VALUE INVESTING WILL BE SUPERIOR BUT IT MAY HAPPEN AFTER THE RECESSION - Weekly Blog # 574

Mike Lipper’s Monday Morning Musings

VALUE INVESTING WILL BE SUPERIOR

BUT IT MAY HAPPEN AFTER THE RECESSION

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

Current Inputs
A few weeks ago, one of our perceptive readers asked what advice I had for his good friends that were managers of value stock portfolios. My unexplained response may have seemed nonsensical in the face of relatively poor performance compared to market. I should have explained my thinking. My reply was focused on the business of providing investment advice. I saw a short-term continuation of poor relative performance leading to less money going into these portfolios and a significant number of the managers withdrawing from the business. Lower prices often result from fewer value buyers participating in the market. Without new performance seeking money in the markets the remaining portfolio managers will need to liquidate some or eventually all their holdings. Typically, they will sell their most liquid holdings first and be forced to sell their less-liquid positions when that is all they have left. These sales will be at bargain prices for those that have the cash to take advantage, but there will be few with the cash, courage, and foresight to take advantage of these great bargains. These insightful managers will have less competition and thus they can earn premium level fees.

Recently I reviewed the performance of a large Planned-Giving Fund run by a well-known and respected manager with a recognized value bias. In looking over their performance record, it was superior for ten years, but not for shorter time periods. Just this week we were informed that a” deep-value” manager was closing his shop, as he was no longer able to produce the good returns he had generated in the past.

These inputs led me to explore the structural reason why this group of intelligent, formerly good performers, were not doing better in a market that was performing extremely well. Like many analysts who are closet history students, my search for an explanation focused on recent US financial history and recorded history from Biblical and Ancient societies.

Last Ten Years
 Because government promoted home ownership, various government subsidies and tax credits led to excessive ownership of homes by those stretched in their ability to support mortgages and the reasonable upkeep on home purchases. In some cases the buyers lied on their applications, but much more significantly lied to themselves and their families as to the predictability of their income and wealth.

In the aftermath of the mortgage crisis the government focused on the mis-selling and mis-labeling of tranches and ended up penalizing the financial industry with burdensome regulation and capital requirements. Further, Central Banks pumped money into the market in what came to be known as “quantitative easing”. This has led to a ten-year period where interest rates have been kept artificially low, depriving savers of the rates that paid them not to spend, leading to a global shortage of savings. More importantly, low rates and the availability of capital has led both commercial banks and non-bank financials to make commercial loans at interest rates which encouraged undisciplined credit extensions. Much of this money went to marginal firms for capacity expansions. This has hurt the value investor, as demonstrated by their poor investment performance compared to other investors.

Companies that value investors favor have the following characteristics:

• Strong balance sheets (under-utilized borrowing power)
• Physical assets where the current market value is larger than the depreciated book value
• Close to impregnable market penetration of good customers
• Unique and highly prized intellectual property
• Respected in-depth management
• Stable shareholder base

It takes many years if not generations to build these. The field of competition changes when marginal companies with a poor financial record and large debt can acquire even more debt at low cost. Often, when marginal companies build excess capacity they fight for market share. They do this by lowering prices, which in turn devalues the more sound companies. With a more leveraged balance sheet the marginal company can report faster earnings growth than the value focused company, at least for a while. Thus, in a period where growth is most valued, the marginals will be the more productive investments, until the next recession.

Ancient History + Human Nature
The Bible and archaeology have recorded various agricultural cycles, often tied to weather but also the expansion of crop or grazing land. Humans are driven by fear and greed. When they are in rough balance, humans tend to be both disciplined and careful. However, when either side is predominant humans tend to do extreme things and concentrate all their resources to gain more wealth/power or horde them to avoid current or future crises. When a mass of people do the same thing, like all going to one side of a boat, they can capsize the boat. That is why we have always needed recessions to correct the excesses of a prior period. I see nothing that has repealed this need and thus I expect we will have a recession at some point.

