We are Progressing - Weekly Blog # 721

 

Mike Lipper’s Monday Morning Musings

We are Progressing

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

                  

This is a blog on investing and is not intended to express any political views. Every single action we take, including taking no action, is an action. Every single action we take has less of a future impact for those we care for emotionally or legally, be they the next moment, day, week, month, year, or the rest of our lives. With that thought in mind, my focus is on the indefinite time periods for those we hold ourselves responsible.

This blog is focused on an investment period measured in years, comprising multiple market cycles. In sharing my thoughts, I am very conscious that humility is the only guarantee in investing. There will be periods of elation and depression as we travel through the various phases of market cycles.

Point of Departure

I believe markets move within their own cycles. I find it useful to measure from peak to trough for the styles of investing which identify most of what we do. In the absence of detailed knowledge concerning the structure of an investment account, I use three major stock indices for the US equity market. The NASDAQ Composite Index, which topped out last November, contains future oriented securities valued for their growth potential. The S&P 500 Index, which peaked on the 4th of January, is meant to contain the 500 largest and most liquid US stocks traded in the US. The S&P 500 Index is representative of the bulk of long-term US stock investments and is often used by institutions to represent “the market’. The Dow Jones Industrial Average (DJIA), which topped out on the first day of 2022, is a selection of the 30 most representative stocks.

Where Are We?

As a working assumption I believe most US equities have topped out for this phase. What phase we have entered is the question investors are asking. The choices are:

• A minor fall to a support level like the Dow Jones Transportation Index, a key component of the oldest market timing model, the Dow Theory. 
• The NASDAQ Composite Index, which fell beyond the 10% correction level used by the press.
• The S&P 500 Index, which is close to entering a correction phase, to be followed by the DJIA.

As we manage long-term money, which has long-term payout needs measured in lifetimes, I believe we have entered a downward slope with periodic upward trading opportunities. (57% of NYSE stocks and 61% of NASDAQ stocks fell last week.) Hardest hit were growth funds, with the T. Rowe Price Growth Fund falling -4.38%, the worst of the 25 largest growth funds. 

Focus

Instead of focusing on trading opportunities, I am focused on the likely investment opportunities in the subsequent rise in the market after the valley. To get to the happy hunting ground we will have to deal with expected problems. In time order: Ukraine, inflation, and Long COVID.

Ukraine

As is usually the case, the media and politicians are focused on the wrong things. First, the Russian Army has a significant number of conscripts due to return to civilian life who are not battle trained. They would suffer significant casualties, which would not go down well within Russia. If the Russians invade, they are likely to suffer casualties caused by a well-armed and trained army and volunteers. They have a lot to fight for, as shown below:

• The Largest proven recoverable Uranium resources in Europe
• 2nd largest explored Manganese ore reserves in the world
• 3rd largest exporter of iron ore
• 4th largest array of natural gas pipelines
• 8th largest number of installed nuclear plants

To an important degree, Putin has already accomplished his goal of weakening NATO by showing the unwillingness of Germany to take up arms, followed by Italy and a weak US response. So far, the only negative from Putin’s point of view is the push by Sweden’s second largest political party to join NATO.

Inflation

From the White House’s viewpoint, it is pleased the market is doing the job that the Fed was meant to do. The markets most sensitive to short-term inflation are the commodities markets, which are pricing commodities higher in the near-term than the longer-term. Members of Congress are preventing the White House from adding to the problem, by resisting an increase in money supply growth. 

A study of 19 recorded pandemics over 700 years shows real interest rates falling in all cases. However, a complete solution to the supply chain issues has several hurdles to overcome and is unlikely to be solved before the next Presidential election. These include: 

• A shrinking number of petroleum refineries, from 301 in 1982 to 124 today.
• The absence of new mineral production and severely restricted new mine and pipeline volumes.
• Fewer skilled workers and supervisors returning to the workplace due to Long-COVID. 

