Five Speculative Selling Solutions

Introduction

A long-term reader of this blog suggested that I write about selling rather than buying investments. In everything I do I want to measure how close I get to my goals. Out of this measurement need, I require a time period. While it is of future betting interest to have the fastest moving horse or other investment at the end  of a race, the payoff is the best performer for the fixed length of the race. The genesis of the TIMESPAN L Portfolios^® was to focus on achieving the ability to meet disbursement goals on a timely basis. 

This requirement is in some conflict with my instinctive ways to invest. Warren Buffett's favorite investment time period to invest is "forever." Mine may be even longer! (Over time some of my long-term investments have tripled to quintupled or more, beyond my exaggerated dreams.) Nevertheless, in focusing on most investors' needs to occasionally sell, I am commenting on five such events. But once again to judge whether selling is propitious or not, some measure of time is needed. Yes, to some extent the seller can celebrate the freeing of cash from investments in other assets. However, in the aftermath of a sale one is often asked whether the timing of the transaction was good. Thus to some extent a successful sale is measured as to how well the exit price compares with future prices. In this light the success of a sale is speculative in terms of comparisons.

The purpose of producing this post is to focus on the various thought processes that lead to successfully evolving solutions for five events when selling occurs.

1.  The Avoid Switch

Rarely people, their companies, their politics, and their investments  behave exactly as we conceived when we entered the transaction. It is difficult to find an investment that does not in some way disappoint, either by its own actions or factors beyond its control. There are times when the results are so good in the eyes of the market that the current price is way ahead of a reasonable long-term projection. Thus, at current prices there is considerable price risk. At times the risk appears to be too large and while an investor has not lost faith in the company, the investor may believe that the current price won't be repeated for an extended length of time. Most of the time the simple solution is to dispose of the holding. At times instead of selling out completely, reducing the size of the position makes more sense if there is not a screaming bargain available.

There are other occasions that selling may make sense. Several times I have been a holder of a security that I thought that I reasonably understood when either the company or the market did something that I did not understand. For example years ago a major conglomerate that I followed as an analyst switched from an under-reporting of earnings to including dealing earnings within operating earnings. Thus from my analyst's perspective, the company went from having a hidden kitty available to cover operating earnings shortfalls in some of its cyclical businesses to reporting every possible element of earnings. In other cases some companies made what I considered to be vanity acquisitions or questionable product pricing policies.  In these cases I felt I did not properly understand  these investments and exited them from my long-term holdings. 

In most cases if an investor is not comfortable in his or her understanding of an investment they would be wise to avoid owning it.

2.  The Bargain Switch

Sir John Templeton, my former data and consulting client, often phrased his sales in terms of purchasing better bargains. While occasionally what is better is only a lower valuation. To me these can prove to be "value traps." Normally things are cheaper because they should be - in terms of quality of product or management. However, we may have entered a period when bargain hunting can be productive.   

The rise of exchange traded funds and other passive devices based on industry sector codes (technology) or market capitalization (Large Cap growth) has led to an unusual level of correlation of stock prices within these data sets. With expected changes in currencies, taxes, import/export mixes, etc., I suspect that there will be greater dispersion in stock prices within many data sets. If I am correct, the number of active mutual funds outperforming the various indices should rise which will attract some of the trading money out of passive/ETF vehicles into either selected individual securities or smartly active mutual funds. As the differences in valuations becomes greater I would expect that there will be opportunities to be long or short individual securities that could favor more bargain switching.

3.  To Trim or Not?

As much as we would like to, we don't control the markets or the spending needs for our money. Thus over time we will have our investment wealth at a different balance than our beginning level. In many ways it is much easier to deal with a smaller amount of money than the beginning portfolio. In that case one should definitely trim the cash. The odds are that the decline in general market prices of stocks will eventually be reversed.

Many of those who have seen their income and wealth rise have already found that their gains do not lessen their problems but rather change them as well as their outlook. Once one has a portfolio, even if is limited to the number of holdings, it is an important part as to how one views the future.  For most individual and institutional investors who have not consciously or subconsciously adapted the timespan philosophy,  they will be dealing with a single portfolio that is probably focused on too short a time frame; e.g., one quarter, one year, or a single market cycle. Under these conditions the fear of near term losses becomes paramount. Thus, in a perceived expensive market the natural tendency is to reduce risk exposure. Perhaps the first technique should be to reduce or eliminate small positions on the basis that if they are still small they are not likely to be favored in the short-term.

