TIME TO PRUNE? - Weekly Blog # 746

 

Mike Lipper’s Monday Morning Musings

 

TIME TO PRUNE?

 

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

 

 

 

Season & Direction

Many businesspeople and some investors normally consider changing plans in September, focusing on the ends of December and January. Many will include the results of the mid-term elections in their timing decision.

 

Some merchants will focus on the end of January, which ends the retail trade year. With possible inventories out of balance and some uncertainty over shipments, particularly from Asia, there is a premium on having the correct inventories to sell quickly, utilizing a diminished senior sales staff.

 

Like Charlie Munger and Warren Buffett, my preferred holding period is forever. In my humble experience, there are times when it is wise to consider pruning the portfolio. Since the earliest investors were farmers, periodic pruning was normal. Even the best portfolio managers follow professional gardeners and prune their portfolios. A good portfolio is more than an accidental collection of securities. A sound portfolio should work well in most non-extreme markets.

As a contrarian I do not accept we have entered a new “Bull Market”. I believe a new market cycle begins from a prior market’s beginning point. In this case, from its prior peak. What we are currently experiencing is a normal rally in a “bear market”. The main reason for this belief is that we have not even begun to address many of the causes of the last bull market’s problems, other than simply prices.

 

I regularly admit that I can be wrong. I urge investors to keep their pruning instruments handy on the chance that I am correct and equity markets decline. Pruning is a necessary tool for the survival of successful portfolio managers.

 

The Need to Prune

The reason one prunes is that it is an essential first step in repositioning the portfolio. The timing of the decision is not necessarily dependent on knowing what to add to the portfolio immediately.

 

There are two motivations to prune. The first is to reduce the level of panic when the market is in freefall. The second, which may not come from the first, is to build a buying reserve. Opportunities are easier to judge when one does not have to decide what to sell before you buy.

 

Voluntary & Involuntary Pruning

Since we have established the necessity to prune, the first way to do it is by the calendar, and the second is by the performance of the market.

 

I have already suggested a calendar prompt, which may be particularly apt in this troubled year. Using September as a month to make financial decisions may make unusual sense. It is the end of the US federal fiscal year and the beginning of the fall shopping season.

 

Some pundits are saying we have entered a new “bull market”. However, history suggests that a new bull market is usually led by new groups of stocks.  The current leaders appear to once again be large-cap technology growth stocks. Going back to the old leaders suggests many of the pundits are failing to look for new leaders, ignoring many fund managers signaling caution.

 

One quick filter that could suggest candidates for pruning is measuring the growth of operating earnings between pre-COVID 2019 and 2021. If these operating earning did not rise 10% or more, an analyst should question a replay of old leadership being conducive to doing well.

 

There are other filters such as evaluating whether the management of competitors has deteriorated or improved, and/or whether price and volume has materially changed. The key is to find some reason to do what racetrack handicappers do, which is to throw out a particularly bad race in assessing the future.

 

I have been a beneficiary of the involuntary pruning of positions held for some time, which made me question why they were continued to be attractive. (Please do not treat these examples as recommendations, which should only be made based on client needs and temperament.) The following discussion of five occurrences result from my background in the financial services industry, although the lessons can be profitably used in other sectors too.

 

ADP>CDK Global

I recognize my investing should be broader than the more familiar targets of mutual fund management companies and broker/dealers. Automatic Data Processing’s (ADP) historic basic business was relieving companies of their payroll processing and payment responsibility. They replaced commercial banks who initially dominated the field. ADP had superior data skills and a lower cost structure. They also learned the wonders of “free float” from Warren Buffett. Earning short-term interest on the payroll account. Since I was convinced the number of payrolls in the US were in a secular growth pattern, this stock was a good “common denominator” base position for a financial services fund.

 

As is often the case when one buys a good company, there may be a “kicker” in the purchase. ADP purchased or originated other financial services activities. but As good as many of these were, they were not as productive as ADP itself. Their usual approach was to spin-off these companies to their shareholders, and a number of good ones went public.

 

One of these spin-offs was CDK Global, which provides data services to automobile dealers, automating their sales and service appointments. The number of individual auto dealers has been dropping and the number of larger multiple brand dealers has been growing. (Berkshire, Alleghany, and the Washington Post, among others, are aggregators.) As CDK’s European business was in the process of being sold, its US activities sold separately at a good price. Thus, we involuntarily had a cash infusion during the “bear market”.

