Many in the popular press and a few politicians believe that current compensation practices do not sufficiently penalize risk taking. Thus, they rail against incentive compensation both for “Wall Street,” (read financial institutions), and for industry in general. As we all have suffered from the collapse of the financial markets in 2008, there is a deep psychological need to assess blame and punish those that created this pain. We need to accept the reality that everyone of us bears some responsibility for over-extending ourselves and our society beyond a level of wise prudence. To come to grips with this issue there are two realizations which with we need to fathom. The first is that risk is not usefully measured as a number, but rather its impact. For me, risk is the penalty for being wrong to such a degree that it forces changes in one’s life’s plans. If one’s financial assets are ten thousand dollars or less, a loss of one thousand dollars may cause a change of plans for college, rent or purchase of a car. The same loss by a millionaire is an annoyance, but not a life changer. The second realization is that while in truth we are at risk every single day from some catastrophe, we don’t feel at risk. We believe almost everything we purchase was bought at an appropriate price, without fear that some subsequent event will cause our purchase to be worth much less. Both the mortgagee and the mortgagor believed at the time the sub-prime mortgage was struck, that neither the buyer nor the seller was at substantial risk. The same could be said of the domestic or foreign institution that bought a tranche in a structured financial package of subprime mortgages as well as those who sold the paper to them. There was little in the way of history which would alert all those who, in actual fact, were taking substantial risks. The size of the extra incentive compensation would not have been worth the large losses which were sustained. In many cases the participants’ jobs, careers, and their own capital in their firms were sacrificed by being wrong. I seriously doubt that any change to the risk/reward matrix would have changed many people’s behavior.
We are not blameless for the mistakes that caused us, our clients and our society to pay the risk penalty. We are guilty of not looking for the unexpected, or if you will the “Black Swan.” Under the pressure to meet human needs for housing on the one side and income generation on the other side, we failed. I am not suggesting that there weren’t liars and others driven by greed, but for the most part the mistakes that were made were made by relatively honest, upstanding people who had no knowledge or experience to guide them through their next set of troubles. Even many of the traders, with their own and their firms’ capital, were unaware of the risks about to fall on them. At the end of the day, the fault was poor, one-sided research, not the compensation arrangement.
In our natural desire to avoid future penalties, we look at what went wrong in a mechanical sense and wish to institute changes to prevent what happened from happening again. I guess this comes under the headline of avoiding a second lightening strike. The theory holds that if one attacks the motivation of the guilty, (compensation), they will become reformed and won’t stray again. I believe that this type of change is unlikely.
To avoid future problems there is a tendency of the great and the good, (to use a British expression), to codify a new and more stringent Code of Conduct. Some of the popular headlines would require more transparency, more capital, and less leverage. These lists of “Best Practices” attempt to correct the past in a systemic approach. Perhaps, they should look at the lack of complete success at past lists of Best Practices. I believe they will find two obstacles in designing effective risk penalties. First, we live in a dynamic world that is always re-inventing or perhaps more accurately, re-packaging financial instruments. In this most creative community, good and bad people will find ways around the current rules. The second drawback to believing that Best Practices or regulations will prevent future problems, is that problems are caused by people, not procedures.
People are human, so they can and will make some mistakes. People have friends and family that they will treat differently than total strangers at times (and in some cases, very subtly different ways). People also have unfulfilled desires which can override their natural caution. I suggest that most problems will be avoided by those groups or families where the supervision knows their fellow workers/members, and can anticipate many of the human problems that drive people to take risks.
Changing financial compensation procedures without changing the psychic benefits gained from various forms of risk taking is like closing the barn door after the animals have fled. Better results will be had by leading people to the benefits of avoiding unwarranted risks rather than by promulgating Best Practices or by additional regulation.
We look for fund managers who lead their organizations effectively, they manage risk well.
Sunday, November 22, 2009
Sunday, November 15, 2009
Post Mortem 2007-8 and Pre Mortem 201X
In last week’s blog, I promised to devote this week’s musings to the causes of the recent declines in the economy and markets. You will find my focus is more of a systemic approach than singling out specific instruments, organizations, regulations or people.
