Critical Decisions: Successors, Appreciation and Preservation - Weekly Blog # 523

Introduction

The combination of long flights and attendance at the Berkshire Hathaway* Revival meeting has led me to think more prominently about the structure of successful investment processes. I have often said that if one slashes the wrist of a securities analyst (even before they become portfolio managers), a historian will bleed.

I have been thinking about the failure of the conqueror of the ancient world Alexander the Great, whose key lieutenants were for the most part bad successors. In contrast, I compared that result with today’s most profitable company, Apple* and the succession of Tim Cook to the product/service genius Steve Jobs. (This not a prediction as to the future of Apple or its shareholders.) Currently we are in the public succession disclosure phase of the distinctive leaders of two companies: JPMorgan Chase* and the aforementioned Berkshire Hathaway. I believe both successful and less successful command changes should be studied in terms of responsibilities for our families and non-profits we care about.
*Held in client and/or personal portfolios

The Wrong Instincts

I have sat on a number of non-profit boards officially or observed them as their external investment manager. I have noted a number of habits that usually led to long-term sub par results. Choices are made by committee which tends to favor the politically skilled candidates. Frequently it is deemed important that the new leader get along well with the existing staff. Often what is needed for optimum survival  is to either seriously remove staff or materially change their way of thinking and executing. This is particularly true for academic groups where the new person is meant to solve the single biggest short-term problem facing the institution without upsetting too many of the existing “warhorses.”

Another road to failure is setting up a competitive horse race. Not to say that the best person not often wins, but all too often some of the better people leave in disappointment, which weakens the firm even if the best person wins. Unfortunately, we have seen this approach in financial organizations. Just think of the number of CEOs that have come out of GE and a number of leading brokerage firms. The same thing happens with both non-profits as well as families.

Successful Patterns

When Steve Jobs recognized that his deteriorating health would lead to the need for a new leader he chose Tim Cook. He was not a “product guy” like Jobs, but was the master of the supply chain manufacturing and selling all the wonderful new products that were dreamed up by Jobs and his tight design crew. Further, Jobs told his appointed successor not to do things they way he (Jobs) would do them, but the way that made sense for Tim Cook. Under the successor, the shareholders (and I presume the Job’s estate) have seen their assets multiply a number of times. I suspect that Steve Jobs’ thinking was in part shaped by having been fired from Apple in 1985 to avoid taking it into bankruptcy. Luckily he learned a lot with new responsibilities and was better prepared to be Apple’s CEO the second time.   

Selecting Two American Generals

We have benefited from two US Presidents making controversial decisions to lead our Army at critical points. President Abraham Lincoln chose a cashiered Ulysses S. Grant to lead the Union forces through a brutal campaign, first in the Midwest and then the South. Grant who graduated from the US Military Academy at the bottom of his class, accepted the surrender of Robert E. Lee who graduated at the top of his West Point class and is generally believed to have been the best general of the Civil War era. Lincoln’s selection of Grant was key to the eventual Union victory.

When it came to choosing the commanding general for the US-led invasion of Europe, President Franklin Roosevelt turned down the highly respected, most senior Army officer General George Marshall

(later a brilliant Secretary of State) in favor a much younger and junior officer, Dwight Eisenhower. I suspect FDR’s thinking was shaped by the fact that for a number of peacetime years Eisenhower was on the staff of the very difficult, but brilliant General Douglas MacArthur, who not only graduated at the top of his West Point class but also returned to the Academy as superintendent.  I believe that the President felt that if Eisenhower could get along with MacArthur he could work with the difficult British Field Marshal Bernard Montgomery. Being a politician himself, Roosevelt recognized the importance and skills of another politician.

People Skills Part of Asset Allocation

Warren Buffett believes his greatest contribution to the success of Berkshire Hathaway is making major asset allocation judgments. Beyond the required investment skill to make these decisions, he has the ability to “sell” his decision both internally within the firm, and also to his outside audience which he does very well. In looking at these decisions, with the help of Charlie Munger, he uses both capital appreciation and capital preservation strategies in building Berkshire Hathaway for the next generations of owners. While Buffett likes to portray Berkshire as a long-term thinker, he can afford to do that as long as he has a bountiful supply of cash or short-term paper.

With Warren Buffett and Charlie Munger as models, the approach that we recommend to prospective clients is based on our Lipper TIMESPAN Portfolios^®. For illustrative purposes only we have divided an institution’s or individual’s portfolio into four unequal timespan sub-portfolios. Each portfolio is assigned a portion of both capital appreciation and capital preservation securities and strategies which can be modified if conditions and specific needs dictate. The following table is illustrative and can be modified when required:

Lipper TIMESPAN Portfolio®	% Capital Appreciation	% Capital Preservation
Operational (Short-term)	25%	75%
Replenishment (Cyclical)	50%	50%
Endowment (Present lives)	60%	40%
Legacy (Future Lives)	80%	20%

Source: Lipper Advisory Services, Inc.

