Are You Suffering from Input Overload? Think Digital, but Judge Analog.

Introduction

Over the last week or so my wife Ruth and I have been with music lovers, including donors and professional musicians where much of the discussions have focused on the musical scores. The very term leads me to think of financial scores. Both are performance measures and there are well-recognized parallels between music, math/science and investing.

All three cultures contain enormous amounts of individual facts (and fictions masquerading as facts). If we paid complete attention to all of these our constrained brains would become overburdened. Instead we choose to narrow our focus to segments; e.g., nineteenth century symphonies, organic chemistry, or equity mutual funds. Even these segments are too large for individual attention, so we tend to array these participants in a statistical rank order. Thus, we become a captive of the digital world order.

Music favorites

In deciding which rendition of a piece of music is their favorite, people choose based on memories. What we may remember is the total effect of the last time we heard West Side Story or Beethoven's Fifth Symphony, which is the result of the orchestra, conductor, venue, acoustics, and importantly our particular location physically and emotionally. Since the sum total of these digital inputs can not be algebraically experienced, the resulting feeling of satisfaction is an analog reaction.

Successful investment choices

As much as it pains me to admit, my learning as a CFA^® charter-holder has provided me with lots of decision inputs, but so far has not been much help in developing consistently winning portfolios.

While I may make imperfect projections of revenues, margins, tax rates, shares outstanding, earnings per share, relative valuations against markets, peers, growth rates, etc., the success of my investing for clients will be an analog of known and more importantly, unknown factors.

Unexpected or unusual combinations of  instruments

In most of our descriptions of Legacy Portfolio investments I have focused on equities or equity funds. However, in the hands of a skilled portfolio constructor/manager I could see the following other types of investments included: long-term commodity shortages, unimproved real estate, long-term TIPS, and currently unpaid royalties. When combined with investments in a combination of secular growers and the beneficiaries of disruption, any or all of these could make beautiful music together in the Legacy, the longest of my Timespan Fund Portfolios.

Question of the week: What lessons can you or have you learned from music?

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Copyright © 2008 - 2015

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Great Music Can Discipline Good Investing

Introduction

The global equity surge on Friday was a political relief rally for stock owners.  The rise could restore the rhythm of alternating up and down months, with May being scheduled as an up month.  This cycle could be considered a possible link from the musical world to the investment arena.  Patterns or streaks in the investment world break down eventually, however great classical music goes on forever.  

Recently I was in Europe on a group tour with donors to the New Jersey Symphony  Orchestra (NJSO), and my wife Ruth, who is the orchestra’s Co-Chair. Before the official beginning of the tour we were in Geneva on family-related matters where I noticed a billboard for a concert of the local Orchestre de la Suisse Romande, which is the orchestra for the French speaking portion  of Switzerland. The orchestra’s visiting conductor for the night was Neeme Järvi, formerly the Music Director for the NJSO. We attended the concert and listened to familiar pieces by Franz Schubert and Ludwig van Beethoven which we heard Maestro Järvi conduct in Newark, New Jersey. When we visited him and a portion of his large, talented family backstage, he was the same genial host we had known.

 
While in Prague (or spelled locally, Praha) we heard the Parnas Ensemble, a quintet playing highly spirited pieces by Mozart, J.S. Bach, Dvořák, Bizet, and Brahms. What does this have to do with designing the correct components to an investment portfolio? Many of the pieces we heard were two hundred years old  and yet sounded new and exciting to us, even though we had heard them performed by individual soloists, quartets, quintets, chamber music groups or full symphony orchestras around the world. At each concert highly trained musicians interpreted the pieces in a different way so it was like hearing the music for the first time.

Turning to investment portfolios

Just as the musicians mix various instruments into their pieces, my structure of timespan portfolios can include real estate, commodities, fixed income securities, stocks from around the world, and my specialty mutual funds. A well-thought investment portfolio can be imaginative and fresh to a savvy investor similar to the experience one receives when leaving a concert that has produced evocative interpretations from old musical works. Similarly, a well chosen set of timespan portfolios can fill a deep and newly awakened investment need.   

