With Value Fully Priced, Expectations are Needed

Introduction

In many periods value focused mutual funds and similar managers perform better than growth oriented managers. When growth managers perform well they can perform very well and in some cases produce doubles without leverage. Value oriented managers in good times don’t do as well. However the secret to their better performance in many periods is that they do not fall as much as the portfolios of growth managers. The smaller declines are not only due to the fact that their stocks don’t rise as much as the growth stocks, but often because of the value managers’ price valuation discipline, they cannot find qualifying securities to buy. Thus, they somewhat involuntarily start to build up their cash positions, particularly if some of their holdings are subject to cash acquisitions. In reviewing a number of fund portfolios as part of my investment practice, I am beginning to notice a rise in the cash and short-term holdings of respected value managers. As these managers do not claim any market timing expertise, in the past the buildup of cash could have been premature to a top of the general market. Now I believe we are seeing early stages of this phenomenon. If this is not a top, market participants will have to see rising expectations.

Fair to full value

From my prior posts one can see that I believe that the large value positions in my financial services portfolio have recovered substantially from their 2008 low points, and perhaps are selling over their fair value levels. A portion of my portfolio is invested for the long-term in good companies. My unwillingness to currently buy more of these good companies would suggest that I have backed into a portion of my portfolio that is currently fully priced. I believe other value focused managers have reached similar views in their broader portfolios. In my case I have not been using current earnings, but my subjective belief in the earnings power of these companies contingent upon a “normal” business and financial expansion. My valuations have been inordinately helped by the currently manipulated interest rates in the marketplace. The math behind the valuation process is to determine a reasonable estimate of future earnings power from existing businesses and then to discount the resultant future stock prices using a somewhat cyclical price/earnings ratio. I use the current level of interest rates to discount this future valuation back to a present price comparison. For high quality companies, historically I have used the yield on 10-Year US Treasuries, now below 2%. For lesser quality investments I have used the yield on similar maturity High Yield (“junk bonds”) currently below 7%. The lower the yield the smaller the discounts applied. In the past these yields have been 5 percentage points higher, 7 and 12% respectively. Therefore my valuations are susceptible to market forces.

Expectations

The value investor uses the current price as representative of perceived value by the market and compares that to his/her perceptions of value, particularly to a what a strategic buyer or a liquidator would pay. The growth buyer perceives what a security would be worth in the future. The future price is based on a series of interrelated expectations. These expectations include broad factors encompassing demographic and psychographic trends, political realities, economics, relative military powers and the willingness to use them. Also included in the list of expectations by smart analysts and smarter investors in dealing with a specific company are its revenues, operating margins, net free cash flow, debt service, market share, new product development and likely competitive responses.

Professional portfolio managers’ expectations should include expected changes in the current shareholder population and their motivations.

Whether we recognize it or not, the play of expectations is at work in the marketplace every trading day. During the “risk on/risk off” phase for the last couple of years, a narrowing fraternity of traders dominated the marketplace. While traders are still important, a renewed group is coming off the sidelines. These are institutional and individual investors who are being forced to remedy the shortfall in the purchasing power of their capital to meet their long-term needs; i.e., retirement and building/rebuilding long-term facilities. For the most part these investors did not leave the investment arena. They either let their cash build up, chased yields into fixed income securities, and/or invested in alternatives in private equity, real estate and some commodity plays including a little bit in gold or gold mining shares. I believe we are in the process of seeing a change of comrades in arms as to the investor army that is taking the lead for market leadership. Recently stock markets around the world have been rising. Many of the trading fraternity, (including aggressively managed hedge funds) have long positions in gold or related securities and their short book has been growing. Some believe the rapid rise in the VIX Index over the last week was somewhat due to panic buying by hedge funds to cover their short positions in response to this supposed indicator of bearish sentiment. The rise in the stock markets coming during a period of extreme negative views toward many elected politicians is being led, I believe, by longer-term investors. If I am correct, the impetus to commit money now into common stocks is based on growing changes in expectations.

New/different expectations

In general, I believe that buyers of stocks these days believe some of the following:

1.    The private sectors of the economy are showing gradual signs of global expansion. Materially higher stock prices are dependent of revenue growth.

2.    The public sector is shrinking its employment base and to some extent its overall compensation load on taxpayers. In an ironic way, this could be good for both the surviving government workers and the public they serve. One of the reasons the private sector is in better shape than the public sector is that business has raised operating margins to high, if not record levels, by significantly improving labor and capital productivity. (Doing things better with fewer people.) Until very recently many federal and some state and municipal governments have not faced these challenges. Traditionally the way governments in control have addressed problems, the same way the North did early in the American Civil War, was to throw enormous amounts of people and money at the perceived crisis of the moment. Over time this technique is self-defeating; as those with more limited resources come up with productive solutions.

