more convinced of this threat when I read an article on the latest Gallup Poll survey, where individuals favored real estate over securities as an investment. As a contrarian I hope they are right but think their view will change as real estate becomes more difficult to sell, due in part to mortgage rates rising and state/local taxes going up.

What to Buy?
As usual, there are investment performance arenas from which to choose current winners and laggards. One advantage our clients have is that I look over the performance of all US and over 26,000 offshore funds each week. In the latest week, measuring from March 23rd which I am using as a bottom, the three leading mutual fund peer group averages were Precious Metals +47.40%, Equity Leverage +46.36%, and Energy MLP +43.16%. These are narrow-based funds enjoying a large recovery, which should probably not be a large part of a long-term mutual fund portfolio. The best performing diversified equity funds for the same one-month period were: Mid-Cap Growth +27.14%, Multi-Cap Growth +25.54%, and Large-Cap Growth +25.31%. Clearly, in this recovery growth has been favored in part due to its positions in the health/biotech sector, which gained +30.12%.  What may be significant is that performance leadership is no longer the sole property of large-cap funds, suggesting the overriding need for liquidity is shrinking.

Future performance leaders often come from the bottom of the performance ladder, which in this case are a few well-managed Value funds. However, one needs to be particularly careful looking for Value today. Far too many base their analysis on the spread between book value and price, which was a scholastic task assigned at Columbia University by Professor David Dodd while I was there.

This was a relatively easy job because we had the published financial statements, which had some relevance back then. This was not the way he and his partner Ben Graham (*), at the closed end leveraged Graham Newman fund, produce his great performance. Book value, according to their student Warren Buffett, is today misleading. It is an accounting number based on the historic cost of assets, which can only be changed by impairments, not improvements.

The task in the class I took was to identify companies that should be liquidated, not purchased as a going concern. There are relatively few of these companies today, as they are usually prey to private funds who specialize in this art form. There are however a reasonable number of companies whose financial statements do not fully reflect their improving value in the right hands. Careful and patient analysis can uncover their true value, the trick is identifying what or who will recognize their true value and change investor’s perceptions.

Conclusion:
Successful investing is much more an art form than a quantitative exercise. It requires patience and luck to make one’s investments profitable. 


(*) I am the recipient of the New York Society of Securities Analysts Benjamin Graham award



Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/04/long-term-investors-mistakes-ahead.html

https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html



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What is Next After the Next Next? - Weekly Blog # 625

Mike Lipper’s Monday Morning Musings

What is Next After the Next Next?

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

Most people focus on the current conditions. However, as someone who has always been influenced by repetitive history, I wonder whether we are approaching a significant turning point. While I do not know, I believe it is worth pondering. Allow me to sight three events that identified turning points that changed the pursuits of individuals and nations around the world.

1. An important change in the direction of human behavior after an extended period of time. 
2. An event or a series of events that distinctly break with the past. 
3. Prominent actors primarily focusing on current problems and being oblivious of the long-term implications of their actions. Three examples are: The end of the Dark Ages in Europe, World War I, and World War II. Each example resulted from the following:

• A different kind of pivotal leadership
• A weakened old order, both politically and economically
• A relatively small invention that changed many lives
• The introduction of a period of rapid change
• People willing to participate in radical change

The end of the European Dark Ages was caused by changes initiated by Henry VIII and his daughter Queen Elizabeth, Martin Luther, fundamental scientific discoveries, and Gold from Latin America.

It was not WWI itself, but the failure of the peace in solving the political problems facing Europe and its place in the world. The development of the airplane changed the modern world, ending geographical isolation and igniting the rapid development of mass arms manufacturing and radio as political weapon.

WWII relied on political leaders inciting their populations to go to war, the development of long-range missiles, nuclear energy, and substantial improvement in medicine/hygiene.

Current Condition
During the current pandemic, many political leaders across the world have put their citizens on a war status, by limiting their movements and working conditions. They are also rapidly developing specific therapies and hopefully cures. The US and other stock markets around the world have ended an expansion driven by lenient and inexpensive credit restraints for both the private and public sectors. We entered the fastest bear market ever, in an economic and financial world measured instantaneously. Whether it is over is subject to debate.

Readers of these blogs know that I identified the March 18th low as a “stealth bottom”. It was successfully tested on March 23rd, which was lower but did not bring on new waves of selling. There are a significant number of market followers, perhaps 1/3 of the financial community, who believe a lower low is coming. They could be correct but utilizing my odds tracking experience I don’t think so.

