Investment Survival Lessons

Introduction

In an accelerating world, I find it necessary to always be learning. I hope to learn from almost every exposure I have. This week’s post is based on three inputs to my investment survival orientation:

1. Future vs. History

2. Markets vs. Economies/Governments

3. Levels of Patience Required

Future vs. History

In an always insightful column in The Wall Street Journal, Jason Zweig interviewed Professor Robert Shiller, the Nobel laureate in economics and the developer of the “cyclically adjusted price/earnings ratio” or CAPE. In the interview there is a particular bit of wisdom for all of us who are condemned one way or another to predict the future. Professor Shiller stated while the current level of CAPE “might be high relative to history, but how do we know that history hasn’t changed?” Asking the question is the wisdom not my answers. There are at least two reasons to believe the certainty of a top of a market.

The first reason is that we live in a very dynamically changing financial world. This is not the first time that governments and their central bank servants have been manipulating interest rates or modern day money; from the ancient times kings reduced the amount of gold and silver in coinage. Add to this that the trading markets have changed due to the use of capital restrictions, markets fragmentation, increased use of lightly capitalized derivatives and the communication of investment methods.

The second reason to question the utility of C.A.P.E. or any Price/earnings ratio measure is my training at the race track. When asked, the wagers who were putting enough of their money on a particular horse that would make the horse the favorite they would focus on one statistic almost to the exclusion of any others. (Favorites typically win only about 1/3 of the time.) With this as a background, you can sense my apprehension when entering the analytical business where the need was to quickly convey brief reasons to make an investment decision through the use of some term or label with the caveat that people would fully understand the limitations, construction, and the past record of misapplication.

 

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax “pre-other” income growth. In addition, I look at net cash generation after debt service as comparative measures before focusing on an evaluation of management to handle future opportunities and problems. Further, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different than today’s version. The calculators of C.A.P.E. use reported data for the S&P 500 companies which is just not good enough for me in the fight for investment survival.

Markets vs. Economies/Governments

While I am very sympathetic to Professor Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey and London using individual tools and data that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed a rapid rise led by the late stage large-cap stocks. Nevertheless, one analyst has supplied some S&P500 benchmarks in terms of downside risks as shown:

a) 200 day moving average: 1905, breaking down from this level could bring more selling;

b) Down 10% from recent top: 1810;

c) Down 20% from top similar to 2011 or a cyclical decline: 1610;

d) Down 33% a la 1987 crash: 1350.

As frightening as these numbers are, they do not include a once in a generation decline of 50% which could take us below 1000 as compared with today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets; e.g., German DAX is down -12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the Emperor is marching naked. 

Current moods of business people and investors are much more cautious than national statistics would indicate. One example may be helpful, Large Cap Growth stocks were up +2.21 % in the quarter vs. -6.39% for the much more economically sensitive Small Cap Value stocks. To show the importance of volume, on October 6^th the stock of T.Rowe Price^* closed at $78.14 on NYSE volume of 872,860 shares. At the end of the week the stock closed at $75.35 on volume of 2,643,245 or close to 3X the earlier day. The interpretation is that the firm’s income will suffer from lower assets under management due to market decline and fewer net sales.

In terms of investment survival I pay attention to the market analysts and have adjusted most portfolios that have a five year or less time horizon to be more cautious. However, each of these bright market analysts see that we are setting up in the long run a major expansion of stock prices and somewhat higher interest rates to which I agree. But this could be delayed by the political forces utilizing inaccurate data trying to create a recovery rather than seeing that they are a main cause of the current malaise. We may need new global leadership.

Levels of Patience

An advantage that I have is owning a large number of stocks of financial services companies either personally or in a private financial services fund that I manage. Thus this week I attended an Investors Day for Jefferies, which is now owned by Leucadia^*, and is owned in our fund. In one way this has been a good holding in that it is up 143% since purchase years ago. In another way it has been a disappointing holding for the last 18 months with the merged stock just about where it was on the day of the merger. Luckily other holdings did better. However, in terms of lessons it may be worth a great deal.  My reason to continue to hold the stock is that I saw it as a unique player in a rapidly changing investment banking and institutional brokerage business with a largely attractive merchant banking portfolio, a significant net operating loss carry forward and new capital resources.

