Length of Stay Contributes to Performance - Weekly blog # 747

  

 

Mike Lipper’s Monday Morning Musings

 

Length of Stay Contributes to Performance

 

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

    

 

     

Blog Focus

Most investment-oriented blogs focus on the selection of individual securities or funds/advisors. I am uncomfortable with crowded fields or markets, believing returns are relatively low when they are correct.

 

I am blessed to be part of an informal group of still active investors, who are or were professional analysts, portfolio managers, and institutional salespeople. For most of my professional life I have studied and used mutual funds and management companies/advisors. These are the results I study.

 

In reviewing my peers’ and other performance records, I am impressed that a large portion of their very successful records were produced by holding securities and other relationships for many years.

 

Holdings held 25 years or more have produced remarkably good performance, with some gains 100X or more their original cost. These gains were achieved by careful initial selection and maintenance of the positions, hopefully reinvesting distributions over an extended period.

 

Recognizing the benefit of compounding returns has led me to subdivide portfolios into length-of-stay (LOS) buckets.

 

While investment and economic cycles don’t overlap or fit concisely within US presidential terms, they are reasonable approximations of most major up and down US stock market phases.

 

Consequently, I take the point of view that periods under five years require superior trading, not investment skill. At this time, which appears to be between a long bull market and a shorter bear market, the five-year average compound growth rate of 7,433 US Diversified Equity Mutual Funds serves as a useful comparison for the next five years without making any predictions.

 

The five-year weighted (by performance) average return through last Thursday was 11.98%. Perhaps more significant was the median return of 10.04%. (Better performing funds raise the average result when compared to the absolute median result. I am more comfortable using the median for planning purposes. It is also closer to the historic return of the S&P 500 since 1926.)

 

A recent discussion with a leading energy analyst concerning Berkshire Hathaway’s interest in Occidental Petroleum confirmed that it is reasonable to expect its stock return of 8% for the next five years. As this is a holding in our personal and managed accounts, I felt it was a good alternative to Berkshire’s cash position, especially in view of the five-year returns mentioned above.

 

L.O.S. Impacts Choice of Value vs Growth

Investment theory is based on fair value being the highest price a knowledgeable buyer would pay. Consequently, the only time you should buy an investment is when it trades at a discount to fair value. A value investor seeks a position selling below the price of a company’s products or services. The elapsed time is usually small and is often dependent on an economic cycle or commodity price change. Most value investors expect this to occur within five years.

 

Typically, a growth investor has a different mathematical approach. Growth usually infers a decline in the price a company sells its products or services as demand grows. This could take many years.

 

When DuPont viewed by itself as a growth company it was willing to build an expensive chemical plant to develop the market for its merchandise. It was willing to wait twenty years to reach an overall breakeven level. It expected it to be followed by very profitable years.

 

Value investors have a relatively short-length-of-stay and expect lower volatility than growth investors. However, most accounts able to earn many multiples of their initial investment have tended to be growth oriented.

 

Current Market

Current market leadership to mid-June has exhibited a relatively short-length-of-stay orientation based on an anticipated recovery in price or demand levels.

 

In the past, mutual funds experienced historic net redemptions when the expected period of investment was complete. This was on average 13 years.

 

With the switch to shorter term wealth management approaches, the new favored sales vehicle seems to be indexed Exchange Traded Funds. This is likely to continue to make markets more volatile.

 

Leading corporate managers by contrast are betting on growth. They expect major changes in how investors will do things in the future.

 

Last week we mentioned Aetna’s recognition of the change in healthcare delivery through CVS Health. In a somewhat similar fashion, Amazon is also looking to provide healthcare directly through a new venture.

 

Apple’s new products and policies are likely to generate dramatic changes in a number of markets

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We are in a volatile period. In last week’s blog I noted that the vast majority of the WSJ weekly prices showed gains, with the two largest declines being the Wall Street Journal dollar index and the Russian Ruble. This week the two largest gainers were the two biggest laggards of the prior week, whereas the bulk of the prices declined.

 

Conclusion

Traders who can use volatility to their benefit should continue to do this. However, relatively few have these skills.

