People Make the Difference – Weekly Blog # 538

Mike Lipper’s Monday Morning Musings

People Make the Difference – Weekly Blog # 538

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

Factor Investing

I have often been told that given an earnings growth rate a bright investor can tell the appropriate price/earnings ratio, leading to a prediction of the right future price of a stock. In only a slightly more complex approach there are a number of investment products or funds being offered that are driven by an identified factor or a collection of factors. As these are new vehicles they are being pitched as something brand new and superior to the traditional methods of security analysis. Investors have for a number of generations used various statistical measures as a filter to determine better than average choices for additional investment analysis.

Modern Portfolio Theory (MPT)

There is very little that is brand-new in investment analysis. Nevertheless, we periodically receive marketing messages that extoll these new methods as a better way to make money. This reminds me that a number of years ago, based on now recognized faulty academic research, we learned about Modern Portfolio Theory (MPT), which actually was not modern in identifying different rates of change in stock price momentum. MPT was identified hundreds of years ago and had very little to do with portfolio construction and management, other than stock selection. The theory before and after its publication did not regularly produce investment success, but did generate marketing success.

Better Tools for Investment Success

What then are better tools for investment success?  A continuing study of successful investors suggests that the biggest help is the analysis of people at three or more very different levels. Behavior of market participants, buyers and sellers of specific products and services, and finally important portfolio managers, which can improve investment success. In each case the study of these areas has been helpful in the past and I suspect will be so in the future.

Market Transactions

There are a group of market analysts and their followers that focus intently on stock transactions to identify recognized patterns of past movements being repeated currently. For these so-called technical analysts the key to success is the improved chance of being right. They are not interested in the known or unknown motivations of the buyers and sellers, just that their actions follow past trends. This type of analysis is more popular when there are fewer new factors or information introduced.

Looking back to Friday August 10^th, the three major stock price indices - the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 and the NASDAQ Composite, all opened below the last price of the previous day and over at least the next four trading days did not bridge the price gap. Most of the time a price gap needs to be closed before the dominant trend can continue. Some of the price gap of the DJIA was probably filled last Friday, but the gaps in the S&P 500 and the NASDAQ Composite remain open. The continued existence of gaps suggests that the forward price movement for the bulk of the US stock market will be limited and will only rise through their past peak at some point in the future. 

From my vantage point, the predictability of gap filling is measured by the quality of the analysis of the market technicians.

Customer Analysis

Successful investors often place their bets on their perception of future changes. My wife and I had the pleasure of spending time this week with Ralph Wanger and his wife Monique. Ralph for many years was the portfolio manager of the very successful Acorn Fund. The fund initially invested in smaller companies that in numerous cases became mid-cap leaders. In discussing a number of his very successful investments it became clear that in addition to studying a great amount of relevant financial data, Ralph had a deep understanding of the people at various companies.

In one example, he noticed that a company’s logo had become a body tattoo, establishing a body of trust with its customers that might give the company enough time to execute a well-founded turnaround plan coming out of bankruptcy. Many sound turnaround plans take too long to reach fruition as existing and potential customers’ patience is worn out waiting for the new and improved products. In this particular case with the tattooed bodies, the present customers and the potential customers waited for a couple of years for Harley Davidson’s new and significantly improved motorcycles. Ralph recognized the potential power of the relationship that the tattoo created,  buying the needed time for recovery. He also had a similar population of patient investors in his Acorn Fund, I was one of them. A number or factor driven investors would not have participated in the stock rise, which multiplied its worth many times over.

Earlier in the week I met with the CEO of a statistically driven company experiencing some disappointing results. While not close to bankruptcy, it is in a multiple year plan to evolve with its big company clients into an enhanced relationship. They perceive, along with a number of their leading manufacturing clients, that many of them are becoming service companies. An auto manufacturer is in the after-sale service business as well as in the financial services businesses.  It is their successes in these businesses that is becoming equal to or more important than the success of their new exciting models coming off the production line. These are some of the required elements being implement in order to increase customer loyalty and market share. They are mission critical for both the manufacturer and its statistically driven suppler, for both the auto company and other companies too. I am withholding my investment judgement as to whether they will succeed in a major way, but I am looking for changes rather than extrapolations.

Need for Tolerance

At any given time the investment process produces winners and losers. I am comfortable with this result from learning basic securities analysis at the racetrack. There I learned that if you bet prudently you can walk away at the end of the day by properly selecting only a few races, varying betting procedures so that you can afford to lose more races than you win. You walk away a winner overall because the money won was larger than the money lost. I apply the same philosophy to investing, particularly with the use of mutual funds. But perhaps more important than the money earned was the knowledge acquired. When something turned out differently than expected, the key knowledge gained was the analysis of what happened. There was a growing recognition that all the actors, either on two legs or four are not perfect and can make mistakes, some surprising on the upside. The key to future racing and investment success is to learn what happens unexpectedly. This allows us to tolerate the unexpected and most importantly to tolerate our own and others’ mistakes while learning to manage our expectations.

