Recognizing a Professional: Ratings vs Ranking - Weekly Blog # 811

 

Mike Lipper’s Monday Morning Musings

 

Recognizing a Professional: Ratings vs Ranking

 

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

 

 

While we can’t know exactly whether someone is schooled in a subject or just pretending, we can presume a lot from their choice of words. In the world of investment statics there are several tribes of analysts that attempt to predict whether a fixed income instrument will go into bankruptcy. They summarize their learned judgements with letter grades, called ratings. These ratings do not give an opinion as to whether they are good investments, just whether they anticipate them entering bankruptcy. The history of the professional credit raters is pretty good, as bankruptcies are relatively few in number. While they give an opinion as to whether the instrument will enter bankruptcy, they do not indicate how much of the issued principle will be lost.

 

One unfortunate trait of inexperienced people is the use of a term from one subject in another. While the term may have some similarities, it is not identical and may not even have the same utility as the original. This is why I used performance ranks and not ratings when developing the practice of mutual fund analysis, using the performance array of mutual funds we tracked each week. This is where my analytical training kicked in.

 

I pity those who passed through the analytical profession and did not learn as I did at the racetrack. My experience instilled in me a strong aversion to losing money. Analysis at the track is similar to the popular method of selecting investments based on past performance. This approach relies on the belief in the repeatability of events and has led to the development of quantitative systems, both in the investment market and at the track. “Quantitative” investing has periodically been very popular in the investment market, buttressed by “ratings” which are meant to be predictive.

 

 I gained an advantage from my many discussions in the grandstands following each race, where some player complained about the failure of “the system” he/she was following. Because I did not like losing money, I paid attention to the complaints of the failed “systems”. What I discovered was these systems actually worked better than half the time for a period of time, but rarely more than 60-70% of the time.

 

Later in life I heard similar complaints from more senior analysts as the corporations they followed failed to deliver the expected performance. The standard complaint was that someone was lying. It took me a while to connect the similarity of their complaints with those I heard over the weekend at the track.

 

This realization led me to think about the process of predicting the future. Since no systematic thinking produced winners all the time, there must be mistakes in the math. As securities analysis is taught as an adjunct to math, or the certainty of law, the losses had to be a function of mechanical mathematic failure. It eventually occurred to me that it was not the process that failed, but the universe of variables being different than those utilized.

 

At the track, the things that could change were the jockey, the trainer, the exercise rider, what the horses were fed, what drugs were administered, or the competition. Each of these possible changes, and others, could and often did impact results. This is why I believe we should pay more attention to changes of people and their attitudes in the investment world. More so than believing in their statistical record.

 

This week was a good example of changes that largely invalidated the past record of the entire global financial sector. As an analyst, investor, and portfolio manager, I have always had an interest in financial services securities. Stock Exchanges have been at or near the center of the financial sector and thus were always of interest. There have been five Lipper brokerage firms that have been members of the New York Stock Exchange. (Never has a son or younger brother succeeded the founder, and consequently none extended to a second generation.)

 

In most commercially viable countries, there are stock exchanges. Considering all I know about these exchanges; none are making most of their money exchanging securities. At best, most make single digit returns on this revenue. This week I attended a capital markets conference of the 300-year-old London Stock Exchange. While it is interesting looking at their history or past performance, it is of no value predicting their future.

 

Unlike racehorses and most people, some companies can be rejuvenated into something quite different than their past history. In the case of the London Stock Exchange, it has grown into the London Stock Exchange Group (LSEG), primarily through a merger with a Thomson Reuters spin-off. (In 1998 Reuters purchased our fund data business. We and our accounts still own Thomson stock, which has a major position in LSEG.)

 

The spinoff included a number of unintegrated number-crunching entities, labeled Refinitive. It was a comfortable fit because the London Exchange had previously acquired a number of similar unintegrated and under-marketed numbers-companies. To this mix they added “expert” management from various financial and tech companies, including a cooperative agreement with Microsoft based on their plans and/or dreams.

 

The CEO believed he had identified all the problems that could delay them. The current management group is investing heavily in new products and services, including the marketing of them. It would not be difficult to improve on the record of its two major founders. LSEG deserves to be ranked highly in its present efforts. I will leave it to others to predict its future.

