The Golden Calf for Investors - Weekly Blog # 519

Introduction

According to human experience as recorded in The Old Testament, in a period of great uncertainty many people look for certainty when faced with a tricky period ahead. Today’s investors are in a similar quandary. In their search for a defined future, there is great appeal in simple tangible answers. Today, many investors have conflicting views as to the future direction of their investments. We are now facing a tricky market and there is great appeal in simple declarations of faith or the lack of faith.

The one thing I am totally convinced of is that there are no good simple answers, despite what future market historians will condense for an impatient audience.


The Known Knowns

Without putting dates or timespans on when these conditions will become dominant and for how long, based on human experience there are two knowns.

1. Due to excessive expansions of capacity and credit there will be future recessions. These could start soon or after various coincident changes. The base causes are what they have always been; imprudent expansion based on excessive enthusiasm. The coincident events or actions will not be the base causes for a period of unhappiness, but will supply a label to those looking to others for an explanation and not to themselves, in order to not get caught up in the tidal wave. Perhaps as an equity owner for clients and my family I don’t see a high level of an immediate risk. As long as the latest survey of the American Association of Individual Investors (AAII) shows that 42.8% of respondents to their weekly poll are bearish for the next six months compared to 26.1% bullish and 31.2% neutral, I am not too worried. Further, a major US-domiciled brokerage and wealth management firm is on record stating that investors should use rises in stock prices as an opportunity to sell. I would agree that it is an opportunity…for the firm to free up investors’ capital, often held with large unrealized gains, which might lead to future investments, often in packaged products with favorable economics for the intermediary. (There is always a risk for all contrarians that a popular view will be accurate. This is a lesson that gets reinforced at the racetrack.)

2.  The second “known” is the human survival instinct. Greed and fear drive all of us. Our primary driver is greed to obtain at least minimum subsistence and beyond to higher and higher levels of security. Fear is the worry that we and our loved ones will not survive without the appropriate levels of financial, intellectual, and health resources. The solution to both primal drives is to secure sufficient resources beyond our subsistence levels. The excess beyond consumption is savings, including debt reduction, and investments for longer term needs.

Unlike the first known which is periodically important, the second is a global constant in all of our lives. For the moment it appears that aggregate corporate and personal revenues will be growing beyond the AAII six month focused period and way beyond for those of us who believe that we will grow on a secular basis. (Note I did not mention corporate earnings, which will discussed shortly.)

One of the long-term reasons to be bullish on the future level of global investment is China. As of May1st (May Day) China will for the first time permit the commercial sale and operation of pension plans. Contributions to the plans will be tax incentivized and open to foreign insurance companies which the Chinese government has authorized. In most of Asia, beneath the level of stocks owned by International Index funds, the valuations appear to be cheaper than those found in the US. However, a detailed accounting and operational comparison is needed to show that they are more valuable to own, although we tend to think so.


Near Term Debt Worries

Because of the insistent drive for current yield, almost every financial institution or intermediary is selling a credit focused product which will hold direct loans rather than tradeable bonds. Three quotes from the Financial Times on the views of S&P sum up our concerns:

• “S&P warns of risks in leveraged loan sector as private equity deals surge.”
• “We’ve already seen weaker (covenant) terms deteriorating over the last couple of years.”
• History shows us that the worst debt transactions are done at the best of times.”

Another long article published in the weekend issue of the FT is entitled “The volatility virus tells the history of turning volatility into an investable product.” The article mentions that today there are at least forty exchange traded products (ETPs), funds and notes that alone trade VIX elements.  This comes to the heart of a concern of mine. Too many of the media pundits treat ETFs and ETNs as retail alternatives to conventional mutual funds, when in reality they have become cheap trading vehicles for professional speculators. The available ETPs have replaced the more expensive futures as the derivative of choice. Not only are they cheaper to transact but they are more easily marginable or borrowed against. I suspect that a significant portion of the trading, particularly near the close of the days’ trading, is to facilitate short sales in “pair” like trading, which entails being long another index derivative or an individual stock or bond.