I would be happy to discuss your expectations and suggest some things that you may wish to consider. Please contact me, as we both might gain from this learning experience. We would be glad to help with the selection and management of funds to fulfill your needs.

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A. Michael Lipper, CFA

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Berkshire - Hathaway & Sequoia Fund: As Seen Through Alphabet, Amazon, and Apple

 Introduction

For the week that ended Friday one could focus on short-term price movements or long-term investment thinking. As my week evolved I did both, which produced positive, but disjointed conclusions.

Short-Term Price Actions

On Thursday prices fell supposedly in reaction to political events. As an analyst and portfolio manager trained in the school of contrarianism, I saw the reason for the decline differently. For some time I have been aware and have commented on the price gaps in the performance of the three main individual security price indices; Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite. In each case the index had two days when  prices through the day were measurably higher than the high price achieved the day before. This price gap phenomenon rarely happens and most of the time a subsequent price action fills the gap before the market resumes its prior trend. In earlier blogs I had warned about this probability. Further, I quoted a knowledgeable market analyst who was expecting a 5% correction.

On Thursday the two price gaps in the two senior indices, DJIA and S&P 500 closed both gaps. By far the strongest index this year, the NASDAQ closed one. I would expect in the fullness of time the remaining price gap will be closed. Historically when the bulk of traders focus on the political issues of the day (in contrast to the financial inputs) their emotions are a bad guide to future investment price performance.

A less followed sign is the Confidence Index published by Barron's each week. The index focuses on the difference in yields between the highest corporate bonds and those of intermediate quality. In the week ending Friday, compared to the prior week, high quality bonds yielded 3.22%, down 17 basis points whereas the intermediate credits yielded 4.27%, down only 13 basis points. This suggests that in the week high quality bonds were considered better value than the higher yielding intermediates. Often this is considered a bearish sign for equities as bond buyers are opting for lower risk securities.

In assessing the value of these two observations it is important to understand that the judgments expressed are based on a feeling for the historical odds and not certainties. As noted in my earlier blog posts there are no pure laws of economics that guaranty the same level of certainty as found in physics. One should assign perhaps a 90% certainty to your favorite economic laws. Most so called "investment laws" would be considered successful if they were correct 70% of the time. Using a technique I learned at the racetrack, I multiply these ratios (0.9 x 0.7 = 0.63). This suggests to me that I would be happy if my analysis was correct 63% of the time. I can improve my dollar return by weighting some decisions compared to others.

General Sun Tzu

Other than the Bible no other text has been used more to teach the military than Sun Tzu's "The Art of War. Considering the importance that we are putting on the rapid progress of China it is very wise for us to remain conversant with China's greatest military scholar. Friday I was refreshed in my knowledge of the general's thoughts when good friends of mine who are life long investment experts on Asian investing gave me a book by Jessica Hagy, The Art of War Visualized: The Sun Tzu Classic in Charts and Graphs.

Since in many ways competitive investing follows the equivalent precepts as successful military warriors, I am going to apply the same principles to investing. There are five particular strategies that the General recommended.

1.  Victory can be achieved through measurement, estimation, calculation  and balancing chances. (In investing it is important to measure accurately what is there and even more important what is not there; e.g., BREXIT and the Republican swing, as well as incomplete financial statements.) These are some of the times when good estimates are critical which makes it essential to know how much reliance to place on calculations of the future. In discussing the short-term data above I showed one possible way to calculate different levels of uncertainties. All of these and other factors need to be weighed in conjunction to determine whether the odds of success are sufficiently high to undertake the risk to achieve victory.)

2.  Always be prepared to attack and always be prepared to defend. (Opportunities will always occur without warning.) A good investor must be able to quickly shift to an aggressive mode and just as quickly shift into defense. Most investors have too little in the way of reserves to dramatically "juice" returns, particularly if they are reluctant to sell or reduce less favorable positions in the new opportunity context. In terms of defense we all need to part with some of our least loved positions regardless of tax implications.

3.  There are dangers to be avoided: recklessness, cowardice, hasty temper, and rich appetites. (Many will find it difficult to react wisely to the opportunities due the dangers listed. As is often the case we can be our own worst enemy. The General called for sound discipline at all times.)

