Collateral Rewards, Risks, & Opportunities - Weekly Blog # 828

 

      

Mike Lipper’s Monday Morning Musings

 

Collateral Rewards, Risks, & Opportunities

 

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

   

 

 

Motivations

The attempt to be successful and original is hard work, as being an originator seldom leads to investment success. Better results come from striving to be an early participant in an investment idea. Great individual analysts search for a single great idea, usually an idea that few if any recognize.

 

Somewhat later and perhaps deservedly less successful are those who are early recognizers of those with great investment ideas or themes. The second group are collateral players, including public and private pundits working to identify these opportunities.

 

At one point in my professional life, I was a candidate for the first group. I devoted some of my time as an analyst to visiting plants, doing walking tours of workspaces, and attending industry sales presentations or government conferences. In order to accomplish these tasks, I often commuted on the earliest and latest trains. In addition, I also read numerous trade journals, which I no longer do.

 

Today, my “remote” research consists of reading or watching business communications, visiting buyside managers and their analysts, and walking through shopping streets and malls. In effect, my first glance at new products and services is when they are introduced to the buying public, so I am going to be late in recognizing new trends. The only offset I have is my prior experience, having seen many things in the past which may have some bearing on present and possibly future trends.

 

What Are Most Missing

Much has changed in the sixty plus years I have been watching.

1. Disclosure rules have changed.
2. Corporate executives meet investors and analysts in tightly scripted conferences or small meetings.
3. The published data is largely statistical in nature and is focused on the immediate past. Much time is spent on complaints about government restrictions and disclosure requirements. Two examples are the focus on demographics and worker counts. (This is the same trap political pools fall into.) A much more expensive and insightful source of useful information is psychographics, rather the demographics. While two workers may have the exact same job classification, one might be solely concerned about wages and hours while the other seeks career opportunities well beyond the current paycheck.

 

Questions Need to be Asked?

• What are the implications for the four largest net free cash flow producing companies, which reported over $50 billion each? This suggests to me that risk-taking finance and technology companies will be central to funding the future and could be its beneficiaries.

Net Free

Cash Flow

$ Billion

Goldman Sachs           $143 

JP Morgan Chase           87

Apple                     85

Google                    69

• The American Association of Individual Investors (AAII) is often viewed as a contrary indicator at turning points and last week the indicator switched direction. Those with a bullish outlook rose to 30.4% from the prior week’s 23.4%, while those who felt bearish fell to 41.4% from 53.7%. (The size of the switch and timing is unusual.)

• Lessons from the past for possible use in the future? In the 1930s the US shrunk its defense strength below its WWI level, while restricting oil exports from American companies to Japan. It also refused to permit the offloading of a ship of European refugees. (These actions were taken by FDR, whose portrait is the most prominent in the current White House. It hangs in the room where the President meets with current world leaders and US politicians.) 

 

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Mike Lipper's Blog: Alternative Futures - Weekly Blog # 827

Mike Lipper's Blog: Bullish Chatter Leaves Out Useful Info - Weekly Blog # 826

Mike Lipper's Blog: Caution: This Time Is Different - Weekly Blog # 825

 

 

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Going to Where the Puck Will Be - Weekly Blog # 750

 

  

Mike Lipper’s Monday Morning Musings

 

“Going to Where the Puck Will Be”

 

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

    

 

  

Lonely Strategies Applied to Investing

Wayne Gretzky, the great Canadian ice hockey player, contributes much of his over 20 year playing success to skating to where the pluck will be, not where it was. He was betting on a specific change.

 

How much of the bet was based on his belief that his teammates would send the puck in a new and beneficial direction? Or did he believe the play would lead to the puck being hit in a different direction? I don’t know. Nevertheless, he positioned himself in a less crowded or lonely position.

 

In a career analyzing winning investment managers, one repeated characteristic is being early to recognize an investment opportunity and staying with that choice for an extended period.

 

The benefits of being early are two-fold:

1. Fewer competitors taking positions
2. Taking up less of senior management’s time (perhaps even more valuable)

 

Another advantage of being reasonably early is that the price paid is often in line with what a disinterested investor would pay. Likely reducing the size of the loss if the expected doesn’t turn out as hoped.

 

Two Current Possibilities

If one is to believe what is currently being written by many. We have seen the bottom of the US equity market, the rate of inflation is about ready to roll over, and the investor is about to be ushered into a new bull market.

 

All could happen. However, the responsibility of an investment manager is to examine views different than those which are popular. This examination could be a good exercise and might even be correct.