Where are We Today?
While I can’t give a date for the top of the market prior to the beginning of the next recession, nor the percent of the market gain, I can make the following observations:

1. Currently, the US stock market is being led by the NASDAQ composite, made up mostly of tech and services providers. However, this past week the stocks listed on the New York Sock Exchange had a higher percentage of gainers 77%vs. 69%. Perhaps the valuation gaps are too great - NYSE p/e 18.47x vs NASDAQ p/e 23.67x. If the rate of gain slows, perhaps yields will be more important - NYSE 2.16% vs. NASDAQ 0.99%.
2. Despite the strength of the equity market NYSE volume is flat compared to a year ago. The absence of speculative enthusiasm for listed stocks suggests there is more upside ahead.
3. While it is broadly proclaimed that the Federal Reserve won’t raise interest rates this year, this week the average interest rate offered by savings institutions rose 5 basis points to 0.65 bps. I interpret this as savings banks encouraging more deposits for them to loan out. This may support the surprise 3.1% first quarter GDP announcement. I have always believed that the Fed is a follower and not a leader on setting interest rates.
4. Each week the WSJ tracks the prices of 72 securities, currencies, and commodities. Until this week, gainers outnumbered the losers, this week they are exactly even.
5. The bond market is often more attuned to changing financial conditions. In the latest week yields on high quality bonds rose 14 bps, while the yield on intermediate credits declined 4 bps. [Prices move inversely to yields.] This suggests that bond investors are concerned about the future value of the highest quality bonds.

What to Do with Value Funds/ Managers
As a portfolio manager of portfolios of mutual funds, we invest globally in both growth and value focused funds. I expect the more growth-oriented funds to provide both more appreciation and volatility. The value-focused funds will probably go down less in poor markets. However, when interest rates go up, as I expect them to do before the next presidential inaugural, the value merchandise should do better and will receive a reasonable amount of M&A activity.

What Do You Think?  


Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html

https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html



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Do You Need to Update Your Thinking?

Introduction

Many institutional and individual investors are frustrated by the current levels of stock, bond, and commodity markets. These frustrations have led to inaction in addition to a state of anxiety. Most professional investors and many individual investors have had direct academic training and they and wealthy individual investors have had indirect or passed-along academic investment theories. With the major central bankers of the world experimenting with various forms of quantitative easing (QE) which has not had the desired effect, most of the reliable past investment measures have not been working.

As part of our responsibilities for managing accounts investing in mutual funds, we regularly have discussions with fund portfolio managers. Recently I had an in-depth conversation with the lead portfolio manager in a group that I have visited with since the 1960s. In discussing her financial services holdings she used the very same ratios and thinking that I have heard from this group for more than fifty years. I was struck that the fund's great long-term success was based on a very traditional approach that predates the current QE era and may explain why it is not enjoying its normal performance leadership position.

Recently Michael Mauboussin, now with Credit Suisse, published a list of ten attributes of successful investors which I have further edited:

1.  Be numerate (understand accounting)

2.  Understand value (present value of future net cash flow)

3.  Think probabilistically (nothing is absolutely certain)

4.  Update views

5.  Beware of behavioral biases

6.  Know the difference between information and influence

7.  Position sizing

Analysis of Financial Services Opportunities

Almost all financial services stocks are selling below their book value per share, and so the argument goes they are cheap now and will go up in price in the future. Under the current environment I am much more inclined to view their value is what they are selling for, as many traders believe. Book value is not a valuation metric but a reflection of historical costs of tangible assets. In the destructive era of QE some portion of loans not yet non-performing will become non-performing and thus their historic asset value is less by some to-be-determined amount.

The managers and owners of financial services companies claim that since the financial crisis the firms have added to their capital base and improved their efficiency and credit controls but their valuations have not improved since the crisis, even though their returns on assets and capital has. When interest rates normalize (read higher) their returns will rise, but probably won't get back to historic levels. Putting all of the current factors together these stocks are probably worth what they are selling for at the moment. However, under a higher interest rate scenario these earnings could be substantially higher. My view is that the current owners have in effect an option to benefit from normalization of economic conditions. Thus, the shares are priced right for the current environment, but with a potential "kicker" for the future.

One of the problems in using a balance sheet/book value approach is one is only dealing with tangible assets. As both a buyer and a seller of financial services companies, I recognize that the intangible assets are often worth as much if not more than the tangible. Think of this as "brand value." Among financial services stocks in the publicly traded market, I suggest that JP Morgan^* has brand value and Bank of America^* and Citi^* do not. I would clearly pay for JP Morgan without its balance sheet, but wouldn't for the other two. Even Chase's^* credit card business has brand value. Goldman Sachs^* has brand value in excess of its balance sheet. Just track how well quite a number of ex-partners and senior managers have done in raising money for their new ventures after leaving Goldman. I find it difficult to say the same thing for other firms, with limited exceptions for Morgan Stanley^*.

