4%, 5%+, Changes, Disruptions, Faulty # # - Weekly blog # 748

 

 

Mike Lipper’s Monday Morning Musings

 

4%, 5%+, Changes, Disruptions, Faulty # #

 

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

    

 

Particularly Difficult to Invest 

Pundits have an advantage over real investors. They eliminate any factors contrary to their proclamations. I don’t have that capability in deliberating how to invest for the multiple futures faced by my accounts. The somewhat obtuse title of this blog is a shorthand list of my concerns.  

 

4% 

4% is my conclusion after listening intently to Chairman Powell’s less than 9-minute speech concerning the Federal Reserve Board’s direction. While it did not reveal much new, it reinforced earlier comments made at the last press conference. It reaffirmed my belief that the minimum interest rate that should be expected is 4%. My belief is anchored in a co-incidence. Most money in the market is invested to meet retirement and estate needs. Long-term research suggests annual withdrawals from these funds should be 4%, which implies leaving the on average basic capital intact after inflation and taxes. If that is the goal for both private funds and social security payments, it requires capital growing at least 4%. This 4% aspiration is higher than the current return earned by Social Security and other government funds. Thus, the basic requirement for a sound economy is 4% growth. 

 

The drop in stock prices on Friday was probably due to expectations the Fed would show signs of “pivoting” toward lower interest rates. Investors should not let wishes drive expectations! 

 

5%+ 

Reported general US inflation is running at 8% or more. Chairman Powell and other Fed leaders have indicated the appropriate Fed interest rate should be sufficiently above the inflation rate to assure consumers and others in the market that rising inflation won’t be a future problem. 

 

The current focus of the Fed and others in government is the belief that they can only accomplish their goal by reducing aggregate demand. This is what is taught at most universities. Advocates of this view have little if any experience in the commercial world. They believe in dropping the level of the water when a tall vessel approaches a low hanging bridge. I and others in the commercial world believe the bridge should be raised, probably permanently. 

 

In terms of current US inflation, the current administration is lowering the water. Energy is probably the largest single contributor to inflation around the world, yet the US government is curtailing its availability. Other constraints placed by the organs of government on a productive economy are various regulations. Without changes, odds are low the US will see inflation less than 5%, and it may be well above. 

 

There is a good chance that assets other than US currencies will appreciate when the Russian-Ukraine war ends and/or when the Chinese government is successful in growing its economy again. Thus, it is appropriate to assume the US dollar will decline in value at some point. Goods and services purchased from overseas will then be priced higher, adding to our inflation. 

 

Changes 

There are likely political power changes coming to the US from both the mid-term and presidential elections.  

 

In the current recessionary environment, we are seeing various senior portfolio management and asset management leadership changes. Many corporate boards of directors are unwilling to continue with their current top management, or even continue to allow their degree of independence. (This could be an early gift to slow moving “value” stocks.)  

 

Disruptions 

One influencer of goods inflation is inflation in the service sector. Customers in supermarkets and malls have changed their buying habits to get more value and less fashion from their purchases. This change has been noted by producers of consumer goods. They have reduced advertising support for some fashionable top-line merchandise. 

 

The reduced support has already led to lower expected revenues for the big five advertising agencies. Broadcasting networks are in turn worried about revenues from these advertisers. At least one network is considering dropping an hour from its prime-time programs. I suspect competition from cable and streaming channels is also chipping away at network audiences. 

 

Another disruption is life insurance sales being down from peak-levels during the pandemic.  

 

A final disruption is the value of real estate. Commercial real estate is carried as an asset on corporate balance sheets. For the most part it is carried at purchase price less “depreciation”. This gets to the heart of the problem. Accountants and asset owners don’t like being sued for inaccurate financial statements. Consequently, they carry their assets at costs less amortization of their purchase prices unless there is a rare contrary price available. 

 

Take an office building costing $1 million being “depreciated” $25,000 each year, straight line. At the mid-point of its theoretical life the property value would be listed as $500,000. The accounting rules would not permit raising the carrying value to $750,000 if a comparable property was sold at that level. Nor would it drop that valuation to $600,000, a drop of 20% if there was a lower priced sale later. Consequently, the owner would carry the building at $500,000 that year. Thus, there is a $100,000 “hidden value” that many “value investors” prize. 

 

Now, bringing the situation up to date. The present tenants have indicated that they only need 25% of their space due to work from home syndrome. They threaten that they will move out unless the rent is adjusted to their needs. If this were to happen in the midpoint year, the real value of the building might be $150,000, (25% of $600,000 if that price is still accurate.) The problem for an uninformed value investor is that this price is considerably below what the investor thought. 

