Picking Winners/Avoiding Losers - Weekly Blog # 823

 

Mike Lipper’s Monday Morning Musings

 

Picking Winners/Avoiding Losers

 

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

 

     

Mindset

Every investor, speculator, analyst, portfolio manager, and politician’s job is to find winners and avoid losers. My fundamental training for accomplishing these goals for my family and others relies on my training at the racetrack.

 

The first requirement for success is recognizing where you are and periodically admitting when you are not right, which is distinct from being wrong. Right now, I admit I have been wrong. Using the S&P 500 index’s closing price performance on Friday plus a minimum 3% premium, WE’VE APPERENTLY ENTERED A NEW BULL MARKET.

 

This assertion is based solely on the numbers, although there is considerable short and long-term evidence to the contrary. Nevertheless, one lesson learned from the track is admitting your mistakes when holding a losing ticket. Learning something from your mistakes should often make you a winner. Mistakes are both normal and repetitive. The most valuable lesson is learning how to avoid them in the future.

 

Current Contrary Conditions

The latest stimulus for the market was surprisingly strong Labor Department jobs numbers, which probably disagree with the household numbers due to an increase in the number of people working two or three jobs. Perhaps more significantly, there were 601,000 more government workers than the 257,000 in domestic manufacturing. (Productivity is difficult to calculate accurately, and it is hard to value its worth. Perhaps the same could be said about the number of government workers.) Hardly a week goes by without an announcement by a large employer laying off 10% or more of their workforce. Those laid-off but receiving some settlement should not qualify for government pay. There are secondary layoffs which don’t normally get noticed, such as Abrdn cutting its use of Bloomberg terminals.

 

Longer-Term Worries

Structurally, we and the rest of the world are living more expensively. For the US it can be summed up on a secular basis. Total interest costs are already larger than defense and Medicare costs combined. An aging population with rising medical costs, fewer workers, and more expensive weapons, among other things is driving these expenses.

 

History does not exactly repeat itself but does rhyme. Technology changes, but the way people act rarely does. It is quite possible we have been in a period of low productivity and stagflation since the COVID years, paralleling the 1930s with some of the aftereffects of the 1940s. Hopefully we will not waste time and money trying to spend our way out of it, although current leadership around the world seems to be imitating those back then.

 

How to Invest

Recognize that the betting odds do not favor straight-line extrapolation. We individually will have to move cyclically and at times it will be unpopular with current opinion leaders. Some suggestions won’t work or will only work infrequently.

 

Targets of Opportunity

• Hospitals and Health Care will grow bigger, more complicated, and require management skills not frequently present today.
• Market popularity will prove to be expensive and will not last long. The gap between leaders, followers, laggards, and mavericks will be large. It will be difficult to consistently travel with the same people. Few, if any, can effectively work successfully up and down the ladder. Very little will be permanent, and it will come at a cost.
• Two lowly valued sectors, transportation and advertising, could be good opportunities for the talented.
• Also of interest are companies that have intelligently managed turnarounds, either by changing dramatically in size, location, or the makeup of their performance drivers.

 

Please share your targets and progress with me.    

 

 

 

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Mike Lipper's Blog: Is This “Bull Market” Real? - Weekly Blog # 822

Mike Lipper's Blog: Worth vs Price Historically - Weekly Blog # 821

Mike Lipper's Blog: 2 Media Sins Likely to Hurt Investors - Weekly Blog # 820

 

 

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Caltech Data Heretics Go to Track for Inspiration - Weekly Blog # 632

Mike Lipper’s Monday Morning Musings

Caltech Data Heretics Go to Track for Inspiration

*Heretics are people holding opinions that are at “odds” with what is generally accepted, “odds” suggests seeking higher returns.

