Should Reputations Have a Sell Date? - Weekly Blog # 562

Mike Lipper’s Monday Morning Musings

Should Reputations Have a Sell Date?

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

                                                               

Remember, the way we make judgements is by comparing the new with our memories. Most of what we remember are the results and perhaps the broader conditions of the event. Thus, we remember that Peter Lynch, John Neff, and Sir John Templeton were great equity mutual fund managers. In the US this Sunday evening, many Americans and others around the world will watch the Super Bowl, which is the game in which we crown the best US football team for the year. For more than a few years my wife Ruth and I attended these games as part of our responsibility as investment adviser to the defined contribution plan of the National Football League and the NFL Players Association. Because the teams, players, and owners were all our indirect clients, we had to appear neutral. That is why when asked who we were cheering for, my answer was for the black and white team, the game officials. All I wanted was for them to be correct with their calls. Thus, I saw the game differently than a very large majority of the fans. My memory is of the close calls and the correct decisions, where the play needed to be looked at from a number of different angles. (One can easily see that I often view things differently than most.)

The reason to bring up the LIII Super Bowl this early Sunday morning is not to predict the results, but to use it as a guide in the selection of investment managers and mutual funds. Come what may, one of the key people or perhaps the most important player in today’s game is Tom Brady, the 41-year-old quarterback for the Patriots. I believe his first Super Bowl was in 2002. He has been playing this game longer than the majority of portfolio managers. Most winning managers keep on doing the same things that generated their winning season. What makes Tom Brady different is that he modified his game as he aged, as rules changed, and as competitors played differently. In other words, conditions change.

Recently, I was examining a very nicely performing portfolio of equity managers. The bulk of the long-term performance of this portfolio came from a subset of four quite different managers. In some ways this recognition introduced a new future risk element to the portfolio. All these positions had for a long time, not as long as Tom Brady’s, generated an above average record and their share of the overall portfolio has risen since the decision to add them to the portfolio. Clearly, these decisions had worked. But would they be as productive in the future as they were in the past? One of the lessons from working within the NFL environment was the recognition that on any given game day almost any team could beat another, as a result of conditions changing. This is the same lesson I learned in handicapping my bets at the New York racetracks. While it was comforting to bet on the horse that had the best record, it didn’t always produce a winning ticket. Thus, I became less reliant on winning streaks. For me to be comfortable betting on a good record, I had to believe that current conditions were very similar to those that produced past victories.

All too often in selecting managers or funds, almost all the attention is paid to a particular portfolio and its allocation, specific positions, and the portfolio manager. As someone that invests in publicly traded investment management stocks, I am conscious of the benefits and pressures that management organizations place on the manager and therefore the portfolio itself. The owners of the management company can earn money, not only from the investment performance of portfolios, but also from the sales and redemptions of all their vehicles. One of the symptoms of a prior good performer reducing its chances for future performance success is a significant increase of flows into the fund. Although this is generally recognized, all too often the concern is not extended to the management company itself. Political changes evolve along with the flows of money, impacting talent allocation. One of the parallels with Tom Brady and his Patriots team today, is that he is the only current player that was also on his first Super Bowl team. This means that the skills of his receivers and defense are different. This also happens more subtly within management organizations through aging, personnel turnover, and technology. Most importantly, the competition changes.

What lessons are learned from these concerns in the selection of good professional investors and mutual funds?

1. There is no certainty, successful investing is a series of art forms.
2. Many non-statistical factors should be considered that are perhaps more important than the current excessive focus on fees and investment performance rankings. 
3. What time period is to be used for measuring future success?
4. What is an acceptable comfort level for a permanent capital loss and the resulting sting of self or external criticism?

Where Are We Today?

1. We have enjoyed a wonderful month, the January Effect has worked so far, with an up first day, first week, and first month. Whether that will deliver an up year is yet to be determined. 
2. The gains achieved in January recovered a good portion of the losses sustained in the fourth quarter. 
3. What are the chances that we have a repeat of 2018, where a strong January was followed by a problematic February and a volatile year?
4. We will soon have completed a thirty-five-year bull market in bonds, where are the successful bond bear market managers? 
5. There has been an increase in the number of investment management company mergers and acquisitions. The sellers have a less optimistic view of the future than do the buyers. Talented people throughout the asset management industry need to be reassured that these changes will not affect them negatively, whether their companies are directly involved or not. Most importantly, these changes need to benefit investors for the industry to progress.