The history of the rise and fall of markets and related economies goes back to the beginnings of recorded time. This history can be described graphically as undulating waves following a cyclical pattern. As these waves began long before the creation of hedge funds and credit default swaps, there must be something more basic in human nature. I believe the drive that causes these cycles is the four letter word that a well known labor union leader enunciated more than a century ago when asked what his laborers wanted; the reply was “More.” It is each person’s desire for more of what is in short supply that drives the demand side of the economic equation. The supply side is provided by those who produce or possess “more” than what they can consume. In periods of population growth and net immigration, there is normally more demand being generated than supply coming onto the market. Spurred on by the dynamite of rising expectations driven by all forms of media, the demands for higher priced goods and services drove demand. There is hardly a human alive today who does not want more of something, including ‘peace of mind,” which itself can be costly. (Think of various forms of physical, medical and financial protection.) In this sense, we are all the sinners of driving for “More.”
There is a two letter word that we do not want to hear from our government or employer. That word is “No.” Thus, governments rarely say no to a demand for more services. The normal solution is reliance on inflation, as governments can repay their enlarged debts with currency that is worth less due to inflation. Employers also want to avoid saying no to increased wage demands if they can avoid it. Employers count on both increased productivity and higher selling prices to meet wage demands.
The growing demands for more goods and services could not be satisfied in their entirety through growth of the market. Most developed economies, including the US, have been growing more slowly than the escalation in demands. The solution to this problem was to borrow money in ever- increasing amounts. In effect, borrowing new money to repay old debts. In the corporate world, debt grew faster than equity, so any shortfall in the ability to issue new debt for old debt would have a dramatic impact on a proportionately smaller equity base. (Leverage has this annoying characteristic of working both ways to magnify gains and shortfalls.)
As an equity analyst and portfolio manager I did not pay much attention to fixed income securities. Neither did most individual investors. I should have been more conscious that segments of the fixed income markets were showing signs of distress by requiring higher yields to clear transactions. These particular securities were housing-related, and mostly the hot new Wall Street product called structured finance securities (which were large packaged and sliced residential mortgages). Their rising prices at the same time that more of the financial community’s capital base was being devoted to this trade, should have been the proverbial chirping of the “canary in the mine.” Like most others, I missed these early warning signs. Along with the regulators, I further failed to understand the implications of counterparty risks on a global basis. I missed the fact that overseas participants had taken on much more leverage. One could borrow more money, at better terms, in London than in New York. The poorly identified mortgage products were sold around the world to satisfy local needs for income to meet “more” demands.
Space and time do not permit for a more inclusive analysis of what went wrong and how we missed spotting the problems. What I want to focus on now is the possible “Pre-Mortem” for a future decline, which history tells us will surely come at some point. (Let us hope years in the future!)
Many people fear two possible causes for the next major decline that I do not. The first is a dramatically worse real estate market. Could residential market prices drop further, causing more defaults? Yes, but in terms of magnitude unlikely to be major. (Remember, I missed spotting the first decline when I knew local prices were unsustainable.) Many have identified commercial real estate as the next big problem. I think these problems have been largely identified. Vacant properties are a problem but I believe the order of magnitude is much smaller than the residential real estate hit we sustained, and the market is prepared for defaults.
The second popular worry at the moment is the relative decline of the US dollar. In the last couple of weeks, I have commented on the decline compared to other currencies, not commodities.
My true concerns however, are for two other problems that I perceive on the horizon. Either one could cause major instability in our markets.
The first concern is the increasing level of speculative foreign exchange trading. Corporations, financial institutions (including hedge funds), and increasingly individuals, have discovered these markets whose daily volume is larger than the traded securities markets on many days and nights. (Currencies are traded around the clock, around the world.) The advertised leverage potential for the retail participant is 500 to 1. (Many of the frauds in the financial markets have been caused by attempting to regain undisclosed losses by the rapid trading of highly leveraged products.) Foreign exchange that goes through banks has some regulatory oversight, but not heavy. Those trades executed outside the bank channel have little or no oversight. Either a suspected (or actual) fraud, or a surprise devaluation/revaluation by a government could cause a significant amount of margin calls. Many organizations and individuals could not immediately meet the repayment obligations on their loans from such margin calls, possibly leading to some bankruptcies. Nevertheless, a foreign exchange collapse is analogous to other kinds of margin calls, with enough case law in place that we should quickly seal off the problem.