Please let me know how you would allocate resources for which you feel responsible.

N.B. One of our long-term subscribers who is both an accomplished mathematician and a successful money manager properly called to my attention that I gave the late Stephen Hawking a Nobel Prize that was not awarded to him. Further he reminds me that his theories were never confirmed by measurement. I plead guilty of being in awe of him as a person and the work he did at Caltech.

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A. Michael Lipper, CFA

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Correlations, Diversification, and Value - Weekly Blog # 521

Introduction

The words correlation, diversification and value are often used to describe purported solutions to avoid losing money. Yet rarely are these tools or concepts in and of themselves fully understood. Currently, many investors with substantial amounts of their investment portfolio invested in stocks and fixed income securities appear to be more worried than usual. This week’s blog post will examine some of my thoughts on these three words. I will be happy to discuss them with you to apply to your own specific portfolio needs.

Correlations

Correlation and its opposite, dispersion, are terms that come from the scientific realm that describe how members of a collection relate to one another. In concept, if there is a group of individual people or securities, they must have some common characteristics. Our psychological need for reaffirmation tends to view correlation as supporting us in our decisions.

In the last week ending Thursday night, the net asset values or prices of mutual funds fell. Eighty nine out of ninety six equity type mutual fund investment objective categories declined. Twenty five out of twenty seven taxable fixed income fund investment objectives also fell, according to my old firm Lipper Analytical Services, now a part of Thomson Reuters. (Money market funds and tax-exempt funds were excluded.)

On the surface it appears that geo-political and interest rate concerns caused the small number of transactors to slightly sell more than they bought.  I suggest that a greater motivation was that after a prolonged period of unrealized gains in their stock and bond portfolios they were worrying about committing the biggest sin of investing - roundtripping.

My racetrack betting experience saw it differently. I saw investor confusion as to the smart bet. At the track this usually leads to many horses with relatively low payoffs if they happen to win. Thus, to me current prices/and price momentum are not particularly useful tools in making investment decisions. I will rely on my continuing analysis as to the long-term imbalance between buyers and sellers and other fundamental investment principles.

Diversification

In discussing investments with a highly respected analyst of fifty plus years of experience, he suggested that in his portfolio it was important to build it in such a way as to be able to sleep well. As I have given up sleeping well years ago in favor of occasional short naps, I didn’t know how to do what he wanted. I countered that sleeping well should not be confused with being asleep for long periods of no intellectual involvement. The sleeper is frozen into position until they wake up. As a US Marine I avoid being frozen into place.

My investment policy rests on the thesis that not only do I not have the skill to predict the future with complete accuracy, but the future will be made up of periods of rotating leadership. I execute this strategy for my accounts and personally through the extensive use of mutual funds. I look to the individual funds’ managements to make smart, occasionally successful tactical moves within their sets of capabilities and mandates. I reserve to myself and my associates the proper mix to meet specific needs and the timing of changes.

Changes should be based on specifics within a fund, such as to tactics and policies, including key personnel, but not performance. Performance is the consequence of prior changes, explicit or implicit. As all human activity tends to be cyclical, periods of poor performance are likely to be followed by good performance.

The key to this portfolio strategy is diversification. I get nervous when all of my investments are doing well at the same time. Thus I am afraid of too much correlation as I won’t have some investments going up, or at worst going down slowly, when others are falling. For the last several years low and declining interest rates have reduced the temporal value of cash or near cash.  The search for yield has reduced the level of cash in many formerly sound portfolios.

We should collectively consider rebuilding our cash commitment as ballast to our investment voyage. As a practical matter, unless cash is above 25% of a portfolio it won’t likely keep the market value of a portfolio positive; what a smaller amount of cash will do is two-fold. First it will allow for the payment of current needs without having to liquidate good investments in a declining market, as would be provided by the Operational sub-portfolio in a Lipper TIMESPAN Portfolio®.  But probably more important than taking care of current needs is a focus on buying bargains. The great fortunes are made by buying bargains near a bottom. As a practical matter better risk diversification can be achieved in less crowded markets, which often means investing in smaller caps and smaller countries.

