Be Thankful for Risk - Weekly Blog # 498

Introduction

In the northern Hemisphere, this is the season of festivals to celebrate the gathering of a good harvest. In the US, we recognize this tradition as Thanksgiving. World Stock Markets have been quite kind to investors so far this year as seen through the eyes of mutual fund holders using category averages and highlighting some exceptional performance:

US Diversified Equity Funds	+14.34 %
Sector Funds.	+9.76 %
World Equity Funds	+16.73 %
Mixed Assets Funds.	+11.25 %
Domestic Long Term Debt	+3.51 %
World Equity Funds	+7.65 %
LeaderGlobal: Science&Tech	+46.84 %
LeaderPacific: Ex Japan	+38.22 %

Source: Lipper Inc., a Thomson Reuters Company.

If the calendar year ended last Thursday night these results would be above average on a historical basis but shows that investing in Asia and in global science & technology issues has produced extraordinary results.

Performance Always Comes With Risks

Investment history is a tale of gains and loses with hopefully some lessons that can be used in the current time frame. This last week we had an example of very long-term rewards from investing in the auction of Leonardo da Vinci’s painting of Salvator Mundi for $450 million. In the Wall Street Journal, our friend and columnist, Jason Zweig made a good attempt to quantify the painting’s return, from presumably its first sale to this week. By his calculations after an attempt to adjust for inflation using gold as a very rough measure, the annual return since the sixteenth century was an outstanding 1.35%. But even this, by today’s standard low return, was better than cash, gold, and bonds, but not stocks. Another author has calculated the gain after inflation in the equivalent of the S&P500 since 1871 to be 6.9%.

There are two important lessons from this data: 

• First, accepting risk can produce better returns than perceived safer investments. 

• The second that the $450 million price compared to an auction house estimate of $100 million did not appropriately consider that this may be one of only 20 finished works by  the talented artist. Scarcity has a value

This is one of the reasons we favor individual stock selection over sector bets. This has implications for our fund selection process of favoring funds with less than 100 positions and even a few under twenty positions over broad index funds or passive sector funds. To us differences do  matter.

Recently we have been reviewing reports on the 13F filings of a number of well-known investment managers. In an over generalization most seem not to have owned a lot of winners in the third quarter, but continue to own and enjoy good results from positions bought years ago. ⁺

+Email me at Mikelipper@gmail.com  for more info on our Timespan L Portfolios®

Whether we like it or not we are all risk takers anytime we get out of bed or cross a street, let alone make a long-term investment decision. In an over-simplified model any portfolio’s strategy can be summed up as capital preservation or capital appreciation or for most, a ratio of the two. In the above model of comparative returns to the value of Salvator Mundi’s portrait, it is important to note the better performance of the painting over cash, gold, and bonds. To me there is a quotient of risk in all three of the under-performers that has been viewed as “safe.” For example, cash is not protected against inflation, particularly the virulent type that has been seen periodically through history. In addition while most of the time the costs of holding cash on account is small, and with minor custodian risks, both have been known to create anxiety for cash owners. Perhaps the biggest risk in holding cash is a dramatic change in the needed use of the cash to meet needs. If these are true for cash, similar risks may be present in other “safe assets.”

At this time holding US Treasuries could be more risky than generally perceived - based on two bits of news not generally appreciated. The first is analysis by Merrill Lynch echoed by others, that Treasuries are the most crowded trade in the market. This suggests that there is a supply/demand imbalance with some of the participants not exercising price discipline which may explain why the yields on US treasuries are higher than agencies UK, German, and Japanese issues of similar maturity and perceived quality.

The second and perhaps related bit of news is an article headlined from the Financial Times which said “US Treasury dealers accused of collusion.” There are similar, other cases pending. The results of these cases one way or an another could cause disruption to not only the market for US Treasuries, but also to many markets that use treasury prices as benchmarks in setting the prices for other instruments and markets.

Accepting Intelligent Risks Can have Its Rewards

Obviously not every single risk works out for long-term investors, but many do.  The key, particularly for our longer term investment accounts is in careful selection of mutual funds. Two of the matrices that we study are prices and related valuations plus the underlying selectivity as evidenced in the portfolios of mutual funds. Currently we appear to be in a two-tier market with a couple handful of good performers becoming price performance leaders. This not true for a second tier.

One study points out unlike in 2000 the fifty largest companies in the S&P500 were selling at 31 times earnings. Today the fifty largest is selling at 17.9% which is generally in line with historic records. One explanation for the high valuations of some stocks is the Charlie Munger belief adopted by Warren Buffet that it is better to “buy a wonderful company at a fair price than a fair company at a wonderful price.” This philosophy depends on the ability to find wonderful companies at fair prices. In my mind, this is dependent on sound and smart investment analysis. A good investment analysis course could be taught exclusively on the wins and losses in Berkshire Hathaway’s^* history. Recently they have been reducing a large position in IBM which perhaps has not yet developed into a wonderful company and have been buying Apple*, still evolving as a wonderful company. While Berkshire is a very long-term investor in a number of securities, it is price sensitive, currently sitting on $110 Billion in cash and $180 Billion in investments.

