Critical Decisions: Successors, Appreciation and Preservation - Weekly Blog # 523

Introduction

The combination of long flights and attendance at the Berkshire Hathaway* Revival meeting has led me to think more prominently about the structure of successful investment processes. I have often said that if one slashes the wrist of a securities analyst (even before they become portfolio managers), a historian will bleed.

I have been thinking about the failure of the conqueror of the ancient world Alexander the Great, whose key lieutenants were for the most part bad successors. In contrast, I compared that result with today’s most profitable company, Apple* and the succession of Tim Cook to the product/service genius Steve Jobs. (This not a prediction as to the future of Apple or its shareholders.) Currently we are in the public succession disclosure phase of the distinctive leaders of two companies: JPMorgan Chase* and the aforementioned Berkshire Hathaway. I believe both successful and less successful command changes should be studied in terms of responsibilities for our families and non-profits we care about.
*Held in client and/or personal portfolios

The Wrong Instincts

I have sat on a number of non-profit boards officially or observed them as their external investment manager. I have noted a number of habits that usually led to long-term sub par results. Choices are made by committee which tends to favor the politically skilled candidates. Frequently it is deemed important that the new leader get along well with the existing staff. Often what is needed for optimum survival  is to either seriously remove staff or materially change their way of thinking and executing. This is particularly true for academic groups where the new person is meant to solve the single biggest short-term problem facing the institution without upsetting too many of the existing “warhorses.”

Another road to failure is setting up a competitive horse race. Not to say that the best person not often wins, but all too often some of the better people leave in disappointment, which weakens the firm even if the best person wins. Unfortunately, we have seen this approach in financial organizations. Just think of the number of CEOs that have come out of GE and a number of leading brokerage firms. The same thing happens with both non-profits as well as families.

Successful Patterns

When Steve Jobs recognized that his deteriorating health would lead to the need for a new leader he chose Tim Cook. He was not a “product guy” like Jobs, but was the master of the supply chain manufacturing and selling all the wonderful new products that were dreamed up by Jobs and his tight design crew. Further, Jobs told his appointed successor not to do things they way he (Jobs) would do them, but the way that made sense for Tim Cook. Under the successor, the shareholders (and I presume the Job’s estate) have seen their assets multiply a number of times. I suspect that Steve Jobs’ thinking was in part shaped by having been fired from Apple in 1985 to avoid taking it into bankruptcy. Luckily he learned a lot with new responsibilities and was better prepared to be Apple’s CEO the second time.   

Selecting Two American Generals

We have benefited from two US Presidents making controversial decisions to lead our Army at critical points. President Abraham Lincoln chose a cashiered Ulysses S. Grant to lead the Union forces through a brutal campaign, first in the Midwest and then the South. Grant who graduated from the US Military Academy at the bottom of his class, accepted the surrender of Robert E. Lee who graduated at the top of his West Point class and is generally believed to have been the best general of the Civil War era. Lincoln’s selection of Grant was key to the eventual Union victory.

When it came to choosing the commanding general for the US-led invasion of Europe, President Franklin Roosevelt turned down the highly respected, most senior Army officer General George Marshall

(later a brilliant Secretary of State) in favor a much younger and junior officer, Dwight Eisenhower. I suspect FDR’s thinking was shaped by the fact that for a number of peacetime years Eisenhower was on the staff of the very difficult, but brilliant General Douglas MacArthur, who not only graduated at the top of his West Point class but also returned to the Academy as superintendent.  I believe that the President felt that if Eisenhower could get along with MacArthur he could work with the difficult British Field Marshal Bernard Montgomery. Being a politician himself, Roosevelt recognized the importance and skills of another politician.

People Skills Part of Asset Allocation

Warren Buffett believes his greatest contribution to the success of Berkshire Hathaway is making major asset allocation judgments. Beyond the required investment skill to make these decisions, he has the ability to “sell” his decision both internally within the firm, and also to his outside audience which he does very well. In looking at these decisions, with the help of Charlie Munger, he uses both capital appreciation and capital preservation strategies in building Berkshire Hathaway for the next generations of owners. While Buffett likes to portray Berkshire as a long-term thinker, he can afford to do that as long as he has a bountiful supply of cash or short-term paper.

With Warren Buffett and Charlie Munger as models, the approach that we recommend to prospective clients is based on our Lipper TIMESPAN Portfolios^®. For illustrative purposes only we have divided an institution’s or individual’s portfolio into four unequal timespan sub-portfolios. Each portfolio is assigned a portion of both capital appreciation and capital preservation securities and strategies which can be modified if conditions and specific needs dictate. The following table is illustrative and can be modified when required:

Lipper TIMESPAN Portfolio®	% Capital Appreciation	% Capital Preservation
Operational (Short-term)	25%	75%
Replenishment (Cyclical)	50%	50%
Endowment (Present lives)	60%	40%
Legacy (Future Lives)	80%	20%

Source: Lipper Advisory Services, Inc.