 

Conclusion: 

These are uncertain times. While some of the uncertainties will be solved, they will not be solved at today’s prices. So prudent investors should move cautiously and probably divide their transactions into parcels for periodic transactions. They should not try to pick a bottom or jump on a sharply rising trend. 

If you have different views, please share.  

  

 

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

https://mikelipper.blogspot.com/2022/08/mikelippers-monday-morning-musings.html

 

https://mikelipper.blogspot.com/2022/08/time-to-prune-weekly-blog-746.htm

 

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.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 - 2022

 

A. Michael Lipper, CFA

All rights reserved.

 

Contact author for limited redistribution permission.

  

Length of Stay Contributes to Performance - Weekly blog # 747

  

 

Mike Lipper’s Monday Morning Musings

 

Length of Stay Contributes to Performance

 

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

    

 

     

Blog Focus

Most investment-oriented blogs focus on the selection of individual securities or funds/advisors. I am uncomfortable with crowded fields or markets, believing returns are relatively low when they are correct.

 

I am blessed to be part of an informal group of still active investors, who are or were professional analysts, portfolio managers, and institutional salespeople. For most of my professional life I have studied and used mutual funds and management companies/advisors. These are the results I study.

 

In reviewing my peers’ and other performance records, I am impressed that a large portion of their very successful records were produced by holding securities and other relationships for many years.

 

Holdings held 25 years or more have produced remarkably good performance, with some gains 100X or more their original cost. These gains were achieved by careful initial selection and maintenance of the positions, hopefully reinvesting distributions over an extended period.

 

Recognizing the benefit of compounding returns has led me to subdivide portfolios into length-of-stay (LOS) buckets.

 

While investment and economic cycles don’t overlap or fit concisely within US presidential terms, they are reasonable approximations of most major up and down US stock market phases.

 

Consequently, I take the point of view that periods under five years require superior trading, not investment skill. At this time, which appears to be between a long bull market and a shorter bear market, the five-year average compound growth rate of 7,433 US Diversified Equity Mutual Funds serves as a useful comparison for the next five years without making any predictions.

 

The five-year weighted (by performance) average return through last Thursday was 11.98%. Perhaps more significant was the median return of 10.04%. (Better performing funds raise the average result when compared to the absolute median result. I am more comfortable using the median for planning purposes. It is also closer to the historic return of the S&P 500 since 1926.)

 

A recent discussion with a leading energy analyst concerning Berkshire Hathaway’s interest in Occidental Petroleum confirmed that it is reasonable to expect its stock return of 8% for the next five years. As this is a holding in our personal and managed accounts, I felt it was a good alternative to Berkshire’s cash position, especially in view of the five-year returns mentioned above.

 

L.O.S. Impacts Choice of Value vs Growth

Investment theory is based on fair value being the highest price a knowledgeable buyer would pay. Consequently, the only time you should buy an investment is when it trades at a discount to fair value. A value investor seeks a position selling below the price of a company’s products or services. The elapsed time is usually small and is often dependent on an economic cycle or commodity price change. Most value investors expect this to occur within five years.

 

Typically, a growth investor has a different mathematical approach. Growth usually infers a decline in the price a company sells its products or services as demand grows. This could take many years.

 

When DuPont viewed by itself as a growth company it was willing to build an expensive chemical plant to develop the market for its merchandise. It was willing to wait twenty years to reach an overall breakeven level. It expected it to be followed by very profitable years.

 

Value investors have a relatively short-length-of-stay and expect lower volatility than growth investors. However, most accounts able to earn many multiples of their initial investment have tended to be growth oriented.

 

Current Market

Current market leadership to mid-June has exhibited a relatively short-length-of-stay orientation based on an anticipated recovery in price or demand levels.

 

In the past, mutual funds experienced historic net redemptions when the expected period of investment was complete. This was on average 13 years.

 

With the switch to shorter term wealth management approaches, the new favored sales vehicle seems to be indexed Exchange Traded Funds. This is likely to continue to make markets more volatile.

 

Leading corporate managers by contrast are betting on growth. They expect major changes in how investors will do things in the future.

 

Last week we mentioned Aetna’s recognition of the change in healthcare delivery through CVS Health. In a somewhat similar fashion, Amazon is also looking to provide healthcare directly through a new venture.

 

Apple’s new products and policies are likely to generate dramatic changes in a number of markets

.

