Beware of Wrong Identities

Introduction

Identifying items that are identical to each other is at the base as to how we learn in the western world. As children we are asked what images are the same as other images. Later on we learn that the values derived from a particular equation are the same as the values derived from another equation, and labeled an identity. Many of today’s college and graduates students learn about investing in forty or fifty minute classes in an academic institution rather than in the marketplace. Thus, it is no wonder that many professional investors and so-called sophisticated investors use identities or labels in finding investment solutions in marketplaces that are always changing. Therefore, it is not surprising that far too many investors will continue to suffer from simplistic, quick, applications of identity labels.

Historical Precedent

This post is being written on the last weekend in June, 2017. Forty-four years ago I first published the weekly Lipper Mutual Fund Performance Analysis. At the time my brother owned the Databank and had been publishing since 1968. There was a large balloon payment due to my brother for my acquiring the Databank. What does this have to do with today’s misapplication of identities?

Going back to the 1930s there were reports on the performance of mutual funds. (None of those reports that were published in those periods exist today.) The commercial purpose of these were to help salespeople in their marketing efforts to sell funds. In the case of my brother’s firm, it was to find outstanding managers to manage separate accounts.

These efforts created a central identity. However, I saw something quite different. I saw first a need on the part of the independent directors of funds to have an accurate, timely, independent source of fund performance analysis covering multiple time periods from very short-term to quite long-term periods. The second and eventually larger user of these analyses were the senior management of fund groups to help them manage the portfolio managers and funds under their command. 

The reason for highlighting the multiple time periods sprang from my experience as an investor, which was based on the thought that one never really understood an investment until one could observe its performance in both down markets and other periods of sub-par performance. Thus, some forty years ago I took what was a then standard identity set and delved deeper into it to get more useful knowledge and applications.

The Current Picture

The nexus of the academics getting interested in the market, perhaps to augment their own income, and the rapid development of fast computers with prodigious memory, the price actions in many marketplaces were translated into mathematical equations. Just as the written word, a published equation takes on the aura of an absolute truth and a sense of inevitability. Currently there is a great deal of money invested in published index matching vehicles. That none of these measures were ever designed to be prudently managed portfolios (which had various liquidity, payment needs, and regulatory constraints as well as expenses) was ignored. Little to no attention was made to the commercial motivations of the index publisher.

This week, the Fortune 500 double issue was published. In the US, the first index-like investment vehicle which started in the 1930s was based on the forty largest companies by sales on the Fortune list at that time. It was perhaps a coincidence that half of the forty were on the Dow Jones Industrial Average and half in what evolved to be the S&P 500. No one seemed to focus on the need of Time Inc, the publisher of Fortune to sell advertising. It was a given that the larger the company’s sales, the more likely the larger its advertising budget.

The original Dow Jones average was to record the dollar value change of leading stock prices or in today’s lexicon, volatility. Publishing the more volatile prices had the greater the likelihood that their newsletter and eventually their newspaper would get paying readers. The NASDAQ indices was designed to focus some attention on the Over-The-Counter market which was not represented in the DJIA. NASDAQ wanted more listings. 

Except for the sales culture, professional investors increasingly found that the published indices were not as useful in the more recent markets. This has led to the production of passive indices based on market capitalization, products produced (energy), legal domicile, largest stock market activity, earnings, dividends, etc. These are often called smart beta or factor based. From my standpoint they are an improvement, but in many cases these are using the wrong identities at the moment.

Information Technology Sectors

Charles Schwab & Co., has addressed the concerns that the soaring tech sector stock price performance is sending a reminder of the “dot com” peak of 2000 and subsequent collapse. The data that they show is persuasive that while the tech group has done well it is more soundly-based than in 2000. What I found of great investment interest in the data was that the tech companies in the S&P500  had net profit margins of 17.8% and a price to sales ratio of 4.5x. Both the Mid-caps in the S&P 400 and the Small-caps in the S&P 600 tech sectors had margins in the 3% range and price to sales of 1.4x. As an investor the way I look at these data points, I wonder how much of the lager tech companies are benefiting from materially lower tax rates due to their more global activities. If and when net tax realizations become lower, the Mid and Small caps should rise relative to Large caps. Perhaps more significant is the major disparity in the price to sales ratios. With all other things being equal, which they almost never are, the prices of Mid and Small caps are much easier for acquirers.

