The Critical Difference Between Experienced and Expert

Selecting winners is part of my game. I am essentially a student of other's investment experience. The general failures to be ready for Brexit and the success of extreme politicians is a wake up call to understand the critical difference between experience and expertise which are also found in the art form of selecting long-term investment winners.

I have spent many enjoyable hours attending classical musical concerts of the New Jersey Symphony Orchestra and other great orchestras and too many painful hours at Operas. Both of these are experiences, but in no way could I become a professional musician. Time spent on an activity lengthens one’s memory of experiences.  Note that the combination of a great orchestra leader and a great orchestra can make the rehearing of a familiar piece seem new and exciting.

We never know what the future brings to us. Will it be an exact repeat of the past or something quite different? The difference in terms of satisfaction and progress can be quite different. Thus we build portfolios of mutual funds and other managers that have experienced experts who have the wisdom to recognize that something is quite different than the past. 

Experienced, Not Expert

The so-called "experts" who predicted the English would vote to remain within the EU and the political pundits who had extreme confidence that the central political forces would keep centralists in political power proved to be experienced not experts. They are not alone in this distinction. Today numerous professional investors including many of the bright analysts and portfolio managers that I have known for over fifty years are very frustrated by the current stock and bond markets. One regularly hears that this is the most unloved bull market. Based on past experience, the current levels are not only unattractive but close to being beyond "nosebleed" levels because past standard ratios are flashing danger signals. The reasons they stay invested are the two abbreviations “TINA” and “FOMO.” (There Is No Alternative and Fear Of Missing Out.)

I like attending repeat performances of music, politics, and investments. I get unnerved with the new, that for which we are not prepared.

Perhaps sharing a Marine Corps tradition with my battle trained Marine Recon. (Reconnaissance) brother has caused me to expect and look for change. In addition, being a senior trustee of what has been recognized as the world's leading research university, Caltech, has very much focused me on looking forward to dramatic changes.

Dr. Simon Ramo

An example of the type of leaders that Caltech has produced is Si Ramo who was entrusted by the US government along with his partner to create a company that developed the intercontinental ballistic missiles which not only gave us many years of strategic security but was an important contributor to our space program. This past week the University, where he was a trustee, celebrated his life having recently died at 103. 

As Dr. Ramo was a globalist, an entrepreneur as well as a member of Caltech's investment committee he might well had noticed that in the first half of 2016 the S&P500  had a small gain of +2.69%,  where Brazilian Dividend Aristocrats were up +82.34% and an index of Low volatility Bovespa stocks were up +77.74%.  Not only did some Latin American stocks do well but many Canadian stocks were up 20% or more. I believe he might have brought up to the investment committee whether these results were just recoveries from deeply depressed markets or had some future portents.

Let me give examples of a very successful experienced portfolio manager with a leading ten plus year record and a single stock that proved that most investors were not the experts that they thought they were.

Many Thought He Was a Great Manager

In the 1960s there was a mutual fund manager whose picture was on various magazine front covers and was world renowned. I studied his portfolio over the years. With rare exception he picked stocks from a list of 120 large cap stocks usually having a portfolio with a list of 60 names. His record was such that he was able to leave one of the strongest mutual fund management houses and start his own fund company that subsequently went public. In the 1970s the market changed as did the market structure and in the end his company disappeared. My analysis is that he was well experienced for the markets of his time, but did not have the expertise to recognize the changes that were occurring or know how to play the new game. (Sound familiar?)

The single stock was one that could well become an entire course in a business school. Started in a garage, the company produced a differently focused computer and developed many new pioneering products, thus creating new market segments over several year, but its financial picture suggested that probably it would go bankrupt.  Its president was fired. Over the next several years he learned to be a businessman and a technological leader and his newly founded company was acquired to bring him back to the company he founded. 

Over the next two decades the company created new products for markets that didn't exist until the new products opened the doors to new markets. As the company became recognized for its technological, stylistic, and business successes, it became the single most valuable company in the world's stock market. This was surprising to many professional investors who came to the party late and as often happens sold out when normal cyclical patterns emerge.

This month, while down from record levels, its earnings came in better than was expected by the virtual cottage industry that now follows the stock. Thanks to dumb luck I have owned a few shares of Apple since the 1970s in part because of the life-changing attitude that my late daughter who was learning-disabled daughter had with the Apple II computer I bought her. She enjoyed working on a device that was intuitive and patient as well as forgiving. The ability to change people's lives suggested to me that this was something different than a number of other computer companies that have subsequently disappeared.

Both of these examples illustrate the difference between experienced and expertise. (Not mine, but Steve Jobs and Tim Cook.)

To some degree we are all captives of our and other’s experiences. However, as investors we should be looking forward to finding elements of expertise.

Are you doing this, and will you share how you are doing it? 

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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Selling, Risk, and Liquidity

Introduction

“Drive for show, but putt for dough” is an old expression on how to win at golf. The vast majority of investment advice is about buying securities that are expected to go up in price. However, the terminal value of investing is the final conversion of paper wealth to spendable cash.

