Understand Numbers Before Using - Weekly Blog # 851

 

Mike Lipper’s Monday Morning Musings

 

Understand Numbers Before Using

 

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

 

The most common mistake made by investors is too brief an introduction to the investment and economic numbers used by most who chatter about “the Market” or the “Economy”. For example, the three most quoted US stock market indices are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the NASDAQ Composite. Each of these unique indices was created for a specific purpose and was designed for a specific audience. However, they are now used for numerous purposes worldwide, including New York, Chicago, Washington, London, Tokyo, and Shanghai. The biggest mistake is assuming the indices are identical. Although the indices all have short comings, proper use of the numbers can lead to useful insights in making decisions.

“The Dow”
The most well-known of all market indices is the “Dow” (DJIA), although it was not the first indicator from the Dow Jones newsletter writers. They originally tracked the performance of trunk line railroads as the most important stocks in the 18th Century. Later, due to the industrialization of America, they created an index of a small number of large industrial company stocks. The main readers of their newsletter were retail brokers. At that time, it was believed that the higher the price of shares the higher the quality, making them more valuable. This led the DJIA to be weighted by the prices of the shares. As is often the case, there was unanticipated demand for the results achieved by the index. Consequently, they took advantage of the wire systems of both the large “wire houses” and the press in developing a national and international market for the index. (The equivalent of the Rothschild’s carry pigeons.) Most local papers, and later radio/television, quoted the close of the NYSE market by using the “Dow”.  Thus, across the US many more people than owned shares were exposed to the index.

The Washington Applications
Political people in Washington started following the index as a measure of the economy. They used it as a gauge of what local voters thought about the economy. The Fed’s Open Market Committee consisted of a rotation of the presidents of the local Federal Reserve Banks, whose districts were roughly tied to the size of the financial assets the local reserve banks supervised. The boards of directors of these local reserve banks all have financial leaders familiar with the DJIA. Thus, the index became an unofficial factor in bank regulation.  Fed PhDs, recognizing the limits of a 30-stock index in producing many economic studies, used NYSE data to supplement the DJIA. (This thinking led to the recognition that other indices would be needed.)

Standard & Poor’s 500
Historically, the index that next came into use was the S&P 500, which was primarily used by institutional investors. This index was designed to correct the acknowledged problems of the DJIA. First, it had roughly 500 stocks. Second, it used the market capitalization of the issuer’s common stock for weighting purposes. Standard & Poor’s is a premier bond rating organization which also covers equities. The company had an extensive menu of data points that it used to assign credit ratings on stocks, which it also applied to the S&P 500 Index. Thus, we can now compare the price of various indices relative to their book values. The S&P 500 Index trades at 5.09 times book value vs 4.08 times for the DJIA. This comparison highlights the S&P 500 index’s investment in companies perceived to possess more growth than those in the DJIA.

In my work in analyzing large-cap mutual funds, which have many more assets than other slices of the mutual fund pie, I use the SPX as the first comparator before more narrowly using growth, value, and core breakouts. I similarly do the same for most global funds. Unfortunately, I can’t find enough data rich breakouts in many local markets, indicating these funds are primarily looking for local shareholders.

NASDAQ Composite
This 3rd index does not have a size bias. The index is comprised of bank stocks, local companies, and companies located in various geographic locations, including Canada, Israel, China, and numerous other countries. Additionally, it is the initial home for companies recently gone public. Consequently, many of the stocks on the NASDAQ have limited liquidity due to the low number of shares offered and/or the founders retaining a significant portion of the stock. It is not unusual to see 4 or 5 times the number of shares traded on the NASDAQ compared to the “Big Board”.  

The “Market” is Changing
Volume is more sensitive to speculative opportunities than highly rated investments and it is amplified by the use of derivatives, ETFs, off-market transactions, and less capital present on the floor. Dow Jones S&P Global is now the owner and provider of both the DJIA and the S&P 500. Even though there have been changes, there are still missing elements in market tools.

