Handling Two Big Future Investment Losses

Introduction

None of us know the future of our investments. Unless human nature is altered we should be prepared for two important losses. According to the Marathon Global Investment Review, the great Ben Graham* (in the Intelligent Investor)  warned investors of the probability that most of their holdings will fall by "one third or more from their high points at various periods." I see no reason not to accept his warning today. This is the first investment loss probability ahead of us.

*I feel drawn to any views expressed by Ben Graham. He and my old Professor at Columbia University David Dodd wrote the Bible for our business entitled,  Security Analysis. I am particularly susceptible to quotes from them. The New York Society of Securities Analysts which Ben helped to found honored me with the Benjamin Graham award for services to the society.

The second big future loss ahead of us is our reaction to seeing our wealth decline, perhaps materially. After each major market decline some investors in their mind retreat from taking on any more risk and withdraw from investing. Often they blame their loss on what the popular press claims was the culprit. That way it is easy to, in effect, give ownership to the bad people and policies that they think led to their realized loss. Rarely do they examine their own behavior and naiveté as a contributor to the loss of supposed value in their portfolio. Thus, they can transfer all of the responsibility to these external factors. In other words, the government, the leaders, acts of nature, new products, foreigners, etc., were the causes so they have passed the ownership of the calamity to others.  Actually, this is a small part of the real long-term loss. The real shortfall is the subsequent loss of opportunity. Fortunately, we live in an equity world that after each serious decline the surviving market prices rise and eventually top all prior peaks and of course valleys. Bottom line: one must be a participant in the game to gain the benefit of the recovery.

For many there is a third risk of loss, a different type of risk: career risk. We are already seeing investment professionals lose their jobs. Often the layoffs start at the bottom of the ladder. Today I know of good analysts, portfolio managers, institutional traders, and various administrative types that have been cut from investment advisors, brokerage firms, hedge funds and some market-making facilities. Hopefully after some difficulty many will survive and quite possibly start or get involved with the new entrepreneurial activities that will become tomorrow's winners.

There is another group who indirectly suffer from the career risks of others, their customers. The current environment, after years of mild investment progress, has had only eight months of slowly accelerating progress except for the last couple of months, when it has been gaining faster. Many careerists have not bought into the current rise, so their portfolios have risen more slowly than the popular markets. This is the final straw that breaks some of their clients’ backs or their investment committees. Many investors can tolerate middling performance when the markets are slow, but when momentum sets in, they want a higher level of participation. Except for race horses that are bred for and trained to come from behind, few come from behind and win in particularly long races.

What To Do Now

Others may disagree with my global belief that we have entered a different phase of the equity markets. Prices are generally rising and have passed out of the comfortable range in terms of average valuations. One clue to this is that most acquisitions are shifting to all or largely stock rather than cash deals. We are seeing proposed deals based on the breakup and sale of the various deal’s parts. Is this a signal that we should withdraw from the global stock markets?

While life is never easy for a conscientious professional investor, a good one can identify the appropriate tool kit for various markets. I believe we have entered the phase where sentiment is more important than published financial information. What is important is not the current facts, but how the market is interpreting the new facts in terms of views as to future stock prices. For example, as is often the case, one can see a lesser risk orientation in the corporate bond market. For the moment forgetting the narrowing spreads for high yield paper versus Treasuries because many of the new buyers are disguised equity buyers, they focus on intermediate credits. Barron’s publishes an index of intermediate grade bond yields. Since the beginning of this year the yields have come down 13 basis points and 100 basis points over the last year, indicating an increased demand for this paper. Similar yields for the highest quality bonds have actually gone up 5 basis points and declined only 21 basis points over the last year. All this arcane algebra is flashing the message that in the most conservative sector of our markets buyers are accepting higher credit risks. They perceive less chance of bankruptcies than a year ago and particularly since the beginning of the year. 

Many of the more retail-oriented sentiment indices are slowly beginning to move. One  indicator has me particularly interested: BlackRock believes that individuals are replacing trading groups as the main buyers of its Exchange Traded (ETF) index funds. I believe BlackRock’s retail investors are principally going into its Large Cap index funds, just at the same time there is a continuing trend of what I believe are mutual fund investors redeeming their Large Cap funds after reaching their investment goals. Actually I believe the main way BlackRock is seeing flows is from retail-oriented brokerage houses, often discount brokers. I am wondering if the flow is from brokers or investment advisors who are playing catch-up from being behind for a long time? Their clients are outer-directed and easily led. (I see fairly little signs that do-it-yourself, inner-directed investors are moving into Large Cap indices.) The reason for my skepticism is that when all the stocks in an index move together or are highly correlated, the low or no management fee is attractive. Today we are seeing that tight correlations are coming apart. Rank almost any industry in term of stock price performance now and a year or more ago. You will see the performance spread between the best and worst performer growing. If you want to get the best performance one needs to be in the better performing stocks or shorting the worst.