Value

Investors should not want to buy fairly valued securities. While not completely accurate, Benjamin Graham is viewed as the father of value investing, with Warren Buffett as his leading disciple. As a proud winner of The Benjamin Graham Award for Service to the New York Society of Securities Analysts, which Graham helped found, I am conscious that his fame rests on his writing of the seminal book for analysts labeled Securities Analysis with Professor David Dodd.

When I took his course, Professor Dodd instructed us to recast published financial statements to determine the real value of the company, which was its liquidating value or as some call it “net-net” value. Graham and Dodd published their initial work in the real depression of the 1930s. They were primarily focused on defaulted bonds, which were many. They viewed them as future equities. Their approach, as implemented in their leveraged closed-end fund, was to use a substantial discount from the net-net value as their entry point into the reconstruction of the defaulted entity’s new equity, with the old equity either completely or largely written off. There were a handful of others playing this game, but Graham & Dodd were the only ones writing about this approach.

What brought this to mind was the Barron’s cover story this week, entitled “Are Value Stocks about to Grow Again?” The article focuses on book value compared to current price as the measure of value, and mentions Ben Graham and Warren Buffett.  The concept may be right but the tool can be very misleading. What most of the time drives up the price of so-called value stocks is an above market bid.

In general there are two types of acquirers, financial and strategic buyers. I have been involved with both. The financial buyer is essentially a liquidator, the faster the better. Often the financial buyer is using borrowed money to execute the raid, so they do not have time to get maximum value out of real estate or unfinished inventory. The quicker they can shed people the better. The strategic buyer sees a bigger value in the acquisition than the present management is producing. The acquirer values the customers, the intellectual property, and often the people.

Since most companies are not about to be acquired, they sell at a discount to their acquisition value. Roughly speaking, I start with a belief that many stocks are selling at a 25% discount to a potential acquisition price, which won’t be realized in the foreseeable future because a financial buyer’s net-net calculation is close to an extended book value calculation. Strategic buyers don’t see what they can do quickly with the targeted acquisition to make the return on the new investment.

Liz Ann Sonders from Charles Schwab suggests that value stocks will rise. I agree selectively. A number of companies are capacity limited, with long lead times to bring on new capacity. As customers for their products and services find bottlenecks causing delays, corporations may either buy new capacity by buying a company or will tolerate higher prices. These are capacity plays not book value plays.

A New Constraint

The Department of Labor is questioning the value of recognizing the “ESG” attraction in selecting securities for employee 401(k) plans. A number of foundations and endowments are devoting a portion of their investment pools for similar purposes. They may be challenged by the DoL’s view as to the investment merit of ESG, no matter how laudatory the objectives. It would be difficult to include ESG elements in the calculation of value for many investors. 

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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.

Moves For 8 Months and 8+ Years - Weekly Blog # 520

Introduction

Probably the single most common investment mistake is to have a single portfolio to meet multiple needs. My suggested cure for this malady that has to leave investors not fully addressing needs is to divide the single portfolio into sub portfolios to focus on specific timespans and their funding needs. Thus, when I look at investing my first focus is on the desired cash flow to meet beneficiary needs in specific timespans, (Lipper Timespan Portfolios^® ).

Today I am focusing on the probabilities for the rest of this calendar year or about eight months. I am also looking at a period of recovery in stock prices after the next recession, which the strong odds will come about over the next eight or so years. Finally, I am looking to the period beyond my personal control or influence on various investment committees in terms of replacing very successful investment managers after a long period of successful and faithful performance.

The Remainder of 2018

As of today the only thing that will come out of the 2018 US mid-term elections is more words about the implications for the 2020 elections and some legislation in 2018 which will probably be wrong. Thus stock prices at the end of the year will probably reflect largely what is known today. One of the advantages of learning security analysis at the racetrack is first to identify the most probable result of a future race. This leads to picking the favorite (which almost always is confirmed by the lowest payoff if correct).

My nomination for 2018 is that we have seen both the high and the low for the year in the first quarter. This would result in a gain or loss of somewhere close to half of 2017’s gain. In this case I suggest that there is a 50% chance that we have seen the high and low for the year already. The remaining fifty percent could be divided in half again with a 25% chance that we go through the last top of the market and/or we retrace the gains of 2017. If one combines the most likely 50% with a new high or 25%, this would produce a 75% chance of a satisfactory return for most investors completing ten rising years.

Probable Causes for 2018 - Gains

Frequently I have referred to the weekly survey conducted by the American Association of Individual Investors (AAII) which is very volatile in part because its sample size is small. In the latest week 37.8% were bullish for the next six months, 33% were neutral, and 29.2% were bearish, as opposed to 42.8% being bearish two weeks ago. Stock markets don’t go higher when all the available money is already committed. A major brokerage/wealth management firm is suggesting its clients should sell into any rise.

