Lessons from Warren Buffett and an Italian Monk to 2nd Generations of Wealth - Weekly Blog # 565

Mike Lipper’s Monday Morning Musings

Lessons from Warren Buffett and an Italian Monk to 2nd Generations of Wealth

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

                                                               

One of the consistent career risks for long-term successful investment managers is dealing with the inheritors of sizeable accounts portfolios at the instant of perceived under-expected performance. Throughout their lives the inheritors have heard about the investment successes of their seniors’ advisors and investment vehicles. They take for granted it will mechanically continue for them. They do not understand that all investments, like all of life, involves risks. There are no absolute guarantees under any condition. Investments are packages of risks and rewards over numerous cyclical time periods and need to be understood.

Lessons from Warren:
We regularly write about Warren Buffett and the incomparable Charlie Munger concerning their investment vehicle, Berkshire Hathaway. We do this not because it has been a successful investment for myself personally and the holders of our financial services portfolio, but because of the valuable lessons that can be gleaned from these two remarkable investors in both words and actions.

Let me put their record into perspective. According to the latest issue of the Financial Analysts Journal, if Berkshire Hathaway had been a mutual fund over the last 40 years it would have beaten 100% of the competition. Even for the last ten years, a more difficult period in view of their size, they would have finished 11th, beating 99.7% of their perceived peers. That is the good news, now the bad news. On Saturday they issued their results for the fourth quarter of 2018, reporting a net loss on investments of $25 billion.

This is not the first time they have reported a loss. The original source of their name could not be turned around and was liquidated. Additionally, there were losses in a Baltimore department store and losses in airline common stocks, among others. Why do we own the stock today when on Monday it is quite likely there will be many commentators bewailing the loss of investment skills of Buffett and Munger. Those critics do not appreciate the evolution of the company and what has been built for future investors.

The first vehicle was the very successful Buffet Partnership, a hedge fund. At the time, when too many publicly traded stocks were trading above their private market value, they began to buy control and at times  a 100% ownership interest in the operating companies. This was in addition to their stock and bond portfolio and led to the acquisition of various insurance companies. For Berkshire, the attraction of these casualty insurers was their sizeable “float”, the difference between the premiums received and the claims paid. Today this is the largest source of leverage for the firm. (A few companies do this, but not as successfully as Berkshire.) Further, the use of the float is not taxed until the claims are paid, which may take many years and creates another form of leverage.

Frequently, during periods of financial distress, good companies with too much debt have been forced to seek additional capital to protect their reputation and credit rating. In the past these companies were willing to pay above market interest rates, pay preferred dividends, and issue options to Berkshire in order to benefit not only from their cash but also from their perceived endorsement. I call this reputational leverage. Finally, it is important to recognize that due to the large tax credits earned by its railroad and energy ownership, Berkshire can shield the operating earnings of any tax paying private companies it acquires. Berkshire also benefits when their publicly traded investments buy back stock and raise cash dividends. For example, over time they have purchased 12.6% of American Express, but currently own 17.9% of the company due to stock repurchases.

In the classic sense Berkshire is not a large user of stock margin loans. From a credit perspective it is not overly exposed to changes in the level of interest rates. In this light its 3rd largest public stock holding is an almost $19 Billion position in Coca-Cola, which is unlikely to move much if interest rates take a sudden jump.

What are they creating? Recognize that much of the stock is owned by people senior in age that have not benefited from cash dividends all these years. I believe to an important degree the 88 and 95-year-old owners are building something for their heirs. When they are no longer leading the company, they will have completed the transition from a capital appreciation vehicle to more of a capital preservation vehicle producing a regular stream of dividends and buybacks. This is not to say, despite Mr. Buffett’s expressed political views, that he is any less than optimistic as to the growth of the US and much of the rest of the world. (This contrasts with a report that the wealthy Chinese have become increasingly pessimistic, with some moving their wealth overseas and some thinking about physically moving as well.)

A Missing Nobel Prize
Getting back to helping the second generation of wealth, there was something missing from their schooling which could have led to their real education. What I am suggesting is that in their study of either history or philosophy there was no mention of an Italian Monk. Luca Pacioli, a Franciscan friar, published the first book describing double entry accounting 1494. Earlier examples occurred in Korea and Egypt centuries before. What they recognized was that every entry created an equal and opposite entry on a proper set of financials. Thus, the original size of an asset would need to be offset by debt or changes in equity. In modern language, it is like saying that there is no such thing as a free lunch. This recognition deserves a Nobel Prize, for it would make us think through all relationships and flows of money. I believe it was Sir Isaac Newton or some other ancient scientist who stated that every action has an equal and opposite reaction. An understanding of this dual nature of human and physical reality could help all those who believe in one-way streets.

