Don’t Let Your Current Perplexity Slip You Into a Comfort Zone

Introduction

One of the better market analysts (who like the rest of us analysts, can chant history) just sent me an email saying that the current market conditions are not like those of our fathers or grandfathers but more like that those that faced the founding fathers of the US. I interpret this reference to be understanding that we are now in a period of great experimentation, unlike anything in history. It also means that there are opportunities both to lose a lot of money/purchasing power or to make a great amount for ourselves and heirs, be they be personal and/or institutional.

Having my first lessons of analysis attempting to figure out at the New York racetracks, l am continuously looking how to improve my odds of both surviving and winning.

Rules to Survive

1.  Get over your successes. Many years ago as a young security analyst, I had a great year. I published six stock reports all of them significant winners. Institutional clients of the brokerage firm for whom I was working were bypassing my senior analyst and wanted to talk with me directly and wanted to compensate me for my ideas. I did not fully appreciate both how politically unwise this was and the minimal odds that I could keep the streak going. I should have fully remembered that at the "track" and various professional sports arenas all streaks come to an end. Mine did and I learned to compete again at other firms.

2.  Like all streaks, the status quo also does not last. Today bond buyers around the world are believing that the "lower for longer" in terms of interest rates will persist, and/or that they can jump out and avoid the losses when bond prices fall.

3.  Not to believe that you know everything worth knowing. Recently not only did the "experts" get the Brexit vote wrong, but many also did not recognize that the new smart phone from Apple could have market-moving positives. We should always expect to be surprised and to be alert to elements that could prove that our beliefs in our superior knowledge are less than what we tell ourselves.

Rules for Success

In his most recent weekly blog post Teddy Lamade (who also advises clients) has listed very sensible suggestions for investors who wish to be successful. These are as follows:

1.          Resist the temptation to sell.

2.          Control spending to build predictable cash flow for investing.

3.          Be willing to look different than peers.

4.          Be comfortable with a concentrated portfolio and accept more volatility.

The Big Elephant in our Room: Lack of Sufficient Retirement Capital

This is not a new topic for our discussions, but one with some additional information. The current issue of The Economist quotes a study by Citigroup. In this study of twenty OECD countries, the size of the public unfunded pension liabilities is $ 78 Trillion. Nine of these twenty have a liability in excess of 300% of their GDP. (The liability is a multiple year obligation whereas the GDP is an annual estimate of a country's production of goods and services or an income account where the pension liability is a balance sheet obligation. All of these governments have assets that could be used to pay partially or all of the obligation which may be what has to happen as the net savings of these countries could probably not pay off the obligation in under fifty years.) With the success of medical science and modern agriculture, people are living longer. An average 65 year old man in 1960 had a life expectancy of eleven to thirteen years, now his life's expectancy is 18 to 19 years more. Women's life expectancy has been extended by twenty to twenty-four years. Several CEOs of life insurance companies have told me that there are some people already alive that have a life expectancy of 125 years.

In most large population countries during this election season, it is wise to remember that many of the young don't vote, but their grandparents do.

You can see my motivation in creating the TIMESPAN L Portfolios^® to meet these and other needs.

In Conclusion

We will be dealing with different strains and opportunities sooner than what may be comfortable for investors. We will need to free our thinking from our experienced-driven mind set to survive and eventually profit.

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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Nervous Investment Instincts and Cures

Introduction

One of the basics in US Marine Corps training is to develop survival instincts which should kick in during battlefield conditions. These are meant to save the lives of individual Marines, but more importantly for the other Marines he/she are responsible. As Ben Graham wrote in The Intelligent Investor, “We are in the battle for investment survival every day.” (Warren Buffett, wrote a subsequent Preface, and called the work  “By far the best book on investing ever written.” Jason Zweig added commentaries and additional documentation to the latest edition of this landmark title.)

An early warning

One of the frustrating emotions that comes from any long-term intensive study of stock markets around the world is that markets move differently than current economic trends and are not particularly good forecasters of economic movements. What appears to me a better forecasting device is extreme indications of sentiments. Remember that large drops in stock prices occur after large rises. Thus, an increasing level of enthusiasm may be interpreted as an early warning sign that some Marines would sense as a possible ambush.  