 Opportunities for Financial Services

Anytime there is a flow of money, there is an opportunity for some financial services organization to make or to lose money. Currently there are concerns as suggested by Moody's* that aggregate corporate earnings in the US is unlikely to top the record 2014 level until 2018. John Authers of the FT suggests that if one wants earnings growth, one should escape reliance on US sources. Fund money is already following fund performance. For the year 2016 through last Thursday, Emerging Market Equity mutual funds’ average is up + 18.50%, Emerging Market Local Currency Debt funds +16.62% and Emerging Market Debt funds in hard currency +13.56%. This is a worldwide trend with the second largest sales of ETFs based in Europe pouring into Emerging Markets. Cross border trades create a need for foreign exchange transactions which can be very profitable for financial services firms. In terms of the growth in emerging market debt, professional buyers conduct these through carry trades with US Treasuries and other elements as well as substantial use of margin. Most of the Emerging Market activities have been in Latin America +36.7% (Brazil + 68.4%) and the following list of countries all with gains exceeding + 20% : Russia, Colombia, Thailand, Indonesia, Hungary, Pakistan, and Chile.

* Owned personally or in a financial services fund I manage.

Perhaps the biggest opportunity for financial services organizations may occur with a new Administration in Washington. While one is reluctant to believe any of the political rhetoric from any politician, it does seem that it is likely that massive infrastructure spending programs will be announced. If these get funded, it will likely mean more bond underwriting at the federal, municipal, and commercial levels. Other increased expenditures that will generate buying is likely to be on defense, education, and health.

Conclusion

There are substantial opportunities for the financial services organizations to make or lose money, but most of the gains will be earned by groups that have talent in excess of their financial resources. Successful investing in this arena will be based on business type analysis not solely on financial statement ratios.

_________________

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Can Stocks Move Higher if Bonds Don't?

Introduction

Unlike "data dependent" economists or media pundits, the jobs of portfolio managers and securities analysts is to attempt to make money for their clients. The past is useful in categorizing what has happened in various periods but our job is to make decisions today about what may happen in the future. The question before me today is: when the bond market is no longer rising can stocks go up in price?

Bonds Drive Stocks Since 2000

John Authers, the very perceptive columnist in the FT Weekend edition compares the performance of bonds to stocks since the prior peak in 2000.  His conclusion is that while stocks performed impressively, bonds did extraordinarily. He further points out that on the basis of inflation-adjusted returns, stocks under-performed bonds by 50%. From a shareholder's vantage point the only positive thing that various measures of quantitative easing (QE) has done is it raised the stock price level as measured by the popular indices. As a matter of fact the surge in the Federal Reserve's balance sheet caused by their bond buying is about equal to the growth in the value of the gains of the stock indices since March 2009. This would suggest that the gains in the stock market were in effect paid for by ballooning the Fed's balance sheet rather than enthusiasm for growing earnings or dividends. No wonder these market gains are called the most unloved bull market.

Bond Market Concerns

There is increasing acknowledgment that the global experiment with QE has not propelled various economies to expand. At the moment the Fed is not increasing its bond buying levels and is telegraphing future interest rate hikes. Already US rates are rising. In the last two weeks Barrons' Best Bond Yield average is up 5 basis points which is the same amount that the average of the nations' banks have raised the rate they pay on Money Market Deposit Accounts, (MMDA). Looking to 2017 one assumes that the Treasury will be issuing bonds to pay for the large or the largest infrastructure program ever by the federal government as discussed by the two main candidates.

Based on history, health, expected restructuring of one or both main parties right now it would be wise as to view the next administration as a one term occupant of the White House which could tie in with a likely recession during the term. Alternatively, according to at least one good technical market analyst a potential peak stock market will occur somewhere over the next six years.

Through the Mutual Funds Lenses

The S&P 500 with dividends reinvested is up +8.40% and the Dow Jones Industrial Average is up +8.64% for the year to date through August 11th . While the average sector fund is up +13.79%, the average US Diversified Equity fund is up only  6.33%. One can see short-term the attraction of bond funds over stock funds when "A" rated bonds are ahead by +8.56%, "BBB" funds +9.60% and High Yield (so-called Junk). +10.71%. However, if one is concerned about intermediate or longer term periods one sees a very different story. In the intermediate five year period on average only the "BBB" funds have a compound growth including their dividends over 5%. They earned 5.34% or essentially their interest payments compounded. On the other hand the average US Diversified Equity fund was up +8.42%. This suggests that over most intermediate and longer time periods stocks have outperformed bonds.