 

The June Bottom

Two and half months ago, in mid-June, the popular US stock indices fell to their low point of the year. The averages rose in July but were relatively flat in August, then started to rise again. The table below shows their low for June, their closing value on September 9^th, and their % change:

 

Index             June Low    Sept 9th  %Change

Dow Jones Ind.    29,888.78   32,151.71   7.57%

NASDAQ Composite  10,646.10   12,112.21  13.77%

S&P 500            3,666.77    4,067.36  10.92%

 

Traditionally, a bottom price is accepted when a subsequent decline is in the same range as the first bottom price.

 

Bottoms also generally occur after capitulation of an important segment of market participants.

 

Neither of these have happened yet.

 

Although the Atlanta Federal Reserve Bank is currently looking for GDP growth, Morgan Stanley and others are expecting declines for some large earners.

 

In past bear markets there have been short bursts of upward prices, often occurring after a period of declining prices. This leads to traders shorting the market. A subsequent sudden price rise would likely force traders or their custodians to cover their shorts.

 

September is a tricky month, as the outlook for the winter shopping season becomes clearer. With sparse inventory, the absence of salespeople in stores, and some weakness in advertising, I would be more comfortable with a confirmation the bear market is over.

 

Rate of Inflation is All Important

As a numbers cruncher I like the attention being paid to this abstraction of reality, but it is not the reality itself. I am much more concerned with reality than the number to the fifth decimal every hour on a screen.

 

For risk-aware investors the nastiest word in our language is leverage, yet it is the basis for all financial growth. After the Volcker Recessions and Global Financial Crisis people desperately tried to recover. Often using leverage in an attempt to generate larger returns.

 

We are well aware of the use of borrowed capital to make money. This is what most in the financial community think of when speaking of leverage. People don’t generally label sales growth and productivity as leverage.

 

Sales leverage comes from getting more profits out of sales, either through generating more sales or selling a product or service for more than its cost to produce. This is often called productivity.

 

We have stretched sales leverage to an unsustainable level, which combined with bad labor management has led to lower productively. This is one of the reasons I feel the world is going to have a recession, which when badly managed will lead to a depression.  

 

Google, one of our great tech companies, is hinting at job cuts. They are approaching the point of too many employees for the expected level of sales.

 

I am disappointed with the quality of people being processed through schools of all levels. This, combined with the reduction in the number of supervisory personnel and executives prizing political skills over leadership. These lead me to believe the problem is not the number people. The problem lies in having the wrong people in positions where they are not properly trained to lead even small groups, let alone large groups.

 

History demonstrates that it unfortunately takes long periods for societies to eventually address their imbalances and grow results successfully.  

 

Question of the week:

What are you going to do to make things better for those who depend on you?

 

 

 

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

https://mikelipper.blogspot.com/2022/09/i-can-be-wrong-weekly-blog-749.html

 

https://mikelipper.blogspot.com/2022/08/4-5-changes-disruptions-faulty-weekly.html

 

https://mikelipper.blogspot.com/2022/08/mikelippers-monday-morning-musings.html

 

 

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A. Michael Lipper, CFA

All rights reserved.

 

Contact author for limited redistribution permission.

Searching for Confidence

Introduction

If we were more confident, we would commit. The lack of confidence is what prevents us to committing to another person, a political view and an investment of time, effort, or money.  Animals as well as humans over-rely on our or others' memory as a guide for our next committed actions. The difference between humans and animals is that out of bitter experience we have been disappointed that in particular cases the past was not repeated exactly as believed.

To protect ourselves from disappointment we search for systematic ways to predict the future. Often not finding the magic formula, we rely on so-called "experts."

Another Lesson from "The Track"

While at the track after I concluded either I couldn't find the next winner or in my opinion the betting odds were too low to make a sound bet, I began a life-long exercise. I listened to those around me in their conversations as to why they thought a particular choice was the correct one. In an over-simplification, these views generally fell into two camps. The first very much focused on especially current information about various horses, jockeys, trainers, times of prior winners, and track conditions. The second camp used various numerical inputs such as past speed records for the race, the weight the horse was carrying, whether horses that were favorites that day were winning at the expected rate, etc, etc. This second group was slavishly following a systematic procedure or as it was known at the track, they had a system.

The post-race reactions after members of each camp that did not win was most instructive. First both blamed various "experts" for not producing winners for them. Those in the first camp restudied the information they had before the race to see what critical insight that they missed that they should apply to future races. The second camp’s followers rechecked their data for accuracy and if their math was correct they would begin the search for a new system and a new set of "experts."

The first camp were my first exposure to the arts of analysis. They searched the very present competitive conditions. The second group were in effect statisticians who believed the future could be determined from the numbers.

Years later I recognized that these two camps exist today in guessing which way various elections will go and what is the most successful way to manage money.

Statisticians

As a career securities analyst I have never seen a number from which I didn't want more information and data. However, I am not a card carrying member of the statistical clan. The reason I do not claim membership is that I do not think the numbers by themselves provide the answers that I need to generate confidence.

