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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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
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Investment Successes: Apple in Dow Jones, New Horizons

Introduction

One of the least favorite tasks of a professional investment manager is to disappoint clients with a report of performance below some benchmark. Contrast this with how we look at our own accounts which we focus on too infrequently and get pleased or less as the account progresses to building one or more nest eggs to meet our or our beneficiaries’ long-term needs. As a profession we continue to do a disservice to our clients by focusing on relative performance when we know that sometimes we will produce above benchmark results and find reasons (excuses) when we don’t.

My wife, Ruth and I have just come back from The Mall at Short Hills, New Jersey, which is very glitzy with parking spaces at a premium like at Christmas. Not one single store was advertising that we could buy their merchandise with the currency of relative performance, though luckily at the moment we have some.

When I look at our own accounts I have two lenses that I use. The first is what appears to be my long-term risk of not producing the capital and therefore the income to meet our collective needs. The second, what do the various future time periods look to me?

Lessons from Dow Jones

In prior posts I have made clear my personal investment and interest in Apple. In the short-term I was pleased in the announcement that the stock will enter the favored thirty components to the oldest of the popular stock indices. I was pleased because, for some of the index investors including many of the closet indexers, they will have to buy a considerable amount of Apple shares.  Supposed gains may prove to be illusory due to either problems in the perception of investors or in the company eventually exhausting almost all the potential buyers for the stock.

Actually I am somewhat more interested as to what the inclusion in the thirty says about the past success of  Apple’s stock and what additional support the inclusion may provide when, not if, the stock price turns down. In prior posts I have briefly discussed “handles,” a trading and media term for a price at or above a round number of headline significance. Often these handles end in double zeroes, like 100. In terms of the Dow Jones Industrial Average there are eleven stocks above the $100 handle. In this segment of stocks priced above $100 Apple will replace a credit card processing company that is splitting 4 for 1.  Almost all of the stocks in the Dow thirty are successful, but this is doubly true of the eleven above one hundred. What this means to me is that when periodic downturns occur that many investors will be more patient with these eleven than most other stocks. After all they have been successful in the past and at lower prices they may be a temporary bargain before an eventual recovery. Thus, I feel more secure now in a long-term holding in Apple than before.

There is another analytical factor which addresses one of my concerns as to the changing structure of the stock market. In prior years there were far fewer stocks with $100 price handles. One could count these well-known companies on one hand. At that time the retail investor was important to corporate management. There was a belief that many retail investors wanted to purchase a round lot of one hundred shares or more to avoid the odd-lot differential. (My first summer job in Wall Street was with one of the two odd-lot houses that executed the below 100 share orders for most brokerage firms for an 1/8^th to ¼ price advantage.) Today the small retail investor is largely absent and the odd lot differential has disappeared. Many of these former individual stock buyers now are primary mutual fund investors. While many funds’ initial price is set at $10, many funds are perfectly willing to see their net asset values rise to well above the $100 handle. The brokers and investment advisers who place mutual funds invest in specific dollar terms not a number of shares and this is why we use to calculate fund performance to five decimal places. (Some funds carry out their net asset values to fourteen places.)

The relative absence of the retail investor in individual stocks probably truncates the extremes of price behavior as they go from all out to all in to all out. That perception is why my view of a market movement this year or sometime soon will +20% to -20% in the same twelve month period because there will likely be less all in and all out players. If they suddenly reappear I would open the gates wider to approach swings of plus or minus

from a zero base.

Winning and losing stock performers

One of the many things that I do for clients in our mutual fund managed accounts is to read their funds’ annual and interim reports as well as their competitors. Rarely will I publicly discuss a fund in a client’s account because they have paid for this knowledge. I am making an exception now because the T. Rowe Price New Horizons annual report was particularly thoughtful and it is closed to new money accounts so my clients won’t be disadvantaged by a wall of money trying to enter the confined place of quality small market caps.

The portfolio manager for the past five years, Henry Ellenbogen, introduced two concepts that have much wider applications beyond the New Horizons portfolio.