 

Those with patience willing to view the future as offering opportunities for extraordinary gains and have patience should invest for growth.

 

 

 

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

https://mikelipper.blogspot.com/2022/08/time-to-prune-weekly-blog-746.htm

 

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html

 

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.html

 

 

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A. Michael Lipper, CFA

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Talented Managers Are Now Good Investments:A Contrarian View

Introduction

A contrarian is always alert to the chances that a popular view is exaggerated. I believe that the generally accepted view that passive investing will become the dominant type of fund management suffers from exaggerated extrapolation of net flow trends. This is particularly true when relying on passive Exchange Traded Funds (ETFs) as the main or exclusive component to a long-term investment portfolio.

The Weaknesses in ETFs

There are four structural weaknesses in passive ETFs as follows:

1. Each passive ETF at the time of inception picks a particular portfolio in which it must invest and in a specified allocation. (An earlier version of today's ETFs were the Unit Investment Trusts which had fixed portfolios.)  One of UIT’s drawbacks was when a security was no longer available to be purchased because it was acquired or went bankrupt, the UIT could not substitute another issue so it was a portfolio that was always looking backwards. In 2016 through the third quarter very few of the stocks in the S&P500 were rising and a small minority of the stocks were causing the institutional index to appreciate. In periods of large successful IPOs they may not get into various ETFs until after they have their initial surge.

2. Actively managed funds almost always have some cash to meet inopportune redemptions and as a reserve for new names to be added. (If in a sudden sharp decline the cash can be used immediately to meet redemptions and not hit panic level prices and/or buy some bargains. On the way up cash is a drag on performance, but it has proven to be a benefit  to many portfolios.)

3.  In the US only Authorized Participants can purchase or redeem shares in an ETF. (These are self-identified competing market makers who have bought a $250,000 creation unit in the ETF. To the vast majority of ETF players, they do not know who these "APs" are, or their capital and in what other activities they are engaged. In many big trades the other side of the trade will be a professional trading organization which temporarily stretches the AP's capital to a breaking point. It hasn't happened yet, but it could.)

4.   The biggest single risk for many investors is the person making the investment decisions in terms of specific ETFs, size of investment, and timing of the transaction.  (While the fees charged for passive funds are usually quite small compared to active funds with all their fees, expenses, and sales charges included, the portfolio manager of an ETF managed account is outside of its stated cost.) Also the commission charged by the broker supplying the trade to the AP is extra as well as the spread between the transaction price and the current net asset value is not revealed. However, the biggest weakness is that many of those who are managing ETF accounts are not as highly trained as the professional portfolio managers of most actively traded mutual funds in terms of choosing sectors, selecting securities, placement and timing of transactions and intelligent proxy maneuvers. At this point no one is tracking the long-term performance of these ETF Managed Account Managers.

Examining an Active Portfolio Manager as an Investment

An Important Caution

The manager that I will use as an example of how to look at this type of actively managed investment is one that is in the private financial services fund that I manage as well in my personal accounts. Further our investment advisory accounts own numerous of its mutual funds. I am not suggesting that you should buy shares in the manager or use their funds or accounts. Those decisions need to fit your particular situation and other investments.

 Why Focus on T Rowe Price?

This weekend when I started to do my note-taking for this post I saw two things that caught my eye. The first was that so far in 2017 many of the funds that were performing well were International funds with a heavy emphasis on Asia. The leader in this particular computer screen I was examining was T Rowe Price New Asia, which was doing well after laboring through most of last year. This reminded me that the management company is opening a series of international sales offices. As many of our readers have learned, I believe that there is a global shortage of retirement capital. In many, particularly Asian, countries there is a strong savings ethic, but not a fully developed mutual fund market.

The second thing that I noted was on Thursday the stock of the management company opened down by 3% and continued to fall the rest of the week. At the low on Friday it had declined 9% from its Wednesday high and now trades a full ten point decline from its 52 week high. The cause for the decline was the release of T Rowe Price’s calendar year earnings report. Unlike most of the financial stocks, the company does not hold earnings conference calls, but issues quite complete releases that you would expect from a firm with an army of analysts and significant employee ownership.