There are still a lot of derivatives being used in fixed income, currencies, and commodity trading. These are global markets with individual country banking rules. All of these vehicles are used as collateral to support trading positions with call loans that can require immediate repayment of the supporting loans. Rarely are these loans repaid with existing cash, but are paid with securities that are not immediately price sensitive. These trading and lending activities are conducted by trading groups and banks that have to maintain given levels of capital. If there is a sudden fall in the level of collateral, other assets will often have to be sold without sensitivity to current prices. We have seen this occur in the past.

Equity Concerns

If one pays complete attention to the media prognosticators, the only thing in the end driving stock prices are earnings per share, or if you will the rejuvenation of the biblical Golden Calf. The followers, including a number of university professors, would have achieved losses on Friday. According to them, the market was going to be led by the earnings reported by three major US money center banks on Friday.

In each case their announcements stressed the favorable comparison to their reported earnings compared to those of the prior year. Thus the stock market should have gone up. It didn’t, which was not a surprise to me. Ruth, my good wife, asked me after I got off the first of the earnings calls what I thought. I replied that the announcement was quite positive, but I saw problems when I went through the detail of the announcement. By the end of the day the stocks of the banks and a good bit of the market was down 2-3%. It was not a case of buy on the rumor or expectation and sell on the news, which often happens.

My concerns were first that the market price assumed that the tax generated savings were a growth element rather than a onetime benefit, (the expected state and local tax increases plus higher sales and use fees one might expect a bigger tax rate going forward).  An operating concern was that the reported earnings benefitted from buybacks and the release of some credit reserves and similar adjustments.

Revenues were largely up but not spectacularly. Often these reports brag about relative investment performance vs. peers, which was missing, but not their selective inflow comments. Bottom line: the results did not trigger additional buying or selling in our long-term accounts. The level of operating pre-tax earnings was acceptable.
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“The Risk to Worry About” - Weekly Blog # 517.

Introduction

Recently I ran into an old friend at a cocktail party who is retired from being the managing editor of a trade newspaper. He expressed concern as to his own investments with the current volatility. I suggested that the time he should have been worrying about risk was during the fourteen months ending in January, after nine years of rising markets! He was much more comfortable with gradual gains and no declines greater than 3%. I said he should have been worried about risk when others were not, which is perhaps the best measure of the reciprocal level of certainty that a large number of pundits proclaim.

You never know about the future, but one can guess what you don’t know. While in the US Marines as an officer, we were instructed when planning for an operation to identify the essential elements of information (EEI). We quickly learned that it was rare to have as much as 70% of the EEI. Applying the same approach to handicapping at the racetrack, I was pleased to find 60% of the EEI. I feel the same today when selecting individual stocks and funds.

I suggest that in each of our attempts to measure risk, the largest single risk is the unknown and it rises when the pundits are more certain.

Is the Public Smarter?

“Americans Hold Off on Spending Extra Tax Dollars” was a page 2 headline in The Wall Street Journal on Friday. In addition, February was the third month that overall retail sales were slightly off from prior months. Consumer spending was up +0.2% compared to a rise in wages of +0.4%. This was not what was expected. I cheered this announcement as it demonstrates consumers are acting rationally. In the end, the article did point out that a number of consumers were using their tax benefit dollars to reduce their high interest loans. (Economists would label this as savings or deferred spending.) 

Consumers should be fearful of increased state and local taxes as well as increased fees paid to government agencies, and for business sales/use taxes. They should be saving and investing to reduce their growing retirement capital deficit. I don’t know whether it has yet entered into the public’s psyche that there is a chance that the purchase prices of their items will bear the costs mentioned and possibly the impact of tariffs.

