Securities Analysis as Taught Leads to Volatility - Weekly Blog # 705

 

Mike Lipper’s Monday Morning Musings

Securities Analysis as Taught Leads to Volatility

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

The long-term history of making money in the market is not  following the majority  with their money. In simple terms, choosing not to conform with what others are doing. Winning in the market means converting some of the wealth of others, often the majority, to our own. This maneuver requires using different approaches and tools than others use.

 

Sector Bets Fail to Produce Top Results

The academic course on Securities Analysis is taught as a companion course to accounting, or worse, macro-economics. Both work on past history and have precious little to do with future movements of companies, stocks, or economies. More useful studies would instead focus on profits and securities. 

All too often securities selection processes screen for companies which appear to be in the same industry, as measured by misleading government data. As a junior analyst I was assigned the steel industry. I quickly discovered that although the number of steel companies was small, it was a mixed bag of companies. You could divide the group by the location of their headquarters and proximity to critical resources, usually coal, or to a growing customer base. In this case an investor did far better with Inland Steel, based in steel-short Chicago, rather than in Pittsburg and West Virginia coal country. 

Another worthwhile distinction was the cost and quality of labor. In the early days of the externalization of producing payrolls, commercial banks were prominent. However, overtime they lost market share and eventually lost the entire market to independent payroll service providers who provided better services. They provided more help filing payroll tax returns and offered lower prices, due to their labor not being paid bank-type overhead. Today the payroll market is dominated by service companies with extensive and modern computer systems, which are good at servicing. (Our accounts own ADP.)

A final example is computers. Many of the large industrial companies manufactured the early computers, the biggest and best being IBM, a stock my grandparents owned. The key to their success was not only adequate technology, but superior leasing prices and great sales engineers. IBM’s top salesman regularly presented to Wall Street and was a missionary sales person. However, the industry changed from massive main frames taking up large airconditioned rooms, to desktop personal computers whose parts could be produced in low-cost regions of the world and could be assembled elsewhere. 

Dell started out by taking customer orders for computers which could be customize and air shipped to customers. Today, many believe Apple (owned in our accounts) is the leading company. This is the result of the late Steve Jobs’ focus on style and ease of use. His most important achievement however was handpicking his successor, Tim Cook, an expert known for supply management and development. What relatively few investors appreciate is its global network of Apple Stores and a growing mail order business generating repeat business, essentially building its own annuity business. (Remember, US automakers had market level price/earnings ratios when customers replaced cars every three years with newer models.)

Less popular ways of analyzing securities included: 

• Paying more attention to insufficient supply than excess demand.
• Focusing on differences in manufacturing approaches and costs.
• Understanding the personalities of key operational people vs known leaders and their educational biases.

We Don’t Create Winners, Losers Do

No matter how prescient and bright we are, to have great results we need others to create attractive entry prices and unreasonably excessive exit prices. Utilizing these as working assumptions, I am getting nervous about the flow of institutional and individual money in private equity/debt (private capital). For many years there were more good private companies offering participation in their attractive futures than potential investors. They attracted investors with relatively low entry prices. 

Recently we have seen a reversal, with a huge flows of institutional and individual money seeking to exit the public markets and enter the private markets. By definition, entry prices either directly rose or the firms had to carry senior debt prior to generating private capital returns. There is so much reversal of traditional roles that one of the oldest buyout firms, with a great long-term record, is converting some of their US and European investments to a publicly traded fund. For some of its investments Sequoia is trading up in liquidity.

One of the disturbing concerns in the privates market is the number of new advisers that have entered the market. They have increased the number of funds and are spreading the investment talent more thinly. In response, T. Rowe Price, an experienced investor in privates, is buying an existing manager to get the necessary talent in an increasingly competitive market. (Owned in Financial Services Fund accounts)

A number of well-known university and institutional portfolios have announced performance in excess of 40% for the fiscal year ended June 30. Some are probably reporting private investments with at least a quarter’s lag. (My guess is performance for the year ended March was better than the year ended June 30.) Most investors did not do as well and consequently some are likely to pile into an overheated private market with scarce investment talent. The history of investment returns is that it is extremely rare to find a manager who can consistently return over 20%, which is roughly three times the growth of industrial profits. The organizations that reported 40%+ profits undoubtedly benefitted from lower entry prices and better terms than is currently on offer. 

