Two Avoidable Investment Mistakes

1. Applying physics discipline to investment careers

2.  Policy makers not thinking

Applying physics discipline to investment careers

I have just returned from the quarterly meeting of the Caltech Board of Trustees. At the meeting we discussed the appropriate preparation of the graduates for their entry into the business world. A survey of the students felt very comfortable in entering the academic world on the basis of their superb education from Caltech. However they did not feel as prepared to enter the business world and particularly the financial world of Wall Street.

As one of a very small number of voting trustees with current investment activities, I pondered how I could help. It occurred to me that the very education that graduates from Caltech achieved actually could be somewhat counter-productive to their early success in investing. This is particularly true for those who go to Goldman Sachs^* and elsewhere as “rocket scientists.”

In their scientific courses, particularly Physics, they look for natural laws. These require exactly the same results to be achieved under all conditions of their experimental work. To the extent that they take Classical Economics they will learn from the works of Adam Smith about comparative advantage where one nation can produce something cheaper than another serving the same marketplace.

The differences in my world are that known conditions are never totally identical and definitely some critical elements of information are not known (the unknown unknowns). For example, some of my fellow aging portfolio managers and analysts are suggesting that the current stock market price structures are similar to the markets that fell dramatically in 1987 and 2007. I recognize the incomplete parallels, but I suffer from Physics Envy in that I cannot completely accept the inevitability of a meaningful decline. That is why we have been cutting back on our equity exposure rather than complete elimination.

To me a general balanced account with a spending time horizon of up to five years should never have less than 50% in stock or stock alternatives.

There are other differences between their academic exposure and the world of Wall Street. As investors we are not interested in comparative advantage, but competitive advantage. We need to find ways to bring to our clients and seniors better risk/reward ratios. I suggest the graduates pay particular attention to the risk part of the equation. In the laboratory it does not matter how many experiments you conduct. In the financial world each experiment has some costs in terms of money or more importantly, time. This is definitely not to say that you should only make an investment when you are absolutely sure. The late and great Ace Greenberg, the last great chairman of Bear Stearns, built a very profitable and effective trading desk by urging his traders to take quick losses. When I was involved with a trading desk I tried to always remember that the first loss was often the best loss.

Another useful attribute for the graduates is to learn how to read the news. They need to look for the non-headlined stories. (By the way, most headlines are fully discounted in a short time after they appear.) Very few of the “talking heads” with their 20 second sound bites will spend much time dissecting the following facts:

In discussing mutual fund net flows they do not make the distinction between the net flows of the traditional mutual fund buyer and the hedge fund and other institutionally-oriented players. For example, two weeks ago the headline was that mutual funds were net redeemers of equity funds to the tune of $7.6 Billion. Few people noted that the net result was the combination of the traditional mutual funds having net purchases of approximately $379 million and the Exchange Traded Funds (ETF) redeeming $7.97 Billion in equities. Even those that noted the difference chalked it up to different levels of speculation.

While I am not positive of this, I suspect that a number of macro oriented funds were unwinding their Quarter-end statements which showed a reasonable equity commitment rather than a significant under-investment in stocks. We use to call this approach “window dressing.”

Other potential straws in the wind from the Financial Times include:

1.      John Dizard’s opinion piece stating that there is “…greater systemic risk in fixed income as it easier to leverage.”

2.      John Authers is worried about prime and sub auto loans in his article, “Bubbles are Forming in the Credit Market.”

3.      The three highest dollar volume securities traded on the NYSE last week were ETFs. One of the reasons that I focus on ETFs is that according to the CEO of BlackRock which manages iShares, some hedge funds which are its clients have been using ETFs rather than futures to adjust their portfolios.

These items suggest that the market structure has changed and therefore sole reliance on back data can be misleading. Investors and traders today need to understand the changing structure. The old needs are still there, but they are being expressed in different ways.