Please let me know how you would allocate resources for which you feel responsible.

N.B. One of our long-term subscribers who is both an accomplished mathematician and a successful money manager properly called to my attention that I gave the late Stephen Hawking a Nobel Prize that was not awarded to him. Further he reminds me that his theories were never confirmed by measurement. I plead guilty of being in awe of him as a person and the work he did at Caltech.

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A. Michael Lipper, CFA

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Moves For 8 Months and 8+ Years - Weekly Blog # 520

Introduction

Probably the single most common investment mistake is to have a single portfolio to meet multiple needs. My suggested cure for this malady that has to leave investors not fully addressing needs is to divide the single portfolio into sub portfolios to focus on specific timespans and their funding needs. Thus, when I look at investing my first focus is on the desired cash flow to meet beneficiary needs in specific timespans, (Lipper Timespan Portfolios^® ).

Today I am focusing on the probabilities for the rest of this calendar year or about eight months. I am also looking at a period of recovery in stock prices after the next recession, which the strong odds will come about over the next eight or so years. Finally, I am looking to the period beyond my personal control or influence on various investment committees in terms of replacing very successful investment managers after a long period of successful and faithful performance.

The Remainder of 2018

As of today the only thing that will come out of the 2018 US mid-term elections is more words about the implications for the 2020 elections and some legislation in 2018 which will probably be wrong. Thus stock prices at the end of the year will probably reflect largely what is known today. One of the advantages of learning security analysis at the racetrack is first to identify the most probable result of a future race. This leads to picking the favorite (which almost always is confirmed by the lowest payoff if correct).

My nomination for 2018 is that we have seen both the high and the low for the year in the first quarter. This would result in a gain or loss of somewhere close to half of 2017’s gain. In this case I suggest that there is a 50% chance that we have seen the high and low for the year already. The remaining fifty percent could be divided in half again with a 25% chance that we go through the last top of the market and/or we retrace the gains of 2017. If one combines the most likely 50% with a new high or 25%, this would produce a 75% chance of a satisfactory return for most investors completing ten rising years.

Probable Causes for 2018 - Gains

Frequently I have referred to the weekly survey conducted by the American Association of Individual Investors (AAII) which is very volatile in part because its sample size is small. In the latest week 37.8% were bullish for the next six months, 33% were neutral, and 29.2% were bearish, as opposed to 42.8% being bearish two weeks ago. Stock markets don’t go higher when all the available money is already committed. A major brokerage/wealth management firm is suggesting its clients should sell into any rise.

Another source of cash is investors adding to their account into a rising market and the market is rising. Each of the three major stock market indices have the very same looking chart of a narrow rising channel starting from the February low points. If upside price momentum starts heating up, the old highs could be challenged. (While my clients and I would enjoy these gains, in a contrarian view breaking out of the old high could suck in all or most of the available cash and that would eventually lead to a major decline.)

Probable Causes for 2018 - Losses 

A couple of weeks ago the Masters Golf Tournament concluded with a new young champion, Patrick Reed. His win verified the old expression, “You drive for show, but you putt for dough.” In a similar fashion, stock price movements are what gets the crowd’s attention, but in the fixed income marketplace winning is achieved by avoiding losses. 

Traditionally fixed income is a seemingly dull game for the professionals. While individuals may buy bonds they often hold them to eventual maturity. They don’t trade them. Also they rarely pay attention to credit instruments such as loans and mortgages. Not only is the total fixed income market larger than the stock market in most countries, it is the source of financing of governments and large corporations.

Compared to equity returns, most fixed income instruments trade off their promise of periodic payments of interest and principal return versus lower average total returns on stocks. However, various trading organizations have leveraged their fixed income investments with borrowed money, usually from banks or the credit markets. Whenever leverage is used a small price decline can shrink the value of an investment to a leveraged owner.

Most brokerage firms, bank trading desks, and some hedge funds use leverage to support their fixed income investments. The origin of most stock market declines is a reaction to traders having their loans immediately called and their collateral holder immediately liquidating the collateral without regard for price. That is one risk. Other risks have been created by the central banks of the world that have manipulated interest rates down so much that investors have become desperate to find satisfactory yields. This has led to an expansion of the use of credit instruments beyond bonds. This has led to a situation, according to Moody’s *,  for the first time in recent memory outstanding high-leverage loans now exceed the outstanding amount of high-yield bonds.  In effect, leveraged credit investors are trading off their safety for yield. That won’t always work.