If I am close to being right, the move of the uninformed public being guided by career risk advisors is an important sign of a top.

In addition to sentiment indicators, a good technical market analyst can be useful. One that I follow has been writing about a major top within the next few years. Others have different views and timespans.

Winning Attitudes

Two wise investors from many years ago are worth paying attention to, even though they are very different. The previously mentioned Ben Graham became quite a stoic so he could tolerate the cyclicality of the market and be prepared to buy cheap stocks with good dividends and operating earnings. Jesse Livermore made and lost fortunes as a market trader. (He may have done some of his trading through my Grandfather's firm.) He is quoted as saying, "The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among professionals." Further, he said, "It was not my thinking that made big money for me. It was the sitting." 

I have had the privilege to converse with some of the great mutual fund investors over the last fifty years. In terms of the market and their funds during cyclical declines they were stoic and accepted the declines as a normal part of their business even though tension producing. However, one of the reasons that they were so good for so many years was they wanted to chat about their "mistakes" and what they learned from each other, and for the most part they did not repeat. Like all of us they made new mistakes. but they were always learning.

Compliance Adjustment

In last week's post I discussed the shareholder letter released last Saturday of Berkshire Hathaway. Since I did not reference the stock, I failed to proclaim that in both my personal and the financial services private fund I manage, that we own some shares. I hope no one was treating the post as a buy recommendation. My attitude is that we can learn a great deal from Warren Buffett and Charley Munger that is worthwhile beyond their stocks.

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A. Michael Lipper, C.F.A.,
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Risks Found in this Week’s Readings

Introduction

Each week I appear to be a one person research or reconnaissance staff looking through the information clutter trying to avoid Improvised Explosive Devices (“IEDs”).  I hope to dance through the minefield that is out there. Like most destructive forces they are initially hidden and like a wary animal I try to sense dangers before they become clear. My search approach is to look for possible analogies that could reveal dangers to all of our portfolios. This week there were four questions that popped up:

• Possible ties between compulsive gambling and ETFs?
• Are there parallels between the collapse of the Weimar Republic and the US?
• Are there amateur real estate winners?
• Is political arithmetic more important than budget math?

Is using ETFs a form of compulsive gambling?

In The Wall Street Journal’s Review section this weekend, there is an article entitled “The Real Odds On Gambling.” I am pleased that the source of the data for this discouraging article is from scholars in the UK supported by gambling business consultants in the US. The findings showed that the odds on winning big in casinos were stacked against the players 31 to 1, (31 losers to 1 winner).  The scholars also found on average, that gamblers who bet somewhat continuously over a two year period, 31 lost money for every one who made money in casino type games of chance. Poker players playing against other players did better winning about one third of the time. A number of poker players and casino players did win periodically. They kept their winnings by walking away from the tables.   

When I wrote the book Moneywise, I noted that two of my great learning institutions for adult life were the Racetrack and the US Marine Corps. Sorry about that Columbia University, where I joined the professional military through the Naval Reserve Officers Training Corps via a scholarship. Actually a good bit of my racetrack experience was learned while I was enrolled at Columbia full time, with an on campus job and a member of a world famous fencing team. What I learned by doing the math was that it was virtually impossible to walk away a winner for the racing season by betting every race. First there is the issue of racing luck/bad analysis/not picking winners. Second, the state and the track replaced the casino in terms of the take they took out of every bet. Finally, the New York betting crowd (possibly the same Wall Street players or their cousins that I competed with later) were too accurate juggling most of the track odds and the probabilities at winning.

I concluded that I materially improved my chance of walking away a winner by betting few and in some cases no races on a given day. Further I looked for opportunities where most of the attention was focused on predicting the winning horse and the odds on either of the first two or three horses aligned more favorably with my analysis of the probabilities.