 

This Week’s Signs of Stagflation

Despite the media and others chanting Good News, there is increasing evidence that smart professionals see an approaching decline in market prices. Whether we are just in stagflation or entering a significant contraction will be determined later. However, it is worth noting the S&P 500 Equal Weighted Index is essentially flat year-to-date.

 

The following announcements have to do with future revenues. The companies making these statements are addressing the second of two measures of their health, their investment performance and the prospect of generating new business, largely from new customers.

• Manulife is laying off 250 employees in its Wealth and Asset Management functions. (Manulife is a Canadian Life Insurance company with significant Hong Kong sales.)
• Wells Fargo is laying off 50 Investment Bankers.
• Burberry issued a sales target warning.
• A 2^nd Hedge Fund is cutting 150 of its 1000 person staff.
• Jim Chanos is closing his short selling hedge fund. (He said the market is changing away from his style.)
• Amazon is cutting several hundred from its Alexa staff.
• Another observation noted in the weekly list of prices in the Weekend WSJ. Only 8% are down, including the US dollar -1.65%.
• Fitch is negative on the investment management sector in 2024.

 

Note From London

At private investment discussions in London during the week, locals were most concerned about the US Presidential election, with differing levels of pessimism. I had two comments.

1. It is incredible considering the size of the US population that the present apparent candidates are such a poor couple. The locals agreed.
2. Much more important to me is that we won’t know the Chairs of key committees until later next year. This is more important on the Republican side, as the Democrats are bound by seniority. According to the intelligent people I talk with, a split Congress is likely, suggesting not much meaningful Legislation will pass, except for emergencies during the first two years of the new term.

 

Share your views with me and let me know what you are watching in terms of markets and votes.

 

 

 

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Mike Lipper's Blog: How to Find the Answer - Weekly Blog # 810

Mike Lipper's Blog: Preparing - Weekly Blog # 809

Mike Lipper's Blog: Indicators as Future Guides - Weekly Blog # 808

 

 

 

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Investment Selection: “Horses for Courses”

Introduction

Each tool has its best single application. Each investment strategy has its best single application. In a similar fashion horse racing professional handicappers have often stated that there are "horses for courses." Meaning certain horses run better at certain race tracks than others. The most productive implementations of these choices are often the function of changed conditions from the immediate past.

As fund performance analysts and investment managers we have been urged to proclaim that past performance does not guarantee future results. Nevertheless all too many institutional and individual investors use past performance and particularly recent past performance as their primary selection screen. Many have taken this to the ultimate decision by investing the bulk of their money in Index funds.

The source of much of my analytical thinking came from handicapping horses races which is what track aficionados call analysis. The daily Bible reading for handicappers is the Daily Racing Form, (in  my day it was the Morning Telegraph.) In these pages the racing record of each horse is shown. From an analytical standpoint what I find of greater value than number of winning races are the conditions of the race to include which track, distance, time of the winner, time of the particular horse, weight carried relative to others, training times and conditions,  plus the names of the sire, dam, and sire of the dam and finally the conditions of the track. Professional analysts and portfolio managers can translate these factors into various selection screens in picking stocks, managers, and funds.

Selecting Investment Strategies for Different Portfolios

When choosing a bet in a race it is wise to start looking at the most popular which is called the favorite. The favorite is based on the most money being bet, not necessarily the horse that has the highest probability of winning. At the track and around the Investment Committee table most decisions are based on avoiding embarrassing losses, not optimizing the chances of large winnings.

The way I handle this challenge is not to bet on each race or every stock that is currently performing well. This tends to produce fairly concentrated portfolios of stocks, managers, and funds. The long-term (but evolving) focus is on a high aggregate dollar win/loss ratio. If you will, I am describing a contrarian bettor. However, as a contrarian, I should not disregard the weight of money bet on the favorite. This is even more true in investing than at the track because by definition popular stocks attract cash flow. In the short-term some investors can make them appear to be right.

Understanding the Investment Favorites

According to Moody’s^* “Globally 10% of all public companies account for 80% of all profits.” Therefore these companies have less credit risk for their bonds. Also, almost by definition, they are large capitalization equities. With the goal of reducing the chances of losses, most investors prefer large-cap stocks or funds. This is particularly true for endowments. 

