Avoid GDP and EPS

Introduction

When the starting focus is wrong, many investors do not succeed. Though I can not judge the veracity of Socrates’ view that the unexamined life is not worth living, I believe the unexamined investment process is not worth continuing.

Starting with GDP

More supposedly learned people spend their working lives following and projecting the various Gross Domestic Product (GDP) statistics than any other measure. The academic community (within their institutions and within their satellites in business and government) start almost all of their future projections with a GDP growth rate. Yet it is rare for any annual or multi-year projection to prove to be accurate in terms of magnitude and occasionally direction. Thus most top down investment processes that start with GDP projections have not produced competitive results.

GDP traps

The basic fallacy of substantial reliance on GDP numbers is that a single number can represent the entire amount of economic activity within a geographic location. As a junior analyst at a trust bank, each of our company reviews required a comparison of revenues to a relevant generic measure. For many years the senior investment person was a well known and respected economist and the comparison was often with the GDP^*.

          ^*At the time we used Gross National Product (GNP).

As industry analysts we were meant to contribute our estimates of various industry statistics. As a budding technology analyst among other sub-segments followed, I was responsible for estimating the growth in the production of timing devices. While clocks or other timing tools were inherent in the production of numerous technological products, we did not follow a single company that provided any numbers as to their production. Not even output for industrially important punch card clocks to determine employee hours were available. There was no focus on changing specific prices (e.g., as transistors were introduced into timing mechanisms). In addition, I suspect at that point there were more clocks and other timing equipment already being used in our military and thus their production numbers were not known or were classified. Similar detailed projections were required by other analysts.

For central authorities the cost and availability of gathering complete production numbers were, and are, beyond their capability. Due to the nature of governments to tax, I presume there has always been a sizeable unreported level of business which probably changed with the taxing authorities’ levels of competency, authority and integrity. I doubt that it was ever a constant ratio of aggregate economic activity. Further, I am guessing that everyday somewhere within an economy business people, farmers, and others are finding new and different methods to produce similar goods at lower costs and perhaps increased worthiness.

A “Man-made” metric

Today we live in a global and increasingly integrated world. GDP analysts utilize export and import statistics reported to them mostly based on tax and other regulatory data provided. While this may be a good attempt, it is a monastic view of a commercial marketplace where transfer pricing is an art form, some over-invoicing occurs as a way to move currency and there is not cross-border comparison as to how the same transaction is tracked in multiple countries.

In sum total, the reliance on GDP pronouncements by government authorities and media pundits seems to me to be a weak crutch upon which to base investment decisions. They are sound bite size, and excessively simplistic answers to the complex question as to how the economy and business in general are doing. As noted in my earlier posts, some of the Chinese political leadership do not trust GDP figures as they are “man-made” and not a direct extrapolation of economic activity.

Most EPS valuations mislead

Currently it is fashionable to quote Professor Robert Shiller’s Cyclically Adjusted P/E (C.A.P.E.) as a valuation metric to determine how expensive the stock market is. Liz Ann Sonders of Charles Schwab^** recently produced a study entitled “Devil Inside: Dissecting the Most Popular Valuation Metrics,” which does a fine job pointing out the problems with this ten year average inflation-adjusted earnings per share of the S&P 500 price/earnings ratio. The problem that I have with relying on this as a tool is though it may make life easy for students and pundits,  the earnings used are only the reported earnings and it is looking backward.

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

Beginning at least some 80 years ago Professors Benjamin Graham and David Dodd taught in their Securities Analysis courses that the first thing the analyst was to do in analyzing an income statement was to reconstitute it, removing all the non-recurring sources of income and expense. Eventually the accounting profession caught up and started to disclose the various reported non-recurring factors; e.g., profit and loss of investment sales by industrial companies.

In addition, to determine fundamental earnings power, one of the tasks that I did some sixty years ago was to “normalize” tax rates and where possible put all competitors on a similar rate which in effect reduced the impact of different balance sheet structures. More difficult was to model all peers on the same inventory accounting system such as LIFO vs. FIFO, etc. Most difficult was adjusting for various unusually large year- end sales and expenses that under other conditions could have appeared in the following years. To me the real benefit of this numbers crunching was to force on me that I was viewing a painting depicting someone else’s view of reality rather than reality itself.

