2021 Lessons and a New Worry - Weekly Blog # 714

 

Mike Lipper’s Monday Morning Musings

2021 Lessons and a New Worry

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

The Mind Set

Every day is a learning opportunity, although we often don’t view it that way. While we begrudgingly accept some of our investment actions not turning out as planned, we find temporarily culprits for the cause of those mistakes. I cannot continue to blame others for my results, I must accept I contributed to those unhappy results. Over the years I have been forced to recognize that some mistakes in thinking are repeated far too often.

2021 Mistakes

First, is not keeping in mind the one truism about investing and life, that there generally will be mistakes. The only market guaranty is that it creates humility in the survivors.

Second, the appropriate way to think about a collection of futures is to assign some rough odds of being correct. The number is not as important as the recognition that you might be wrong. The general reasons we might be wrong includes the following “3 I’s league”: Incomplete analysis, Inaccurate inputs, and Indefinite time periods of success or failure.

Third, there are other rules of the game which guide our actions:

1. Recognition that the numbers we use are an abstraction of reality, not reality itself, which is full of unpredictable people.
2. In a news centric investment world, we tend to value the latest news above the flow of past information.
3. There is a search for fairness, which has never existed in the real world, particularly among new or amateur investors. In truth, life and investing is not simple or fair.
4. The following unrecognized shortening of decision times has led to much more volatility, which some confuse with risk. 

• Politicians intensely focused on the mid-term elections will try to force more stimulus payments on the portions of society likely to vote for them, not really caring about the induced inflation. Furthermore, they will attempt to raise the taxes of the capital bases in opposition. (Remember, money is the mother’s milk of politics.) 
• The investment industry has also shortened the performance period by introducing wealth management asset-based fees as an alternative to brokerage commissions. This has caused the switch to increase trading in ETFs. The sale of mutual funds, have anti-churning restrictions. 
• In 2021, for the first time, the compounded dollar impact of traded short-term options was greater than the aggregate value of shares traded. (Typical of a contrarian, I have lengthened the period for measuring investment success.) 

5.  Whether we like it or not we are all globalists by circumstance, not by choice. It impacts our lives and investments and will become even more important in the future.

Missing the Significance of Pandemics

In seeing how point 5 is likely to impact our investments, recognize that the two major variants of COVID-19 came out of China and South Africa to infect much or the world. Globalization follows the path of commodity prices, which drive both food and energy prices higher globally. Bottom line, we cannot escape the impact of globalization on our lives and investments.

Just as we used horsepower to measure the influence of internal combustion engines on society, investors are similarly using the incorrect measure to understand the power of globalization.

Last week I mentioned at least one investment manager who focused on the supply side of trade, rather than the much more popular demand side. Carrying this analysis further, China is the largest single importer. I think we should be looking at China’s impact on the exports of other countries. Germany, US, Canada, Australia, and Japan are increasingly dependent on exporting to China.

China’s domestic growth, while still a multiple of the rest of the world, is slowing down. They have been building their financial reserves, which could backstop their export earnings if they were to slow. China’s slowdown is due to their population growth declining, both in terms of the overall birthrate and the movement of rural peasants into cities. Once in the cities, the peasants find work for domestic or foreign owners and the productivity of their labor grows. (One of the issues facing the rest of the world is labor productivity not growing as fast, due to the focus on schools, rather than education and useful learning. This concern is multiplied by the Chinese being savers and soon investors, which our populations are not.)

We are correctly concerned about the Chinese growing militarily, including in space. In their long history, the Chinese have gone to war to protect their borders and critical suppliers perceived to be vulnerable to opposing forces. They, like the Japanese, don’t want to add people to their country, just their goods and services. (In the West, Rome conquered much of the known world to get slaves, which were often freed once acclimated within the Roman Empire. Europeans hope to grow their population base at a lower cost by expansion, rather than through growing their own population.)

Simultaneous slowdowns in China and the rest of the world are not likely to be bullish for the global securities markets.