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

One of the luckiest occurrences of my life was being asked to join the board of Trustees at the California Institute of Technology (Caltech). Participating in board/committee meetings, as well as the informal gatherings, has been one of the great learning experiences of both my and my wife’s lives. I had not focused on the thinking process leading to the 39 Nobel Prizes awarded to Caltech scientists until this weekend. Ruth and I watched a podcast hosted by fellow trustee Rich Wolf on “The Making of The Lonely Idea”, one of several podcasts covering a few of Caltech’s scientists outlining their thinking and discoveries. On the broadcast a few realizations became clear to me:

1. Some of these great minds drew inspiration from the racetrack which is the leading source of my security analysis and investment career thinking.
2. The building blocks of our thinking rests on data, and it is often believed with religious fervor.
3. A careful analysis of the data requires a probing mindset for validation and adjustment.
4. Sound thinking must be anchored in the real world of human experience. 
5. A driving humility that accepts the reality of what is not knowable, as well as a realization of how little we individually know.

This is a particularly good weekend to focus on the investment implications of Friday’s surprising announcement of job growth in the private/commercial sectors, and a much smaller than expected rise in unemployment. The good professors at Caltech would first focus on the generation of the data that led to the burst of enthusiasm for stock prices on Friday. The enthusiasm resulted from a series of global occurrences, including China’s recovery from its shutdown and the announcement of massive US and European stimulus for their economies, to be paid largely by wealthy members for the benefit of those less fortunate.

For the purposes of this discussion I will focus on the US scene as it is the largest portion of most of our subscribers’ wealth and consumption. Nevertheless, few of us lack exposure in our investing and consumption to the influences beyond our borders. It is critical we appreciate that we are living in an incredibly fast and evolving situation as the data is flashed to us. The employment/unemployment report for “May” was for the week ended May 12th. In most months, a mid-month read is a reasonable summary glance for the entire month. However, this is not the case for this report. During May and June, the US, Europe, and Japan have been coming out of a COVID-19 lockdown. With good reason, private citizens have been reluctantly exposing themselves and their families to more contact with the outside, resulting in more people normalizing every day. Consequently, I believe the numbers for the second half of May will be materially more favorable than those of the 12th of May. With the Northeast and California coming online in June and July the employment numbers will get even better.

Humility
One of Caltech’s regular teaching lessons is that there is something to learn from every experiment, typically with more learned from those that did not deliver on their objective. (With a bunch of losing betting tickets and occasional market losses I have a reinforced need for humility.) While we never truly know what the future will hold, the breadth of today’s possible outcomes is extremely wide. In talking to people struggling to make financial plans for the fall and next year, it becomes clear that the probabilities concerning the direction of prices is currently more uncertain. Some see an initial a wave of price declines, due mostly to retail/office space rentals and the liquidation of existing finished goods inventory. This appears to be a short-term view, as almost every serious person I chat with expects prices to rise in the future. An interesting aspect of these discussions is that they initially expect the focus to be on a limited number of critical items purchased at higher prices. When asked about other prices, I am often met with “Oh, I did not think of that, but it should be added to the list”. At the end of these discussions the roster of price increases is considerably larger than the list of expected price bargains.

The key to future prices is the expected level and nature of demand. In assessing this I believe I need even more humility. The consequences of first and future waves of COVID-19, as well as geo-political considerations and habit changes, suggests that as we climb out of our foxholes people may see their lives, jobs, and homes very differently than in the past.

Financial Security
One important area of concern is the understandable desire for financial security. In our own minds we build our own fortress (prison). Until recently, many felt their jobs were the foundation of their security and this was particularly true for those who worked for large organizations. We have seen many of these employment centers “Right-sized” and many are threatened by it coming. Beyond what we earn from our labor, many count on individual and/or group investments: pensions, 401ks, 403bs, Social Security/Medicare, etc. Except for low earners, none of these are impregnable, particularly regarding high inflation. While stocks may be attractive to individual investors in the long-term, they are likely to be more volatile, with the cushions provided by floor specialists and contra-cyclical investors getting smaller. The price of gold and gold mining shares is signaling materially higher inflation. Even if the “gold bugs” are only half right, the biggest surprise to many may be the loss of purchasing power from owning “high quality” bonds.

