Understanding the Universe May Help - Weekly Blog # 842

                   

 

Mike Lipper’s Monday Morning Musings

 

Understanding the Universe May Help

 

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

 

 

 

How can High Growth Stocks Co-Habitat with Flat Value stocks? 

Well-known commentators have recognized that stocks with radically different investments attractions can co-habitat without the more enthusiastic followers driving out less ebullient investors. Although from time-to-time the dominant species kill off weaker ones. 

 

As is often the case, earth bound investors have too limited a view. My exposure to the Jet Propulsion Laboratory managed by Caltech suggests a broader view, including other planets and similar elements. So far, we have not found any planetary bodies possessing a similar atmosphere to earth, so war between them seems unlikely. 

 

This suggests to me that growth and value can co-exist. The high price to earnings for extreme growth is neither a threat nor an inducement to own single digit p/e stocks. Extreme growth “planets” will move to their own rhythm and will not usually be impacted by value-oriented bodies, despite attempts at colonization.  

 

To show the difference we can look at the current year-to-date investment performance of two funds managed by Vanguard.  Their S&P 500 index fund has gained +15.51% this year, while their Total Bond II Institutional fund has fallen -0.20% for the same period. The S&P 500 has fellow travelers like the NASDAQ Composite, with a +18.65% return. The performance gap between the S&P 500 and the NASDAQ may be closing. This past week saw stocks on “The “Big Board” decline 44% vs 53% for the NASDAQ. 

 

Trading liquidity could be a contributor, with small and mid-cap stocks dropping for the past 13 weeks. Another factor could be the lack of dividends.  The 30 stocks in the Dow Jones Industrial Average (DJIA) have 3 non-dividend payers, or 10%. There are twice as many non-dividend payers in the Dow Jones Transportation Index, with one-third less positions, representing 30%. 

 

Market Structures are Changing   

Large Multi-Product/Service Financial firms have reacted to the slowdown in their revenue growth by forcing their various product/services silos to work to expand the firms’ sales base. Their model is similar to department stores which are closing or becoming depots for orders placed online. Another issue is good department store salespeople believing the customers are theirs, not the stores.

 

One attraction for sales teams leaving “wire houses” is Raymond James’* belief that customers belong to the brokers, not to their firms. They offer three alternative ways to join Raymond James. I believe there is a natural peak of good customers for every trade, after which new efforts will lead to lower margins.

 (*) Designates a position either owned by customers and/or personal accounts.  

 

An example of a smart move is Morningstar’s sale of their TAMP business, which recognizes that the number of fund distribution points is shrinking. 

 

T. Rowe Price stated in their mid-year outlook that the risk of recession is now lower. That is possible, but history suggests the higher securities prices go for a narrow segment of the general market, the more risks rise. 

 

Other Brief Comments and Observations 

The US and China agree that they prefer seniors stay in the countryside rather than come into the cities. They also both want more babies produced. The rich country replacement rate is currently 1.5% vs. a neutral rate of 2.1%.  

 

In a period where national productivity is low, the idea of creating holidays like Juneteenth and Labor Day looks politically motivated. Each day of lower productivity increases the risk that lower income jobs will be replaced by machines that can work 24/7, 365 days a year. 

 

Institutional investment sentiment was lower in June than May and April. Currently, 53% of the surveyed institutions believe a recession is not expected for the next 18 months. (I suspect there is a bias at work in their projections. Many, if not most of the respondents are primarily employees rather than owners of their businesses.) 

 

The big four accounting firms are laying people off. 

 

There is a somewhat useful Walmart Recession index of future risk, which increases when store sales are higher than the movement of their stock price.      

 

The standing military in Russia, Ukraine, and China are finding that they are not properly equipped to accomplish their mission. They point to corruption as the cause. (I suggest corruption is something of global problem. Perhaps Dr Spock or his replacement can solve the issue during an intergalactic conflict.) 

 

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Mike Lipper's Blog: Stock Markets Becoming More Difficult - Weekly Blog # 841

Mike Lipper's Blog: Transactional Signals - Weekly Blog # 840

Mike Lipper's Blog: Investment Markets are Fragmenting - Weekly Blog # 839

 

 

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Statistical Correlations are Costly

Introduction

Why are most stocks down in the first two weeks of 2016 and far too many down in 2015? I submit that our brains are wired to use statistical comparisons rather than to accept uncertainty. Far too many of us learned about investing through academic institutions or pundits. Rarely do investment discussions go beyond the second sentence without relying on accounting terms and comparisons with popularly available indices or their derivatives. I suggest that we have gotten too far away from the early successful investors of merchants and farmers.

