This Weekend’s Learning Sources - Weekly Blog # 939

 

 

 

Mike Lipper’s Monday Morning Musings

 

This Weekend’s Learning Sources

 

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

 

          

 

Identifying sources of learning

One of the main differences between us and most animals is that our brains are larger, which hopefully means we can learn more. The end of this week supplied three sources of learning. The three teams of instructors were: Tim Cook (Steve Jobs), Berkshire Hathaway’s Annual Meeting with shareholders (Warren Buffett/Charlie Munger and Greg Able), and the Bettors and Horses at the Kentucky Derby. From each I can learn a lot. Matter of fact, each could be a whole semester at Business Schools instead of what they are currently teaching.

 

Tim Cook (Steve Jobs)

At the end of the so-called work week Tim Cook conducted what was his last quarterly meeting for shareholders and analysts of Apple (*). He focused on the company’s critical relationships with customers and what is owed to them. He stressed what Steve Jobs taught, the betterment of the users’ lives. These were the critical thoughts passed onto the oncoming new President of Apple. We should pass these views onto all we deal with, focusing less on what they paid us and more on what we did for them.

* Owned in personal and client accounts.

 

Warren Buffett/ Charlie Munger & Greg Able

Mr. Buffett spoke to many of the shareholders attending the annual Berkshire Hathaway (*) meeting, both in person and electronically. His advice for people reaching 50 years or older was to switch their primary investment focus from making money to capital preservation. He emphasized saying no, particularly to not well understood new investments. (I do not own any “AI” stocks directly, but there are many in mutual funds I own. The key to their future is what they have yet to produce, not what they are selling today.) He believes investors in retirement should prune their holdings and try to explain what they own to their heirs, feeling it is more beneficial to focus on how the inheritance should be used rather than the intricacies of what is owned.

* Owned in personal and client accounts.

 

Greg Able is the new President of the company and is focused on improving the operations of the company. When the talented Chief Financial Officer transitions into retirement, he will be replaced with both a CFO and a new lawyer. Furthermore, for the 31 private companies owned by Berkshire, he has appointed a trusted internal executive as leader. Instead of doing just financial oversight, he will be reviewing the operations of the formerly private companies. Good policies of the past will be reviewed to see if they are right for now.

 

My personal view is that there are two major trends which we did not have to deal with in the past, but which could be much more important in the future. The first is one of the causes of financial and economic cyclicality resulting from not repaying debt on time and at full value. Defaults on debt have led to depressions in the past and have been the cause of unplanned contractions.

 

In the decade of the 1920s into the early 1930s society encouraged the global extension of debt at the retail level, including its use as a defense against tariffs (Smoot Hawley).  Currently, we have an expanded federal debt led by someone who needed to renegotiate his own debt. Our government encourages investing retirement capital in debt. The national debt is larger than the GNP. (Old debt has a due date, while GNP is produced each year.)

 

The second dangerous trend is the value of the dollar in world trade. As debt grows, overseas investors value it less. Meaning, it not only becomes more expensive for funding our debt, but also for paying for imports of food, clothing, and raw materials. We are better positioned than many other countries who are in worst shape, but not all. Asia, which has a younger population and a disciplined workforce, is in better shape. Higher inflation leads to lower long-term value of the currency. One measure of inflation not issued by our overworked government is the ECRI Index of Industrial Prices, which was up 140.35% this week for the last 52 weeks.  

 

Kentucky Derby

I brought this on myself by stating that I learned the basic tenants of analysis at the New York Racetracks. A subscriber asked who I was betting on in the race. Where do I begin? Perhaps with two axioms. First, as with most things in life, short answers are often wrong. The short answers are wrong because they are stated without limits and conditions. That brings us to the second axiom, I don’t like losing. I don’t like losing because it is a double loss. The first loss is the sum wagered, and the second is the loss of funds necessary for future betting and other things.

 

There are two negatives against betting at the track. First, the track takes a cut of all bets and there are personal expenses of travel, admissions, and food. Second, as a game of chance it is rigged because of the track’s take. Additionally, winnings are taxable at federal and state levels. There is still another drawback, about 30% to 50% of the time the lowest yielding horse wins. Most of the time those winnings are not large enough to offset losses and expenses incurred. I address this problem by limiting the number of times I bet, usually 3 out of 9 races and rarely at the lowest odds. The advantage of this approach is staying away from betting at the lowest odds, which are the most popular horses.

 

If these issues did not cause you to find other things to bet on, the elements of the Derby might. First, the race is only for three-year-old horses. While horses are born for the record throughout the year, under racing law all horses are born on January 1st. Some horses start their racing history at 2 years old, but many do not. By the time they are three years old they are adolescent. (From a scientific standpoint it would be useful to know the actual date of birth. There is poor but available information as to the number of official races the horse has run. In terms of the Derby, the range I heard was 1 to 4 races.) For those of my age, I am reluctant to take adolescent horses and most humans seriously.

