Fear of Instability Can Cause Trouble - Weekly Blog # 848

 

         

 

Mike Lipper’s Monday Morning Musings

 

Fear of Instability Can Cause Trouble

 

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

 

 

 

Instability Changes the Players

Historically, the perceived strength of allies provides comfort to all fearing future conflicts. Changes can lead to instability, including a change in leadership, an unexpected industrial and military technology change, and demographic change. Some of these changes may happen almost overnight, while others may take generations.

 

In studying what caused World War I, all too many focus exclusively on the assignation of the Archduke of the Austro-Hungarian Empire. I suggest the following causes which arose at least 50 years before the assassination on June 28, 1914.

1. The declining economic power of Austria, due to excessive spending by the government and the wealthy.
2. A population still loyal to their old national governments.
3. The unification of Germany, which came much later than the other European and Middle Eastern countries. Germany was also late establishing colonies in Africa when compared to Britain, France, Italy, Spain, Portugal, Belgium, and the Netherlands.
4. The evolution of shipping from wind to steam power, and the development of the land-based maneuver practiced by Stonewall Jackson.
5. The rise of the US as a global sea power during the Spanish-American War (Great White Fleet).

Applying the same type of geo-politics/economics to the US after the meaningful stock market drop that followed the decline in jobs. The following elements should be noted:

• The pundit led consensus was wrong on the President’s capabilities and many factors concerning the economy.
• The rapid fall in the quit rate points to a further decline in the employment cost indicator.
• Commodity funds are cutting copper positions.
• Fundamental changes in the structure of the US stock market: In the latest week, NASDAQ trading was 6.6x more than the NYSE.
• In July, the performance of the equal weighted S&P 500 was 3% better than the cap-weighted version. Among the stocks with positive performance for the week were: Apple*#, Coke#, and a number of insurance stocks. (* owned by personal accounts, # owned by Berkshire Hathaway)
• 77% of NASDAQ stocks declined last week, versus 66% for the “Big Board”.

As both a contrarian and someone who reads history, I believe that Mr. Buffett building his cash & equivalent pile is the most bullish view I have seen in a long time. Mr. Buffett is getting ready to make positive investments in the future, he is not building reserves. I hope all of our subscribers are preparing to be bullish, which does not mean buying right now.

 

 

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Data Performance/Easy.Interpretation/Not - Weekly Blog # 774

 

Mike Lipper’s Monday Morning Musings

Data Performance/Easy.Interpretation/Not

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

 

Simple Numbers Not Useful Answers

The Standard & Poor’s 500 index with dividends has annualized compounded performance reported to be 10.81% since its theoretical inception in1871. The index’s performance since 1965, the period for which Berkshire Hathaway has a public record is 9.9%.  The Buffett/Munger record for this period is 19.8%, or twice the index. I find the three-year record of Berkshire Hathaway compared to the S&P 500 and NASDAQ of greater interest. Berkshire’s compound growth rate was +11.34%, the S&P 500‘s +7.66%, and the NASDAQ +7.80%.  

 

The overall superior Berkshire result produces more comfort to me and clients than just the raw performance numbers. Remember, Berkshire’s combined results include their operating assets and expenses. I do not normally use three-year performance comparisons, as they frequently do not include one or more down years. The S&P 500 had three periods of two consecutive down years in the 58 years, vs. Berkshire which had only one such period. Over the entire 58 years the index fell in 13 calendar years, vs.11 years for Berkshire. (Psychiatrists tell us we feel twice as much pain from a loss vs. a similar gain, which makes sense arithmetically.)

 

Since we manage money for ourselves and others, investment performance is only part of the gain. Our reward is having the proceeds used productively by our beneficiaries or ourselves. If we or others squander the proceeds through bad choices its human impact is the penalty we should calculate in assessing success or failure.

 

Perspective on the last Three Years

On a purely mathematical basis, performance for the last three years suggests we have entered a different period than before. For the five years ended this past December, the S&P 500 index rose by an annualized 9.43 %, which is not a great deal different than its annualized 10.81% return since 1871. However, what is different is the S&P 500 Index growing only 7.66% annualized over the last three calendar years. (Berkshire, because it didn’t have the down year and had its operating side perform better than the security side, produced a compound annual return of 11.34%.)

