Searching for and Suffering Great Funds - Weekly Blog # 545

Mike Lipper’s Monday Morning Musings

Searching for and Suffering Great Funds

Tied to Columbus Day Image Control

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

My Perspective
Commercially for the most part, I manage mutual fund only long-term accounts for both institutions and wealthy individuals. In general, I and my associate Hylton Phillips-Page attempt to construct equity portfolios that contain Good Funds and Great Funds. The dividing line between the two is the long-term fear and greed ratio. In some cases this can be translated into the tolerance for embarrassment. To paraphrase what Warren Buffett has said, he would prefer an investment whose path is an uneven compound growth of 12 % over a more even 10%.

Our Three Bucket Tasks
Exercising experience, judgement, and a lot of performance and portfolio data, we divide the fund universe into three buckets.

• The first bucket are possible candidates for the great fund managers, which is a small group. 

• The second bucket are the good funds that most of the time produce satisfactory results. 

• The third and largest bucket are the other funds, which should be studied to identify characteristics to be avoided. These observations require long records to be reviewed and entail visits to managers, their staff, competitors, and clients.

Numbers Filters
Analyze the fund’s record under the same portfolio manager, pretty much the same staff, senior management, and the same investment and commercial goals. Some minor adjustments can be made, but if there are too many we need to begin the analysis at the point where these inputs are reasonably stable. Thus, a stable universe is created.

The next step is to compare the manager’s relative quarterly performance quintile among the appropriate peer group over 40 quarters. A good manager’s performance will be in the mid quintile and the next highest performance quintile between 24 and 30 times during the 40 quarters. In the remaining quarters the preponderance of the quarters should favor the top quintile over the bottom quintile.

Great managers will spend most of their time in the best quintile. However, the second most likely placement will be in the bottom quintile. Those quarters need to be examined carefully. Great managers are often out of phase with the current market and give up current market opportunity for capital preservation. Thus, the worst quintile performance is often a small absolute gain or loss. Large losses need special explanation. It would help if a bad quarter is followed by a top quintile performance.

The Human Filter
Investments are an art form based on a mix of personalities operating at the same time. Too often investors treat the short hand of numbers as reality. The interaction of the various personalities throughout the ecosystem of the fund drives the results. In discussions with the various participants, total intellectual honesty should not be expected. I have learned to group responses into categories in order to build a more complete picture from the various fragments. The following is an example of this approach:

Good Fund Managers limit their cash to 5-10% of assets and are politically sensitive in their organizations to clients. They try to avoid excess volatility and are often top-down thinkers, motivated by the long-term prospects of promotion translated into money.

Great Managers will use cash as a residual, primarily when they can’t find attractive holdings. Thus, cash holdings in extreme cases could rise to 50%. They are very individualistic in many of the things they do. They will occupy the best and worst quintiles more frequently than the more controlled good managers. Great managers are very bottoms-up and are detail oriented in their thinking. Their preferred time-period is a lifetime, but they will sell when disappointed. These are “rare ducks” who are quite introspective and may not provide the best interviews. Rarely will they enter crowded stocks and are contrarian by nature. They are hard-working and would probably fit in with the current Chinese work effort of 12-hour days, six days a week. When focused, they are good observers of people and consumer trends. They feel deeply when they make mistakes and try to learn from them, even though they often repeat the same types of mistakes. When they are early into a stock they can hold the position for a long period of time. These can produce what Peter Lynch called “ten baggers”, or gains of ten times or more the original investment.

Image Control/ Columbus Day Perspective
Most successful professional investors are by nature private people and don’t like to discuss their current investment thinking. Several r of them overcome their shyness, driven by commercial needs, to bring new money under their management. Often, others have the responsibility to use the successful investor’s record and skills to make them both rich. One of the fears of the successful manager is that the public relations machine will exaggerate the investor’s accomplishment.

Monday in the US we have a national holiday, Columbus Day, to celebrate the popular view of his discovery of America. In truth, he never landed on the North American continent. Prior to his voyage, at least two other explorers landed here. Nevertheless, there are aspects of his life that some of the Great Managers have paralleled in their own careers. These are:

1. A man of great conviction [right in concept and wrong in details]
2. Could not raise the money for the exploration at home and went abroad to Spain.
3. Leveraged the Queens’ jewels to get the needed cash.
4. Diversified risks by having three ships, tow returned.
5. Lost control of the theme upon completion of his successful voyage.
6. His discovery was an excuse for US politicians to grant an important urban political group of union workers a national holiday. No similar holiday exists in either Spain or Italy.

Thus, an investor’s success becomes a commercial vehicle for the greater success of others.

Where to Hunt?
As every single day is a day to think about the search for great managers, what does last week possibly signal?