The “Modern” Investment Mind

In the pioneering work done at Caltech and other places on the motivations and actions of brain functions, scientists have discovered that different parts of the brain light up when dealing with fear and greed but essentially brains are memory devices. We store our own experiences and in some cases others. I believe what we store are the differences or deltas between the experiences and expectation.

This factoid is more easily stored than “we did better or worse than the “model” +100% or -50%.” This mechanism explains our need for comparative data. Bear in mind this is where the current state of the art is, but two quotes from Caltech suggests future refinements or changes.  A motto of the Jet Propulsion Laboratory (managed by Caltech) is: “Dare Mighty Things” and a quote from a Life Trustee Charles H. Townes, the only person to win both a Nobel Prize and a Templeton Prize, “The fundamental nature of exploration is that we don’t know what’s there. We can guess and hope and aim to find out certain things, but we have to expect surprises.”

Confession of an Index Maker

As someone who probably created more mutual fund indices than anyone, I know  something of the black art of creating indices for use by others. The critical building blocks were finding statistics already accepted by professionals individually and combine them to find a central tendency with a reasonable level of dispersion. For example, in a recent study to guess at future investment expectations, I was able to look at the various mutual fund sub-indices of funds in a client’s account for the last ten years.  The top two doubled over the 10 year period with annual gains of 7.52% and 7.30%. Perhaps more significantly was that an index of Balanced funds (owning stocks and bonds) gained only 5.43%. The significance of this finding is that as a US foundation with an IRS requirement to distribute at least 5% of its corpus, if inflation exceeded 0.43% a year the purchasing power of the foundation would decline and thus its grant making capability.

In a somewhat similar matter the popular securities indices were put together by publishers or brokers to capture the central tendencies of a market. There was no attempt to assemble a prudent portfolio for an individual or more significantly an institution to own. With that understanding I find that it is unsound to use these vehicles even in their index fund or ETF versions for fiduciary comparisons. With the majority always wanting to take the easiest comparisons not only are these indices being used as comparisons but also as correlation devices.

As bad as the general market indices are, what is worse is the sector/industry indices that are being used. The components of these indices are based on the principal products being sold as found in the US Government’s Standard Industrial Code (SIC). As an old specific industry security analyst, in numerous cases I found much greater differences in companies I covered rather than the products they sold. (Note I said sold rather than produced - either totally, white labeled or just assembled.) No wonder the stocks and bond prices for these entities move differently.

More Difficult to Define But Better

Believing that good analysts and portfolio managers are closer to artists than accountants, I think at any given time the single most critical element in wise selection is one of four attributes. While each of the four are almost always present from an investors’ standpoint, one or possibly two should be identified as the basis for comparison in building a properly diversified portfolio. Some of this thinking is parallel with Howard Marks of Oaktree Capital, whose latest thoughtful letter I will discuss below.

The four critical elements are: Supply, Demand, Time and Talent. The use of a firm’s capital to address the needs for expanded supply or increased demand is of particular interest to Marathon Asset Management in London who in a recent study identifies where in a capital commitment cycle a firm is. In an initial stage often the market will absorb all the supply that is available, be it in raw materials or semiconductors. That is until supply overcomes demand and then the critical focus is generating sufficient demand at reasonable prices. With many new product/services companies their initial focus is creating demand in the first place. Often this is the first business need for intellectual property companies.

The third critical element is Time. This needs to be looked at from both the producer and investor standpoints. From a producer’s position the time to produce and deliver is a competitive challenge. The first to be able to deliver in quantity and appropriate price will command the market as long as this condition lasts. From an investor’s viewpoint time issues involve average expected holding periods, payments to wait, expected terminal prices, and possibly certain critical performance dates.

The fourth critical element is talent management throughout the organization. This is critical regardless of size and it starts with the top but also includes, developers, client-facing staff and appropriate control and regulatory elements. The absence of a working plan to secure all of these creates substantial risk for the investor and in the long run for the employees and customers.

While I have yet to see funds or managers show their portfolios in terms of these four elements, some of the smarter ones can and do discuss their portfolios this way. To me this approach allows me to be a longer term holder of their portfolios.

During the kind of decline we are currently experiencing, I am seeing too much cross correlations with stocks in multiple industries, but very similar investment characteristics. Thus, in effect they have become a singular investment which we can use by providing our own diversification by marrying the questioned portfolio with other managers or funds. However, we would have to reject the singular focused fund as not appropriately diversified for some accounts.