         

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html



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Stock Prices Up with Economists/Analysts Unconvinced

Introduction

There are no perfect rules about investing. Everything we think we know should carry with it a notation of a margin of error.

One of the advantages that I had growing up was to learn that one could have a winning day at the thoroughbred race track by cashing tickets only on one third of the races; in other words by picking one’s bets carefully and knowing when not to bet. The big advantage, in theory, that individual investors have over most fund managers is that individuals can be like me and not bet every race because of a lack of conviction as to its outcome or that the odds did not have an appropriate risk/reward ratio imbedded in the bet. My long-term analysis of the historical records of investors who stay in the game is that they are right on the order of 50% of the time and if they wind up by having more of their money on winning positions, can come away a monetary winner being right only 40% of the time. I believe most fund managers that have long-term records of ten or more years are right around 60% of individual quarters and years. The great ones are right perhaps two-thirds of the time.  With all that as a statistical prelude to indicate that being wrong is part of the game, I turn my attention to the remarkable first week of January trading. US stock prices were up roughly 5% in the four trading day week. One of the favorite market tales is that there is a “January Effect” which states that as January prices go, so goes the year. The believers in this theory are encouraged by the first day’s trading and the first week’s as well. Historically the “January Effect” does work, as do most months in most years. (The US market goes up over time most of the time.) There is some reasoning behind the belief in the “January Effect.” In early January many pension funds, 401(k) and similar plans get their money destined for the equity market and therefore they are buyers. Despite all the dour headlines and pundits’ chatter, the first week is actually a continuation of the halting rise in market prices that was evident in the fourth quarter of 2012. Nevertheless, the purpose of this post is not to jump on the momentum train, knowing full well about error rates and that optimism is contagious and often leads to unfulfilled results. The purpose of this week’s blog is to understand the dichotomy between the rising market prices and the very subdued comments of well-known and somewhat learned economists and investment strategists.

The focus of economists and analysts

1.    The recent tax bill is being celebrated by the media as saving the country from entering another recession. (My personal point of view is that it will hurt the economy long-term.) The tax bill did not address the causes for the deficit and actually added to the deficit. The real losers from this bill will be the lower and middle level income tax payers as well as those who pay no income taxes. All of them will suffer from an increase in the rate of inflation as capital owners will attempt to offset the increase in their tax costs through raising prices and slowing any hiring plans, particularly to reduce the impact of Obamacare on their income. What is probably the worst thing about the tax bill is a continuation (along with the central banks of the world) in attempts to manipulate the economy. After a generational expansion of the US economy, we need to materially improve the management of our own spending as well as to maximize our  productivity.  From time immemorial we have had economic cycles. Attempts to delay the cycle have often led eventually to a much worse result.)

2.    The tax bill included a number of benefits to particular special interest groups. This was evidently needed politically to get enough support or was a “due bill” to be paid. Mohamed A. El-Erian in his latest piece points out that politics drive economics in Italy, Japan, and the United States whereas in China, Egypt, Germany, and Greece economics drive politics. (I believe the second group are much closer to dealing with their structural problems than the first group.

3.    The US Federal Reserve, the Departments of Labor and Commerce, as well as the SEC have publically admitted that they do not have the correct statistical tools to fully understand what is happening within their specific areas of regulation. If they don’t have the right tools one has to fear their regulatory policies and recognize that it will be unlikely that the Congress or the White House can come up with appropriate policies.

4.    Some economists are pessimistic as to the long-term growth for the US. They cite the record levels of operating margins and expect less in the way of major economic benefits from innovation. (Ironically Professor Krugman believes that some are underestimating the growth potential from wider adoption of robotics.)

5.    Analysts have significantly lowered their current estimates of soon to be released 4^th quarter 2012 earnings, with particularly lower estimates for tech and financial companies.