What is Happening Now?
Using my familiar lens of looking at the markets through mutual fund performance averages. For the year-to-date through last Thursday night Small-Cap funds were the leader, with an average gain of +13.08%. The best of the best were the Small-Cap Growth funds +17.62%. Part of the gain was due to global science & tech funds, but an equally important part were the gains resulting from the recovery after the fourth quarter decline. I believe the decline was the result of a liquidity squeeze on traders and dealers, rather than the consequence of fundamental concerns. In the weekly WSJ list of 72 price changes for indices of stocks, bonds, ETFs, currencies, and commodities, only 9 fell, an unusually low number.

With many funds and stocks displaying double digit gains, the idea of a mid-single digit gain for the year could be wrong. Being wrong does not bother me much unless it is very wrong. Let me suggest a warning level for the much expected overly enthusiastic top. If the rest of 2019 produces a return, that when averaged with 2017 and 2018 is substantially above the corporate return on equity, watch out.


  
Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/could-biggest-risk-be-confirmation-bias.html

https://mikelipper.blogspot.com/2019/02/some-retire-while-others-sense.html

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html



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A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Could the Biggest Risk Be Confirmation Bias? - Weekly Blog # 564

Mike Lipper’s Monday Morning Musings

Could the Biggest Risk Be Confirmation Bias?

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

                                                               


Have we entered a phase that will lead to substantial losses and mixed opportunities? This comes back to my perennial question of why so many bright professional and other investors wind up with substantial losses and missed opportunities. I have posed the question of whether there is some malfunctioning in our investment brains to Caltech professors studying neuro-economics. The best answer I have heard is that judgement is derived by comparing inputs with past memories. Apparently, when we are presented with a new element we compare it to past elements. If it matches closely to what is in our memory, we see it as confirming our views from the past, re-assuring us as to the correctness of that view. This process is labeled confirmation bias.

Earning Recession Confirmation Bias at Work?
Arbor Research & Trading, utilizing data published in The Wall Street Journal from Bloomberg, displayed the frequency of forecasting an “earning recession” by various T.V. business news channels. It showed that the forecast was much more prevalent on CNBC than Bloomberg and was not mentioned materially by Fox Business. One suspects that those who tend to support Democrats largely view their business news through CNBC, with perhaps some clarification from Bloomberg. Others, often with more money to invest, get more of their news and views from Fox Business. Each camp goes to their likely source for conformation of their views.

“Contradictory Data Confound Economists”
This was the headline in a Wall Street Journal (WSJ) weekend edition article. Economists that either work for the government or academia tend to focus on time series captured by long-term government workers. Marketers and investors tend to be more comfortable with data that is accessed through the private sector. In an over simplification, data supplied through government sources is currently showing signs of deceleration in the US economy, whereas commercially produced data continues to see an expansion. Is Confirmation Bias at work?

Stock Market Data Shows Continuing Recovery and Faith in the Future
Every weekend the WSJ compares the last reading of the week with that from a year ago, for the Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 (S&P) and the NASDAQ Composite (NASDAQ). The price recovery for the indices, measured against their all-time highs established in August through October of 2018, continues. The DJIA is only down -3.65%, the S&P 500 down -5.48% and the NASDAQ -8.52%. Looking at these declines from peak levels, one might be surprised to learn that for the latest 12 months and the next 12 months,  the NASDAQ has the highest P/E valuation and the DJIA the lowest, which is the opposite of their performance rank. In a gross simplification, this suggests that the future is perceived as being better for the NASDAQ and its technology/growth-oriented stocks than the industrial and consumer focused DJIA. This opinion is buttressed by the current market performance of diversified equity funds. The S&P 500 has more growth than the DJIA and has a lower industrial weighting.

For the calendar year through last Thursday afternoon, 61% of US diversified equity fund averages gained more than the low-cost, fully invested, S&P 500 Index fund average. Active managers, despite the handicap of higher expenses and the burden of cash, were selecting equities that were more attractively priced than the S&P 500.

The Untold Story About Dividends and their Price Value.
The yields on the three indices are 2.3% for the DJIA, 2.0% for the S&P 500 and 1.09% for the NASDAQ. While the yield numbers are small relative to earnings and market movements, they play a real role in declining markets and may well be one of the reasons the DJIA has declined less than the S&P 500. The key is the growth rate of dividend payments. For example, in our private financial services fund we hold shares in Moody’s. This  week the company raised its dividend by 14% despite announcing cyclically declining earnings. They have a history of raising dividends each year. While the current yield is below 2%, the yield at our cost is over 10%. Even though the stock has risen 8x its original cost, the tax impact is a multiple of the dividend. As it would be one of the last positions sold for the more senior holders, there is a reluctance to sell before other positions are liquidated. It is my impression that tax-paying investors in stocks in both the DJIA and S&P have held some of their holdings longer than many investors in NASDAQ stocks, so they probably turnover their portfolio at a slower rate. Thus, in down markets there is a slight tendency for the more senior holdings to fall less than the newer ones. This in-turn may reduce their daily volatility.

