Not Yet! - Weekly blog # 800

 

Mike Lipper’s Monday Morning Musings

Not Yet!

 

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

 

 

 

The Thinking Behind Blog 800

When I realized the 800^th blog was coming up I tried to think of something special to discuss, like a critical turning point at the beginning of a new long-term market cycle. I see a turning point in the future which will begin a new corrective cycle. It will address multiple imbalances facing the US stock market, a reflection of increasingly problematic domestic and global problems.

 

However, it now appears we are likely going more toward a shallow dip, which could be labeled either a “soft landing” or a ripple in a stagflation period. Regardless, the underlying tensions continue to build and they will eventually lead to a deep corrective stage. With the 100^th blog less than 4 full years away, I have high confidence we will see a major correction.

 

Regardless of the timing and depth of the correction, we remain largely invested in equities and stock funds. These funds will need guiding principles to survive the correction and prosper from the following “bull” market.

 

Sources of My Guidelines for Long-Term Successful Investing

• Fidelity has published their views on 5 mega trends.
• Marathon in London has written about the benefits of low turnover and stable managements.
• Howard Marks expressed his views on escaping extreme investing.
• Finally, my own observations on the investment decisions of funds, commuters, and actuarial lessons on betting.

 

Productivity/Profits- Fidelity

Fidelity probably invests in almost every investment any place in the world. They serve different types of clients in many capacities and countries. Of the 5 Mega Emerging Trends, the most easily measured is the slowdown in the growth of productivity, more specifically in the productivity of labor. Labor is easily measured in terms of the number of hours committed to work, likely for compensation. (What is not evaluated is the quality of the work.) The number of hours worked in the US is in the upper portion of the lower half as shown below:

   More than US      US    Less than US

UAE          2709  1892   UK        1866

India        2480         Germany   1783

China        2392         Australia 1669

Mexico       2220         Canada    1664

South Africa 2154         France    1565 

Thailand     2108

Poland       2085

Indonesia    2043  

Philippines  2039  

Russia       1965

 

Implications

1. In a world that has higher interest rates and is short of opportunities, there are more places competitive with the US.
2. When US proclaims politically motivated holidays, such as Labor Day.

 

In an article by Howard Marx, he warns about extreme stock prices. When extreme enthusiasm pushes prices to record highs or lows, investors sell stocks priced for perfection, or buy/retain stocks which can never generate good news. Most of the time securities trend in one direction or the other. A dangerous condition is when all opinions on a security are totally one-sided. Very few investors understand that it is rare for there to be no salvage value for knowledgeable investors with patience and legal backing.

 

An example of too many one-sided beliefs was the 50 institutionally favored stocks in the early 1970s (Nifty Fifty). It was believed that these stocks could be bought and never sold, after the recommendations of the leading institutional brokerage houses didn’t work out. In 1972 the list contained Eastman Kodak, Polaroid, Sears, and Kresge. In the years that followed, all four disappeared through bankruptcy. To demonstrate how much reputational power these stocks had. One senior investment officer was an early promoter of Polaroid and managed to ride that performance into being hired as the senior investment officer at a New York based mutual fund house. He didn’t last long in a company that was studied daily, including its longer-term performance.

 

Marathon in London has a successful record with its European fund and others. They are a low portfolio turnover shop who pay a lot of attention to industrial and corporate capital cycles and meet with long-term senior management extensively. They are very proud of the 26% of their portfolio that has been held for more than 10 years in the European fund. Those positions represented 45% of that portfolio at the end of the period. When I visited them, I was amazed at their detailed knowledge of their companies, managements, and critical competitive information.

 

There are many investment lessons I have learned from just observing and listening to people. For example, I suspected the market was getting frothy in the late 1960s when a person I commuted with on a 6 AM train mentioned he had gotten a personal computer and was going to stay home and day trade a handful of stocks. He was a mid-level executive at a famous financial institution and appeared to have average intelligence. I was working for a firm that had a very active trading desk that regularly dealt with some of the sharpest trading shops. Very occasionally I heard one-side of a phone conversation between the traders. I felt I needed a translation regarding their words and tactics. I am sure my former train buddy knew no more than I did about institutional trading. Hopefully he learned quickly or found a new job. I never saw him on the train again.

 

I owe UPS a gift for the two investment lessons I learned from them this week. There was a public announcement that the company was offering early retirement to 167 senior pilots. Each of their planes carries about 30,000 packages and is designed to fly every day. Consequently, in terms of delivery capacity, it meant UPS would deliver 1.8 billion fewer packages or these packages would be flown by less expensive junior pilots. It suggested to me that UPS was expecting less business after their expensive settlement with their truck drivers. Within the week our friendly regular UPS driver delivered some low value drug store items, which may have come from a warehouse or a local store under half mile away. In either case, it was not a bullish indicator for me.