The separation between stock and commodity markets does not make it easy to provide a fuller solution to evaluate a uniform portfolio of assets and their risk modifications in a 24-hour, seven-day world. Agricultural products, impacted by weather, are important to food manufacturing and distribution industries. Many, if not most business cycles, are impacted by agricultural disruptions, real or feared. One of the causes of the great Depression was farm belt problems caused by excessive debt creation and poor climate conditions. These led to the passage of the Smoot-Hawley tariff and its global ramifications.

(While agricultural products as a percent of population is much smaller today than in the 1920s, the global impact may be the same order of magnitude.)

Moving on to the hard commodities, the timely completion of new mines and transportation systems can be disruptive to many areas, including stock markets.

For every global consumer, global producer, shareholder, and military person, the fluctuating value of major currencies is a cause of concern. This summer the US dollar dropped from $106.4 to $100.7. (This is likely to have an impact on inflation)

A Working Conclusion
Indices are a useful snapshot, but what is needed is a continuous motion picture and an understanding of what is causing the change, including built in construction biases and an identification of what is missing. If you have any thoughts, please share them.

 

 

 

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Current Investment Traps

Introduction

To use a term from tennis, a trap is an unforced error. In our arena of investments a trap is a concept/thought that leads us to significant losses of capital, or worse, opportunities to make sound productive investments.

Last week I had the opportunity to address ASCOSIM, an organization of Italian investment advisors. My talk in Milan included a brief list of ten concepts in structuring portfolios of collections of mutual funds. Email me at MikeLipper@Gmail.com, and I will send you a copy of the ten slides which might promote useful conversations with investors.

I mention this journey to highlight one of the advantages of spending sixteen hours in an airplane over the course of two days, the ability to have ample time to read, think and to write.

In the world that I inhabit of professional investors and their competent advisors, there are many opportunities for mistakes of judgment. During my flight home from Milan, I kept wondering why these smart people make dumb, unforced mistakes. In thinking about the mistakes that I and others have made, I realized that we all fell into traps. Most of these traps first started with the principles we utilized. We use tools for the impatient. Instead of celebrating data diversity, we use labels as a way to bunch information so we can quickly narrow our focus to making a selection from a pre-sorted list of alternatives. We believe that we can reasonably predict the relative outcome of the labeled alternatives. For example “growth,” “value,” stocks, bonds, developing markets and a whole bunch of other classifications. Our problem is the comfort brought by these and other navigation skills. One example is the ability to predict with a high degree of certainty our arrival time on an airplane trip covering more than five thousand miles with greater precision than our arrival time in our daily land-based commuting. In math and physics we are taught by problem-solving and experiments that there is only one correct answer, and to get it all one needs is to follow the prescribed formula. 

The focus of this post is the current traps that I see smart and perhaps very smart people falling into. They are examples of using labels that can lead to traps. They are not listed in any particular order. Pick your own trap as we all do.

Value

We all enjoy the warm feeling when we believe that we have bought a bargain. We want to pay a price at a significant discount from its true value. There are two traps here. The first is that we can mathematically determine the exact true value of something, including securities. The second is not being concerned with the seller’s motivations which could well change our evaluations and results.

One of the ideas that I hope to get over to the incredibly smart Caltech students (including Doctoral candidates as well as post-docs) that I will be addressing this week is that the person on the other side of the trade may be even smarter and may have better information.

Successful young investors

Having grown up in the investment business I have experienced and benefited from the battle for investment thinking supremacy between young analysts, portfolio managers, and investors and those who are older. Wisdom is not chronologically based, but the work being done at Caltech and elsewhere indicates that memory plays an important role in judgments. The cyclicality of markets and investment themes over time reinforces the need to avoid obvious risks. It has been many years since the general stock market has risen significantly above previous peak levels, thus many of today’s enthusiastic investors have only had the experience of the decline and recovery phases of the last five and ten years; they think a bull market is a new phenomenon. They don’t see that within every surge of higher prices and volume that there are built in time bombs of future problems. Some of these rises will produce spectacular results. Enjoy them, perhaps participate, but don’t count on today’s gainers getting you out ahead of time of their collapse, it will be new to them. In other words it could be a trap.