1. For the week, six of the seven biggest market performance leaders tracked commodities. 
2. Five of the seven worst performers were stock indices.
3. While most funds declined, there were some winners that gained more than 1% for the week - Base Metals Funds, Agricultural Commodity Funds, Precious Metals (Gold) Funds, Natural Resources and Energy Funds. DOES THIS MEAN THAT THE MARKET IS MORE CONCERNED ABOUT INFLATION THAN GROWTH?
4. Longer-term targets of future opportunity: Longevity Care and Management, Food allocations, Disruptions to come from AI/VR, TIPS.

Conclusions:

• The world is changing in both identifiable and unidentifiable ways.

• Good equity managers perform credibly well most of the time.

• The rare great managers will find ways to make a lot of money, but it won’t be a comfortable ride unless one builds that likelihood into ones’ expectations.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

Actions Coming from China, Berkshire Hathaway, and Caltech

Introduction

I am always looking for help in investing clients’ and my family’s money each week. I review my exposures to breaking news and views. l have reviewed the actions of the latest week and there was a lot to learn.

China

One of my basic beliefs for the next fifty or so years is that what happens in China will have material impacts on global markets as well as individual lives in many locations. Whether these impacts will be positive or negative will probably be a function on how well we are prepared to understand the implications of the actions taken in the Middle Kingdom.

Market reports noted growing illiquidity in both the internal stock and commodity markets. The volume in the steel contracts is twice the combined volume of the two largest Chinese stock markets. This demonstrates that speculative interests can find outlets in local as well as global markets. I do not know how much of the steel action is short covering or anticipation of growing infrastructure spending which could well impact global commodity demand and therefore the craving for industrial stocks.

To get a handle as to how important the Chinese markets are to the global picture, one needs to understand that almost half of the derivatives traded in the world are traded in China. Because of the huge amount of leverage that can be involved in derivatives they can be a source of disruption that will affect both the banks and the stock markets in general. Thus my fellow domestic stock and equity fund holders need to keep an eye on the commodity and derivative markets in China. This is particularly true as government policy is favoring restructuring the Chinese economy and society into companies with fewer employees producing products and services in which demands exceeds supply. This is not an easy task even in a command economy.

Berkshire Hathaway's Annual Shareholders Meeting

Some may have come away from the 51^st annual meeting with the belief that very little new information was released. However, there were a number of forward-looking comments that could be useful in thinking about future investing. Some of the nuggets are as follows:

1. Too much capital going into a sector or asset class can reduce its attractiveness. A UK manager, Marathon Asset Management, has developed a successful record using the swings in capital market flows.

2. Increasingly consumers are being attracted to "pull" over "push" marketing, particularly through the Internet. Consumers are actively pulled into the net as distinct from reacting defensively when pushed. This favors manufacturers/distributors over the retailers.

3. Eventually the real value of hydrocarbon production will be to supply chemical feedstocks. Remember Dustin Hoffman’s discovery of plastics in the film “The Graduate.”

4. There are areas that are unattractive for investment that include packaged goods, general leasing, and reinsurance.

5. Cash has imbedded an option cost inherent when it is not employed.

6. As a private company rather than a public company there are distinct operating advantages (such as freedom from quarterly earnings pressure) that Berkshire can offer to an entrepreneurial, publicly traded company.

Caltech Fund Raising

Those of us that have deep interest in both commercial and non-profit activities are well familiar with fund raising. Most of the time money is being raised to expand physical capacity. More people are to be hired to serve a greater market size.

As usual, the California Institute of Technology is unusual in its fund raising. Using its own words, “Transformative investigations underway at Caltech will come to life as institute scholars recount the powerful questions they are posing and the surprising answers that emerge.”

This weekend it is entering the public phase of a $ 2 Billion campaign after raising $1 Billion in its private phase. What is unusual is the new capital is not being raised to add students to its small base of undergraduates, graduates, and post doctoral students. The money, in effect, is being raised to expand its intellectual capacity to evolve groundbreaking research. New planets and black holes are to be found, new linkages from advanced developments of biology, chemistry, physics. What particularly interests me is developing an understanding how different elements in the brain lead to various micro and macro decisions; e.g., getting married.

The big investment lesson that I draw from the Caltech campaign unlike most capital raising, is its intent is to get better not bigger which is a tall order because on many scales it is already the best at what it does. For those of us in the investment business it is a call to get better at what we do rather than getting more money to manage.

Question of the week: What are your reactions to these lessons?

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Copyright © 2008 - 2016

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

Investment Survival in a Disruptive Age

Introduction

The First Commandment for all investors is to play to survive.

In my discussion of the Legacy Portfolio part of the Timespan L Portfolios^®, I suggest including stocks and funds that focus on being disruptive to the established order. Thinking deeper about the attributes of disruption, I know we have entered a disruptive age.

