Do You Need to Update Your Thinking?

Introduction

Many institutional and individual investors are frustrated by the current levels of stock, bond, and commodity markets. These frustrations have led to inaction in addition to a state of anxiety. Most professional investors and many individual investors have had direct academic training and they and wealthy individual investors have had indirect or passed-along academic investment theories. With the major central bankers of the world experimenting with various forms of quantitative easing (QE) which has not had the desired effect, most of the reliable past investment measures have not been working.

As part of our responsibilities for managing accounts investing in mutual funds, we regularly have discussions with fund portfolio managers. Recently I had an in-depth conversation with the lead portfolio manager in a group that I have visited with since the 1960s. In discussing her financial services holdings she used the very same ratios and thinking that I have heard from this group for more than fifty years. I was struck that the fund's great long-term success was based on a very traditional approach that predates the current QE era and may explain why it is not enjoying its normal performance leadership position.

Recently Michael Mauboussin, now with Credit Suisse, published a list of ten attributes of successful investors which I have further edited:

1.  Be numerate (understand accounting)

2.  Understand value (present value of future net cash flow)

3.  Think probabilistically (nothing is absolutely certain)

4.  Update views

5.  Beware of behavioral biases

6.  Know the difference between information and influence

7.  Position sizing

Analysis of Financial Services Opportunities

Almost all financial services stocks are selling below their book value per share, and so the argument goes they are cheap now and will go up in price in the future. Under the current environment I am much more inclined to view their value is what they are selling for, as many traders believe. Book value is not a valuation metric but a reflection of historical costs of tangible assets. In the destructive era of QE some portion of loans not yet non-performing will become non-performing and thus their historic asset value is less by some to-be-determined amount.

The managers and owners of financial services companies claim that since the financial crisis the firms have added to their capital base and improved their efficiency and credit controls but their valuations have not improved since the crisis, even though their returns on assets and capital has. When interest rates normalize (read higher) their returns will rise, but probably won't get back to historic levels. Putting all of the current factors together these stocks are probably worth what they are selling for at the moment. However, under a higher interest rate scenario these earnings could be substantially higher. My view is that the current owners have in effect an option to benefit from normalization of economic conditions. Thus, the shares are priced right for the current environment, but with a potential "kicker" for the future.

One of the problems in using a balance sheet/book value approach is one is only dealing with tangible assets. As both a buyer and a seller of financial services companies, I recognize that the intangible assets are often worth as much if not more than the tangible. Think of this as "brand value." Among financial services stocks in the publicly traded market, I suggest that JP Morgan^* has brand value and Bank of America^* and Citi^* do not. I would clearly pay for JP Morgan without its balance sheet, but wouldn't for the other two. Even Chase's^* credit card business has brand value. Goldman Sachs^* has brand value in excess of its balance sheet. Just track how well quite a number of ex-partners and senior managers have done in raising money for their new ventures after leaving Goldman. I find it difficult to say the same thing for other firms, with limited exceptions for Morgan Stanley^*.

 Opportunities for Financial Services

Anytime there is a flow of money, there is an opportunity for some financial services organization to make or to lose money. Currently there are concerns as suggested by Moody's* that aggregate corporate earnings in the US is unlikely to top the record 2014 level until 2018. John Authers of the FT suggests that if one wants earnings growth, one should escape reliance on US sources. Fund money is already following fund performance. For the year 2016 through last Thursday, Emerging Market Equity mutual funds’ average is up + 18.50%, Emerging Market Local Currency Debt funds +16.62% and Emerging Market Debt funds in hard currency +13.56%. This is a worldwide trend with the second largest sales of ETFs based in Europe pouring into Emerging Markets. Cross border trades create a need for foreign exchange transactions which can be very profitable for financial services firms. In terms of the growth in emerging market debt, professional buyers conduct these through carry trades with US Treasuries and other elements as well as substantial use of margin. Most of the Emerging Market activities have been in Latin America +36.7% (Brazil + 68.4%) and the following list of countries all with gains exceeding + 20% : Russia, Colombia, Thailand, Indonesia, Hungary, Pakistan, and Chile.