If one were going to select on the basis of statistical factors alone, I would, at the moment, be more interested at tax rates paid and price to sales ratios than market capitalizations. The Federal Reserve Board  has come up with their own factors to approve the capital spending of large banks which could well lead to useful factor investing which can be summarized as follows:

• Credit and counterparts risk

• Liquidity risk

• Operational risk

• Information technology risk

• Trading activities market risk

• Interest rate risk

• Strategic risk

• Model risk

• Reputational, fiduciary and business conduct risk

As all the banks passed their recent exams, we know it is possible to do so.

Shrinking Number of Small Caps

I was delighted to see that my old friend Jason Zweig had a front page column in the weekend edition of The Wall Street Journal on the shrinking number of publicly traded Small-caps. He felt that with an aggregate universe that is half what it was in the past that it would be difficult to beat the index by active Small-cap managers. I don’t like to disagree with someone as well read and knowledgeable as Jason, but I do and it ties into my concerns about identity or label investing.

First, I am under the impression that about one quarter of the stocks in the Russell 2000 are not currently making money. Over time some of these will disappear. Next the job of an active portfolio manager is not to use a pre-determined list with given weights. One of the key tools of an active manager is weighting. In some cases the heavier weights in a portfolio are caused by better than average performance of individual issues, but in some cases it is the manager not the market that makes the weighting decisions. Timing of purchases and sales can make a big difference. The best way to beat an index is to get out of the index. This can be done by owning issues before they go into an index either in their pre-IPO life or at the instance of a successful underwriting. Finally what particularly appeals to me is if the organization is appropriately knowledgeable is to judiciously add some right-sized international issues.

  

Is Indexing Peaking?

The problem with sticking to an identity is that we live and invest in a dynamic world. For an extended period of time the individual security price trends were closely correlated. As with any universe there comes a “Minsky Moment” when greater dispersion takes place. One then wants to be long the winners, some of the Large-cap tech stocks, and short the energy stocks at the moment. I find it of interest that the leading performance of the average Large-cap Growth fund on a year to date basis is so great that now for the first time in five years Large Cap Growth funds are beating the S&P500 index funds for five years. I don’t know how long this will last or it will be led by the best performing sector as of now, Science and Tech. What I do know is that all performance is cyclical.  

Looking for the next Winners

Going back to the rationale I used while publishing the Lipper Mutual Fund Performance Analysis, my recommendation is to focus some of your research time on those managers and funds that are clearly out of step. Understand which tunes they are marching to and be prepared to change your attitude when the big band starts to follow their lead. Remember the identity or label that you wish, first a survivor and second an occasional winner.

__________

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

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Governmental ‘Good Efforts’ and their Unintended Consequences

All too often what is intended to be good works by members of government lead to significantly more powerful consequences to the unsuspecting beneficiaries of institutional investment. This reaction holds true for the present day and future implications of actions that took place in 1830 in Massachusetts and this week in Washington.

The “Prudent Man Rule” causing investment mistakes

In 1830 Judge Putnam found against Harvard College in how the college's endowment was invested. He held that a trustee should invest the funds that he is responsible for as other men of intelligence and prudence invest their own funds. In our more politically correct world this precept is now entitled “The Prudent Person Rule” and has been adopted as dictum for institutional investment. This concept has been particularly helpful to me in building my commercial career as it introduced the “need for peer related comparisons.” This was the legal basis for me to begin to sell the Lipper Mutual Fund Performance Analysis which in turn led to further performance, fee and expense, and portfolio analyses.

Now that I serve on various non-profit investment committees and have some as fee paying clients, I perceive that the prudent person rule can lead to significant losses. Note that the good judge’s words did not define prudence, only how to compare it. The rule suggests that to avoid being found to be imprudent one needs to do what others do with their investment portfolios. In many fields of human endeavor being part of a crowd is comforting. Any serious history of investments (particularly of major declines) will conclude that being with the crowd is to lose substantial amounts of money and perhaps more importantly the confidence to take advantage of rare opportunities that only occur at the emotional bottom of a market. Further, the courage at the top of a market to take different actions than the crowd can be the savior of various non-profit institutions that will leave them with capital when others have to curtail their good works or close their doors. Recently, I have been a witness to situations where well intentioned executive committees made up of people without career knowledge of investments were dictating investment policies to investment committees of professionals. The executive committee or full boards wanted the comfort of “looking like the others” rather than giving the professionals the latitude to be different. For example, following the popular view that diversification is a risk avoidance technique, a certain non-profit board would not approve of allowing its investment committee to have the discretion not to own any of a particular type of asset. I guess the view is that we should have investments in a large number of asset classes even though the professionals believe that there is a substantial risk of loss of capital. (Can you think of situations when you would want to own US Government Bonds with the possible exception of TIPS securities?!)