Book value’s trap

Many purveyors of investment products use a corporation’s book value as a measure of investment value. People tend to forget the calculation of book value is a balance sheet measure of subtracting the liabilities from the assets found on the balance sheet to get the equity and translating that to a book value of a corporation. This may be like choosing a new friend solely based on their precise phone number. Remember that the assets are shown on the basis of the cost to acquire them if they are demonstrably below their current market value. The liabilities are based on the size of known obligations. People tend to forget that the book value they were taught in college or graduate school as well as the CFA exams is a teaching device not a measure of reality.

A better way

As someone who has both bought and sold intellectual property companies and have advised others to do so, I have found book value is only of use in comparing other transactions when their true value is unknown. When one is privileged, or perhaps burdened, to get into the mind of the driver of the transaction, one sees an entirely different set of algebraic calculations. The first is what would be the cost to recreate that portion of the subject company’s customer relations and sales? This is then compared with the potential buyer’s estimate as to what it would cost to build the desired value itself and how long would it take.

The trap of overlooking human factors

All businesses have inherent problems usually involved with human relations. What will be the costs and bother to deal with these?  Most importantly can the buyer supply the talent needed to solve these issues? With those questions what are the balance sheet assets really worth to a particular buyer? One of the more difficult imponderables in evaluating an acquisition or disposal is the reactions to the announcement. What will the customers think and long-term what will they do?  What will the “good” employees do, what will the various regulators and communities attitudes be, what affect will the acquisition have on the acquiring company, will the combination lead to enhanced talents or to a talent drain? These are just some of the questions that should be determined.

Moving to the liabilities; do they reflect all the reasonable contingent costs including retention bonuses, possible adverse law suits and tax consequences, costs to shut down and move facilities and people, unmet needs for research and development and other elements of essential research? As one can see there are real differences between the real value of a company and stated book value. This is not to say that book value is meaningless.  If one can make the tentative judgment that the sum total of the missing factors are similar to the same or related questions of other transactions, the relative multiple of book value of other transactions is a somewhat useful guide as to the trend of deal pricing. (When I know more I prefer to use the metric of price times sales. Stratifying companies that are worth one half of their sales, or even better one times, two times, three times, and more is a good measure of what buyers believe the future value of an acquisition is.) My bottom line is that present valuation is a good current guess of future valuations, but you should not rely on book value as a sole measure.

Predictability of VIX

S&P Dow Jones Indices publishes monthly comments on various indices. In its latest commentary the first point was as follows:

  “The VIX is down over the past month and the current reading of 12.84 suggests that the potential for significant moves lies only to the upside…..The Australian, Hong Kong, and Canadian VIX equivalents are also down, a pattern repeated elsewhere across developed markets.” 

In its simplest terms the VIX is a measure of the implied volatility of S&P 500 Index options.  Often market professionals view the level of the VIX as a measure of fear operating within the market place. Considering the absolute closing high for the VIX was 80 in late 2008, one can see that currently there is not a great deal of price pessimism in the marketplaces around the world. As a contrarian this is exactly when a negative surprise could be its most potent. The sell off thus far in January, which appears to be worldwide, may be the trap that was sprung on those that use immediate market movements to predict future trends including turning points.

The failure of stock investors to pay attention to bonds

Stocks can surprise both positively and negatively. In most cases the best thing that can happen to owners of bonds is that they receive timely payment of interest and principal. Thus bond prices are more sensitive to potential bad news than the stock market. As a stock investor, I am aware that bond prices can be a useful warning device for me. Changes in credit ratings are often a coincident indicator of bond price movements. Nevertheless, they can be leading indicators for the general stock market prices. Moody’s^* has published a schedule of quarterly down grades and upgrades. For the 4^th quarter of 2013 there were 78 high yield downgrades (68 upgrades) and 21 downgrades of investment grade issuers (12 upgrades). The extreme downgrade readings were 303 for high yield and 93 for investment grade. 

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

The current preponderance of downgrades in an economy that is meant to be recovering is a cause for one to be cautious about committing new money to the stock market.

Please share with me the traps that you have avoided and which ones are you wary about now.      