We are in a volatile period. In last week’s blog I noted that the vast majority of the WSJ weekly prices showed gains, with the two largest declines being the Wall Street Journal dollar index and the Russian Ruble. This week the two largest gainers were the two biggest laggards of the prior week, whereas the bulk of the prices declined.

 

Conclusion

Traders who can use volatility to their benefit should continue to do this. However, relatively few have these skills.

 

Those with patience willing to view the future as offering opportunities for extraordinary gains and have patience should invest for growth.

 

 

 

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

https://mikelipper.blogspot.com/2022/08/time-to-prune-weekly-blog-746.htm

 

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html

 

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.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 - 2022

 

A. Michael Lipper, CFA

All rights reserved.

 

Contact author for limited redistribution permission.  

TIME TO PRUNE? - Weekly Blog # 746

 

Mike Lipper’s Monday Morning Musings

 

TIME TO PRUNE?

 

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

 

 

 

Season & Direction

Many businesspeople and some investors normally consider changing plans in September, focusing on the ends of December and January. Many will include the results of the mid-term elections in their timing decision.

 

Some merchants will focus on the end of January, which ends the retail trade year. With possible inventories out of balance and some uncertainty over shipments, particularly from Asia, there is a premium on having the correct inventories to sell quickly, utilizing a diminished senior sales staff.

 

Like Charlie Munger and Warren Buffett, my preferred holding period is forever. In my humble experience, there are times when it is wise to consider pruning the portfolio. Since the earliest investors were farmers, periodic pruning was normal. Even the best portfolio managers follow professional gardeners and prune their portfolios. A good portfolio is more than an accidental collection of securities. A sound portfolio should work well in most non-extreme markets.

As a contrarian I do not accept we have entered a new “Bull Market”. I believe a new market cycle begins from a prior market’s beginning point. In this case, from its prior peak. What we are currently experiencing is a normal rally in a “bear market”. The main reason for this belief is that we have not even begun to address many of the causes of the last bull market’s problems, other than simply prices.

 

I regularly admit that I can be wrong. I urge investors to keep their pruning instruments handy on the chance that I am correct and equity markets decline. Pruning is a necessary tool for the survival of successful portfolio managers.

 

The Need to Prune

The reason one prunes is that it is an essential first step in repositioning the portfolio. The timing of the decision is not necessarily dependent on knowing what to add to the portfolio immediately.

 

There are two motivations to prune. The first is to reduce the level of panic when the market is in freefall. The second, which may not come from the first, is to build a buying reserve. Opportunities are easier to judge when one does not have to decide what to sell before you buy.

 

Voluntary & Involuntary Pruning

Since we have established the necessity to prune, the first way to do it is by the calendar, and the second is by the performance of the market.

 

I have already suggested a calendar prompt, which may be particularly apt in this troubled year. Using September as a month to make financial decisions may make unusual sense. It is the end of the US federal fiscal year and the beginning of the fall shopping season.

 

Some pundits are saying we have entered a new “bull market”. However, history suggests that a new bull market is usually led by new groups of stocks.  The current leaders appear to once again be large-cap technology growth stocks. Going back to the old leaders suggests many of the pundits are failing to look for new leaders, ignoring many fund managers signaling caution.

 

One quick filter that could suggest candidates for pruning is measuring the growth of operating earnings between pre-COVID 2019 and 2021. If these operating earning did not rise 10% or more, an analyst should question a replay of old leadership being conducive to doing well.

 

There are other filters such as evaluating whether the management of competitors has deteriorated or improved, and/or whether price and volume has materially changed. The key is to find some reason to do what racetrack handicappers do, which is to throw out a particularly bad race in assessing the future.

 

I have been a beneficiary of the involuntary pruning of positions held for some time, which made me question why they were continued to be attractive. (Please do not treat these examples as recommendations, which should only be made based on client needs and temperament.) The following discussion of five occurrences result from my background in the financial services industry, although the lessons can be profitably used in other sectors too.

 

ADP>CDK Global

I recognize my investing should be broader than the more familiar targets of mutual fund management companies and broker/dealers. Automatic Data Processing’s (ADP) historic basic business was relieving companies of their payroll processing and payment responsibility. They replaced commercial banks who initially dominated the field. ADP had superior data skills and a lower cost structure. They also learned the wonders of “free float” from Warren Buffett. Earning short-term interest on the payroll account. Since I was convinced the number of payrolls in the US were in a secular growth pattern, this stock was a good “common denominator” base position for a financial services fund.