Inter-relations between timespan portfolios

The structure of the first four portfolios is dependent on each of the Operational, Replenishment, Endowment, and Legacy Portfolios doing its job and relying on subsequent units to do their job. One of our perceptive readers, a professional portfolio manager, and one of my sons, asked the question, “How much of one's wealth should be devoted to each stage?” Unfortunately, there is no set answer.

The continual process of development

One begins sizing the initial timespan portfolio, the Operational Portfolio, with the first version of a funding needs spreadsheet starting with a two year spending budget estimate (including a reasonable contingency factor). Input by the CFO and/or external accountant is critical as well as the real planning officer, often the CEO.

The task of assessing the size of the second portfolio, the Replenishment Portfolio, is to make a somewhat independent judgment of the probability of the timing of the exhaustion of the Operational Portfolio, which is slightly dependent on the expected interest rate and cash flow in that account. This timing will determine the probable schedule of replenishment.

There is no hard math as to the allocation of capital to each of the four separate portfolios. Assuming that spending can be limited to 3% of capital, the Operational Portfolio should get two years of spending or 6% of the total. In the current time period, I am assuming no real income generated over minor administrative expenses will be paid out.

The Replenishment portfolio normally should have a five year timespan during which one should expect at least one period with a 10-20% decline. Making the bold assumption that on average, equity markets continue to rise about 9% per year, it is reasonable to assume that in aggregate, including any decline, they could produce replenishment capital of about 6% of the portfolio value. On the basis of this logic and on assumptions given, the Replenishment Portfolio should represent 50% of the capital of the account, assuming no additional contributions. (If in cash, additional contributions could substitute for some of the estimated rates of return.)


The Endowment Portfolio

Utilizing the above general example, there remains 44% (100% minus 6% minus 50% =44%) to be split between the Endowment and the Legacy Portfolios. How the split is made may be a factor as to how the current generation of senior management perceives the identified long-term needs of the account organization. If the organization has been regularly investing for its future, or if the family grantor perceives that the existing family members will receive enough without ruining their incentives to be productive, the bulk of the 44% might go into the Legacy Portfolio for expected but unknown needs/opportunities.

Even when heavily invested in equities, an endowment account is typically going to be judged on its long-term generation of income, including realized gains. A Legacy Portfolio should be judged on its ability to grow its capital.

Music lessons for investors

There are many ways to hear a great piece of music, but hearing the different approaches gives the listener a broader array of benefits and can lead to different choices for different listening pleasures. The same thing can be said at analyzing different portfolios with some of the same positions. A number of so-called active portfolios might hold shares of Apple, Google and IBM. For sake of discussion, assume that each holding represents 5% of the total portfolio and in aggregate 15%. (I know of no such fund portfolio.) One might expect that portfolios with similar holdings would produce roughly similar results. This is rarely the case, for the other 85% of the portfolio is likely to produce meaningfully different results.

There are many answers as to why funds perform differently. When I was consulting with the independent directors of fund groups trying to judge whether they should renew investment management contracts, I pointed out important differences beyond performance and holdings. I will admit relatively few directors wanted to listen to the whole piece. Some of the elements I mentioned to them were as follows:

1. How well did the managers follow instructions in the prospectus
    and from the board?
2. The impact of differences in fees and expenses.
3. Different flow characteristics.
4. Management of critical personnel + backup development.

Let me over-simplify a comparison of Warren Buffett/Charlie Munger of Berkshire Hathaway and Peter Lynch, the great long-term portfolio manager of Fidelity's Magellan Fund, who had similar performance in some years and from time to time actually owned a portion of the same stocks. Both Buffett/Munger and Lynch had professional disdain toward economic projections, but they each played to different tunes. Buffett relatively through securities he owned, his large positions made him technically an insider with holdings of 10%+ of the voting securities. Because he had the use of the long-term float of other people's capital, he was leveraged. Peter was very conscious that his good investment  performance was bringing to Magellan bundles of capital, with Magellan becoming the first equity fund to have assets of over $100 billion. Peter was very conscious that as easy as the money came in it could go out, as learned by the managers who followed him. The portfolio swelled at one point to perhaps 1800 individual issues, including 130 with the initial name "First" (as in Savings & Loans and Savings Banks). At one point he had three traders working effectively just for Magellan’s accounts.

