More to Learn by Seeing More - Weekly Blog # 640

Mike Lipper’s Monday Morning Musings

More to Learn by Seeing More

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

Yogi Berra it was reported to have said that you can see a lot by observing. The distinguishing characteristic of most investors, be they institutions or individuals, is that they thrive on information. However, most investors devour what is served up to them and don’t take the time to observe how the information is served up to them. This week’s blog will focus on two critical streams of information driving the portfolio allocation of many investors. My purpose in displaying how I look at these factors is to illuminate how to look deeper than what is served up, not to suggest that you adapt the way I think.

Asset Allocation

When reviewing investments, most investors start with a listing provided by an advisor, broker, or custodian. The way the information is arrayed often directs our thinking and therefor our actions. We don’t realize that the array reflects how the producer of the portfolio organizes their information flow, often to reduce their liability. When was the last time you were asked how you’d like your investments shown to you? When was the last time your agent asked what other critical information would be useful to you to in making decisions?

During this lazy summer, with the aid of the computer and forced companion in isolation, creating an information matrix giving a different viewpoint. The different view will probably show you how to think about investments and give you a more complete picture, like when your investments will be depleted after meeting various significant expenses.

The following discussion is my first pass at creating an investment framework. It will probably evolve from more thinking and hopefully from the reactions of some of our thoughtful subscribers. I am not recommending this structure for anyone, I’m challenging you to develop your own thinking from a similar exercise.

Once a second investment is added to your first, a portfolio is created. The ability to meet future payments will likely result from the performance of the portfolio, not just a single position. That is true even if the money comes from a position, as it is chosen from the list of available choices. Most investors are collectors of investment opportunities of different natures. Thus, I find it useful to group investments in different categories based on some common theme rather than looking at a portfolio in alphabetical order.

For this first exercise, I created five categories or buckets. In this case the buckets are based on their desired usage and not necessarily their investment characteristics. The five are Capital Preservation, Capital Appreciation, Long-term Hedges, Future Merger & Acquisition candidates, and Expenditures. These terms have specific attributes for me and reveal a great deal regarding my thinking, as described below:

• Capital Preservation requires a belief that these assets will grow reasonably in value over time relative to inflation, purchasing power (currency risk), sustainability through economic cycles, and after-tax benefits. Assuming none of the positions fail to meet the continuing criteria they will be part of my estate. Because the criteria changes over time, the portfolio is also likely to change. For example, a major change in tax regulations could cause some of the holdings to move out of the Capital Preservation bucket. (Notice, I did not specify stocks, fixed income, or public/private investments. Each of these could qualify in the right hands.)
• The Capital Appreciation bucket includes holdings, which over an investment cycle, are expected to do better than the appropriate index. The bucket includes both positions doing well and some fallen angels, where there is hope for recovery. Some fallen angels with large losses should be held until they can be used to offset large realized gains. Because of the inclusion of both fallen angels and some leveraged holdings, I do not expect them to be considered “trust quality”.
• Long-term Hedges are those positions likely to rise when specific Capital Preservation issues are falling. They can be competitive with the Capital Preservation items, e.g. Morgan Stanley vs Goldman Sachs, or an economic trend contrary to a Capital Preservation holding, like Jet fuel oil vs airlines.
• Future Merger & Acquisition holdings would be good companies with attractive products and market share, possibly with an aging senior management with estate problems and weak middle management. Amazon or Tesla could be examples.
• Expenditures would include available cash in various currencies and instruments. The currencies result from fund and individual security distributions, where their initial purpose was to be a small reserve for future purchases of investments in those currencies.

In the table below is the current percentage commitment to each bucket and the current number of holdings.

                                  

Allocation            % of Total  

Capital Preservation       40   

Capital Appreciation       34   

L-T Hedges                 10  

Future M & A               13  

Expenditures                3   

                        Approx. #

Allocation             of Holdings

Capital Preservation        29

Capital Appreciation        54

L-T Hedges                   2

Future M & A                22

Expenditures                 7

Clearly, there is little relation between the level of commitment and the number of holdings in each bucket. To emphasize that point, adding the single most heavily owned position in each bucket would represent 42% of the total portfolio, demonstrating the power of compounding winners. The large number of holdings represent a behavior pattern of investing in a number of companies when entering a new industry or sector. It also reflects the retention of a number of fallen angels, either due to a belief in an eventual recovery, or the desire to reduce the tax impact of selling large winners.

What would you do with this portfolio instead of one heavily invested in financial services, that is globally diversified with an Asia heavy focus and a substantial Canadian commitment? I am not suggesting the unconventional display above is superior, it is just different and might add to your decision making capabilities.