The following statistical sample utilizes the average mutual fund performance from 3/19 to 4/16, which arrays in a pattern seen in the last bull market: Growth funds +17.27%, Core funds +14.87%, and Value funds +13.48%. The more narrowly focused funds were led by Global Science and Tech. +21.16% and Real Estate +20.46%. These were followed by mid and small-cap funds.

The leading performance of narrowly based funds is significant because they do not have the same market liquidity as the larger and more diversified funds. Investors appear to be willing to accept more risk, suggesting they may believe we have seen the bottom.

If there is going to be another major down-leg, there is lots of “dry powder around to absorb it. Money market fund assets have reached record levels, with retail investor’s cash reserves now representing 14% of their allocation. Last quarter clients of JP Morgan Investment Advisory accounts added $75 Billion in liquid reserves, while redeeming $2 Billion in long-term accounts.

Those who follow the investment management business are familiar with Howard Marks. (I have known him since he was a portfolio manager of a closed-end convertible securities fund in the early 1980s.) He has been a very successful investment manager since his early days. Recently he sold control of Oaktree Capital to Brookfield Asset Management, retaining his ownership in the company. His public intention is to raise $15 Billion in a distressed securities fund. One can read this two-ways, he may be anticipating a lower market where he can buy cheap assets, or he could be anticipating an opportunity to sell assets at higher prices.

The Next after The Next
There is a good chance the investment world will not return to “normal” once we declare victory on COVID-19. I believe this period of working from home in various forms of isolation has fundamentally changed our behavior patterns. How we live, operate, invest, shop, entertain, receive healthcare, contract for loans/insurance, and how we conduct family and other relationships. At some point we will come to the realization that we have become too fixed-asset oriented. I expect changes in shopping, education, and healthcare. Furthermore, we will become more dependent on technology for all these things, through instruments like the Apple Watch, cell phones, and other instruments not yet on the market.

As investors we may be paying less attention to physical assets and more attention to leadership, applied to our specific needs. Management will need to get out of their offices, plants, and laboratories to learn of our desires and how they can solve our problems. I expect the world of my grandchildren and great grandchildren will be quite different than they are today, creating an additional burden on me as an investment advisor. Please help with any suggestions you have. 
 


Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2020/04/long-term-investors-mistakes-ahead.html

https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html

https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html



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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Long-Term Investors, Mistakes Ahead - Weekly Blog # 624

Mike Lipper’s Monday Morning Musings

Long-Term Investors, Mistakes Ahead

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

We wish and hope that all of our readers and
their loved ones are in good health and none
suffer from Covid-19 and its aftermaths.

Investing is, or should be, a series of learning experiences. In the long-term, we apparently learn more from our mistakes than from our “successes”. One puzzling occurrence that I have noted are some individual and institutional investors making repeated mistakes that impact their long-term investment results. At critical points in time, instead of utilizing their usual contemplative decision making, they allow emotions to drive decisions. I believe we are approaching a juncture where a sizeable number of otherwise smart investors make investment decisions that significantly hurt their future long-term returns, if not reversed.

The Focal Point of Large, Sudden Recoveries
We hit a “stealth” bottom on March 18th, with a “test” on March 23rd, in the US and many other markets. (A test occurs below or higher than the first bottom, but critically does not lead to more selling and substantially lower prices.) Since these low points, some mutual funds have jumped by 40% or more. In just the last trading week, the 25-best performing mutual funds gained between +35% and 21.36%. Traditional investors could choose to ignore these results due to the performance leaders likely making successful extreme bets. Relative to the impact on the wealth of the total investor population, the performance of the 25 largest long-term funds is relevant. It’s also worth noting from a national economic standpoint that the performance of the middle of the road “Core” equity funds is especially important, as this is where the largest portion of individual and institutional money is invested. I believe it is significant that the best performing large mutual fund for the week was American Fund’s Washington Mutual Investors. It rose +10.03%, while the worst all large-cap equity funds, a global equity income fund, gained +4.98%. To put this perspective, annualizing the gain of +4.98% would surpass 250%, an impossibility. This demonstrates how unusual the week was.

Ok it is Unsustainable, Now What? = Mistakes
There are three mistakes people make when investment performance appears too good.