 

While our accounts benefitted from Berkshire’s performance, the accounts will track a bit more closely to the index. I don’t know how much longer this particular phase will last, we have quite possibly entered a stagflation period. The president and past president have been spenders, comfortable with debts rising faster than the ability to repay it.  

 

If we define a period of stagflation from purely an investment perspective, we had six multi-year periods where the index did not produce a single year rising 20% or more, (1968-1974, 1974-1981, 1986-1989, 1992-1994, 1999-2002, 2004-2008, 2010-2012, 2014-2016).

 

A number of CEOs are changing. In many cases the new ones have strength in operations rather than skills climbing the political ladder.

 

We are also seeing changes at the supermarket. In one of the normally high-priced markets they are no longer carrying the highest price merchandise, e.g. lobster bisque. The weekly list of prices for stocks, bonds, commodities and indices are fluctuating wildly. Less than 10% of prices on the WSJ weekend list rose the week before last. This week 88% rose. To add to the confusion in the securities marketplace, the NYSE saw prices decline for four of the last five trading days, vs. three out of five for the more trading-oriented NASDAQ. For the week, 62% of prices dropped on the NASDAQ vs. only 54% on the NYSE.

 

American investors and their institutions have been selling US stocks but buying both European and Asian stocks. Those buying in the US have favored small-capitalization stocks, including those having more physical assets.

 

Low transaction volume in US stocks is being offset by investors favoring perceived to be less risky investments.

 

We may well be in a phase like the period between the Archduke being assassinated and the formal beginnings of World War I, which was obviously going to happen.

   

Question: What are you looking at to signify a new market phase?

 

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Mike Lipper's Blog: “This was the Worst Week of the Year” - Weekly Blog # 773

 

Mike Lipper's Blog: A Terrible Week - Weekly Blog # 772

 

Mike Lipper's Blog: Primer on Starts of Cyclical & Stagflation - Weekly Blog # 771

 

 

 

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Changing Focus in a Changing World - Weekly Blog # 719

 

Mike Lipper’s Monday Morning Musings

Changing Focus in a Changing World

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

Changing Focus

Securities analysts should come with two perspectives. The majority attempt to read the current minutiae of what companies are saying, with the goal of assessing the current price and the probability of relatively short-term future prices. The second perspective, rarely produced for public or client consumption, eventually pays bigger rewards when correct. 

For some time, this blog has highlighted the relatively unreported negatives concerning the current optimistic outlook. Entering 2022, there are more comments about risks and possible recessions, which while still in the minority of published opinion, has increased in coverage. At this point there are enough bearish comments, so I can move on to the much tougher challenge of finding reasons to be optimistic. The eventual major stock and bond market decline is inevitable, although I cannot identify the time and headlines that will label the decline. Furthermore, I cannot stipulate the length of the bear market, which is normally a function of what owners do, not what issuers do. In other words, from the current lofty levels I am beginning to look across the valley of disappointment to the beginnings of the next expansion. 

I look forward to learning the views of subscribers, both concerning the down phase and the recovery.

Changing Environment 

The future will contain a multitude of changes, many small, but a few unexpected by most will verge on being seismic. At some point in many developed countries, the growing size of government debt owed to non-citizens will be too large. Not only will foreigners refuse to buy more, but they are also likely to push for debt repayment, not rollovers. 

For many Central banks and commercial financial institutions, US debt is a prized asset. However, Mae West may finally be wrong in that “too much of a good thing is wonderful”. In 1990 the Federal Debt totaled $3 Trillion, now in under half of a lifetime it is $30 trillion. Politicians of both parties are responsible for this growth in our children’s and grandchildren’s debt. Interestingly, 35 of 50 states require balanced state budgets. (One can examine the financial health of the 15 states that don’t have this restriction, comparing local crime and inflation.)  While the growing debt is deplorable, it is probably a good indicator of how the government meets its other responsibilities. (Some houses never have a single broken window.)

