VALUE INVESTING WILL BE SUPERIOR BUT IT MAY HAPPEN AFTER THE RECESSION - Weekly Blog # 574

Mike Lipper’s Monday Morning Musings

VALUE INVESTING WILL BE SUPERIOR

BUT IT MAY HAPPEN AFTER THE RECESSION

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

Current Inputs
A few weeks ago, one of our perceptive readers asked what advice I had for his good friends that were managers of value stock portfolios. My unexplained response may have seemed nonsensical in the face of relatively poor performance compared to market. I should have explained my thinking. My reply was focused on the business of providing investment advice. I saw a short-term continuation of poor relative performance leading to less money going into these portfolios and a significant number of the managers withdrawing from the business. Lower prices often result from fewer value buyers participating in the market. Without new performance seeking money in the markets the remaining portfolio managers will need to liquidate some or eventually all their holdings. Typically, they will sell their most liquid holdings first and be forced to sell their less-liquid positions when that is all they have left. These sales will be at bargain prices for those that have the cash to take advantage, but there will be few with the cash, courage, and foresight to take advantage of these great bargains. These insightful managers will have less competition and thus they can earn premium level fees.

Recently I reviewed the performance of a large Planned-Giving Fund run by a well-known and respected manager with a recognized value bias. In looking over their performance record, it was superior for ten years, but not for shorter time periods. Just this week we were informed that a” deep-value” manager was closing his shop, as he was no longer able to produce the good returns he had generated in the past.

These inputs led me to explore the structural reason why this group of intelligent, formerly good performers, were not doing better in a market that was performing extremely well. Like many analysts who are closet history students, my search for an explanation focused on recent US financial history and recorded history from Biblical and Ancient societies.

Last Ten Years
 Because government promoted home ownership, various government subsidies and tax credits led to excessive ownership of homes by those stretched in their ability to support mortgages and the reasonable upkeep on home purchases. In some cases the buyers lied on their applications, but much more significantly lied to themselves and their families as to the predictability of their income and wealth.

In the aftermath of the mortgage crisis the government focused on the mis-selling and mis-labeling of tranches and ended up penalizing the financial industry with burdensome regulation and capital requirements. Further, Central Banks pumped money into the market in what came to be known as “quantitative easing”. This has led to a ten-year period where interest rates have been kept artificially low, depriving savers of the rates that paid them not to spend, leading to a global shortage of savings. More importantly, low rates and the availability of capital has led both commercial banks and non-bank financials to make commercial loans at interest rates which encouraged undisciplined credit extensions. Much of this money went to marginal firms for capacity expansions. This has hurt the value investor, as demonstrated by their poor investment performance compared to other investors.

Companies that value investors favor have the following characteristics:

• Strong balance sheets (under-utilized borrowing power)
• Physical assets where the current market value is larger than the depreciated book value
• Close to impregnable market penetration of good customers
• Unique and highly prized intellectual property
• Respected in-depth management
• Stable shareholder base

It takes many years if not generations to build these. The field of competition changes when marginal companies with a poor financial record and large debt can acquire even more debt at low cost. Often, when marginal companies build excess capacity they fight for market share. They do this by lowering prices, which in turn devalues the more sound companies. With a more leveraged balance sheet the marginal company can report faster earnings growth than the value focused company, at least for a while. Thus, in a period where growth is most valued, the marginals will be the more productive investments, until the next recession.

Ancient History + Human Nature
The Bible and archaeology have recorded various agricultural cycles, often tied to weather but also the expansion of crop or grazing land. Humans are driven by fear and greed. When they are in rough balance, humans tend to be both disciplined and careful. However, when either side is predominant humans tend to do extreme things and concentrate all their resources to gain more wealth/power or horde them to avoid current or future crises. When a mass of people do the same thing, like all going to one side of a boat, they can capsize the boat. That is why we have always needed recessions to correct the excesses of a prior period. I see nothing that has repealed this need and thus I expect we will have a recession at some point.