A Second Example of Consumer Smarts

For the last several years American investors have been net buyers of “non-domestic equity funds.” I am guessing that these buyers are not largely the same fund investors that have been redeeming older domestic equity funds. I believe the redeemers are completing their expected retirement, estate building, and large purchase needs. To the extent that older fund investors are adding foreign stock investments, they are hedging their domestic equity funds. For a number of years the US dollar has been weak compared with other currencies and deservedly so. Despite foreign investors buying US securities for refuge, it makes sense for US investors to invest overseas. Often there are lower valuations in local markets, which makes sense when considering they are also in less liquid markets. They are also unique investments not found within US borders.

Traders are also buying more overseas investments while redeeming domestic ones. Each week my old firm, now a part of Thomson Reuters, measures the net flows of both conventional mutual funds and Exchange Traded Funds and Exchange Traded Notes. For the last week, ending on Wednesday, ETFs had net redemptions of $11.5 Billion in domestic equity vehicles while conventional mutual funds had $2.5 Billion. (Remember the assets of ETFs are much smaller than conventional mutual funds.) It is worth noting that just two ETFs had combined net redemptions of $10.6 Billion in S&P 500 invested portfolios. This suggests to me that the redemptions came from a small group of trading desks and not the general public.

The fallacy of the “risk on/risk off” approach

The financial media has gotten into the habit of describing market movements as either “risk on” or “risk off.” This is simplistic but can be a binary switch for a quantitative portfolio. It assumes that the investor has identified the risks. Perhaps, this in and of itself is a big risk.  Many can produce a roster of risks. Few can weight them. Fewer still can set the time when their impact will be felt.

The fallacy of the “risk on/ risk off” approach is that it is one directional. At all times we should be looking at both the opportunity for risk and reward. In this case those that invest in mutual funds have an advantage over those that use only individual securities. Mutual funds have flows that many individual investments don’t have. Flows drive buy and sell reactions which cause the portfolio to change. (Often a fund in net redemption benefits from pruning the least attractive current holdings and has an additional opportunity to switch into new investments.) 

Regardless of how one’s portfolio is structured, you should always be looking to add opportunity.

Quotes from Berkshire Hathaway’s Annual Report*

While Warren Buffet lays out their thinking about acquisitions of companies, the principles can be applied to selected individual stocks.

•     good returns on net tangible assets and a sensible price

•   “We evaluate acquisitions on an all-equity basis.”

•  “Betting on people can sometimes be more certain than betting on       physical assets” (I would include shown financial assets.)

•  Berkshire’s goal is to substantially increase the earnings of the non-insurance group through a large acquisition.

•   Berkshire has suffered four short-term price declines of 59.1%, 37.1%, 48.9% and 50.7%.

•  “An unsettled mind will not make good decisions.”

• “Charlie and I will focus on investments and capital allocation.”

Perhaps the single most important clue to Berkshire Hathaway’s long-term thinking is the following statement:

• “The Yahoo broadcast of the meetings and interviews will be translated simultaneously into Mandarin.”

*Held in client and personal portfolios

Question of the Week: What are the risks to your portfolio that others don’t see?

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A Good Week for Long-Term Stock Investors - Weekly Blog # 516

Introduction

“Six months ago everything was good you couldn’t find a reason to sell stocks. Now you can’t find a reason to hold them.”  I was delighted to read this quote in The Wall Street Journal. I only hope there are more expressed sentiments of discouragement. As our subscribers have learned, such views and increased volume of transactions are necessary to have a successful test of a bottom. The actual index close can be higher, lower, or equal to the questioned low point, but without a change in sentiment it is just statistics.

Parsing out the quote I found the singular buy and sell driver encapsulated in one word, “a”. Perhaps it is my long training as an analyst and portfolio manager, as well as a racetrack handicapper, or just living through these times. However, I have never not had conflicting reasons to buy or sell or take any other actions. One of the training techniques for salespeople when trying to make a sale is called “The Ben Franklin Close”. Perhaps the wisest of the Founding Fathers, who was essentially a successful businessman, used the approach of listing the plusses and minuses of a proposal in two columns on a single page. As long as the potential buyer accepted the validity of the list and the positives out-numbered the negatives, Ben Franklin closed the deal. To make a final decision, I require the weighting of each listed item not just the number of items. My experience has made me a contrarian. I always have doubts.