*An equity in our private financial services firm

In Europe and some parts of Asia, gold is a normal part of many conservative investors’ portfolio. This is not true for most US portfolios.  From my standpoint it doesn’t matter whether one owns gold or not, but what matters is what others are doing. A current buyer of gold sees trouble ahead. Each of us can probably create a list of future troubles. That doesn’t matter in terms of one’s own beliefs, what matters is when more people believe it. The way I follow it is represented in a chart that in the recent past depicted a high was established in September of 2017. Since January of 2018 there have been three attempts to meaningfully to supplant it. The chartists tell me that gold is in a rising triangle from a December bottom and could go through the 2017 peak on the way to challenging earlier higher peaks. If this were to happen I would be concerned as to equity and debt values.

Concerns of Jamie Dimon, Warren Buffett and Charlie Munger

Jamie Dimon at JP Morgan Chase plus Warren Buffett and Charlie Munger at Berkshire Hathaway have spent considerable time and thought about short/emergency and long-term succession. I am struggling to do so as well. I have sat on a number of non-profit boards who when faced with the need to relatively quickly replace a retiring CEO look for someone that possesses a skill set that the older CEO did not have and that seems to be more important than continuing the good attributes of the retiring CEO.

Since my professional responsibilities as well as family requirements have to do with the replacement of investment managers, largely of mutual funds, it appears easy to replace funds that are deemed to become poorly managed in their execution of their process, which is much more important than periodic poor investment results. What is difficult to do is to replace a successful manager such as the three gentlemen mentioned. No two people are exactly alike and future periods are going to be somewhat or completely different than the successful periods that we have enjoyed in the past. Do we search for a copy of the successful manager? Do we look for some one quite different? What are the missing skills that will be needed in the future that are not needed presently? How do we assess success? How long a trial period is reasonable, particularly if we enter difficult times? I would be greatly in your debt if you could send me an email or even a snail mail with some of your views to these questions.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Asset Allocation - Three Psychological Inputs

Introduction 

The psychological need of the investor is a major contributor to the dominant asset allocation chosen. This is a preliminary, hopefully useful insight in a world of over-simplification. Further it can be a useful aid in structuring timespan portfolios. For the moment think of an asset allocation spreadsheet with three psychological columns and four timespan rows.

The investment account needs to fill in the matrix below:

TIMESPAN	Income	Value	Growth
Now Operations Portfolio
Intermediate Term Replenishment Portfolio
Long-Term Endowment Portfolio
Longest Term Legacy Portfolio

                        TIMESPAN L Portfolios^®

Income

The oldest investment need is to meet critical expenses. For each investor these may go from the immediate need to put food on the table to obtaining the most expensive item of fashion which can be real estate, life style, breakthrough medical care or the latest gadget. The income need includes the cash generation from capital and capital itself. Enough income is in the end not a statistic but a feeling of well being.

The need for income may be immediate and/or a stream of cash for different timespans. For example, it may be high immediate expenses or future streams of payments requiring well covered cash generations. To the extent of long-term payments in a world of paper or electronic money, the impact of inflation should be considered as to the value of cash levels.

Most income driven investors tend to live very much in the present. They view loss of income as much more serious than a missed opportunity to enhance income and capital generation. They believe that they are conservative, but often they are taking into account only what is present and not the value of current and future income.

At prevailing interest rates on presumed high quality fixed income paper, investors are being pressed to meet perceived payment needs. This is particularly true for US foundations with a tax requirement payout of 5% over time. Currently, in most cases income investors are ignoring the present but low level of inflation. This is reducing the real value of both the spending and capital base.

Our preferred solution is to invest in established companies that have a long history of growing well protected dividends in good times and bad. Currently there are a number of these in the financial services field which we can discuss offline. In these cases I believe the income is secure and generally grows faster than normal inflation. The risk is in the fluctuation of the price of the shares. In many existing cases they are reasonably priced in terms of their intermediate- term outlook.

Value

Value investors really don't like making meaningful mistakes. Perhaps earlier in the investment experience they were exposed to big mistakes made by others or themselves. Their reaction to prevent future mistakes is to accept a well defined price discipline. They will often quote the two big investment rules:  Rule 1: Don't lose money and Rule 2: Don't forget Rule 1. This is the historic coda from my old professor David Dodd of Graham & Dodd fame. This strong survival instinct at times prevents them from buying into big opportunities with substantial risk of loss. They are just the opposite of successful venture capital investors that have more losers than winners but the winners are large enough (and then some) to make up for their losses. Because we live in an uncertain world, most often they own lots of securities to diversify their risks. 