The first is he attempts to select two different kinds of stocks, emerging growth companies and durable growth companies. The second groups, durable growth companies, are the types of predictable growers that I would populate most of the third L. Time Span Lipper Portfolio ™ or the Endowment Portfolio. While the second portfolio is designed to replenish the first with spendable capital for two or more years, the third portfolio has a time span of five to fifteen years to produce the capital and income needed to realistically meet the beneficiaries’ needs. 

Emerging growth companies are in some respects the most difficult to find and hold on to. Some will be acquired away and others will be either temporary or permanent disappointments. In today’s ultra competitive environment often the best way to start to build a position in these companies is through participating in one of the pre IPO (Initial Public Offering) financing rounds. While they only participate in a limited number of pre IPO rounds for a daily net asset value fund, they are temporarily illiquid. To use the words of Fidelity’s great Peter Lynch,  the portfolio manager is “swinging for ten baggers,” if not more, a difficult task to do well.

While I can understand the product need to combine these two separate types of companies, to help me with filling out the Time Span Portfolios I wish there were two separate funds. The emerging growth company fund would attract more investor interest with our present and expected future book of business; the durable growth companies would get more of our clients’ money because of their needs. I would hope that for my family’s accounts we would over time build up a significant investment in the emerging growth category as long as it was reasonably well managed.

Perhaps Mr. Ellenbogen’s greatest contribution to the art of portfolio management is his analysis of his twenty biggest contributors and detractors over the five years he has managed the fund. What he found was that the 20 biggest winners contributed more than 117% of his overall gain versus market. The negative contribution on the same basis deducted 24%. Thus the combined leaders and laggard produced 93% of the total advantage over their benchmark. In other words the literally hundreds of other stocks owned during the five year period produced an advantage of only 7%. To be fair for many funds and their investors a 7% over the benchmark would be acceptable. My question for the fund’s independent directors and its investors: “Was the fund overly diversified?”

To answer in the affirmative there is a presumption that one could have excluded certain losers or average performers. This is an endless debate which in some cases I was a participant. This is not a simple problem. There are times particularly early in the emerging growth arena when there are multiple companies trying to accomplish the same goal with different approaches and technologies. I can see a prudent investor putting a small bet on each with the hope that when the eventual winner becomes more visible, the other positions can be eliminated and more capital put into the rising star. 

All managers are likely to make some mistakes if they are really trying and some room should be afforded for a good manager. Actually I am more impressed with the smallness of New Horizons' losses. Compared to the Russell 2000 Growth Index, the aggregate of the twenty largest losers was -7.06% and the twenty biggest winners was a +65.9%. The largest single loss was -1.3 % and the smallest of the twenty largest contributors was a + 1.95%. It is just this sort of analysis that we develop when we analyze a fund for purchase. The losers normally tell us more than the winners.

N.B. Both the financial services private fund that I manage and my personal accounts have had a holding in the management company’s stock. My clients are aware of our ownership of T Rowe Price and other publicly traded management companies and other financial services companies which we believe work to the benefit of our investment management clients.

Question of the Week: Do the Dow Jones components make any difference to your investing?

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

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Copyright © 2008 - 2015

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

Good Investment Outcomes Can Lead to Poor Investment Results

Introduction

In last week's post I mentioned that much of what I have learned about investment analysis I learned at the racetrack, and that a bet on California Chrome while understandable, was a bad bet from a rate of return basis. Some have asked me what about handicapping, the term used for analyzing horse races that I find so appealing. My initial response was that within the half hour between races one could make a thought-out decision and shortly thereafter you learned whether you were right.

As with most rapid response answers this one was not fully responsive for it focused only on results. The real benefit from handicapping races at the track, particularly with knowledgeable other people, is not about their choices but rather observing their well-reasoned thinking. After the race there was often a post-mortem on what we did not fully appreciate in the past performance tables we studied. In the case of the Belmont Stakes the very fast workout a few days before the race by California Chrome was combined with the fact that the eventual winner was more rested than the favorite, as it did not run in the Kentucky Derby. Another item that should have factored in the analysis was that there were a few more horses entered in the race than normal for the Belmont.