 

I kept ADP, who used its strong connections providing payroll services to assist clients in their hiring of financial services and other specialist. By the time this pattern became visible, they were already developing the business of “renting” employees to their clients and others. Initially it was in the financial services business but expanded to other fields as well. This “PEO” business made continued ownership of ADP even more attractive.)

 

Little “Berkshire” Joins the Big One

Alleghany Corp was the old Kirby family holding company with a long history of owning interesting companies, including IDS the forerunner of today’s Ameriprise. Alleghany is largely an interesting collection of casualty insurance companies, plus a collection of minority interests in a wide portfolio of ventures. Alleghany’s capable CEO recently retired and was replaced by a former CEO of General Reinsurance, which was acquired by Berkshire Hathaway. Alleghany is very familiar to Berkshire, so it was an easy decision for Mr. Buffett to make a cash acquisition offer for Allegheny to close later this year, at a record price. (No competing bid came in!)

 

Aetna>CVS Health and Eaton Vance

Two other holdings got new owners through a stock deal because they recognized a major change in the natures of their businesses.

 

As a newly married young US Marine Corps officer I purchased a life insurance policy. When I entered the financial services field, I realized I had bought the wrong product from Aetna if I didn’t die early. Years later it became clear to me that the cost of selling insurance was too expensive. Aetna’s management saw the same thing. They realized the healthcare industry had much better prospects, as did their competitor Cigna. Aetna bought the larger CVS drug store chain. By combining its healthcare funding and processing capabilities with the store fronts. It then put medical professionals in the stores. and They were better addressing the needs of the public than by serving each of them separately. (In previous blogs I mentioned three major sectors growing less efficient and not doing a good job: schooling, defense, and healthcare. CVS health is addressing some of the issues involved with the latter, which is one of the many causes of inflation and lack of growth.)

 

Eaton Vance is one of the oldest US mutual fund management companies. They have been one of the more innovative management companies developing new vehicles for institutional and individual investors. But the game has changed. Their original base was being one of two Boston based investment advisors dealing with rich clients and offering funds for the related but less wealthy retail accounts. They sold their mutual funds and closed-end funds through commissions salespeople at major brokerage houses. The business changed with individual brokers restyling themselves as wealth managers, earning annual fees rather than commissions. These wealth managers have inserted themselves between the fund complex and the ultimate client. This has had two effects. The wealth manager feels compelled to prove his/her worth by having an opinion separate from that expressed by the asset manager at the fund company. All money management accounts lose money for the provider of investment services on day-one of the relationships with the client. The client moves into a profit position with the asset manager over time. There is less effort in managing the account than getting it. In practice, the money stays with the wealth manager for less time, so the economic value of the relationship declines. In addition, Eaton Vance’s competitive strength is in sophisticated fixed income and tax managed products. With interest rates going lower, their book of business was becoming less profitable. A merger into Morgan Stanley locked in their largest wire-house distributor and opened international distribution opportunities.

 

Thus, each of these involuntary prunings helped the owners of the accounts I manage.

 

Weekly Insights

1. The US Treasury inverted yield curves persist, with the 2-year yield higher (3.257%) than the 10-year (2.848%) and 30-year (3.117%). The bond market still sees a recession.
2. In a volatile week, the best performing mutual fund investment objective was Natural Resources +8.24%, with General US Treasury -2.36% being the worst for the week ended Thursday.
3. The weekend edition of The Wall Street Journal tracks the prices of 72 stock indices, and index funds, commodities, and currencies. 93% were higher, catching Friday’s exuberance. The two that generated losses of 1% or more were the WSJ Dollar Index -1.05% and the Russian ruble -2.77%. Both could be of significance.  

 

 

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

https://mikelipper.blogspot.com/2022/08/investors-politicians-other-children.html

 

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html

 

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.html

 

 

 

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Beware of Cheap, Seek Fair Slowly - Weekly Blog # 743

 

Mike Lipper’s Monday Morning Musings

 

Beware of Cheap, Seek Fair Slowly

 

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

    

Current Conditions

This coming week we will get the Federal Reserve’s view of the appropriate level of interest rates. Much of the focus will be on the interest rate number. Far less attention paid to the cause of the action. Without understanding the causes, it is difficult to comprehend whether the resultant rates and other measures are going to have the desired result.