 

During the very same period institutions were locking into long-term investing in the nifty-fifty stocks, there was a more valuable lesson a few miles from Wall Street. On a Saturday in June of 1973 the Belmont Stakes was run. It was not much of a contest. Secretariat won by 31 lengths, setting a track record. While that was interesting, the real lesson of the day was that I didn’t bet on what was clearly the best horse in the race. More importantly, I did not bet on any horse in the race. When Secretariat won, the horse paid $2.20 for each $2.00 bet. What I learned was that even with the best horse in the world things can happen, or if you will “racing luck” might happen. (Sounds as if I was conscious of Howard Marx’s avoiding absolute certainty.) I was practicing good actuarial science, which excludes events so rare that they are unlikely to reappear. What I learned was that to not bet is a bet. Wagers should only be made when the odds of winning are high enough to cover losses in the past or in the future.

 

Conclusion

Investing should not be considered a single chance to make or lose money. The more you are aware of the world around you, the better your chances of finding some winning investments and keeping your losses small.

 

 

 

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Mike Lipper's Blog: What Do Single Digits Mean? - Weekly Blog # 799

Mike Lipper's Blog: Some Past Errors Create Future Problems - Weekly Blog # 798

Mike Lipper's Blog: Inputs to Implications - Weekly Blog # 797

 

 

 

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Five Speculative Selling Solutions

Introduction

A long-term reader of this blog suggested that I write about selling rather than buying investments. In everything I do I want to measure how close I get to my goals. Out of this measurement need, I require a time period. While it is of future betting interest to have the fastest moving horse or other investment at the end  of a race, the payoff is the best performer for the fixed length of the race. The genesis of the TIMESPAN L Portfolios^® was to focus on achieving the ability to meet disbursement goals on a timely basis. 

This requirement is in some conflict with my instinctive ways to invest. Warren Buffett's favorite investment time period to invest is "forever." Mine may be even longer! (Over time some of my long-term investments have tripled to quintupled or more, beyond my exaggerated dreams.) Nevertheless, in focusing on most investors' needs to occasionally sell, I am commenting on five such events. But once again to judge whether selling is propitious or not, some measure of time is needed. Yes, to some extent the seller can celebrate the freeing of cash from investments in other assets. However, in the aftermath of a sale one is often asked whether the timing of the transaction was good. Thus to some extent a successful sale is measured as to how well the exit price compares with future prices. In this light the success of a sale is speculative in terms of comparisons.

The purpose of producing this post is to focus on the various thought processes that lead to successfully evolving solutions for five events when selling occurs.

1.  The Avoid Switch

Rarely people, their companies, their politics, and their investments  behave exactly as we conceived when we entered the transaction. It is difficult to find an investment that does not in some way disappoint, either by its own actions or factors beyond its control. There are times when the results are so good in the eyes of the market that the current price is way ahead of a reasonable long-term projection. Thus, at current prices there is considerable price risk. At times the risk appears to be too large and while an investor has not lost faith in the company, the investor may believe that the current price won't be repeated for an extended length of time. Most of the time the simple solution is to dispose of the holding. At times instead of selling out completely, reducing the size of the position makes more sense if there is not a screaming bargain available.

There are other occasions that selling may make sense. Several times I have been a holder of a security that I thought that I reasonably understood when either the company or the market did something that I did not understand. For example years ago a major conglomerate that I followed as an analyst switched from an under-reporting of earnings to including dealing earnings within operating earnings. Thus from my analyst's perspective, the company went from having a hidden kitty available to cover operating earnings shortfalls in some of its cyclical businesses to reporting every possible element of earnings. In other cases some companies made what I considered to be vanity acquisitions or questionable product pricing policies.  In these cases I felt I did not properly understand  these investments and exited them from my long-term holdings. 

In most cases if an investor is not comfortable in his or her understanding of an investment they would be wise to avoid owning it.

2.  The Bargain Switch

Sir John Templeton, my former data and consulting client, often phrased his sales in terms of purchasing better bargains. While occasionally what is better is only a lower valuation. To me these can prove to be "value traps." Normally things are cheaper because they should be - in terms of quality of product or management. However, we may have entered a period when bargain hunting can be productive.   