*Held either personally or in the private financial services fund I manage.

Conclusion

Accepting the risks of disappointing results from time to time does not diminish the odds in favor of long-term gains. One needs to balance the goals of capital preservation and capital appreciation. The ratio should

probably shift inverse to near-term market performance.

Question of the Week:

If you were forced in terms of your own account how would you divide your portfolio into only two buckets between capital preservation and capital appreciation and is the mix different in your professionally managed accounts?

Use Simple or Complex Mixes of Tactics and Strategies to Attain Investment Success.

Introduction

The global stock markets are probably not priced with a lot of bargains. High quality, fixed income markets are full of fears. All markets including commodities and real estate are likely to be more volatile for the next couple of years than what we have recently experienced. If you disagree leave the worrying to the rest of us.

Our concern is based on the volatility that won’t be constrained and lead to panic-driven major disruptions. Since we don’t know what our next investment voyages will be like, we should examine our navigational tools. In our lives we know from our own or observed experiences that frequent changes rarely produce optimum results and in many cases deplete resources substantially. Thus the key to using the appropriate tools is the discipline to use them correctly and even when periodically they produce sub-optimum near-term results. Nevertheless there may be times when changing tools makes sense. Usually the best time to make switches is whenever a tool is too successful and not when it is underperforming. This reliance on intelligent discipline is one of the may lessons that I learned in the US Marine Corps.

Our basic four investment philosophical tools are:

1.   Reliance on Simplistic Approaches

2.   Recognition of Complexity

3.   Goal focused Strategies

4.   Timely Tactical moves

Simple

A study of most very successful individual investors appears to demonstrate that large wealth is generated by investing in ownership of equity, usually very concentrated to the point of a single investment.  It takes an unusual person that can tolerate the cyclicality involved in a single or even a highly concentrated portfolio. This cyclicality produces too much trauma for most. So they start to diversify. The problem with diversifying is that almost every day a new potential threat to one’s wealth shows up, particularly in the media. The standard risk control measure for new risks is to add some new protective investment. Over time this approach leads to a large number of investments.

In the modern world, people and institutions seek comfort in becoming part of the masses and either directly or indirectly index their portfolios. The thinking behind this is that all of these investors can’t be wrong, but equally they can’t be as right as the successful wealth-builders. Other simple philosophies are to only invest in highly credit rated stocks and bonds which produce similar upside and downside results. It is like someone who goes to the racetrack to bet on winning horses, so they bet on almost every horse in the race. Quite often they will have a winning ticket, but most of the time the money received will not pay for all the losing tickets. The nice part of simple moves is that they do not require additional thinking or analyzing.

Recognizing Complexity

There are no two people exactly alike. Even my twin grandsons, not only are they different, but they strive to be different. While each market has on the surface similar characteristics of prior market cycles, there are enough differences so the past is a bit instructive but not totally predictive. I believe that each portfolio and investor are different than others. One of the risks that some investors face in dealing with live managers and brokers as well as the so-called robo advisors is that at times one’s needs and preferences are not utilized in portfolios. One of the ways I recommend dealing with this is to divide an investment portfolio in terms of expected payouts. I start often with four timespan portfolios.

Each portfolio can be selective in terms of levels of aggressiveness/conservative as well as many other selection functions. Because consultants want to deliver the past to clients, they ask about the dispersion of performance within a manager’s book of business. To the extent that there is little dispersion, there is little attention as to the differences between people and institutions. All 401(k), pension plans, endowments, and families are different and deserved to be  treated that way. However, there is an expense to managing complexity. The difference is similar to buying off the rack versus custom produced and fitted clothes. Each has its place, but overtime the old rule of getting what you pay for generally works.

Goal Focused Strategies

Almost every physical and investment trip has bends and turns with occasional reversals. Those who successfully complete their trip do so because they have a navigational tool of an effective compass. We all understand that prices go down as well as up. While there are relatively few complete wipeouts, we have seen 90% declines in leveraged, highly speculative stocks in the 1960s and the 1930s. These are rarities. Most general stock market declines in a single generation are on the 50% variety. Within each rolling ten year period there is a 25% fall, and often within a ten year period there are three years of greater than 10% decline. Strategies should recognize the downside potentials, but also be aware and positioned for the upside.

Since 1926 the general stock market has on an annual basis gained in the range of 9%. We have experienced gains of three or four times the average and have seen a number of concentrated funds with speculative holdings post annual gains of over 100%.