Question for Subscribers: Are you worried? What Do you intend to do?      

  

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

https://mikelipper.blogspot.com/2021/12/are-investors-taking-too-much.html

https://mikelipper.blogspot.com/2021/12/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/12/selections-weekly-blog-710.html

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A. Michael Lipper, CFA

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Investors Can Learn from History, If Diligent - Weekly Blog # 631

Mike Lipper’s Monday Morning Musings

Investors Can Learn from History, If Diligent

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

Most memories are summaries of what people think happened and these memories over an extended period become enshrined as facts that are used for future investment decision making. Current investors are under the impression that “history” favors “value” and “Goodbye Globalization”, without being fully conscious of the history that created these impressions. Upon further study, one would realize that the underlying history is more nuanced and complex.

Value vs. Growth
We like to use short labels to cover complex situations. For example, we use the same label for both a company and its stock price, which often go in different directions. A company’s growth is essentially dependent on increasing sales and possibly its earnings, whereas stock prices are the result of buyers and sellers, often evaluating the stock in relation to other investments. Daily stock prices make them easy to rank from best to worst performance for each time period, which probably has little predictive power for long-term investing. Nevertheless, some investors search through the poorer performers looking for turnarounds, fitting with a part of the American psyche that likes to cheer for the underdog. Many investors who have missed being heavily invested in different forms of growth are now cheering the long-awaited trend of “value” beating “growth”, at least for a period.

I believe the first textbook publishing of Security Analysis by Ben Graham and David Dodd was written during the Depression in the 1930s. (The first was an adjunct professor and the second a full professor at Columbia University, which twenty years later suffered having me in his class.) Their approach, both in class and to some extent in their practice at a successful closed-end fund, was to find a security selling at a substantial discount to their analysis of value. What worked for them and others like Ruth Axe and Max Heine, was looking at distressed bonds and preferred shares using this approach.

The first thing the good professor taught us was to reconstruct the balance sheet by discounting finished inventory by 50%, work in progress by 100%, and raw materials by 75%. In the same fashion we reduced the value of physical assets to our estimate of quick resale prices. We wrote off all intangible assets and what was left of the underlying equity (more on this later). Comparing our new estimate against the depressed price of the senior securities became our initial estimate of value. During the 1930s and into the war years, this led to some very successful investments in railroad bonds and preferred shares. In effect, what we were taught was the rapid liquidating value.

Today, Merger & Acquisition activity has become the main determiner of value. Instead of determining the liquidating value, the acquirer is interested in what accountants call the going concern value. However, the acquirer often writes off some of the assets, adds the cost of expected layoffs, and determines an estimated increase in earnings based on “better” management and new opportunities from existing assets. I suspect that in the acquirers view of the future there is no estimate for a down period or the reactions from competitors.

M&A driven prices create an accounting problem, because after accepting the remaining costs of fixed assets transferred to the new balance sheet, an amount must still go to the consolidated balance sheet. Some of this gap can be labeled as the value of intangibles, such as customer lists and patents. However, even with these additions there is typically still a gap labeled “goodwill”. (I was the beneficiary of this math when I sold the operating assets of my data business, a service business who’s price was substantially above the value of the physical assets sold.) This is where the fictional portrayal of balance sheets and  book value come into the picture.

For publicly traded companies, “goodwill” and other assets cannot be written up but can be written down if there is clear evidence of loss of value (a non-cash charge which lowers reported earnings). The CFA Institute notes that private companies can write off goodwill over ten years and there is a movement to allow publicly traded companies the same privilege. In an article they pointed out that there are 25 corporations that have between $28-$146 billion of goodwill on their balance sheets, including Berkshire Hathaway, CVS Health, and JP Morgan Chase. In my case it would be difficult to write off the goodwill from the transaction, as they continue to use the name and basic calculations for the statistics. As the acquirer continues to have many of the same clients after a sale 22 years ago.