There are two other reasons that I don't wish to fit under the statistician label. The first is historical. In the era when the Dow Jones Industrial Average was being constructed, those hard working clerks in brokerage firms who produced recommendations for investors and whose main source of corporate information were the very thin reports published by companies. These clerks were unable to visit companies or third party sources and were called statisticians. My guess is that my Grandfather's firm had one or more. It was not until the era when Benjamin Graham was going beyond the ratio analyses of annual reports that the term securities analyst evolved.

The second reason I do not want to march under the statistician banner goes further back in history, but is equally important today. Another Benjamin, Benjamin Disraeli the Prime Minister of the United Kingdom in the 19th century is quoted (most often in the US by Mark Twain) as saying "Liars, Damn Liars, and Statisticians" were  the source of bad information and conclusions. I am afraid, particularly this remains true in the political world today. Part of this tarnished label attached to statisticians has to do with polling. Not only did the Brexit polling not capture the true intentions of those in Northern England but that it was followed in Colombia. There were three pre-referendum polls that showed that the no vote in Colombia was between 34 and 38%. The final vote was the "No" vote carried 50.2%. Again the issue has a geographic focus. Most of the No vote was largely rural, which is more difficult and expensive to gather. I am guessing many of the current US polls are similarly flawed.

One of the mistakes some British made is crediting the bookies with analytical inputs. A similar mistake, I believe, is being made on this side of the pond. The believers in the efficacy of these inputs, do not understand that both measures are similar to the pari-mutuel system at the racetracks where the odds are not judged mentally but are calculated by the amount of money bet. Further, my guess is that the northern English farmers and most Republicans in the US are not by nature gamblers, so the weight of money is not representative of the voters.

Turning to our investment world, those that believe in factor investing or other asset allocation dictates are essentially statisticians looking for their "system" as some of their brethren did at the track. Recently JP Morgan Asset Management published a 72 page   "Guide to the Markets®". An analysis of some of its data is as follows:

It has identified seven  major factors; including High Dividend Yield, Small Cap, Minimum Volatility, Cyclical Sectors, and  Momentum. The two best factor portfolios in 2015 were the last and next to last in the first nine months of this year.

Asset allocation funds may have many adherents, however since 2006 in a performance array of ten different types of Fixed Income funds on average they ranked fifth out of ten with two years in fourth place and three in sixth place.

In a similar selection of ten major asset classes from 2000, asset allocation returns were again in the middle on average, with the best in one year getting up to third place and five times in seventh place.

There is a problem with the statistical-only approach. When will the creators of the factors or asset classes recognize the changes in our dynamic markets? If those changes are perceived too late, much of the growth in value will not be achieved. For example, when the four largest global companies in terms of current market cap are recognized with appropriate weights they are all relatively young companies that are still in their first to third  generation of management.  The four are Apple, Alphabet (Google), Microsoft, and Amazon.

Analytical Approaches

A good analyst examines the past statistics to see what items are likely to be absent going forward and/or deserve a different weighting going forward because of a change of conditions. In projecting the future it is also wise to assume some level of intellectual or financial fraud as well as less than perfect executions of plans. In addition one should expect that technology will both help and hurt people's efforts. At one point, it was good analytical practice to calculate eventual scrap value from written off plant and equipment. Today it may actually cost a company to close down and get rid of plant and equipment without a tangible scrap value. In today's fast moving world useful lives may be shorter than the depreciation schedules.

Beyond the analysis of the past what can the analyst use to project the future? To an important extent demographics is destiny. However, the raw numbers have to be modified by changes in social structure and education. The answers may be quite different from work force and consumer market applications. These trends are not just national but global in implications. In turn this suggests that any US investor that does not have approximately half of his or her earnings coming from beyond our borders is not appropriately hedged. However, we already live in a global world where almost every company large or small is benefiting or suffering from multi-national influences. Thus no matter where you pay your taxes, locally based multi-nationals are diversifying the national sources of your investment income without your instruction.

Investment Implications

One of the lessons from the racetrack is that short races are more difficult to get right. The first one out of the gate has a tremendous advantage over the slightly slower. In investing I have noted a similar phenomenon. Catching up is difficult. Thus, at the track and in terms of portfolio management I prefer the longer races where there is time to recover. Therefore, at this point in our history I would like to focus a couple years after the next series of US elections which may not end until 2019. At that point demographics from today's level and mix will be playing out. There will be some major technological changes, hopefully positive.

I am more confident in the run up to my preferred investment horizon, I will rely on the past pattern of periodic and relatively painful declines followed by much longer periods of gains which in total produce a reasonable rate of return for those who are in for the long-term. This philosophy will work until it becomes dangerous because of “fellow travelers’ enthusiasm.”   

Question of the Week: Are you more a Statistician or an Analyst?