Some may feel that because the number of publicly traded stocks is down by a factor of 50%, the institutionalization of trading, and the growth of index funds that past upsides will be curtailed. I would argue eventually the reverse. Periods of extreme concentration as we have been in, lead to lack of focus on securities that are not part of the highly valued concentrated portfolios particularly in the market capitalization weighted indices.

A very important point in assessing long-term investing is the power of reinvesting cash distributions (interest, dividends, and capital distributions). The great Sidney Homer, the long term head of Salomon Brothers fixed income research pointed out that for the long term bond investor there are three returns of cash over the life of the bond:  (a) proceeds from maturities, (b) current interest coupon payments, (c) and interest on interest.

Most people don’t fully appreciate that the third element produces the most cash. For example a bond with a 4% coupon held for a twenty year maturity will receive 100% of its issue price, 80% of its issue price for twenty years in interest payments, and if they can reinvest the interest payments at the same 4% for the period they will receive 119% of the issue price. The message here is that by buying and holding solid bonds and reinvesting the income, the return to the investor is larger than most believe. The key is not spending the interest and reinvesting it at a similar rate as the initial issue. (If you sense a certain rhythm to this approach it is worth noting Mr. Homer’s parents were both professional classical musicians.)

The interest on interest example is actually more powerful in investing dividend stocks and funds. Today they are many solid equity companies who are yielding 2% to 3% that over the next twenty years are likely to raise their current dividends at least at the rate of inflation, if not higher. Many of these stocks’ twenty year dividends will be higher than a 4% coupon on a high quality bond. Both many dividend paying stocks and all mutual funds have reinvestment mechanisms, so the equity investor does not have to look for current income opportunities the way the bond investor does. I am biased, but I believe the reinvestment potential through good mutual funds is better than many individual stocks. The US and UK regulators do not value the reinvestment mechanism in their assessment of the value to investors. Dividend paying stocks and mutual funds could represent a significant part of endowments and individuals long term portfolio segments.

Timely Tactical Moves

The first thing is to determine is whether the investor has trading skills. Can they recognize the difference between intra day and daily volatility vs. a meaningful change in price trends? There are some that believe that they posses this skill and a few may. It is very definitely an art form that requires the right personality approaches with extreme discipline.

Others attempt to be anticipatory and get ahead of new trends. As someone that has been known to be premature, too soon is often equivalent of being wrong. At times one may have to concede that one is premature and reposition for closer to fruition trends.

Contrarians can identify where they think the crowd is wrong and take a contrary view. Most of the time these moves don’t have much price risk as the market doesn’t believe in them.

My Dilemma

My dilemma is to find the correct communications with potential clients as to which of these tools should be used with all or a portion of their accounts. Any thoughts would be appreciated.

__________

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

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

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Janet Yellen Could be Right, If……

Premise

Janet Yellen, Chair of the US Federal Reserve Board of Governors, has said she does not expect a 2007-2009 financial crisis in her lifetime. For many reasons we hope that she has a long life. One of the lessons learned from lots of sports, including horse racing, and applied to business, portfolio management, and life in general is to be conscious of what could go wrong. If you will “the known unknowns” as well as making some allowance for “the unknown unknowns.” 

As an investment fiduciary I feel it is essential that one develops an appreciation for the odds that Ms. Yellen may be right.

What Causes Crises?

Major financial crises typically have both preliminary causes and a galvanizing event. The preliminary causes are relatively easily to spot, often by looking in a mirror. The event is often the unintended consequence to an action that forces many to brutally re-examine an intellectual or emotional structure in which we had total faith, that suddenly is found wanting.

Underlying Causes

The first cause is the belief in the inevitability of a pre-determined future. The growing enthusiasm for this belief overrides all past cautions. Because we all believe that we should be richer than we are, we will borrow to multiply our stake in the inevitable “goody.”  Often people and institutions look to borrow from any available source including surreptitiously from others without their notice... embezzlement. Thus, the essential second underlying cause for  crises is leverage. (For my mathematical readers- Enthusiasm in the “inevitable” times expanding use of “cheap” leverage = precursor of crisis.)

Where Are We Today?

Chair Yellen can not identify any major causes for concerns. She is right at the moment. Focusing on my continuing analysis of the global mutual fund business, I see some potential worries.

Are Equities About to Take Off?

One of the reasons that mutual fund performance is so often quoted by media, academics, and even government officials is that the data is quite accurate and rapidly and relatively available. I have been following these numbers for fifty years. This how I start to view the movements in the marketplace. On Friday we finished the first half of 2017. While the data is preliminary and subject to minor modification, it is instructive. There are at least nine investment objective averages producing double digit returns for the first half. (A copy of the list is available by contacting me. The leading investment objective is the Health & Biotechnology average of +18.46%)  Without dividends both the Dow Jones Industrial Average and the S&P500 were up 8% and using the Vanguard S&P 500 Index fund’s total reinvested return was 9.3% as a rough guide to the market.