Where are We Today?
While I can’t give a date for the top of the market prior to the beginning of the next recession, nor the percent of the market gain, I can make the following observations:

1. Currently, the US stock market is being led by the NASDAQ composite, made up mostly of tech and services providers. However, this past week the stocks listed on the New York Sock Exchange had a higher percentage of gainers 77%vs. 69%. Perhaps the valuation gaps are too great - NYSE p/e 18.47x vs NASDAQ p/e 23.67x. If the rate of gain slows, perhaps yields will be more important - NYSE 2.16% vs. NASDAQ 0.99%.
2. Despite the strength of the equity market NYSE volume is flat compared to a year ago. The absence of speculative enthusiasm for listed stocks suggests there is more upside ahead.
3. While it is broadly proclaimed that the Federal Reserve won’t raise interest rates this year, this week the average interest rate offered by savings institutions rose 5 basis points to 0.65 bps. I interpret this as savings banks encouraging more deposits for them to loan out. This may support the surprise 3.1% first quarter GDP announcement. I have always believed that the Fed is a follower and not a leader on setting interest rates.
4. Each week the WSJ tracks the prices of 72 securities, currencies, and commodities. Until this week, gainers outnumbered the losers, this week they are exactly even.
5. The bond market is often more attuned to changing financial conditions. In the latest week yields on high quality bonds rose 14 bps, while the yield on intermediate credits declined 4 bps. [Prices move inversely to yields.] This suggests that bond investors are concerned about the future value of the highest quality bonds.

What to Do with Value Funds/ Managers
As a portfolio manager of portfolios of mutual funds, we invest globally in both growth and value focused funds. I expect the more growth-oriented funds to provide both more appreciation and volatility. The value-focused funds will probably go down less in poor markets. However, when interest rates go up, as I expect them to do before the next presidential inaugural, the value merchandise should do better and will receive a reasonable amount of M&A activity.

What Do You Think?  


Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html

https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html



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A. Michael Lipper, CFA

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Get Ready for: Declines, Recoveries, and Growth – Blog # 537

Mike Lipper’s Monday Morning Musings

Get Ready for: Declines, Recoveries, and Growth – Blog # 537

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

One of the prior major stock market declines was signaled when the O’Hare airport authorities would not let United Airlines sell its gate positions to reduce its debt. We may be approaching a similar signal. Media reports that after 31 years of owning the management company for Oppenheimer Funds, Mass Mutual Insurance is considering putting it up for sale at around 2% of assets under management. While this may be a fair price, many professionals would treat this result as negative because it is below full bull market valuation. At the same time the much respected T. Rowe Price (*) is reducing its commitment to large-cap in favor of small caps and international on the basis of valuations. Both of these elements are good reasons to prepare for future declines, recoveries, and growth as discussed in this blog.

As a long term investor in search of other long term investors we are confident that we collectively will experience declines, recoveries and growth. So much for recorded history, but the value of history is primarily the recognition that these types of events happen. Far too many look for history to be repeated exactly, without adjusting for the dynamic changes of the past. My task is not only to understand history, but to also understand the changes that will modify future paths.

We know that declines, recoveries and growth will happen because greed and fear exaggerate the natural cyclicality of nature. Successful predictors can use this for future events or dates, but should never predict both. That is why I can envisage the three events mentioned, but I clearly don’t know when they will occur or their magnitude. However, what I can do is prepare my thinking for each of these inevitabilities.

Declines
There is no question that there will be future declines in both the stock market and the global economy, which are often related, but not always.

As with most wars there are underlying causes of critical imbalances which can be readily observed, but there are also unpredictable flash points e.g. the assassination of the Arch Duke. Populations and their governments can manage through declines reasonably safely, or they can overreact and try to correct both the imbalances and the bad actors. Based on the historical record in this country, overreactions can lengthen and deepen declines. Many of those who lost lots of money in the stock market crash” of 1929-1932 and 1937 discounted their prior gains on paper then swore they would never return to investing in stocks. They and their families missed out on participating in the benefits of the long bull markets of the 1960s and post 1980s.