I am a long-term member of the investment committee of Caltech, an internally managed investment account with a talented staff. They have put a cap on their exposure to buyouts and venture capital. I applaud this decision because of the history of hedge fund performance. It shows that even very good hedge funds suffer when a minority of hedge funds experience serious liquidity problems. This was in part because of debt, but some of their holdings were also owned by trading interests desperate to liquidate some of their excessively leveraged holdings created by falling prices. This is a classic example of others causing some investors to have poor results.

Moody’s is also concerned about the rapid growth of inexperienced managers offering private capital vehicles. The credit-rater was criticized for the exponential growth of CMOs. (Moody’s recovered, and just this week was selling at a record stock price. Moody’s is owned in our managed and personal accounts.)

Historical Odds of Equity Bear Market

There is wisdom in the saying that history does not repeat (exactly), but rhymes. The ebb and flow of markets are driven by emotional excesses, with investors reacting to various stimuluses. I previously mentioned a successful pension fund manager liquidating his equity portfolio after it gained 20% in a calendar year, reinvesting the proceeds at the beginning of the next year. He produced a record absent of large losses, with reasonably good gains on the upside.

We may be approaching a “rhyming event”. I feel more confident taking a contradictory view when it is supported by large scale numbers. The US Diversified Equity Funds (USDE) have combined total net assets of $12.4 Trillion, representing 2/3rds of the aggregate assets in equity funds. According to my old firm’s weekly report, the year-to-date average gain was +21.01%, vs a 3-year average gain of +19.21%, and a 5-year average of +16.76%. More concerning is only 4 of the 18 separate investment objectives within the USDE bucket produced over 20% 5-year annualized growth rates. Of the 14 Sector Equity funds, only 2 grew +20%, and only the World Sector Fund average gained 20%+. At the individual fund level, only 3 of the 25 largest funds produced 20% growth rates. During the same 5-year period, the average taxable fixed income fund gained 3.34%, and the average high yield bond fund grew 5.47%.

Recently, a number of endowments reported gains of over 40% for their June Fiscal years, driven by successful private equity/venture capital investments. Some of these private investments were reported on a logged basis. Remember, in many cases they had spectacular performance through March, and have been relatively flat since then.

The cyclical nature of human emotions suggests that when earnings growth does not support lofty valuations, we are likely to have a “rhyming event”.

What do you think? 

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

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

https://mikelipper.blogspot.com/2021/10/guessing-what-too-quiet-stock-markets.html

https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html

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A. Michael Lipper, CFA

All rights reserved.

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Normal or Abnormal Decline Approaching?Weekly Blog # 499

Introduction

Future stock market declines are inevitable unless we modify human behavior. Also, as days follow nights, after the declines there will be future rises. None of these statements are new or profound. The critical questions are, what to do in anticipation and during a decline?

John Vincent messaging through Seeking Alpha, regularly reviews the 13F reports filed by investment management organizations as to their stock holdings. In reviewing a number of independent investment managers with over $1 Billion in their portfolios for the third quarter, I have observed some trends.

First, many managers who have sold recently acquired positions did not report significant profits. Secondly, sales of shares acquired years ago are producing large returns, some on the order of two, three, or four times original cost. Since my investment clients and I are long-term investors, it is the second observation that becomes something of a guide to our management philosophy.

Since few or any managers consistently buy at the bottom (or sell at the top), there will be periods of time that they will likely hold positions at a loss before they eventually sell at a profit. Thus, the critical question is how big a loss is acceptable as a price to earning large profits? A further and more difficult question is, how long does one have to wait to get into a profit condition?

Accurately predicting the future without incorporating a mistake is a fool’s errand. However one can apply both logic and past history as a guide. Stock prices regularly decline for periods of one year or longer, “normally” two to three times over a decade. These corrections may be 10% or more up to so-called “bear markets of 20%+.  Few investors have experienced getting out at or near the top of a “normal” decline and getting back in before prior peaks have been achieved. Thus one is probably better off holding through a cyclical downturn and subsequent recovery.