How to Reduce Confirmation Bias?
While there is no perfect person except your special person, mere mortals have weaknesses, including the inability to totally research problems completely. Divide inputs between those that have a good record of success and those that are more wrong than right. Both should be listened to and studied. Recognize that it is exceedingly rare for people and their actions to be correct more than 2/3rds of the time and certainly any record of 75% should be disbelieved. But also pay attention to negative indicators, they may be correct 1/3rd of the time and quite possibly at least 10% of the time. These ratios are point of time oriented, whereas many of our decisions deal with a continuing process, such as dollar cost averaging, building a position in an important investment or deleveraging a portfolio. During such a process one can change the rate of engagement, pause it, or even temporarily reverse direction. The key is to be correct on balance with your money, not just with the number of right vs. wrong decisions. And most importantly, to learn about your own process, particularly when mistakes are made.

Questions of the week: 
What have you learned about your confirmation bias?
What have you learned about investing in 2017-2018? 
 


 Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/some-retire-while-others-sense.html

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html




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A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Some Retire while Others Sense Opportunity - Weekly Blog # 563

Mike Lipper’s Monday Morning Musings

Some Retire while Others Sense Opportunity

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

                                                               

                                                               

Two-way markets are generally the safest, because most investors become aware of both the future upside and downside. For those of us who were privileged to attend the New Jersey Symphony Orchestra’s Lunar New Year Concert Celebration, not only did they hear great music but they were also introduced to the year of the Pig. According to the Chinese horoscope, the year of the pig favors wealth, good fortune, and dedication to hard work. I am earnestly in favor of those sentiments for all our friends and subscribers. We can all use good fortune and a little bit of wealth and I will continue to be dedicated to hard work for our clients and family. For many investors the road to wealth is participating successfully in the primary direction of the markets. I am hard at work trying to fathom the primary direction of the markets, particularly the global stock markets. Currently there are signals that point in both directions.

Downside Signals

The near-term economic trend-rate of growth is slowing. Evidence of this emanates out of China and its pivot away from exports toward a more service-oriented economy. Signs of this are also evident in Europe, Asia, Africa, Latin America, and North America. The political picture reflects this slowdown. Markets have responded with frequent changes in direction. Underneath this increase in volatility there is a sense that we have entered into a new market.

This week’s Barron’s highlights two investment managers who announced their retirements after an incredibly successful career. Both very recently produced way below career average rates of return as the structure of the market changed. Few stock and bond investors have not heard of Bill Gross, formerly of PIMCO and more recently Janus Henderson, who for a while was acclaimed “The Bond King”. Part of Bill’s skill was his insightful short-term trading of mortgages and his ability to identify cyclical changes. His techniques are now are copied by many smart competitors. The other retiree is Steve Mandel, the portfolio manager of the hedge fund Lone Pine Capital. His long-term record of gaining 14.4% since 1998 vs. 6.6% for the S&P 500 makes him one of the best hedge fund managers. He was a successful retail analyst at Goldman Sachs and moved to Tiger Management, the home of many very successful hedge fund managers. The retail market is going through a series of rapid structural changes. One of the warnings for poker players is, if you can’t identify the “chump” or likely loser, it’s likely to be you. Thus, it’s time to retire from the game as quickly as possible. These two well-known names are not alone, a bunch of “value” focused managers who have not performed well are also in the process of considering retirement. 

Worth noting in the latest week’s ranking of the top 25 performing mutual funds, 8 were growth funds and 6 were science & tech funds. Most of these were small or mid-cap funds with a likelihood of common holdings. These appear to me to be more the result of trading decisions than the decisions of long-term investors.

Upside Signals

For some time the large and growing global retirement capital deficit has been both a concern and potentially an expanded source of new funding for investment markets. Although both political parties are aware of the problem in the US, I don’t believe discussions in the House Ways & Means Committee will produce large results.

A significant number of US corporations are raising their quarterly dividend, desiring to keep their dividend payout ratios reasonably stable. Many of their existing shareholders bought into these companies years ago and now have a cost basis that is way below the current price. While not a popular measure, the new dividend relative to the initial purchase price is producing a current yield at mouth-watering levels. If the step-up basis at time of death remains in place, the yield at cost will in most cases tend to prevent their sale. As the market structure rotates into a new phase of favoring good but not cheap companies, many of these will be like the companies that attracted Charlie Munger and Warren Buffett as discussed below.

We may have entered a “Munger” Market Phase

Charlie Munger is the long-time partner of Warren Buffett. Before they joined up, Warren concentrated on buying securities that were cheaper than others. In effect, buying the discounted vehicle in an intellectual capital arbitrage. Charlie taught Warren to buy good companies at a fair price. This switch can be seen in Berkshire Hathaway’s record of successes in buying both whole companies and stock positions, which in part is the reason we own the shares both personally and in our private financial services fund.