The above elements give greater depth to the results. Many who will follow the favorite's future races will focus only on the disappointing results or blame the jockey for a bad ride; for instance California Chrome’s jockey who described his colt as "empty" when he urged a final stretch run. I would suggest that when rested at equal weights California Chrome will be difficult to beat in the future. (Until we get more current information.)

The failure to separate outcomes from critical analysis   

A quick focus on outcomes is often used to confirm one's own thinking without looking at it as an opportunity to search for other elements of useful wisdom. One of the differences between a number of investment committees and professional investors is that investment committees want simple definitive answers that they can extrapolate into the future. The manager or fund that did not meet or beat the assigned benchmark failed, and should be replaced in favor of more promising candidates. Races are often won or lost due to the unexpected element of “racing luck” which is unlikely to be repeated in the future.

Avoiding habit-based decisions

In the current market environment of an aging bull market (980 trading days without a 10% correction), “racing luck” might be attributed to an unexpected merger or acquisition announcement. Just as a professional jockey keeps his mount out of trouble and does not fruitlessly exhaust his/her horse, a prudent portfolio manager exercises appropriate risk management. Good jockeys don't run every race the same way. They avoid habit-based decisions in trying to find new ways to win races.

In looking at various races one should be looking for what is the preferred length of the race for each horse in the race. Some are very good at short distances and try to hold on for mid distance races. Others are using a race as a warm up for a richer, longer race in the future.

Parsing the analyses

As subscribers to these posts have learned, I am a believer in breaking up a single portfolio into at least four sub-portfolios based on the expected time-span to meet the investor’s and particularly the institution's needs.

The definitions to the four Time-span Fund Portfolios are listed in my blog post last week, click here to read.

If one assigns each position to one of the sub portfolios then one can make a more incisive analysis as to whether the securities’ results are likely to be delivered against the needs of the account. Just as at the track one should separate sprinters from middle distant and longer race horses.

Another factor that one can take away from the track (particularly when looking at fillies and mares) is whether they may be good brood mares. Many believe that the male line provides the stamina and the female line the racing ability. Numerous individual and institutional investors want to hire a manager that will work with them for many years or a couple of generations. Thus, they should look at the ability to develop replacements for their key players which should include portfolio managers, analysts, traders, critical administrative personnel, and beyond.   

Other sources of good and bad investment results

If the only source of investment expertise is distilled from going to the races, there would be huge crowds at all the tracks all the time rather than the sparse crowds that normally show up. One contribution to another important element can be gleaned from a Barron's article by Stephen Mauzy, who I don't know. In his article he describes investing as entrepreneurial rather than formula driven. He suggests while risk could be considered probabilistic, uncertainty is where the opportunities lie. The entrepreneur type of mind is used to dealing with uncertainty and the good ones thrive on it. We prefer, when possible, to invest with managers that are entrepreneurial in nature and in shops of a similar nature.

The source of what may turn out badly are some very bright people who are quite numeric, according to a New York Times interview, where the subject stated, "There's a lot of behavioral psychology around the fact that the smarter you are, the easier it is for you to make up metrics that make you think you are doing the right thing.” 

The biggest risk: the Operational (Cash) Portfolio

There is not meant to be any risk or at least very little in the most secure of the four Time-span Portfolios, the Operational Cash Portfolio. While we are used to taking risks in venture or disruptive type equity portfolios, we believe that our operational needs are completely secure in the portfolio that is set-up to fund immediate needs. The problem is as long as the Federal Reserve and other Central Banks keep manipulating interest rates so short-term interest rates are close to nil, there will be experimentation at getting elevated rates on this supposedly secure money. Probably nothing will happen, but even a potential loss of one to five cents on the dollar will cause a great deal of stress on the operating people in the family or non-profit institution. The stress from this disappointment is likely to be more intensively felt than the satisfaction from prior gains achieved from stretching. In the real world this is the difference between genuine analysis and outcome focus. So be careful, particularly now.

Whether your observe Fathers Day or not, as with horses we all have gotten a great deal from our fathers which I hope you celebrate. 

How are you safe-guarding your short-term capital accounts? 

 __________________

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

Did you miss Mike Lipper’s Blog last week?  Click here to read.

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Copyright © 2008 - 2014

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