As is often the case it wasn't the announced fourth quarter earnings which were slightly above the average analysts' estimate, it was the "Other Events" three paragraphs that evidently shook out some holders.

For the first 3 days of the week the average volume was slightly below 1.5 million shares, on Thursday it was five times that at 7.6 million shares and 4.6 million on Friday. The essence of the three paragraph note was that in the fourth quarter there were outflows of $1.9 Billion from the Target Date funds and $6.3 Billion in net inflows for the year.

With about 2/3rds of the firm's assets in retirement accounts depending on conditions in the market, there can be a significant amount of exchanges between retirement accounts and the Target Date funds. In examining these flows/exchanges with various accounts and Target Date funds, it was determined that the fourth quarter outflow was $63 Million and an inflow for the year of $8.1 Billion. These disclosures did not  change the overall outflows of T Rowe Price funds for the 4^th quarter of $2.8 Billion and $5.0 Billion for the year 2016. The firm noted that net cash outflows were largely caused by institutional and intermediary clients reallocating to passive investments.

The Way a Contrarian Sees the Situation

As someone who has served on various institutional investment committees, I have experienced the pains of under-perceived trend performance and understand the strong desire to go passive and get the performance bug off one's back. Unfortunately much of this tendency is based on conformation bias. On a casual basis up to the election, which should not have been a surprise to good data analysts, the various market indices were out-performing most institutional accounts. Too few investors recognized the positive effects of gradually rising interest rates from last summer. When investment committees move they often do it slowly and often wait until the later part of the year. Thus the shift in the fourth quarter is not surprising. What I find disheartening is the ETF discussion above. A somewhat similar set of issues are involved with other passive techniques.

Relative to other large mutual fund complexes T Rowe Price has the best long-term record of out-performance of peer funds. As previously mentioned it is expanding its global sales efforts and is increasing investment into internal technology along with some other leaders.

As regular readers know, I believe in dividing an investment portfolio into various TimeSpan slices or portfolios which I have named TIMESPAN L Portfolios®. I have placed the stock of T Rowe Price in the long-term endowment portfolio as a good representative of the expected growth of global retirement capital. With the current decline in its stock,  TRP is now yielding over 3% compared with the yield on the market averages of about 2%. Further, the yield over time is likely to rise if T Rowe Price continues to buy back stock in excess of  internal needs.

Implications

You can use a similar or even better approaches to investing in a contrary way. Good Luck.   

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

The Failure of Investment Failures

Introduction

This past week I had several opportunities to chat with Tom Rosenbaum, the new president of Caltech; in one session he asked for suggestions as to what additional subjects should be taught. I suggested a course that covered most of the world’s major scientific failures. My thinking was that there may be a common theme to what has gone wrong. I later realized that this was a half-baked idea. On the one hand the very nature of most scientific discoveries is through experimentation. Some scientists however keep changing various elements until they get the result that they want to achieve or recognize that what they did produce is surprising and a good but unintended result. What is often missing from this application of the scientific method is that there is no attempt to learn from what went wrong or at least what did not turn out as expected. 

In the investment world we also examine why something doesn’t work out as expected. As many regular readers of these posts are aware I believe that essentially I learned security analysis at the race track. In some ways my most valuable time (after not cashing a winning ticket) was spent re-examining the prior records of both the winning horse and my losing bet as well the actual racing conditions. I often found that I had overlooked some critical set of facts and my expectations were sadly out of kilter. I humbly suggest that the 2014 investment performance through this week gives scope to look at a number of investment theories that have not produced the expected results. We should not fail to learn from these failures.

Friday's failures

After a week of significant global stock market losses, on Friday the Dow Jones Industrial Average (DJIA) rose +1.63% easily beating gains of +1.29% for the Standard & Poor's 500 and +0.97% for the NASDAQ. I believe the message from this data is that more of the gain was achieved in the indicator with the smaller number of securities which would demonstrate to me some lacking of enthusiasm for most securities. This view is reinforced by looking at one of the DJIA components, JPMorgan Chase^*. On Wednesday the stock hit its low for the week at $54.26, on 37.9 million shares. On Friday the stock closed at $56.20 on 19.5 million shares or little more than half of its high volume day.  Don’t look at Friday’s rise as the beginning of a major recovery.

