Building Long-Term Investment Portfolios - Weekly Blog # 720

 

Mike Lipper’s Monday Morning Musings

Building Long-Term Investment Portfolios

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

After the Valley

We don’t know what future investment markets hold for us. Nevertheless, we have an obligation to those who rely on us to guide their assets, both currently and when we are no longer around. The nice part of the latter responsibility is, we won’t suffer the consequences.

Based on both recorded and geological histories, we expect the future will contain both up and down periods. We often don’t know which type of period we are in or going into. Unlike most others, I am professionally imbued with a need to plan, no matter how wrong the projections may be.

I start with the premise that we are on a winding slope of a market decline. The following are brief abstracts from four highly respected investment leaders, which in total point to a downward slope:

Goldman Sachs - Expect lower returns for market indices

T. Rowe Price - Global growth is primarily dependent on China

GMO Capital - Stocks are expensive and resources are cheap

Merrill Lynch - Late stages of a maturing bull market

Thus, I have started to prepare a portfolio of both stocks and funds that would benefit from a subsequent rise in the global stock market.

Cyclical or Structural Decline?

A cyclical decline essentially corrects for overly enthusiastic valuation measures in earnings multiples and/or the attractiveness of current yields. Most market declines are of a cyclical variety and are quickly corrected. 

The problem with assigning a cyclical label to the expected decline is history vs outlook. Due to excessive government stimulus spending, many corporations have reported unsustainably high earnings growth, with earnings growth much larger than revenue growth. First half 2022 earnings growth rates are going to look puny compared to the first half of 2021. Many companies will show modest growth compared to 2019. 

One should recognize that for ten years or more price/earnings ratios have expanded and have been a meaningful contributor to prices increasing dramatically more than economic growth. Thus, there is a reasonable probability that the coming recession will be a cyclical one. However, there is a historic example of the federal government taking a cyclical recession and turning it into a structural depression, by implementing radical policies to reorient society. The President that did that based on his “brain trust” was FDR, who is a model for the current resident in The White House.

Is there a societal need to reorder our economy and society? I suggest there is a need to reverse the damage done by the school system, which has produced students who cannot find jobs due to both their behavior and lack of educational discipline. Increasingly, the growth in STEM jobs is overseas, a precursor of future relative economic growth. A structural decline is somewhat unlikely, but one should consider it in developing investment portfolios.

Four Portfolio Approaches

Large-Caps

Most individual and institutional investors prefer to invest alongside others. That is why 30.3% of mutual fund investors are invested in Large-Cap funds, with an additional 19.8% invested in S&P 500 Index funds. While the stocks in these portfolios get most media and pundit coverage, there is “decay risk” lurking. Over the last 100 years, not one company on the largest companies list has survived in the Dow Industrials Index. As the old saying goes, success breeds failure. Companies reach their peak relatively quickly and become more interested in maintaining position rather than growing, particularly in new products and services. 

Small-Caps

In many, if not most time periods, small-cap aggregate earnings grow faster than the largest-caps. However, there are four drawbacks to investing in small-caps.

1. They have a higher rate of business failure, with the larger ones being rescued.
2. Some of the better small-caps are bought by larger companies, cutting off their price growth.
3. Lack of media and analyst coverage leads to greater volatility.
4. They have an absence of critical talent at stress times.

“Barbell”

A favorite technique of the investment community is to take two extreme positions and “barbell” a portfolio, e.g., large-caps/index funds with small-caps. The absence of selected mid-caps and internationals, or enough heavily weighted winners, can produce poor relative returns.