I believe too many investors lump “value” stocks with cyclical stocks, which is why they have been greeted by poor performance for over ten years. Most of the world’s economies have grown during this period due to increasing services revenue growth. Over the same period there have been relatively few goods and materials shortages. Prices of goods, particularly manufactured or natural resources, have not kept up with inflation.

In our fund selection process we like to find true value stocks that show substantial discounts from their intrinsic value. These tend not be economically sensitive and are found infrequently. Most of what others call value, are cyclical stocks selling at the low point in their cycle. Typically, their stock prices rise when shortages appear, often when large competitors drop out or the demand level shifts in their favor.

There is a difference in when to sell a true “value” stock versus a cyclical stock. One completes a trade when the discount disappears in the value stock price. Cyclical stocks should be sold when the investor believes the demand for a company’s product or service is peaking. My own way of timing this is to watch commodity prices and commodity fund performance. We could be entering a more favorable period for cyclicals as 66 of the 72 weekly prices tracked by the WSJ were up, but most commodity funds did not rise, except for those invested in energy.

“Goodbye Globalization”
Goodbye Globalization is the headline in a recent edition of The Economist. This magazine is in the running to replace Time and Fortune magazines as excellent negative indicators. They do not know their history, countries and companies that build fortresses by gathering all needed resources within their walls have proven to be builders of self-inflicted prisons, with high costs and lowered productivity. History suggests that even during wars, opponents trade with each other through third parties. In WWII, the relatively easily conquered Sweden and Switzerland were left unoccupied to serve that purpose. Even when the US was clamping down on an increase in Japanese car imports, they still came in through factories in Mexico and Canada.

But the real historical lesson happened in the 15th Century, within those one hundred years created the “new normal” that guided economic and political trends until the late 18th century. During the 1400s the new young Emperor of China decided to recall its very powerful ships from the Mediterranean, India, Africa, and possibly America, before destroying them. At the time, China was the most advanced country in terms of science, gun power, and business structures. China has still not recovered from that decision and this is one of the reasons for China’s leadership moves today.

By mid-century the Ottoman Turks captured Orthodox Constantinople, turning it into the Moslem dominated Istanbul, enabling them to challenge Eastern Europe. An event that has effects even up to today.

Finally, by the end of the century there was the discovery of the misnamed America. This led to the extraction of Latin American gold which turned the European economy positive and the investment opportunity that the US proved to be.

The lessons to be learned from the 15th century was:

1. Adam Smith in his book titled "The Wealth of Nations" showed the benefit of countries/companies specializing to get economic advantage through world trade.
2. Fortresses become prisons, eventually.
3. Often, new critical stimulus come from outside the recognized ecosystem.

It would be difficult not to be a global consumer and investor today, it would deprive us of a better life.

Good News
In April we saw some individual mutual funds and mutual fund management companies having positive net inflows. The winners had particular selection skills rather than being focused on sector section. Much of the inflows came from institutional or retirement investors. In brief discussions we heard that the trends seen in April continued in May. Nevertheless, on an overall basis equity products had net outflows, but larger amounts went into fixed income investments. Being a contrarian suggests to me that once the risks of higher interest rates and inflation rates become more pronounced, we are likely to see substantial equity inflows that can absorb the actuarially driven outflows.

Any thoughts? Please Communicate.



Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html

https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html

https://mikelipper.blogspot.com/2020/05/top-down-sells-bottom-up-pays-weekly.html



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

Investors Are Worrying About Wrong Assets - Weekly Blog # 606

Mike Lipper’s Monday Morning Musings

Investors Are Worrying About Wrong Assets

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

Historic + Present Background
Ever since there were publicly traded securities they probably faced questions about how to mix and match them. Starting in the United Kingdom in the mid 19th century, the public was offered a portfolio of securities in a single trust, launching the beginnings of the mutual fund industry. The early providers of these products were established money managers for the wealthy. The wealthy almost always have poorer or younger relations that should have their money managed for them. Thus, wealth managers developed a lower capital base solution, ”retail” as an additional service for their wealthy clients.