My second concern is pure conjecture. Assume, whether, we like it or not, some healthcare legislation is passed. Initially the first victims of this price- control legislation will be the profit margins of doctors, hospitals, pharmaceutical companies, medical equipment providers, as well service companies. Most important of all, individuals will find their costs will rise; particularly the elderly and the formerly wealthy. Many different approaches will be attempted to restore their past financial relationships. Almost guaranteed, more debt will be found on hospital balance sheets,* doctors’ practices, as well as many other organizations. I suspect some individuals either by happenstance or by conscious decision will find it necessary to borrow money against some future financial stream. As many of these groups are inexperienced in shopping for, and managing external debt, they will fall behind in their repayments. My fear is that we will see medically-induced bankruptcies with enormous emotional pains, and very little easily convertible collateral. As a society, we are not prepared for this contingency. Pity the judges who will have to deal with these issues.
___________________________
*I sit on the Financial Oversight Committee and chair the Investment Committee for an important not-for-profit hospital group that currently holds a very good credit rating.
The history of the rise and fall of markets and related economies goes back to the beginnings of recorded time. This history can be described graphically as undulating waves following a cyclical pattern. As these waves began long before the creation of hedge funds and credit default swaps, there must be something more basic in human nature. I believe the drive that causes these cycles is the four letter word that a well known labor union leader enunciated more than a century ago when asked what his laborers wanted; the reply was “More.” It is each person’s desire for more of what is in short supply that drives the demand side of the economic equation. The supply side is provided by those who produce or possess “more” than what they can consume. In periods of population growth and net immigration, there is normally more demand being generated than supply coming onto the market. Spurred on by the dynamite of rising expectations driven by all forms of media, the demands for higher priced goods and services drove demand. There is hardly a human alive today who does not want more of something, including ‘peace of mind,” which itself can be costly. (Think of various forms of physical, medical and financial protection.) In this sense, we are all the sinners of driving for “More.”
There is a two letter word that we do not want to hear from our government or employer. That word is “No.” Thus, governments rarely say no to a demand for more services. The normal solution is reliance on inflation, as governments can repay their enlarged debts with currency that is worth less due to inflation. Employers also want to avoid saying no to increased wage demands if they can avoid it. Employers count on both increased productivity and higher selling prices to meet wage demands.
The growing demands for more goods and services could not be satisfied in their entirety through growth of the market. Most developed economies, including the US, have been growing more slowly than the escalation in demands. The solution to this problem was to borrow money in ever- increasing amounts. In effect, borrowing new money to repay old debts. In the corporate world, debt grew faster than equity, so any shortfall in the ability to issue new debt for old debt would have a dramatic impact on a proportionately smaller equity base. (Leverage has this annoying characteristic of working both ways to magnify gains and shortfalls.)
As an equity analyst and portfolio manager I did not pay much attention to fixed income securities. Neither did most individual investors. I should have been more conscious that segments of the fixed income markets were showing signs of distress by requiring higher yields to clear transactions. These particular securities were housing-related, and mostly the hot new Wall Street product called structured finance securities (which were large packaged and sliced residential mortgages). Their rising prices at the same time that more of the financial community’s capital base was being devoted to this trade, should have been the proverbial chirping of the “canary in the mine.” Like most others, I missed these early warning signs. Along with the regulators, I further failed to understand the implications of counterparty risks on a global basis. I missed the fact that overseas participants had taken on much more leverage. One could borrow more money, at better terms, in London than in New York. The poorly identified mortgage products were sold around the world to satisfy local needs for income to meet “more” demands.
Space and time do not permit for a more inclusive analysis of what went wrong and how we missed spotting the problems. What I want to focus on now is the possible “Pre-Mortem” for a future decline, which history tells us will surely come at some point. (Let us hope years in the future!)