Policy makers not thinking

All too often various politicians react strongly to pressure “to do something” about their political base’s current problem. An old example was the reaction to Walmart when it wanted to open stores in strong union towns.  The local politicians colluded and made it difficult for Walmart to open in their communities. The politicians and their supporters did not pay attention to the fact that many from the poorer communities lined up to get job applications. Further, there is some good analysis that demonstrates that Walmart itself has lowered food price inflation by at least 1% point.

The latest element of short-sightedness by politicians is the attack on the

traitors to the US that practice the art of inversion; i.e. moving their tax domicile offshore. To the best of my knowledge none of my individual company  investments have inverted. (I can not attest to all of the companies owned by the funds that we own for ourselves or clients.)

On Friday of this past week I listened in on the quarterly earnings call for Moody’s^*. While there was no discussion about the company shifting its tax domicile, I started to think about the implications if Moody’s or other companies moved overseas.

Under the law, the management is elected by and responsible to its shareowners. In the case of Moody’s and most “American” companies the vast majority of their direct and indirect holders are Americans. Either they own shares directly or they are part of  some collective; a mutual fund, 401(k), defined benefit plan, non-profit endowment, etc. Each would benefit if his or her investment paid lower taxes which should translate into higher earnings and dividends and in turn should increase the investor’s wealth and ability to spend money largely in the US. Thus the economy would benefit.

            ^* Stock owned by me personally and/or by the private financial services fund I manage.

There is another class of company that is growing faster outside the US than within perhaps due to both taxes and regulations. Moody’s is one of these. The needs for its services continues to grow faster outside. In order to serve those needs, they employ people overseas.

Years ago when I was the owner of Lipper Analytical Services two of our five offices were overseas. We had these offices to service our American Mutual Fund clients. We like many others were in effect, following the flag as carried by major financial institutions. This in turn led to discussions with a foreign buyer who recognized from its own global perspective the value of global suppliers to the global investment management business. While I did not directly create an inversion, by selling to a foreign owner some of our taxable earnings went offshore. If the politicians attempt to stop US companies from reducing the potential returns to their US shareholders, these shareholders will be replaced in part by non-US holders and our tax take will be reduced.

For us to fully understand how our system works in reality, all of us need to follow the money throughout the cycle from initial  investment all the way through the spending cycles.

Question of the Week: In the long run how do taxes matter to you?

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Turning Disappointments into Long-Term Gains

One of my sons has called me a dedicated contrarian, and he is right. I try to look at the whole of a situation rather than accepting the popularly described middle description. Focusing on elements that others do not has yielded unusual profits in the past; and more importantly, avoided significant losses. Thus, one should treat various contrarian views with interest. I believe most deliberative bodies, particularly boards of directors and investment committees should have at least one contrarian to more fully examine decisions, rather than always expecting unanimous votes with limited discussions.

As a self-proclaimed contrarian I will focus on two initial disappointments that lead me to the opportunities to profit as others catch up with their thinking. I will start with the smaller in terms of importance of the two.

Bleak Friday

Many of the longer-term readers of these posts know that each Friday after Thanksgiving I visit the Mall at Short Hills, New Jersey. For those who have not experienced such a visit, the two level mall (which is approaching one mile in circuit), is full of high-end brand names. The appropriate term for most of the stores is “glitzy.” My visit is true market research, in that I study the difficulty in finding an unoccupied parking space, the number of shopping bags being carried and the labels on those bags. The survey is not meant to be representative of the American public, but of a sliver of the population who can afford to own common stocks outside of their tax deferred accounts. In other words, I am looking at the shopping patterns of the rich or those that are called ultra high net worth (UHNW).

This year we were able to find a convenient parking space in less than ten minutes. In past years more than a half an hour was needed, and in some cases I had to park off the property and take a shuttle bus to the stores. The ease of parking should have been a clue. Within the mall, walking was only slightly more crowded than a normal weekend. The big bag carriers were toting merchandise from Macy’s, which appeals to the low-end income buyer as well as some of the more well-heeled. My guess is that the store had advertised significant discounts and an early opening. In contrast, most other stores’ signage indicated a 25-30% mark-down. They were not the kind of discounts that lead to “binge” buying. One indicator that people wanted to buy was that a number were carrying shopping bags from home, without labels and that were mostly empty. In clothing stores, inventory was attractively displayed, but there was little depth.