Endowments are one of the four TIMESPAN L PORTFOLIOS^®, and depending upon on the needs of the account can be aggressively or conservatively invested.  Many of the standard endowment portfolio managers are getting frustrated as it has been a year on Monday since the S&P500 has hit a new high, and for the last four weeks the DJIA has been declining. (Perhaps there is some validity to the pre-air conditioning ditty of “Sell in May and go away.”)

The frustrated investors, the media pundits, and the various sales forces have not been paying attention to Charlie Munger, Warren Buffett, and their two investment associates. As a group, Berkshire Hathaway^* has been selective long-term buyers of stocks and companies. As the oracles of Omaha have often said, they like declining markets for their long-term holdings. Despite what they recommend for others, they are not buying an S&P 500 Index, they are selectively buying a small collection of Large, Mid, and Small-Cap stocks.

I believe that size does not define a stock as a good investment, but due to size many stocks have increasing difficulty making progress. (This does not mean that investors are blind to the attractiveness of some Large-Caps in their recent purchases of Apple^*, IBM, and Wells Fargo^*.) One of the reasons that they are more active now than when there is more enthusiasm in the market is Charlie Munger’s belief that is wise to buy a good company at a reasonable price rather than a less good company at a good price.

Applying Betting Principles to The Preakness

In a postscript to my blog that commented on The Kentucky Derby,  I urged bettors not to bet on its winner to Win the second race of the Triple Crown for 3 year-olds. I suggested to find a good Place bet. (A Place bet pays off if the horse comes in first or second, a Show bet pays off if the horse comes in first, second or  third. The pool  of money that is used to payoff winning bets is divided into three parts for a Show ticket, two parts for a Place ticket and one part for the Winning ticket.  Thus it is normal that winning tickets pay more than Place tickets and Place tickets pay more than Show tickets.) I felt the dollar odds would be larger if the Derby winner came in first. This was before I knew that the track would be muddy on Saturday, and based on past experience was an advantage to the eventual winner. Racing luck and jockey skill  produced the result. Regardless of the change in track conditions, my suggestion to make a Place bet on a non-favorite was valid.  On a money basis a $2 Place bet paid $3.20 whereas the favorite, which came in third, paid $2.20.

^*Stock owned in a managed private financial services fund and/or personally.

Question of the Week: What methods do you use when investing in Large-Caps and Small-Caps?

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The Many Lessons from Berkshire Hathaway

 Introduction

Earlier this week I felt like I was accused. In a message from an investment committee colleague who is a retiring senior officer of an institution I was thanked for being a teacher to him. This upset me because I always wanted to be with the “good guys,” the students. For I believe I am a lifelong student of human behavior, particularly in terms of investments. In that search I am always looking for sources of knowledge and wisdom. One of the lessons I learned from my otherwise much too liberal education was that the Bible is more than an inspirational document about morality. Selective chapters and verses can provide lasting insights into economics, agriculture, military tactics and strategy, training, law, sociology, psychology, management development, and leadership among other lessons.

In a similar fashion, a continuing study of the ever changing Berkshire Hathaway can be very instructive as to how one should lead his or her investment life. As a long-term owner of the stock both in a private financial services as well as personal accounts, I attempt to read almost all that is published on the company. I am not totally successful as the amount published by the company is voluminous, including various commentaries by its twin leaders Warren Buffett and Charlie Munger. It is popular with some “arm chair” critics to cast doubt as to the current wisdom of various moves that the company is making on numerous multi-tiered chess boards.

The purpose of this post is to share with our community what I learned in reading just one document. Almost all of my comments come from reading and thinking about the 45 page 10-Q document filed with the US SEC addressing the third quarter of 2015. Please do not interpret this as a recommendation to buy the stock which would only be appropriate after a thorough understanding of one’s current portfolio, time horizons, and views. However, it is a recommendation to various colleges and graduate schools to use a study of certain aspects of the company including accounting, contracts, global economics, management approaches, personnel and personal development, insurance risk management, financial and economic history and developing a long-term, loyal shareholder base. 