This jaundiced view of reported earnings was reinforced years later when I had to deal with mergers & acquisitions. There were significant differences in the views of the buyers and the sellers of a company which led in part, to a dissimilar valuation that motivated each, and in many cases varied from public perceptions as to the value of the deal. In effect, the beauty of the deal was in the eyes of the beholder.

Having helped some financial organizations make acquisitions, the real focus was identifying the range of likely future earnings. The buyers were buying what they thought about the future, both without major changes and with changes that the acquirer expected to make. In almost all cases this led to a bargain purchase with a valuation below the valuation that the buyer’s stock was selling at for at the time of the purchase. Keeping the point of view of potential acquirers in mind, I estimated what I thought long-term future earnings might be in my purchases of individual securities and various funds. Thus, I am a future oriented investor along with others beyond the halls and bypasses of academia.

Three steps to take

1.  Adopt the appropriate valuation measure for each account. Some investors appear to be more comfortable in the past as they fundamentally believe that the current and future will be an extrapolation of the past. Of course the trick here is to pick which past. You could start with the Eighteenth Century, or perhaps 1926 when the first tracking services became evident, or a rolling ten year C.A.P.E. model. You could use a period since last the major peak or troth, or chart when new leadership of a company or country came to power or use another timespan.

2.  Use selection approaches that are appropriate for the timespan. For example in our four Lipper Timespan Fund Portfolios^TM, we will be much more focused on short-term GDP pronouncements and reported earning valuations in the first two portfolios, Operations and Replenishment. In both cases we recognize that a significant downturn is a matter of major concern. As the timespan lengthens we become more future earnings-focused and more interested in changes of demographics and psychographics than in GDP. Thus within our Timespan Portfolios, the shorter timespans will be much more influenced by cyclical factors,  in the intermediate timespans secular trends and in the Legacy Portfolio likely disruptions to historic extrapolations.

3.  An important advantage of investing through a portfolio of funds is that select smart managers that have well thought-out, but different investment strategies are available. This third step is critical to avoid locking into a single philosophy. The one absolute positive as to the future is that every investor and investment manager will be wrong from time to time (or if you prefer, premature). The risk when this happens to all of us is to overreact with an abrupt reconstruction of investments. By instead using a selection of sound, good managers, most of the time the total portfolio will benefit and move toward its funding responsibilities.

Question of the week:

What are the three most likely future changes that your investments can tolerate and what are the two that would force major changes to your investments?

__________   

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Copyright © 2008 - 2015

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

Bear Market Thinking Prevents Future Gains

Introduction

Most people react to present investment conditions in terms of the dominant financial conditions when they first became aware of financial markets and influences. Very few young people entered the financial community after WWII until the mid to late 1950s. I was part of the second wave when I became an investment trainee working for supervisors at least thirty years older than myself. These gentlemen were operating under the canopy of their parents’ experience during the Depression. They were not prepared for the growth experienced in the late fifties and most of the 1960s. Thus their investment accounts underperformed and they in turn were easy to be replaced by a group of young, inexperienced analysts and portfolio managers. 

I was somewhat prepared for this turn of events.  In 1957, I had the honor of taking Securities Analysis under Professor David Dodd who co-wrote the book of that title with Ben Graham. The course stressed risk reduction by using financial statements to represent value. I used to argue that expected future growth was important as a way to make money. While I did not know it at the time, Warren Buffett reached a similar conclusion.

Replacing an investment committee member

Recently I had two meetings with some very bright people that were being handcuffed by the current market conditions. The first was with members of an investment committee which had an opening. I suggested that it might be wise to add someone who understood commodities. The idea was rejected as supposedly the commodity thirty year super cycle was over and commodity prices were now tied to China which was slowing. This thinking is focused at the beginning of price trends and not what I think should be the focus, which is the terminal price.

Future investors

Later that day I met with undergraduate and graduate members of a university investment club. Some of these bright people were interested in being employed within the financial community and/or wanted to learn more about investing.  By their questions they were reacting to their media-driven views of what they thought was happening in Wall Street.  I tried to suggest that they focus on the future; e.g., global shortage of retirement capital and the loss of jobs due to changes in minimum wages driving technological replacement of human labor.