All too often market commentators take the raw net flows into mutual funds as a sign of what investors are thinking and currently supporting; e.g., putting money into fixed income funds and products. These views may prove to be incomplete and naive. At one point in time the bulk of mutual funds sales were made to individuals for long-term investment needs. Somewhere around 2/3rds went into Stock funds and the rest into Balanced and Fixed Income funds. For the most part funds were sold through salespeople or directly through the funds. Within each sale there was a built in redemption usually when the investment need was met or for some unexpected emergency. Today, I believe this type of completion is the main reason for redemptions, not dissatisfaction. What is different today is that selling forces find it more profitable and less burdensome to sell other products to retail individual investors. Thus it appears that money is moving because of dissatisfaction. This will be less of a factor going forward as most of the new money going into mutual funds is for retirement plans and a growing number of tax exempt institutions. This could lengthen the average holding period in funds.

The other misconception about fund flows is the inclusion of the transactions of Exchange Traded Funds [ETFs] and similar products as they presumably have the same kind of holders as mutual funds. For instance in the latest week some $0.6 Billion net came into the combined Equity fund base. What is more significant is that $3.6 Billion came in from two large Index funds. My guess is that most of this money is from hedge funds and other traders who are using Index funds to hedge their individual securities shorts and will sell their ETF positions once they cover their shorts. In the same week on the fixed income side $3.5 Billion went into Fixed Income ETFs, $1.3 Billion in High Yield ETFs and $1.0 Billion flowed into High Grade ETFs. (All of fund flow data is from my old firm, Lipper Inc., now part of ThomsonReuters.)

The First Question: When Interest Rates Go Up Will There be Buyers?

For some time investors in bonds and credits have been able to make money through price appreciation caused by new buyers in addition to the income generated. A period of rising rates will cause fixed income products to get lower prices. I believe there will be a meaningful reduction of flows into these products.

Second Question: Where Will the flows Go?

Long-term investors particularly retirement programs and endowments have a long-term need to generate sufficient income to meet their obligations. If they can not generate the needed funds they will seek investment vehicles elsewhere. Various forms of equity may become more attractive.

Third Question: Why Will Stock Prices Rise Significantly?

Perhaps the best answer is that very few of the market professionals believe that it will. Many of these "experts" have been wrong on Brexit and the rise of various extreme political candidates. Interesting there is relatively low risk because of the previously mentioned unloved bull market. One of the few brave commentators is James Paulson of Wells Capital Management whose latest letter is entitled "Stock investors should look a yonder" where he makes the case for a global economic bounce. He sees a bigger chance for dramatic earnings improvement outside of the US. We have been buying International Equity funds that have portfolios that have lower valued securities growing faster than many domestic funds.

Fourth Question: What is Needed for the Market Bears to be Correct?

As there have always been down markets, we have learned to expect them. Even though we have not had a major decline for sometime, we need to be watchful for such a calamity. For example in a 31 month period from March of 2000 to October of 2002, the NASDAQ Index fell some 78%. While it is interesting that today it is selling above its March 2000 level, it is instructive to note that on a year to date through July 20^th, 71% of its gain was achieved by ten stocks. And yes it took 25 years to recover from the 1929 peak. These kinds of declines have been proceeded by extended period of excess enthusiasm which we have not yet seen in at least seven or perhaps even sixteen years. Using price histories that go back hundreds of years some are looking for the next big one to drop over 50%. While this action could happen anytime, at least one technical market analyst believes it is most likely between 2018 and 2022. This somewhat ties in with the next presidential campaign which may be even more concerning than the present dance.

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Two Reversible Negatives

Introduction

For some time I have been worried about a market top in stocks. In a classic sense, a major decline is less likely today for structural reasons than I had previously thought. Two obstacles to higher stock prices are Politicians and Commodities.  Both of  these drawbacks are reversible, but could cause the “once in a generation fall” of my fears.

The Enemy = Politicians

All politicians, as distinct from statesmen or stateswomen, wish to avoid being tagged with unpopular political decisions. The very nature of human and animal life is one of periodic successes and failures. A student of financial history recognizes peaks and valleys. The current crop of political leaders recognize that job preservation and job creation are critical to their reelection. To deliver on these goals they have adopted a policy of bailing out large employers who have sufficiently poor financial conditions that there is fear of substantial job losses. Such bailouts ignore the historical fact that it is natural for businesses to expand and contract, and in many cases particularly good for their customers. When a significantly large number of voters in key areas are employed by a company that is in distress, the modern reaction is to bailout the troubled company or industry with taxpayer money.

The recognized problems of late 2007 and 2008 in the US led to massive bailouts of both major auto makers and very large financial institutions. The public was revolted by this use of its hard earned money in the face of needs for spending on infrastructure, education, and defense. To avoid future bailouts and to protect themselves, the politicians came up with the doctrine of preventing large corporations from becoming “too big to fail” so that the government would be politically forced to bail them out. From the standpoint of protecting the politicians, the various “reforms” such as the Dodd Frank legislation appear to be doing a good job currently, as we have not had a major failure since the financial crisis.