There are any number of other buckets you can use to group your investments. The following is just a sample for both individuals and institutions, it is far from exhaustive.

                              

Sample Allocation Categories

For Individuals             

Pre and Post Retirement     

Acquisition of Major Real Estate      

Major Family Event                          

Large Educational Bills                       

Death and Inheritance Issues            

 

For Institutions

Credit Rating Protection

New Buildings or Laboratories

Funds for strategic acquisitions

Balance sheet to repel a raid

Sufficient Flexibility to Pivot

Operating Leverage

So far, in the second quarter of this year most companies reported materially larger declines in operating earnings than in revenues, excluding some tech companies. Under normal conditions this would indicate the company has lost control of its costs and should be sold. However, as with everything on our march to a series of “New Normals”, our experience and training may prove to be wrong. 

Many companies claim their staff is their most critical asset. (I disagree and believe their customers are their biggest asset, followed by their people.) Most successful companies are labeled as skilled or non-skilled, regardless of their existing employees bringing them to their recent former highs. Instead of slashing employment along with sales, some are consciously increasing their losses by maintaining employment or payroll for as many of their people as possible. In many cases this is likely to prove to be wise from the employee, management, and shareholder point of view. Thus, when analyzing second and possibly third quarter’s earnings, try to grasp how much of the operating earnings decline is due to the fall in sales and covering current expenses. How much of the cost is for carrying employees that are not currently producing? That is exactly what I did when I was running a larger firm during periodic market declines. It proved to be a wise move for our clients, employees, and not bad for me either.

Please let me know if I am making sense to you or if you need help in building your own Personal Allocation View.

  

   

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

https://mikelipper.blogspot.com/2020/07/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/07/that-was-week-that-was-change-weekly.html

https://mikelipper.blogspot.com/2020/07/currently-selling-more-important-than.html

Did someone forward you this blog? 

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Faulty Decision Processes at Change Points - Weekly Blog # 607

Mike Lipper’s Monday Morning Musings

Faulty Decision Processes at Change Points

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

On the surface stock owners are expecting seasonal presents----unless they have already received them. By Friday morning media headlines were mostly good and had set up a favorable 2020, unless one looks deeper. Frequently, I reference a chart in the Weekend Wall Street Journal that measures the change in the current prices of stocks, commodities, currencies and other investments. This week 65 of 72 prices rose, suggesting some form of inflation is mounting. The numbers hawk in me saw a possible problem, as we normally see positive category price changes in the 31-42 range. (The seven falling prices were: S&P 500 Real Estate, Natural Gas, Lean Hogs, Yen, S&P 500 Telecom, US Dollar, and corn). The out of normal price behavior made me think about the benchmarks that investors use to guide their decisions.

The most prevalent sales pitch in moving investors into or out of securities is a short comparison of two alternatives. If “A” is larger than “B”, “A” is a buy. This assumes the measure is relevant to the needs of the investor and most importantly, the relationship between A and B is reasonably constant and meaningful. Currently, the price of gold mining stocks is going up, yet the price of gold is flat. One could say that this is compensation for the plentiful risks in mining. Alternatively, some stock buyers expect gold to become more valuable due to the fall in the dollar. Regardless of the reason, the market for physical gold is not sharing the same enthusiasm. Perhaps the comparison is faulty, as one alternative represents a view of future attractiveness and the other a measure of current value. This dichotomy suggests that simple statistical comparisons need to be understood more fully.

As someone who’s developed a large number of open and closed-end fund indices, I question whether many benchmarks are relevant in making decisions as to the future value of investments. This week my old firm noticed that two mutual fund categories, equity income and utilities, were getting net inflows, while other equity categories were not. Some buyers, perhaps spurred on by their wealth managers or other investment advisers, were attracted to these two investment categories because of their comparatively high dividend yields and/or lower volatility. In our investment management practice we rarely use funds from either category. If some of our accounts need current income we use higher yielding funds, but not the highest. Furthermore, we prefer to use funds growing earnings and cash flows that pay higher dividends. A few growth and income funds have delivered both rising dividends and capital appreciation for years, which over time has given investors a better return than either Equity Income funds or Utility funds.

There were two recent articles in The Financial Times that I believed should have been tied together. The first, based on Morgan Stanley research, was titled “Investors Braced for Low-return Decade after years of Robust Growth”. The article compares the last ten years to the last thirty years and estimates that current investment performance is below both. Initially, I felt they’d failed to adjust for inflation and currency depreciation.

