Time to Change Investment Labels?

The secret is out! The volatility around a flat performance in the second quarter proved that successful investing is difficult for most equity managers. While the quarter was essentially flat, individual months, weeks, and certain days showed wide up and down swings. (Future posts will deal with the mechanical/devoted capital sources for this volatility.) Even before this saw tooth pattern, a number of fund organizations and astute investors were seriously questioning their reliance on labeled strategies.

The label trap

In our work selecting mutual funds for clients, we have detected at least five sizeable fund organizations that are having deep internal discussions as to how to improve the overall performance of their family of funds. I suspect there are many others quietly going through the same exercise. Similarly, various institutional investment committees are asking related questions. A magnetic compass has the comforting aspect that it always points to magnetic north and one can then, with a high degree of certainty, triangulate to where one wants to go.

In these internal fund group discussions there is a sense that possibly they have lost the arrow pointing to magnetic north. All of the groups that are troubled by their recent performance have in the past had good absolute and relative performance, just not now. In many cases this unease has been building over the last several years. Their fundamental question is whether they should throwaway the compass because after all we now live in a “GPS World.”

In the equity world, the compasses that worked well in the past were various labels; e.g., growth, value, growth at a reasonable price (GARP), quality, income, etc. I believe that these supposedly distinctive labels have been proven to be traps for investors and managers. Traps because they did not provide winning results. The dispersion of performance results of portfolios gathered under these labels has been much too wide to be useful. Bad performers on an absolute basis can be found under each label and the top performer rosters include funds that march under different labels.

The need for labels and abbreviations

We live in an abbreviated or sound bite society. Because so much is happening in the various worlds around us, we feel compelled to gather an ever increasing bundle of information. In order for us to store all of the elements of information we need to file in our mind (or on our computer, smart phone, etc.) distinct categories are needed to help us in recovering the relevant information when we need it. Even in our enormously underutilized brains (both physical and digital) there are capacity limits. To be able to cram more information into these spaces we abbreviate the addresses for each element of storage.

I used the expression “GPS World” above. All of the travelers out there know what GPS is and what it does. Many may not immediately recall that GPS stands for global positioning system. Fewer will remember that it is based on signals from satellites in the sky. These satellites were put in place initially to help our space probes. (Much of this pioneering effort was conducted at the Jet Propulsion Laboratory of Caltech where I am lucky enough to be a trustee and sit on their investment and other committees.)

Notice how the combination of labeling and abbreviated addresses has replaced relying on magnetic north to guide us. I wonder whether we have adjusted our philosophy due to this switch. This change is very similar to the quandary facing many investment organizations and investors today.

Labels are investment commands

As we grew up our parents and other authority figures reinforced their observations and directions by the label “good boy” or “good girl.” Years later we hardly remember what the original issue was, but we do remember the label of being good.

Often our first serious investing class is taught by an academic, with or without a CFA. In an enlightening period of roughly fifty minutes the instructor wants to present an investment concept often with complex graphics and tables. The clear message is that if one follows the concept, “good” things will happen. Perhaps the professor briefly discusses the data, rarely pointing out the holes in the data or periods when the concept did not work. Unfortunately, these courses are not taught from the vantage point of handicapping horses at a race track. Horse racing data always has holes in it because most histories are quite short and conditions of the track, the race, and the nature of the competitors change. From a gambler’s (or if you prefer, an investor’s) standpoint, the odds or perceptions in the marketplace are a measure of the reliability/ predictability of the data. For a numbers junkie like me, the data does not show the direct impact of personalities of the jockey, trainer, owner, groom, and racing officials. Thus, the appellation that a horse is a sprinter, or comes from behind, has beaten worse horses, or similar moving up in quality labels should be taken in with skepticism. The terms “growth,” “value,” and “good quality” should be received with some doubt, as periodically they are not predictive of investment results.

While the academics and other pundits are the initial broadcasters of these labels, investment sales people are major users of labels as they have an even a shorter period of time to convince an investment committee or an individual investor the wisdom (predictability) of a concept. If in the first five minutes of the encounter positive interest and possible excitement is not raised, the odds are that it will be a tough sale. The marketing force behind the salesperson is also a heavy user of recognizable labels as it tries to find the right existing products to fit its perception of the quick reaction marketplace. Within many investment organizations the political power structure is driven by sales and marketing people and the labels that they have been taught.

New labels are needed

Coming out of the Great Depression of the 1930s most investors were focused on preservation of their equity capital with heavy emphasis on price-to-balance sheet factors. These concepts were generated by Benjamin Graham in his portfolios and taught by him and Professor David Dodd at Columbia University. Professor David Dodd then taught me. They were the authors of the seminal book, “Security Analysis” which many investors (including CFA candidates) use as their Bible.