Another source of cash is investors adding to their account into a rising market and the market is rising. Each of the three major stock market indices have the very same looking chart of a narrow rising channel starting from the February low points. If upside price momentum starts heating up, the old highs could be challenged. (While my clients and I would enjoy these gains, in a contrarian view breaking out of the old high could suck in all or most of the available cash and that would eventually lead to a major decline.)

Probable Causes for 2018 - Losses 

A couple of weeks ago the Masters Golf Tournament concluded with a new young champion, Patrick Reed. His win verified the old expression, “You drive for show, but you putt for dough.” In a similar fashion, stock price movements are what gets the crowd’s attention, but in the fixed income marketplace winning is achieved by avoiding losses. 

Traditionally fixed income is a seemingly dull game for the professionals. While individuals may buy bonds they often hold them to eventual maturity. They don’t trade them. Also they rarely pay attention to credit instruments such as loans and mortgages. Not only is the total fixed income market larger than the stock market in most countries, it is the source of financing of governments and large corporations.

Compared to equity returns, most fixed income instruments trade off their promise of periodic payments of interest and principal return versus lower average total returns on stocks. However, various trading organizations have leveraged their fixed income investments with borrowed money, usually from banks or the credit markets. Whenever leverage is used a small price decline can shrink the value of an investment to a leveraged owner.

Most brokerage firms, bank trading desks, and some hedge funds use leverage to support their fixed income investments. The origin of most stock market declines is a reaction to traders having their loans immediately called and their collateral holder immediately liquidating the collateral without regard for price. That is one risk. Other risks have been created by the central banks of the world that have manipulated interest rates down so much that investors have become desperate to find satisfactory yields. This has led to an expansion of the use of credit instruments beyond bonds. This has led to a situation, according to Moody’s *,  for the first time in recent memory outstanding high-leverage loans now exceed the outstanding amount of high-yield bonds.  In effect, leveraged credit investors are trading off their safety for yield. That won’t always work.

*An equity in our private financial services firm

In Europe and some parts of Asia, gold is a normal part of many conservative investors’ portfolio. This is not true for most US portfolios.  From my standpoint it doesn’t matter whether one owns gold or not, but what matters is what others are doing. A current buyer of gold sees trouble ahead. Each of us can probably create a list of future troubles. That doesn’t matter in terms of one’s own beliefs, what matters is when more people believe it. The way I follow it is represented in a chart that in the recent past depicted a high was established in September of 2017. Since January of 2018 there have been three attempts to meaningfully to supplant it. The chartists tell me that gold is in a rising triangle from a December bottom and could go through the 2017 peak on the way to challenging earlier higher peaks. If this were to happen I would be concerned as to equity and debt values.

Concerns of Jamie Dimon, Warren Buffett and Charlie Munger

Jamie Dimon at JP Morgan Chase plus Warren Buffett and Charlie Munger at Berkshire Hathaway have spent considerable time and thought about short/emergency and long-term succession. I am struggling to do so as well. I have sat on a number of non-profit boards who when faced with the need to relatively quickly replace a retiring CEO look for someone that possesses a skill set that the older CEO did not have and that seems to be more important than continuing the good attributes of the retiring CEO.

Since my professional responsibilities as well as family requirements have to do with the replacement of investment managers, largely of mutual funds, it appears easy to replace funds that are deemed to become poorly managed in their execution of their process, which is much more important than periodic poor investment results. What is difficult to do is to replace a successful manager such as the three gentlemen mentioned. No two people are exactly alike and future periods are going to be somewhat or completely different than the successful periods that we have enjoyed in the past. Do we search for a copy of the successful manager? Do we look for some one quite different? What are the missing skills that will be needed in the future that are not needed presently? How do we assess success? How long a trial period is reasonable, particularly if we enter difficult times? I would be greatly in your debt if you could send me an email or even a snail mail with some of your views to these questions.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

“Data Dependent” Portfolios

Introduction

Future interest rate moves of the US Federal Reserve are described by its members as “data dependent.” This is meant to suggest that when a statistic reaches a certain level, a future action is ordained and carried out. The immediate present (or actually slightly old) figures determine the future according to these economists and other politicians of the top-down persuasion. Considering how bad the record is of the Fed’s predictions, it is a “puzzlement” why these predictions are given so much credence that some mythical king of Siam might wonder.

What is even a bigger puzzlement is why so many investment performance reports start explaining their performance based on the latest data dependent pronouncements. Strange that so many so-called professional investors dwell on the current price (yield or P/E) level and not what as an investor I am really interested in. What I care about is the terminal price of my investments.