On the other hand once a generation stock prices decline in the range of 50% or more. We have had bouts of these types of declines in 1973, 1987, and 2007-9. In the last two cases we held through the declines in part because we recognized the potential market risks after the decline had begun. There is a greater risk that the recovery period could be extended. The recovery from the “Great Depression” of the 1930s lasted until the mid 1950s for the average stock and in the case of one of the popular growth stocks, RCA, until the mid 1960s. Thus, there is a real advantage to attempt to sidestep an “abnormal” market decline.

Even if we can determine the odds of a forthcoming decline, particular diligence is required to separate a future “normal” decline when the odds favor holding through the decline and an “abnormal” decline when side stepping would be advantageous. I am considering to attempt the last task. I do this with the hope that my heritage will give me an advantage. The family folklore is that in the late 1920’s my Grandfather persuaded  his clients to pay off their margin loans and go to cash. The family legend is that they did.

Next I am examining the current conditions to separate which of the current trends point to a future “normal” decline and which could be indicating a larger problem. 

Trends that Presage a Decline

No single present trend guarantees a future event and even the aggregate weight of trends do not guarantee a particular result. One of the useful concepts learned at the race track and as an analyst is to assign odds to various factors that could influence the result. Always leave room for “racing luck” or “unknown unknowns” as well as unintended consequences. Nevertheless, reasoned analysis is better than relying exclusively on hope.

Sentiment Overriding Numbers

Utilizing the distinction that S&P* is making between Growth and Value components of the S&P 500, one can see two different stock markets being created. Value stocks are being evaluated on both the basis of their financial statements and the near-term price and volume trends in their business. Using many measures these stocks are being valued within the range of fair value. Their stock price trend is moving up in tandem with an economy that is somewhat errantly expanded. However, the value stocks are moving slowly compared to the growth component.

Led by a little more than a handful of stocks labeled as the FAANG group, Growth stocks are significantly outperforming the aforementioned Value stocks. This is happening globally and particularly in terms of Asian security prices.

One of the reasons that up to the present I felt that the next market decline would be of a “normal” type that we would hold our good stocks through the cycle, is the general lack of enthusiasm for stocks. I have not seen the kinds of enthusiasm I saw in the run up for the Dot Com bubble. Nor did it reach the levels of enthusiasm seen many years earlier in the South Sea Bubble or the Tulip Bulb craze. But the level of enthusiasm for certain stocks and for the market in general is worth watching. Two of the lenses that I look through are the research that Liz Ann Sonders puts out for Charles Schwab & Co.*  and the weekly survey by the American Association of Individual Investors (AAII). This is a very volatile time series. In the latest week only 29.4% of those surveyed are bullish as compared with the prior week when the reading was 45.1%. If, over time, the bullish contingent numbered consistently over 40% and the bearish group is below 30%, I would be nervous short-term, as I view this particular indicator as a contemporaneous measure.

Fixed Income Signals

As has been often pointed out that most of the modern declines in stock prices were preceded by some disruptions in the fixed income markets. We have already seen some price nervousness directed at the High Yield bond  market in spite of no generally expected increase in defaults by the major credit rating agencies. This nervousness has not yet been felt in the intermediate credit market. Barron’s has two bond indices, one labeled Best Grade Bonds which saw its yield rise 5 basis points this last week. The other  measure, for the Intermediate Grade bonds, saw its yield drop by a single basis point. This suggests to me that there is wide scale disenchantment with the credit market this week.

My main worry after the collapse of Lehman Brothers and Bear Stearns is not the price/yield of credit instruments but their availability in a stressed market. Recently I have mentioned that the market for US Treasuries is considered to be the most crowded and is under investigation for price manipulation in the related foreign exchange currency markets. There are some professional press articles raising concerns about liquidity. A liquid market is one where trades can be executed without moving prices. Most high grade markets are extremely liquid almost all the time. The meaning of the last sentence pivots on “almost.” At the final point of their crunch both Bear Stearns and Lehman could not access the repo market to satisfy their desperate need to refinance short-term debt.