* Owned personally or in a financial services fund I manage.

Perhaps the biggest opportunity for financial services organizations may occur with a new Administration in Washington. While one is reluctant to believe any of the political rhetoric from any politician, it does seem that it is likely that massive infrastructure spending programs will be announced. If these get funded, it will likely mean more bond underwriting at the federal, municipal, and commercial levels. Other increased expenditures that will generate buying is likely to be on defense, education, and health.

Conclusion

There are substantial opportunities for the financial services organizations to make or lose money, but most of the gains will be earned by groups that have talent in excess of their financial resources. Successful investing in this arena will be based on business type analysis not solely on financial statement ratios.

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A. Michael Lipper, C.F.A.,
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Thanksgiving and Investment Performance

Introduction

Most cultures have a harvest festival where people give thanks for what they have gathered. I am particularly blessed by the opportunity to communicate with such intelligent people globally through both this blog as well as through my investment responsibilities. One of my investment blessings is uncertainty as to the future. Contrary to many people’s belief, uncertainty is the arena where most investment gains are made; as various elements sort themselves out prices will react appropriately. However once things become crystal clear the vast majority of the price movement has been achieved. Thus I am thankful for levels of uncertainty as I attempt to deal intelligently with expectations.

Expectations

Faithful readers of these posts know that I visit the nearby Mall at Short Hills each Thanksgiving weekend. My report this year is mixed. By far the biggest attraction with long lines of grandparents, parents, and children was an expansive display of products and photos based on Disney’s “Frozen.” I marvel as how successful the “House of Mickey” has been with a product that was in public domain that they didn’t invent, but brilliantly promoted. The other big winner was apparently the iPhone and related merchandise. The large Apple^* store was jammed, but did not have outside lines. A much smaller Verizon store was quite crowded. AT&T’s much too large store had a sprinkling of people within it. While this mall ranges from mid price points to high prices, the high-end stores looked quite empty. My walking conclusion is that it will be a good season for Apple and not so good for high-end shops. I do not have a big feel for the purchases over the Internet. Some retail groups have jumped on to it, Macy’s claims that it is the fifth largest seller on the net.

^*Owned by me personally and/or by the financial services fund I manage

From an economic viewpoint the absence of many “must have” purchases may mean that the savings (not spending) ratio will not retreat from its current 5% level. The use of debit cards is probably not going to soar.

Liquidity concerns

One set of expectations on the part of members of the SEC is the rapid redemptions in bond funds and ETFs when interest rates begin their “inevitable” rise. Quietly they are asking leading fund groups and their independent boards about plans to handle the expected tidal wave. Curious to me they do not appear to be as concerned about equity liquidity which I believe under the present shortage of trading desk capital could react just as quickly. In terms of investment performance in both the debt and equity markets, it has paid off to invest in large, but illiquid positions. We will be watching intently as to how those portfolios that have been more illiquid than others handle any significant squeeze on liquidity. (More on this relating to performance below.)

Longer term economic expectations

Pensions & Investments magazine (P&I) and Aberdeen Research conducted a poll on Macroeconomic expectations over the next ten years by region. The majority of respondents would improve as shown in the following ratios of improvement vs. decline:              

                  

Market Location	Ratio Improve vs. decline
Emerging Markets	47% vs.13%
Frontier Markets	36% vs. 18%
Brazil	33% vs. 17%
China	31% vs. 31%
Japan	16% vs. 11%
non-US dev.	11% vs. 7%
Canada	9% vs. 4%

Other major regions including US, UK, and Europe were expected to have deteriorating macroeconomics over the ten year period. I have little confidence that these projections will work out as expected. However, I believe that they are useful in understanding current price/earnings ratios in these markets.