The recognition of a “good” company is in the eyes of the beholder. There is a coterie of portfolio managers who believe that they own and buy high quality companies in various markets and sizes. Each have found their own high-quality companies. A recognized common characteristic of quality companies is their owners reluctance to sell. Often, the only time they become available in the market is when a principal owners’ estate is selling them or when an owner is desperate for cash. Unfortunately, during periods of economic turmoil more of these jewels come into the market. We may have entered such a period.

When I look at a quality company candidate the last thing I look at is price, either in absolute or relative terms. The single most important element I look for when evaluating a company are its people. It is worthwhile remembering that the concept of an organized company comes from military organizations and groups of professionals e.g. weavers and goldsmiths. Companies were organized based on skill levels, discipline, and respect. Respect for other members of the company, critical clients, and others. Integrity within the company resulted in the reputation generated.

The same approach should be used in selecting partners in private relationships. As the sole owner of a private company who made a few acquisitions, including some that really worked and others that didn’t, I know what I am looking for in new partners who can share the enhanced value from our working together. Being smart is important, but smart is not necessarily brilliant. Smart people have a good idea of what they know and have the intellectual integrity to know what they don’t. It is the second trait that makes them good partners and different from those that are brilliant. Too often, those that are brilliant claim it is based on solving problems completely by themselves. In looking at people I find that this kind of brilliance is a sometime thing. In periods between bouts of creativity, brilliant people are often frustrated, frustrating, and difficult. Smart people, when they are wrong recognize it and seek help in new directions.

Another key characteristic to look for is high physical and intellectual energy. Often the most creative time for developing useful ideas is not during regular work time and rarely during committee meetings. The real test of a manager or management is how they work their way through problems. One will only know how good someone is when you know how they handle surprises and mistakes. Years after dealing with a crisis, some public companies  are still benefitting from their recoveries, e.g. American Express (salad oil), IBM (360), JP Morgan (whale), and Johnson & Johnson (Tylenol).

Most of the time owners of good assets are loath to part with them. We may have entered a period when more of these high-quality assets can be bought at “fair prices”, but not necessarily on the cheap. We should watch Berkshire Hathaway and other high-quality acquirers who take advantage of these opportunities. History suggests that these periods don’t last long.

A particularly difficult task in selecting companies or people is separating current popularity from long-term value creation, i.e. Hula-hoops vs. home equipment for exercising. A related concern is gauging the probability of solving future concerns.

The list of desired attributes is both long and difficult to determine and capture. Thus the strong likelihood that when they are found their price will not be cheap. If we have entered the “Munger” market, the odds may have improved.

    

       

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

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A. Michael Lipper, CFA

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Should Reputations Have a Sell Date? - Weekly Blog # 562

Mike Lipper’s Monday Morning Musings

Should Reputations Have a Sell Date?

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

                                                               

Remember, the way we make judgements is by comparing the new with our memories. Most of what we remember are the results and perhaps the broader conditions of the event. Thus, we remember that Peter Lynch, John Neff, and Sir John Templeton were great equity mutual fund managers. In the US this Sunday evening, many Americans and others around the world will watch the Super Bowl, which is the game in which we crown the best US football team for the year. For more than a few years my wife Ruth and I attended these games as part of our responsibility as investment adviser to the defined contribution plan of the National Football League and the NFL Players Association. Because the teams, players, and owners were all our indirect clients, we had to appear neutral. That is why when asked who we were cheering for, my answer was for the black and white team, the game officials. All I wanted was for them to be correct with their calls. Thus, I saw the game differently than a very large majority of the fans. My memory is of the close calls and the correct decisions, where the play needed to be looked at from a number of different angles. (One can easily see that I often view things differently than most.)

The reason to bring up the LIII Super Bowl this early Sunday morning is not to predict the results, but to use it as a guide in the selection of investment managers and mutual funds. Come what may, one of the key people or perhaps the most important player in today’s game is Tom Brady, the 41-year-old quarterback for the Patriots. I believe his first Super Bowl was in 2002. He has been playing this game longer than the majority of portfolio managers. Most winning managers keep on doing the same things that generated their winning season. What makes Tom Brady different is that he modified his game as he aged, as rules changed, and as competitors played differently. In other words, conditions change.

Recently, I was examining a very nicely performing portfolio of equity managers. The bulk of the long-term performance of this portfolio came from a subset of four quite different managers. In some ways this recognition introduced a new future risk element to the portfolio. All these positions had for a long time, not as long as Tom Brady’s, generated an above average record and their share of the overall portfolio has risen since the decision to add them to the portfolio. Clearly, these decisions had worked. But would they be as productive in the future as they were in the past? One of the lessons from working within the NFL environment was the recognition that on any given game day almost any team could beat another, as a result of conditions changing. This is the same lesson I learned in handicapping my bets at the New York racetracks. While it was comforting to bet on the horse that had the best record, it didn’t always produce a winning ticket. Thus, I became less reliant on winning streaks. For me to be comfortable betting on a good record, I had to believe that current conditions were very similar to those that produced past victories.