In assessing investors' risks with these managers, Buffett represents a leveraged, highly concentrated balanced portfolio which he personally owns as a 50% principal in the company. To an extent his favored investment period was and is forever. Magellan was going to be only as good as its short-term performance with a broad equity portfolio.

While these three great minds made great investment music which seemed similar; just as one hears the difference between great orchestras playing from the same score, the results were quite different. A careful analyst of portfolios needs to understand the differences between outcomes and casual features.

 
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Question of the week: What are the differences that you think are important other than past/present outcomes?

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

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

Enjoy Enthusiasm Now, but Not for Too Long

Introduction

All of us want the stock market to rise, particularly the ones that our clients and we own; that is unless we are net short or have a disproportionate portion in cash. While Mae West, the burlesque queen said too much of a good thing is wonderful, wiser advisers have suggested that people should be careful for what they wish. A number of commentators have said that the current rise in the stock market is the least loved bull market in memory. It is unquestionably lacking enthusiasm.

I agree that on the surface the general public is not enthusiastic about the stock market. Market peaks are characterized by great bouts of market enthusiasm. Previously, I commuted into Manhattan from the suburbs with an individual in a well paying position who one day announced that he quit his job and would be sitting at home and would be day trading one particular dot-com stock which he said would provide him a handsome wage. His financial fate and those of his kind are well known. Others have described similar historical periods as the madness of crowds. I suggest that most important peaks are so characterized.

Up, Up and Away

Regular readers of these posts are aware that while I believe that we are, for the moment, in a melt up, I am concerned that the next eventual decline could be severe if selected market prices rise in the short-term in a parabolic fashion (1>2>4>8>16). Managers of long-term funds producing rates of return 2-3 times the normal (ten year rates of return) will be fired in favor of mysterious managers producing gains, at least in the short term of 5-10 times normal rates. When these “hot hand” managers no longer deliver they and much that they invest in will plummet.

Breakthrough handles

 There is considerable enthusiasm today within the professional and pseudo professional communities as we have pierced various prior statistical barriers. In previous posts I discussed the term “handles” used by the news media to describe various breakthrough price levels expressed in round numbers. The three big handles recently touted and their handles were the S&P500 (2000), Berkshire Hathaway^* ($200,000 for the “A” shares), and Apple^* ($100 on the 7/1 split shares). A fourth one may well be looming in Alibaba ($100).

^*Shares owned by a managed private fund or owned personally

Masking

The proper job of a professional investment manager and analyst is to look underneath the enthusiasm. There are elements that need to be understood and may be of concern in each case mentioned below.

S&P 500

The recent rise may be a function of an extreme amount of money being invested by institutions into ETFs tracking the index. Popularly it is believed that hedge funds and other aggressive investors are the main drivers. In the last week investors only redeemed net $0.6 Billion in domestically focused mutual funds, in the same week ETFs had net equity sales of $6 Billion of which $5.7 Billion went into the largest, S&P 500 ETF.

Berkshire Hathaway - $200,000

Unlike last year it is likely that Berkshire’s published book value and unpublished intrinsic value will rise more than the S&P 500, as it is already doing. Most equity oriented institutions are underweighted in the stock and some feel that they must catch up.

Apple - $100

While the stock is reacting positively to the various new product and service announcements, I believe the gently rising stock price is in part due to a massive buy back program. Ruth and I visited The Mall at Short Hills twice over the weekend to check out the lines not only at a massive Apple Store but also smaller, but still busy Verizon and AT&T stores. What impressed me in all of these stores was very sound and pleasant crowd control. They know what they are doing.

All four of my older personal Apple units have now been upgraded to the new iOS8 software and we are seeing already important improvements. From my particular point of view Apple is not an equipment producer and seller, but a creator of annuities which can probably go on long after the neat new products are no longer annual events.

Alibaba - $100

The high NYSE price on its opening day was $99.70 which could well set up the Alibaba $100 handle. There is enough which is not fully fathomed about the company as well as China that a highly volatile future is likely.

Contrarian Corner: Hedge Funds

There was a negative column on hedge funds in Sunday’s New York Times indicating that a very large California state government pension plan intends to exit some $4 billion dollars they have invested in hedge funds. I suggest that this may well be a clarion call for those sophisticated institutions and some individuals that have not invested in hedge funds to begin their hedge fund research in earnest.