4.  Do not feel safe and be a good generalist full of caution.  (Quite possibly the biggest risk to our wealth is a feeling that we are safe. We are not on the outlook for possible problems, most of which won't materialize, but some or one can be like a hole below our boat's waterline. This can be caused by our bad navigation or an enemy torpedo, Perhaps at least mentally we should practice fire drills as well as abandon ship actions.

5.  An experienced General is never bewildered. Once some level of activity is commenced it is easier to accelerate or decelerate than to start to move from a standing stop. I am a believer, at times, of making partial commitments and at other times full actions. Often the key to an investment decision is not the action itself but how it positions a person or portfolio for subsequent steps.

How Sun Tzu Might Have Viewed the Actions of Berkshire Hathaway and Sequoia Fund Through Alphabet, Amazon and Apple

One is always at risk of misinterpreting or over simplifying by abbreviating some of  The General's thinking. For this exercise I am only going to focus on his first step to victory through calculation and his fourth, balancing chances. Almost all of the named securities (Alphabet, Amazon, and Apple) are owned by me or close relatives. However, the purpose of the ensuing observations are not meant to be taken as any form of recommendation. For those who are interested in converting the observations into actions, I will be happy to discuss my views tied to your specific needs, “off line.”

Berkshire and Sequoia share the same source of inspiration, Warren Buffett. Not surprising over the years they have owned some of the same stocks derived from their own work. The three highlighted stocks were recently discussed in investor meetings. The reason to focus on these three specific stocks is that it revealed their thinking.

Alphabet, the parent company of Google, was well known to both. Mr. Buffett’s view is one that was under its nose as it was extensively used by Berkshire’s subsidiary GEICO. It was just not in its universe, which is strange as GEICO is so advertising-centric (both they and I owned Interpublic one of the largest global advertising complexes recovering from very poor results). As it wasm't looking at Google, it was not in the calculation. This is similar to those who were following the polls prior to the BREXIT and Trump votes in analyzing data, perhaps the most important task is identifying what is not there.

To some degree Sequoia also had a calculation failure. Sequoia quickly grasped the advertising power that the Google search engine produced. However, it needed a "kicker" to be added to its calculation. The kicker was "AI" or artificial intelligence. Sequoia believes that Alphabet is "by far" the leader in AI, which it may be. My problem is that the current level of earnings from AI products or augmented services has not been revealed. In this particular case the lack of numbers on the AI effort was probably a factor in its balancing of chances.

Amazon is another example where the two intrinsic value investors disagreed. Because of Berkshire's operating experience it had some doubts that Jeff Bezos could succeed in the highly competitive distribution business. If he could succeed, it doubted that the same mentality that could build a highly successful distribution business could aptly handle the technologically challenging task of developing a commercial cloud business. I suggest that the financial analysts in Berkshire focused on the financials which showed robust revenue growth and marginal reported profits. Sequoia saw that the financial statement hid the internal process of taking substantial operating profits and reinvesting them into the cloud. Further, Sequoia probably saw that the keys to the success of Amazon's distribution business were based on highly automated warehouses and tightly controlled transportation. However, Sequoia like many of us, were captured by its collective experience. Bill Ruane the founder along with Rick Cunniff often focused on buying stocks "at the right price" and thus they did not buy as much as they should have as the price of Amazon went up.

Apple is another example where these two investment groups came to different conclusions based on their research methodologies. Sequoia in calling on Apple's management, could not get them to speculate what handset sales would be three years in the future, so they passed. Again the words of its founder were a hurdle. Bill said that they understood potato chips not computer chips. Berkshire only recently viewed Apple as a consumer not a technology company. They focused on both the "eco-system " that Apple was growing and the potential use of its technology and related skills in substantially new product categories not yet on the market. Interesting that both Berkshire and Sequoia want to invest in companies that have competitive advantages, which is often translated into unique products or services. Sequoia will sacrifice future growth for competitive advantage. Berkshire under Charlie Munger's prodding is more attracted to growth at a fair price. Apple effectively used the General's formula of balancing chances.

Bottom Line

As with all "school solutions" there is no guaranty of success. While the odds improve with a well thought out plan, nothing beats good execution. Thus, when we pick mutual fund and separate account managers we pay attention to both their investment philosophy and their history of good executions. More often than not good executions are the results of front line troops. That is the lesson that I learned as a US Marine Officer where it was my job to develop a plan of action and inform my senior non-commissioned officers of the plan and the logistics, communication, and heavy arms support, but let them carry out the mission as they saw how to do it. The same principle works at the racetrack. While I did not see the running of the Preakness the two horses that were leading coming into the homestretch had a good plan, but a third horse had a better execution and thus won the race.

As you can see I am always learning and hope to do so all of my intellectual life.

What are the sources of what you have been learning recently?

__________

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.