Classic bear market thinking

In both cases and along with the majority of those who follow investments they were demonstrating classic bear market thinking.  Reacting to past stresses they focus on the current and look for proven results.  In today’s time that means placing great emphasis on statistical value including looking at average price/earnings ratios for the last ten years, (including C.A.P.E. which was discussed in last week's blog.)  One way I attempt to learn where we are in the cycle of investment thinking is to look at what periods of time investors are using in their price/earnings calculations.  When people are being governed by fear they use the past earnings of the latest quarter, year, or ten years.  We are not today seeing anyone quoting P/Es or yields based on their estimates of future 5 and 10 year results.  Historically when we do see these, the market is much higher than markets priced on current or past results.

Today’s investments for tomorrow’s needs

My professional responsibilities include managing money to pay future tuition and faculty paychecks, new laboratories and building maintenance and replacement.  The money to pay for these things will be needed many years in the future, so I must look at today’s investments as to what they will produce in the future.

I must be doing something right as numerous of the present holdings that I am responsible for today are yielding 5% or 10% on current dividends on initial purchase prices.  Thus the money can fulfill the capital generation needs of the beneficiaries entrusted to me.

Speculation isn’t new

Investing with an eye to the future is not new.  Much of the European investment into the US and elsewhere was based on the belief that in aggregate, the investment would generate future capital.

Another investor who focused in part on future returns was the advisor to a number of US presidents, and a friend as well as a fellow park-bench sitter with my grandfather, Bernard Baruch.  During the congressional committee hearings in the 1930s, certain congressmen felt that the Depression was caused by speculators.  They got Mr. Baruch to identify himself as a speculator, which meant that he was a cause for the collapse.  “To the contrary,” he explained the Latin derivation of the word speculator, “a speculator is one who sees far out (to the future).”

In last week’s post I expressed a view that the problem facing the global and US domestic economy was not primarily the lack of cash or credit which can be seen in surplus, but the lack of perceived long-term opportunity.

Being a bit of a contrarian and a disciple of Baruch and Buffett/Munger, I believe now is the time to be looking for long-term growth opportunities.  I believe this is wise for the beneficiaries of my long-term investment responsibilities even though there are substantial odds of a major market decline over the next several years.  I am much more confident of my long-term views than my ability to retreat from the market and then reengage.  Over the cycle very few have been able to do that and produce better results than those who intelligently invest throughout the cycle.

Additional thought

Each day our personal, family and corporate real and contingent liabilities grow.  The growth in liabilities without an offset will reduce our net worth.

Question of the week

Where are you investing for growth and when will you increase your growth portfolio?

__________    

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

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

Investment Survival Lessons

Introduction

In an accelerating world, I find it necessary to always be learning. I hope to learn from almost every exposure I have. This week’s post is based on three inputs to my investment survival orientation:

1. Future vs. History

2. Markets vs. Economies/Governments

3. Levels of Patience Required

Future vs. History

In an always insightful column in The Wall Street Journal, Jason Zweig interviewed Professor Robert Shiller, the Nobel laureate in economics and the developer of the “cyclically adjusted price/earnings ratio” or CAPE. In the interview there is a particular bit of wisdom for all of us who are condemned one way or another to predict the future. Professor Shiller stated while the current level of CAPE “might be high relative to history, but how do we know that history hasn’t changed?” Asking the question is the wisdom not my answers. There are at least two reasons to believe the certainty of a top of a market.

The first reason is that we live in a very dynamically changing financial world. This is not the first time that governments and their central bank servants have been manipulating interest rates or modern day money; from the ancient times kings reduced the amount of gold and silver in coinage. Add to this that the trading markets have changed due to the use of capital restrictions, markets fragmentation, increased use of lightly capitalized derivatives and the communication of investment methods.

The second reason to question the utility of C.A.P.E. or any Price/earnings ratio measure is my training at the race track. When asked, the wagers who were putting enough of their money on a particular horse that would make the horse the favorite they would focus on one statistic almost to the exclusion of any others. (Favorites typically win only about 1/3 of the time.) With this as a background, you can sense my apprehension when entering the analytical business where the need was to quickly convey brief reasons to make an investment decision through the use of some term or label with the caveat that people would fully understand the limitations, construction, and the past record of misapplication.