^*Owned by me and/or by the financial services fund I manage

A number of my market analyst friends suggested that the pickup on Friday was to correct a significantly oversold condition and represents a sales opportunity rather than a buy opportunity. This pattern is present in numerous countries' stock markets. Those focusing on the US expect another test of the recent Standard & Poor's 500 lows. Nevertheless they perceive a good chance for a substantial rally in the winter; but a failure to go to a new high in late 2014 or early 2015 would suggest the potential for a major decline.


Mis-reading fund flows

Many market participants jump on aggregate net fund flow data to ascribe a level of demand for stocks and bonds without understanding the broader implications. First, the published data is often based in part on the net differences between fund purchases and sales. To me there is an analytical difference between a $10 Billion net inflow made up of gross income of $11 Billion and gross redemptions of $1 billion compared to a situation when $25 Billion is incoming and $15 Billion is leaving.

Further some analysts add the flows of Exchange Traded Funds (ETF) and conventional mutual funds together. There are two problems with their approach; the first is mutual funds are typically owned by individual investors directly or through financial  institutions that are long-term in nature, like the accounts that we manage, whereas many ETFs are owned by hedge funds and other short-term trading accounts. In the week ending October 15^th, $17 Billion were invested net into equities by the ETFs. Of this, approximately $12 Billion were invested net in S&P500 ETFs. The analysts at my old firm Lipper, Inc. believe that a good bit of this inflow was created by the authorized participants who are largely brokerage firms and other institutions who offer these shares to short sellers in exchange for the interest earned on the short positions. The net effect of this activity is that a major portion of the supposedly supporting purchases to the broad market are betting on a decline.

US fund investors redeem domestic funds

For the last six months fund investors have been redeeming US oriented funds and buying International funds except those that focus on European investments. I believe that fund investors like much of corporate America are concerned about the near-term future for the country. The failure is to treat fund flows as a single-dimension.

Poor economic analysis

I write this post from Washington, DC, where the US Congress sits in the Capitol, a building whose inhabitants usually do not understand capital and the need to make it.

Some want to stimulate through throwing taxpayer money on infrastructure and other ways to fuel the US and other global economies. What they fail to understand is the only economic quantity that is of commercial concern to many of us is the opportunity to make money for beneficiaries. Both cash and credit are in surplus. If the politicians really want to invigorate the economy they should reduce the burdensome bureaucracy.

What are your investment failures?

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Successful Investing Is Not a Ranking

Introduction

All too often we unconsciously use arbitrage selection. We compare a given result against a perceived standard. This often leads to ranking against the standard. A classic old gag is an example of comparison. A man is asked how his wife is, he replies, “Compared to what?” In the same light I would suggest that it is equally wrong to confuse performance ranking with successful investing. One should invest as a process to produce income and capital to meet a spending goal. However, the real measure of successful investing is how the investor feels about the result. Feeling good about the result is an unwritten, but very important, psychological goal.

Switching the measurement device

In the United States this week the College Board announced that is making substantial changes to its Scholastic Aptitude Test (SAT) used by increasingly fewer colleges in their admittance process.  There were spoken, and I believe unspoken, reasons for the change. The most obvious reason is that the SAT exam is losing market share to a more knowledge-focused ACT exam (a competitor to the College Board). To some extent these exams are used, I believe, incorrectly in making selections. Having sat on two university Boards of Trustees I am under the impression that high school grades modified by a view on the academic rigor of the secondary school is a much better predictor of a student’s ability to handle college level work. A similar level of higher analysis is more useful in making decisions as to selection of investment managers or funds.