Investors make the most money in periods of doubt. These periods of doubt are often ones where the bulk of the “experts” are on one side or the other. For example, the vast group of experts who were against the British leaving the European Union predicted dire results if the foolish people voted for Brexit. They predicted unemployment would rise significantly, the value of the currency would drop, and London would be deserted by the financial community. In a front page article in the weekend WSJ Review section, a British editor indicated that the Brits are doing just fine. Unemployment is the lowest it has been in years and the pound is higher than it has been in some time. Additionally, the number of the financial people being transferred to the Continent appears to be in the hundreds not the thousands predicted.

Recognizing that I can and have been wrong, or at least premature, periods of doubt represent opportunities that “experts” can be wrong. After all, the Western Hemisphere was discovered during a period where many “experts” believed the earth to be flat, because they could not see beyond the horizon. By definition, long term investors must look beyond their current horizons.

An Explanation via Fund Data

Investment Performance

One of the main differences between growth and value fund investors is the time horizon expected to bring gains.

The growth investor is looking to a brighter future for the companies in which they invest. Value investors are betting that there will come a time when the values they perceive become more appreciated. Over time both have produced good results, but at different times. (This is why in many of our fund portfolios there is a sample of each discipline. Due to the long underperformance of value-driven funds, a contrarian might start to nibble. It is quite possible in the next wave of acquisition activity that smart acquirers will recognize the value properties before the market does.)

Currently, while the “popular” media is full of headlines as to problems, successful investors are evidently favoring growth. In the year to March 22nd, most equity funds are down a bit, but there are only eight fund peer group averages that are up 3% or more. Of the US Diversified Equity funds, only the four growth fund categories produced 3% or more. In the Sector fund group, just the Global Science and Technology funds make the grade, and they were higher than the Growth funds. Just two other investment objective categories: Latin American funds and China Region funds made the 3% gainers leaders.

Flows

While exchange traded products are governed by many of the same regulations as conventional mutual funds, the reasons their owners use them are different, therefore they should not all be lumped together in deciding market implications. The vast bulk of the money in ETFs and ETNs is invested in broad Index funds, which are primarily used by trading entities like hedge funds and discretionary advisors. In numerous cases these have replaced more expensive derivatives.

Mutual funds, a much older investment vehicle, were primarily designed for retirement, estate building, and other long-term needs. They are found in individual accounts, defined contribution plans [401k], and individual retirement accounts [IRA]. As the participants fulfill their needs they redeem their existing funds and use the money, or change to more conservative investment options. For many years growth funds were among the most popular funds, performing quite well and above most retirement measures. Because of the lack of growth of new investors, redemptions are not being offset by new sales. To my mind these are “completions” of earlier promises.

To respond to the lack of growth in sales of funds at the retail level, brokers in the US and elsewhere have been reducing the number of funds being offered and reducing the number of fund houses with which they are dealing. Funds are not the most profitable products for brokers and some managers. At some point this may change.

On the Horizon

Committees in the US Congress and the Administration are working on a second tax bill. Some of the possible provisions address the need to create more retirement capital in the US. Other countries are also addressing the lack of sufficient retirement capital in an era of extending life spans, expensive health care, and slower to no worker growth. Seniors vote, while often young people don’t.

Conclusions

Despite perceived and perhaps more importantly unperceived problems, equity risk investing is needed by the world and will happen.

The more people sell the more opportunities exist for the patient buyers and their advisors.

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Look to London When Seeking Global Views

Introduction

Too many American investors and managers do not search for investment wisdom beyond their national borders. For years Byron Wien wrote about "the world's smartest investor who has passed away.”

 I do not have the skill to identify the smartest investor. For decades I have been calling on some very smart investors in London. Some of these were clients of various fund data services and resulting consulting. Others were leading investment shops or investment trusts. I continue this journey.