Bailouts not the answer

While I was preparing to give a US stock market view to a very experienced group of former stock exchange leaders, the Institute of Stock Exchange Executives Emeriti (ISEE), I was approached by a somewhat  sophisticated investor wanting reassurance that the market is safer now since the financial crisis. The mere question instinctively put me on my guard. (Perhaps I was reacting to my Grandfather's instinct. He had a high carriage trade NYSE brokerage firm that according to family folklore, got all of the his clients’ investment accounts out of the stock market before the 1929 crash.)

Since the 2007-09 "crash," various governments have been trying to build a defensive doctrine against "Too Big to Fail" bailouts. If anything these moves have increased the risk to long-term investors. The real purpose of the Too Big to Fail doctrine was to protect the politicians from their own folly. The public was incensed by the use of taxpayers' money to bail out commercial activities that created their own problems over many years if not decades. In the US the federal government bailed out Chrysler twice, one of the biggest commercial employers in the important electoral college state of Michigan and bailed out General Motors once. (DuPont bailed GM out of its over-leveraged position a long time ago.) In all cases a weaker company evolved while maintaining high relative prices for their merchandise. But the labor unions delivered the votes to elect Democratic presidents.

Mortgage underwriting debacle

When the financial community expanded the mortgage base as directed by Congress through the loosening of the underwriting standards of the federal mortgage companies, the somewhat expected financial crisis occurred. Instead of letting the private sector rescue the borrowers and some of the better servicers, the government elected to bail out the existing financial service companies. If they had not, following the tradition of financial bankruptcies, almost immediately new banks and mortgage companies would have been established taking over the loan books. They would have been populated by experienced middle managers from existing shops. Most of the equity owners would have lost almost all of their risk capital and some of the fixed income holders would have had meaningful haircuts. For the most part the depositors would have come out either whole or almost whole. Since this series of bailouts was directed to the hated Wall Street, the populists were particularly upset. They wanted to ensure that never again would there be a bailout of a large financial institution.

None of these bailouts added any value to existing or future stockholders. As a matter of fact because of their restrictions on some money making activities; (e.g., trading) and the requirement to have large amounts of underutilized capital, the big banks operating under the new rules became less attractive as investments. Large money center banks currently have lower price/earnings ratios than mid size or smaller banks.

As there are bound to be future crises, the existing big banks or insurance companies are likely to have sizeable excess capital available to buy a large worthwhile financial in trouble. Thus future prospects around the world are less safe for equity investors than prior to 2007.

Additional signals

Recently at an institutional investment committee meeting, the main point of discussion was a hedge fund that was making unexpected moves partly due to their success but beyond the expected portfolio discipline. Overwhelming the professional members of the Investment Committee,  the meeting was concentrating on the expected further capital appreciation. There was only one member who was concerned about the risk that was generated by exposures beyond the expected.

While in this particular instant we were talking about investing domestically in the US, the institutional community appears to be betting on foreign stock prices but not on foreign currencies. In the week that ended Wednesday, March 18, three times the number of net dollars were invested in non-domestic ETFs than domestic ($18.4 Billion vs. $5.4 Billion, according to my old firm, Lipper, Inc.).  Most of the money going into the international ETFs went into two country index funds with their currency hedged by WisdomTree^* and one other ETF invested into the MSCI un-hedged. These to me, are short-term trading type of judgments.

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

More conservative investors are also showing signs of becoming additionally comfortable with assuming risk. Domestic Health Care funds are up on a year to date basis +15.69 % and Global Health Care funds are up +13.0%, a continuation of last year's performance leadership that has benefited from spectacular M&A prices, though it raises some risk concerns.

Even in the high quality bond market we are seeing yields dropping much more than normal this week and for the latest 12 months. The lower yields translate to higher bond prices which is unsettling given the general view that eventually there will be a significant interest rate rise/bond price decline.

Cures

The best cures for nervous investors are:

1.  Understand the hyped enthusiasm

2.  Focus on the more important longer term, and

3.  Remember the implications from history.

One of our readers, Teddy Lamade, a fellow weekly blogger and an investment professional with Brown Advisory suggested reading Michael Mauboussin's More than you know: Finding Financial Wisdoms in Unconventional Places. The thoughtful book is a compilation of unconventional approaches to understanding problems from many walks of life-financial, sports, science, politics, and gambling. Below are thoughts from the first part of the book that I felt were particularly relevant to the nervous concerns expressed above:

You are better off focusing on decision-making than outcomes. (This applies to my concern about judgments of managers and therefore risks of repeated poor judgments as distinct from the potential of capital appreciation.)

