Dull Markets Are Dangerous for Investors - Weekly Blog # 683

 

Mike Lipper’s Monday Morning Musings

Dull Markets Are Dangerous for Investors

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

Why?

Not only because “quiet comes before the storm”, but dull markets give you the luxury of time for thinking and researching. Investors can use unhurried time to search for better investments and improve on the selection process, although most investors focus their energies on security selection. Some wise investors will ponder the processes used to manage their investment responsibilities, while commentators focus on the first group in the majority. As an investor for more than sixty years managing money for a limited number of investors and for my large family group, I am more concerned with the second need. Few pay enough attention to a periodic review of how we make decisions. Assuming you can make reasonable selection decisions, improving the decision processes will produce better results for the beneficiaries of your efforts in the long run.

Why Now?

Rarely can we assess in an unhurried fashion and review how we think about investing. We have such an opportunity right now. For at least the last six weeks the popular US stock market indices have been fluctuating within a trading range on relatively low and unconvincing volume. This is very logical if you believe equities are primarily priced on what they are expected to report in future periods, not what they have already reported. Expected future earnings are usually discounted at the current “riskless” interest rate of government bonds. Currently, many believe interest rates on US Treasury paper insufficiently discounts future inflation, pointing to the weakness in the valuation of the US dollar in multiple foreign exchange markets.

Others feel that after more than year of stock market gains it is time for a rest. Some point to the likelihood of not as favorable earnings comparisons after an expected large jump in the second quarter, especially when compared to the slow initial rebound in last year’s second quarter. Naturally, third and fourth quarter comparisons are expected to be more labored considering the 2020 recovery began picking up steam in the second half. (On the same basis, some believe earnings gains in 2022 will have tougher comparisons versus those in the coming quarters of 2021. Current spending plans for the rest of this year very much favor consumption with a lower investment value than productive capital expenditures.)

US stock markets are currently being held back by what one large US bank affiliated brokerage firm refers to as the 3 Rs= Rates, Regulation, and Redistribution. Some global investors, including those in the US, see foreign stock markets performing better than those in the US, as shown in the following table:

Stock Market Year-to-Date Gains

Canada        +20%

South Africa  +17%

France        +16%

U.K.          +15%

Taiwan        +15%

How to Improve Your Investment Processes

There are several ways to improve the various processes, unfortunately they require more work than  the sound-bite/pundit driven world would suggest. Often, the best communicator is more of a commercial success than a better investor. 

People like quick comparisons that lead to an ordinal ranking result, often leading to the identification of a leader at the peak of their performance. One of the more successful institutional investors, Marathon Asset Management, decries this approach in the following quote “categorization purposefully reduces complexity and nuances”.

Nuances are critical to the understanding of comparisons, no critical analysis of peers is simple and straight forward. The following is a list of categories: stocks, bonds, growth, value, return on sales, operating earnings, earnings per share, book value, and tax rates. On a personal level, what about our significant others, or the schools we chose to attend. What is missing in these comparisons is the attention to quality, sustainability, integrity, personality, and the fit within the existing structure or portfolio. I suggest statistical comparisons do not provide answers, although they are useful in framing important questions exploring the answers to the “soft” questions.

Another critical technique is to not pay more than once for the same positive. For example, the chance of success for a company developing a new product or service creating new customers and opportunities is generally priced into the value of that stock. However, that premium should be eliminated once the product is on the market and operating earnings from the new product are counted in current earnings. R&D is critical for many large companies to maintain existing earnings power, it is therefore not worth an added value.

Turnarounds can be great investments, but the key is understanding if they can keep adding value in the future or are one-trick ponies. Proxy statements are useful in this analysis. After a new CEO has been in place for about five years, the degree of senior management and director turnover provides a clue as to whether the heavy work of the turnaround is complete or ongoing.

While I would be happy to discuss other analytical techniques with subscribers privately, I will include one final critical analysis for portfolio managers. How a considered investment modifies the existing portfolio and at what cost.  A new investment will determine how the existing portfolio is modified and at what cost. Is the new investment going to reduce the chance of risk or add to performance in good periods? How much time will be needed to follow and deepen an understanding of the new investment? What is the appropriate starting position size and what are the likely points to augmenting the size over time? Are we comfortable with the other shareholders, both old and new?

Question of the Week: 

Have you modified your investment thinking in 2021? If not, are you likely to make changes before year end?   