The natural reaction to these concerns is to build ones own financial fortress, which has historically become a prison due to the lack of mobility. Stock markets in many countries are currently signaling just the opposite, with increased speculation, waves of new IPOs, and a rush into private equity, or its disguised companion private credit.

What to Do?
My investment views rests on Caltech’s practices and my track and investment experiences. Caltech’s 300 faculty and less than 2500 undergraduates, graduates, PhD, and Post Docs are always examining perceived knowledge and looking for a deeper understanding of the world as it exists. More experiments and more mistakes equal more learning, which combined with humility produces good results. Not having the breadth of Caltech, I use a twin approach. For clients and family, we build portfolios of funds, mostly equity. The portfolios use concentrated/narrowly focused funds, along with some broad-based funds. In personal accounts we occasionally add individual stocks to provide exposure to investment areas insufficiently covered in our funds. The big difference in our approach is time horizon, which when successful is for multiple generations.

Question:
Is your investment thinking evolving? If not, why not?

 

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https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html



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Government Debt vs. Tough Love

Introduction

Introspection is forcing many managers and investors to privately reconsider the basic premises of their long-term investment strategies. With the popular US stock indexes at or near all time highs, why don't they feel better?  The relative investment performance of many high quality value-focused managers is lackluster. The companies they own are doing well and for the most part they are sitting on lots of cash earned overseas from faster growing markets than their own home market.

One of the sectors which is doing very well for many portfolios is financial services securities. In terms of market value this sector is the second largest in the S&P 500. Further, in most other markets, the financials are the largest high quality names. Our own private financial services fund is having a good year producing returns at least twice a "normal" year would produce. And that dear reader may be a symptom of the deep problem.

The two drunks structure

When two people who have had too much to drink and are marching down the street supporting each other, there is a symbiotic mutual support system at work. In most countries, governments are thought to be the guarantors of at least the banks’ depositors, if not the majority of its creditors. In most societies, the largest owners of the governments' debts (those that are not a government entity like social security) are the banks. The drunks are into each of their pockets in a major way.

The reason and the costs of financial dependence

We all know the historic reasons for these relationships. In the past each side was feared to be in danger of failing. Under these circumstances heads, some of them innocent, would roll. There would be disruption of “normal” activities and many things would grind to a halt. That is until replacements came into being with new leadership and fresh capital. Order would be restored with the absence of some wonderfully historic nameplates such as Bear Stearns, Lehman, Washington Mutual, Countrywide and Merrill Lynch; as well as, at least initially, more assorted spending and investing. In a parallel example, think about some function or people who were let go and not replaced. In all likelihood they were not earning their cost of capital and in the past were a drag on all who were.

No bailouts plus “tough love”

In a somewhat simplistic view the bottom line of corporate, bank, and government failures is that they run out of money. This was probably due to the fact that they did not earn enough to pay their debts (including to their own people), and because their clients and citizens did not value their services highly enough to meet their obligations. As an independent investment advisor and private citizen, no one is holding a safety net beneath me to meet my obligations. Recognizing that I am not likely to get some form of bailout, and that with the specter of tough love, I have to manage my affairs to pay off my legal and more importantly for me, my family and charitable obligations.

What would the world look like under tough love?

Governments would rely on their taxing authority to meet much more limited needs. Some of present expenditures would be taken over by the private sector; this would include the postal system, Medicare, Social Security, Patent Office, Library of Congress, mortgage companies, student and farm loans, many government facilities and more.  At the same time the private marketplace would determine what would be the minimum level of capital required for a bank to be considered sound and safe. This probably would mean that banks would keep very little of their capital in medium to long-term bonds.

Do I expect this to actually happen?

No, but I think there is some chance that we will haltingly move in this direction.

If there is any chance, how should this be played?