To comprehend the growth in the US federal government’s direct and contracting payroll, drive as we did this weekend through Northern Virginia and Maryland on the run up to Baltimore and observe the enormous real estate developments that are full of employees and their families dependent on US taxpayers. Smarter and further automation is likely to improve the delivery system of necessary government services.  In field after field society has found that externalizing various government services has produced better results, particularly when there is no union involvement. The non-profit world is going through similar problems. As they become more market disciplined their audiences will benefit from more efficient delivery of their vital services

3.    The unstoppable march of demographics is producing several cohorts of capable people who want to work. At the one end is a better schooled, (notice I did not say educated) population. These individuals are eager to earn and for the most part eager to learn commercially viable skills. I believe the expectation is that these willing workers will be absorbed into the work force both here within the US as well as in many other countries. High-speed computer communications have made locations less sensitive to success than specific expertise, including customer service. At the other end of the age spectrum, we and many other “developed” countries have a growing segment of seniors who want to work for income or socialization. They have useful skills and in many cases seniors are the fastest growing learners of new computer techniques. These two leagues, the young and the seniors, represent to me and my Marine Corps training, a large reserve element than can support and supplement those who are more advanced, but at lower net wages.

4.    Technology and particularly medical/health technology is producing a potential population that can be productive in every sense of the word. Many of these improvements will actually lower the cost to society which can have dramatic impact on the growing gap of retirement funding that is a global phenomenon. All of this represents investment opportunities.

5.     Because of European colonization efforts we currently live in a world where the Northern Hemisphere is economically and financially more advanced, with a number of exceptions. Identifying three of the exceptions demonstrates what can happen in the Southern Hemisphere; Australia*, Chile*, and South Africa. I expect over time that money and talent from the North will leverage the local talent and other resources in the South to create a long-term investment boom.

*I have investments in these markets through single country funds.

Changes in levels of expectations are normal in the attitudes towards the stock market. One can gauge where we are in terms of the distance from a speculative top by looking at the period that the bulls are using in their purchase recommendations. While quarterly numbers are taken as verification of longer-term trends, they are having less impact now. Currently the focus is more on the second half of this year which leads to the full year results which for the most part are used for valuations. We are entering the time of the year when professional analysts will start to publish their next year’s estimates. Recent visits to sound buy-side shops focused on the detail in their five year estimates. As part of my responsibilities for a non-profit I was asked to come up with a ten year estimate of endowment performance to test the ability to meet spending needs. I am also in the process of working with my accountant to come up with the ranges of expected performance to be contemplated for a dynasty trust. Thus I am already dealing with different time period expectations, but so is the market. The price of Apple at over $700 in September, 2012 was largely based on a long-term projection of the continued growth of their recently introduced iPhone 5, with particular focus on the perceived potential in China. For lots of reasons that I will be happy to discuss privately, these expectations were wrong or at least way too premature. The current price of 430.17 displays the risk in rising expectations. As the stock with the largest market capitalization, it is note-worthy that the fall in the price did not lead to a general market sell off (which has happened previously when the leader’s price balloon was popped) and may signify that market participants do not currently expect a market decline. 

Please share with me, perhaps privately, what are your expectations for your money in the period you are most focused?

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Labels Can Be Dangerous to Your Wealth

Introduction

In our modern lives we are inundated with information. To avoid chaos we organize information in silos and give each of the silos a label. Unfortunately we (the universities, the governments, media)  rarely ever examine whether we have misfiled the information or whether those informational relationships have changed. If so, the current label on the current fact is often misleading.

One of the few benefits of long plane rides is that I get to read the news of the day more thoroughly and from many different sources. As I read these pieces, different relationships between the elements of information and some important investment implications occasionally come into focus.

How and where do we shop?

On October 18 in the London edition of the Financial Times there was a front page article headlined “Retailers Shut 20 Stores Each Day.” The article was based on research conducted by the accounting firm PricewaterhouseCoopers. In a study of 500 UK cities/towns, PwC found that in the first half of the current year some 953 stores were closed, compared to 174 in a similar period in 2011. (While I don’t have data on the US and other countries, I suspect that the trends are roughly parallel.)  Computer game stores, toy shops, clothes shops, gift shops, jewelers, card/poster shops and furniture stores were hit the hardest. Places offering check-cashing, pawnbrokers, discount and convenience stores, coffee shops, currency changers (and wire sites) and charity shops were far less effected. After reading the article, the analyst in me had three different thoughts that bumped heads with the traditionally-labeled silos.

First, did the UK statistical offices note the change in the mix of retail activity? Second, the realization that we are seeing marked changes in behavior. Trading down from higher-priced merchandise and conversion of assets to various forms of money, replacing merchandise spending for service spending are all important changes. Third, the data is incomplete, I am guessing a good bit of the store traffic has been lost to the Internet.