Many people fear two possible causes for the next major decline that I do not. The first is a dramatically worse real estate market. Could residential market prices drop further, causing more defaults? Yes, but in terms of magnitude unlikely to be major. (Remember, I missed spotting the first decline when I knew local prices were unsustainable.) Many have identified commercial real estate as the next big problem. I think these problems have been largely identified. Vacant properties are a problem but I believe the order of magnitude is much smaller than the residential real estate hit we sustained, and the market is prepared for defaults.
The second popular worry at the moment is the relative decline of the US dollar. In the last couple of weeks, I have commented on the decline compared to other currencies, not commodities.
My true concerns however, are for two other problems that I perceive on the horizon. Either one could cause major instability in our markets.
The first concern is the increasing level of speculative foreign exchange trading. Corporations, financial institutions (including hedge funds), and increasingly individuals, have discovered these markets whose daily volume is larger than the traded securities markets on many days and nights. (Currencies are traded around the clock, around the world.) The advertised leverage potential for the retail participant is 500 to 1. (Many of the frauds in the financial markets have been caused by attempting to regain undisclosed losses by the rapid trading of highly leveraged products.) Foreign exchange that goes through banks has some regulatory oversight, but not heavy. Those trades executed outside the bank channel have little or no oversight. Either a suspected (or actual) fraud, or a surprise devaluation/revaluation by a government could cause a significant amount of margin calls. Many organizations and individuals could not immediately meet the repayment obligations on their loans from such margin calls, possibly leading to some bankruptcies. Nevertheless, a foreign exchange collapse is analogous to other kinds of margin calls, with enough case law in place that we should quickly seal off the problem.
My second concern is pure conjecture. Assume, whether, we like it or not, some healthcare legislation is passed. Initially the first victims of this price- control legislation will be the profit margins of doctors, hospitals, pharmaceutical companies, medical equipment providers, as well service companies. Most important of all, individuals will find their costs will rise; particularly the elderly and the formerly wealthy. Many different approaches will be attempted to restore their past financial relationships. Almost guaranteed, more debt will be found on hospital balance sheets,* doctors’ practices, as well as many other organizations. I suspect some individuals either by happenstance or by conscious decision will find it necessary to borrow money against some future financial stream. As many of these groups are inexperienced in shopping for, and managing external debt, they will fall behind in their repayments. My fear is that we will see medically-induced bankruptcies with enormous emotional pains, and very little easily convertible collateral. As a society, we are not prepared for this contingency. Pity the judges who will have to deal with these issues.
___________________________
*I sit on the Financial Oversight Committee and chair the Investment Committee for an important not-for-profit hospital group that currently holds a very good credit rating.
Sunday, November 8, 2009
Winning Calls
Life rarely presents us with celebratory events sponsored by others for us. Thus, occasionally we need to create our own in the fashion of Lewis Carroll’s wonderful invention of the “Unbirthday.” With this as a premise, I am indulgently going to celebrate the recent successful calls in our blog. If I don’t, who will?
The first correct call was the recognition that the month of October, 2009, had specific characteristics; which this year resulted in a negative bias to equity performance for the month. I also pointed out that mutual funds end their tax reporting year in October. While most funds have accumulated large realized losses created in ’08 and ’09, it would be possible (and perhaps prudent) to recognize some gains. The gains would not trigger a tax payment because the gains would offset the losses. Since there are no “wash sales” rules on gains, the smart thing to do is sell some of this year’s winners and either repurchase the same stocks, or perhaps to use Sir John Templeton’s phrase, search for “better bargains.” As the SEC no longer requires funds to disclose transactions on a quarterly basis, we no longer see a list of transactions made by the funds, thus I do not know what happened.* However, during the last three weeks of October, a significant number of the best performing stocks for the year were met with selling. On an overall basis, the month of October was down. My supposition is, that with the removal of the incremental mutual fund selling, the short term performance (at least in early November) would be up. This actually happened. I call it a win.