Long COVID

Long COVID is the inability of some workers to return to the workforce due to PASC symptoms, which stands for Post-Acute Sequalae of SARS COVID. (Cumberland Advisory has a good blog on their panel discussion on the subject.) One study predicts between 10 and 20% of those who get COVID will get the Long version. One must expect other pandemics in the future, and we have not yet come to an understanding the best way to reduce their damage.

Investment Shopping List

While it may be a long-time before a terminal bottom is hit, and more importantly recognized, one should start building a shopping list. There are two categories that appear to be worth examining: common denominators and the not yet dead that are still working.

Common Denominators

At times it is difficult to pick a potential winner out of a crowded sector. I have followed two approaches on this issue. 

1. The first is to find a sound sector manager or fund to make individual choices. The problem is that manager’s need to diversify, resulting in too many choices. The second is to find one or two stocks that capture most of the future expected benefits. Two common denominator stocks in the financial services industry are Moody’s and S&P Global (already owned). Internal developments and acquisitions should capture additional business. These are to be put on the hunting list and should not be bought today, they are already more than adequately priced.
2. The second approach is to look at the non-winners in the current market to see if the sick/dying corpses have elements that will blossom in a new market. I use the multiple of current price to sales as a primary initial filter. Four large companies that could have something to value, in order of their price/sales ratios, are: 

Corning (2.55x)

Intel (2.49x)

IBM (2.15x)

HP Enterprise (0.78x)

HP Inc (0.64x)

I am sure that there are others, and they should be researched.

Subscribers: Please share your thoughts and suggestions. We unfortunately will have some time before we select new holdings   to new heights. However, it takes a lot of time to get to know new names and get comfortable with them, after what may be an unhappy period. 

  

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

https://mikelipper.blogspot.com/2022/02/building-long-term-investment.html

https://mikelipper.blogspot.com/2022/02/changing-focus-in-changing-world-weekly.html

https://mikelipper.blogspot.com/2022/01/things-are-seldom-what-they-seem-weekly.html

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

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

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Adjust Investment Tools for Next Phase - Weekly Blog # 667

 

Mike Lipper’s Monday Morning Musings

Adjust Investment Tools for Next Phase

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

As Rules Change, or are Better Interpreted

For many years to the extent possible, I managed the Defined Contribution Plans for the NFL and the NFL Players Association. At the time of each Super Bowl, when asked which team I was rooting for, I replied “for those in the black and white uniforms”. I hoped the officials would see all the relevant plays and correctly interpret the changing rules of the game. As it turns out, that was good training for watching the constantly unfolding investment games between buyers and sellers, various regulators, shifting weather conditions, injuries, mistakes, and pure luck. None of the results were pre-ordained and would be argued about for many years into the future. I approach each market and market phase with the same weariness in preparing for the next market phase. Part of the preparation is examining the terms used to describe the game, and when appropriate improve definitions. This exercise may be particularly important this year, as it appears we are close to a crossroad.

Enthusiasm vs Crumbling Underlying Structure

Many global stock markets are rising in February, despite the historical odds that after a decline in January there is only a 22% chance that the remaining eleven months will produce a profit. The general media, revealing their political views, interpret the various executive orders and other political pronouncements as accomplishing their goals, and see an economic expansion beyond the release from the lockdowns. It could happen, but the odds of complete success are unlikely. 

The current small-cap +5.03% and emerging market +3.07% leadership in January is like other late stages of the past. Fixed income funds often lead equity funds in terms of direction. For the year through Thursday night, the average S&P 500 Index fund was up +3.16% vs -2.95% for the average General US Treasury mutual fund. Another worrisome note is the size of margin debt, which perhaps due to short squeeze actions has reached record levels.

A good investor should look beyond stock prices to see a different economic view, which I attempt to do. Large futures speculators are increasing their shorts in copper, Eurodollars, S&P 500 minis, emerging markets, and US Treasury bonds. In recent blogs I mentioned the Industrial Price Index rising compared to a year ago and this week it accelerated to a gain of +33.18%. The bond market recognizes these tensions and the yield curve has continued to steepen. Even the Congressional Budget Office sees that inflation will likely be over 2% by 2023. (My guess is that it will be a lot sooner, raising the cost of financing the politically generated deficit.)