A few pages later there was a news article about the rapid movement in the location of magnetic north. It has been moving for 500 years, causing navigators on land, sea, and in space to adjust their navigational instruments. To me, the second article reflects the reality of change and should also be required before we apply benchmarks. The world of medicine adjusts for changes in height, weight, and other characteristics when it compares modern people to those in the past. Popular stock and bond market indices should also be adjusted and consider both the world we live in and what the future might hold. “Political scientists” that use pooling data to predict attitudes and voting preferences also need to adjust their slicing and dicing of the population and the way they collect data, which will be between expensive and very expensive.

A Barron’s panel of experts have concluded that the S&P 500 will rise 4.1% in 2020. The precision is breathtaking, but if you actually believe the number wouldn’t it be prudent to sell now and wait for a better re-entry point, likely to occur in most years? (This applies to tax-exempt and not tax-deferred investors).

Alternatively, a contrarian indicator is the number of puts vs. calls traded on the S&P 100. Last week the ratio was close to three times normal. While buy and hold investors in aggregate have a better record than traders, those in derivative markets and on NASDAQ are better short term. I believe we will remain in a sentiment driven trading market for a while longer, which could be emotionally trying for investors. However, those who are steadfast will likely accomplish most of their realistic long-term goals.

Please privately share what you think with me, as my crystal bowl is unusually cloudy.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.html



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To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

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Our Investment Mistake is in Labeling - Weekly Blog # 582

Mike Lipper’s Monday Morning Musings

Our Investment Mistake is in Labeling

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

Mixed Results Change in Focus
While the S&P 500 went to a new record high on Friday, it and the other major stock indices closed down. This is both good and bad news. Investors were not sucked into the market, which confirmed their growing concern for future growth. Currently, many pundits are expecting the same, both in the slower growth of GDP and earnings per share. That is the bad news. The good news is the current lack of enthusiasm for stocks. The reason that this is good news is that often the final phase of a "bull-market" is wild enthusiasm for a subset of the market, which in turn drives the bulk of the market higher. This has not happened-----thus far. Also, more and more analysts are recognizing the deterioration of quality in credit instruments, including CLOs. With these concerns present, now is a good time to examine one's asset allocation. However, this should be done in terms of the intended use of capital, not as is more commonly done by asset class. Purposes are more useful than instruments.

Segmenting a portfolio
We learned long ago that a good way to avoid large losses is to divide our investment efforts into different parts that have different characteristics. The mistake that most make is labeling the diversified parts by asset class e.g. stocks, bonds, real estate and commodities. These labels are too broad and do not suggest their intended portfolio use. Each of the labeled asset classes can be used aggressively or conservatively in terms of intended risk and reward.

The investment spectrum
I suggest that a single spectrum is more useful in building a successful portfolio. This spectrum incorporates the long-term movement of capital, from preservation to appreciation. Every investment is likely to have elements of both capital appreciation and capital preservation; however, at any given time one characteristic is more prominent than the other.

The Prudent Man Rule
If one thinks about the prudent (man) rule that Judge Putnam issued against Harvard in 1830, he was ruling based on what other intelligent men (thus the Prudent Man rule) used in their own affairs. (The judge did not recognize that men, while they may have been the ones transacting, needed to include the desires and wisdom of women in the decision-making process if they wanted a harmonious family life.) What the judge recognized was that different mixes of assets and liabilities produced different results and it was imprudent to rely on a single type of investment.

Betting on an uncertain future
In looking at my personal portfolios of assets, liabilities, and identified responsibilities, I try to group investments in terms of capital appreciation and capital preservation. I do this recognizing my inability to predict the future accurately, as life is full of surprises. This is where my analytical training at the racetrack shapes my thinking. Most money bet on a race is on the horse that appears to have the best chance based on prior success. The problem with this is that the pay-off odds are low and the winnings are insufficient to cover prior losses, unless a great deal more money is bet on the favorite.

While we all celebrate the story of a single-minded inventor betting all on a single invention, we realize that the chance of finding this magic are extremely low. This may well be the cause of my being a contrarian, rather than it being a personality failure. Thus, in my mix of capital responsibilities, my investments are spread out along the expectation line.

Considerations for capital preservation
Judge Putnam did not take into consideration the fluctuating levels of inflation and currency movements we face in the modern world. Capital preservation is not maintaining a specific number of dollars, pounds, euros, or yen, it is maintaining the financial ability to meet a standard of living that is appropriate. Thus, capital preservation stocks and funds are based on expected spending levels. In my own thinking it covers the cost of healthcare and education. Several investments in my capital preservation portfolio are in well managed, secular growing companies, often paying a predictable dividend. Over an investment cycle I expect this portion of the portfolio to do slightly better than average, mainly because it will go down less in periodic down markets.