The second call was on the relative value of the dollar, which I felt was bottoming. This appears to be happening. Please note that I phrased my comment in relative terms. I agree with many of the views of the dollar’s detractors, that the buck should be worth less due to the present deficit, the almost certainty of a larger deficit, and the strong odds of a pick-up in inflation, probably induced. Why then should the dollar stop falling? World trade currencies are priced relative to other currencies. From a managed trade point of view, the decline in the US dollar is an increase in the value of the counter currencies. In many countries exporters are politically important. They see a rising price of their own money as an inhibitor to their export sales. Thus, I believe that other countries will buy some dollars to prevent their own money from being priced out of the world market. I have great respect for George Soros and his investment accomplishments over the years, even though I rarely am in agreement with his political views and actions. When he was recently asked about the worth of the US dollar, he replied that it was over-valued, except in comparison with other currencies. Today, I do not see a better value in other paper currencies, even though personally I own some other currencies to support my foreign equity investments.
From the standpoint of those who are focused on the absolute value of the dollar, that is to spend rather than trade, the price of gold (and to a lesser extent prices of some other commodities) is instructive. The nominal price of gold is at record levels, about $1100 a troy ounce. However when translated into today’s dollars, the old record price of over $800** an ounce in 1980 would be at least a thousand dollars higher. One reason for the recent strength in the gold price is that several central banks have made it known that they will not be carrying out their previous plans to sell gold. In addition, both India and China are buyers. I will claim this call as a winner in light that the other side is not winning.
On a tactical side, my recent calls for long term investing for growth, and particularly technology-driven innovation, appears to be winning relative to bets on value, and to some degree on industrials. I will claim these as short term winners, even though they were meant for long term investment.
Emotionally, the final two words in last week’s blog, “Go Yankees,” (written by the ‘born in Manhattan boy’ in me) proved to be the week’s biggest win. Please remember that there are legions of New York haters who resent the swagger generated by this culture of winning. Thus while I am very pleased, after eight long years of lack of fulfillment, my guard is up to defend against those who wish to punish New York. New York is a state of mind and not just a place. The biggest threat we face is a repeat event as severe to our economy and the financial markets as we experienced last year. We will retain our “license” to be central to the progress of the world only if we have learned something and we change our thinking.
I believe that we must change our thinking, thus next week’s blog will be devoted to my attempts to become more aware of the shape of future problems before they overwhelm us.
Any contributions from readers will be appreciated.
---------------
* Years ago, the SEC required mutual funds to report their transactions quarterly, allowing a deeper dimension to the analysis of funds than is now available. The SEC caved-in to the funds in abolishing this report, reasoning that the SEC and its staff could get the specific information anytime they needed it. Fund owners and their analysts no longer have access to that insight.
** A very valued former associate of mine, the late Alling Woodruff, of Greenwich, CT, did sell his physical gold position above $800. He was an independent director of what was then the largest US gold fund and was going to South Africa to visit some mines, thus out of touch with the market for a couple of weeks.
The first correct call was the recognition that the month of October, 2009, had specific characteristics; which this year resulted in a negative bias to equity performance for the month. I also pointed out that mutual funds end their tax reporting year in October. While most funds have accumulated large realized losses created in ’08 and ’09, it would be possible (and perhaps prudent) to recognize some gains. The gains would not trigger a tax payment because the gains would offset the losses. Since there are no “wash sales” rules on gains, the smart thing to do is sell some of this year’s winners and either repurchase the same stocks, or perhaps to use Sir John Templeton’s phrase, search for “better bargains.” As the SEC no longer requires funds to disclose transactions on a quarterly basis, we no longer see a list of transactions made by the funds, thus I do not know what happened.* However, during the last three weeks of October, a significant number of the best performing stocks for the year were met with selling. On an overall basis, the month of October was down. My supposition is, that with the removal of the incremental mutual fund selling, the short term performance (at least in early November) would be up. This actually happened. I call it a win.
The second call was on the relative value of the dollar, which I felt was bottoming. This appears to be happening. Please note that I phrased my comment in relative terms. I agree with many of the views of the dollar’s detractors, that the buck should be worth less due to the present deficit, the almost certainty of a larger deficit, and the strong odds of a pick-up in inflation, probably induced. Why then should the dollar stop falling? World trade currencies are priced relative to other currencies. From a managed trade point of view, the decline in the US dollar is an increase in the value of the counter currencies. In many countries exporters are politically important. They see a rising price of their own money as an inhibitor to their export sales. Thus, I believe that other countries will buy some dollars to prevent their own money from being priced out of the world market. I have great respect for George Soros and his investment accomplishments over the years, even though I rarely am in agreement with his political views and actions. When he was recently asked about the worth of the US dollar, he replied that it was over-valued, except in comparison with other currencies. Today, I do not see a better value in other paper currencies, even though personally I own some other currencies to support my foreign equity investments.