Understanding the Tools of Security/Fund Selection

Headline writers and many marketeers prefer short words to describe complex tools, e.g., “growth” and “value”. These create good pictures or charts, with ever rising growth and ever declining value. Would it be so. As with the changing weather at a football game, conditions change, as do the useful definitions of terms. 

Speculators essentially bet on what others will pay for their shares, bonds, or loans in the future and a successful speculator primarily knows his/her markets. An investor is a partial owner of a company that at some point could be purchased by a knowledgeable buyer. It has been the motivation of buyers and sellers in marketplaces around the world since recorded time. Perhaps in response to the “great depression”, securities analysis became a separate academic subject, distinct from older economics courses. 

Benjamin Graham was a successful analyst/portfolio manager/investor. He was also a good writer as an adjunct professor at Columbia University and worked with Professor David Dodd in writing the first textbook on Security Analysis. Graham and Dodd were primarily interested in avoiding unnecessary investment losses in their writings and emphasized the use of financial statements, particularly balance sheets. In early editions of their six-edition book, they emphasized anticipated liquidating value, an issue appropriate during a depression.

While Ben Graham is often erroneously called the “Father of Security Analysis” and the first value investor, this is not where he and his partners in a closed-end fund made most of their money. The fund became a dominant shareholder in an insurance company which had no real equity left on its balance sheet. What it did have in this period of substantial unemployment was a customer base of relatively low wage employed government workers. They saved and ended up controlling Government Employees Insurance Company (GEICO), which Warren Buffett analyzed and eventually bought outright.

Years later I personally had the honor of taking the Security Analysis course under Dave Dodd, but I disagreed with him and believed that growth was an important factor in choosing investments. He  quickly shut me up by indicating how much money they had made on their investments. Years later, as a small entrepreneur, this led me to include growth and more importantly the evaluation of key people in making successful investments. (In evaluating three cases, one had to be closed, another was key to a bigger product, and the third was very successful). As a side matter, I was particularly pleased to receive the Benjamin Graham Award from the analyst’s society in New York for a private matter requiring some investigative skills a few years ago.

Today, when I review financial statements, particularly the footnotes, I have little confidence they will reveal the “true value” of the company. We live in a litigious world and accounting practices are designed to protect the accountant, the underwriter, or the company itself against lawsuits, rather than to ascertain value. However, there are some very good analysts that are pretty good at finding the range of values for a company. These analysts don’t publish their work, as they are employed by investment bankers, private equity funds, or serial acquirers. While they don’t publish, the price of their bids and deals are known, and this sets the market price for similar deals. If I can’t get enough data, I use the multiple paid for earnings before interest, taxes, depreciation, and amortization on successful bids. 

To understand value investing, one needs to understand where the current market is and what is best indicated by the price of deals. These in turn are influenced by the level of interest rates used to discount future growth and the cost of acquisition.

How to Measure Growth

Many believe that any number larger than the previous number is growth. For valuation purposes however, what is useable are growth comparisons. They should deduct inflation, exclude acquisitions, currency changes, and the impact of changes in regulation or competition. To me, each period may be different, so a long period growth rate can be misleading. 

I like to see the consistency of growth rates. There are times when highly variable growth rates leading to above average long-term trends are valuable and times where a more consistent return is more valuable, particularly for accounts that have finite payments requirements. (For mutual funds, we measure both total return and consistent returns.)

What about both Growth and Value?

In truth many companies go through periods of growth and value. IBM, before it changed its name and was under Tom Watson’s management, had so much debt that it was viewed as an underwater stock. Years later, it became the prime example of a growth stock and later still its growth slowed to the point where at times it was viewed as a value stock. Because of various recent changes I don’t know how to characterize it. What I do know, is that past financial history is not of much use to an outside investor. 