 

Not discussed is what I am labeling the “Politicians’ Put”. Where politicians avoid responsibility for causing harm to people’s income, jobs, and capital by making the Fed and Administrative State Commissioners responsible. There is precious little evidence that the Fed and various commissioners have any skills at predicting the future or recommending wise actions.

 

Part of the fallacy in relying on these individuals is that they tend to depend on numbers questionably put together. Too little attention is paid to the weekly local Reserve Bank presidents’ lunches with businesspeople and consumers. Some Presidents are better at asking follow-up questions than others.

 

I have seen the coming of the recession since last autumn. My source of information was walking various malls, talking with competent people unable to find jobs, and employers failing to find applicants possessing the right attitudes. In many cases, the supply shortages were due to a lack of front-line labor and supervisors.

 

The following data is mixed in terms of future implications:

·      An inverted yield curve with the ten-year rate at 2.78% vs the two-year rate of 2.99%

·      The JOC-ECRI Industrial Price Index falling -9.5% vs last year

·      The Labor Force Participation Rate falling -5% vs 2000

 

Start Buying?

The sign a bottom price has been reached is often a surge in transaction volume, signifying massive capitulation. “While everyone is talking bearish, no one selling is being heard”. Stock transaction volume is mild, although bond transaction volume may signify capitulation.

 

In the weekend Wall Street Journal (WSJ) there is a headline titled “Business Activity Declined Sharply”. In addition, showing the US and Global purchasing managers index dropping to 47.5 from the prior week’s 52.3, clearly showing a contraction.

 

After a significant decline there is a burning question in the heart of every investor about when one should begin buying stocks? The question pivots not on timing, but price.

 

I have had the extreme pleasure and honor of knowing great investors over 60 years. The first is Charlie Munger, who taught Warren Buffett that it is better to buy a great company at a fair price than a good company at a cheap price. His belief is that a great company gets better over time, whereas a cheap price only goes up for a period.

 

Before John Neff created a great record with Windsor and Gemini funds. He worked at a midwestern bank where they evaluated corporate loan applicants based on their average earnings power over five years. He applied this process to stock selection at Wellington Management for Vanguard funds, which helped his winning funds during bear markets.

 

One must be very careful applying the lessons of these two investor giants today. Some pundits are currently recommending so-called fallen angels. These are good or possibly great companies currently trading at depressed or “cheap” valuations. Current prices compared to last year’s earnings, or the last period of rising earnings is not particularly relevant. Particularly if we are in a recession that extends beyond a year. It is quite possible with future depressed earnings and today’s prices some stocks may be selling at record high valuations.

 

Depressed Earnings

There are two main causes for depressed earnings.

• A fall in demand for their products or services. As demand is a function of people’s attitudes, demand tends to fluctuate fast and cyclically.

• Companies investing substantial resources in future products and services will materially leverage current sales and earnings if successful.

I am following a few financial services companies in the second group. Their earnings are being penalized substantially more than their peers who have only cyclically depressed results in this downturn. My job as an analyst/investor is to attempt to select a company becoming a greater company, by accepting a bigger stock price decline than peers. This approach could lead to a different roster of candidates than held presently.

 

To some degree the relative size of a price decline is related to the nature of their shareholder base. That is why I tend to favor institutional quality companies, where a substantial portion of shares are owned by those relying on their own experienced internal analysts.

 

Question:  Have you changed your way of selecting securities due to the changing structure of the market.

 

 

 

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

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html

 

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.html

 

https://mikelipper.blogspot.com/2022/06/switching-prime-focus-weekly-blog-739.html

 

 

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Price Trends, Clues and Concerns - Weekly Blog # 506

Introduction

Bonds, stocks, and commodity prices are sending different clues while the pundits proclaim synthesized global economic growth. After thirty-six years of rising returns for fixed income, almost a decade of stock market gains, and commodity prices entering a new cycle, thoughtful market participants are confused. The one common impetus is growing confidence in decision-making. With more confidence investors are consciously or not accepting more risk because they are getting a somewhat clearer view of the future. As a contrarian, and often allergic to popular views, I have my doubts. I am not totally alone. Ian Bremmer of the Eurasia Group has said, “2018 feels ripe for a big unexpected crisis." My concern is that the growing confidence is crowding out a reserve for surprises, good or bad.