All too often in selecting managers or funds, almost all the attention is paid to a particular portfolio and its allocation, specific positions, and the portfolio manager. As someone that invests in publicly traded investment management stocks, I am conscious of the benefits and pressures that management organizations place on the manager and therefore the portfolio itself. The owners of the management company can earn money, not only from the investment performance of portfolios, but also from the sales and redemptions of all their vehicles. One of the symptoms of a prior good performer reducing its chances for future performance success is a significant increase of flows into the fund. Although this is generally recognized, all too often the concern is not extended to the management company itself. Political changes evolve along with the flows of money, impacting talent allocation. One of the parallels with Tom Brady and his Patriots team today, is that he is the only current player that was also on his first Super Bowl team. This means that the skills of his receivers and defense are different. This also happens more subtly within management organizations through aging, personnel turnover, and technology. Most importantly, the competition changes.

What lessons are learned from these concerns in the selection of good professional investors and mutual funds?

1. There is no certainty, successful investing is a series of art forms.
2. Many non-statistical factors should be considered that are perhaps more important than the current excessive focus on fees and investment performance rankings. 
3. What time period is to be used for measuring future success?
4. What is an acceptable comfort level for a permanent capital loss and the resulting sting of self or external criticism?

Where Are We Today?

1. We have enjoyed a wonderful month, the January Effect has worked so far, with an up first day, first week, and first month. Whether that will deliver an up year is yet to be determined. 
2. The gains achieved in January recovered a good portion of the losses sustained in the fourth quarter. 
3. What are the chances that we have a repeat of 2018, where a strong January was followed by a problematic February and a volatile year?
4. We will soon have completed a thirty-five-year bull market in bonds, where are the successful bond bear market managers? 
5. There has been an increase in the number of investment management company mergers and acquisitions. The sellers have a less optimistic view of the future than do the buyers. Talented people throughout the asset management industry need to be reassured that these changes will not affect them negatively, whether their companies are directly involved or not. Most importantly, these changes need to benefit investors for the industry to progress.

         

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Excessive Security Risks - Weekly Blog # 561

Mike Lipper’s Monday Morning Musings

Excessive Security Risks

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

                                                               

This last week may possibly have been part of a third correction. After 2017 where there was not a single trading day the market moved 3% either way, 2018 had fifteen such days and finished slightly down. The first correction experienced frequent and rapid sentiment change. The second started after the bottom reached on Christmas Eve and finished after the first full trading week in January, with equity gains in the middle single digits recovering a third to half of the 2018 losses. The third correction was a materially smaller gain last week. For the week ended Thursday, the average US Diversified Equity Fund gained 6.5% for the year to date period.

Investors and particularly investment managers, should always be learning from the present to aid in their thinking regarding their long-term responsibilities to their beneficiaries. (We are all temporary renters of our talents and other assets.) One way to look at the current level of the market is to assume a lower rate of return on risk, be it an investment in stocks, bonds, commodities, and real estate. This somewhat pessimistic view suggests that for retirement and other long-term future payments, the old assumption that equities will continue to appreciate at 9%-10%, as they have since 1926, may not continue. This belief has led to an institutional stock/bond ratio of 60% in stocks and 40% in fixed income. Actuaries in turn assumed a combined return of 7-8% for pension funds, led by the gains in stocks. During this lengthy period, we experienced several deep market declines, wars, and periods of high interest rates, all of which may have been necessary to set-up the subsequent gains that propelled the overall stock gains into the 9-10% range. Although I do not rule out these kinds of wide swings, I do not feel justified in including them into a planning norm. I am considering a different model that looks to the last five years as a better representation of the next five years. In the five years through last Thursday, the average US Diversified Equity (Mutual) Fund gained +6.16%. Future fixed income returns are expected to be lower because we have lower interest rates than in the historic past. Credit losses could drive rates materially higher, which would not be good for stocks.

A Bigger Risk: Seeking Security
For a professional investor, I have often felt that their stomach was a better guide to turning points than their brains! First, it is important to understand how the brain works. Based on conversations with the neuro-economics professors at Caltech, our memory system works on chains. We attach a single thought to an existing chain if it is important to be remembered. We need to find patterns, even in a pattern less world, in order to reduce anxiety. Most of the time, what we believe to be judgement is pattern recognition. Second, the mark of a professional is the willingness to doubt and make mistakes. After all, the experienced investor and hiker know that “no man steps into the same river twice”.