Their focus was what on the assets could be turned into cash quickly. They did not value inventories highly and paid no attention to intellectual property or franchise value. Nevertheless, these precepts are often the basis of so-called value investing today. A few years later, but still in the 1930s, an investment counselor in Baltimore, among a few others, favored investing in the stocks of companies that were regularly growing their earnings. Thus, Mr. T. Rowe Price was one of the very first investors to invest for growth. Well into the 1950s and early 1960s growth was not a popular label for stock portfolios.

In recognition of the needs to come up with new investment strategies, Investment & Pension Europe in June published a special report on Risk and Portfolio Construction which showed that in Europe, investment people are looking to find better ways to construct successful portfolios. As with US based consultants, they have noted that there has been “style drift” in portfolios. Instead of treating this as a violation of a mandate, I would suggest that either market conditions or specific security conditions changed or the manager is groping his/her way to a perceived better investment dictum. Another factor, (discussed in last week’s post) are the impacts of flows. In the short-term, large in or outflows can dramatically change the performance characteristics of a portfolio’s performance which to the untrained eye might be seen as a violation of some label.

New labels on the horizon

Goldman Sachs has also recognized the problems with the existing popular labels. In their analysis of the performance of the S&P500 they have introduced a large number of filters. My favorites from their long list are: 

• EBITDA growth
• Sales Growth
• Enterprise Value to EBITDA
• Enterprise Value to Free cash flow
• Profit margins
• Return on equity
• International Sales (also by region)
• Leverage
• Tax rate
• Balance Sheet strength.

I would add a few others:

• Franchise value
• Replacement value
• Ability to successfully disrupt
• Major changes in management attitude and capability
• Institutional ownership
• Media sensitivity.

Bottom line

Since I am not confident that I can predict the future with any degree of certainty, like a good general I want to learn quickly what killed my troops (investment positions) and avoid those types of losses in the future. One of the lessons undoubtedly will be not to put too much emphasis on labels. For those beneficiaries that I have responsibility toward, I hope to make new mistakes not to hold labeled errors.  

Which investment label do you feel is most dangerous?        

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Exploring for $1/Gallon Gasoline

This is the season that the great religions of the world celebrate the past and look forward to a rewarding future. Analysts should also study the past and look to the future by thinking the “unthinkable thoughts.” Today’s blog seeks to do exactly that. I am exploring the possibility of $1 per gallon gasoline. Like most prospectors and researchers, our work is a series of explorations, not of successful predictions. Whether we will ever see $1 gas is dependent on many of the variables to be discussed. As with successful prognosticators to the public, I should not predict both a direction and timing; but I suggest that if you choose to save these thoughts, it should be for your children or probably your grandchildren.

An incomplete list of the variables:

Taxes

No government that I am aware of will let a major stream of energy move from its source to its consumption without layering on taxes. (The main differences between our close to $4 price and Europe’s about $9 price for the same amount of auto fuel are the taxes imposed. There are some governments that subsidize the retail price, but find other ways to collect tax revenues.) Thus, the final price that we pay is dependent on tax distribution policies of host countries.

Technology

Due to my biases as a US Marine Corps communication officer, a securities analyst of tech companies, and most of all as a trustee in close contact with Caltech, I admit to being in awe of technology. Fundamentally, most forms of physical energy are found in nature and converted to power through various mechanical steps. Just as wars have spurred on the development of much of what is considered to be modern medicine and organizational management practices, I suspect that our exploration of space will lead to material changes in finding sources of energy, the extraction of energy as well as the processing, distribution and safe use of energy. Already, major oil deposits have been found through the use of manned and unmanned satellites. In order to accomplish our mission of exploring the planets, various remote techniques have been developed that deal with dangerous gasses and techniques for probing and “mining” from land surfaces. Some of the technological developments from space such as efficient payload management and global positioning systems (GPS) found use here on earth.

Technology is at work uncovering more efficient and safer ways of developing our natural resources; bringing into economic production energy sources that today look to be too expensive and too dangerous. Clearly we will utilize more fuel efficient vehicles on land, sea, and air in the future. Homes, offices, and manufacturing/processing plants will manage their usage of energy better. There are many other ways in which technology will both help give us more bang for our energy buck, and will also make us even more dependent on the increasingly efficient use of energy. Thus technology will affect both sides of the supply/demand equation.

Oil, natural gas, coal and nuclear

Ever since I first started looking at the economics and politics of energy in the 1950s, I have heard about reaching “peak oil production,” as we are not finding oil as fast as we are using it. I recall that some believed that we would have found all the oil the Earth had to give us by the 1960s. In each decade since, the peaking date has been reestablished, and in each decade more “juice” has been found. For both commercial and regulatory reasons, the size of these discoveries has been downplayed. Further, I suspect secondary drilling through the use of advanced technology will be more productive than is currently believed. In this season of heightened religious belief, I believe that there is more productive oil out there than most others believe, and a good bit of it in or near the US.