Since many companies go through numerous growth and value changes, I favor looking at many periods. However, it is more important to look at changes within the company, including the people hired at the senior and entry level, changes in product/service/prices, and the reaction to competition/regulation.

Conclusions

1. Look at how things are, don’t overpay for history.

2. Expect surprises!

3. Take partial positions initially.

4. Admit mistakes quickly and serially.

Your Thoughts?

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

https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

https://mikelipper.blogspot.com/2021/01/contra-messages-weekly-blog-664.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 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Be Thankful for Risk - Weekly Blog # 498

Introduction

In the northern Hemisphere, this is the season of festivals to celebrate the gathering of a good harvest. In the US, we recognize this tradition as Thanksgiving. World Stock Markets have been quite kind to investors so far this year as seen through the eyes of mutual fund holders using category averages and highlighting some exceptional performance:

US Diversified Equity Funds	+14.34 %
Sector Funds.	+9.76 %
World Equity Funds	+16.73 %
Mixed Assets Funds.	+11.25 %
Domestic Long Term Debt	+3.51 %
World Equity Funds	+7.65 %
LeaderGlobal: Science&Tech	+46.84 %
LeaderPacific: Ex Japan	+38.22 %

Source: Lipper Inc., a Thomson Reuters Company.

If the calendar year ended last Thursday night these results would be above average on a historical basis but shows that investing in Asia and in global science & technology issues has produced extraordinary results.

Performance Always Comes With Risks

Investment history is a tale of gains and loses with hopefully some lessons that can be used in the current time frame. This last week we had an example of very long-term rewards from investing in the auction of Leonardo da Vinci’s painting of Salvator Mundi for $450 million. In the Wall Street Journal, our friend and columnist, Jason Zweig made a good attempt to quantify the painting’s return, from presumably its first sale to this week. By his calculations after an attempt to adjust for inflation using gold as a very rough measure, the annual return since the sixteenth century was an outstanding 1.35%. But even this, by today’s standard low return, was better than cash, gold, and bonds, but not stocks. Another author has calculated the gain after inflation in the equivalent of the S&P500 since 1871 to be 6.9%.

There are two important lessons from this data: 

• First, accepting risk can produce better returns than perceived safer investments. 

• The second that the $450 million price compared to an auction house estimate of $100 million did not appropriately consider that this may be one of only 20 finished works by  the talented artist. Scarcity has a value

This is one of the reasons we favor individual stock selection over sector bets. This has implications for our fund selection process of favoring funds with less than 100 positions and even a few under twenty positions over broad index funds or passive sector funds. To us differences do  matter.

Recently we have been reviewing reports on the 13F filings of a number of well-known investment managers. In an over generalization most seem not to have owned a lot of winners in the third quarter, but continue to own and enjoy good results from positions bought years ago. ⁺

+Email me at Mikelipper@gmail.com  for more info on our Timespan L Portfolios®

Whether we like it or not we are all risk takers anytime we get out of bed or cross a street, let alone make a long-term investment decision. In an over-simplified model any portfolio’s strategy can be summed up as capital preservation or capital appreciation or for most, a ratio of the two. In the above model of comparative returns to the value of Salvator Mundi’s portrait, it is important to note the better performance of the painting over cash, gold, and bonds. To me there is a quotient of risk in all three of the under-performers that has been viewed as “safe.” For example, cash is not protected against inflation, particularly the virulent type that has been seen periodically through history. In addition while most of the time the costs of holding cash on account is small, and with minor custodian risks, both have been known to create anxiety for cash owners. Perhaps the biggest risk in holding cash is a dramatic change in the needed use of the cash to meet needs. If these are true for cash, similar risks may be present in other “safe assets.”

At this time holding US Treasuries could be more risky than generally perceived - based on two bits of news not generally appreciated. The first is analysis by Merrill Lynch echoed by others, that Treasuries are the most crowded trade in the market. This suggests that there is a supply/demand imbalance with some of the participants not exercising price discipline which may explain why the yields on US treasuries are higher than agencies UK, German, and Japanese issues of similar maturity and perceived quality.