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

https://mikelipper.blogspot.com/2021/05/faulty-comparisons-weekly-blog-682.html

https://mikelipper.blogspot.com/2021/05/extreme-views-can-be-good-lessons.html

https://mikelipper.blogspot.com/2021/05/where-is-stock-market-going-next-weekly.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Short and Long-Term Opportunities with Risks - Weekly Blog # 593

Mike Lipper’s Monday Morning Musings

Short and Long-Term Opportunities with Risks

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

Mid-course corrections and structural changes represent both opportunities and risks. Opportunities and risks are rarely separate from each other. My process for dealing with each, travel along similar routes:

• Early, but not too early recognition. (Statistically there is not much difference from a discovery that’s too early and being labeled wrong)
• Identify the magnitude (Large to life-changing vs. time and reputation risk, which can’t be recovered)
• A research plan to narrow the number of opportunities and risks. (We can’t deal with too many variables)
• An initial plan of action (Casualty lists are full of those who were too motionless)
• Frequent adjustments to the plan. (Frequent but not too frequent, there is time needed for others to react reasonably)
• Listen to both extreme historians and futurists. (They are often the same)
• Create short-term achievable goals. (A passing grade is better than 100%, from which you can’t learn)
• Cut the losses when other opportunities appear with lower risks. (Most great discoveries/inventions are bi-products of research efforts seeking other solutions)

Subscribers could use the above principles in reviewing what comes next.

Mid-course Correction?
US stock prices since late July have violently fluctuated in a trading range, as measured by the three major stock indices.  At the lowest point they were about half-way to a normal 10% correction. As of Friday, they were within a good trading week to their former peaks, achieved in July: Dow Jones Industrial Average -2.05%, S&P 500 -1.56%, and NASDAQ Composite -2.73%. This blog is prepared for long-term investors and I am therefore not going to focus on the momentum driven traders that dominate the market these days, especially when long-term investors are nervously enjoying gains generated over the last ten years.

While the market and economies are not driven by the calendar, investors and the media tend to focus on annual returns. I am concerned that while most stock and equity fund investors have not yet reached a gain of 20% year to date, a large number have. I am wondering whether the market indices will go through their old highs with some enthusiasm, or whether they will be stuck in a price range with high volume, encouraging some equity investors to take some chips off the table and wait for the clarity they expect in November of 2020.

This is not a political judgement; one expects to see some damage from low interest rates and falling currencies. These investors should remain equity investors in stocks and funds, perhaps with some rearrangement of their choices. However, under no circumstances should they have less than 50% invested in the stock market, re-entry costs and tensions are high for taxable investors.

Fundamental Changes for Long-Term Investors
There are two very important changes that are likely to impact successful investing in the future:

• The appropriate nature of invested capital
• Fewer workers and more mouths to feed 

Adapting to the Changing Nature of Capital and Investing
The earliest identified capital included physical things like land, jewels, and weapons, etc. One could see them, and an experienced person could evaluate their worth. Thus, the earliest recorded loans were mortgages or collateral. The wonders of double entry accounting recognized an assets value as the residual of its depreciated cost. Thus, the earliest investors concentrated on collections of assets, which led to analyzing balance sheets. This may well be appropriate in a world where the physical reality of assets is well understood, but that is not the reality today and increasingly it will be less so in years to come. Over one hundred years ago JP Morgan, himself that as a banker, made loans based on a person’s character, not their collateral. Nevertheless, today we still group companies in terms of their manufactured products, while our politicians focus on manufacturing jobs and their related products.

The service sector has been more productive in the production of wealth than the manufacturing sector for some time. Matter of fact, most successful manufacturers are also good at providing service and arranging financing for their customers and themselves. I would certainly include salespeople as being service workers, both within and outside every business today. We have entered a low interest era which appears to limit profitability.  Some wonderful old companies having more physical constraints are producing well respected brands but have suffered sales and other problems leading to significant layoffs. Some of these workers will retire or leave the industry, others will go to competitors in much smaller and more specialized elements of their industry. I see this occurring in older tech, pharmaceutical, and financial companies.

For many years CEO’s have thanked their most important asset, their employees, in their annual report letter. Since recruitment has become an important responsibility of senior management, critical employees are identified as “talent”. To those who think about these things it creates a dilemma. Do we as customers continue to rely on highly respected brands, or do we seek out products and services from which organizations are supposedly attracting the best talent? We face the same question as investors, especially the choice of colleges for those with children and/or grandchildren.