In-store orders were being taken for merchandise that was going to be shipped to the buyers at home. Clearly, merchants wanted to avoid excessive inventory that would lead to large markdowns before the end of their fiscal years in January. There are three phone stores in the mall. Apple was the most crowded, but still I recognized some sales people that were waiting for new walk-ins. Verizon had normal sized traffic, and as usual, the large AT&T store was practically deserted. My initial reaction to this visit is that the prospects would have to be labeled disappointing.

This is when my contrarian thinking asserted itself. First, it is just possible that the wealthy are spending less to leave room for an eventual binge buying of equities. (After reading this, some may believe that I consumed too much Thanksgiving feast). Second, like some investors, consumers are looking for growth markets and are doing their purchases online. If your responses from office workers Monday is a little slow, it could well be that they are using their employers’ computers to participate in Cyber Monday buying. Third, and much more importantly, it is possible that people of all economic levels are acting prudently by controlling their spending in order to generate money to carry them through an uncertain period. If I am correct, consumer-focused banks will have their loans paid off more quickly and see their deposit balances rising. Possibly one should look closely to savings banks and S&Ls.

The big disappointments: the euro and the deficits

Around the world stock, bond, and commodity markets shudder as values of currencies fall, particularly against the US dollar. (A future blog post will deal with the biggest bubble, the US dollar.) Almost all of the focus is on propping up the euro through various fiat or leverage techniques. The few articles that are coming out about the potential disappearance of the euro are encouraging. As a dedicated contrarian, I am happier when I see someone considering the reverse of the current view. Some articles have made a calculation as to what it would cost in debt repayments if the euro ceased to exist. These are very high, one-sided numbers. One-sided because they do not take into consideration the gains that some companies and families would benefit. One of the more thought provoking columns appeared in the weekend edition of the Financial Times by John Dizard, who pointed out that sovereign debt is governed by each country’s own laws which are relatively difficult to change or abort. Most corporate debt in “Euroland” is governed by English law and courts, which is more difficult to change. Even if a country defaults on its debt, that does not release most of its corporate issuers. Thus in today’s mixed up world, corporate debt could be safer than the debt of various countries. I believe markets on both sides of the Atlantic are recognizing this, with more institutions owning or buying corporate debt than government debt. Perhaps the rating agencies may even change their long-term policy that corporate debt could not be rated higher than that of its own country; the markets would agree with this action.

“With all the discussion about currencies, there has been little if any focus on the root cause of the economic problem,” so says the contrarian. If one looks at currency as a price mechanism, one needs to examine the base cause of the price disequilibrium sparked by almost worldwide deficit spending in Europe, America, Japan, and China. This is not a new problem as pointed out to me by my brother who sent me the following quote:

“The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.”
–Cicero, 55 BC.

There is much controversy on this quote’s accuracy. Many claim that the original quote is: “The arrogance of officialdom should be tempered and controlled, and assistance to foreign lands should be curtailed, lest Rome fall.” Others claim Cicero said nothing on the subject, and source the quote to later accounts. Whatever the case, this is an age-old series of problems.

We all know what eventually happened to Rome through authoritarian governments and the need for booty to sustain them. In the end Rome was not conquered by the barbarians but by its own corruption and inefficiencies. If there is not a willingness of the people all over to world to cut their reliance on government payments and services, then keep your eyes on military spending. Despite the political threats to the defense budget, I believe that a prudent long-term investor needs exposure to defense stocks. I suspect technology will increasingly play a role in protecting us even if we get our spending below our revenues.

All contrarians expect their views will lack popular enthusiasm, but they are willing to learn from others who represent more mainstream thinking. Thus, I ask you to communicate your views.
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