While investors in individual securities can benefit from my thoughts, my comments are directed at institutional and high net worth investors that have one or more portfolios of mutual funds. Those that own multiple portfolios of mutual funds should modify these comments due to the different expected timespans for each portfolio. (These can be discussed privately, if you would like.)

Drive for show

When a competitive golfer addresses his or her tee shot at a crowded first tee almost all the comments will be on the distance and direction of the first shot. However, the first shot is only positioning for the follow-on shots and in the end the key is how many shots it takes to complete the hole. Thus to some extent the first shot is like relative performance versus peers or benchmarks. If all you know is how good the drive off the first tee is, you really won’t know about the ultimate success of the player. Therefore, what the investor wants to capture is the cash conversion from the ultimate sale as one can not spend relative performance.

The more professional golf observer would pay attention to the form of the golfer, the particular club that was used, the amount of power the player used in hitting the ball, and the tactical position of where the first shot landed. If I knew these things I would be in a much better position to judge whether I wanted to bet on the success of the player rather than just remark that he/she hit a nice first shot. Applying this to the fund selection puzzle, I am much more interested in the process and procedures followed by the manager of a fund than their current relative performance.

Relative performance is a rearward looking device. We get paid to make future judgments and thus I am much more interested in the way  managers addresses their task, such as:

a)    What tools are likely going to be used?

b)   The time spent on studying the opportunities

c)    What comparisons with other opportunities in the present or past time periods?

d)   Compensation pressures, which might impact decisions?

e)    What does one know about the competitors that are playing in the game?

f)     And finally, what is the pattern of flows going into and out of the fund?

Since our major investments occur after several visits or points of contact, any changes in these processes or procedures need to be understood. We expect there to be changes as we live in a dynamically changing investment world. If there were no changes there is an increase of being blindsided.  Each of the items listed above can have an impact on future performance beyond general changes in the market. Our objective is to use process and procedure changes as early warning signals to begin to exit a meaningful position. To quote Sir John Templeton, “Progress requires change. Focus on where you want to go, instead of where you have been.”

Three reasons to sell

The first reason to sell is an actual or expected change in the nature of the account. This is particularly true if the account requires a higher than expected conversion to cash for operational spending needs.

The second reason to sell is actually to buy; the late Sir John said “the reason to sell is to buy a better bargain.” (We have had the honor and pleasure of supplying special data reports to him and also being called down to Nassau to consult with him and his colleagues.)

The third reason to sell is if some important deterioration in the process being used or fundamental change in the longer-term outlook for the investment occurs.

What to sell

Anytime one needs to add or subtract from a portfolio, the whole account should be reviewed. The change is an opportunity to partially redirect the course of the portfolio. Thus, the first pass should be to see whether the various components of the portfolio are properly balanced in today’s environment and future focus. This could be the ideal time to reduce a position that has gotten to be way out of balance. Depending on the nature of the account the natural barriers might be 10%, 20%, and 25% for an individual sector. In terms of a balanced account, the fixed income range should be between 25% and 60% with equities between 40% and 75% in most cases. If one is not hurried, changes should be averaged in or out over at least three time periods which can be days, weeks, months, or quarters.

The role of risk

If the account is all of the money of an institution or an individual without any expected new money coming into the account, a prudent investor needs to weigh the impact of a loss of capital on future spending needs. In the same light the investor needs to understand that the risk of not growing capital and therefore income can be a bigger risk than some downside diminution particularly after taxes and likely high inflation. While I am very conscious that various studies have shown that individuals feel a loss 2 ½ times more than a similar amount of gain, nevertheless for most tax-exempt institutional accounts whose demands go up on a countercyclical basis when economic times are poor, the risk to the organization of not growing the capital base is worse. A less than optimum capital base puts extreme pressure on earned income and fund raising in difficult times.

The role of liquidity

Another former client, Howard Marks, of Oaktree Capital Management wrote about liquidity in this week’s Barron’s. He said that liquidity is not important until it becomes vitally important. Further he characterizes liquidity as transient and paradoxical. Liquidity is the ability to get the last published price in a transaction, particularly when one is selling in troubled times. Normally mutual fund investors are not concerned about liquidity because when they place their redemption order they know it will be executed at the price (net asset value) calculated for the next close of the market. However, some fund investors may be surprised by the gap between one day’s price and the next one.

Some SEC commissioners and certain members of the US Congress are concerned about the potential evaporating liquidity in the bond market including US government issued debt. The professional investors (hedge funds) invested in various debt and equity Exchange Traded Funds (ETFs) could overwhelm the marketplace with a wall of redemptions, which will probably be met by the market makers immediately selling the heavily weighted securities in the ETFs which will put more price pressure on the final net asset value for the ETF and the companion mutual fund.

As a student of the market for over fifty years I would urge fund holders not to panic during troubled periods and add to the forced sales. Well designed investment portfolios of mutual funds should survive the decline and could be very well positioned for a subsequent rise.

Question of the week: For your accounts is there more risk on the upside of not generating enough future capital than on the downside of avoiding forced losses?  

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Copyright © 2008 - 2015

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