• An immediate attempt to lock-in an unsustainable gain, a smart decision if one is never to invest again. The first problem in selling at the presumed top is that it puts a high premium on making two correct investment decisions consecutively. The skill to recognize tops and bottoms are quite different. Recognizing the present situation while fathoming the future, or more correctly futures, is quite different. Remember, many investors believe the sole reason for the market decline in the February-March period was the Coronavirus, not our concern of a tactical and strategic slowdown in earnings power generation. (The odds on identifying future trends different from those extrapolated from the present is probably 50% to 65%, allowing for the occasional surprise.) 
• The nature of critical turning points is the second problem. Almost by definition a turning point is when the bulk of trading actively changes radically, an emotional change. To be in a position to timely anticipate the change you must believe you can accurately feel what the crowd is thinking and when it is changing. From a profit and loss standpoint, there is no difference between being premature and wrong.
• The third hurdle is the assumption that the investor completely knows of any changes in demand placed on the advisor of the capital in the investment account. As an investment advisor I have never been comfortable with such assertions by others, or myself. We live in an uncertain world.

Another group of investors that has a substantial proportion of their wealth uninvested is driven by “FOMO” (Fear Of Missing Out). They want to quickly make up for lost time and get invested in stocks that are moving up. Their answer is to jump on whatever is moving most. This is called momentum. The problem with this choice is that after the original investors’ needs are met, as the only thing driving these stocks higher are other momentum players who may quickly move on to other investments.

To avoid these problems, if you find yourself with excess capital after filling all your essential reserve requirements, I suggest you divide the excess capital into perhaps ten segments, then invest a segment on each down day, which often fall on Fridays. For those more long-term oriented who have obligations to others, I suggest with bias that they consider a portfolio of mutual funds, allowing professionals to make tactical decisions.

A Contrarian’s Dilemma
Almost all investment courses take the easy way out by statistically analyzing financial statements and past economic conditions. The reality is the value of a stock is comprised of two very different aspects. While the first is taught, the second relies on the attitudes of those with buying power. This in turn is impacted by the buyers urgency to buy and the present owner’s urgency to sell. Price is where the two forces meet, with the next price a function of the size of the commitment of both sides at current prices. If the competing buyers have more money, the sellers will benefit from a higher price. If the seller demonstrates a larger desire to offload his/her merchandise, the intelligent buyer will get a temporary bargain. This equilibrium price is not only recorded in the regulatory records, but is also remembered by the participants and those who analyze their actions, e.g. market or technical analysts who don’t have the benefit of the specific motivations behind the trade. When there are a significant number of price changes in one direction, a trend is identified. No trend goes on forever and eventually reverses. A successful contrarian attempts to capitalize on trends that reverse direction. Historically, the trend best expected to reverse is the one trumpeted by many “experts”, or other pundits. Most of them currently anticipate further single digit gains following those generated since mid to late March. With the preponderance of investors sharing that view, I as a contrarian (long-shot better) am wondering whether we are setting up for a period of double-digit future gains?

This is where market analysis might foretell the future, without knowing the motivation of future buyers and sellers. Because of my background in analyzing mutual funds and similar vehicles, I often turn to their performance data for clues. For the last five years through Thursday’s close the three largest categories by current assets have produced very sub-par compounded returns: US Diversified Equity +3.83%, Domestic Long-Term Fixed Income +2.09 %, and World Equity +0.24%. None of these averages meet actuarial requirements or satisfy planned endowment expenditures. This suggests that many pension and probably other retirement funds, including endowments, are underfunded, potentially requiring larger future contributions and lower reported earnings, or in the case of endowments less ambitious plans. They could also be bailed out by a significant period of gains over 20%. (It used to be that gains over 20% were excluded in actuarial calculations.)

As someone who must meet payroll and other business and family expenses, I cannot completely live in the world of market analysis or contrarianism. Thus dear reader, please send me a message of what will motivate buyers of securities enough to raise returns to high single digit levels, with an occasional low double-digit gain year and only minor declines. I need help!!

Long Shot
As is often the case, the solution could come from beyond the present universe where we have the vast bulk of our assets. Perhaps there will be a reversal in the value of the safe-haven dollar, without medical and demographic plagues interfering with them. Emerging markets, with particular emphasis on Asia and later Africa, are currently an unpopular area. Both could make sense for our younger grandchildren, or more likely great grandchildren, but it won’t meet retirement needs or the needs for better educational diversity and other worthwhile goals.

Question: How are you addressing your investments today in order to meet longer-term needs? 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html

https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html

https://mikelipper.blogspot.com/2020/03/stealth-bottom-and-other-considerations.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 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Time to Get out of the “Foxhole”? - Weekly Blog # 623

Mike Lipper’s Monday Morning Musings

Time to Get out of the “Foxhole”?