Those who take a longer than current period view have history on their side for US equities and quite possibly for equities in general. The other historical trend worth recognizing is that great wealth comes from extreme concentration of effort, intelligence, and investment which suggests that concentrated portfolios in knowledgeable investors’ or managers’ accounts can produce great results.

After due consideration, trimming or completely eliminating positions could be the correct decision even if investments under other managers are doing well.  It might be helpful to not let the tax man become the portfolio manager.

The shorter term oriented accounts will tend to be much more market price sensitive than the longer term accounts who are more focused on building absolute capital. I suspect the shorter term accounts have higher portfolio turnover and on average pay more in taxes over time than the longer term accounts.

4.  The Familiarization Trade 

Most of those who read this blog have a substantial portion of their wealth in tradeable securities. Some do not and receive the major portion of their wealth in a concrete package of stock options, private company interests, convertible securities, and various types of trusts. For many, these instruments are difficult to understand even with professional help that may not be specifically knowledgeable on these particulars. As these managers are unfamiliar to the new recipient, there is some substantial fear of making a mistake in the process of converting their new illiquid wealth to easily tradeable securities and/or cash. My suggestion (regardless as to the perceived value of the new investment) is to take the smallest portion of the investment and convert through the many steps to cash. This will equip the new owner with an understanding of how the process of unwinding the concentrated wealth package can be converted, which should help with some understanding of the benefits of not doing anything more than evaluating the next and future steps. As is often the case, selling something can be a valuable learning experience.

5.  Quitting 

Recently those who have robust national or global political views in light of the strong to very strong stock markets are pondering whether they should quit the game and sell all their exposed equity positions. In terms of recorded history there have been a very limited number of times this has been a correct decision. Those instances have been very rare. But no one can be certain that at any given point stock price declines of more than half are not possible.

My own views are based on the beliefs that we have entered a different market phase. For at least the last ten years and perhaps longer we have been a world of single digits in terms of almost all main statistics of market prices, earnings, revenues, demographics, etc. I believe that starting with last summer we are accelerating into a double digit world, both up and down. In this new world sound investment principles will continue to work, but for some time the numerical bands won't. May this lead to an eventual market, if not economic collapse? Yes, it might, but not necessarily so. Rather than focusing on only the historic ratios, like Liz Ann Sonders of Charles Schwab, I am focusing on sentiment and currently the general lack of wild enthusiasm which is positive in my judgment that there is more time in this expansion.

As a contrarian and as a manager of portfolios owning mutual funds, I am often premature in my market judgments and actions. I am not yet ready to hit the quit button and retreat to cash, which is losing value regularly. Perhaps this time I will accept the downside volatility as the sign to exit.

Even if we do have a top and a subsequent fall, I hope I will not forget my responsibilities to future generations and totally "go to ground" in a foxhole. 

Conclusion

There are times and conditions when selling is wise. However, these decisions should be made carefully without too much attention to the current and a reasonable review of the longer term future. The sellers historically have the burden of history against them, but they can win.

Question for all time:

Have you successfully sold an important part of your wealth and re-entered the market? Was it at a lower or higher price?   

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A. Michael Lipper, C.F.A.,
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Enthusiasm Now, but Little Appreciation for the Long Term

Introduction

One of the reasons I developed the concept of the Timespan L Portfolios^® was to be armed with a tool kit for market conditions just as we are seeing now.

Whenever I am asked whether this the right time to buy or sell a security, my immediate responses is to inquire, “What is your time horizon and what is the benchmark that you will use to judge your success?” Depending on the answers I often try to help with suggested actions or at least elements for future consideration.

All too often securities analysts think of the future only in terms of the past. For periods of a month, the range of the vast majority of outcomes is roughly plus or minus twenty percent. If the measurement period is extended to a year the range of expectations could be bound by plus 100% and minus 50%. Over  longer periods, including average lifetimes, the extreme range is over +1000% to a total wipeout. Thus selecting your time frame or better yet the timespan of your controlled actions becomes critical as to how you organize and manage your investments.

Investment Satisfaction

In many ways the choice of appropriate benchmark has much more to do with your ultimate level of satisfaction than many of your other investment decisions. Your choice of benchmark comparisons will demonstrate the thoughtfulness that you apply to the investment decision-making process. All too often most people will compare their results against the unmanaged indices published in the media. They won’t understand the selection biases that are built into every index produced, including the ones that I created for much of the mutual fund industry. But the biggest fallacy in using securities indices is they don’t capture the investor’s expenses including an appropriate allowance for the individual’s time, expertise, and worries. These drawbacks are largely answered by using mutual fund indices that are also available in most professional media. Included in the fund indices are all of the costs of operating the funds that largely address the investor’s own costs of operating an individual security portfolio.