Considerations for growth
Capital Appreciation stocks and funds are expected to add to our wealth over time and should generate growth above the expenditures inherent in the capital preservation portion of the portfolio. These investment vehicles can only accomplish this mission by entertaining more risk of capital loss. Over a limited number of investment cycles, capital appreciation stocks and funds should lose no more than 50% of their beginning value and should multiply their starting levels two or more times.

When one examines an investment vehicle, I hope you can see the combination of capital appreciation and capital preservation qualities inherent in each investment. Further, I hope your portfolios will have your own appropriate mix of capital.   

How to Apply Capital Allocation
Making precise judgments about the future is probably impossible, but making judgments about the relative growth of capital and volatility is easier. I am sharing my thinking, not as a recommendation to follow, but as an example of how to assign relative probability to your holdings.

In terms of capital appreciation I have identified BYD, a Chinese auto manufacturer which produces the largest number of electric cars in China and has a contract to provide buses in Los Angeles. Furthermore, its chairman is busy working on other transportation products and services. These characteristics and developments, added to the cyclical nature of auto sales, suggest that reported earnings will be erratic for a while. Nevertheless, the possible potential is intriguing. A more diversified approach to capital appreciation would be mutual funds that focus on innovation and discoveries.

In terms of capital preservation, I use Berkshire Hathaway. It has built a portfolio of private companies and publicly traded securities designed for the heirs of Warren Buffet and Charlie Munger, as well as for a considerable number of their shareholders. One could also include the Rothschild Investment Trust, traded in London as a somewhat similar capital preservation vehicle.

Question of the Week:
What have you identified as Capital Appreciation and Capital Preservation vehicles for you and your accounts?
     

     
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/06/on-right-learning-from-left-weekly-blog.html

https://mikelipper.blogspot.com/2019/06/confidence-deteriorating-normally.html



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Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

The Most Dangerous Part of the Portfolio - Weekly Blog # 581

Mike Lipper’s Monday Morning Musings

The Most Dangerous Part of the Portfolio

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

Our portfolios are invested with our emotions, perhaps unconsciously. While we don’t label each investment, we probably assign each to a capital appreciation or capital preservation label. We are willing to take a relatively large risk of temporary or even permanent loss of capital for expected larger returns with our capital appreciation assets. Much less risk is assigned to our capital preservation assets and we don’t expect to take significant risks with those. (Future blogs will discuss the thinking behind this allocation.)

My concern is that some investors, lured by perceived history, are potentially taking unexpectedly larger risks with their capital preservation assets. If there were some material losses with any of these assets it might shake us up emotionally and cause us to question our whole investment philosophy and portfolio. With this shock to our investment system, it could cause us to retreat from investing at exactly the wrong time and cause us to fail to generate long-term capital growth for the entire investment portfolio. The rest of this blog is devoted to specific risks related to our capital preservation assets.

What We Don’t Know
If we are to be honest we could right volumes examining what we don’t know. For the sake of brevity I will highlight just three topics of what we don’t know:

• The timing and extent of the next major market decline?
• Where today’s fragmented data leads?
• When will interest rate risks be materially higher and under what conditions?

The reasons these are questions is that I don’t know the answers. The reason that they are important to identify are because they are critical to the prudent use of high-quality bonds and bond funds as capital preservation assets. In looking at these assets it is important to recognize some of the essential differences between debt and equity, which impacts how we use capital preservation assets. Major bond considerations are as follows:

• Bonds and credits have fixed maturities, with some variability due to call features.
• Some fixed income instruments fit specific needs and might be held to maturity.
• Bonds are primarily traded between dealers acting as both principals and agents, without a consolidated tape.
• There are some differences in both law and regulation between stocks and bonds.
• Governments, through both their treasury and central bank intermediaries, use bonds to transmit messages to the economy.

Investment decisions are based on both experience and current thinking. In reaching any decision, investors would be wise to listen to the words of the late, great, and former client Sir John Templeton and recently quoted Howard Marx, another former client. They said the four most dangerous words ever spoken are “this time it’s different”. Or, is this the wrong standard of probability? (Lessons can be learned from the racetrack too.)

What Does the Current Data Show?
The answer is mixed and one can choose to emphasize almost any piece of data for either the bullish or bearish side, as follows:

1. The year to date share volume on the New York Stock Exchange is down 39%. (Investors not exercised)
2. Three major stock indices have eclipsed their 65-day moving average.
3. The ETF weekly performance winners are sector bets.
4. 47 of the 72 prices of stocks, ETF, commodities and currencies are generally rising.
5. Deposit interest rates jumped this week to 0.75% from 0.72% for MMDA.
6. The Barron’s bond confidence indicator is only a little less favorable to the highest quality.
7. The total returns on the average High Yield bond fund has rotated around those of General US Treasury funds. (No convincing pattern year-to-date, but behind for five years)

Where’s the Risk?
The risk is in the belief of some bond holders who hold low risk securities on the assumption they won’t go down materially in price. What could go wrong? Bonds, most of the time, move in tandem with general interest rate moves. (Current interest rates are historically low and many think they will go even lower still. However, current rates are insufficient to cover a possible partial or complete default at a time when there is increasing need to roll over maturing debt. At the same time rates are below the needs of retirement accounts, which are facing greater demands from retirees living longer.)