From the standpoint of those who are focused on the absolute value of the dollar, that is to spend rather than trade, the price of gold (and to a lesser extent prices of some other commodities) is instructive. The nominal price of gold is at record levels, about $1100 a troy ounce. However when translated into today’s dollars, the old record price of over $800** an ounce in 1980 would be at least a thousand dollars higher. One reason for the recent strength in the gold price is that several central banks have made it known that they will not be carrying out their previous plans to sell gold. In addition, both India and China are buyers. I will claim this call as a winner in light that the other side is not winning.
On a tactical side, my recent calls for long term investing for growth, and particularly technology-driven innovation, appears to be winning relative to bets on value, and to some degree on industrials. I will claim these as short term winners, even though they were meant for long term investment.
Emotionally, the final two words in last week’s blog, “Go Yankees,” (written by the ‘born in Manhattan boy’ in me) proved to be the week’s biggest win. Please remember that there are legions of New York haters who resent the swagger generated by this culture of winning. Thus while I am very pleased, after eight long years of lack of fulfillment, my guard is up to defend against those who wish to punish New York. New York is a state of mind and not just a place. The biggest threat we face is a repeat event as severe to our economy and the financial markets as we experienced last year. We will retain our “license” to be central to the progress of the world only if we have learned something and we change our thinking.
I believe that we must change our thinking, thus next week’s blog will be devoted to my attempts to become more aware of the shape of future problems before they overwhelm us.
Any contributions from readers will be appreciated.
---------------
* Years ago, the SEC required mutual funds to report their transactions quarterly, allowing a deeper dimension to the analysis of funds than is now available. The SEC caved-in to the funds in abolishing this report, reasoning that the SEC and its staff could get the specific information anytime they needed it. Fund owners and their analysts no longer have access to that insight.
** A very valued former associate of mine, the late Alling Woodruff, of Greenwich, CT, did sell his physical gold position above $800. He was an independent director of what was then the largest US gold fund and was going to South Africa to visit some mines, thus out of touch with the market for a couple of weeks.
Sunday, November 1, 2009
Random Thoughts on November 1st
One of the pleasures and pains of writing a weekly financial blog is determining what to say. This weekend I have a number of incomplete thoughts from various stimuli I received over the weekend. Any of these ideas could be developed into blog in and of itself. However, by focusing on a single subject, one would not see a number of the cross-currents that are washing over my mental boat in rough seas. In no particular order, my thoughts include the following ideas:
We should not expect any solace from the vice president, his administration or Congress for New York. One of the critical issues recognized by the current CEO of the New York Stock Exchange is that its future is dependent upon on what Washington pitches at New York. In the long-run, those of us who are spiritual New Yorkers have to find ways to become more loveable to the rest of the country. This tension is not new, as Alexander Hamilton and Thomas Jefferson, as well as Theodore Roosevelt and JP Morgan somewhat successfully worked on creating conditions from which all benefited. That is our job today. Go Yankees. .
- Peggy Noonan writes in The Wall Street Journal that many people either believe our various structural problems will not get better and we have to live with the current imbalances, or that they have a sense of optimism without any focus on innovation. I believe that both views are wrong. Some of the structural imbalances are cyclical, made worse by government intervention which prolongs the period of healing. Other imbalances will get worse, such as structural unemployment; we have produced a labor force that does not know how to labor in today’s world. I am afraid this is a multi- generational problem of education in the home. On the optimistic side, I believe that technology will create new products and services that will make much of our existing ones obsolete to a point that we will replace the old with the new, even before the old wears out. My optimism, particularly in technology, leads me to favor funds that have significant technology holdings, often found under healthcare and energy classifications, as well as those that have a separate technology classification.