In terms of our analysis, the key point: if the fund and general market performance produced high single digit gains in the first half, is it a reflection of growing enthusiasm which is relatively higher than the current sales, operating earnings, earnings per share or dividend growth? Remember that most institutions such as pensions and endowments have a targeted goal of between 4 and 9% for the year. The biggest gains were experienced by Growth rather than Value-oriented funds. Growth enthusiasts tend to be more future-oriented than value investors who are basically betting on correcting mis-priced securities. Either the markets are now premature in discounting future growth or will be in the future. Thus, we may begin to exhibit one of the standard precursr to a crisis.

Could Fixed Income be a Trigger?

The thirst for income is a global phenomenon to pay current or future bills. Almost everywhere that has a sizable Mutual Fund marketplace, money is pouring into bond funds at the retail level and into other credit instrument funds at the institutional level. What makes this concerning is the general market perception that interest rates will rise, and if things go wrong the rise could be significant. While Fixed Income investors typically focus on yields on purchase price, they are often shocked when they sell at prices below their initial purchase price. At some point at least the institutional investors will look at their investments on a total return basis incorporating current prices which could be materially lower due to interest rates rising. Future prices could be hurt by various trading entities like hedge funds being forced to meet collateral calls as their Fixed Income holdings are marked down to a declining market. My own suspicion is that the two segments which are most exposed to high leverage is government issued paper and credit instruments.

Archduke Accident Replay

Popular beliefs hold that World War I was begun as an outgrowth of the murder of the popular Archduke Franz Ferdinand of Austria on an automobile route in Sarajevo that had been changed due to security precautions from an incident earlier that day. The change was ordered without telling the chauffer.  The sad event set in motion countries that were already preparing for war and forced their allies to come to their aid. Often the trigger events are caused by an unintended consequence of a well intentioned act, often by some force within the government. Usually the forces that trigger the consequences have a much too narrow of a view of their impact. Allow me to suggest a hypothetical and probably improbable series of events.

Government officials and media pundits look at mutual funds as products with a sole goal of producing a higher return than some other measure. They fail to understand the history of the fund business. Mutual Funds started as a way to mobilize existing savings (usually on deposit) into long-term investing. To convince savers to part with some of their savings was not a simple exercise of giving the reluctant saver enjoying a level of security something to read. The sales process often took a number of sessions. The global fund business was a financial service activity not a financial product producer. Perhaps the key value of these financial services is not just the initial purchase, but subsequent purchases. Probably the greatest value during periods of scary market declines is urging the investor to stay invested. Finally, the process permits and encourages partial withdrawals and perhaps some switching into more appropriately aged investments. All of these services need to be available everyday and often in aggregate, cost more than the pure investment expenses. In recognition of these needs many fund distributors and allocators have styled themselves as wealth managers.

The UK’s Financial Conduct Authority is complaining that UK funds are not competitive enough. They want competition based on a single fee covering all the holder’s costs and performance. (They are not focusing that in many cases the services aspects of the fund business are equally or more important to the holder than fees and performance.) We have in the past seen similar naivety occasionally in the US. Some similar concerns had been expressed in the EU’s MiFid rules.

What Could Go Wrong?

For the moment assume that this type of thinking becomes popular in many countries, sales people and to some degree, service people will leave the fund business and migrate to more expensive products and services like hedge funds, private equity, venture capital, real estate, or “investment art.” There is some chance that the returns will be below mutual funds. Where this could create a large problem for various governments is that the growing retirement capital deficit is expanding and there will be pressure on taxpayers to fill the gap at the expense of other government services. Expanded government services will lead to higher inflation as the government will have to borrow more to pay its bills. Or taxes will rise which can in and of itself cause a financial crisis as taxpayers rapidly change their investing status.

What Are the Odds that Janet Yellen is Correct?

At the track regular horse players understand that in spite of all their considerable handicapping (analyzing) skills there is something called “racing luck.” Things happen that are the providence of the “unknown unknowns.” Ms. Yellen could luck out and there won’t be a financial crisis the rest of her life. 

For my responsibilities I am prepared to have to deal with some or more of these. I am growing particularly nervous over the next 18 months as governments that in general have a record of creating unintended impacts cope.  

Both the US and India are early in redefining their tax structure, France is going to attempt to become competitive through labor reform, China is restructuring economically and financially, and there is the little matter of Brexit.

One may need good advice now more than just faith that there won’t be any crises.        

__________

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

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

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.