As an investment manager using financial services stocks and diversified mutual funds from around the world, I deal with this problem daily. A good long-term investment in these arenas needs good portfolio managers, salespeople, and good administrators. It also needs top management who wishes to have these people and can manage them, which is not easy. The problem today is dealing with the layoffs. The Financial Times noted that trading and advisory revenues dropped 11% in the first half of 2019 for the 12 largest investment banks in the US and Europe. We have seen most of these businesses shedding people, many of which were servicing and supporting the investment and wealth management efforts, both for their own companies and external clients. The people I know are looking because they have been laid off, or because they see significant elements of decay in their shops and want a better home to practice their art. With these people I could produce the best investment team in the world, but it unfortunately won’t happen because these people aren’t capable of working well together.

I am currently focusing on a small number of turnarounds which have similar characteristics. In the past they’ve had some good performing mutual funds, good sales teams, and good administration that was largely done in house. What makes these potential turnarounds interesting is that they have retired their old management. They now have new management that is busy trying to hire the right people to run critical parts of their organization. While the companies I am looking at are publicly traded, the new top management is long-term focused and not looking to the next earnings report. Not all of them will succeed, perhaps none will. But if they don’t succeed in a reasonable time, they’ll not be able to attract the needed talent and will be forced to merge to save a limited number of jobs. Often the acquirers are not much better than the acquired, just richer. Some will be successfully turned around if they can benefit from what I see and show next.

Retirement is Necessary for Our Success in the Future
Barron’s had a cover story this week “How to Fix the Global Retirement Crisis”. It points out that in 2050 there will be more people over 65 than under in the US. Japan has already reached having 59% over 65, in the US we are at 38%.  I would suggest we need to find ways to keep able and willing people working. At the same time, we need to find humane ways to free up some of their jobs for younger workers who can do more with those jobs. Most of the time seniors are healthy and want to be active mentally and physically, if they have the financial resources to do so.

In some respects, the mutual fund industry is one of the luckiest of all industries. A substantial portion of its growth has come from external forces, usually the government looking after senior voters. In the US the federal government passed legislation which created individual retirement accounts, salary savings accounts (401k, 403b, and 457 plans), tax exempt mutual funds, and money market funds. Without these the fund industry would have been much smaller. Things are similar in other countries, but they’ve used different measures to aid their own fund industry. The leader is Australia, which mandates that 9.5% be contributed to superannuation funds, a number that is expected to rise to 12% in the future. If one combines that with a history of no recession for 28 years, future retirees can look to a sustainable retirement. Considering seniors vote more often than other age groups, one would think that the US government might address their needs.  This could even cause the interest rate of savings to rise to a level that would reduce future unemployment through sounder loans.

Investment Suggestions

1. Use the present market to clean up your portfolio of losers that are unlikely to soon return your cost.     
2. Focus new investments on companies attracting good talent.
3. Restrict brand buying to your consumer needs, not investments.
4. Be prepared for opportunities and problems.    

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/excess-capital-less-equity.html

https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html

https://mikelipper.blogspot.com/2019/08/short-term-recognitions-plus-longer.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Short-Term Recognitions Plus Longer-Term Work - Weekly Blog # 590

Mike Lipper’s Monday Morning Musings

Short-Term Recognitions Plus Longer-Term Work

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

Short-Term Recognitions
We have reports of financial cycles since the beginning of recorded history and are always in some phase of a cycle. The keys to financial survival and future success are to recognize where we are in the present cycle, something which is almost always difficult to do emotionally. It is tough to label the current down draft. Is it a trading incident, a correction (normally about 10% from peak), the beginnings of a “bear market” (normally about 20% from peak), or a major crises that occurs once in a generation, with a decline of 50% or more? Only time will tell which of the alternatives describe our immediate future.

In the current US stock market most of the trading volume is from groups that are short-term oriented. With this orientation they tend to react to changes in sentiment rather than long-term trends. In the current market environment, I tend to focus on price changes for the NASDAQ Composite Index, which has risen the most of the three main stock market indices. The Composite includes a fair number of tech stocks and companies that provide services. Both of these have been growing their revenues faster than the industrial companies in the Dow Jones Industrial Average (DJIA) and the more broadly invested Standard & Poor’s 500 Index. (If it weren’t for the weak performance of the mid/small mixed financial services companies in the NASDAQ Composite, the lead would be even larger.)