^*Owned by me personally and/or by the financial services fund I manage

What I was counting on was the continued regulatory pressure on the major banks and their investment banking activities in terms of their use of their capital. I was further counting on a significant a number of successful investment bankers and other highly trained technical people seeking employment with an organization that could materially increase its market share through their efforts. Where my analysis was faulty was that these changes would have effect much more quickly. What I should have recognized is that it often takes two to three years for the investment bankers to bring in more revenues than their cost.

Judging by their underwriting and deals success many of the Jefferies bankers are on the verge of becoming profitable to the firm. I should have been more patient to see the expected improvement. It was easy to recognize the pressures on the majors and the deteriorating service levels throughout many of the organizations. This is why I suggested that currently one might not open new bank relationships due to pressures throughout the organization. I thought these pressures would immediately translate to more and profitable business to the non-bank competitors. It didn’t happen on my schedule thus I am reluctant to suggest purchase at this time. I will have to see not only operating earnings coming through, but also a steady decline in Jefferies compensation ratio.

PS: Last week’s suggestion that some of the money planning to leave PIMCO should consider reducing its allocation to bonds may be happening in that the flows this week into money market funds were unusually high. I would hope as equity ratios decline because of falling prices and other disappointments that new capital can be prudently introduced into expanded equity holdings.

Perhaps, once again I need to be more patient.

PPS:  Bloomberg Television Sunday night is showing a weak opening in Asian markets which followed a report from Business Insider that the Dubai Stock Market index fell 6.5%. Be cautious and do not try to catch a falling knife.

Question of the week: Do you have plans to increase your investments in stocks?

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Entering the Most Dangerous Market Phase: In Three Parts

Introduction

Many years ago I heard an unoriginal line in the elevator (lift for my British friends) coming down from the New York Stock Exchange Luncheon Club. “Do you know how to make a small fortune,”  the old floor broker asked then he quickly supplied the answer, “start with a large one.”

There are two important axioms about a major stock (and bond) market decline.

1.    Big losses are only possible after big gains. This is not quite as earth-shattering as Sir Isaac Newton’s discoveries. But the result to one’s portfolio is indeed grave.

2.    Historically by far the biggest loss suffered by investors is not the decline from the peak to the bottom. A much larger loss over time is sustained by the disheartened investors who feel foolish or embarrassed by the loss and withdraw from participating in future markets. One of the reasons that those of us who entered the US market in the mid to late 1950s did so well was that many of the more senior investors were concerned about another Roosevelt 1937-38 type collapse and so were sellers and not buyers.

Part 1: The Market Can Go Higher

My last several posts focused on some of the pre-conditions present in past peaks. I am not flashing red lights for investors to come to a stop of what they are doing. I am stressing that I perceive the need for additional caution. I fully recognize that the stock markets in many countries can get further extended by those who are focusing on the upside by touting the following points:

1.    In a chart supplied by Strategas Research Partners and T. Rowe Price^*, after 57 months of expansion of the last 13 Bull Markets, the average gain was 165% which compares with our present rise through mid November of 164%. Thus we are on track in terms of up phases. There were four Bull Markets which showed further up-side. In terms of greater S&P500 advances the 1990-2000, 1932-37, 1949-56 and the 1982-87 Bull Markets performed greater than we have achieved in this phase. The first two on the list had gains of about twice to three times what we have gained so far. So there is potential for more upside. Morgan Stanley^* is leading the cheering section with a published view that we will see 2014 on the S&P 500 in the year of same number.

2.    The financial conditions in Europe are not only not getting worse, but Moody’s* is selectively raising up various lowly-rated sovereign debt ratings. (In the end, if he could have held on, Jon Corzine would have made money on MF Global’s leveraged bet on the euro.)

