Introduction
In last week’s post I
focused on too many investors that are not identifying the correct correlation
models. Building on that foundation, this week I will focus on most investors,
including professionals making investment decisions on today’s headlines rather
than future potential prices.
Correlation
Traps
Scientists who study
how the brain works and those of us who have developed performance and fee
tables recognize the need for comparisons. We are taught that higher ranked
items are better than lower. Because rankings are so important, we prefer that
the leagues be mathematically constructed, even though our choices of art,
music, and significant others are not mathematically based. I will leave it to
others to decide which mindset produces better results. Clue: My wife Ruth and
I regularly go to concerts performed by the New Jersey Symphony Orchestra.
In the investment arena
we measure nanosecond by nanosecond how well a stock or a fund performs versus
market indices. (At my old firm, now known as Lipper, Inc., I convinced funds’
independent directors to compare with similar funds.) Because professional
investors recognize that there are differences between companies, the popular
approach is to measure companies that generally produce the same type of
products or services.
This particular matrix
approach did not help explain the performance of most security prices in the
first three weeks of 2016. On the downward slide at least 80% or more fell, and
on the not too inspiring recovery of this last week, a majority of stock prices
rose from a Wednesday bottom. (See my friend Jason Zweig’s weekend Wall
Street Journal article entitled “Market Capitulation is Nowhere in
Sight (So Far).”
As a life-long student
of investing and a professional investment manager, I am not satisfied with the
comparisons normally produced as a jumping off point for analysis of investment
decisions. This bears on fiduciaries and individual investors as well.
Starting from the
premise that a stock and a company share the same name, but often not some of
the same characteristics, I suggest for stocks (as distinct from whole company
buyers) the perceived characteristics of the stock has more to do with its
current and near-term performance than those of the operating company. I am suggesting
that there are distinguishing characteristics that stock buyers and owners
attach to a stock. All of these are far less mathematically defined than price
indices, but like identifying the sought after traits of a life-long companion,
lead to actionable conclusions. Because there is no easy math to guide us into
putting a stock in a particular bucket, investors will reach different
decisions at different times as to what is the single most important element.
Improved
Correlation Elements
Over time I am sure
that we will find other ways to group stocks and corporate bonds. The first
four that I use are:
•
Demand
•
Supply
•
Time
•
Talent
One example of the
criticality of Demand was the sharp reversal on Wednesday which seemed to be
driven by overturning the depressing view that the decline in the prices for
oil and selected other natural resources was a fall in demand. Apparently
investors understood that supply was in excess of demand temporarily which many
feared was showing signs of a recession. The prices of crude oil and a few
minerals jumping higher was a sign of increased demand from the global economy.
(That supposed surge in demand could be right, but based upon my over half
century of market experience there could be another explanation. Any time after
a material decline is experienced in prices and then there is a sudden price
spike it may well be caused by the covering of exposed short sellers.)
Too often we think of
supply in terms of the items mentioned above, but I am more concerned with the delivery
bottlenecks that are developing and are lengthening distribution times of
various products and services produced in the US.
Regularly the number
one or two major worries of small businesses are their inability to find
qualified labor at reasonable wages. As consumers, people are experiencing
delays which is annoying and could be a cause for imports remaining strong even
with the escalating dollar. In answer to these concerns, there were discussions
as to the impact of robots and artificial intelligence at Davos last week. The
shares of companies that are seen to be addressing this supply of qualified labor
will be in demand.
Time has two very
different buckets. The first has to do with the aging process that can’t be
accelerated; nine women can’t have a baby in a month nor can anyone produce 12 year old Bourbon in
a year. Similarly, waiting for the next CEO can require patience. The second
bucket is the time proclivities of various shareholder and bond holder groups.
At one point an
important group of institutional shareholders were the general accounts of Life
Insurance companies who held these securities against the expected maturities
of their insurance policies. Often growing defined benefit pension plans had
somewhat similar needs. Today hedge funds with currently shaky performance need
quarterly successes. Sound defined contribution plans (401k) invested through
prudent mutual funds are somewhere in between in terms of time sensitivities or
at least the ones we have managed. The nature of the shareholder base for any
stock is likely to influence its price behavior.
Talent
In many respects the
recognized talent in a company is the most difficult and often the single
biggest differentiator for many stocks. Currently there are three major US
investment banks. Because of regulatory changes and the persistent low interest
rates all three are cutting employment. The leader (while perhaps slightly
increasing its annual cull rate) is still hiring a significant number of bright
accomplished young people. The second, managed by a former consultant, views
people as one of the ingredients to making profit goals and is cutting deeply.
The third with a slightly different business mix has raised senior executives’
compensation because they executed well. From time to time I have owned all
three, though I now only own the first in our private Financial Services fund.
One of the reasons for
this belief in talent is what I have learned about the discovery of the Ninth
Planet, one of the only three identified in modern times. The work was done at
Caltech and started with a couple of graduate students who found compelling
elements in the sky. Their professor of Planetary Astronomy went down the hall
to discuss what the students found with an assistant professor of Planetary Science.
Thus they combined observation and theoretical science to confirm the existence
of the Ninth Planet. It is just this sort of cooperation of in-house experts in
a maturing organization that I look forward to in a smart, talent heavy
organization.
Interesting enough all
three investment banks are now selling below their published book value which
does not carry talent as a balance sheet item. Certainly in the case of the
first and quite possibly the other two, if I could buy just their talent and
none of their other assets and liabilities, I think I would.
Entry Point
Microscope vs. Terminal Telescope
For my sins I sit on a
number of Investment Committees and chair some. At this point my fellow members
are focused on reading the current “tea leaves” about the near-term conditions
including the likelihood of further market declines. Considering their brains
and experience they are probably right in the short-term. My frustration is
that this microscopic focus is preventing them from acting to position some of
the money we are responsible for by investing in the future.
There is no question
that a microscope will provide much more accurate measurement than even a
thirty meter telescope. However, part of every fiduciary’s responsibility is to
provide benefits to the last beneficiary. Since these institutions are designed
to be eternal and some of the families that we serve expect eternity, we should
be looking to the future. We can not be as precise about 10-50 year futures as
we can be about tomorrow’s opening price, however that does not relieve us of
our responsibilities to future beneficiaries. I am reasonably confident that
this is the right time to invest for the future.
As a contrarian, I like
that most investment professionals are focusing on current market and economic
conditions. Historically, one can age a “bull market” by how far out investors
are discounting the future. The focus on this quarter’s earnings or the next
rate hike or the number of producing drilling rigs is reassuring to me. I have
lived through periods when investors were using five to twenty year projections
for their investment decisions.
A
study of great investors depicts that many have been lonely in their exposed
positions before achieving success. While I recognize that there are numerous
flashing caution lights, such as the sudden drop in the confidence index
published by Barron’s each week of the spread between high
quality and intermediate quality bond yields, I am comfortable with some money
for some clients investing for the long-term. You probably should as well.
__________
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A. Michael Lipper, CFA,
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