Inverted Yield Curve Fear

While it is true that the last seven fixed income prices declines came after the 2-10 year US Treasury yield curve inverted, I do not believe it is an immutable law of investment science. Nevertheless, it is a proper place for study. There is a similar pattern in the futures market when near-term investments are more expensive (higher yield) than long-term ones. What is important is that the market view is that the near-term future has more risk than the longer-term. Often this is right, but not always. Remember the surprise factor. In my opinion an inverted yield curve if and when it happens is more descriptive of current fears than predictive of long-term prices. Fixed income prices are set by supply and demand and are similar to the odds posted by book makers which are not the result of careful analysis but prices that will bring new bets into balance to keep the bookmakers’ capital risk into reasonable balance. The bookies and the bond market will lose out only if there are too many surprises.

The fears that there are oncoming inverted yield curves or other causes for bond prices to decline have been operating for the last few years. The biggest concern is not credit losses, but inflation. To service those who are concerned that inflation will rise above current levels, the US Treasury and others have created TIPS (Treasury Inflation Protected Securities) funds which are issued in roughly the same maturities as the other treasury paper. For more than the last three years the total return investment performance of the average TIPS fund is slightly better than the average intermediate US Government Securities fund. For longer periods the reverse is true. One wonders what the relative performance results would be when the reported inflation rate finally reaches or exceeds the Fed desired 2% level. It is possible that our and others are from time to time paying premiums to buy inflation protection and this is why the TIPS funds perform better rather than their pricing mechanism?

If one is managing retirement capital accounts for those that are currently working, I would substitute 30 year treasury yield for the 10 year. (More on this later.) 

Individuals investing in fixed income securities or funds should separate the total return numbers between income (interest) payments and market prices. Inflation will not nominally impact the income stream, but may have significant impacts on both the prices of the bonds and the purchasing power of the proceeds.

At Caltech and other places studying how the brain makes decisions, they have found that most humans make decisions on finding past memories that coincide with current conditions. Every now and then, the occasional winner will see the current situations as sufficiently different than the past that they opt for a new strategy. In other words the preferred algorithms will give way to new thinking and actions.

Stocks Are a Confidence Game

Almost every prognostication from brokers, advisors, and commentators in terms of the stock market were expansive. Two recent examples display the enthusiasm for the stock market are as follows:

Extrapolating the first full trading week suggests that the S&P500 will triple this year.

Goldman Sachs believes that the Bull market should run for another 3 years.

“Investors Intelligence” tracks letter writers in its latest report in Barron’s; 64.4% are bullish and only 13.5% are bearish. In approximately the same period the AAII weekly survey showed a significant reversal in their volatile report with the bulls declining to 48.7% from the prior week’s 59.8% and more significantly the bears gained to 25.1% from 15.8% the prior week. The AAII sample shifts each week which could have caused the changes and this week some were more worried about the impact of the bond market or were reaching to political news.

Commodities are Active

Based on perceived increasing demand from China and rising demand from US manufacturers, industrial metal prices are rising. In a classic example of a surprise, the price of oil touched $70 a barrel this week and there is a press story that some expect the price to reach $80 this year. In response, over the last four weeks the best performing mutual fund investment average is the Natural Resources funds, up 12.66%. As a contrarian and a long-term investor I am wondering when the increasing population and shrinking farming land will be seen in rising prices for grains. This hasn’t happened in a long time.

Very Long-Term Outlook

The latest available estimate of the global retirement savings gap in 2015 was $70 trillion and by 2050 it is estimated to be $400 trillion. Thus, in only 35 years there is a need for over five times more capital to be invested for retirement. (This is why I suggested using the 30 year yield for the spread calculation.) How should one invest to meet this long-term need? I do not believe that today one can evolve a consistent investment policy to meet these needs. My contrarian nature suggests that it may be easier to identify what not to do. The average S&P500 mutual fund beat 90 out 96 mutual fund investment averages for the last five years and 84 for the last ten years. I don’t think that will continue. The best performing hedge funds in 2017 were invested in large caps and securities driven by momentum (FAANG + 2 from China).  Different strategies at different times will be needed to avoid losses and achieve gains. This is why I believe that a portfolio of different funds or managers is the most prudent for the long-term.

Question of the week: What are the most prudent strategies for the long term?

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Contact author for limited redistribution permission.