Strategies and Tactics
Essentially there are two  strategic approaches: abandon or ride through. Neither works particularly well if they are followed minimally. The abandon strategy promotes a misplaced sense of safety  because it does not recognize inflation.  As long as governments spend more than they take in we will have inflation eroding currency values.

The ride through the crisis approach assumes more than a full recovery, including perhaps some inherent gains for the loss of income during the period.  Clearly, even under the best of circumstances not all commercial entities will survive, but most will. However, it may take time. One of the high flyers in the excitement of the radio era (read mobile phones or the Cloud) was the old Radio Corporation of America (RCA). The stock price of RCA did not reach its pre-depression price until the 1960s, on the back of the promise of color television. Also, many farmers lost their lands to foreclosure due to leveraged borrowing.

Few investors fully subscribe to the two strategies of abandon or stay put,  utilizing tactics that address some of the concerns and opportunities of each. Some build up cash reserves, but there are two drawbacks to that approach. Firstly, a study of mutual fund portfolios and performance suggests that unless cash reserves exceed 25% of the portfolio near the top, it will only satisfactorily cushion a typical cyclical decline of 25% or less, not a secular decline of 50% or more. The second drawback, which a study of portfolio manager behavior reveals, is that there is too much comfort in cash and these portfolio managers miss out on buying cheap bargains.

There is another approach that probably works better for long-term investors, that is to gradually move equity portfolios into more defensive stocks. These stocks are generally absent in most market commentary and are often found by examining the rosters of relatively underperforming sectors and stocks lagging near the peak of the market. To me, two of the better hunting grounds for these searches are international and dividend paying “value” stocks.

International
There are two long term reasons to invest internationally. First, it is a hedge against the larger domestically traded stocks/funds in your portfolio. If one looks at our rank in terms of standard of living in the US compared to other countries, we have been slipping for sometime. The main reason for the relative strength in the dollar is that we are living in a period where almost every other country has threatening dissident groups, whereas our currency is perceived as safer than others.

Using mutual fund performance averages based on their investment objectives, of the 18 global and international fund objectives versus their US focused peers, only in real estate is the foreign fund better. I suspect that at least half the performance superiority in the first seven months of 2018 is the direct impact of the strength of the US dollar, which is unlikely to continue forever.

In many ways the more hopeful and sounder reason is that selectively there are many more opportunities outside the US than in it. There are world leading companies beyond our borders in technology and natural resources. Occasionally these stocks are priced more attractively and their younger populations create an attractive market opportunity. Educational standards and wealth are rising both in Asia and Africa, which should be fertile for investments long term. Thus for defensive (hedging) and aggressive (demographic) reasons, investing internationally makes sense, particularly if one uses select funds for administrative and liquidity reasons.

Value
In utilizing value for diversification purposes I am excluding “deep value”, which requires corporate actions, mostly mergers or acquisitions (M&A) to work out. Most M&A occurs during expansionist periods, not declines, so it may not provide much downside protection. For diversification purposes, the ideal value stock must have a history of paying dividends with an average payout ratio of about 50%- 75%, with a history of raising the dividend rate at least as much as recognized inflation. “Trust quality” or above BBB credit rating would also be good. Some strong institutional ownership would be a plus, as would a reasonably liquid stock. Some and all of these characteristics are found in average in some mutual fund portfolios.

Recovery Candidates
Product or service providers that are likely to be considered essential in the future include those that have sufficient management depth beyond the CEO to be the next generation of sound leadership. Also attractive are those companies that have surplus borrowing power to take advantage of product and corporate opportunities which may occur in troubled times.

Growth Candidates
Growing target markets rather than growth in market share is an important growth criteria. A multi-generational attitude also helps in the selection for legacy investment accounts. Sufficient internal research & development open to external sources would be best.

Fund/Manager Selection Tips
If the bulk of one’s assets and dreams are tied up in one asset, diversification should lean toward a couple of portfolios with a reasonably large number of securities, with the portfolios different in investment style. For the asset owner that is more liquid,  a portfolio of concentrated funds that complement each other rather than compete for attention is preferable.

We would be glad to help with the selection and management of funds to fulfill your needs.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.