The messages from a professional’s stomach are involuntary. They come from self-experience or observation of others. They send a message of caution not to be greedy when prices are going well, contrary to the brain’s enjoyment of compounding winnings. The other life-long message is the disbelief in absolutes. After the emotional rollercoaster ride of the last eighteen months they instinctively don’t believe in absolute security. They have seen unfortunate surprise endings to securities, firms, jobs, marriages, and lives. Retreating to cash or cash equivalents can be subject to both regulatory changes and inflation. After eight years of gaining assets, an ETF closed due to redemptions (96 months of net sales vs. 1 month of net redemptions.)

What to Do?
Risk was one of the lessons I tried to impart to a board of a liberal arts college attempting to aid enrollment by adding business courses. The presenting professor said he was going to teach about risk avoidance. I suggested he got it all wrong and pointed out that we cannot avoid risk. He should instead focus on risk assumption, with a focus on unintended and unavoidable risks. For our clients we try to move from risk avoidance to recognizing the risks assumed. Taking appropriate measures to reduce the overall risks is an art form, not a science. The single most important risk management goal is to protect future payments on specific future dates.

The second tool in risk management is to understand the leverage that is already being applied to your investments, directly or indirectly. Stock, bond and commodity prices are leveraged by some investors with margin loans. These currently total $554 Billion according to FINRA. This does not include “non-purpose” loans used to support non-securities purchases, which are often used as a cheaper substitute for mortgages. Also not included are corporate loans to employees for the purchase of their own stock, or in some cases relocation benefits. Most of these could be called instantly, forcing the liquidation of all or part of the stock position. We have reason to believe that many Chinese CEOs have had their loans liquidated by selling out their position. In addition, there is operating leverage when operating earnings move more than operating revenues, due in part to corporate borrowing.

One new point of leverage is the delay of deliveries caused by bottlenecks both in the US and China, which stretch critical supply chains and lead to squeezed profit margins.

From a portfolio of funds viewpoint I am looking at some funds differently. We’ve always looked for funds which gained more than the market and average competition on the upside and lost less on the downside. Often that meant we wound up with more volatile funds than some of our clients would like. Recently, I have been paying more attention to funds that go up and down less than peers. What attracts me is higher capture of the up markets than down markets. In one case the fund’s upside capture rate was 72% and downside 62%. This could be a good lower risk addition to a pension type account that is looking at a minimum five-year time span for the portfolio. If the next five years is close to normal and has only one or two down years, this fund will meet their reasonable actuarial standard.

Question of the week: 
Can you meet your obligations over the next five years with a 6% equity return? 
     

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html


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Copyright © 2008 - 2018
A. Michael Lipper, CFA

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Contact author for limited redistribution permission.

Completion Analysis: Fuller Picture - Weekly Blog # 560

Mike Lipper’s Monday Morning Musings

Completion Analysis: Fuller Picture 

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

                                                 

One of the first things I learned as an analyst selling sell-side research conclusions to a skeptical institutional audience were the negatives to my view point, or at least the contrary facts. Often when I thought I had a sound point of view I would arrange a week of visiting mutual funds and other institutions in Boston. In many respects this was an intensive course in the analysis of both more facts to consider, including the points of view of more knowledgeable analysts from the vantage points of their portfolios. By the end of the week I had a much fuller understanding of my own views. Further, I made up my mind that I should not consider a sales pitch until I was familiar with the opposite point of view. Thus, for me and those who eventually worked with me I insisted on learning and using a more complete picture, or as complete an analysis as possible.

With that as an introduction, this blog will discuss the other side of two very popular items in the popular and professional press, Saint Jack Bogle and the celebration of high return on equity and operating profit margin.

“Saint Jack”

Jack’s high intelligence and high intensity appealed to the CEO of Wellington Management, then located in Philadelphia. At that time Wellington was a load fund group relying on good wholesalers to convince retail brokers to sell the Wellington Fund and its new and much smaller, all equity and value focused, Windsor Fund (managed by the great John Neff). Walter Morgan decided it was politically smarter to name Jack president, rather than one of the competing sales people. At that time fund buyers were more interested in investment performance than the relative safety of the Wellington balanced fund, which was losing market share in the fund business. Jack trusted numbers more than people. He was taken in by the advocates of Modern Portfolio Theory (MPT), which in truth was not modern, not a portfolio theory. Nevertheless, Jack had urged the SEC to require alpha and beta numbers to be required in fund prospectuses. Luckily, even with the endorsement of the CFA Institute, the SEC, some recognized that these numbers were history and might be used to make poor decisions. Jack was determined to get Wellington moving again.

Accelerating growth was the rage at the time and Jack engineered a deal with a Boston manager of growth funds. The deal gave the acquired control of the merged company in a ten-year voting trust. I was visiting Jack either on the day the announcement was published or very soon thereafter. He was pleased with the deal. I cautioned that he might have lost his company. Thus, I was not surprised when he was removed. (By the way, this follows a long tradition of an antipathy between Boston and Philadelphia, since the American Revolution.)