Finding the correct context for successful selection

Investing is both an art form and a competitive sport. The art form attempts to use, within constraints, creativity to produce periodic investment results. Too often these are expressed in terms of the latest quarter, latest 12 months, five years, ten years in addition to "since inception." (Please note that I excluded 3 years, which statistically is the single worst period for future extrapolation, but loved by consultants who can earn their fees by replacing a manager on the basis of poor three year performance just before the market changes and the manager looks much better.) The competitive sport comes in to see how well a fund does versus others which are operating under the same or similar constraints.

The misunderstood constraints

Often liquidity management is the most severe constraint. Some of the elements of the constraint matrix are possible abrupt changes in cash flows. The impact of these changes can determine the need to maintain a minimum cash balance at all times, to size positions relative to their average (or extreme) market volume, and minimum number of holdings.

Another set of constraints has to do with the quality of the management, market share, and balance sheet strength. Some managers can use IPOs, even if they own them for a very few days. Other managers can use private placements. None of these constraints apply to the popular stock and bond averages. Thus they are inappropriate as investment measurement devices even though they are used by their publishers and others in the media business. The Exchange Traded Funds (ETF) who try to mirror the indices are also not an appropriate investment vehicle because they lack the flexibility and fiduciary responsibility that are imposed on active managers.

Two filters for successful investing

The first filter has to do with a non-profit institution, a personal fiduciary, or an individual when it comes time to authorize spending to meet the goals of the account. Clearly any time one withdraws money from an account one is reducing the capital to make more money in the future. As the exchequer, you should psychologically feel positive about the goals of the money. If the withdrawal is less than the total, one should feel good about the ability with the remaining money to meet future planned goals and recognize the courage of spending over investing when warranted. 

Before you feel too good about yourself,  I was struck by a quote in the weekend edition of The Wall Street Journal. The quote was, “The first principle is that you must not fool yourself…and you are the easiest person to fool.”  The source of this quote was Richard Feynman, a Nobel Prize winner, and a famed professor at Caltech who provided critical work for the Manhattan Project (Atomic Bomb). I appreciate his wisdom for itself and because of an affiliation to Caltech where I am a current Trustee and as graduate of Columbia University where the initial work on the Manhattan project was conducted. The purpose of utilizing the quote is a warning that it is easy to fool ourselves, particularly in the roles of a fiduciary.  This thought came to mind this week when I had to terminate a manager over the firm's surprise because it was celebrating that it was number one over five years in a particular category. My point was that is exactly when, as a fiduciary, one should leave the party. They can only go down on a relative basis from here.

Where are we now?

As regular readers of these posts know, I am wary of a forthcoming major peak. Thus each day I scan for data points that would indicate that I am premature in my concerns or add to my concerns. This week the roster of insiders, mostly corporate officials and directors were heavy sellers of their own stocks. The leading sellers came from the Health industries with sales of $1,945, 467 and only $185,247 buys, or more 10 times greater sales than buys. This was the case in all sectors. 

Clearly many executives were selling their newly acquired shares received through stock options and had taxes to be paid. Nevertheless inside selling of significant size is not often viewed as a positive. This was happening with both the S&P 500 and the MSCI World indexes posting new highs. These new highs were driven by large capitalization stocks trying to catch up with the valuations afforded to the mid-cap and small-cap stocks. According to Standard & Poor’s, the average price/earnings ratio on large caps is 15.4 times, 18.55 x for mid caps, and 19.32 x for small caps. The lower P/E on large caps is mirrored by only a 12.76% gain expected in their operating earnings vs. 22.26%  and 35.15% for the mid and smaller capitalization stocks.

Putting it all together

Others are sensing that at some future point we will see a major peak and a subsequent decline, but not now. Speculation is growing using the surge in IPOs as one gauge, but it has not gotten to the fever pitch which describes a top. Nevertheless there is growing attraction into investing into large capitalization stocks, not because they will grow faster than their smaller compatriots, but because of the need for liquidity. We used to call some of these stocks "warehouse" positions that would go up reasonably well with the market, but provided large exits when needed. (That worked when there were large amounts of capital on trading desks which could be compensated through wide spreads and/or commissions. This is not the case today.)

Please tell me, how are you protecting your investments?

___________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

 Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.