In my recent discussions with UK portfolio managers, no one directly discussed these changes, however many held Internet-oriented stocks as long as they were moving higher in price. National governments do not seem to be aware of these changes. Local governments around the world are very conscious of disappearing storefronts and therefore employment, but seem powerless to stimulate sales on their High (Main) Streets.

Does the US have the same labeling problem?

The labeling of various stocks as consumer staples or consumer discretionary is misleading.  These are terms from outmoded economists based on the goods and services once sold, not how they are bought today. Amazon and similar online merchants have changed the world and both investors and policy makers need to catch up.

Another example of mislabeling

In a recent conversation with a very intelligent mother of children who are now in the workplace, I was told that she educated her children as they were growing up at various ages by the stocks she bought for their accounts. At an early age she bought McDonald’s for them, as it was the place they went to get rewards for good behavior and good marks. I am delighted that it worked out well for the family. She followed that thinking and at some point bought shares in Apple for them. (I suggested that now as they are in the workplace she might look to buying some of the recruiting firms. In the past they have not been big winners as stocks but are very much leveraged to mid to high-income employment growth.)

All of the stocks mentioned appealed to her and her lucky children because they knew of the companies and their products. But in each case these are globally-oriented companies. It would probably surprise her and many Americans to learn that McDonald’s has more sales in Europe than it does in the US. (Interestingly there are more Burger Kings in Barcelona than McDonald’s even though McDonald’s has the Airport location beyond security.) In a similar fashion, Apple’s future is very dependent upon both production in China and whether the iPhone 5 will increase the potential market from 17 million users to 200 million users.

The fastest growth for many recruiters is their foreign placements. Not only are local offices around the world filling local needs with local talent, they are searching for qualified US talent to work overseas. These are examples of stocks that are labeled as US domestic because they are legally domiciled here. Most portfolios owned by US institutions and individuals need to recognize the global nature of their holdings and adjust to the world not as it is, but how it is likely to be.

Fidelity has come up with some very important numbers

Following the trail of the now grown up children mentioned above, they and their cohorts need to start to think about their retirement capital needs NOW!  In an article  in the October Financial Advisor magazine, Fidelity Investments has laid out the math for meeting a working person’s retirement needs which I have outlined below. (Bear in mind that Fidelity is the largest factor in the 401(k) market.)    

1.     To reach 85% of final salary level at age 67 retirement, including social security, one needs retirement capital of eight times the ending salary. They assume the age at death is 92.

2.     To reach this goal one needs to enroll in a 401(k) at age 25 and make continuous contributions beginning at 6% and raise it 1% each year until it reaches 12%. (This plan presumes an employer contribution of 3% p.a.)

3.     The intermediate benchmarks would be an account equal to one year’s income by age 35, three times by age 45, and five times by age 55.

4.     The underlying investment assumptions are a 5.5% rate of return, the employee’s income grows by 1.5% p.a. more than inflation and no breaks in employment or savings.

There are very few people that I know that are on this track (excluding those who have access to outside capital) and most workers won’t get to these numbers. Thus, we need to come up with a new label for the period of our lives beyond our primary employment.

Can we discuss your retirement planning?

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Steve Jobs and Lessons for Fund Owners

We have all benefited from the life and genius of Steve Jobs. One can only speculate whether in our own lifetimes, Apple Computers, “Toy Story,” the iPad and the iPhone would have been produced and at the prices we paid, without the guiding force of Jobs. He married Art with Technology, and came up with magic to give us products that we didn’t know we wanted, but demanded nevertheless. His attention to detail, particularly to the fit and feel of Apple’s products, was amazingly accurate. Part of his genius was organizing the supply chain of essential parts that would be assembled into his finished products. Knowing of his medical condition, Steve Jobs left his company with new products planned out for the next four years. He built a team of successors that he felt would carry on with his goals. Clearly, I am a fan. The smartest thing I ever did outside of marrying Ruth was to give my late, learning-disabled daughter an Apple IIc. Because of its intuitive operating system and keyboard, she was able to communicate with a whole new world of people and learning. Important disclosure: I personally own Apple shares which I received many years ago as a distribution from a closed-end fund. Luckily I kept half the position; since then, I stupidly sold a portion to take an outsized profit to offset some realized losses from other transactions and to free capital for new investments. Like Steve Jobs, I was able to make mistakes and learn from those errors. Jobs certainly did make blunders, several which could have bankrupted Apple if others had not intervened. Despite the very fact that as good as he was, he had a combination of tremendous successes and near-fatal mistakes. These extremes are somewhat similar to many very successful fund portfolio managers.