_________________

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Awareness Risks and Opportunities: The Search for Outliers

Introduction

After stock prices slumped last week, particularly Thursday and Friday, we should be aware that our judgments are far from perfect. To help us in our deliberations, I am calling up our top strategy team, RT&E. Let me introduce the team: they are more formally known as Donald Rumsfeld, Mark Twain, and Albert Einstein. Rumsfeld divided knowledge into “Known Knowns,” “Known Unknowns,” and “Unknown Unknowns.” Mark Twain cautioned us as to what we “know” that is just not true. Einstein, a three-time visiting professor at Caltech, told us “Everyone sits in the prison of his own ideas, he must burst it open.” He suggested that we must think differently to produce different results. We should always be aware of risks and opportunities including those that we create by our own narrow thinking.

Known Knowns

1.      In the modern era, where the leading academic institutions teach the unsuspecting students a top/down view of the world in order to put the academics near the top of the power structure, they teach that markets are primarily driven by monetary policies implemented by the Fed and other central banks.

2.      The best examples are China and Russia, both are command economies and therefore the governments can totally deliver what they want.

3.      Price momentum leads to further price momentum for stock prices.

(see table below).

Known Unknowns

Each of the “knowns” are macro trends, or if you prefer, gross understandings that can be transmitted to the audience in sound bites up to 40 minutes of class time.  These averaging or actuarial approaches to human behavior lead to surprises or counter developments that are derived from the study of micro trends which when netted against the gross trends cause periodic reversals. This may well have been what happened last week with the gross beliefs being carried beyond their “sell date.”

For some time it has been reported that most publicly traded stocks in the US were falling, but the popular market averages were being held up by a couple handfuls of favored shares. Many of these favored stocks prices in one day fell into a correction (10%) or a full bear market (20%).

Filtering the largest dollar volume declines on NASDAQ the following names could lead a major price trend change list:

Priceline	(-67%)
Google	(-45%)
Amazon	(-37%)
Netflix	(-19%)
Tesla	(-12%)
Baidu	(-11%)
GoPro	(-10%)
Gilead	(-10%)
Apple	(-10%)

These stocks have preformed very well in the past, but the unknown element is when would they give some back, and how quickly would it occur.

(I am not commenting on the attractiveness of these names, but the surprising rapidity of their decline in high dollar volume which up to last week was unknown.) 

Unknown Unknowns

The “knowns” are premised on “all other things being equal.” We live in a world of small and occasionally large changes daily. Strange as it may seem, each day we grow older and perhaps wiser, but not definitively different than the day before in terms of our attitudes and mental and physical health. Not only are we changing, but we are experiencing the never-ending changes caused by technology.   Because of cell phones, billions of people are now aware almost instantaneously of any important news item, interesting rumor, or critical price change. Markets move with the speed of electronics; in many respects for major “chunks” of money no market is closed.

Teenagers’ buying habits and other consumer demand swings occur rapidly, responding to perceived models can lead to major changes in distribution chains globally, with much unsold inventory.

The Known is Untrue

While I am a professional analyst and money manager at my core I am also a student. Thus each day I am aware that some of my rock-solid facts are going to be challenged. Many of these “facts” come from respected sources. The best of which are my own experiences and yet some of these are extrapolated too far to be general cases and not just specific relationships. For example, for many years I have been following the weekly Barron’s Confidence Index which measures selected Intermediate-rated bond yields compared to a selection of High Grade yields. When the yields of the High Grades go down relative to the Intermediate Grade, which means that high grade prices are raising at a faster rate than the lesser quality is a measure of risk coming off for bonds, which often is indicative of current attitudes toward stocks. Most weeks the change in relative yields is under 1%. This week the move itself was 3.7 percentage points which is the most dramatic change I can remember and signifies a major risk aversion. Whenever some ratio goes to a historic level most people believe it is a confirmation of a trend. My training from the racetrack is to either doubt the mechanics or believe it is less reliable in terms of the future because it represents an extreme. At the moment I am being cautious and doubting the validity of the ratio, but I can be wrong.

Dr. Einstein’s Prison Breakout

We all like the past because we know what happens. The future is uncertain and we need to learn when to jump off the comfort of extrapolating the past. One of the advantages of my practice is that regularly I can examine extreme performance both good and bad. I would be a poor analyst if I assumed that these extremes would continue. The odds are that there will be some reversals where a poor performing fund will do much better than average in some future period. Often this happens because the portfolio manager or the CEO of a company sees something in a different light than the rest of the pack. My job is to find these rare reversal types and get enough confidence in their approach to follow them. The nice part of our portfolios is that almost always there can be room for an unusual approach as they breakout of the conventional prisons.

Question of the week:

Which managers are doing unconventional things that we should study?

__________   

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