The Price

To fund the bailouts, the Federal Reserve bought almost all of the debt the federal government put out and in so doing increased money supply which led to materially lower interest rates, particularly hurting the retired population, living on fixed income returns from their savings and pensions.

As harmful as that policy was to an important part of the population, a much bigger price was paid by the retail investor. Over the five years that the Dodd Frank bill has been operating there has been a withdrawal from individuals buying individual stocks. This has been caused by two simultaneous elements. The first by making the investment community seem to be the sole source of the financial crisis without regard for the contributions of government policies, labor unions, and inappropriate education.  By demonizing the financial community many otherwise rational investors voted with their feet. In the past, this kind of withdrawal would have brought a response from the financial community.

Because of greatly increased regulation on large financial institutions they needed to add highly paid compliance people and capital buffers that made the cost of serving the middle income public sky-rocket.

For many brokerage firms, the retail cash agency business has become unprofitable. This in turn has led to a change in the nature of the sales force serving the public. They have shifted into selling packaged products that have higher margins and often include borrowing (leverage). This shift has led to a number of the older and more trusted sales people leaving to become fee-paid advisors, replaced with younger sales people with increased sales quotas (this did not sit well with established clients or younger would be-investors). The net result is that far too many investors did not benefit from the doubling of market prices over the last five years. Their absence is being felt today by their lack of enthusiasm for investing to meet long term retirement needs.

Despite various politicians’ beliefs, human nature has not been repealed. Eventually the animal instincts will drive greed over fears and we will get enthusiasm for risk taking. While it is likely to be more muted than what we have seen in China, it will become a force that will override the damage to investors’ psyche caused by the Dodd Frank bill.  (Retail investors own 80% of the small Chinese market often with substantial margin debt. The Asian institutional market is a heavy user of equity derivatives which did not help in the last couple of weeks.)

Commodities, the Second Reversible

I have not owned any commodity future for more than thirty years. Nevertheless, whenever I see the media coverage of a major decline with the expressed view that it will continue, my investment instinct is to look for exhaustion on the part of the late sellers which will create a bottom. To most investors, commodities and particularly futures are of little importance in developing longer term investment policies. With high quality interest rates being manipulated by the central banks, I wonder whether the fixed income market will continue to serve its historic role of alerting the equity market of on-coming problems. If that is the case I am beginning to examine whether there is useful information in commodity prices.

According to Calafia Beach Pundit, while commodity prices are down they are still substantially up from their bottom. For example, Copper, often called Dr. Copper because of its economic ties, is down 40% from it peak but still 290% above its 2001 bottom. The price of commodities is a function of perceived and actual scarcity. One of the students of commodities recognized that in truth, the only scarcity of mankind is “human ingenuity.” Over time technology has eaten away at the use of any commodity through improved mining and manufacturing techniques plus growing substitution of less expensive elements. Also history reminds us that higher prices bring out more supply including new discoveries.

This is not going to become a “gold letter” for I believe that there are a different set of constraints on gold than on other commodities. Nevertheless, the price of gold hugged the CRB Raw Industrials Index in lock-step from 2001 to about 2007-2008. At that point the industrial commodities declined in sympathy to the then economic slowdown. Gold continued to rise until 2011. One might suggest it is when those that view gold not primarily as a commodity but a hedge against the decline in the value of currency became the dominant buyer as the US entered various phases of “quantitative easing.” Since that peak the price of the metal has had a parallel decline to the industrial materials. Gold bullion may have suffered the ultimate substitution by the increase use of “paper gold” in the form of futures and Exchange Traded Funds (ETFs) which absorbed some of the demand for currency safety.

China has become the pivot for commodity prices including grains. The command society shift from manufactured exports and internal infrastructure to consummation of goods and services has changed the global demand for industrial commodities. At some point this shift will meet its logical end and we will see growth in commodity imports into China. In the meantime the other developing economies will need to import commodities to fill the needs of their growing populations.

I do not know when commodity prices will turn upward, but as a student of history, I believe they will. If that happens at the same time as the lust to own securities deemed in short supply, we could have one enormous market rise which we will need before we have a generational type of decline.

Question of the week: Where are you seeing signs of growing demand? (The Mall at Short Hills was crowded on a warm and clear Sunday, today.) 

__________   

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All Rights Reserved.
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