What does this have to do with investing in Exchange Trade Funds (ETFs)? I believe a great deal. Over-simplifying, the bettor using ETFs is in for a fast trade, essentially betting against the market’s view of valuation; or else he/she wants to participate for an extended period of time (which is sort of like some of my relatives who wanted to cash a ticket so much that they virtually bet almost every four legged vehicle in the race). Both the short-term and long-term approaches do not have good odds on winning big, particularly when compared with other opportunities.  In truth, I should not be anti ETF as I own shares in publicly traded investment groups that are the sponsors of various ETFs. I have improved my odds by betting on the house rather than with the crowd. I will admit that I have used index funds in various institutional accounts to balance the concentrated investments of some active funds with broader and cheaper passive funds. However, I do not use them personally.

Possible parallels to the Weimar Republic collapse

The inspiration or perhaps more accurately my fear was generated by The Wall Street Journal, in this case a book review of “The Downfall of Money” by Frederick Taylor.  He describes the monetary trap that the German government, the Weimar Republic, found itself in attempting to pay off its high reparations debt calculated in terms of gold. Germany’s answer was to inflate the money supply to such an extent that the internal value of their currency collapsed. (In the week of the French invasion of the Ruhr to seize the coal it was owed, the Germans needed 7,260 deutsche marks for a US dollar. By October the purchase of one US dollar required 65 billion marks and this was not the final quote before the mark became worthless. Under such circumstances one should have seen that a charismatic leader who would fix things and repair the wounded German pride would arise to take over and indeed Hitler did. This part of the story is well known and should be taught in every school in the world.

What is not as nearly well known is the contention of the author that the economic problems actually started in August of 1914. In order to raise the money needed to feed their war machines each of the soon-to-be combatants began to inflate their money supply. By 1920 the purchasing power of the US dollar had declined by 50% since 1914. In reaction to the induced inflation one after another of the major countries returned to a gold standard pushing up the value of gold to offset the purchasing value of the internal currencies, thus wiping out arbitrage opportunities and the competitive advantage of various exporting countries. With this background we can understand the fears of some of the implications of the problems at the periphery of Europe, potential problems in Japan, China and clearly the US with its growing deficit. (At least for now our debt is all dollars based.) We could see at some time in the future a reversal of Franklin Roosevelt’s arbitrarily raising the price of gold behind the US dollar and Richard Nixon’s closing the gold window. (What a strange combination!)

These fears are a good reason that corporations are doing more of their business overseas and in some cases in local currencies. Securities investors should follow remembering that US listed securities represent less than half of the world’s securities.

Investing in residential housing has worked

In an article from the Financial Times it was noted that the UK wealth gap grows as homeowners save more but renters suffer. The article focuses on first time, but well off buyers of residences. They are intelligently reacting to some remaining softness in home prices, low mortgage rates and rising rentals. The same pattern appears to be happening not only in the UK but other countries including the US. There may well be a political as well as economic implications to this as more people begin to think of themselves as a “little bit wealthy” and change their spending, investing, and possibly their political habits.

The real arithmetic of the partial Shut Down

Both the trade press and the general circulation news media are focusing on the size of the current US deficit and the ability to pay the incurred debts. On the surface these are important, but are not the motivating drivers of the politicians leading the battle. For them the key numbers are 17 swing seats in the House of Representatives and 5 seats in the US Senate. If the elections bring additional cover for the Administration more socialistic laws and regulations should be expected. If the reverse happens there will be a stalemate on the legislative side leaving the actions to take place mostly on the regulatory front. The battle is being fought through various press releases and interviews on or off the record to influence the relatively small number of swing voters who will make up their minds in terms of local choices one year from now. Largely the long-term economic impact of what is finally decided in 2013 will have limited dollar impact by October of 2014. Thus the keys to watch are the growing changes of perceptions as to which specific local candidates will be considered less bad than the other person to fight for a better share of rewards for the swing voter. At this point delivery will be more important than wisdom

The Benjamin Graham Award

Earlier this week, I received the Benjamin Graham Award for Distinguished Service to the New York Society of Security Analysts. I have been active in the Society for more than fifty years serving the leadership with energy and advice. In a very brief acceptance speech I stated that I was delighted to get an award named after Ben Graham who was the spiritual godfather of the society. Having taken Security Analysis under his writing partner David Dodd, I was able to say that Ben taught us (including Warren Buffett) that one could lay out various principles but in the heat of the day do something different. (I believe this is an important realization for all who participate in the market at any level.) I also thanked the audience for the ability to give back to a business that has given so much to me.

How are you looking at the investment world now?        

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.