If you are a keen observer you will see that almost every major activity is experiencing some form of disruption. In virtually all areas we are trained in some classical way of thinking derived from past successes and failures. The neuroeconomists at Caltech assure me that we make important judgments on the basis of our or others’ experiences. We like to follow patterns. The problem with this comfortable approach is that in many spheres there is disruption. Just look at Science (colliding black holes creating time warp evidence), Economics (experimental quantitative easing), Politics (populism usurping establishment roles), and even some money managers. Our instinctive reaction is at first to reject the disrupters and then fight them as they are threatening our classical way of thinking and operating. What we should be doing is examining the facts/data and trying to understand the power of their proponents. Whether the disrupters are right or not they may represent an opportunity. They may not be completely wrong, and without rigorous study we may not recognize when they are more right than our older models.

This is far too big of a series of subjects for me to thoroughly deal with now. Because I feel that I have some responsibility to those that have used various investment performance measures to select mutual funds and other managers based on their past records (which for a period of about a year have been underperforming) this set of disruptions deserves some attention. I am going to briefly review what is in the process of changing which may explain what is now happening and more importantly what may happen.

Sound Bites

Look at almost any front page of a newspaper or the first story on a so-called news broadcast. The strong odds are that it will be negative in terms of life, limb, and the pursuit of happiness or gain. We need to understand that the media has discovered that negative sells. The people who believe that principle the most are the politicians. In almost every country they are focusing on the problems as a way to attack the “they” who need to be replaced by a different set of politicians. Interesting that each day many if not most things in this world get a little bit better.

Last week I devoted most of my blog post to the annual letter from Warren Buffett as edited by Carol Loomis. I, and others, found the letter to contain reasons to be bullish in the long-run. In her letter this week to her largely retail audience, Liz Ann Sonders stressed a preference for what Mr. Buffett was saying rather than the politicians and their pleas of misfortunes if they are not elected. The statistical odds favor investing in US equities in the long-run.

The Cost of Regulation

Around the world banks and other members of the financial community were blamed almost exclusively for past financial crises. To prevent repeats without reforming the political leadership, the financial community and particularly the large banks were subjected to intense and costly regulation. Due to this additional regulation banks need to increase their capital at all levels. The higher the value placed by the market, the belief is the better the future results and the lower the cost of raising the required capital.

According to Standard & Poor’s the price/earnings ratio of the banks in its 500 index is 12.38 X where the P/E for the banks in S&P's small cap 600 Index is 18.51 X. Thus the smaller banks have to give up less of their equity to get capital than the larger ones. In a period of manipulated low interest rates banks will have difficulty making enough money to attract more capital to make more loans. One of the disruptive forces being unleashed are non-bank financials that are less regulated and often less transparent. Thus the portions of the economy that need loans will likely get their loans with less regulations but at higher interest rates. In Europe banks are often less well capitalized and in some cases have materially larger non-performing loans relative to their assets.

Most private businesses get their money from local banks. In the US, businesses approaching mid size have the option of publicly issued paper. This would be a new experience for many European companies which they may find disruptive in terms of disclosures, costs, and tax implications. On the other side of the coin, retired individual pensioners are not earning enough on their deposits to meet their living needs. So their senior lives have been disrupted.

Price of Oil Links

Disruption can be positive or negative in terms of direction and whether one is a natural buyer or seller. The more established participants are in the camps of lower prices for longer. Moody’s has just lowered the credit rating of many Gulf and African government bonds. T Rowe Price New Era Fund which maintains half of it portfolio in energy stocks views that the price can descend into the twenties from the current prices in the thirty dollar a barrel range, rebounding for a longer term target of $40-50. Sounds bearish, but in February the leading developed market broad market index performer was Canada +4.27% compared with S&P’s measure for the US of ‑0.28%. (For many years, I have hedged my investments in US domiciled mutual fund management company stocks with some of their cousins above the border.)

Another link to the disruptive changes in oil prices are many securities in the emerging and frontier markets. In general, as a group they have fallen in sympathy with the fall in imports into China. One of the reasons for the decline in energy prices is a cutback in its imports of oil and other raw materials. Based on their valuations close to the lows of the prior cycle, they appear to be “cheap.” They may be cheap, but not a bargain. In revamping the Chinese economy its import needs may be permanently altered which would certainly be disruptive to buyers of these stocks.

How to Invest In a Disruptive Period

During disruption, most of us mere mortals do not know how things will turnout. We do know that we are in a period of rapid change at many levels. While we may return to the pre-disruption stage, it won’t be really the same because in the back of our mind we know that there has been a disruption and others could come.

The standard investment strategy in dealing with risk is to diversify into different instruments. Most investors do that within various individual securities. What we do for clients is to offer a better way to diversify. We assemble a specific portfolio mostly of mutual funds from different managers who think differently about market conditions, risks and opportunities. All too often even those who are early recognizing a problem or opportunity only see a portion. Hopefully we can assemble a task team that can get a fuller picture and thus give us and our clients more confidence in dealing with disruptions.

I would be happy to discuss how to deal with the disruptions that you perceive.

Question of the Week: When was the last time before an important election you were correct as to what the newly elected leader was able to deliver?

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

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

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

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