The rise of exchange traded funds and other passive devices based on industry sector codes (technology) or market capitalization (Large Cap growth) has led to an unusual level of correlation of stock prices within these data sets. With expected changes in currencies, taxes, import/export mixes, etc., I suspect that there will be greater dispersion in stock prices within many data sets. If I am correct, the number of active mutual funds outperforming the various indices should rise which will attract some of the trading money out of passive/ETF vehicles into either selected individual securities or smartly active mutual funds. As the differences in valuations becomes greater I would expect that there will be opportunities to be long or short individual securities that could favor more bargain switching.

3.  To Trim or Not?

As much as we would like to, we don't control the markets or the spending needs for our money. Thus over time we will have our investment wealth at a different balance than our beginning level. In many ways it is much easier to deal with a smaller amount of money than the beginning portfolio. In that case one should definitely trim the cash. The odds are that the decline in general market prices of stocks will eventually be reversed.

Many of those who have seen their income and wealth rise have already found that their gains do not lessen their problems but rather change them as well as their outlook. Once one has a portfolio, even if is limited to the number of holdings, it is an important part as to how one views the future.  For most individual and institutional investors who have not consciously or subconsciously adapted the timespan philosophy,  they will be dealing with a single portfolio that is probably focused on too short a time frame; e.g., one quarter, one year, or a single market cycle. Under these conditions the fear of near term losses becomes paramount. Thus, in a perceived expensive market the natural tendency is to reduce risk exposure. Perhaps the first technique should be to reduce or eliminate small positions on the basis that if they are still small they are not likely to be favored in the short-term.

Those who take a longer than current period view have history on their side for US equities and quite possibly for equities in general. The other historical trend worth recognizing is that great wealth comes from extreme concentration of effort, intelligence, and investment which suggests that concentrated portfolios in knowledgeable investors’ or managers’ accounts can produce great results.

After due consideration, trimming or completely eliminating positions could be the correct decision even if investments under other managers are doing well.  It might be helpful to not let the tax man become the portfolio manager.

The shorter term oriented accounts will tend to be much more market price sensitive than the longer term accounts who are more focused on building absolute capital. I suspect the shorter term accounts have higher portfolio turnover and on average pay more in taxes over time than the longer term accounts.

4.  The Familiarization Trade 

Most of those who read this blog have a substantial portion of their wealth in tradeable securities. Some do not and receive the major portion of their wealth in a concrete package of stock options, private company interests, convertible securities, and various types of trusts. For many, these instruments are difficult to understand even with professional help that may not be specifically knowledgeable on these particulars. As these managers are unfamiliar to the new recipient, there is some substantial fear of making a mistake in the process of converting their new illiquid wealth to easily tradeable securities and/or cash. My suggestion (regardless as to the perceived value of the new investment) is to take the smallest portion of the investment and convert through the many steps to cash. This will equip the new owner with an understanding of how the process of unwinding the concentrated wealth package can be converted, which should help with some understanding of the benefits of not doing anything more than evaluating the next and future steps. As is often the case, selling something can be a valuable learning experience.

5.  Quitting 

Recently those who have robust national or global political views in light of the strong to very strong stock markets are pondering whether they should quit the game and sell all their exposed equity positions. In terms of recorded history there have been a very limited number of times this has been a correct decision. Those instances have been very rare. But no one can be certain that at any given point stock price declines of more than half are not possible.

My own views are based on the beliefs that we have entered a different market phase. For at least the last ten years and perhaps longer we have been a world of single digits in terms of almost all main statistics of market prices, earnings, revenues, demographics, etc. I believe that starting with last summer we are accelerating into a double digit world, both up and down. In this new world sound investment principles will continue to work, but for some time the numerical bands won't. May this lead to an eventual market, if not economic collapse? Yes, it might, but not necessarily so. Rather than focusing on only the historic ratios, like Liz Ann Sonders of Charles Schwab, I am focusing on sentiment and currently the general lack of wild enthusiasm which is positive in my judgment that there is more time in this expansion.

As a contrarian and as a manager of portfolios owning mutual funds, I am often premature in my market judgments and actions. I am not yet ready to hit the quit button and retreat to cash, which is losing value regularly. Perhaps this time I will accept the downside volatility as the sign to exit.

Even if we do have a top and a subsequent fall, I hope I will not forget my responsibilities to future generations and totally "go to ground" in a foxhole. 

Conclusion

There are times and conditions when selling is wise. However, these decisions should be made carefully without too much attention to the current and a reasonable review of the longer term future. The sellers historically have the burden of history against them, but they can win.

Question for all time:

Have you successfully sold an important part of your wealth and re-entered the market? Was it at a lower or higher price?   