Lessons from Fidelity Magellan

Chapter 16 of my book Money Wise details some early lessons from the progress of Magellan, from its initial restricted launch through some of the later portfolio managers. This chapter should be required reading for all those interested in the economics and portfolio history of the mutual fund business. While there have been many portfolio managers of the fund, none were better than Ned Johnson and Peter Lynch. Very recently a new portfolio manager has replaced one who produced lackluster results. To some degree, his appointment is recognition of less-than-successful succession planning, which highlights how difficult the task is, particularly for the management and board of Apple. In terms of Magellan, like with Apple, there are two elements that are required to make succession work. The first is the outward results: e.g., will the iPhone 5 and iPhone 5s continue Apple’s astounding growth? To do so, these devices will need to open up new markets as well as to convince owners of Apple’s older versions to crave these new phones. On the fund side, I wonder, will Magellan become a performance leader once again? The other key element to whether a successor works out well is on the business side. Can Apple’s management keep its gross and net margins where they are, through managing both the supply chain and distribution margins up to the current level? For Magellan, the issue is more challenging. The fund is largely a retirement vehicle, as distinct from a performance vehicle; its shareholders are different and getting new flows from retirement plans will take a lot of work. Further, at one point in time Magellan was the flagship and largest fund within Fidelity. It is not today, which raises the question as to whether it will get all of the top attention that may be needed to succeed in a much more competitive world.

I have a reasonable degree of comfort in the prospects for Apple over the next four or so years; I approach the decision in terms of Fidelity Magellan differently. If one already owns shares in the fund, I would not redeem them until one sees the next portfolio of the fund after the new manager took over. The key that I would be looking at is to see how many of the old holdings are left in the portfolio. In the case of someone contemplating buying into the fund on the basis that the new portfolio manager has a better record than the old one, I would wait until the publication of the second listing of investments in the portfolio. I would be interested in whether the portfolio looks like his old portfolio or whether he is branching out to new names and policies.

Applying successor concerns to Fairholme

As famous as Peter Lynch was during his high performance years, Bruce Berkowitz has been shepherding his Fairholme Fund for the eleven years between 2000 and 2010. In all but two of those years he handily beat his peer group as measured by the Lipper Large Cap Value Fund Index, in most cases by ten percentage points. (For our UK members of this blog community, the name Fairholme may seem to be familiar, it is the name of the street where Bruce lived while he was in the brokerage business when he was in London.) Bruce’s fame was such that Morningstar named him as the best equity manager of the decade. As with Peter’s Magellan fund, the outstanding performance attracted a huge amount of inflows. So much in the way of inflows, that Fairholme was larger than Lynch’s Magellan when Peter was managing it. (Fidelity merchandised Magellan after Peter Lynch stepped down, to a point that it had assets over $100 billion, and for a time was the largest active stock fund.) Unfortunately, we have seen poor performance patterns appear after great performance. For the twelve months ending September 30th, Fairholme was down -22.20%, compared to the minor -3.54% loss of the Lipper Large Cap Value Fund index. All of the decline could be attributed to Fairholme’s poor third quarter of -25.47%, compared to its peers of -16.67%. Bruce’s concentrated portfolio, with heavy emphasis on financial-related stocks, was hurt. Is this poor performance similar to the period when Steve Jobs was producing poor financial results and lost control of his own company? Only the future will tell whether Bruce can snap back, though I hope so. For many years until he moved to Florida, his New Jersey office was about a mile away from my office.

Just as I focused on Magellan in terms of both the investment and business side, I think shareholders need to examine Fairholme. Bruce is managing what he does with a small staff of investment and administrative people. If something unfortunate was to happen to him, I do not see a succession plan in place. Who could run both the portfolio and the business? Unlike the present day Magellan where existing holders may be wise to wait to review the new portfolio manager’s holdings, my fear is that Fairholme’s holders won’t be patient. This does not appear to be a Steve Jobs type of succession in terms of people and products.

Why did I focus on Fairholme and succession issues?

For awhile we did use Fairholme in a number of portfolios that we manage; however we limited the size of the commitment below what we would have done had there been a well thought-out succession plan. Further, we cut back our position, as the fund’s analysis was very different than our views on specific holdings, most particular in the financial sector. (Please bear in mind that I manage a small private financial services fund.) The purpose of sharing my views is to indicate some of the ways I analyze funds and fund managers. Further, as with all good analysts, I could reverse my views on the basis of new information and once again build positions in Fairholme. When Steve jobs returned to Apple, both he and the company were better off than before he left. Both had matured and were ready for exponential new growth. From the time he came back until this last week, the price of the shares of Apple went up 7000%. Thus, there is always hope for a great second act.

Wall Street protesters

I am gathering my thoughts about the significance of these demonstrations. I may devote next week’s blog to thoughts about the meaning of the “occupations” for the rest of us. Please share your thoughts with me on how I should think about these events.
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