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

Quite possibly the biggest mistake in the world is not recognizing that some critical fundamentals are changing. This mistake rests on strongly held views of the future, that it will seamlessly extrapolate from the immediate past or quickly be governed by a new order that will make sense of it all. Good luck to all who believe this.

I start from the assertion that I don’t know what the future holds, either for us or our investment responsibilities. Nevertheless, we know that we cannot stay still in our present condition. Now is the time to recognize that there have been some small changes in the last two weeks that could be meaningful. They have already rewarded some double-digit returns.

In the weekly ranking of traded price changes, a minority of 24% are going up. Not surprisingly, the biggest gains were for those related to oil, which had a relief rally of 25%. However, several unrelated prices also rose somewhat. (Consumer Staples +3.46%, Copper +1.63%, TIPS +0.90%, 7-10 Year US Treasuries +0.79%, Gold +0.54%, +20 Year Treasuries +0.48%, and the Yuan +0.06%). I find the rise of both copper and the yuan hopefully significant. The commodity market players and economists often refer to copper as “Dr Copper”, because it is often an indicator of early demand. The minuscule rise in the Chinese yuan is another indicator that some things in China are improving.

Fixed Income Quandaries 
All too often people group investments with a specified maturity and expected interest rate into the same category, such as government bonds and other bonds with a high credit rating. This can be quite misleading, as evidenced in this week’s Barron’s. The Best Credit Bond Yield average dropped by 37 basis points, while the yield on intermediate credits rose by four basis points. (Remember, bond prices go in opposite direction of yields). The market was therefore pricing the safety of credit more than it was higher yield.

I was at a meeting recently where a money manager included the high yield portion of the portfolio with other bonds. I suggested that high yield paper normally travels parallel to stocks, not bonds, and he agreed.  With interest rates currently at historic lows, high quality bonds should not be counted on for income. They should be recognized as a source of capital to be reinvested into bonds at higher rates (lower prices). This is particularly true now as the yields on longer maturities are rising. (One of the reasons that retail investors with high yield mutual funds underperform total returns is that they spend the distributions rather than electing to reinvest them.) Many disagree with my view in last week’s blog that rising deficits around the world will drive inflation and interest rates higher, and in time a lot higher.

Market Structure Changes
There is some inconclusive evidence the US stock market has hit a bottom. Market analysts suggest that some time must pass for the market to establish a large base before a successful assault on prior record levels can be made. One reason this makes some sense to me is that recessions are meant to correct the excesses of a prior bull market. Perhaps the reason the previous long expansion did not go higher was too many old zombie companies not earning their cost of capital. If this was the case, the next expansion will likely be shorter.

There is plenty of “dry powder” that could fuel a big expansion. One metric Wall Street focuses on are the portfolios of individual investors and for years they looked to Merrill Lynch to provide this view. This now comes from Merrill’s new owner, the Bank of America. They have indicated that the amount of cash in their client’s accounts are at a ten-year high, with the amount in bonds at a seven-year high. Additionally, the large amount of uncommitted funds in private equity is blocking them from raising new funds. The recent market decline has brought the S&P 500 ratio of market price to book value to below 3 times, a level at which M&A deals are often considered.

Covid-19
The public, media, and politicians are looking forward to the “flattening of the curve”.  This may be occurring in Italy, Spain, and New York state in terms of death, not number of new cases. Much more important to me are the vast majority of those who died in both Italy and China having other medical problems. What I don’t know is what killed them, the virus and its complications or their other problems. The following table, provided by US authorities, lists the proportion of patients that had other medical conditions:

Chronic Renal Disease     74.8%
Cardiovascular Disease    61.0%
Diabetes                  54.7%
Former Smoker             49.4%
Immunocompromised         42.4%
Chronic Lung Disease      40.4%
No Underlying Condition    9.7%

Perhaps a positive spin on this tragedy is that it is causing us to rethink, not only our healthcare systems and personal relationships, but also the structures of business and educational organizations.

Hylton and I wish you and your love ones good health. We hope you are practicing good procedures to protect yourself, your loved ones, and the people you are in contact with. We will get through this together.

Question: From where we are today, how should we organize to make us all better?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html

https://mikelipper.blogspot.com/2020/03/stealth-bottom-and-other-considerations.html

https://mikelipper.blogspot.com/2020/03/searching-for-bottom-understanding-and.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 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.