Looking at the implication of the growing debt and its likely impact on the investment environment in 30 years. The debt will impact our children’s assets and the future value of what our grandchildren inherit. It would be prudent to expect taxes of all sorts to increase. Increased taxes will lower the reported earnings of companies and will probably delay the dividend increases the third generation may be living on. Will it likely lead to lower price/earnings ratios? (Since the 1950s we have generally benefited from rising earnings multiples.)

There are at least two other changes to our investment environment, both positive if one’s portfolio is properly positioned. The first is that winning companies and institutions, no matter what they do, will make progress by improving customer service. Because technology will likely continue to lower the costs to manufacture and transport, the winners will have the attitude of successful service companies.

We are already seeing the third trend that is going global. Year-to-date figures show the US market declining more than 5%, while Brazil is up +10%, Greece +8.5%, South Africa +6%, and Chile +6%. Five other countries have positive equity markets. We are also seeing positive fund flows into Western Europe, Japan, and Emerging Markets. This is probably not a short-term phenomenon. While one can understand a certain reluctance to disclose critical information in patent applications, the number of patents granted suggests a large amount of technology innovation is taking place outside the US. The percentages of patents awarded in 2021 was: China 49, Japan 15, South Korea 11, US 10, and Europe 8.

Changing Companies

Many companies continually evolve, some more dramatically than others. As my primary focus is financial companies, I see some making changes that should impact earnings patterns in the future. Goldman Sachs (*) is developing a retail banking base to fund their investment banking activities. It is my speculation that when Buffett and Munger are no longer involved with Berkshire Hathaway (*), shareholders will own more than one stock certificate. Over time it is reasonable to assume a number of their activities could generate higher stock prices if separated. I also suspect that if the Fed, FDIC, and Treasury come under more restrictive management, a number of banks will split their activities requiring a bank license, placing the more profitable businesses in another company. Watch JP Morgan Chase (*) for such a move within ten years. The financial sector may initiate dramatic changes in how they manage their human relations and work from home activities.

(*) Owned in managed accounts or personal accounts.

Changing Investors

The current effort of some governments to regulate an increasing amount of corporate activity through regulatory bodies will drive more investment into private companies. There is already some level of private market transactions, which will increase. NASDAQ (*) has been active in this, as have a number of brokerage firms and banks. This drive may well lead to more cross border transactions. In dealing with private companies, valuations are often based on verifiable sales data, which includes a price/sales comparison. There is a lot of room for such transactions. For example, the P/S ratio for the Russell 1000 Growth is 5.12X, with the MSCI World ex US Small Cap being 1.05X. 

In terms of investment sophistication, there are private investors capable of protecting themselves as smaller institutional investors. There are times where not being public is better for both the company and its investors. In many cases these investors have entered a second career as a supervisor or confidant to multi-generational family assets.

Question: In your thinking about the future, what changes are you expecting and how will you handle them?

  

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

https://mikelipper.blogspot.com/2022/01/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2022/01/two-critical-questions-weekly-blog-717.html

https://mikelipper.blogspot.com/2022/01/current-causes-of-concern-weekly-blog.html

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London Calling, with Concerns

As regular readers of this blog may know, my wife Ruth and I spent last week in London; several days with temperatures in the 80’s (F). In my many previous visits to London, I have found some of the most sophisticated investors in the world. Topic one for them last week concerned the problems with the Euro and how that would affect other markets. In addition to those concerns, now that I have a Facebook group, I am getting regular inputs from old and new friends who have strong views as to what should be done by various politicians. All of these concerns expressed by many people far beyond the small world of the financial community has led me to think through the large and growing deficits being experienced in Europe, the UK, Japan, and the USA.

There are two causes for this crisis in my opinion. The first is that at least since the great depression of the 1930s, people have believed that they needed help beyond their means and wanted the various governments “to do something.” The second cause is that in our elected societies we are governed by politicians, not statesmen. A statesman has a long term view as to the correct path, often unpopular, and tries to convince people as to the correctness of his/her view. Politicians, always looking toward the next election, try to find an already exiting parade of supporters for a particular policy and place themselves as the leader of the parade. In each of the countries and regions mentioned above, both the governments and their principal oppositions are headed by politicians, as distinct from statesmen. To my analysis, the structural problems facing most of the democratic world is that for about 80 years (or three-plus generations), we have been directly and indirectly spending increasingly more than we have been willing to pay for in taxes as well as fees.