The second and perhaps related bit of news is an article headlined from the Financial Times which said “US Treasury dealers accused of collusion.” There are similar, other cases pending. The results of these cases one way or an another could cause disruption to not only the market for US Treasuries, but also to many markets that use treasury prices as benchmarks in setting the prices for other instruments and markets.

Accepting Intelligent Risks Can have Its Rewards

Obviously not every single risk works out for long-term investors, but many do.  The key, particularly for our longer term investment accounts is in careful selection of mutual funds. Two of the matrices that we study are prices and related valuations plus the underlying selectivity as evidenced in the portfolios of mutual funds. Currently we appear to be in a two-tier market with a couple handful of good performers becoming price performance leaders. This not true for a second tier.

One study points out unlike in 2000 the fifty largest companies in the S&P500 were selling at 31 times earnings. Today the fifty largest is selling at 17.9% which is generally in line with historic records. One explanation for the high valuations of some stocks is the Charlie Munger belief adopted by Warren Buffet that it is better to “buy a wonderful company at a fair price than a fair company at a wonderful price.” This philosophy depends on the ability to find wonderful companies at fair prices. In my mind, this is dependent on sound and smart investment analysis. A good investment analysis course could be taught exclusively on the wins and losses in Berkshire Hathaway’s^* history. Recently they have been reducing a large position in IBM which perhaps has not yet developed into a wonderful company and have been buying Apple*, still evolving as a wonderful company. While Berkshire is a very long-term investor in a number of securities, it is price sensitive, currently sitting on $110 Billion in cash and $180 Billion in investments.

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

Conclusion

Accepting the risks of disappointing results from time to time does not diminish the odds in favor of long-term gains. One needs to balance the goals of capital preservation and capital appreciation. The ratio should

probably shift inverse to near-term market performance.

Question of the Week:

If you were forced in terms of your own account how would you divide your portfolio into only two buckets between capital preservation and capital appreciation and is the mix different in your professionally managed accounts?

Can You Blame Your Investment Model?

Introduction

Every moment of every trading day we are confronted with the question, “Do we buy, or sell, or just rearrange?” While one does not know exactly when the next major investment peak or bottom will be, almost all of my time should be spent on how to function between these extremes. Nonetheless, since the actual future turning points are not known, I probably should not expend a great deal of intellectual energy or emotion focusing on the search. If I have this discipline it puts me in a minority of those who make statements about the market. Perhaps my investment accounts and I are benefiting from this redirection of my emotion and mindset. Nevertheless, most of us operate in a relative performance world, my performance will be judged as how it compares with how others perform. Thus, I need to grasp how other investors, particularly institutional investors, view the market. As Hylton Phillips-Page, our firm’s VP of fund selection and I have frequent discussions with both mutual fund portfolio managers and some of their investors, I am struck that most of these chats revolve around  “the market” in general, or the price of a particular stock is expressed as a ratio of the current price to some other variable. Most of the time the managers believe they are buying and owning at some attractive discount to the larger variable. In other words they have a model which is generating a distinct benefit for their investors.

Experience as The Model

What I have learned from the Neuro-economics professors at Caltech, (where I serve as a senior trustee) is that when most are forced to make a judgment, the brain reviews its experiences. If the experiences generated pleasure it was good and thus similar situations will also be judged as good. Having been essentially a student of investing not only through my life but also of others over history where I can get some historical insight, I see a particular pattern emerging.

Most of the time prices move gradually. Often at the final run up or collapse one can divide professional investors/traders in general by age categories. Whatever driving enthusiasm is largely supported by the young, who view the then current offering as new, different, and wonderful will be the opposite of their older brethren that distrust the surge as it looks suspiciously like past problem-producing situations. Thus the more experienced players don’t participate until the parabolic price move that comes just before the turning point. Some of the more experienced players can’t stand missing out these “goodies” and need to defend themselves against the arrogance of the newly rich. (The same pattern occurs on accelerating declines to a bottom when the twin views that the world is coming to an end and/or prices fail to reflect the survival realities.)