A more current concern is the inclusion of separate analytic slices for domestic and foreign stocks. As a practical matter many large and small US companies are dependent upon non-US customers for their growth and manage their foreign exchange risks for the most part well. These so-called domestic companies compete with both foreign multinationals as well as local companies and all three groups are subject to the same trends in their business. As an investor for over 30 years in stocks whose main trading markets are outside of the US and as an analyst who has been studying both domestic and foreign multinationals for fifty years, I see less and less distinction between stocks that trade in any of the major marketplaces in the world. In my mind the world is made up of equities for growth of capital and dividend income; and fixed income for interest and capital along with interest on interest. In many ways the main difference between the two is that in theory equities have an indeterminate life and fixed income has stated maturities. There are other legal differences of some importance.

I suggest that the first definition of investment prudence is the avoidance of permanent loss of purchasing power to the extent that the beneficiaries must alter their important plans. The bottom line: one wants to have both the capital and courage to survive and take advantage of investment and other opportunities that occur in periods of stress. To me prudence is all about not taking comfort from seating next to others as a ship is going down.

Senate investigations may lead to unintended structural changes

On Friday the US Senate Permanent Committee on Investigations held forth on three panels involved with the $6 Billion loss of JP Morgan Chase^* through the actions of the so-called “whale.” As a practical matter most of the time was taken up by the soon-to-retire chairman of the committee asking pointed questions of people that were in the US that had some involvement with the loss or the intensive internal investigation by uninvolved senior officials of JP Morgan. I listened to most of the ranting questions by the chair and the ranking Republican member. But most of the time the chair was the only questioner in the chamber. As far as I was concerned, I learned nothing particularly new from what I have read in the papers. However, the hearing perhaps did have some effect in the marketplace. The volume of trading of the bank’s stock was 60 million shares on Friday compared with 26 million on Thursday and 16 million on Wednesday all with relatively little final price move. On Friday, in addition to the hearing, there was the announcement of what the Federal Reserve Board (FRB) would permit the bank to do in terms of dividend increases and stock buybacks. The key to me is that there are enough buyers to absorb the sellers’ disappointments emanating from either the hearing or the FRB action. Thus, I would conclude that there was a lot excitement, but no serious damage to the value of the stock. 

However, there may well be a future development coming out of the hearing that could impact depositors in not only this bank, but a number of others as well. To justify the extensive work of the committee staff for three months and the expense of the hearing, the ranking Republican kept referring to the fact that some of the money that was being hedged was depositors’ money that was protected by the taxpayers through the Federal Deposit Insurance Corporation (FDIC).  Perhaps what the ranking member was saying is if there were no direct risk to the US taxpayer that the Congress would not be investigating a loss that was fully absorbed by the shareholders of the bank, including me in a tiny way. At this point JP Morgan is awash with depositors in the US and overseas because of its reputation for possessing a fortress balance sheet. Many other banks including community banks are similarly burdened with deposits that require they pay fees to the FDIC and cannot earn a reasonable return by investing in the government market and/or find relatively safe loans to make. Under these conditions, I wonder whether a number of banks will elect to leave the FDIC system. If some depositors want similar insurance, I am reasonably confident the private sector will provide such services on a risk assumed basis.

^*  I have owned shares of JP Morgan for many years.

Tip to the wise

We should all be sensitive to the deeper implications of “good works” that we perform and how they could impact how others will act in the future.

Please share some of your thoughts with me.   