I do not want to appear as an apologist for the current US President, but we need to find a parade of strong volunteers to both cut our spending and to advocate for paying a larger portion for what we receive. As we dug this hole in our national balance sheets over three-plus generations, we should expect the change in our life patterns to take one or more generations. While there are likely to be some “band aid” attempts, progress will be slow until there is general acceptance of shared pain for all. This pain will come in lots of different ways. The deficit problem cannot be solved by simple eliminations, but only by a thorough review of every entitlement and subsidy each of us individually receives; for example, tax deductible mortgage interest and gifts to charity, (which would hurt me). The overall solution will be granular and thus will take lots of time. What I have outlined is not pleasing to anyone, perhaps particularly not to investment market participants.

Portfolio Reactions

The more people contemplate the deficit issues, the more bearish some react. As we know, the third calendar quarter was ugly in terms of performance; and as time passed, market participants became increasingly bearish. One example of these bearish actions is that the short interest ratio rose almost 44%, from 2.92 days to 4.2 days for NASDAQ stocks in just 15 days to September 15th. Over the same period, the short interest ratio of the supposedly higher quality stocks on the NYSE rose to 3.7 days from 3.2 days, a gain of 16%. (This measure is of the number of days volume of transactions that would be needed to cover all of the existing short positions. While the increase in shares sold short is an immediate bearish sign, keep in mind that when the market starts to move up many of these positions have to cover to avoid losses.) One of my personal concerns about the growth in the use of Exchange Traded Funds (ETFs) is their growing short positions. The two largest short positions on the NYSE are two ETFs, as a matter of fact, of the 40 largest short positions, ten are ETFs.

Many of the investment managers that I saw in London use European based ETFs. (Not of minor importance is that apparently the UBS trading fraud was conducted in ETFs, which were meant to be hedged.) I do not believe that there is equivalent public data on European ETFs short positions, but considering there is a smaller retail market in Europe, my guess is some of the short positions could be larger than their equivalent US ETFs.

Is there any good news?

Yes, there are three positive elements that could be of some help. First, the chart pattern on the Dow Jones Industrial Average is displaying something of a bottoming since the August decline. (However, there is not as helpful a sign in the transportation average; this could have some bearing on the Warren Buffett discussion below.) The second positive note is that the Barron’s Confidence Index, comparing high grade bonds with intermediate grade bonds, rose 2.4 points last week to a 70.3 level; most of the time this index moves less than 1.0 point per week. Often when the index moves up it is good for stocks, for it shows that investors are willing to take on more risk (intermediate quality bonds). The third somewhat misplaced positive, in my opinion, is the bullish reaction to Warren Buffett’s decision to buy back Berkshire Hathaway stock. I believe one of the best things about Mr. Buffett is that he corrects some of his mistakes. For many years, he has only bought companies for cash and has not used stock for acquisitions. Because of the large size of the acquisition of Burlington Northern, he had to use stock to supplement his cash to buy the railroad. (I believe despite the uncertain price pattern for the transportation average, over time this will prove to be a very successful investment.) What he is really doing now is buying back at a lower price than what was used for the acquisition, and in effect turning the purchase into close to an all-cash deal after the fact. With the buyback, I believe, he is not making a market call. Buffett and/or his new investment manager is probably buying some “cheap” stock also.

Investment Posture

As indicated, deficit solutions will be a long time coming and there is increasing speculation on the downside; nevertheless I believe that one should view the current market and periodic dips as opportunities to add to sound investments. The next 100% move will be on the upside, even if it takes a long time.

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ANSWERS FROM WARREN AND CHARLIE Omaha Highlights

There are legions of books written about Warren Buffett, Charlie Munger and their performance at the Berkshire Hathaway* (NYSE:BRK-A) annual meeting. While I have been following them since the early 1980s, and had the distinct honor to introduce Mr. Buffett to the New York Society of Security Analysts, this was my first visit to the annual meeting. (I plan to return again.) There was not much written in the Sunday paper about the meeting except their support for the Goldman Sachs CEO, but I suspect that coverage will be extensive beginning with Monday. As an exercise for myself as well as the members of this blog community, the following 38 briefs come from my five pages of notes, which I hope share some of the wisdom of these two remarkable men.