Bullets from Howard Marks' Paraphrased Wisdom

Howard’s latest letter is over twenty pages. Below are brief thoughts from his letter:

1. In order to be a successful investor you need to understand psychology.

2. Strike a balance between offense and defense strategies. (single teams)

3. Too many overlook negatives until they capitulate.

4. Daily markets are a barometer of sentiments.

5. Perceptions swing from flawless to hopeless. (Apple?)

6. Investors know less than they thought.

7. There is false belief in investors’ rationality and objectivity.

8. Expectations should be included in transaction prices.

9. Illiquid assets + capital flight = investment disaster.

10. Markets move from yield focus to recovery potential.

Question of the Week: Would you like to discuss any of the points mentioned?

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Unpopular, Unconventional, Painful and Disruptive

Unpopular, Unconventional, Painful and Disruptive is not the name of the new hot law firm. The title is a summation of some of my "out of the box" thinking flying home from a too-brief visit to an offsite board meeting of the California Institute of Technology and a visit to PIMCO, the world's largest bond manager.

"The New Normal"

One of the reasons bond managers think in terms of secular trends is that at times they invest, rather than trade, bonds with long maturities. While those who buy stocks should be thinking in terms of long to infinite time periods, many of them focus on much shorter periods; e.g., quarters, twelve months, five or ten years - certainly not thirty years. That is why understanding bond managers is important to equity investors.

In meetings held by senior PIMCO investment people with a group of Caltech trustees, PIMCO focused on an expected period of prolonged very low interest rates. They also shared their opinion that the various stimulus moves by leading central banks and governments will not lead to effective de-leveraging. I got the distinct impression that these moves would prolong the valley of low employment and a decline in the developed world's standard of living, while many of the emerging countries enjoy rising standards of living. A further examination for the sluggish response to the various government actions reveals that in the US, 71% of GDP comes from consumer spending with 47% of that total spent on services and only 24% on goods. As services are time perishable, the old pump-priming techniques of the 1930s don't work as well.

Re-thinking

If the present generalized approach is only going to prolong the problems, why not stop banging our heads against the stone wall and let the natural correction forces operate? In other words, let rapid de-leveraging happen through a normal bankruptcy cycle. During bankruptcies, various contracts can be abrogated. I would carry the process further by removing various constraints and restrictions in government policies that are no longer valid. What should come out of a bankruptcy is a new beginning with an enthusiastic attitude. Unfortunately, only 42% of the American public believes that hard work leads to success as indicated in a recent Wall Street Journal article. This attitude must change.

 

The whole idea of re-thinking past dictates of government is accelerating. I recently attended a conference organized by the Museum of American Finance at the New York Stock Exchange. The focus of the conference was how to restore individual investors' confidence in the equity market. For some time I have maintained that the regulatory pressure to lower transaction costs is a significant contributor to the problem. When commissions and spreads were large, retail salespeople sold stocks and provided other investment services to the public. As their remuneration rapidly diminished, salespeople gravitated to higher commission products such as hedge funds and structured securities. The chair of the NYSE recognized that the switch from quoting prices in fractions to decimals, including sub-pennies, has reduced the attractiveness of selling stocks as a business. I find it interesting that there are news accounts that the SEC is considering a test of a return to the use of fractions. If the SEC can see itself reversing some of its past policies, there may be hope that other government bodies can re-examine their past actions to become more pro growth.

One of the most rigid congregations in the world is the scientific community. Scientists regularly make pronouncements of various laws and theories. This weekend my wife Ruth and I listened to leaders that supervised the work at JPL (Jet Propulsion Laboratory, an affiliate of Caltech) of the Mars landing of  "Curiosity." Each manager described some of the various scientific beliefs and budget constraints to carry out the mission. This remarkable success is viewed around the world not just as a success of Caltech/JPL or of the US, but of mankind as part of its conquest of knowledge beyond our earth. I hope this achievement and the continuing reports back from Curiosity will lead to a greater understanding of what we are capable of doing with our collected talents. We can achieve growth by re-thinking our various constraints.

Investment implications

The markets ahead can be painful either on a prolonged basis with current government policies or more painful but of shorter duration if we allow normal "animal instincts" to operate. In terms of investment policies, in most cases I would not want to own government bonds. I believe the risk premium will rise and stocks will do better than bonds in general. In terms of stock selections, I favor disruptive companies that can take advantage of significant structural changes in our various market places.

What disruptive securities do you own?

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