 

So, after all this I did not place a bet on this year’s Derby. Most of the time I am not interested in races for three-year olds that are run any earlier than June, which starts with the Belmont Stakes race. These races are also a bit suspect because the course has been altered.

 

I would not have bet on the winner this year. However, the trainer deserves to be congratulated as she was the first woman trainer to win the Derby. The night before she had a dam which won the Kentucky Oaks with the same jockey who won the Kentucky Derby. Quite an accomplishment.

 

All of this shows I am still a student and hope you are as well.

                                        

 

 

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

Mike Lipper's Blog: Watch Out for the Four - Weekly Blog # 938

Mike Lipper's Blog: Investors’ Interlude - Weekly Blog # 937

Mike Lipper's Blog: Not Yet Ready for a long-term Solution - Weekly Blog # 936

 

 

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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

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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



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Copyright © 2008 - 2018
A. Michael Lipper, CFA

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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



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Copyright © 2008 - 2018
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Investment Committee/Investors Prepare for Mistakes - Weekly Blog # 570

Mike Lipper’s Monday Morning Musings

Investment Committee/Investors Prepare for Mistakes

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

     
                               

Bright People Are Sometimes Wrong

I have assembled and often chaired investment committees of bright, experienced investors. I have been curious as to why these bright investors make unexpectedly bad judgements. Individually, they have a history of making good choices in terms of securities and the timing of their transactions. I bring this up as we approach a general market turning point. I am totally convinced that we will see record high prices for the major indices and I also have confidence that we will experience both recessions and substantial market declines. The order, timing, and magnitude of these are unclear to me. What I am sure of is that many investment committees and most investors will get their timing absolutely wrong!!!.

Why?

We are social people who mostly prefer to agree with others than to express a strident minority view. The group dynamic in most investment committees is to move to a unanimous decision. Unless we have very deep-seated opinions there is a tendency to go along with the sensed majority view, despite our own private opinion which may be better. This tendency has been labeled the “Abilene Paradox”. I suspect that this is one of the reasons that political pools have proven to be inaccurate. One can often sense the answer the questioner wants to hear and we have sympathy for those who ask.

Current Factors

Double digit gains were achieved by the major stock market indices despite the global slowing of economies. The gains if repeated would result in record price levels, led quiet possibly by the NASDAQ Composite, the most volatile of the major stock indices. This volatility could be driven by the larger tech companies or less capital being committed to over-the-counter market making.

The latest Atlanta Fed Real GDP fan chart estimate ranges from under 2.5% to under 1%, reflecting market fears.

China appears to be the most important driver of global economic growth. Some believe changes in Chinese policies are having a bigger impact than the Fed. In part this is true because interest rates driven by the Fed are currently in the mid-range. They have not gone high enough to attract savings (4%) or low enough to spur a declining economy.

One large fund of funds manager has re-juggled its list of managers in favor of concentrated “high-conviction” managers. Others are adding leverage to their portfolios to overcome low returns. From a market viewpoint the combination of leverage + volatility = dynamite.

Helpful Hints from Mutual Funds

Mutual funds are now required to show their best and worst quarters. These are often next to or close to each other. Often the magnitude of the gains and losses when linked together almost cancel each other out, although sometimes it may take two up quarters to recover the losses from the bad quarter. If the percentage gains and losses are large, it is an indicator that the fund is volatile.

The coverage of mutual funds can be misleading, as media and sales efforts focus almost exclusively on the best performers in relatively short time periods. The leaders and laggards are often highly concentrated in terms of the number of issues held, giving the impression that these mutual funds are bought for speculation, although that is not always the case.  

The vast majority of the equity funds are in just four investment objective categories and are listed below in descending order of assets, which also appears to be at increasing levels of perceived risks as you work your way down the list: 

Growth & Income    $4.27 Billion  

Growth              3.84                 

International       2.48                 

S&P Index           2.19                 

The first three investment objectives carry cash to meet extreme redemption needs and opportunity reserves. The biggest use for these funds is to meet retirement and for estate building purposes. Most redemptions are caused by life changes. Index funds always have no cash and buy the most popular stocks.

Turning Point Reactions Produce Relatively Small Gains and Large Losses

Historically, momentum becomes the enemy of capital preservation when we near peaks and troughs, unless an investor possesses trading skill. Investment committees at this juncture become captives of the “Abilene Paradox”.

Don’t say that you weren’t warned, but good luck and stick to your convictions.

  

Did you miss my past few blogs? Click one of the links below to read.

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

https://mikelipper.blogspot.com/2019/03/the-top-before-big-top-weekly-blog-567.html

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