Financial Services

While it is much more, Berkshire Hathaway is essentially a financial services holding and portfolio management company. For the quarter 80% of the revenues came from insurance and other related sources. This simple title covers many different activities. It is somewhat like celebrating a winning horse without recognizing the contribution made by the jockey, trainer, breeding and ownership elements including many whose names we do not know. Some may downplay its contribution, for in the quarter as insurance underwriting contributed only 9% of operating earnings. What they are missing is the generation of insurance float which at the end of the quarter stood at $86.2 Billion up $2.2 Billion from year-end. In many ways this is the single most important figure in the financial statement. The float was essentially the source along with operating cash flow that led to a $133 Billion investment portfolio housed within the insurance complexes. For those of us who grew up within the brokerage community, float represents margin debt without interest cost. If one applied all of the float to the total net assets of the company one could take a somewhat exaggerated position that the company is 33% leveraged. However, the key value of the float is as excess capital that can be applied in a matter of hours as part of, in essence, rescue missions for sound, high quality companies that need cash and Berkshire’s imprimatur and are willing to pay preferred dividends or interest way above markets rates plus equity “kickers.” These companies have included GE, Goldman Sachs*, Bank of America*, Dow Chemical, Mars, among others.

Insurance is not the only source of financial earnings for Berkshire Hathaway. If one looks through the activities of its railroad, utilities, and energy, the objective is to convert its own and others capital through operations into financial gains that are soundly leveraged. In the third quarter these activities produced 18% of total revenues. Finance and financial products represented the rest of the revenues even after a $764 million believed to temporary loss in derivatives

Messrs. Buffett and Munger clearly believe in the long-term attractiveness of financial services investing, which reinforces my personal biases. (Friday saw bank stocks rise sharply, with JP Morgan Chase* up 2 points on almost double the volume of Thursday, perhaps its timing is right) Berkshire has devoted some $ 48.9 Billion to financial services stocks with 74% in Wells Fargo and American Express. It believes in well chosen concentration; including the two mentioned above, some 58% of its equity investments are in just four stocks. The only one of which is showing a loss against purchase price is IBM which is down some $2 Billion from a cost base of $11.7 Billion.  Not being a registered investment company it is treating the decline as temporary and not writing down its value. (This option is available to private investors and not registered participants and could be a useful approach as long as the investor is highly confident of recovery to purchase price. While I might like to do this personally, I am afraid my clients’ financial people are more interested in immediate liquidating values to meet their funding obligations with money to spare.)

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

In a somewhat different situation in terms of Tesco, Berkshire took a write down of $ 678 million, but did not sell the stock which shows that it lost faith in the ability to get back to purchase price but thought that this summer’s prices were unnecessarily depressed. Looking at fourth quarter UK prices Berkshire may be able to salvage some of its admitted loss.

Viewing Berkshire as a Source of Investment Inputs

I found the following nuggets useful to aid my broader investment thinking. I will be happy to expand upon any of these with our regular subscribers.

After a super-heated second quarter, I was not totally surprised that the summer proved to be slow for many of the operating activities. What did disappoint me is that in many of the financial activities sales slowed materially more than seasonally. This slow-down hit our financial services stocks particularly in the asset management business.

Luckily for Berkshire the big bet on Kraft Heinz paid off with the carrying value of this common stock, including additional investments, jumping to $15.8 Billion from $3.95 Billion at year-end. The characteristic boldness of the management is a hallmark of the way it understands the importance of moving decisively when opportunity knocks looking for massive capital deployment.

As predicted by Mr. Buffett, the reinsurance business has fundamentally become less attractive due to excess capital being deployed by new entrants into the business who are lowering premiums. For the nine months Berkshire Hathaway Reinsurance Group saw its underwriting gain drop to $247 million from $617 million for the prior nine month period. Once rates move back to attractive levels they are likely to return to the leadership of the big ticket business. The General Re subsidiary has analogous experience, dropping to $ 58 from $322 million operating gains in the same periods. The ability to tolerate these cyclical swings shows the benefit of the overall financial strength even with GEICO suffering a sharp increase in accident claims in the first half of the year ($213million vs. $746 million) before level results occurred in the summer driving quarter. One of the acknowledged skills of the company’s activities is risk management. In the long run it seems to know which risks the company should take. For example, it will undoubtedly turn the $130 million insurance property loss in China this year to higher revenues next year with substantial rate increases.