6.    The expected growth within the US of electricity use is expected to be below 1% even with all the new electronic gadgets in-use. This is important for two reasons. First, if the electric utilities cannot grow their bottom lines they will be unable to directly pay for either major upgrades to their transmission grid systems or the new energy sources that the government is pushing. If these new expenses are to be mandated, either utility rates will have to rise and/or the government will have to subsidize these efforts. Neither will help the consumers or a struggling economy. The second reason is that slow growth in the US use of electricity is an issue for those of us who are concerned about the growth in China. One of the departing leaders from the top group of government officials publicly indicated that he felt the quality of the data for their own GDP calculation was “soft.” He preferred to use data on electricity usage and bank loans as more accurate indicators of their growth. If the Chinese eventually follow our pattern, their growth in the use of electricity per person will decline which may possibly hurt our ability to understand what is happening in what will be a major market for our goods, services and capital.

What do these market prices indicate?

1.    The first week’s surge, which cannot continue for long, may have had three unusual inputs. First, those with too much cash un-invested felt they had to get in, for the realization of the impact of the tax bill was turning their cash into trash. Second, those who had large accumulated losses without much near-term hope of getting even wanted to recognize their higher tax value losses. Third, US investors wanted to protect the dollar value of their portfolio by moving some of their money into multinational stocks.

2.    Lipper, Inc., now a part of Thomson Reuters has international, global, and largely domestic mutual fund categories for the various types of funds. On average the international funds performed better than the global funds which in term did better than the domestic oriented funds. Most of the superior results, particularly in the fourth quarter, were due to translation gains. The foreign currencies, euro, yen and pound, rose relative to the US dollar or if you prefer the dollar declined relative to its investment competitors, just as the Fed wanted.

3.    The yield spread between high yield bonds relative to treasuries of similar maturities is the narrowest on record, below 6%. The owners of these “junk bonds” are betting on an economic recovery with a relatively low default rate. As some of the buyers of this paper are essentially “yield hogs” rather than sophisticated analysts, this may be a danger signal. One indicator that I have quoted before may show the growing confidence in taking risk. The Barron’s Confidence Index published each week is a comparison of the yields of higher-quality bonds to mid-quality bonds. The index typically moves about 1% point a week, This week it rose  2 percentage points which normally is favorable for taking risks in stocks and therefore "junk bonds."

4.    The movements of the stocks of financial services companies are important to me for two reasons. First, in our global economy we transmit our wishes through financial channels; so the health of those channels is important. Second, as most of the readers know, I manage a private financial services fund along with much larger portfolios of mutual funds that I also manage. As mentioned above, some analysts significantly lowered their 4^th quarter earnings estimates for the financial stocks. The prices of these shares have been rising and particularly in the first week of the year. I believe one of the reasons for their gains is that the committee proclaiming the Basel III agreement has wisely become more flexible as to what is to be considered good capital for banks’ liquidity reserves and delayed its full implementation to 2019. (I suspect moving away from a reserve made up of sovereign bonds was viewed as slightly risky compared to a collection of high quality securities including some mortgages and even equity.)

5.    The markets reacted strongly to the publication of the latest Fed meeting minutes, where for the first time in the minutes (but not the first time in individual governor's speeches), there was concern expressed by some with the continuation of their various “quantitative easing” policies expanding their balance sheet. Possibly we won’t see their attempts to manipulate interest rates forever. As already mentioned, the Fed recognizes it may not possess the right tools to understand the economy. (I am wondering if in the future our “normal” level of unemployment will not be deemed to be closer to 7% with lower rates touching off higher inflation fears.) Further, I suspect that in examining the labor force participation one should look at six sub groups: employees at small, medium and large enterprises plus federal government workers, state and municipal workers excluding teachers. I would suggest that each of these groups have different needs and impacts on both our economy and more importantly our society.

6.    Later this coming  week my good friend Byron Wien will formally present his thinking about the surprises he expects for 2013. One of the reasons that I like Byron is that he has a strong streak of a contrarian in him, as many survivors do. He has a good batting average on being right on his surprises. As a contrarian myself, I hope that this year he will not do as well as usual, as many of his pre-published ‘surprises’ are already uncomfortable to me.

Please share with me how 2013 looks to you.

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