Idiosyncratic Selection

Idiosyncratic selection from the entire global marketplace. Many investors who practice this artform kid themselves, as there is great similarity in their selections. The following is a list of characteristics that can be limiting to successful investments at times:

• Best Product/Service
• Top Market Share or Fastest Growing
• Great CEO (Replaceability risk)
• Lack of Debt or Too much Cash
• Institutionally Owned (Liquidity risk)
• High earnings growth (Unsustainable)
• Smart Ownership
• Large customer base (High renewal potential unless market changes)
• Well-connected within industry and government (Things change)
• Estate and other ownership issues
• Speaks ESG language (Plus or minus?)
• Never moved headquarters
• Strong social connections 
• Ownership too concentrated by age and type of investor
• Etc, etc, etc.

Career Investing

Current and future persons making investment decisions should view themselves as career investors. Part of career investing is accepting periodic mistakes and learning from them, but also carefully exploring fields for potential investment, particularly beyond current borders.

What are your thoughts 

  

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

https://mikelipper.blogspot.com/2022/02/changing-focus-in-changing-world-weekly.html

https://mikelipper.blogspot.com/2022/01/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2022/01/two-critical-questions-weekly-blog-717.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

The Other Side - Weekly Blog # 677

 

Mike Lipper’s Monday Morning Musings

The Other Side

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

Approaching a Trade

Both buyers and sellers are essential ingredients in making a market. While I am an advocate for buying and owning securities to produce desired returns in a particular timeframe, most participants don’t consciously follow that approach. Many buyers and sellers ignore probable returns for a period, other than in the current trading environment. Consequently, many transactors deal with similar sets of information but have different views.

How to Develop an Investment Position

When I was the chairman of a non-profit investment committee, I wanted an investment committee similar to a Mid-Western Pension fund’s external investment committee, composed of outside investment professionals guiding a competent internal investment staff. However, I went a step further and included an experienced bear as a member of my committee. The questioning our bullish views forced us to consider the alternative and do better research. In one case, because it looked washed out to him, he recommended investing in a sector that had produced very large losses. Because of his normal bearish attitude, we paid attention to a rare bullish suggestion which turned out to be one of our best investments. This experience taught me to look at the “other side” of the argument in executing each investment.

The Purpose of This Particular Blog

Almost all commentators on the market and the US economy are bullish. Readers don’t need me to add my voice to the commentary on pent-up demand, the supply of savings, and the use of government money. You can get lots of “happy talk” elsewhere. What may be helpful are some brief points from the “other-side”. This is particularly true in the study of market cycles, where a characteristic of reaching a turning point is the almost total rejection of thoughts contrary to the dominant trend. 

Points to Consider (Not Necessarily to Accept)