As part of its large diverse holdings of operating companies, managers are responsive to problems as shown below:

1. In response to a 37% decline in NetJets, it paid penalty fees for canceling aircraft purchase orders.

2. Sale of unprofitable operations within Fruit of the Loom.

3. One of the transportation companies is in the business of leasing cranes, the decline in the US business was being offset by gains in Australian infrastructure gains.

One of the reasons I believe that a study of Berkshire is appropriate for many MBAs is what they can learn from studying both the company’s mired accounting policies and capital development. In the first case the company made two $1.7 Billion acquisitions this year. In the first the Van Tuyl Group, now known as Berkshire Hathaway Automotive, will amortize the purchase goodwill. (The timing to participate in both the shrinking of the dealer community and getting close to peak annual auto sales seems good.) At the very same time it bought AltaLink a Canadian distributor of electricity which Berkshire will not amortize the purchased goodwill. By definition these two acquisitions will produce significantly different booked returns even though economically they perhaps should be similar.

The final revealed tool in Berkshire’s tool kit (which most investors are not aware of) is the ability of Berkshire to swap some of its security holdings which have appreciated in price, for some very specific operating subsidiaries of that company. This is a classic example of swapping investment assets for operating assets. I suspect that not only are these transactions tax free, but the new operating assets will be carried at the original costs of the transferred investments. This is another example that the stated book value of $151,083 for each “A” share is vastly understated under any reasonable liquidation program. To my mind the 20% premium that Mr. Buffett has suggested for buybacks would be a real bargain.

Bottom Line

I opened this post with an initial view of the Bible as a good teaching device for many subjects. However, in the end to be completely accepted it requires a good bit of faith. Because of the creativity and brilliance of Warren Buffett and Charlie Munger and the complexity of their structure and accounting, a somewhat similar level of faith may be required.

Question of the week: Will you share what lessons can be learned from a study of Berkshire Hathaway?  

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Can Credit Ratings Be Sexy?

The Mae West quote that “too much of a good thing is wonderful” reflected her playful method of sexual innuendo and is the way many investors view credit ratings. Upon her other revelations, I do not believe that the burlesque queen, movie star and stripper was conversant on how bond credit ratings affect relative stock price performance. But that is the dilemma that I have been working on this week. I come to view this issue from two divergent vantage points .

My challenge

I manage a number of balanced (bonds and stocks) accounts for institutions as well as wealthy individuals. As part of our responsibility for one client with multiple accounts we have the task of managing an all fixed-income portfolio in separately managed fixed-income securities and fixed-income mutual funds. In connection with this client I am reviewing and updating the account’s investment policies. At the time of the inception of the account in 2007 certain quality and diversification standards (or what now appear to be constraints) were mandated. As mere thoughtful mortals drew up these policies they did not consider the current tiny short-term interest rates and their manipulation by the major central bankers of the so-called developed world.

High quality, poor relative performance

My associates and I have been reviewing various stock investments of certain equity funds to understand their past two years of relative under performance compared to their perceived peers. In these cases the absolute performance of individual stocks and funds has produced positive results. However their relative investment performance was disappointing. The one common characteristic of the portfolio managers of these funds is that they are oriented toward owning high quality investments, a bias that I share. On average many of these relatively underperforming stocks are higher quality than those found in their relatively better performing peers.

These formerly successful funds are believers in investing in quality companies many of which would have sounder balance sheets and higher margins than found in their relatively better performing peers.  The market recovery phase started in 2009, accelerated in 2012 and continued thus far in 2013. During this period of extremely low interest rates the less credit worthy companies were able to borrow money at historically low rates. With new capital they expanded their capacity and were also able to lower their selling prices which put their higher quality companies at a disadvantage, at least in the eyes of the stock market.

The fiduciary’s selection dilemma

On the one hand we need to set the filters so that managed accounts can meet their funding requirements under practically all absolute conditions. And on the other hand we seek to earn relatively good intermediate and long-term investment performance.