3.    Surprising to some, the US domestic economy is showing a pickup in growth. One might wonder whether what we need are more bouts of government shutdowns to help productivity?

4.    There appears to be some chance that we won’t see another US government furlough program as some members of Congress are putting together a budget that takes us through next year’s elections.

Part 2: Deep Structural Problems Are Not Being Addressed

All is not well or improving in our world with some very serious structural problems not being part of current proposals.

1.    We live in a paradoxical world where there is substantial unemployment and under-employment at the very same time that businesses cannot find qualified applicants to fill job openings. The missing elements for the employers are not just a mismatch of training skills. In talking with employers what are missing are basic academic skills, work and discipline attributes as well as work-oriented integrity. Even with an expanding economy many may not find work. In effect we have structural unemployment.

2.    Around the world the size of individuals’ retirement capital is significantly insufficient. To the extent that this lack of retirement funding is going to be addressed by individuals, the only place that they can get the money is by spending less and saving more which will hurt our consumption models.

3.    As a nation there is every chance that, in aggregate, US health care costs will go up beyond various budget assumptions. The strong odds are that society will pay more with less-strong odds that the quality and efficacy of health will improve to the same degree as costs will rise.

Part 3: The Trap is Being Set

There is nothing that I have laid out in this post that is startling new. Most investors will focus on Part 1, the upside. With the rising momentum people will not be overly concerned about Part 2, the problems not being addressed. This behavior is similar to the aforementioned Sir Isaac Newton who bought and then sold out of the parabolic rise in the South Sea Bubble caper only to be sucked back into re-purchasing out of envy and then again lost all that he had committed in the subsequent collapse. He fulfilled the same role that my professor friends at Caltech have demonstrated in the study of the brain which focuses on past successes or pleasures. As a junior securities analysts we quickly learned of the power of the greater fool theory. For a long time fools have more buying power than prudent investors.

What to Do?

I have five suggestions:

1.    Be careful it is easy to get sucked in, many bright people will.

2.    Focus on investment with well-financed companies that have quality products and services that remain essential in the future. You probably will earn less, but probably will also lose less.

3.    Reduce the ratio of your net purchases to your net sells. While cash is the equivalent of trash today in these low interest rate markets, Warren Buffett has amply demonstrated his acumen at Berkshire Hathaway^*, emphasizing the value of cash during periods of stress and accepting under-performance until the rising cash pile can be used dynamically.

4.    Remember that future opportunities will occur and in the long run that will be good for you.

5.    Use the time horizon strategy I have previously suggested separating your intermediate time horizon investments from your longer-term investments. (Please contact me if you would like these posts emailed to you.) The intermediate investments should be current price-oriented. When the bidding for these good companies gets excessive on a historic basis, be a supplier (seller) into the market. Ride out your long time horizon investments and when they periodically decline due to short term factors buy more.

Do You Disagree? Please let me know I am always anxious to learn from wise people.

^*Stocks of the companies mentioned are either owned in my private fund or are in my personal portfolio or both.

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The Shoemaker’s Children and the Empty Cookie Jar

Day of reflection

We had a particularly long New Year’s Day which started with a 5:30 AM drive to the airport with the last of our house guests. During the day my wife, Ruth, filled me in as to the various tuition bills we were going to pay for the family. While this is a good tax planning move, it requires cash. Normally I spend time analyzing the various needs of my client accounts. As with the old tale of the Shoemaker, I do not focus on my own portfolio. For a professional investment advisor to admit a policy of benign neglect is not wise, but similar to many other managers that I know well.

The resulting analysis on my own equity (stocks and funds) showed a 40% commitment to international (excluding US) securities. This was not the result of a plan, but rather individual selections which happened, on balance, to produce good results (or at least better than my so called domestic choices). Looking at the current investment environment I am not displeased with this commitment, but I probably would not start a new client with this allocation today.