From this base of collective investment vehicles, mostly mutual funds, it became a global multi trillion-dollar vehicle to satisfy the needs of both individual and increasingly institutional investors. For regulatory reasons, funds were required to disclose their performance, portfolios, fees and expenses, as well as some other things. Today, most mutual fund managers run separate accounts for institutional and wealthy individual investors. Their publicly available vehicles generally being representative of their overall investment thinking. Thus, I believe that studying these most disclosed vehicles can impart a good bit knowledge about the publicly traded global securities markets, which has application for many investors.

Fear of Loss May Come with the Pleasure of Gain
As securities prices fluctuate, each individual security can by definition lose money from their initial acquisition price. To reduce the chance of loss, investors can largely use two tools, selection skills and diversification. Good diversification appears to be easier for most than selection skills. Thus, an analysis of diversification practices reveals a great deal about an investors’ worries. Security selection deals with a narrower based view of the future. (Most entrepreneurs and a few a great investors, like Charlie Munger, prefer a very limited number of investments to broad diversification.)

The two tales below show the amount of total net assets invested in Trillion-dollar US mutual fund categories:

Mutual Fund Total Net Assets in $ Trillions by Investment Objective 
Core Equity (*)           $5.95
Growth Equity             $3.36
Taxable Money Market (*)  $3.39
Other Fixed Income (*,**) $3.32
Mixed Assets (*)          $2.68
International Equity      $2.17
Value Equity              $1.19
Sector Equity             $1.01

(*) Perceived to be less risky
(**) Taxable

By Market Capitalization within Equity Portfolios
Multi Cap                 $3.75
Large Cap                 $3.33
Small Cap                 $1.10

Interpretation
Mutual Fund investors in aggregate believe in diversification and reasonable exposure vs. perceived risk of growth and small caps.

Major concern - Reduced equity risk exposure comes with increased sensitivity to interest rates. At some future point in history, government deficits suggest that interest and inflation rates will rise, possibly with a shock.

“Canary in the Mutual Fund Mine”
This week, my old firm’s owners Refinitiv highlighted the combined net positive inflows going into Ultra-Short Obligation investments through Mutual Funds and ETFs. These funds on average keep their maturities below one-year. Money market funds by comparison have more limited maturity and quality constraints. Currently, the assets in this category are more than twice their year-end 2017 level. This is another sign of perceived equity risk reduction, particularly by ETF investors.

Longer-Term Observations After Historical Thoughts
It is popular to state that the market is “climbing a wall of worry”. Another way to look at that statement is to say it’s signaling a lack of confidence in a positive future. Good investments begin with good entry prices, but not those exclusively based on the past. A good investment for the future will be a bargain purchase, viewed from the future, not the past. Suggesting a view of confidence about the future.. Part of the problem, particularly for those of us who have dwelled in past performance records, is that due to technology, globalization, and political currents, the future may be quite different than the past. (“Quants” pay attention.)

Some of the earliest fortunes made in America existed at the time of our first Thanksgiving in Massachusetts. These resulted from skills in farming and negotiating, although their greatest skills evolved into estate management. Sometime later in Boston, a small group of lawyers were put in charge of the money of successful Sea Captains away for more than a year working the China Trade. They were paid a percentage of the revenues/profits. The skills of these lawyers, not only in management and financial planning but in selling to the rich, was an important factor in the growth of the mutual fund industry. Also, perhaps as a tribute to the “Boston Tea Party”, they demonstrated against taxation imposed from across the water, a familiar complaint today. 

In using history to guide future actions, one of the critical tasks is to not focus on past numbers, but the circumstances that created the working equation of a situation. The understanding of these relationships is why I suggest that those lessons from Massachusetts are important to managing money today. The consideration of financial planning, development of successors, understanding taxation implications and  working hard.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/conventional-wisdomcontrarian-options.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.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 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.