Jack was always resourceful, from his scholarship days at Blair Academy through Princeton. He recognized that while he had lost control of the investment advisor, the independent directors of the mutual funds remained his friends. He convinced them they should internalize the operation, like many closed end funds in the US and Investment Trusts in the UK. The idea of investing in a passive market vehicle was not new. Since at least the 1940s, the Founders Mutual Depositors Fund had been a UIT invested in the 40 largest companies in the Fortune 500. I believe there were several UK Investment Trusts that had similar strategies.

What particularly appealed to Jack was that by going no-load he was materially reducing the power and presence of the sales people. He had the view that they were just a bothersome expense. There was never a study done as to the value of the sales people. (Having known many of them over the years, I suspect some were good and provided both good advice and service to investors.) Jack was a very good student of the mutual fund industry and what he saw as a benefit for Vanguard was the difference in Total Expense Ratio (TER) between an index fund and an actively managed fund. While a lower fee was a plus, what probably aided performance more was that index funds were fully invested in the market and did not have a built-in redemption reserve. Most active funds have up to 5% in cash to meet redemptions and opportunities. By getting these reserves committed, all of the investment was working for them in rising markets. When markets went down, which happens a minority of the time, active managers holding cash can outperform. This advantage also persists in the early phase of recoveries. For example, the average S&P 500 index fund was up +5.22% in the first 17 days of 2019, compared to the average US Diversified Equity fund which gained +6.22%. There were other advantages for index funds, the first is that when dealing in size active funds may have knowledge of something of upcoming importance. To protect themselves the dealers who were providing liquidity to these funds, wanted a wider spread in their favor. Index funds convinced the marketplace that their trades were without information value and that there was no need for a wider spread. There were also administrative expense savings possible.

While this numbers-oriented pitch would have appealed to Jack, there were some sales aids that were also of great help. The first is that New York State in the 1940s permitted the Teachers Investment Annuity Association (TIAA) to sell the College Retirement Equity Fund (CREF) to college professors. For many years the bulk of CREF was indexed. Many Professors had proven to themselves that they were poor investors and therefore didn’t trust the market. When Vanguard’s group of institutional sales people discovered this, they had found a fertile field of investors at both educational institutions and foundations. The benefits of indexing were taught at lots of schools, without giving a fuller understanding of investing or indexing. Many of today’s media pundits were educated in these incomplete classes.

In summary, I have great respect for Saint Jack, the mutual fund business’s Don Quixote. He brought a number of important issues forward, but his motivation was not as pure as is being memorialized. We do use index funds within our managed accounts when we can not find better actively managed funds at a reasonable cost.

High Number Celebrations

We are probably at the crest of the current economic expansion. As has happened in the past, markets can decline while the general economy remains in expansion. However, one of the functions of a prudent investor and manager is to be on the watch for signs of trouble ahead. During this season of reading annual reports and conference call pep-talks, one should be looking into the celebration of big numbers. As an analyst I pay little attention to reported earnings, as they have been adjusted by favorable accounting moves or management’s focus on what is working now and avoiding what is not, which is more difficult to spot. While I look at many ratios, the three that are the most important to me are return on equity (ROE), operating profit-margin, and net cash generation after debt service.

This season I am seeing record results reported for ROE. In one case, a net interest earner reported average ROE at an annualized 20%. This is being created by shifting client assets into more favorable earnings for the organization and there isn’t a great deal more to go. The 20% number reminded me that before the Bogle impact and other structural changes, members of the NYSE could attract general and limited partners based on a 25% return on partner’s balances. These firms were not particularly special in terms of skills so I declined to join them, which saved me from several failing firms. 

One of the lessons coming from a recent experience with Apple (*) is the danger of showing high profit margins based on high prices. In effect, Apple is holding out an umbrella over competitors in order to use price competition to successfully take market share at lower levels of profitability. Apparently, investors are expecting revenues to grow slower than they were in 2018, but sufficiently enough to be acceptable. I wonder whether a 1% slower revenue growth will lead to a 1% decline in either profit-margin or ROE. Instead of 1%, a 3% or 5% revenue decline will have a more serious impact on the ratios, as operating leverage works both ways.

After four favorable weeks of US stock market performance we could be slowing down in the recovery, even if the three major stock indices appear to have gotten over their 65-day moving average. I continue to wonder, even with bouts of enthusiasm in between, whether 2019’s average performance results will be in single digits, similar to their first full week’s performance. By the way, the AAII sample survey has all three choices in the 30% rage: bullish, neutral, and bearish.

Thoughts?     