Natural gas was a waste product in the days of early oil production; it was just burned away at the wellhead. Through the use of technology and higher prices for oil, the governments and the people of the world have begun to appreciate the economic advantages of natural gas. We are addressing the concerns about fracking in terms of environmental dangers. Actually, at the moment we have too much natural gas, and this week we hit the lowest recorded price for this commodity in ten years. To me, it is only a matter of time and some technology until we have a significant expansion in the use of “NG” (No longer standing for Not Good, but for Natural Gas.) Thus, I see that the available supply of energy will rise and at some point impact the price of oil.

Coal

We are all aware of how dirty coal is. We are conscious of the dangers of manned mining and the effects of coal burning on our once pristine environment. Because of these issues and to some extent unwise government regulation, coal in all its forms has lost share of market. However, as a firm believer both in technology and the eventual power of economics, I do not think we have experienced the last of the beneficial use of coal on a global basis. In South Africa, I have seen the conversion of coal to oil to meet a politically-driven need, which demonstrates the creativity of some of the coal business leaders.

Nuclear

If you don’t want coal burning in your backyard do you want to have an atomic reactor quietly producing energy? The tragedies both in Japan and Russia were caused by faulty locations and poorly constructed facilities. Little publicity is seen on the safe use of atomic power in Europe, US, and elsewhere. After a period of twenty years, the US government has authorized the first new non-military use of a reactor. (The US Navy and others have been successful users of atomic power for a couple of generations.) Will procedures be developed to reduce the odds of fatal accidents? Yes.

Thus, I believe that with technology’s help, we have sufficient potential supply of energy.

The demand side

The Saudi Arabian government and others are vitally aware that the price of energy is, in the end, driven by demand. One of the best ways to measure the level of economic development in a country is to track its use of energy. (Some of the political leaders in China are more sensitive to the level of electricity use than they are to the softer calculation of GDP.) While the price for oil will have an impact as to the costs of a society to produce a particular standard of living, Saudi Arabia’s fear is that too high a price will drive substitution efforts even faster. On a long-term basis they should be worried. (As mentioned above, there are energy alternatives and technology is making them safer and cheaper.)

Habit changes

Slowly we are becoming more efficient consumers of energy. However, this is being offset by our growing demand to use more energy by our various appliances, including computer and entertainment devices. Some governments recognize that gradualism won’t work to bring energy demand into better balance. As an Easterner I hate to admit it, but the government of California has a useful idea. A recent Wall Street Journal article, entitled “California Declares War on Suburbia” suggests that a more efficient use of resources would be to gently move people into the cities, which is what is happening in China. Not only could this improve our use of energy, but could significantly improve the overall level of education and safety available within the cities. If it were to happen, then the number of energy consuming cars is likely to drop.

Two other considerations

Our current world is, as always, a balance of power. The current fulcrum of power is in the amount of energy that is produced both for internal and external use. If we had a world with a more balanced use of energy, various forces would likely cause changes of political leadership, and perhaps even the composition and identity of various countries. Many political leaders are not blind to these possibilities.

The second consideration is the monetary value of energy. At the wholesale level, energy today (particularly oil) is priced in dollars. This is a historic accident of past wars, economic development and relative stability of the value of the US dollar. At the moment, I believe the US society is committed to inflation, therefore at some point the rest of the world will wish to price things in dual, if not multiple currencies to protect from politically-inspired deficit spending by the US government. Thus, perhaps I should amend my search for $1/gallon gasoline to a level commensurate with about a $1700 per ounce price of gold.

Investment afterthoughts

Consider the following on how to put these thoughts into practice:

1. You should not bet that the price of oil will always be a good inflation protection.
   
   
2. Inflation is a product of global excessive spending relative to saving, and is likely to continue
   
   
3. View some of the large international oil companies as akin to investment banks. If they choose investment wisely within their circle of competence, they can have good results. (Interestingly, both international oil stocks and those of investment banks are low price/earnings ratio groups. The difference is that the oil companies have higher dividends and yields.)
   
   
4. Find technology producers that have a pattern of producing labor and energy saving devices, particularly those that can be applied to finding, extracting, transporting, processing, and using energy.
   
   
5. Watch for useful lessons from space activities in terms of uses of energy on earth.
   
   
6. Bet on increased urbanization, some of which will be cajoled by the government, which will lead to better primary and secondary education and safer streets.
   
   
7. While $1/ gallon gasoline is not an “odds on favorite,” it could happen and that may not be a good thing
   

Does any of this make sense to either discuss with your children/grandchildren or to pass it on to them at some future point?


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