The very act of investing beyond one’s likely spending arena is hedging against seen and unseen domestic problems. In the past, when one market declined sharply others held up, and in some cases went up. Today I believe this approach is simplistic. First, when I look at my so-called domestic stocks, T. Rowe Price, Goldman Sachs, Franklin Resources, NASDAQ and Raymond James through a long term focus, each of them expects its foreign activities and clients will produce earnings growth faster than the domestic ones. (These are the five largest positions in the financial services hedge fund I manage as well as being in my personal domestic portfolio along with other stocks.) Second, stock and bond markets around the world are much more correlated today than they have been in the past. For the moment at least, commodity markets march to a whole band of different drummers. Third, the largest single economic and investment locomotive is China. While there is no sign that the management of China is making serious, long-term mistakes, if one was to actually happen (or perhaps worse, rumored about to happen) the market recuperations would be swift and unfortunately dramatic. Fourth, most of the world’s high quality fixed income markets are not yielding enough to be attractive as a holding vehicle.

The empty cookie jar

At least while they were waiting for their own new shoes the shoemaker’s family could rely on a stocked food larder often with a full cookie jar. Today, in a worst case scenario the cookie jar would prove to be empty. Thus, my various reserve elements or if you prefer hedges, could prove to be insufficient to meet our needs.

Memories

In terms of historic investment patterns, for all practical purposes there is nothing new under the sun. While our various Judeo-Christian leaders urge us to read and take to heart the lessons of long ago, in terms of investment thinking most of modern society does not. A significant number of those who are active in the market have been doing it in the present positions under ten years. Notice when many investment funds and ideas are presented as back tested that the length of the test is ten years. (Many machine readable data banks only have or make available ten years worth of data.) Sales managers tell their recruits and younger sales people that their targets have short memories and once a set of prices start to accelerate people will join. Unfortunately, they are probably correct.

Completing the circle

I began this blog post with the need to provide cash for various tuitions. I note with interest that in the Holy Bible, which is a great economic text book, coins were referred to as "talents." Having despaired about the ultimate safety of various reserves, the purchase of knowledge for succeeding generations seems to be a higher and perhaps safer long term return than my other investments. Undoubtedly, the new world we are creating will be different than today, but those with the appropriate talent, energy, and most importantly integrity, are likely to be winners.

What do you think?

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Unintended Consequences: Investors Again Lose to the Politicians

Two quotes came to mind last week, the first was by New York Judge Gideon Tucker (sometimes attributed to Mark Twain): "No man’s life, liberty or property are safe while the Legislature is in session. The second was Will Rogers', “This country has come to feel the same when Congress is in session as when the baby gets hold of a hammer.”

We are about to watch the ultimate sausage manufacture of legislation, which continues a long line of unintended painful consequences to American investors, and much more importantly, to our economy. Soon there will be a conference committee named to resolve differences between the US Senate’s “Restoring American Financial Stability Act” and the House’s “Wall Street Reform and Consumer Protection Act.” As the various lobbyists and their dependent members of Congress write the new legislation (in which almost anything can show up), there is one almost guaranteed certainty. The ultimate result will not provide either meaningful stability or reform. This is not to say that there won’t be change. There are likely to be many changes, some large, drafted in the desire to help us avoid future problems similar to what we have suffered from over the last several years. Almost in a Newtonian fashion, the problem is that any legislative action will produce an opposite reaction by those beyond the Washington Beltway. If history is any guide, the unintended consequences will produce additional serious dislocations and risks to the soundness of investors and their retirement capital.

FEAR AND GREED

The legislation is an outgrowth of the clamoring by many “to do something” about the losses of capital, income, and most importantly, jobs. Unfortunately, changes in the rules of the game (like moving the goal posts in football), probably do not significantly alter the actions, ambitions, and the talents of the players for the most part. Throughout history, from Biblical times to the volatile trading of May 6, investors’ “animal instincts” drive people in the market place whether it is in the stock markets or the job markets. In a gross oversimplification, these are often summed up as fear and greed. (For those interested in these drivers, you may wish to read my book, MONEY WISE.) No law or regulation can prevent someone from buying something they shouldn’t own because they either do not understand it or can’t afford it. When there is a rush to leave a sports arena it is difficult not to join the exit rush.