 

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax “pre-other” income growth. In addition, I look at net cash generation after debt service as comparative measures before focusing on an evaluation of management to handle future opportunities and problems. Further, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different than today’s version. The calculators of C.A.P.E. use reported data for the S&P 500 companies which is just not good enough for me in the fight for investment survival.

Markets vs. Economies/Governments

While I am very sympathetic to Professor Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey and London using individual tools and data that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed a rapid rise led by the late stage large-cap stocks. Nevertheless, one analyst has supplied some S&P500 benchmarks in terms of downside risks as shown:

a) 200 day moving average: 1905, breaking down from this level could bring more selling;

b) Down 10% from recent top: 1810;

c) Down 20% from top similar to 2011 or a cyclical decline: 1610;

d) Down 33% a la 1987 crash: 1350.

As frightening as these numbers are, they do not include a once in a generation decline of 50% which could take us below 1000 as compared with today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets; e.g., German DAX is down -12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the Emperor is marching naked. 

Current moods of business people and investors are much more cautious than national statistics would indicate. One example may be helpful, Large Cap Growth stocks were up +2.21 % in the quarter vs. -6.39% for the much more economically sensitive Small Cap Value stocks. To show the importance of volume, on October 6^th the stock of T.Rowe Price^* closed at $78.14 on NYSE volume of 872,860 shares. At the end of the week the stock closed at $75.35 on volume of 2,643,245 or close to 3X the earlier day. The interpretation is that the firm’s income will suffer from lower assets under management due to market decline and fewer net sales.

In terms of investment survival I pay attention to the market analysts and have adjusted most portfolios that have a five year or less time horizon to be more cautious. However, each of these bright market analysts see that we are setting up in the long run a major expansion of stock prices and somewhat higher interest rates to which I agree. But this could be delayed by the political forces utilizing inaccurate data trying to create a recovery rather than seeing that they are a main cause of the current malaise. We may need new global leadership.

Levels of Patience

An advantage that I have is owning a large number of stocks of financial services companies either personally or in a private financial services fund that I manage. Thus this week I attended an Investors Day for Jefferies, which is now owned by Leucadia^*, and is owned in our fund. In one way this has been a good holding in that it is up 143% since purchase years ago. In another way it has been a disappointing holding for the last 18 months with the merged stock just about where it was on the day of the merger. Luckily other holdings did better. However, in terms of lessons it may be worth a great deal.  My reason to continue to hold the stock is that I saw it as a unique player in a rapidly changing investment banking and institutional brokerage business with a largely attractive merchant banking portfolio, a significant net operating loss carry forward and new capital resources.

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

What I was counting on was the continued regulatory pressure on the major banks and their investment banking activities in terms of their use of their capital. I was further counting on a significant a number of successful investment bankers and other highly trained technical people seeking employment with an organization that could materially increase its market share through their efforts. Where my analysis was faulty was that these changes would have effect much more quickly. What I should have recognized is that it often takes two to three years for the investment bankers to bring in more revenues than their cost.

Judging by their underwriting and deals success many of the Jefferies bankers are on the verge of becoming profitable to the firm. I should have been more patient to see the expected improvement. It was easy to recognize the pressures on the majors and the deteriorating service levels throughout many of the organizations. This is why I suggested that currently one might not open new bank relationships due to pressures throughout the organization. I thought these pressures would immediately translate to more and profitable business to the non-bank competitors. It didn’t happen on my schedule thus I am reluctant to suggest purchase at this time. I will have to see not only operating earnings coming through, but also a steady decline in Jefferies compensation ratio.

PS: Last week’s suggestion that some of the money planning to leave PIMCO should consider reducing its allocation to bonds may be happening in that the flows this week into money market funds were unusually high. I would hope as equity ratios decline because of falling prices and other disappointments that new capital can be prudently introduced into expanded equity holdings.

Perhaps, once again I need to be more patient.

PPS:  Bloomberg Television Sunday night is showing a weak opening in Asian markets which followed a report from Business Insider that the Dubai Stock Market index fell 6.5%. Be cautious and do not try to catch a falling knife.

Question of the week: Do you have plans to increase your investments in stocks?

__________    

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

Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2014

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