I don’t have any independently derived measures of liquidity.  However, I may something of a mirror image of available liquidity looking at major Money Market funds. (Remember when Lehman went down it caused one large Money Market fund to “break the buck” or to be slightly valued below the level of its deposits including interest earnings? They had to suspend redemptions which could have created a “run” on Money Market funds if the government did not step in. Thus, liquidity is very important to Money Market funds.  JP Morgan has four large multi billion dollar funds in the US. These four range in size between $21 Billion and $140 billion. What is perhaps of interest in this matter is that three of the four have between 50% and 64% of their investments maturing in eight days or under. Only their 100% US Treasury Securities Money Market Fund is much more exposed to longer maturities, with only 21% maturing in eight days or less. This difference could be due to a belief that the owners of this fund are less likely to need cash as quickly as the owners of the other funds.

Two of the four funds have more than 50% of their holdings in repurchase agreements, largely with other capital markets providers. (What we do not know is whether JPMorgan is on the other side with the same organizations so their net exposure may well be much less.) The real key to the questions as to the size and nature of short-term liquidity is that it is a matter that is currently being worked on by the major participants - not because they want to for the tiny current interest rates - but because they must to keep the global financial system working.

The Thanksgiving Weekend Visit to the Mall

As many of our long term subscribers to these blogs may know, my wife Ruth and I visit the glitzy Short Hills Mall in New Jersey to frequently do our market/economic research. Due to family commitments, we could not get over to the Mall until Sunday afternoon. The Mall was crowded but not jammed. The high end stores were generally attracting a good crowd, but this was not universally true. While a number of jewelry stores were busy, Tiffany looked sparse as some of the others were almost vacant. Both Verizon and Apple* were doing good to great business, we think. While some couples had a handful of bags, they did not seem to be burdened down. There were a few empty store spaces and ads for sales help were generally lacking. I had the feeling that most merchants were not over-inventoried, as some were in the past. All in all a good but not a great beginning to the shopping season. We don’t yet have a view on the online business and whether shopping habits have shifted.

     

 From an investment viewpoint retail will do okay but won’t be a leader.

*Held personally or in the private financial services fund I manage.

Conclusion

We should be careful with our investing. There are too many moving parts to this puzzle to be dogmatic, but risk levels are probably rising.

__________

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A. Michael Lipper, CFA

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Signals or Static Perspective?

Introduction

I can’t avoid thinking like a US Marine this Sunday. We just received the notice of the memorial service for General Carl Mundy who was the 30^th Commandant of the USMC and my fellow classmate in Basic Officers Class. As Marines we learned to observe every detail about our surroundings and most particularly about our enemies. As in the battle for investment survival, which requires a degree of investment success, we also need to observe all elements that are visible and look for those that are beneath the surface. We know that each day or week could hold the clues to future actions. The difficulty that I face is separating meaningful signals from day-to-day statistical static. Carl did these well both in battles and in his post active duty service and I will try to emulate his skills.

First quarter 2014 mixed messages

Extrapolating the large gains achieved by equity funds, particularly the Small Capitalization funds with significant holdings first in technology and second in financial services, one would have been prepared for a continuation of these trends. On the surface there were very few surprises in the first quarter based on the financial headlines. Yet the natural order of performance was quite different. The leading performing large asset class was commodities, not across the board but a number of industrial and agricultural goods, in addition to gold and energy had positive results. Under normal circumstances this kind of price behavior would indicate inflation and significant shortages of supplies. But this was not the case as the central bankers were complaining about the lack of inflation to provide economic stimulus that the fiscal authorities were not.

Focusing on the next best asset class for some, which was taxable bonds, the best performing fund group was those funds that had mostly “A” rated corporate bonds in their portfolios with an average gain of +3.94%. They were followed by funds with somewhat lower credit rated bonds (BBB) which gained +3.32%. Somewhat surprising in a period of expansion, the third best bond category was the High Yield or junk bond funds up +2.75%. They normally lead in bullish times as in the last twelve months with gains of + 7.32%. What may be happening is that the wave of acquisitions that were being financed through high yield paper may have created supply bigger than demand. Further, those with a historical perspective may have felt that the yield spread versus the poor performing treasuries was too narrow. All of these results suggest to me that the fixed income and commodity investor was acting cautiously, but was questioning the value of the US government’s paper as well as the reality of inflation production.