In a conceptual sense we are already seeing replacements for traditional banks. You can't tell this from midtown Manhattan or in many wealthy suburban communities, but the number of bank branches is dropping. The financial agents for college age kids are credit cards, student loans and the “Bank of Mom” or other relatives. In some respects Google, Alibaba, Amazon and undoubtedly others including financial services web-based brokers, large family offices, gatherers and distributors such as BlackRock, Blackstone, KKR and T Rowe Price* will play roles that banks have played in the past. Not all of these stocks will be successful, but some exposure in portfolios will be warranted
          *Held by my private financial services fund.

A question

Who is providing financial services for your children and how will this impact your plans in the future?

___________________

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Troubling Near Term Indicators and Longer Term Challenges

• Emerging Markets in Reverse
  
• DJIA Peaking?
  
• The Threatening State of "USA, Inc."
  
• Buffett Reloaded with Itching Trigger Finger

Emerging Markets in Reverse

In January of 2010, the net inflow into regional equity (emerging market) mutual funds was some $500 million. In December, the monthly inflow was almost identical, $453 million. The next month, (January of 2011) saw a net redemption of close to $1.4 billion. Remember that the troubles in Egypt really started on the 25th of the month which did not leave much time for reactions. The $1.8 billion swing from inflows to outflows on a $73 billion base is truly remarkable and a sign as to the volatility of mutual fund demand. True, that emerging market funds are usually no-load funds and are used by investment advisors and hedge funds to a greater degree than the normal mutual fund demand. In addition, there was growing evidence that the gush of capital created by the “QE2” (the second tranche of the Federal Reserve’s “quantitative easing”) had peaked. This flow into the emerging markets helped to set off inflationary pressures in many emerging market countries. Some of the pull back may have been caused by weather related damage which may get us back to the original meaning of “high water mark.” (Not the highest value a hedge fund reaches for performance fee purposes.) Whatever were the reasons, the rapidity of the change is unnerving to longer term investors who were looking for the inflows to continue to raise the valuations in these markets beyond their historically high levels.

DJIA Peaking?

One of my required jobs each weekend is to pore over Barron’s magazine, which has the most complete set of market statistics generally available. This week on the "Market Laboratory" page there are charts of the daily movement of the three major Dow Jones averages covering the Industrials, Transportation, and Utilities since the last week in August through last Friday. The patterns are revealing.

• Utilities reached a high in mid October barely surmounted in January only to fall back to their end of November reading earlier this last week. Most often utility stocks move as bond substitutes when interest rate moves, but occasionally they react to perceived changes in the prices of heavy oil. On an overall basis, one has not earned any capital appreciation since mid October.
  
  
• The transportation average over this period has risen from approximately 4000 to a high the week before last of 5298, before plunging to the level of November’s last day of 4855. The average regained this week to a final reading of 5060.
  
  
• The Industrial average has been going straight up, the average low in the last week of August was about 9900, before consolidating in November. Last week the DJIA peaked at 12,389. There are lots of reasons given for this remarkable rise; QE2, better third and fourth quarter earnings, a normal seasonal recovery, and the beginnings of a tepid re-engagement by the retail investor.

To say the least, the lack of forward moves by the Dow Jones Utilities and Transportation averages makes the sprint by the Industrials questionable or at least unconfirmed. Later in this blog I will make a few comments on Warren Buffett’s copyrighted letter, but in this context I should mention that he has substantial investments in transportation and utilities, and is generally bullish. When in the latter part of 2010 I came out with my view that we could challenge the markets’ old highs, I intoned that it would not be a straight line and there might be several attempts needed to reach and surpass the old highs. Since then, several times I have indicated that I was getting nervous about the increasing number of bullish comments by pundits of all types, but particularly from the brokerage fraternity. While I earnestly hope that the turmoil in the Middle East quickly settles down and that we reach working compromises on the 2011 and 2012 budgets, prudence demands that I express considerable doubts. Thus, we could have seen a seasonal high in many stock prices and won’t see much in the way of forward prices until the last four months of the year. Please bear in mind all future projections are dependent upon geopolitical events beyond our knowledge and perhaps understanding. For those with a reasonable commitment to equities, particularly those that are labeled domestic equities, maintain your overall positions. For those underinvested in equities, pick your spots and place orders below market prices and if you get some buys, put more orders in further down.