In the UK, bond fund holders have suffered from the collapse of net asset values caused by a well-known “bond king”. In the US, in every decade we have had at least one formerly very successful leading bond manager fall materially. The repeated pattern is that the manager discovers a group of bonds or credits that are under appreciated in the market before they rise. The manager’s success brings in more money for him/her to manage at the very same time that the cheap bonds are bid up by other managers and competitors who were not previously aware of these “bargains”. In time the formerly “cheap” merchandise becomes “expensive”, often at roughly the same time there are problems with the issuer of the bonds. What was expected to be credit quality gains become credit quality losses, with some of the bonds suffering from the withdrawal of buyers. The pattern has been repeated since the age of Shakespeare’s “The Merchant of Venice”, as well as in numerous other markets. Thus, I have high confidence that it will happen again at a time and place to be determined. Part of today’s problem is that there are very few bond analysts and portfolio managers who were operating more than 35 years ago when the bond bull market began.

Two Worries
The first is that for the relatively small number bond holders, directly or through investment vehicles like mutual funds, they will withdraw from investing at the very point when there are more than the normal number of bargains available.

Markets around the world are synchronized across asset classes with a reasonably fixed level of liquidity and move to where they can get the highest risk assumed rate of return. Thus, it is possible that a large problem in one asset class in will drain other markets, at least temporarily.

I have done my fiduciary duty by warning you, but I hope I am wrong, although the odds will be on my side eventually.

Question of the Week:
What would you do if one or more of the bonds you hold drops 10% in a day?
   

      
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/on-right-learning-from-left-weekly-blog.html

https://mikelipper.blogspot.com/2019/06/confidence-deteriorating-normally.html

https://mikelipper.blogspot.com/2019/05/memory-traps-judgement-weekly-blog-578.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 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Investing in Quality for Growth or Value - Weekly Blog # 571

                               

Mike Lipper’s Monday Morning Musings

Investing in Quality for Growth or Value

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

     
                               

Capital Preservation vs. Capital Preservation
Occasionally I assign Capital Appreciation or Capital Preservation labels to each security in my portfolio. These identities may change with each time period examined. The purpose of this exercise is to examine my decision process during the expected top and bottom phases of a cyclical market. (Perhaps a +/- 10% move before or after a recognized turning point has been reached.) For me, this is not an easy exercise and needs to be repeated periodically.

What makes this process particularly difficult for me is dealing with it in my mind, as it’s a small distinctive asset class of high quality companies. My two somewhat contrasting filters are the Charlie Munger type of good companies to own forever and most securities owned by portfolio managers with turnover rates in excess of 20%. (On average they hold their positions for less than five years.) One way to look at the capital preservation companies is that these are the positions I hope to hold for the future generation of the investment committees I serve and for the future generations of my family. On the capital appreciation side I expect market sentiment to become much more favorable to the stock, either because of general changes in attitude or changes specific to that name.

Divining Rods
Old farmers in the search of below surface water used a bent stick to find the critical element necessary for success. Most professional investors use numbers. That is why I was delighted to see Jamie Dimon’s 74-page shareholders’ letter in the JP Morgan Chase annual report, where he made the following statement “earnings is not a perfect measure of performance and economics”. Despite all the billions/trillions of dollars being spent on technology by JP Morgan and many others, as in “the world is going digital”, basic human processing remains an analog art. (I suspect the utility of earnings estimates was downgraded when analysts switched from slide rules to calculators. Slide rules produced good approximations, not precision certainties.) Jamie’s letter is full of what of they are doing for people, including clients, customers, employees, local communities and sovereign nations. This is how he is building what he calls “a financial fortress”. (I wish he would have used another term for such a high-quality organization. A study of military history shows that the strongest fortress falls due to the actions of those within the fortress, causing internal deterioration.)

One fallible measure of effective capital preservation is the company’s lowest stock price relative to tangible common equity. For example, the lowest price for JP Morgan was above its tangible common equity. This is more difficult for a service company and the number of contractual subscribers might be used as a measure in some cases.