Robert Rubin is quoted in a commencement address saying, “The only certainty is that there is no certainty...decisions are a matter of weighing probabilities...despite uncertainty we must act.”

In selecting investment managers it is important to understand both portfolio turnover and concentration. (The numbers themselves are the beginning of the discussion not the answer appearing on a screen.)

What is generally good for investors is not the same as what is good for the owners of the investment management businesses. Investors improve their odds by focusing on long-term horizons, (timespan portfolios should help), low fees and expenses, plus consideration of contrarian views as distinct popular choices.

Mr. Mauboussin also mentions one of my favorite investment anecdotes, that the year Babe Ruth set the home run record he also had a record number of strike outs. This highlights the concept that the frequency of correct decisions is less important than the magnitude of correctness. Warren Buffett and Charlie Munger have translated this into investment decision terms.
 

The probability of loss times the amount of possible loss vs. the probability of gain multiplied by the amount of possible gain is the way to make a judgment. (This is why in the long run Dedicated Short-biased portfolios underperform Long-only funds.)

Investors feel the impact of a loss 2½ times more than a similar gain. (Destruction of investment capital reduces the capital that can grow.)

One of the key differences between gambling and investing is that the more one wagers the greater the odds of losing; in investing the longer you invest the greater the odds that you will generate positive results. (Two reasons for this: first the more fees and expenses one pays, the smaller the capital in play. The second is that at least in the US equity market there is a long-term secular growth rate, which is why Mr. Buffett urges people not to bet against the US. However, he is increasingly willing to hedge that stake with international investing, a position we should all consider.

More insights

Another Michael, Michael Cembalest of J.P. Morgan Asset Management has written a very useful piece on his ten years of authoring market insights, three items of which are especially instructive.

1.  Mr. Cembalest expects a marked increase in the level of volatility. (We don't hear much about volatility during rising markets. The prevailing wish is that every price increase is fundamentally based and not a reaction to a trading imbalance.)

2.  Sentiment indicators are better forecasting devices than price/earnings ratios. He quotes five separate surveys each currently reporting at 90%+ of past records.   (As regular readers of these posts may remember, I am tracking the levels of market enthusiasm, which eventually builds to a peak prior to a major decline.)

3.  Central banks are determined to re-inflate their economies no matter what the long-term costs to their societies.

Question of the Week: what is your level of enthusiasm?

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Investing Your Time for Better Results

Introduction

In my 2008 book MONEYWISE, I suggested that one’s investment results are more a function of how one spends his or her time on investing and giving than the size of the original capital or the initials after one’s name. This week I had reasons to think about what George Soros, Jesse Livermore, Irving Kahn, Warren Buffett, and two bank CEOs have said.  Each of these gentlemen had worthwhile messages for investors, perhaps particularly at this time when so many people are indecisive as to their investment posture.

George Soros and Jesse Livermore on market direction

[While I have met Mr. Soros and supplied his firm fund information in the past, I do not really know him but respect his skills. Jesse Livermore may well have traded a margin account through my Grandfather’s brokerage firm, I did not know him.] The source of the thoughts that I share with you is from a reader who publishes his own personal weekly blog, Teddy Lamade of Brown Advisory. Teddy quotes George Soros as saying, “Markets are constantly in a state of uncertainty and flux. As a result, money is made by discounting the obvious and betting on the unexpected.” This is in effect the motto of those of us who have been called contrarians. On the other hand, Jesse Livermore said, “The public wants to be led, to be instructed, to be told what to do.” He indicated that people will become a mob as they want the comfort of others going in the same direction.

I am not being diplomatic, but analytical when I state that both of these managers are correct. One should recognize that George Soros above all else wished to survive and go on to future paydays. Jesse Livermore was much more interested in the size of his winnings during the game.

My current investment outlook is that for awhile the trading instincts of Livermore will lead us to higher levels of stock prices as the crowd of investors on the sidelines or in broad market index funds and ETFs will become a mob chasing various pundits and politicians in the obvious trends that Mr. Soros feared. This in turn will lead to financial and psychological collapse. This is the psychological underpinning to my +20%/-20% call which could happen sometime soon either this year or next.