______________________________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com .

Why Some Individual Investors Produce Better Results than Investment Committees

This statement seems counter intuitive to the practice followed by most of our great non-profit institutions. I am going to use as my point of departure a talk given by Jeremy Grantham, a very original and thoughtful thinker who is the CEO of GMO, a Boston-based investment management group. Jeremy’s October 7th, 2009 talk was entitled “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” The talk focused on the potential disadvantages of Graham and Dodd-type investing. A little background may well be helpful for the members of this blog community who are not professional investors and/ or securities analysts. Columbia University is extremely proud that both Benjamin (Ben) Graham and David Dodd taught at Columbia and wrote the fundamental bible for analysts, not surprisingly titled “Security Analysis.” I had the great experience of taking the course under Professor Dodd when Ben Graham had fully returned to his investment management activities. The essence to the text and the course was to seek out value as the basis for investing in both bonds and stocks. This task was to be done by professional analysts using financial statements to find stocks and/or bonds selling below their current value. I remember arguing with the good professor, that while finding price disparity was nice, it was likely to produce a lower return than by finding prices that did not adequately reflect future value. While Professor Dodd did not totally disagree with me; he felt that there was less risk of loss by pursuing value than by following a future-focused growth approach. (At the time I was not conscious of the investment career of one of Ben Graham’s students, Warren Buffett. When Buffett looked at an underlying business, he created sensible measures of quality not found in financial statements, thus adding immensely to the valuation equation.)

Grantham's Criticism

Jeremy’s main criticism of the value-oriented investors is that they are not sensitive to the extremes in the marketplace. The value investor conducts his or her investment search the same way in up and down markets, always looking for the cheap jewels in the expensive weeds. This practice can lead to many years of gains which leads to value investors focusing exclusively on the search for value, as defined by low price/book value. Jeremy points out that when cataclysmic changes occur in the market, these investors are not prepared. At the 1932 bottom, 41 years of previous gains were lost. Ben Graham lost 70% in that market collapse, in part because he was on margin (using borrowed money). Among the others who lost a bundle earlier in currency speculation were Lord Keynes, also a user of margin. Some more trading-oriented investors recognized the extremes, like Roy Neuberger, who was short (selling shares that he did not own, but borrowed) going into the crash.

Two Critical Questions

Two critical questions came out of this experience. The first is to question the effectiveness of diversification, an accepted part of investment dogma today. The goal is to hold many assets that don’t go down at the same time, thus preserving capital. The only problem with this principle is 2008, when practically every asset class around the world rolled over into a decline of mammoth proportions. There were some, very few, investors who did not suffer substantially. I personally know of no investment committee-led institution that avoided the decline, but I do know of a few individuals who appeared to have escaped the onslaught. This realization leads us to the second critical question: Why did so many investment committees, made up of honest, hard working, investment professionals (our British friends call them “worthies”) have such bad performances?

"Prudence"

There are two parts to the answer. The first is that the legal charge to fiduciaries is to act prudently. The guiding principle comes down from the ruling by Judge Putnam in 1830 in Harvard vs. Amory, where Harvard lost the case because it did not act prudently. “Prudently” was defined as how other men of intelligence and prudence would have acted in their own accounts. In effect this set up peer-focused comparisons. This was the intellectual foundation of the Lipper Mutual Fund Performance Analysis, which made money by creating appropriate fund peer groups and measuring performance for mutual fund directors. Thus, a fiduciary that is doing approximately the same thing as his/her peers, is being prudent whether the account is going up or down in value. While this prudence fulfills the minimum requirements and answers the career-risk issue for trustees and investment managers, it does nothing to fulfill the desires of the client. The non-profit needs to pay operating expenses and occasionally capital expenses, therefore it may not be well-served by “prudently” losing money. Why then are some individuals better able to produce results than the combined brain power of a group of the worthies?

The second answer is best summed up in a quote that Jeremy uses from Warren Buffet. “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.” The very function of an investment committee leads to prudent actions. I am currently chair of three different investment committees. I find that after an informed, polite discussion, a consensus is formed which rarely calls for taking an extreme action. Members of all of my committees are well-meaning people who have volunteered their time (and quite often their capital) to the institution. We almost never have the sharp disagreements that often occur within corporate or family partnerships. I wonder whether the pleasant decisions are of the same quality as the more intense discussions?

Individual vs. Group Decisions

I believe that Warren Buffet would suggest that at critical turning points, an individual’s decision-making is better than even an intelligent group decision process. Buffett might even favor a strong personality over an agreeable one. I know that trustees that do not ask the tough questions are not acting in the long term best interest of their institutions. They should find their friends elsewhere.

One of my sons and I will see whether Warren comments on this topic while we attend his annual meeting next Saturday. Stay tuned.

_________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.