Performance analysis

One of the elements that I am thankful for this holiday is that we are in deep discussion about managing one particular new account’s money. A vital key to a high level of satisfaction is to agree as to what is important to be measured. I have difficulty determining a worse measure to make decisions as to hiring or firing a manager than raw absolute performance or even relative performance to some securities index. These are not the primary tools we use in selecting funds for a portfolio of funds. As J.P. Morgan himself stated, he only loaned money on the basis of the borrower’s character. Thus we want to understand the managers as individuals.

We also recognize the need to be patient and that is why we look at long-term developments.

There have always been some spectacularly performing managers often with very successful sales people attached that I do not believe. Many times when I dig into their records I find a particular, undisclosed relationship that is the main engine of their success. Some of these engines can keep functioning for a number of years until they are found to be wanting. One of the keys to our analysis is to try to determine where the good and bad performance come from. In some cases all of the extreme performance comes from a limited number of securities. I remember one quite ordinary fund with a skilled portfolio manager salesman touting its good performance. When I looked further into the fund’s performance I noticed that all of the truly great performance was coming from a single analyst. I suspected that he would quickly find better employment elsewhere. When that happened the air was let out of the fund’s good numbers which eventually led to the sale of the management company.

The significance of turnover and fund flows

A rapid turnover producing a good record is not as valuable to me as one whose portfolio is turned over more slowly. The first fund may possess trading skills which are often relatively transitory while the second one may have real selection skills. As even the best investment managers have periods of significant underperformance, we need to understand both the causes of the underperformance and what the manager does about it. The impact of cash flows and how they impact the portfolio has a distinct implication to evaluating the result. Often a surge of money coming in can overwhelm either the position size or the number of holdings. (An important corollary of the surge is what the organization does with its increased profitability. Does it change the life style of the key investment personnel?) Withdrawals or redemptions can reverse some of the behavior changes. However, we are not disturbed by the outflows. I have never seen a portfolio that couldn’t benefit from some pruning.

The question that I am currently grappling with is how to introduce sound judgment into the investment performance question. With the large group of very intelligent investment professionals and sound investors reading these words, I appeal to you for help. Your assistance will give my accounts and me something to be thankful for.

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Investment Implications of November’s Inflection Points

There is a good chance that when we look back at November 6^th to November 14^th, 2012, the period that includes the US election and the Communist Party Congress in China, we will recognize an important secular inflection point.

The key was to sell

There are three time scale references that are useful in looking to the future. The first is that the media and other pundits focus primarily on the tactical or temporary time slots; e.g., when in last week’s post I recommended selling on the day after Election Day. I was wrong that there might have been a relief rally on the basis that one unknown was now known. The key to the recommendation was to sell because of the large number of remaining unknowns which were not likely to be decided until the spring of 2013. On a short-term basis the decision to sell last week was correct. Several astute investors have informed me that they reduced their 60% equity allotment to 30% on Wednesday. Another smart investor decided not to take advantage of the drop in stock prices as there were too many unknowns.

Cyclical periods

The second time frame (and the one most used by institutional investors and members of investment committees) are cyclical periods which go on for a few years. Election cycles, crop cycles, fashion cycles, economic cycles and market cycles are examples of outside forces that somewhat predictably influence market prices and portfolio returns. To participate in these cyclical periods, consultants like three years, older CEOs prefer five years and younger CEOs favor ten years as calendar periods to capture most of the other cyclical behaviors.

Always is a long time

For those of us who are managing money for succeeding multiple generations and/or institutions who believe in their eternal lives, secular time periods are more appropriate. The demographic trends, the technological changes and long-term medical developments are some of the factors that impact secular growth rates and the attractiveness of various investments. I have always been more focused on secular changes than shorter term phenomena, particularly today. I am writing the first draft of this post Saturday night, the 10^th of November, the 237^th  anniversary of the US Marines Corps. Marines believe in lots of practical virtues, but our motto is Semper Fidelis, which is Latin for ‘always faithful.’ Always is a long time and it is from this background that I look to our future, including our financial future.