1. Quarterly earnings growth rates will decline. Many companies will experience the largest percentage increase in the forthcoming cycle. The habit of comparing the current quarter to the same period in a prior year is meaningful but can be misleading. For many companies, the second quarter of 2020 was impacted by the biggest lockdown ever. Starting with the third quarter of 2020, the recovery began and accelerated in the following two quarters. For some, current earnings are a function of addressing pandemic generated shortages, which will not continue. This may be particularly true for so-called value stocks, which are often cyclical performers. A more useful comparison for many companies would be the same quarter in 2019. To claim a specific company as a growth company might require double-digit growth from the prior best seasonally appropriate quarter.
2. Recognize some of the probable drivers of inflation now and in the future. The JOC-ECRI Industrial Price Index is up +101.01 % compared to a year ago and up +2.85% in the latest week. The increased reliance on corporate tax collection drives up inflation. There are two main forms of tax collection, sales/use taxes/fees and income taxes. In many “blue governed” states and municipalities, we will likely see increases in fees for services where deficits are common. A bigger source of future inflation will likely come from an increase in income tax rates, both at the corporate and individual level. When a company is faced with a tax rate threatening after-tax income, they take steps to lesson its impact. These include raising prices and reducing expenses, the largest of which is probably labor. They might also move earnings to more favorable locations and reduce quality.
3. Understand the implications of the current size of the Majority in the House, which is 6 members. The senior vote counters are worried about the 2022 Congressional election and their solution is to pass HR1, their first bill of the year. This bill would federalize the election process and remove the states regulatory power over elections. HR1 supporters have already attacked, without reading, the latest election law in Georgia.  They now plan to bring a proposed expansion of the number of Supreme Court Judges to the floor. 
4. This weekend, the deep political division in “the chattering class” was very evident in two half page articles in The Wall Street Journal and The New York Times. The headlines for the two articles are instructive: “How a Physicist Became a Climate Truth Teller” (WSJ) and “Learning From a Family’s Investment Mistakes” (NYT). The second article fails to mention it is a repeat of a Biblical question to Jesus, asking if it is proper to pay taxes to a government not seen as carrying out God’s work. Looking at a coin and seeing the image of Caesar, He intoned “Render Unto Caesar the things that are Caesar’s; and to God the things that are God’s”. The Ford Foundation saw it differently, much to the disappointment of Ford’s heirs. (As an analyst, I believe you can make an investment portfolio grow in numerical value over time, with difficulty and some mistakes. One of the hurdles in reaching that goal is learning what and whom to believe. It is relatively easy to make judgements in terms of dollars, expenses, and reputation. The sources of verifiable truth in the “good deeds” arena are much more difficult, as truth and beauty are in the eyes of the beholder). Because of this need to find “the truth”, The Wall Street Journal interview with Steven Koonin is so valuable. (Before briefly mentioning his views, I need to identify my biases. Steven Koonin was a Provost at Caltech, where I am a senior trustee. Additionally, two members of my family are past and current students at NYU, where he started and ran their Center for Urban Science and Progress.)  His base case seriously questions man being the main cause of climate change. From my days as a geology student, I was taught how the geology of the earth apparently evolved as measured by the different levels of sediment making up the earth’s crust. At one point our midwestern region was underwater and the Sahara Desert was rich with plant life, all before man walked upright. I agree with him that we should instead be focusing on the dangers and causes of pollution impacting our health. One of the policy problems that needs to be addressed is the bailing out shore communities after repeated flooding. We need a more truthful analysis of the problems we face and how to voluntarily modify human behavior.
5. Do large commercial banks know something about credit? The leading banks made two moves this week, JP Morgan Chase (*) sold $13 billion in bonds and Bank of America (*) sold $15 billion. These sales were easily absorbed, as net flows into mutual funds and ETFs were increasing. Along with other mega banks, they also reported meaningful increases in deposits, even though interest rates on demand deposits fell to 8 basis points from 10. At the same time, they reported a decline in the amount of loans. Thus, banks are not making loans after being flooded with deposits and the proceeds from the sale of bonds. Is it possible that under the flood of stimulus cash they are seeing a smaller number of credit worthy borrowers? (*) Shares owned in personal accounts.
6. Charles Schwab Corporation (**) reported a record number of new account openings, excluding those that came in from acquisitions. Many of these accounts were young, first-time investors buying into more speculative securities, in many cases on margin. One leading market analysis group commented on the extended historically high bullish sentiment in the American Association of Individual Investors sentiment survey, saying the “lack of AAII fear is a fear itself”. (**) owned in private financial services fund and personal accounts.
7. For some time I have maintained that on balance the investors in the NASDAQ stock market are more investment savvy than those investing in the New York Stock Exchange, in which I was a former member. This is due to the NYSE attracting more non-price sensitive passive buying. This past week, 20.8% of the stocks listed on the NYSE recorded a high, vs only 11.4 % of the shares on the NASDAQ.
8. The two best performing fund peer groups for the week were commodity funds focusing on Energy +5.03% and Agriculture +3.14%. There were another 11 peer groups that gained between 2% and 3%.

In order to remain comfortable with their holdings, fully invested subscribers likely believe the somewhat negative indicators mentioned are sufficiently wrong. Please let me know privately what you believe.           

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

https://mikelipper.blogspot.com/2021/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html

https://mikelipper.blogspot.com/2021/03/the-biggest-risk-we-all-face-weekly.html

Did someone forward you this blog? 

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

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.