Quality Can Be Expensive
Most of the time the US stock market goes up and the market often prices quality at a significant premium to its “bear” market price. Therefore, purchasing a new high-quality name could lead to a significant drop before a new bottom is established. However, if the purchaser is interested in long-term capital preservation, the odds are good that future cycles will give the investor substantial rewards for many years and decades into the future.

Why the Focus on Bear Market Prices?
The job of a prudent manager is to always be aware that markets can surprise on the downside. This is particularly true when sentiment is rising. The following news elements make me cautious:

1. The current low double-digit stock market gains are much larger than current earnings projections for 2019, suggesting the bull market will continue into 2020.
2. Volume is dropping as prices rise. 50 of 72 index prices rose last week and bond prices weakened.
3. Barron’s Cover “Is The Bull Unstoppable”
4. Barron’s article headline “There’s no Expiration Date on this Bull Market”
5. The risk of professional investors actually running companies may be growing, in spite of poor past results.

Question of the Week:
How Do You Identify Quality?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/03/investment-committee-and-investors-be.html

https://mikelipper.blogspot.com/2019/03/the-actively-worrying-classpassively.html

https://mikelipper.blogspot.com/2019/03/long-term-trends-may-not-be-friend.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 - 2018
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Critical Decisions: Successors, Appreciation and Preservation - Weekly Blog # 523

Introduction

The combination of long flights and attendance at the Berkshire Hathaway* Revival meeting has led me to think more prominently about the structure of successful investment processes. I have often said that if one slashes the wrist of a securities analyst (even before they become portfolio managers), a historian will bleed.

I have been thinking about the failure of the conqueror of the ancient world Alexander the Great, whose key lieutenants were for the most part bad successors. In contrast, I compared that result with today’s most profitable company, Apple* and the succession of Tim Cook to the product/service genius Steve Jobs. (This not a prediction as to the future of Apple or its shareholders.) Currently we are in the public succession disclosure phase of the distinctive leaders of two companies: JPMorgan Chase* and the aforementioned Berkshire Hathaway. I believe both successful and less successful command changes should be studied in terms of responsibilities for our families and non-profits we care about.
*Held in client and/or personal portfolios

The Wrong Instincts

I have sat on a number of non-profit boards officially or observed them as their external investment manager. I have noted a number of habits that usually led to long-term sub par results. Choices are made by committee which tends to favor the politically skilled candidates. Frequently it is deemed important that the new leader get along well with the existing staff. Often what is needed for optimum survival  is to either seriously remove staff or materially change their way of thinking and executing. This is particularly true for academic groups where the new person is meant to solve the single biggest short-term problem facing the institution without upsetting too many of the existing “warhorses.”

Another road to failure is setting up a competitive horse race. Not to say that the best person not often wins, but all too often some of the better people leave in disappointment, which weakens the firm even if the best person wins. Unfortunately, we have seen this approach in financial organizations. Just think of the number of CEOs that have come out of GE and a number of leading brokerage firms. The same thing happens with both non-profits as well as families.

Successful Patterns

When Steve Jobs recognized that his deteriorating health would lead to the need for a new leader he chose Tim Cook. He was not a “product guy” like Jobs, but was the master of the supply chain manufacturing and selling all the wonderful new products that were dreamed up by Jobs and his tight design crew. Further, Jobs told his appointed successor not to do things they way he (Jobs) would do them, but the way that made sense for Tim Cook. Under the successor, the shareholders (and I presume the Job’s estate) have seen their assets multiply a number of times. I suspect that Steve Jobs’ thinking was in part shaped by having been fired from Apple in 1985 to avoid taking it into bankruptcy. Luckily he learned a lot with new responsibilities and was better prepared to be Apple’s CEO the second time.   

Selecting Two American Generals

We have benefited from two US Presidents making controversial decisions to lead our Army at critical points. President Abraham Lincoln chose a cashiered Ulysses S. Grant to lead the Union forces through a brutal campaign, first in the Midwest and then the South. Grant who graduated from the US Military Academy at the bottom of his class, accepted the surrender of Robert E. Lee who graduated at the top of his West Point class and is generally believed to have been the best general of the Civil War era. Lincoln’s selection of Grant was key to the eventual Union victory.

When it came to choosing the commanding general for the US-led invasion of Europe, President Franklin Roosevelt turned down the highly respected, most senior Army officer General George Marshall

(later a brilliant Secretary of State) in favor a much younger and junior officer, Dwight Eisenhower. I suspect FDR’s thinking was shaped by the fact that for a number of peacetime years Eisenhower was on the staff of the very difficult, but brilliant General Douglas MacArthur, who not only graduated at the top of his West Point class but also returned to the Academy as superintendent.  I believe that the President felt that if Eisenhower could get along with MacArthur he could work with the difficult British Field Marshal Bernard Montgomery. Being a politician himself, Roosevelt recognized the importance and skills of another politician.