November Elections

In a period of under 10 days the US and China, the two largest economies of the world conducted elections (albeit differently) that may be viewed as inflection points to the future.  The practice of analysis rests heavily on an examination of past actions. There is a well-documented history of the rise and fall of empires, or if you prefer, dynasties. The characteristics of large empires that go into declines over many years, and in some cases centuries, start with public displays of moral decay, demographic changes that create distrust between elements of the population, excessive spending by central governments, inflation leading to the practical devaluation of the currency and weak political leadership which translates into too cautious military and naval deployments. While empires fall because of their internal problems, they are finally subdued by new empires that are led by hard-working populations that want more. Often the rising empire is to the east of the falling one.

The victors in the US election and the California Proposition 30 referendum ran on the platform of raising taxes on others, temporarily defined as wealthy income generators. Few of those who supported these policies stopped to think that in the long run these impacts will be self-defeating. Ultimately, if the wealthy do not physically move, as from France to Belgium, California to Nevada, US to Singapore, or change their cost structure (employing fewer people), they will raise the prices for their goods and services. Some of the price increases will be disguised as reduced services and support, as well as less quality. This phenomenon is called inflation. We know that the impact of inflation tends to be retrogressive. The poor will suffer more than the wealthy. Central bankers around the world desire inflation which will lead to the practical devaluation of our fiat currency compared with hard assets. We are setting up a weak dollar, which will be dangerous if combined with a less capable US military/naval force.

To the East of the US is China, beginning the installation of the fifth generation of its collective leadership this week. The composition of the Politburo Standing Committee (expected to be seven) was determined by the retiring fourth generation leadership, and to some extent the third generation leaders. On November 9^th, China Daily published an advertisement in the Financial Times as to the progress that has been made under the fourth generation. The results compare 2011 data with that of  2002, which can be summarized as follows:

·        Percentage of Urban Population: 51% vs. 39%

·        Private Vehicles: 79 million vs. 10 million

·        Foreign Students: 293 thousand vs. 86 thousand

·        Fortune 500 Chinese Companies: 69 vs. 11

·        Refrigerators per every 100 rural families: 62 vs. 20

·        Cell Phones per every 100 rural families: 180 vs.15

and many other measures of physical and financial progress.

The expected fifth generation leaders have prepared detailed plans which have apparently been approved.

Investment Implications

Near-term (tactical) events move markets; thus volatility will pivot on news from both Washington and Europe. While stock market volume will probably remain relatively mild, there will be an increase in selling by taxable investors trying to avoid higher capital gains taxes. It is possible that the number of insistent sellers could create some bargain prices.

Cyclical investors should recognize that the odds are that an economic cyclical recovery has already started; led by housing, replacement/replenishment cycles, Sandy-induced repair and rebuild needs and perhaps some longer-term attention to prevent severe damage from future natural disasters. Casualty insurance stocks will get a boost when they announce their premium increases.

The secular investor needs to recognize that the next generation is going to hinge on the opportunities and problems emanating from China. Successful investing in China is problematic for us who are used to Western accounting and contract law. However, there are three other alternatives. There are some mutual funds and other institutional investors who may well be able to be successful investors in China. A second alternative would be a handful of US, UK, and European companies that expect a large part of their future growth will come from China. The third alternative would be to invest in those areas that can be critical to Chinese growth, such as Africa, Australia, Brazil and Mexico.

One secular trend identified by Sir John Templeton years ago is the shortage of high quality shares to buy. The combination of cash acquisitions and stock buybacks is reducing the pool of available shares for purchase. To a similar degree, the credit problems facing many bond issuers have reduced the amount of the highest quality paper that is available. As these needs become apparent, I have no doubt that the investment and commercial bankers of the world will try to fill the void; the question will be the quality of the new paper. Under these conditions, and I speak with bias as an owner of shares in a number of investment bankers, I would rather own them than the paper they sell.

It’s your turn

What portion of your investments do you assign to your tactical, cyclical and secular buckets?

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