The Threatening State of "USA Inc."

Many of the members of this blog community will remember the name of Mary Meeker. She was the single most effective analyst/investment banker/marketer of the dot com companies. As in the past, she has just published a thoughtful analysis of the United States government with lots of sad detail and many Power Point charts. She is persuasive and may be correct in her analysis. She is not trumpeting solutions. Her approach is to look at the federal government as a business which has both balance sheet and off-balance sheet debt problems of enormous and threatening proportions. She looks at the data as a professional turn-around analyst would. To oversimplify, her base case entitlement expenses amount to $16,000 per household per year and entitlement spending outstrips funding by more than $9,000 per year. (The unfunded entitlement spending includes, in trillions of dollars, $35.3 for Medicaid, $22.8 for Medicare and $7.9 for Social Security.) She has follow-up arguments illustrating that as these debts grow, our balance sheet will lose all of its equity at some point, considering the low savings rate in this country. I would argue with the last presumption, for the federal government has huge levels of assets that are not priced at market, e.g. gold stored in Fort Knox, unused real estate and the strategic oil reserves, etc. (I personally would love to see the transfer of all non-operating assets to a reconstituted Federal Reserve, as some backing for our fiat currency from the current political control.)

Without getting lost in the details of this analysis, there are some very important analytical inputs to each of our own asset allocations. Due to our political system, the “investor class” will pay for the shortfall either directly through taxes or indirectly through induced inflation beyond what is driven by natural scarcities. I would suggest that we need to add a significant contingent liability to our balance sheets that either we, or our heirs will pay.

As our asset listings should be net of expected taxes, this contingent liability is an after tax amount. As a working number, not a good one, I would multiply the $9,000 shortfall of entitlement spending by one’s expected lifetime or (perhaps if one wanted to be really conservative, the life expectancy of one’s heirs). We also need to recognize that the so-called rich will pay the bulk, if not all, of the shortfall, thus a further multiplier is needed, perhaps 4X as the burden of the shortfall that will be placed most heavily on the top 25% of households. No matter how you do the math, it is a staggering amount that can reduce our real long lasting equity. To me, this suggests that we need to move to an all equity and tactical reserve posture. The equity does not have to be in publicly traded stocks. Often private earning property and/or businesses is a better position.

There is one way to avoid this dire prediction, and that is to generate the political will to tackle the very hard job of getting all of our governments under materially better financial control. This won’t be easy or fun.

Buffett Reloaded with an Itching Trigger Finger

One of the pleasures of the last Saturday in February is to read the Berkshire Hathaway Annual Report and Warren Buffett’s letter to shareholders. Point of disclosure: for many years I have personally been a small shareholder, and in later years my private hedge fund has been an owner of Berkshire Hathaway shares. As mentioned above, Berkshire owns the largest freight railroad in the country and one of the leading utilities groups as well. The announced theme for the annual meeting this year is transportation: Train, Plane, and Automobile. Buffett clearly believes that these are good investments. Due to the prodigious ability of Berkshire Hathaway’s owned insurance companies to generate “float,” plus an expected maturity of several investments made at the depth of the last market collapse, Buffett will have about $60 billion to invest and he is anxious to do so in one or only a few major investments. With that kind of buying power in the hands of a skilled investor, I have to be optimistic. For those who are interested in the complexities of long term equity puts of the European version and other intriguing derivatives, the letter and Annual Report are worth reading. Click on the following titles to read:

Warren Buffett’s 2010 Shareholder letter and Berkshire Hathaway Annual Report

My blog post covering Warren Buffett’s 2009 letter

My blog post covering Warren Buffett's 2008 letter



In Conclusion

Be particularly careful now, but you owe it to yourself and your heirs to be an equity investor either directly or with an advisor.

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