Most of the time they are attempting to arbitrage the difference between current price and some standard of value. It is in the selection of this standard of value where the value investor tribe breaks into sub smaller units  or families. Many of these families use the various corporate accounting statements to determine their values; e.g., book value, net tangible value, revenues per share/per customer or net liquidation value. It has been my experience that often many stocks sell at a 30% discount to their theoretical value. However, normally this discount is not fully captured quickly without some internal or external activist event.   

In effect the value investor lives in the current price range and wishes for the market to relatively quickly recognize the present value. These kinds of investments, when they work well, are found in the Replenishment Portfolio which invests through the present cycle. Because of their risk aversion value investors have better than market performance record, but often underperform when the market is looking for dramatic changes in the future.

Growth

The growth investor fundamentally believes in dramatic change that most do not fully comprehend. The change could be based on technology, radical price movements because of fundamental and largely permanent supply and demand shifts, as well as substantial and lasting impacts of demographic evolution. The successful growth investor not only believes that he or she can spot future changes but also which company can be the most successful exploiter of these changes. Relative to the value investor they are more tolerant of near-term price risk because they see larger and longer-term price rewards. Except for large funds investing in smaller companies they tend to have more concentrated portfolios. However, they are much more sensitive to changes on the horizon  which makes them less patient than value investors. Thus often they have more concentrated higher turnover rate portfolios.

Putting Income, Value and Growth to Work

In each cell of our intellectual investment matrix of the three asset allocation types and the four timespan investment periods, the investor should determine the appropriate mix. Thus one might have 60% in income, 30% in value and 10% in growth for the Operational Portfolio; 60% in value and 40% in growth for the Replenishment Portfolio and the reverse in the Endowment Portfolio. The Legacy Portfolio could have 70% in growth and 30% in value. Please note that I do not divide the world into domestic and international. I believe just about every company and most individuals are increasingly impacted by activities beyond their national borders. As indicated in earlier blogs "We are all Global." The location of incorporation or main securities market is a third level sort for administrators and sales people to worry about.

         

Rebalancing

The very next trading day changes the actual allocation from the planned and prior day. Far too many investment organizations rebalance mathematically back to an original allocation. I believe rebalancing is an account-specific responsibility. I am very conscious that most large successful investors/entrepreneurs have made most of their money in a few or even one security. I am also aware that a family's concentrated wealth can be wiped out in a major failure. Thus, I  suggest that rebalancing is a critical decision for the capital owner to make. One can see the degree of concentration will change as investment control shifts from the founder to succeeding generations of family workers and non-workers. Further, to me rebalancing is essentially a market call of quasi permanent market change or a return to some concept of "normal."  The decision may be heavily influenced on payout considerations from how "income" and capital are defined.

What Not to Invest in the Legacy Portfolio

The whole concept of the Legacy Portfolio is that since the current generation of investment managers are responsible there are likely to be future periods of disruptive change compared to the present construct of our investment thinking. Often we may want to focus on investments that would benefit from expected changes. It is equally important to focus on what should not be there.

Two possibly negative trends that should be considered for reduction or elimination in a Legacy Portfolio are:

1.  JPMorgan Chase

I have great respect for JPMorgan Chase and its CEO Jamie Dimon. Personally I have owned the stock for many years and it is our main deposit bank. Nevertheless, it should not be considered in a Legacy Portfolio of companies to benefit from disruptions. I commend Dimon’s brilliant 46 page letter to shareholders that describes their success and outlook. It is the bank’s very success under Jamie that makes me question whether at some future point the stock of JPMorgan Chase may not be an investment leader. If one links the performance of JPMorgan Chase from the date of its merger with Bank One  its stock was up 211% compared with a gain for the S&P500 of 154.8% and the S&P Financials 32.3%. For the last ten years the annual compounded growth was +8.6%, vs. +6.9% for the S&P and -0.4% for the financials. JP Morgan Chase has been a great stock. In the same period the large foreign banks have retreated. My fundamental concern is that it is less likely that the bank's relative performance advantage will continue. I expect that at some point the global financial businesses will be restructured to reduce the odds of continued  success for the current bank.

2.  Urban Real Estate

The second area to possibly exclude in the Legacy Portfolio is urban real estate. Cities are absorbing rural populations all over the world for sound economic and demographic reasons. At some point there will be intolerable overcrowding and with the advent of the internet and driverless vehicles, some of the people and capital will migrate to exurbia.

Whether these two thoughts work out, the key message is to look for those investments that will be advantaged and disadvantaged in the future.

Your Thoughts? 

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Copyright © 2008 - 2017

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