People Skills Part of Asset Allocation

Warren Buffett believes his greatest contribution to the success of Berkshire Hathaway is making major asset allocation judgments. Beyond the required investment skill to make these decisions, he has the ability to “sell” his decision both internally within the firm, and also to his outside audience which he does very well. In looking at these decisions, with the help of Charlie Munger, he uses both capital appreciation and capital preservation strategies in building Berkshire Hathaway for the next generations of owners. While Buffett likes to portray Berkshire as a long-term thinker, he can afford to do that as long as he has a bountiful supply of cash or short-term paper.

With Warren Buffett and Charlie Munger as models, the approach that we recommend to prospective clients is based on our Lipper TIMESPAN Portfolios^®. For illustrative purposes only we have divided an institution’s or individual’s portfolio into four unequal timespan sub-portfolios. Each portfolio is assigned a portion of both capital appreciation and capital preservation securities and strategies which can be modified if conditions and specific needs dictate. The following table is illustrative and can be modified when required:

Lipper TIMESPAN Portfolio®	% Capital Appreciation	% Capital Preservation
Operational (Short-term)	25%	75%
Replenishment (Cyclical)	50%	50%
Endowment (Present lives)	60%	40%
Legacy (Future Lives)	80%	20%

Source: Lipper Advisory Services, Inc.

Please let me know how you would allocate resources for which you feel responsible.

N.B. One of our long-term subscribers who is both an accomplished mathematician and a successful money manager properly called to my attention that I gave the late Stephen Hawking a Nobel Prize that was not awarded to him. Further he reminds me that his theories were never confirmed by measurement. I plead guilty of being in awe of him as a person and the work he did at Caltech.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Contrarian Experiences Suggest Worries

Introduction

As we are in the early stages of an indefinite expansion, the self imposed function of a contrarian is to question the primary trend.  As a contrarian I was not surprised by the Brexit and Trump votes.  If you look carefully at the polling data and understood the customers for the data, you could have joined me in these contrarian views.

My worries can be addressed in the context of the TIMESPAN L Portfolios^® by allocating them into several time slots where they may have the most impact. All of the worries question Mae West's statement that "Too Much of Something Can Be Wonderful" as applied to investing, particularly long-term investing.

Operational Portfolio Time Frame

Using The Economist's table of national market stock price indicators for the week ending Wednesday 31 of 44 rose. More significantly 20 out of 23 economic leading country markets rose including US, China, and most of Western Europe. In this type of market environment far too many buy orders are "at the market" or are price insensitive. Thus, to some extent some current market valuations are being driven by an unusual amount of sentiment and are not particularly price sensitive. This surge could be driven more by retail buyers than institutions. On Friday the Dow Jones Industrial Average went to a new closing high of 18,847.66. The more institutionally followed S&P 500 and the NASDAQ did not. There may well be one or a few days of delay before the other two indices confirm the record high of the media's favorite indicator.

Clearly for most, the enthusiasm for stocks was due to the surprising to most sweep of the Republicans in terms of the Presidency, the Senate, the House, and a number of governors and state houses. In theory this means with a single party dominance, legislation action will be quite rapid. Large majorities tend to give some rebellious members license to be obstreperous as party discipline will be less powerful. Our history going back to when the Democrats had a roughly similar condition is that the ruling party can not deliver on all of its main elements, it will be blamed for their lack of control and the long cycle of "throw the rascals out" will begin. As I suggested today to a Democratic friend, (I do have some) if you can't win big the next best thing to do is to lose big, and that could have just happened.

From a short-term standpoint the market could be exposed to some sudden unpleasant surprises. A trading desk mentality is warranted. If you don't have exposure to a powerful trading desk be more price sensitive than normal. Limit orders are useful, the worst that happens is that one does not get an execution. (Which can be more beneficial than filling an order at too high a price.) I suspect many of the buyers are closing out short positions. When they have completed their covering operation that source of demand will have dried up.

Replenishment Portfolio Time Span

This total return portfolio is designed to fund the next edition of the spent out Operational Portfolio. At the moment I have three principal worries over the next five or so years.

1.  A generational long bond bull market is over where astute bond holders may have made more money through price appreciation than through receiving interest payments. The discredited central banks will no longer manipulate low interest rates and expanding economies will be using much more credit than previously. The increase in the demand for money will push its cost up and therefore interest rates will go up. Thus instead of getting capital appreciation for owning bonds they will get capital depreciation absolutely until maturity and real at maturity in terms of spending power.