 

As is often the case when one buys a good company, there may be a “kicker” in the purchase. ADP purchased or originated other financial services activities. but As good as many of these were, they were not as productive as ADP itself. Their usual approach was to spin-off these companies to their shareholders, and a number of good ones went public.

 

One of these spin-offs was CDK Global, which provides data services to automobile dealers, automating their sales and service appointments. The number of individual auto dealers has been dropping and the number of larger multiple brand dealers has been growing. (Berkshire, Alleghany, and the Washington Post, among others, are aggregators.) As CDK’s European business was in the process of being sold, its US activities sold separately at a good price. Thus, we involuntarily had a cash infusion during the “bear market”.

 

I kept ADP, who used its strong connections providing payroll services to assist clients in their hiring of financial services and other specialist. By the time this pattern became visible, they were already developing the business of “renting” employees to their clients and others. Initially it was in the financial services business but expanded to other fields as well. This “PEO” business made continued ownership of ADP even more attractive.)

 

Little “Berkshire” Joins the Big One

Alleghany Corp was the old Kirby family holding company with a long history of owning interesting companies, including IDS the forerunner of today’s Ameriprise. Alleghany is largely an interesting collection of casualty insurance companies, plus a collection of minority interests in a wide portfolio of ventures. Alleghany’s capable CEO recently retired and was replaced by a former CEO of General Reinsurance, which was acquired by Berkshire Hathaway. Alleghany is very familiar to Berkshire, so it was an easy decision for Mr. Buffett to make a cash acquisition offer for Allegheny to close later this year, at a record price. (No competing bid came in!)

 

Aetna>CVS Health and Eaton Vance

Two other holdings got new owners through a stock deal because they recognized a major change in the natures of their businesses.

 

As a newly married young US Marine Corps officer I purchased a life insurance policy. When I entered the financial services field, I realized I had bought the wrong product from Aetna if I didn’t die early. Years later it became clear to me that the cost of selling insurance was too expensive. Aetna’s management saw the same thing. They realized the healthcare industry had much better prospects, as did their competitor Cigna. Aetna bought the larger CVS drug store chain. By combining its healthcare funding and processing capabilities with the store fronts. It then put medical professionals in the stores. and They were better addressing the needs of the public than by serving each of them separately. (In previous blogs I mentioned three major sectors growing less efficient and not doing a good job: schooling, defense, and healthcare. CVS health is addressing some of the issues involved with the latter, which is one of the many causes of inflation and lack of growth.)

 

Eaton Vance is one of the oldest US mutual fund management companies. They have been one of the more innovative management companies developing new vehicles for institutional and individual investors. But the game has changed. Their original base was being one of two Boston based investment advisors dealing with rich clients and offering funds for the related but less wealthy retail accounts. They sold their mutual funds and closed-end funds through commissions salespeople at major brokerage houses. The business changed with individual brokers restyling themselves as wealth managers, earning annual fees rather than commissions. These wealth managers have inserted themselves between the fund complex and the ultimate client. This has had two effects. The wealth manager feels compelled to prove his/her worth by having an opinion separate from that expressed by the asset manager at the fund company. All money management accounts lose money for the provider of investment services on day-one of the relationships with the client. The client moves into a profit position with the asset manager over time. There is less effort in managing the account than getting it. In practice, the money stays with the wealth manager for less time, so the economic value of the relationship declines. In addition, Eaton Vance’s competitive strength is in sophisticated fixed income and tax managed products. With interest rates going lower, their book of business was becoming less profitable. A merger into Morgan Stanley locked in their largest wire-house distributor and opened international distribution opportunities.

 

Thus, each of these involuntary prunings helped the owners of the accounts I manage.

 

Weekly Insights

1. The US Treasury inverted yield curves persist, with the 2-year yield higher (3.257%) than the 10-year (2.848%) and 30-year (3.117%). The bond market still sees a recession.
2. In a volatile week, the best performing mutual fund investment objective was Natural Resources +8.24%, with General US Treasury -2.36% being the worst for the week ended Thursday.
3. The weekend edition of The Wall Street Journal tracks the prices of 72 stock indices, and index funds, commodities, and currencies. 93% were higher, catching Friday’s exuberance. The two that generated losses of 1% or more were the WSJ Dollar Index -1.05% and the Russian ruble -2.77%. Both could be of significance.  

 

 

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

https://mikelipper.blogspot.com/2022/08/investors-politicians-other-children.html

 

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html

 

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.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 - 2022

 

A. Michael Lipper, CFA

All rights reserved.

 

Contact author for limited redistribution permission.