The terminal price of my investments is difficult to guess, but that is exactly what I will use to meet future spending needs, whether I am acting as an individual or a fiduciary for a public or private endowment. To determine my terminal price I will need to project the range of the most likely future price trends for the investments. Estimating my place on these price curves will be determined by the range of my likely factors including spending/saving habits including health-related, some actuarial assumptions and probable reactions to cyclical markets. Not a single one of these unknowns is easy to determine. Nevertheless, each one of us unwittingly does this at every buy, sell, or hold decision we make or we allow to be made for us.

A Helpful Took Kit from the Racetrack

When we are besieged by too many questions it is useful to break them down into logical groups. At many US racetracks there are up to ten individual races a day. This translates into about 100 horses trying to win. Luckily for the handicapper, or if you will the analyst, the horses are only trying to win their specific races. These races are divided by length of the race from short to long distances, age of horse, racing experience of the horse, prior level of winnings, and whether the owner is willing to sell the horse at a specified price. One could take conditions of the race as a determinate as to which of the myriad factors on each horse that is to be considered for a bet. Out of this you could come up with a single or a very limited number of probable winners for the race. That is half the job at best. Moving away from the past you should look to see whether the horse looks healthy and is being ridden by a jockey (portfolio manager) that is experienced with this horse and others who run the same way.

While there are numerous other factors, the final decision on what to bet and how much to bet is a function of the odds or the weighted opinion of others compared to your own views. If you are in total agreement with others even if you win, the payment odds after the track's take and taxes are deducted won’t be very large. On the other hand, if your analysis leads you away from the crowd’s choice as most great portfolio managers do, your payoff will be larger but you will suffer the indignation of hearing about the brilliance of the popular choice. Racing and investing are not like picking a winning political candidate. In politics it is guessing what the majority will do rather than picking the most qualified.

Applying Data Dependent Factors to Racetrack Tools to Win

One of the reasons we developed the Lipper Timespan Portfolio concept is that different data points have vastly different impacts on portfolio orientation. For example, demographics are unlikely to have much impact on the investment performance for the next five years. Bear in mind that in the last five years today’s equity funds (now numbering 14, 834)  rose +11.79%.  Taxable fixed income funds (now numbering 4831) gained, including income, +3.66% in the same period. However, when I look to invest money for a minimum of ten years I am struck with the fact in 2014,  Germany & Japan’s average age was 46 years, Italy & Austria  44, Canada was 41.7, Russia 38.9, Australia 38.3, US 37.6 and China 36.7 years old.    

On the other hand Nigeria and Uganda averaged 15 years and three several other African countries averaged 16 years. India was in the middle with an average age of 27.

To avoid a political collapse which can lead to military problems, we will need to aid in the retirement of the senior populations of the so-called developed world which suggests that taxes on the productive sections will go up. For the teenagers in Africa we will need first to feed them, then educate them to find useful jobs with a future. 

Currently almost all general portfolios are invested largely in the Northern Hemisphere and in developed countries. We don’t have ten years to make the shift if we want to be ahead of the data dependent crowd betting on low return solutions. At some point we will need to understand demographics as we answer the cover of this week’s Barron’s, “Commodities: Time to Buy?” In building our longer term portfolios, we need to recognize that increasingly people will be living in or very close to cities, not in the country. This should refine our investments even further.

For most investments you can see a lot by just looking.  Earlier this week, in walking relatively few blocks into the local business district I saw a uniformed workman with a meter rapidly going from home to home. When I caught up with him, he announced without breaking stride that he was a meter reader and the day was so pleasant that he wanted to finish his task. Years ago, as an electronics analyst I followed companies that were developing remote meter reading that could be done from some base station. I was pleased and somewhat dismayed that my brief walking companion still had a job. I don’t know that if he had been replaced by technology he would go to the mall or the downtown where stores were looking to add sales people.

Last year I told someone that I could assemble a world class investment organization knowing a large number of investment professionals that were out of employment or were unhappy where they were. Enough of these individuals have now found their conditions have changed that I feel I could not back that statement up today. From my friends currently running financial groups I hear they are finding it difficult to find the right type of people to hire.  Because of our educational systems' failures we are likely to have increased structural unemployment such as the meter readers or the children recently graduated with liberal arts degrees. Nevertheless our economy is showing signs of strength. The five year and under portfolio is likely to enjoy both improved results and a measurable downturn which hopefully will come later.

Question of the week: Which will come first, DJIA 32,000 or 10,000?

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All Rights Reserved.
Contact author for limited redistribution permission.