*Held in personal accounts

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

T.W.T.W. > Recognizing Capitulation+Risk Growth - Weekly Blog # 559

Mike Lipper’s Monday Morning Musings

T.W.T.W. > Recognizing Capitulation+Risk Growth 

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

                                                                                                                       

The Week

A long time ago on TV, on both sides of the Atlantic, there was a comic review of the current news titled “The Week That Was” or TWTW. Occasionally, news and commentary of significance are bunched into one week, as happened this past week. The items they covered may be of serious significance for 2019 and beyond.

One Day, One Week, One Month, One Year

Some of the US stock market followers can point to instances where the first day of the year market performance predicts the first week, which predicts January’s results, and in-turn forecasts the calendar year. They have some statistics to support their view. At any rate, both the first trading day of the year and the first full week of the year produced gains for the leading stock market averages. After surviving a year where only cash produced a positive rate of return of the main asset classes, one can hope that 2019’s results will have a plus sign ahead of it. With that thought in mind, the following mutual fund performance table could address the question of magnitude for 2019’s results:

  

     Mutual Fund Major Asset Class Average Performance

                      ---------------Return----------------

Fund Asset Classes    Week Ended 1/10/19  5-Year Annualized

US Diversified Equity        +6.63%             +5.80%

Sector Equity                +5.62%             +3.00%

World Equity                 +5.64%             +2.47%

All Equity                   +4.54%             +4.47%

Mixed Assets                 +3.47%             +3.65%

Domestic Long-Term Fixed Inc +0.53%             +2.11%

World Income                 +1.02%             +1.46%

Remember, the numbers above are not our predictions, they are a look at history. There were much better results over the past ten years because during this period we saw multiple expansion. The only way for the numbers above to be achieved is for further expansion of the market multiple, assuming the optimistic projections coming out of Washington. With the current size of sales forces contracting it will be difficult unless societies (governments and Private Sector) meaningfully address the growing retirement capital deficit, even assuming the optimistic projections coming out of Washington.

I recognize that absolutely none of the readers of this blog are average investors or investment managers, but there is still hope for you and your accounts to do much better. Barrons each week publishes a list of the 25 leading mutual fund performers for the week, sourcing my old firm now housed in REFINITIV. For the week, these 25 funds had gains of 19.45%-12.43%. (In eleven instances the funds had stablemates on the list.)

Attitude Changes Required?

In analyzing the 2018 results, several deeply held attitudes probably contributed to the poor results:

• Only Earnings Per Share growth counts in selection
• TINA=There Is No Alternative to equities for success.
• Demographics is destiny (without population growth no expansion is possible)
• Four interest rates hikes in 2019.
• A bear market is defined as more than 20% from peak. (Bear Markets are a sustained period of selling by Public investors.) AAII bearish sample 29% from 50% in 3 weeks. Never higher than 50%
• Capitulation requires large selling volume followed by large buying.

Three Longer-Term Considerations

1. Ken Rogoff is quoted as saying “Over the course of this year and next, the biggest economic risks will emerge in those areas where investors think recent patterns are unlikely to change.” His lists includes:

• A Growth Recession in China
• Rising Interest Rates
• Populism undermining central banks
• Higher interest rates on “safe” government bonds 

My concern is a data dependent world where the numbers are incomplete and wrong due to disruptive technology, increased under-reported transactions, poor data gathering, data expenses that are too low, “sound bite” analysis, and surprises.

2. The Historically Speaking Column in the Weekend WSJ briefly reviewed several financial panics going back to ancient Rome and government reactions to them. The column concludes “the only thing more frightening than a financial crisis can be its aftermath”. In many cases the crisis was created by leadership trying to extend a tiring expansion beyond its “normal life.” The solutions applied were an unwise attempt to prevent a repeat of the problem without recognizing the series of faulty decisions made by leadership. This included punishment of unpopular sectors and people rather than an attempt to guide better judgement and the rebuilding of appropriate reserve elements, which could have been quickly and expertly mobilized.

3. Gallop regularly measures the public’s view of the honesty and ethical standards of various occupations. Of the 20 occupations reviewed by far the highest esteem goes to Nurses. The following table shows the ranking of the professions we deal with as part of our professional lives:

Profession      %Low/Very Low   Rank out of 20

Accountants           7%               6

Journalists          34%               9

Bankers              21%              11

Lawyers              28%              14

Business Executives  32%              15

Stockbrokers         32%              16

Telemarketers        56%              18

Car salespeople      44%              19

Members of Congress  58%              20

Similar surveys are probably done in most countries. These public attitudes are probably similar worldwide and represent a major constraining force in the development of a modern financial community where we ask people to trust both our integrity and our wisdom. My fear is that during some future economic crisis the unpopularity of government will lead to an upheaval that promises more honesty and efficiency, but in the end doesn’t deliver on those promises. As bad as our current delivery system is, it will produce better results than any other long-term system. What we need to do is make it much better.

Thoughts? 

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

https://mikelipper.blogspot.com/2018/12/cash-is-four-letter-word-weekly-blog-556.html

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.