- Alan Abelson in Barron’s quoted John Williams of Shadow Government Statistics, stating that 92% of the 3.5% gain announced for the 3rd quarter 2009 GDP was essentially contributed by “one-off” items, i.e. “Cash for Clunkers,” and expiring first-time home owner mortgage credits. Abelson’s comments reinforce my concern on the reliance on government numbers. One might add to the list, the President’s claim of 1 million jobs created or saved by the stimulus. As primarily equity investors, our focus should be on the revenue production of companies and the bottlenecks they are discovering in their sales and delivery processes. Commodity prices and transportation data are much more reliable indicators.
- Little mention is being made in the financial press, and none in the stock market comments of the general press, about the fact that Mutual Funds operate on an October tax year. Most of the equity funds have large realized losses created in 2007 and 2008, as well as earlier this year. I suspect that in October, a number of portfolio managers sold some of their positions that had gains, without incurring any additional tax liability for their shareholders. They may share my point of view that it is unlikely that any significant news will break in the next thirty days, suggesting at best, a flat market for a month. This hiatus in the market recovery will allow them to reallocate their portfolios or return to their prior positions, (we will never know for sure, as the funds that report on a calendar quarterly or semiannually do not have to report on intra-quarter activity). In my mind, I believe this factor is a possible additional explanation why the month of October was flat. If I am correct, the stock price weakness shown in the last week is not a canary in the mine giving us a signal to get out of the stock market.
- Another market phenomenon is that in the last week Berkshire Hathaway disposed of another major portion of their holdings in Moody’s, at current prices. The credit rating company is regularly under attack in the press, the regulators and some well known short sellers. What I find significant is that the stock absorbed this selling without further declines. As the company is not currently buying back its shares, the other side of the trades may represent one or more substantial buyers, as the public does not appear to have any interest in this stock. Often I find when a stock does not decline much in the face of a strong, well-known seller, there is a “story” in the unidentified buyer. Perhaps these thoughts are wishful thinking in that Moody’s is a long-standing position in our Financial Services Hedge Fund.
- Now for a non-market thought: Saturday night’s, or more accurately Sunday morning’s, victory by the New York Yankees in the third game of the 2009 World Series is something of a cultural identity. People have a visceral reaction to the New York Yankees; they either like them or hate them. Friends of mine from all over believe that everyone who currently works or lives in New York, or ever did, is a Yankee fan. Never mind that many of these people are not baseball fans, and like me, have difficulty in naming the starting team, but the Yankees represent something. I would suggest they represent a culture of winning. (The image is greater than the statistical history. Nevertheless they have won more pennants and World Series than any other team, although in any many years they are not the best team). To many others, the Yankees represent a swagger or arrogance. This is one of the deep root causes for the current Administration’s and Congress’ desire to “reform,” or some may say punish, Wall Street. During the rain-delayed game I saw the Vice President of the United States in the front box seats. As a kid growing up in Pennsylvania, and a long-time Senator from the neighboring state of Delaware, one can easily understand his affection for the Philadelphia Phillies. Parenthetically, I find it interesting that his brother and son are involved with a hedge fund.
We should not expect any solace from the vice president, his administration or Congress for New York. One of the critical issues recognized by the current CEO of the New York Stock Exchange is that its future is dependent upon on what Washington pitches at New York. In the long-run, those of us who are spiritual New Yorkers have to find ways to become more loveable to the rest of the country. This tension is not new, as Alexander Hamilton and Thomas Jefferson, as well as Theodore Roosevelt and JP Morgan somewhat successfully worked on creating conditions from which all benefited. That is our job today. Go Yankees. .
Sunday, October 25, 2009
When Experience is not the Best Teacher
In my book Money Wise, I began with the desire to explore the principles of investing to find laws of certainty similar to that found in the physical worlds. I have been unable to find these supports in terms of securities selection or in portfolio decisions. Many others, however, have believed that they have found such rules.