__________

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The Importance of Turnover in Picking Managers

Most of my posts end with a question to our readers. I ask questions not only to promote a dialog, but more importantly to learn from some pretty smart people who regularly read these posts. Last week one of the long-term members of this community sent me a series of thoughtful questions. One of which was, “When you conduct your analysis of funds and manager(s), how important is portfolio turnover in your calculation?” In effect, he is asking, do turnover rates matter?

When an investment analyst is asked this type of question you should not be surprised that the answer is “yes and no with an explanation.”

 A compliance invention misused

The earliest use of the term turnover rate was by the US Securities and Exchange Commission (SEC) in required prospectus disclosure. (As I hope to be visiting our British friends shortly, I need to distinguish between the US use of the term and UK’s use of turnover as a synonym for sales.) The SEC’s prospectus requirement was not designed as a selection tool to pick funds. The purpose of the calculation was to spot excessive churning of a portfolio to generate, what used to be valuable brokerage commissions. This purpose will become clearer when one knows the methodology of the calculation which is take the smallest of aggregate purchase dollars or sales divided by the monthly average of total net assets. Now you have learned more than you ever wanted to know about turnover rates.

Turnover is a good place to start asking questions

Portfolio turnover is an important place to start, but perhaps more important is personnel turnover which I will discuss further below. In terms of portfolio turnover data, when I talk with portfolio managers the following questions are asked:

1.      On balance are they selling losers or winners?

2.      What is the average length of time before transacting?

3.      Is the average length of time different for the winners and losers?

4.      Do they do any post-transaction analysis to see in the succeeding six or twelve months whether the decision was a good one?

5.      In general, what did the transactions do to the portfolio?

6.      How does the current turnover rate compare with those in the past and does this have any particular significance?

There are other questions that are then asked about the research behind particular positions in the portfolio. However, if the Portfolio Manager (PM) does not have answers to most of the turnover questions above, I find it difficult to have the requisite confidence in the fund for it to be owned by my clients.

There is an important caveat about turnover rates that needs to be recognized. That is they seem to be rising; meaning that the weighted average in the portfolio is being held for a shorter period of time. One of the reasons for this is the consultants'/selectors' “Three Year Fallacy.”  Under normal conditions three years is only a portion of an investment cycle. Four years fits closer to the historical trends and normally contains a US Presidential cycle. Actually the command economies have favored a five year period for their planning. I personally prefer a ten year period which would give ample time for a recovery from a management mistake. Enough of the numerology, the real reason for the intermediaries to focus on three years is that it is the shortest period that they can earn a new fee for a search to replace a poorly performing manager. (Often there is a substantial relative performance recovery after a three year period. This could be caused by redemptions that are forcing the PM to sell and often he/she sells some positions that didn’t do as well as expected in the recovery.)

There is a second and more structurally dangerous factor causing turnover rates to rise. I have been on non-profit investment committees who are doing a good job meeting the twenty or more years need for funding. They invest for the long-term and review their performance intensively once a year and less so quarterly. Because of the long-term nature of their tasks they will put up with a number of underperforming periods before they switch investments. That period of disappointment might last five years or 20 quarters. Today we have the ability to get publicly traded portfolio performance monthly, weekly, daily and perhaps even hourly. If it took 20 observations for the long-term manager to finally terminate a fund, the same number of unhappy reports could occur in a month of twenty trading days or a year and eight months if monthly numbers are the trigger.

Hopefully owners of accounts in funds and/or individual securities will be mature enough not to be solely driven by performance numbers and will pay attention as to what is happening within the portfolio and within the investment organization.

The important turnover report: Personnel

In our meetings with various fund groups we are sensing many more portfolio managers being switched than what we have seen in the past.  The same trend is also being noted by Citywire outside of the US, where at the current rate by year-end over 1000 portfolio managers will be replaced. Several US organizations which have been remarkably stable for years are now experiencing portfolio manager turnover. Some of this may be due to financial or psychic compensation or in a number of instances, performance problems. In some cases these changes are not disclosed. What is definitely not disclosed is the turnover in analysts. Only at a recent face to face meeting with a PM did we learn about a reduction in the number of analysts in the office. (Interesting enough the PM believes that it could help improve the quality of investment research and decisions.) 

The turnover of senior officers in a firm is important to me. Recent turnover of CFOs has caught my attention as these are not just bookkeepers but play critical roles in developing and carrying out corporate strategies. Rarely do we see announcements of critical changes on the trading desks at institutions. For many funds that have a high portfolio turnover and/or invest in small or micro-caps, the traders can add great value. This also true in the fixed income and credit markets. 

Is turnover important?

Yes, the context of the turnover in the portfolio and in the organization is important, but the number itself can be misleading.

How do you view turnover?

Please let me know privately or publicly.

I am looking forward to seeing some of you in London in September.

______________________

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