Viewed in this light, the most recent weekly difference in the number of stock prices rising or falling may be instructive. The New York Stock Exchange (NYSE) had 373 gainers and 440 losers, whereas the NASDAQ had 203 gainers and 516 decliners. The NASDAQ is only off -5.21% from its peak, half-way toward being labeled a correction. Clearly one goes through each gradation until the ultimate bottom is reached. Whatever the appropriate level, some further fall is a reasonable expectation.

As I and others have stressed, the current market is led much more by sentiment than the investment fundamentals found in financial statements. Nevertheless, one should recognize that sentiment can impact prices for securities, currencies, and commodities. Each week The Wall Street Journal (WSJ) shows the weekly price movement of 72 items. Like many sentiment indicators, the rises and falls are normally bound in a 60/40 range. This week only 30% of the prices rose, with 70% declining. If attitudes toward prices remain outside of their normal range, it could be significant and could point to a larger decline than a mere correction.

One statistical series that may be misinterpreted is the constant sale of stocks by well-known value investors. These trimmings are being viewed as disenchantment with the holdings and while some disenchantment may be true, before reaching that conclusion it is necessary to review their record of inflows and outflows. When these previously successful investors are forced to make a partial liquidation they often choose among their most liquid positions, not necessarily their weakest. This has been the pattern for many quarters. If the downturn becomes more pronounced the time for trimming will likely end and favor totally selling out of selected names that may not have the same chance of price recovery. This typically happens near the end of market declines.

Time to Build Research Lists
In past market declines my fellow analyst friends would have lists of names and prices they wish to recommend to clients and/or purchase for themselves. All too often these lists are not executed due to the low-level of confidence in the new analytical work being done. It is with these thoughts in mind that I am now suggesting that this is the time to begin in-depth work on new names, not in portfolios or coverage patterns.

The first place I would look for candidates is the mutual fund investment objective averages. There are 19 fund averages that have risen less than 6% this year and 4 that have produced negative returns. These are:

Agricultural Commodities     -8.88%
India                        -5.58%
Natural Resources            -5.26%
Base Metals Commodities      -2.80%

Apart from the funds focused on India, the other three are classic supply/demand vehicles which are now suffering from insufficient demand for the current supply. We know from history that these conditions lead to future supply being curtailed by the withdrawal of some of the participants, although with both population and wealth growth there is little question that future demand will be higher than today’s level in the future.

India is a fascinating opportunity currently experiencing internal political issues. Nevertheless, it is the fastest growing major economy in the world. Faster than China and within twenty years it will have a bigger population too. Fourteen of the remaining investment objectives focus on international investing, many with an Asian mandate, highlighting two possible attractions. The first is summed up in a quote from the Chief investment Officer of Matthews Asia. “Growth that depends less on trade and more on continued savings, efficient investment, and institutional reform. All things to which Asia remains committed.” For a global investor, the largest risks is a decline in the value of the US dollar relative to other major currencies. (This may also reflect a relative decline in the standard of living for many US residents.)

The only domestic oriented investment objective with a low year-to-date average return of +4.25% is Small Company Value Funds. As with other value-oriented investment objectives, performance has lagged most other groups for the past several years. These funds must meet redemptions by liquidating and dealers might not be willing to take their discard into their limited inventory. The three commodity types mentioned above will rise when their markets are dealing with shortages.

There is another category that at some point may include some real bargains, internally driven turnarounds. Internally driven turnarounds most often result from new leadership and the restocking of operating management with new talent. Introducing new products and services with attractive pricing will also help. Unlike the swing from oversupply to shortage, internally driven turnarounds take time and may attract short sellers who are not patient.

Investment Conclusions

1. Review your portfolio for those positions you want to own for the next bull market and dispose of the rest.
2. Start the lonely job of researching new potential holdings which are likely to be winners in the next new market phases.

Questions of the Week:

1. Are you prepared for a down market?
2. Are you looking for the next Bull Market Winners?  

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/08/sentiments-approaching-reversal-points.html

https://mikelipper.blogspot.com/2019/08/is-last-week-significant-weekly-blog-588.html

https://mikelipper.blogspot.com/2019/07/chinese-emperors-learn-all-roads-lead.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.