This last week I accompanied my wife Ruth to London to hear our New Jersey Symphony Orchestra's wonderful music director, Xian Zhang conduct a superb concert at The Proms, held in the Royal Albert Hall. I took a ‘busman’s holiday’ and spent the rest of the week speaking with a number of great money managers, corporate leaders, old friends and former associates. As usual our far ranging conversations covered both the current global investment environment through to multi-generational investing.

Shakedown Cruise

Most of my British friends don't know what to make of President Trump. He is a definite interruption of the past policies and trends that they had become accustomed. The only way I could help them with their concerns was to explain that the current occupants of the White House have embarked on what the US Navy does immediately after it launches a ship. The Navy conducts a "shakedown cruise" where the crew learns how to handle as many of the problems that might occur in carrying out their missions. From a training viewpoint, the more problems the better. Over time they learn to solve most of the problems. At the beginning of the cruise the crew does not know how long the shakedown effort will last.

I reminded my hosts that the President learned command at military school. He is a product of a Queens County, New York real estate family. Using his threatening negotiating skills, he successfully attacked other New York City boroughs and regulators to accomplish his business goals.  

President Trump is going to be different. The intramural battles in Washington are what the founding fathers expected. They did not want an imperial king. We all are going to have to learn the new dance steps to unfamiliar music.

International Investors and the US Markets

For international investors putting money into the US, it is a double bet on the dollar and local stock prices. In the past these moved in the same direction which increased their total returns. More recently while share prices were rising, the value of the dollar was dropping. (One good technical market analyst believes the dollar is "bottoming" and will rise to new highs.) Due to a left leaning press, many in London tie it to Mr. Trump. I see it very differently.

To me the dollar should not have been strong for a number of years, which in part was a contributor to the 2016 Republican electoral wave, all the way down to state legislatures and counties. The reason the dollar was strong until recently was that almost all other currencies were weak in view of their own problems. The prospects in many of these countries are sufficiently improving to a point that the locals are reducing their conversions into dollars. (I have not yet seen a reversal where there is significant selling, just less buying.) This phenomenon is being recognized by US investors who have been replacing some of their domestically-oriented mutual funds with international funds, a trend that has been going on for many years. We are also participating in this trend for our accounts.

When I see very successful multi-generational families, I look at their investment portfolios and philosophies. Most of the positions in the trust-quality portfolios are not likely to be top performers, near term.  Thus, they won’t make the lists, to use a British expression, of the “Tops of the Pops.”  As it is almost impossible to always be in the most popular successful stocks, there will be times when these former leaders will under-perform. Thus their records will appear to be more cyclical than the somewhat slower moving secular growers.

Harking back to my first professional investment job at a trust bank, the multi-generational families opted for quality of management and products. Today the long-term concerns of multi-generational investors remain focused on quality and selectivity. We seek to answer these issues in the Endowment and Legacy segments of  TIMESPAN L Portfolios^®, though these portfolios may contain other instruments that are more price-sensitive as well.

Interesting enough, the striving for quality has a place in their portfolio investing in under-served markets and these exist in all societies. The keys to these investments is to be providing uplifting services to the underserved.

The new European regulations coming into effect in January, MiFid II will raise the costs of both investors and brokers, which will lead to a reduction of investment industry capacity and is likely in the short-term to reduce the support for smaller and many mid-sized stocks.

There is recognition of the large and growing global retirement capital deficit, but at the moment no one is addressing it in a major way.

Short-Term Concern

While we focus long-term, we do not ignore short-term. One of the short-term factors that we look at is the relative yield dispersion, what Barron’s calls Best Bond and Intermediate Bonds, based on credit quality ratings.  In the last week, the demand for Best Bonds drove their yields down by 12 basis points, and prices up,  whereas the Intermediate Bonds’ yields dropped by 5bps.  The increase in price of the Best Bonds relative to the Intermediates is viewed by some as a bearish signal for stocks.  

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.