Most replenishment type portfolios, whether they call them that or not are collections of stocks and bonds. Where bonds were meant to provide both income and capital stability if not appreciation, over the next five years bonds they are likely to be a depressing input. This concern is highlighted this week with US based TIPS funds attracting the second biggest inflow on record at the very same time as High Yield ETFs saw redemptions. The mutual fund business is global. In just about every market bond funds have attracted significant sales whereas equity funds have been in redemptions. I suspect that the intermediaries that sold the bond funds will see an opportunity for another transaction, selling the bond fund and buying the stock fund. If this happened in extraordinary volume the prices of bonds, if they can be traded will drop significantly.

2.  To fill the demand for loans there has been a sharp increase in the number of credit funds and other types of non-bank financial institutions. These are not policed the same way banks are. Years ago I sat through a course for bank examiners. One of the lessons from the course was the examiners were cautioned to look hard at banks growing their loan books too fast, outrunning some of their credit ratios and their staffs of seasoned underwriters. While I have no information as to various non-bank credit granting institutions, I am under the impression that many are growing faster than the banks and the newer ones may be competing for customers with more favorable terms. Most of the time this can be dangerous, but now or soon it could be particularly dangerous as interest rates move up, a lot of unsound loans could be unable to be rolled over during the replenishment portfolio period.

3.  A good bit of the enthusiasm for the new Administration is based on the repatriation of  US companies’ overseas earnings. Based on past experiences this money will be used for increased dividends and buybacks of voting common stock. In the near-term this is positive, but does nothing for longer or even intermediate-term holders. Worse, a management that is focused on its short-term stock price may pass up sound opportunities to invest overseas in markets that in the long run are likely grow faster than the US market.

Endowment Portfolio Time Span Input

Are we currently suffering from a cyclical or structurally slow period is the question for the investors trying to manage future payments for periods that their current investment committee or investment officer is functioning. Clearly most of the developed world including the US is going through a flat or sub-normal growth period. Some of this may be caused by central banks and various government regulations and taxation. Through the political system we can be hopeful that many of these issues will be addressed. Because policies go in cycles I believe these are cyclical factors that suggest that endowment management needs to wisely make changes periodically. However, these switches do not address the current reality of structural problems.

Throughout the developed world labor and therefore capital productivity is low by historical standards. One of the main culprits is demography. Birth rates are low and declining in many societies, but at least in the US people are working longer. Currently the growth rate in the population that is working between the ages of 16 to 55 is equal to the number of people over 55 that is working. As one of those I would say that shows that there is some value to experience and work ethics. I am very conscious of the benefits that my brother and I, depression babies, received when we entered the investment community. Very few young people entered the financial community from the 1940s-1955. When we entered we had a few senior elders in the field who were psychologically recovering from the depression and very little in the way of middle management. Our progress at a relatively young age was rapid and remarkable. Today's youths have too many of us still in the picture and because of the advances of medical science, we are likely to stay involved.

A very important part of the political upheaval caused by Brexit and the Trump victories has to do with immigration. The odds are if the developed world had more good, competent, workers we would see our national productivity numbers rise. The more difficult set of questions revolves around how to pay for their training and placement in productive locations. This is a societal issue that won't be quickly solved, but without it being successfully addressed our long-term rates of return on Endowment assets are likely to be below historic norms at the very same time we are living longer.

Legacy Portfolio Inputs

In some ways this is the easiest as well as the hardest portfolio to manage. It is easy as we won't be around to see whether it works and thus avoid whatever criticism that is directed at it. At the same time it is hardest, for by definition we must deal with the future and that is predictably unpredictable. Nevertheless, for those who take on this responsibility for grandchildren and great grandchildren and beyond, the best thing we can do is to lay out some useful principles.

At the heart of the dilemma is who do we trust to use the right instruments. In some ways it is dealing with the risk and reward questions that we already must deal. Almost all of the advise that is around today assumes an investment in a liquid portfolio which can periodically be readdressed to handle market turmoil. An incomplete study of great wealth indicated that once it is converted into portfolios, short-term and personal concerns reduce the size and power of the family's wealth perhaps over many generations.

Another study of great wealth is based on great entrepreneurs. These ladies and gentlemen typically have a keen understanding of a particular market niche and with high energy plus some inspiration develop a needed product or service. Then comes the much more difficult task of building a sustainable company, very few succeed beyond the third generation.

I believe a wise legacy portfolio should be invested in securities and operating businesses and have different managers for the portfolio investments and the operating business opportunities. Because I can not predict the future I am searching for the right mixture and right managers for some institutional and personal accounts. But times are changing and one should anticipate some of these changes, and that is really our legacy.

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

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Copyright © 2008 - 2016

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