Within the Timespan L Portfolios often there is a mix of fixed income securities and stocks. That is why many of our managed accounts are primarily benchmarked against the Lipper Balanced Fund Index. For some investors who are managing their portfolios against specific spending plans, an absolute measure is useful; e.g., “Don’t lose money,” which was my informal instruction from the late Executive Director of the NFL Players Association in terms of their defined contribution assets. A further refinement to an absolute return requirement is one reasonably adjusted for long-term inflation.

Thus, I believe the selection of time periods and benchmarks are of critical importance. This brings me to my dilemma today, seeing risk and opportunity in different time frames.

Potentially Rewarding Long-Term

Various market commentators focus their comments on current valuations without regard to the flows into and out of the market. In effect, they are looking at the size and weight of a boat on the sea, whereas I believe they should include the long-term flows and evaporation of the water in their outlook. Some focus is currently being addressed to buy-backs, hopefully net of issuance expenses.

The principal reason that I am bullish in the long-term is the global deficit in retirement capital at the government, corporate, and individual levels. Using the US as a model (which is paralleled elsewhere in 2016) US corporations are expected to add $15.6 Billion to their pension plans. (I expect an even larger amount will flow into their defined contribution plans which are growing faster than their defined benefit pension plans.) The 2016 funding is under 4% of the S&P500 underfunded aggregate of $403 Billion.

Pension plans are shrinking as the major US corporations are not fully replacing retiring employees. A similar trend is likely to happen to the earlier adopters of 401(k) plans, but they will grow through market appreciation.

I expect that we will see some significant adjustments to both IRAs and 401(k) plans that will allow retirees to continue to accumulate assets in these vehicles on a tax deferred basis rather than mandatory distributions.

I also expect many governments around the world will move out of reliance on defined benefit pension plans and into defined contribution plans.

The political, social, and tax implications of creating a new class of focused investors could be a bigger benefit to all than the funding of defined contribution plans.

Short-Term Concerns may be Warranted Soon

After a very trying first six weeks of 2016, global stock markets have entered five surging weeks with current expectations of more to come in spite of the belief that market indices will have a decline in overall reported earnings per share in the first half of the year, including Energy. Current estimates for the S&P 500 as published by ThomsonReuters is for fourth quarter per share earnings to rise by +10.6% led by Financials +21.8, Materials +20.1%, Energy +11.9%. (I have some doubts about analysts’ estimates in general, particularly those that extend too far out.)

As some of the longer term readers of these blogs know, I was not concerned about a major market break because I did not see a great deal of enthusiasm being expressed for market prices. I am, however, starting to get a little bit nervous now. One of our holdings in our private Financial Services fund and personal accounts is the well respected T Rowe Price, a firm that has entered into something of a flat period. On March 14th the stock traded 1.05 million shares. By the end of the week the company traded 2.45 million shares. During this period closing prices went from $71.67 to $73.54. (I am detecting enthusiasm because I believe in the thesis that people and societies will address the retirement capital deficits. One of the logical solutions will be good for mutual fund management companies, however I am not beginning a gradual reduction program that I might do to be an inverse participant in the market.)

There are other signs of bullish market actions. Following a technique that friends of mine used during the Cold War to triangulate the truth they read in Pravda and the Christian Science Monitor, I read the New York Times and the Wall Street Journal. In the Sunday edition of the NYT on page 2 of the Business section there are two tables of interest which are quite bullish. In the first table of the twenty largest traded stocks, eleven were up on the year to date. On the negative side there was only one approaching the normal guideline suggested, -20%. The stock was Amazon ‑18.3%.

From my vantage point the second table of the fifteen largest mutual funds was more revealing. Nine out of the 15 were up on the year. Also nine were actively managed. Six actively managed funds were on both lists and if you include the two that were flat on the year, there were eight out of nine that showed progress or were flat. With all the media hype as well as various pundits pushing index funds, it is nice to see that some active managers are earning their fees in what has been a very difficult market.

Bottom Line

For our second or Replenishment Portfolio in the Timespan Portfolios I would start to plan gradual risk reductions in inverse proportion to signs of enthusiasm. For the Endowment and Legacy Portfolios I would continue to selectively add well managed funds and advisors.

Question of the week: What are your personal indicators of too much market enthusiasm?         

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Contact author for limited redistribution permission.