The equity funds also sent out mixed and not very strong signals. Of the 31 equity investment objective classifications tracked by my old firm, now known as Lipper, Inc., four produced slightly negative results and five positive results. The losers were hurt by disenchantment with growth regardless of size (Small-Cap Growth -0.47%  and Large-Cap Growth -0.11%). The gainers were led by two traditional bets against the future lower value to the US dollar and/or increased inflation. The average Precious Metals fund was up +12.28% but still down -29.29% for the trailing twelve months. The second best was the Real Estate funds +8.13%. From a macro point of view the most surprising performance was from the average Utility funds +6.69%. This result was clearly better than any bond category. Often utilities are viewed as bond substitutes. The fourth best was Health/Biotech at 6.69%. The fifth best was the Mid-Cap Value funds up +3.14%. The other twenty two equity funds had gains below 3% or under the results for both bonds and commodities.

The ends of March

As indicated in last week’s post I detected a significant change in equity leadership. This change is better defined when one examines the month of March performance. The four worst performers were the Precious Metals funds -7.82% giving up some of their recovery, Health/Biotech funds -5.30%, Large Cap growth -3.22% (all of the growth fund categories declined in March). A good further explanation for their declines was the fall of -2.67%
in the Science & Technology classification.  Science and Technology has driven a good bit of the Growth funds' performance. Clearly the old war horses of the 2013 leadership in healthcare and technology were no longer producing bigger dreams for their owners. The new leaders seem to be very specific in terms of their own merits even though there appears to be greater attraction to value-oriented portfolios (see April observations below). British funds seem to be reading from the same playbook being used in the US.

If one is following the script of an aging bull market the switch to larger caps that have perceived value safety nets beneath them makes sense. However, if the next market collapse proves to be spectacular, we will need to have sudden, sharp, parabolic price explosion on the upside. That kind of performance is normally needed for a 50% decline. Without such a runup, the next decline is more likely to be in the neighborhood of  25% which is not enough to dislodge sound long-term investment portfolios.

Early April flows and ratings pluses

Being indebted to my old firm for flow data,  I can see some interesting cross trends if I parse the data carefully. The traditional equity mutual fund had net estimated inflows for the week ending on Wednesday of $2.2 billion; however $1.6 billion were non-domestic stock funds. This would indicate that only about $600 million was betting along with the Administration that good things are in the offering for the US economy. Some of the money leaving the US may be going to Europe on the basis that Moody’s is regularly raising western European credit ratings, that business is improving and the price/earnings discounts to comparable US stocks makes them attractive. I suspect a smaller piece is going out to buy Asian stocks that are recovering somewhat from their prior fall. In term of investment objectives, the traditional mutual funds buyer put the bulk of their net money in Large Cap core funds which category included index and closet index funds. Some of that money probably came from the $429 million net outflows from the Large Cap growth funds. These shifts were aligned with our prior observations.

What are most interesting are the flows into the ETFs. Their assets are considerably smaller than the traditional mutual funds, but they managed to put more money, $3.2 billion into their equity funds of which $2.5 billion were in non-domestic portfolios. The domestic fund investment benefited from a $941 million flow into a large S&P 500 index fund which appears to be a “parking lot” type of investment, rather than a long-term commitment.

Why focus on mutual funds?

First, mutual funds around the world, according to the Investment Company Institute (ICI) have $30 trillion dollars under management. In many markets they are the most transparent institutional investor. Often some of the 76,200 funds are managed in the same fashion as the other institutional accounts in their shops. Thus an analysis of what mutual funds are doing gives one useful intelligence as to what is happening in both the institutional mind set as well as the general investing public.

Second, I spend most of my working hours focused on the proper selection of funds for clients as well as our extensive charitable activities. Third we eat our own cooking, as we invest in these funds for my family along with a private fund that invests in mutual fund management company stocks and other financial services providers.

My question for the week is:

How prepared is your thinking for the next market decline? Please let me know, for General Mundy would expect me to look at any moving object that was somewhat visible.

___________________

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Copyright © 2008 - 2014

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