EXAMPLE: EXECUTIVE COMPENSATION

There are many trails of unintended negative consequences created by various actions of governments. I could not list all of these, but let me start with one example and trace out some of the implications. Perhaps as a way to control compensation for executives, the IRS limited the tax deductibility of compensation expenses over $1 million dollars, unless the compensation was tied to performance. Within a year after the passage of this diktat, companies found ways to measure performance. Often these were earnings and revenues among other statistical measures. (Note that there were no restrictions on how these success ratios were to be achieved.) In some cases, executives could be richly rewarded but the investors suffered as their stock prices declined. In partial answer to these complains, the movements of stock prices were included in the reward criteria. Most often there was a comparison against a general market index as well as a narrow and hopefully more relevant subset. As CEOs were now less likely to be founder/owners, they looked to their compensations as their payoffs for doing a commendable job. Thus these professional managers now had to worry about relative stock price movements.

LOSING FOCUS ON THE LONG TERM

This change in motivation set off three impulses. First, managers manage against the time period for their assessment, which in many cases led to more short term decisions. Often these short term decisions postponed longer term benefit to the shareholder. Second, my fellow analysts were quick to sense the change in management’s focus and they also became more short term oriented. Further they understood that relative performance ranking became increasingly important. In turn, this could lead to building mathematical models in order to predict stock prices in the short term. (Later on, these and other mathematical models have led to the development of algorithms which some traders now use exclusively.) The third impulse was to view defined benefit pension plans as profit centers to hopefully produce the equivalent of earnings. At all costs, significant pension losses were to be avoided. (Again the long term investment value could be sacrificed for the benefit of this year’s financial statement.)

PORTFOLIO INSURANCE

As the concern to protect the corpus of the pension fund progressed, many institutions were attracted to “portfolio insurance,” which was an approach that in part, used futures to hedge the market. When the market went down, futures were sold, or in effect, “puts” were put on. The more the market declined, the more “insurance” was placed. Thus in the aftermath of the 500 point drop in October 1987, when the market rallied sharply, the results for some funds were disastrous. To avoid a repeat of this type of automatic trading, once the market started to drop midday on May 6th 2010, many statistical traders cancelled their automatic buy programs. This purported action may well have led to the 997 point intraday loss. (Sometimes it takes awhile for unintended actions to explode.)

A YEAR IN ONE WEEK

Last week the news was full of European debt and related problems as well as some disappointing domestic economic news. Not only was the Senate passing a stability act but there was also legislation attacking the capital gains treatment for “carried interest.”

Perhaps investors showed their fear of the unintended consequences of the week that ended on Thursday, May 13th, when we saw a “normal” year’s net asset value moves in only five trading days. There were twelve fixed income funds up 5% or more for the week and eleven down 5% or more. We saw twenty equity funds up 25% or more and ten that were down a similar amount. What is important to note that is all but one of the equity funds that gained were those with a dedicated short bias. The next best performing group was funds that held general US Treasuries, which was up about 3%. To put this calendar week in perspective, one stock, T Rowe Price (NASDAQ: TROW), perhaps the highest quality publicly traded mutual fund management company (and a personal and fund holding) ended the week at $50.99 after hitting a low of $47.32 and a high of $54.01. Another indicator of the fear in the market place is the VIX which measures the fear level surrounding the S&P 500. VIX is now about 45 compared to close 15 a few months ago.

IMPLICATIONS FOR INVESTORS

What this means to investors is that we are likely to see more swinging markets for there will be fewer swingers on the dance floor, another unintended consequence of government intervention.

What do you think?
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To Members of Mike Lipper's Blog Community:

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