Risk Identification is More Important Than Volatility

Up Markets Cause Change in Sales Pitches

Notice how quickly the commentary from numerous money managers has shifted away from quoting so-called “risk adjusted performance.” This shift is a clear sign of two different stances. The first is after seven or eight weeks of rising stock prices, many are identifying the current surge as a rising market. Because we have not topped the historic highs of 2007, few are calling this a new bull market. But they are directing their attention almost exclusively to rising rather than falling prices for stocks and bonds in most markets around the world. From a market standpoint it is almost like shouting, “The king (of the bear market) is dead. Long live the new king (of not yet the bull market).”

Intellectual Dishonesty or “They Should Have Known Better”

To me, the second stance that becomes evident from the dropping of the risk adjusted handle is intellectual dishonesty. This strong statement indicts not only many managers but also their marketing people and many academics. The fallacy started in academia, as finance and investment teachers with their reliance on mathematical formulas wanted to balance potential rewards with potential risks. The problem is that risk is the uncertainty of loss. In their 50 minute lesson-plan world they latched on to the volatility of price movements over a rolling 36 month period. If a stock or a fund had a wider than “normal” variance to the trend of prices or adjusted net asset values it was deemed to be more risky than one that hugged the central tendency line more closely. Thus, index funds are by nature less risky than actively managed aggressive funds. The practice started of adjusting absolute returns by these volatility factors to develop “risk adjusted returns.” These numbers appealed to various consultants and other gate-keepers because they generated a selection screen that eliminated the wild performers. The problem with these exercises is that they had nothing to do with actual risk. The purveyors of these numbers knew or should have known that risk adjusted results had nothing to do with real world risks.

What is Risk?

From an investor's viewpoint, risk is the penalty for being wrong in the future. To me as an investor, investment advisor, and a member or chair of non-profit investment committees, risk is the inability to pay for planned and vital expenditures. In the real world risk is different for each account. For some Ultra High Net Worth investors, risk is all about running out of funds for the fourth generation or the new wing to the hospital (which is likely to be one’s last used medical facility).

There Are Two Risks

In assessing the elements of risk identified above, there are really two risks. The first (and of paramount importance) is running out of cash to accomplish the critical mission. The fourth generation will have to become working stiffs (which could be a good thing compared to their third generation parents); or the new wing will be delayed until other sources of funding are secured; or the hospital or university will be forced to scale back, merge, or close. (Perhaps if the potential patients or students won’t support the expansion, once again the wisdom of the marketplace could be correct compared with a donor’s wishes.) The second risk is not running out of funding, but the more likely outcome of not earning a high enough rate of return to accomplish the planned goal in a timely fashion.

Managing Both Risks on a Time Horizon

The simplest way to handle the risks is to have the investment side control the granting side. One of the foundations that we have managed money for years has largely limited its grants to other charities to the capital earned by the charity in the prior year. Politically that is not how most pots of money are run. In reality, the operating or granting side determines what it wants and the investment side concurs if the spending rate is reasonable in light of the time horizon of its mandates. Most wealthy families or endowments believe that their responsibilities are never ending thus they see their funds need to remain in place forever. Others actually plan (or would allow themselves) to, in effect, die. This extreme, and perhaps irresponsible attitude can be summed up as “expending the last dollar with the last breath.”

A further constraint on managing the twin risks is the importance of planning the time horizon. Actually the addition of a time horizon can make it easier to manage risks.

My Approaches

With a great deal of conversation and work with clients, and even more with investment committees, I try to attach to each planning goal time to completely identify the goal with the client. Even more difficult is to array the various goals in some sort of priority setting. The next step is to determine whether the client wishes to intellectually fund each goal until the capital runs out. In setting the investment returns for each of the goal-oriented portfolios (assuming that the intention is to have the capital last forever), I use the following rules of thumb:

• If the account is a tax exempt account, a payout ratio of total return income to capital of 4% is reasonable.
  
  
• For a taxable account, a maximum payout ratio might be 3%. In both cases I would reduce the ratios if long-term inflation is expected to be higher than these ratios.
  
  
• For accounts with a limited life or if the account was a beneficiary of new cash flow, somewhat higher spending ratios would be appropriate as long as the net cash flow continues.
  
  
• For investments in equities, whether in the form of individual stocks, funds, private equity or hedge funds, I would expect over time the returns would be between 50% and 75% of the net cash generated by taxable entities.
  
  
• In terms of fixed income, on the very highest-quality paper, yields to maturity might be appropriate if the account could hold the paper until maturity. More specific fixed income approaches are very much account dependent.
  

Social Media

I urge the members of this blog community to share with me your use of social media.Would it be helpful to you if I used a particular social media outlet for shorter thoughts, perhaps at different time intervals?

I want to stay current with my grandchildren, grandnieces and grandnephews as eventually they will become the clients that will benefit from my work.

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