INVESTMENT OVERVIEW

One of the first steps in the Buffett/Munger intuitive capital allocation process is to develop their thinking on the potential and likely return on invested capital generated by the businesses being examined.

At this point for Berkshire, capital-intensive investing is a bigger drive than intrinsic (value) investing.


THEIR VIEW OF GOLDMAN SACHS & AFTERMATH

In terms of the ABACUS-2007 deal, based on the SEC complaint, Goldman Sachs* (NYSE: GS) did nothing wrong. The motivation of the other side is not relevant when trading. Berkshire may even benefit from the complaint, as it will probably delay the calling of Berkshire’s preferred stock, currently earning 10% annually.

A new version of Glass Steagall is likely. If Berkshire was forced to put up collateral for its derivative position, it would probably put up its stock holding of Coke (NYSE: KO). At the same time it would demand some additional payments from its counterparties, as they paid for uncollateralized derivatives.

NOTES FROM THE EXTENSIVE Q & A SESSION

In terms of currency exposure, they have exposure on both their assets and liabilities sides. They are bearish on all currencies, particularly those who have to borrow using other currencies.

Each July, Warren Buffett will give 1.5% of the stock to five foundations. The current turnover in the stock on the NYSE is over 100%.

Over the next 50 years there is a high risk of a nuclear, chemical, or biological attack on the US. The risk is low in any given year. (This statement which is not new, it may be a plea for some sort of federal guaranty.)

The list of four candidates to replace Buffett on the investment side changes periodically. The directors are familiar with the candidates, They did well in 2009 without leverage.

It is easier to build a new culture than to change an old one. They failed in an attempt to change the culture at Salomon Brothers.

They think that despite the worldwide size of McDonald’s (NYSE: MCD), the company does a better job of educating its employees than universities do their students.

Munger was the one that discovered Chinese auto parts maker BYD and drove the acquisition of its position.

The various CEOs are paid on the basis of the economics of their business. There is not a Berkshire standard and there is no compensation consultant. Managers are paid to widen their “moats.” Headquarter fees for the 21 employees are not charged to the various operations, but there are capital charges.

The major railroads have been rebuilt over the last 30 or 40 years. The big 4 railroads are allowed to earn 10.5% on their invested capital.

In terms of insurance risks, the company will accept volatile returns while others want to have their earnings smoothed.

Read chapter 12 of John Maynard Keynes’s The General Theory of Employment, Interest and Money, written in 1935.

In 1982 Buffett submitted to John Dingell the only letter in opposition to permitting futures on the S&P 500.

Employees should think and act like owners.

Generally they hope a dollar of increase in equity to be equal to more than a dollar increase in market value.

Warren Buffett, Charlie Munger and some of the board members are visiting China in September.

Thomson (NYSE:TRI) always seems to want a 40% return on capital, a habit held over from its newspaper days.

Munger is converting his IRAs to a Roth IRA.

The federal government will have difficulty in not bailing out the failing states. Due to too-low rates, they are no longer writing new municipal bond insurance policies.

For the next 10-20 years one should want to own equity and not bonds and cash.

Moody’s* (NYSE: MCO) is a wonderful business, but they made a bad mistake on residential housing, They, like others (particularly graduates of business schools), relied too much on models.

Berkshire does not have an annual budget for a fear that various managers would “game” the system.

“We can get along without oil if we must.”

“If scared when others are fearful, you won’t make money in securities.”

In practice they are much more comfortable averaging down than up.

Advice to a new investor: “Get your feet wet with a little failure.”

“Solar panels will get cheaper.”

There will be a truly national electrical grid system.

Their portfolio is often undervalued, they do not own any major future winners.

“There is no better way to get happy than to lower expectations.”

They are blessed by not having an investor relations department.

“One should know the perimeter of one’s circle of competence.”

“One should always keep learning as the competitors are surely doing."

“Very few people fail totally.”

“Follow one’s passions.”

Many of these notes might be cryptic. I would be happy to discuss them to the extent of my understanding of what was said and what was meant.

*indicates securities owned by me or by my financial services hedge fund.
_________________________________________

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