The keys to understanding a hedge fund

Probably there is more misleading information about hedge funds than any other financial community topic. While there are services that track those funds that are willing to be tracked, people do not understand that hedge funds are not an asset class that has well defined rules and regulations. The key documents in the relationship with a hedge fund are the various agreements with the investors which are not necessarily the same for all investors. Because of the perceived profitability to the managers of hedge funds, they have attracted some of the best portfolio managers, analysts, traders, and sales people from both mutual funds and broker/dealers. The attraction has been too great! Thus the ability to distinguish one fund from another has narrowed. We are seeing a number of hedge funds retiring from competition either because they were not successful enough or they made too much money so their principals could retire from client-facing work.

The market environment has not been favorable to many of the past ways some hedge funds have made money. A number of funds in the last couple of years have underperformed, particularly when compared with market indices that were inappropriate measures. Using an average performance measure often gives an inaccurate picture of skills. For example, I was recently made aware of the three year cumulative performance of funds investing in India. Goldman Sachs^* came out on top with a gain of +19.1% and worst was -8.4% by a fund managed by Jupiter^*, taking a mean of 5.4% tells us nothing about the two extremes and more importantly as to how either will act in the future.

We may well be on the cusp of a new period where the skills of hedge funds could produce good results. First instead of a low interest rate environment, Moody’s^* believes that we are coming to an end of the period of cheap credit.  Already one of the measures that I look at daily is the average interest rate paid by banks on deposits which has gone from 0.38% to 0.42%, which indicates that banks are making loans above the rate they can earn leaving their money with the Fed.  This changing environment will introduce opportunities for significant rewards and risks particularly in the intelligent use of leverage. Notice in the discussion above the underlying elements of the market could be significant opportunities through more volatile markets. A retired very successful short seller tells me that profitable short selling is something of a lost art. In the aftermath of greater enthusiasm which will drive prices too high, the art form may resurface.

My thoughts are biased because I serve on a number of investment committees that have used hedge funds successfully in the past. Further, my private fund could be considered a hedge fund, because we can sell short. We haven’t done so in many years as we thought there was, in general, more to gain on the upside than on the downside.

How to play in an enthusiastic arena

As most of you are aware we recommend the use of Time Span Portfolios (Operational, Replenishment, Endowment, and Legacy). The portfolios that have time horizons of five years or less need to be able to use the expected volatility to their advantage or at least to avoid major losses. The longer term portfolios should be conscious that from time to time there may well be attractive bargains available.     

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Comment or email me a question to MikeLipper@Gmail.com  .

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Copyright © 2008 - 2014

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

The Need to BUY Now

Introduction

I have a belief that for the moment we are in a melt up phase which is short of the type of parabolic explosion that signifies a generational top. Further, I believe that in general we have moved from a fairly valued stock market and are on the way toward a fully valued market. Thus, I have been focusing on reducing the opportunities to take large risks of losing substantial capital. I have not, however, devoted as much space in these posts to all the different types of risks there are out there. The quotable Howard Marks of Oaktree Capital, a long-time user of our performance data, has produced another one of his great letters where he has enumerated 24 risks which show the breadth of ways to lose significant chunks of capital.

Nevertheless, a number of professional investment managers feel compelled to buy some positions now. Some may be sensing a “bandwagon” surge on the part of their clients to more fully participate in the melt up. Others have picked up my view to look for unconventional investments. Still others have devoted too much effort on avoiding losses over the years and now need some new winners. These feelings need to be corralled under a term similar to the one that earlier drove investors into the market which was TINA (“There Is No Alternative”) to assuming risk and enter the market. The new term suggested by Howard Marks is FOMO (“Fear of Missing Out”).

A buy a day

I believe that on any given day that there is a security someplace in this world that represents a real bargain. However, to paraphrase Jason Zweig’s excellent interview with Charlie Munger in this weekend’s The Wall Street Journal, one must recognize the extent of one’s circle of competence and not stray beyond it. Further, Mr. Munger has said that patience is needed. He has gone through a period of years without adding a new name to his roster of investments. Charlie’s innate wisdom may be greater than mine, but I am willing to suggest areas that professional investors should examine as long as they are within their own circle of competence.