The hard search for value

The dichotomy between Soros and Livermore is why finding great investment value is so difficult and is the basis of the lesson that Charlie Munger taught Warren Buffett after Buffett’s training by Benjamin Graham. Livermore was a believer in price momentum as all who participate in the ultimate bullish phase of a market surge. Ben Graham’s point of departure in seeking value was price. When he started his writing as a guide to students at Columbia University, he was ably assisted by Professor David Dodd, who for many years had the difficult task of teaching myself and others Securities Analysis. In addition, Graham had a teaching assistant named Irving Kahn who just passed away at 109 years young. (More on my friend Irving will be found below.)

Dodd had much more of an accounting background than Graham. This is why he instructed us to reconstruct financial statements before we applied any ratio analysis. For example, writing in the Depression Era of the 1930s he wrote down or completely off any inventory, particularly work in process and raw materials. He wanted us to include unfunded pension amounts before determining book value. We then had to do similar exercises on competing firms. Often he had us look at corporate financials from the standpoint of the bond holder. In some cases with proper analysis the stated equity value should have been greatly reduced. With bonds selling at steep discounts from their par value, if one could get enough bonds one could force the corporation into bankruptcy with the bond holders representing the new equity. That practice as is being done today is called “loan to own.” In some ways Graham, Dodd, and Kahn in their Graham Newman fund became the equivalent of today’s activist investors, but often using bonds as their entry point. Max Heine, who later founded the Mutual Shares Fund that eventually Mike Price sold to Franklin Resources, played a similar game. Others had followed similar practices on railroads so much of the rolling stock of America fell into financial hands. Thus, many so-called value investors were essentially adjusted book value investors looking for the ultimate liquidation or sale of their companies. As we came out of the Depression and World War II periods, general prosperity lifted stock prices so it was more difficult to find statistically cheap investments. In recent years it became even more difficult. In the past it might takes months that stretched into quarters of the year to find suitable candidates. Today with almost all the financials available on easy to manipulate data banks and a large number of activists who want to play, the number of statistically cheap investments has shrunk.

As with almost all trends that eventually are played out, newer versions appear. Irving Kahn, Ben Graham’s teaching assistant and founder of Kahn Brothers, was a successful broker/investment adviser who became the prototype of the new Value investor. Irving went beyond the numbers into what was the company’s particular advantage. Often he found some gems through his life-long interest in science and often found some pioneering work at reasonable stock prices. Irving believed in the global professional securities analysis business. While he was an important founder of the New York Society of Securities Analysts, he was also a member of the London Society  and had some successful investments in Japan when few others did. Until recently he traveled extensively and we met his late wife with him on one of his many analysts’ trips.

Irving got started in the investment business in 1928 and was conscious of my Grandfather’s firm on which he was complimentary. As a future- oriented investor he was aware of periodic market declines which is why he combined what many might have said was aggressive stock picks with half his portfolio in or near cash. Basically what he did was to redefine value to include the corporate advantage that some today call moats on top of his statistical analysis. He and his sons would require managements to keep shareholders first in their deliberations. In many ways he was among the first modern investors.

The lessons that Warren Buffett learned

Like many followers of Berkshire Hathaway, Saturday morning was devoted to reading this year’s letter from Warren Buffett and Charlie Munger. While I could devote a lot of time and space as to what was said and why most investors in the stock will be happy with it, I would like to finish this post with comments about value investing.

In Buffett’s early years he followed Ben Graham’s model of investing in “mediocre companies at bargain prices” which produced gains but with some losses. That changed with the advent of Charlie Munger on the scene who converted Warren to buying great companies at fair prices. This has worked much better than the value-oriented investments in the past. The other general comment that is worthwhile to all investors is the need to be prepared for periodic 50% drops. (I will be happy to discuss my other comments on the Berkshire letter. At some point I may devote a lot of space to it or hold it to report with my impressions of the Berkshire annual meeting weekend.)

What to do?

As Shakespeare would say “to your own self be true,” follow your instinct. If you are a growth investor enjoy the crowd’s surge and ride out periodic dips of 50%. If you are a value investor you will need to practice patience and look for value beyond what is just plain cheap.

The beauty of the L Time Span Portfolios^TM is that either or both growth and value oriented managers can be utilized. In most of our managed accounts we use both in different proportions based on the individual accounts needs.

Question of the Week: Where are you on the Growth-Value spectrum? 

 

__________    

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.