One of the characteristics of all professions is to use codes to abbreviate concepts. In the investment world one very important code set is bond credit ratings. These are thoughtfully issued by three major credit ratings groups Moody’s^*, Standard & Poor’s^*, and Fitch in various stylized alpha numeric abbreviations starting with the most secure, AAA and declining in terms of potential defaults down to D. On average and over time these ratings have done a more than reasonable job of alerting investors as to forthcoming defaults. However, as with all work done by humans, they are not perfect. As a practical matter investors worldwide recognize as far as taxable issuers are concerned that the first four full ratings are so-called “investment grade.” The term investment grade came out of a case in the 1930s that decided that the first four grades  (AAA, AA, A, BBB or their equivalents) were appropriate as high quality investments for fiduciaries. Since then the lower credit ratings were referred to in polite society as non-investment grade or high yield but the in argot of  “the street” as junk. Notice this whole exercise deals with the probability of timely payment of principal and interest, not whether they are good investments particularly in considering current prices.

Funding vs. performance

There is another decision tree axis which is not quite as well known, but in many respects more important. The filter for this matrix is the earliest expected involuntary pay back or maturity date. Once one is assured that the debt will in all likelihood be paid back, the twin questions facing the investor are how long will this stream of income be delivered and (in many ways much more significantly) the interest earned on the reinvestment of the interest received. For long-term bonds, under “normal” conditions, the size of repayments of principal, total interest received and the income earned on reinvestment are listed in reverse order of aggregate size. For instance even a low 3% coupon payment reinvested for 30 years in available, high-quality paper will be significantly greater than just adding up the interest payments paid on the bond, or the return of the original issue price. While this concept of interest on interest is mathematically correct, for many individual and institutional investors it doesn’t work that way. The reason they own fixed-income securities is so that they can consume the interest payments to meet their various funding needs, for example to make grants, pay for maintenance of people and facilities, etc.

Investment Policy Statements

One of the advantages of blogging is that occasionally one can see the discontinuity in one's thinking. Investment Policy Statements (IPS) are legal documents typically imbedded within contracts or board minutes. Often they are drawn up by lawyers or at least blessed by them. As with the U.S. Constitution, essentially they are limiting the powers; in this case the investment manager or investment committee. IPSs do not focus on how to make money for the account, but detail what not to do. This blinding realization came to me as I started to write about credit ratings, recognizing credit ratings can be sexy.

AAA vs. AA

We prize high credit ratings in an IPS, the closer to AAA, the better. In terms of attempting to make money for the account, as an analyst/portfolio manager and investor there are times that I question the cost to the investor of an AAA rating. Let me give an example of two holdings in my private financial services fund. Both Automatic Data Processing^* and Berkshire Hathaway^* are major beneficiaries of the floats of their clients' money. At one time both companies had AAA ratings. Now ADP has the highest rating, Berkshire does not. (Berkshire was downgraded to AA some time ago.) ADP is one of a handful of large US companies that has an AAA. The reasons given for the downgrade of Berkshire was the increasing risks inherent in its reinsurance activities. Both of these companies have had a practice of acquiring other companies. ADP has slowed down in these activities while Berkshire has not, as it has been buying large and mid-sized companies. While both companies' stocks and bonds have risen in price, the AA has clearly outperformed the AAA. Many analysts believe if ADP could find suitable acquisitions that do not threaten the perceived quality of its large short-term float, the prices of its securities would have done better.

Betting against dropping ratings

Recently Moody's^* announced that will be lowering the ratings on four of the leading financial services companies; JP Morgan^*, Goldman Sachs^*, Morgan Stanley^* and Wells Fargo^*. For the moment Moody’s is leaving the ratings on Bank of America^* and Citigroup^* unchanged. Interesting the two unchanged companies have very recently done better shedding their endangered zombie species. The bulls on these two stocks will acknowledge that they are work in progress with the hope that they can approximate the returns of the four leaders.

^* Owned in a wide range of sizes by my private financial services fund or by me personally.

The official reason for the downgrade is the belief that if any of the four leaders ran into financial problems the levels of bailout will be less. Quite possibly true, but I wonder how germane? As an investor and entrepreneur addicted to the long-term, I would much rather own the businesses and more importantly the people of the four leaders than the two turnaround candidates. If protecting their credit ratings and other fortress-like characteristics has prevented them from intelligently expanding their activities or handling their leverage better, the lower ratings could help us shareholders.

I could use your help

I am still struggling with what to put into an institutional IPS in terms of its fixed-income investment accounts to meet some specific needs as well as general strategic balancing needs. Please contact me with your views.

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