Framework for seeking new names

My preferred search procedure rests on my introduced Lipper Time Span Portfolio concept. This concept rests on four independent portfolios which may contain funds or individual securities. The four time spans are the Operational Portfolio to provide the next two years of funding. The Replenishment Portfolio which is designed to renew the funding capability of the Operational Portfolio within five or so years. The Endowment Portfolio is to cover the currently identified longer-term needs of the major beneficiaries. The fourth and ultimate portfolio is the Legacy Portfolio which is to produce capital for spending beyond the grantor or initial investor. Typically the Endowment Portfolio is to cover a time span of more than ten years or beyond the competence of the existing investing decision makers; while the Legacy Portfolio, if desired and well managed could be, in effect, a perpetual portfolio.

With the time spans in mind, I find it useful to make some general predictions of the currently likely investment environments in each of the four time spans recognizing the old quote of “Humans Plan and God Laughs.”

At this point in time I believe that the Operational Portfolio will struggle with below historic interest rates which at very best may reach double current rates.

The Replenishment Portfolio should expect at least one major market melt down of at least of 25% and if the current melt up goes parabolic, 50% or possibly more.

Assuming that the market is in a form of recovery by the time the Replenishment Portfolio has done its job, the Endowment Portfolio should be moving up in a cyclical fashion over its life, averaging an inflation adjusted return on equity for stocks and a “real” rate of return similar to returns on capital employed by the general economy. The Legacy Portfolio will largely be driven by the disruptive forces unleashed by technological and sociological changes.

While I would prefer to focus on the longer-term portfolios, my investment management friends and I need to perform well with the first two portfolios or we won’t be given the opportunity to direct the two other portfolios.

Looking for short-term winners

If we were in “normal” times with interest rates tied to credit concerns and inflation, high quality short-term paper would be earning in the 4-5% range which could easily acquit the funding requirement. The so-called riskless investment in US Treasuries can’t do it. My suggestion is to research within your circle of competence the following unconventional thoughts:

1.     In August there were a number of currencies which gained 1% which could be of interest; Norwegian Krone +1.42%, Malaysian Ringget + 1.39%, South Korean Won +1.37%, Brazilian Real +1.24%, and Mexican Peso +1.01%.

2.     Very selected Commodities; Cotton +5.89%, Natural Gas +4.75%, and Aluminum +4.74%, all for the month of August. I would not recommend Livestock +11.45% gain year-to-date or shorting its corollary, Grains -11.28% year-to-date.

3.     Not immediately but in time, one should also select, high quality municipal bonds which are likely see their interest rates go up when newly issued. The banking authorities have ruled that these issues can no longer be counted as High Quality Liquid Assets (HQLA) for bank reserves' calculations. Combine this news and the fact that banks are being forced to cut back on their trading desk’s Muni positions. This means that there will be fewer buyers of this paper particularly at a time that the US needs to dramatically improve its physical and educational infrastructure. Demand for financing will force interest rates up.

4.     Bank loans recently shunned because of fears of a recession may well be priced attractively if we are entering a slow down, not a recession.

Searches for the Replenishment Portfolio

The next five years or so are likely to be difficult for portfolio managers. The melt up momentum will drive a lot of stock prices higher, but one needs to be careful with some biotech and new small companies being priced generously. Focusing on firms which are spending their excess funds wisely to build competitive advantages might be prudent.

Because we believe in the rising capabilities found in many emerging markets we have a number of investments in these kinds of funds for our Endowment and Legacy Portfolios, but I would not be adding them into the Replenishment Portfolio now as these stocks have led in seven of the last ten and half years.  Most of the flows into this sector come from institutionally-driven ETFs (Exchange Traded Funds) which added $3.5 billion in August compared to the much larger and more conservative mutual funds which added only $1.8 billion. Our financial services private fund is doing better recently by not being burdened by deposit-oriented banks.

Question of the week

Where are you finding stocks to buy for the short term (five years)?

__________

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

Comment or email me a question to MikeLipper@Gmail.com  .

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Copyright © 2008 - 2014

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