I have noticed throughout my career that many formerly successful investors miss out on “the new thing” because the load of their experiences reminds them of past failures from over-excited enthusiasm. One of the advantages of investing through medium to large mutual fund management groups is that they often have bright analysts and portfolio managers, some with a great deal of successful experience and often, younger ones that perceive greater futures. In assembling a portfolio of mutual funds we choose some of each.

Which Past is Relevant?

To choose as the statistical base for a predictive model we have recorded human history, derived history from scientific sources in addition to yesterday’s news. I suspect we could do far worse than being guided by The Bible. It tells of seven fat years followed by seven learn years, currency manipulation by rulers, collectible and uncollectible taxes, famines, wars, disease, population growth and immigration, etc. While no one has proven that these lessons are not still applicable, we have chosen to shift to statistical measures. Most often we rely on government produced statistics. Since I have met some of the tabulators and understand how they gather data,  I have always had a jaundiced eye on their product. That is even before today’s fully expected (by me) article in the New York Times about groups of government employees developing “slow walking” strategies showing their opposition to the new Administration.

We measure our deficit, that will undoubtedly grow, as a % of our GDP which is an output measure not a wealth measure. As a matter of fact the government’s main view of the population is derived largely from aggregating tax returns. I ask how many of our readers attempt to show the largest income and the least expenses?! Further, often as people get older their wealth grows and in retirement it is their wealth not their income that motivates them.

Another source of questionable value is reported earnings of public companies. When evaluating a possible acquisition of a public company the excess assets and the operating business are separately evaluated. (I sold a data business’s operating assets, not the company and its balance sheet.)

One of the more popular valuation metrics is averaging the last ten year’s reported earnings. This is in contrast to my first lesson from Professor David Dodd, of Graham & Dodd, which was to restructure both the balance sheet and income statement to put them on a comparable basis with other companies that could have been investment candidates. Many models are based on industrial sectors as defined by either the government or a major credit rater. Over the years both IBM and Apple^* among others have been shifted from sector to sector. I suggest that if one wishes to be long or short either of these securities, it will not be because of different statistical ratios with whatever industrial sector someone places them.

^*Held personally.

We are in a New World

I am well aware the typical reason given to buy a security that is historically over-priced is, according to the salesperson, “This time is different.” To some extent that could be right today in that we have entered essentially a new phase. In the past the leading countries were growing in population and wealth. Often they were clearly technological leaders. In the United States, China, Japan, and developed Europe, the size of the work force is declining relative to their total populations and all are experiencing growth in seniors. (This may inhibit the new Administration’s ability to grow the US labor participation.)

Interesting that some have looked askance of my announcing our firm’s smallest new commitment to a fund that invests in the Middle East and Africa, because of favorable demographics, savings rates, and progress in their educational institutions. Based on current trends it is only a matter of time that Africa will house one quarter of the world’s population.

We are now living in a world where farming and manufacturing are becoming smaller relative to the growth of the service sector. (Service sector includes financial services which is experiencing growth from traditional sources but also new entrants and technologies. Unschooled farmers in Africa are daily monitoring the price of their commodities on cell phones. The fastest growth in the financial sector is in mobile finance and banking.)

The world is facing the integration of currencies, taxes, trade and military policies. One should expect that in the future we will understand the difference between schooling and useful education.

Do I Have a Model?

The simple answer is no. But I have a process to benefit and protect my investment responsibilities. First, I attempt to get our accounts to utilize the TIMEPSAN L Portfolio^® approach which addresses the importance of getting the future right. The shorter term portfolios live in the world of the present whereas the longer term portfolios are more future oriented. Since we use funds from a number of the leading investment organizations each has their own views of the future, they will change over time.

My model essentially leans on the investment lessons that have been learned over the millennia and watching what smart commercial and investment professionals do with their long-term money.

Question of the Week (or perhaps the year): What Model Drives Your Investments?  

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A. Michael Lipper, C.F.A.,
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