_____________________     

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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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Judicial Temperament Required for Credit Ratings and Portfolio Management

In most professional military forces, important punishments are the result of judicial trials. In these cases, relatively senior officers are chosen to be the judges and when a jury is required, those seated need to have a representation of similar rank as the defendant. When I was in the US Marine Corps, one of my collateral duties when aboard ship was to serve as the legal officer. When there were military courts martial of significance, I had to participate in the selection of members of the jury. In selecting marines and sailors, I was required to be guided by choosing people with “judicial temperament.” This term describes an individual, who after reviewing all of the evidence presented, makes decisions based on the facts without any pre-conceived biases. These judgmental approaches to military jury selection are not shared with either the public or the press. If disclosed, these judicial screenings might spur a rush to judgment that could lead to an unpleasant set of reactions. This weekend after the Friday downgrade of the US Intermediate credit rating from AAA to AA+ by Standard & Poor’s, there were harsh and uninformed statements made in the press by various members of the government and their flacks, all lacking judicial temperament in my judgment.

The Recognition of the Downgrade

To put the action of S&P into perspective, I believe one should understand the function of a credit rating agency. (Important disclosure: we have a position in Moody’s in our financial services private fund.) The job of a credit rating agency is to express an opinion as to the odds on the failure of an issuer of timely payment of interest and repayment of principal. Since their establishment, the three main credit raters, S&P, Moody’s, and Fitch have done a remarkably good job adjusting their ratings to expected risks of default, with one glaring exception. The glaring exception was in the securitized packages of residential mortgages. (The mistake made was to treat these packages on the same risk rating scale as corporate and governmental issuers. Further, the short history of payment of interest and principal in a securitized form was not fully appreciated.) The credit rating process is to gather all the known facts about the issue to be evaluated, as well as the issuer itself; then a ratings setting committee of senior researchers evaluates the whole package as to the likelihood of default. The focus is on all of the evidence not just a sub-set. In assessing the risk of default, both the ability to pay and the willingness to pay should be considered.

The published thinking of S&P (which was discussed with the issuer, the Administration, since last April) was to take into consideration the political will to address the growing deficit. The raising of the debt limit was never a real issue, as the government had numerous ways, all painful, to avoid the immediate need to borrow more money. S&P’s view is that fiscal policy is married to political policy. The unwillingness to find a solution to the deficit issues, in the end led to lowering the credit rating. One should note that the AAA rating is like being number one on any ranking list. The history is that over time, most number ones lose their ranking.

As this is being written on Sunday we do not know what Moody’s and Fitch will do immediately, but both have made statements of concern recently. Their methodologies are similar, but not identical to S&P's. At the moment we have a split rating which at least temporarily gives a combination of AAA/AA+. Many in the traditional fixed income world give Moody’s a slight preference, as the older and perhaps sounder agency. Thus, it will be significant when and how it issues a new opinion. At the moment the focus is only on the intermediate debt, as the belief is that both the short term and the long term debt remains with the highest ratings.

While I believe that the AAA credit rating should have been removed years ago because of perennially unbalanced budgets stretching back to the 1930s, there is ample evidence that all of the recognized credit raters are currently exhibiting sound judicial temperaments.

The Fast Reactors

People believe that securities prices move on the latest incremental bit of information. That is why many analysts and the electronic media are very quick to report any and all incremental bits. To emphasize the importance of the increments, often they proclaim that various securities should be immediately bought or sold to move ahead of those investors whose information is not as current, or those who move more slowly. The prize goes to the first movers. Most often there is not a review of all the relevant facts and so there is a lack of judicial temperament being offered.

The Prudent Long Term Portfolio Manager

As fiduciaries entrusted with quasi-permanent funds, we need to balance the current changing environment with the long term needs as to the disposition of the assets that are our responsibility. We need to weigh carefully the likely impact of the news along with the costs of changing positions in terms of meeting our clients' long term goals. I have believed that the US Government and many other governments have been debasing not only their currency, but more importantly their societies, ever since they have undertaken “to do something” about employment. Thus the recognition of the initial downgrade does provide some comfort that the basic laws of economics do work eventually. As most currencies have been debased through years of inflation from unbalanced budgets, and there is only a limited amount of gold available, I would be surprised to see a major shift near term in the disposition of large portfolios. In the longer term I suspect we will put our faith in commercial companies producing reliable earnings to be our principal store of value.

What do you think?


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