One can often learn more from reading the apology letters from poor performing funds than from winning funds. Brandywine Funds is one of the better communicators of this group. Their basic investment approach is to invest in stocks that they believe are selling at a discount to a future price, based on their estimate of future operating earnings. In bemoaning their under-performance, they focus on the “Quality Ranking System” of Standard & Poor’s, an analytical approach that focuses on relative growth of earnings and dividends over time. Using letter grades to signify the best of these measures, S&P assigns “A” to the best and “C” and “D” to the worst. In the first nine months of 2009, the “C” and “D” companies gained on average 134%, while the high quality “A” stocks were up 21%. To add insult to injury to the earnings modelers, the best performing stock in the Russell 3000, Human Genome Science, was up more than 3,300%. The company has not reported an annual profit since 1994, and is expected to have larger losses in 2010 than in the current year.
Another currently poorly performing manager focuses on the fact that the companies reporting earnings gains often are doing so by significantly reducing expenses. In many cases they are also experiencing reduced sales and/or share of market. Yet in the current market, these stocks are substantially outperforming others that are showing revenues gains and increasing or maintaining market share. Consumer stocks are doing well on Wall Street, but not on Main Street, and they have attracted significant short interest.
Under normal conditions, the focus on accelerating earnings produces performance leaders. The apologists for current relative poor performance have, in some ways, been bitten by one or more Black Swans. In the nineteenth century many Europeans believed that all swans were white, thus there was shock and consternation when they were introduced to Black Swans from Australia. This introduction violated their experience. For hundreds of years before the early twentieth century, the world was an orderly place following the rules of science as pronounced by Isaac Newton. Then Albert Einstein’s thoughts changed the way we looked at the world. In these two instances we are confronted with the choice of the experienced and normal, but recognize that under some conditions exceptions will occur.
Our market and economic experience over the last two years does not follow the normal past experiences. We clearly have been in an exceptional time. History suggests that past exceptional periods eventually coalesce into some form of repetitive patterns that become the new normal. I am not sure what these new relationships will be. PIMCO believes that they have found the new normal, which produces more subdued growth. I am not sure. In view of the fact that, in general, equity returns for the last ten years have been flat, I am of the view that over a longer period we will see growth. My feeling is that at least we will see high single digit growth with some years, like 2009, showing double-digit gains. Further, I believe some form of the old “normal” rules will work for investors, perhaps when we least expect it to work. In other words, this is not like saying to hold on to your Confederate Dollars. But rather, it is a recognition that the South did recover eventually, and is now often a growth leader.
Keep an eye on formerly successful managers, for some of them may be future leaders again, particularly if they do not chase the new normal.
One can often learn more from reading the apology letters from poor performing funds than from winning funds. Brandywine Funds is one of the better communicators of this group. Their basic investment approach is to invest in stocks that they believe are selling at a discount to a future price, based on their estimate of future operating earnings. In bemoaning their under-performance, they focus on the “Quality Ranking System” of Standard & Poor’s, an analytical approach that focuses on relative growth of earnings and dividends over time. Using letter grades to signify the best of these measures, S&P assigns “A” to the best and “C” and “D” to the worst. In the first nine months of 2009, the “C” and “D” companies gained on average 134%, while the high quality “A” stocks were up 21%. To add insult to injury to the earnings modelers, the best performing stock in the Russell 3000, Human Genome Science, was up more than 3,300%. The company has not reported an annual profit since 1994, and is expected to have larger losses in 2010 than in the current year.
Another currently poorly performing manager focuses on the fact that the companies reporting earnings gains often are doing so by significantly reducing expenses. In many cases they are also experiencing reduced sales and/or share of market. Yet in the current market, these stocks are substantially outperforming others that are showing revenues gains and increasing or maintaining market share. Consumer stocks are doing well on Wall Street, but not on Main Street, and they have attracted significant short interest.
Under normal conditions, the focus on accelerating earnings produces performance leaders. The apologists for current relative poor performance have, in some ways, been bitten by one or more Black Swans. In the nineteenth century many Europeans believed that all swans were white, thus there was shock and consternation when they were introduced to Black Swans from Australia. This introduction violated their experience. For hundreds of years before the early twentieth century, the world was an orderly place following the rules of science as pronounced by Isaac Newton. Then Albert Einstein’s thoughts changed the way we looked at the world. In these two instances we are confronted with the choice of the experienced and normal, but recognize that under some conditions exceptions will occur.
Our market and economic experience over the last two years does not follow the normal past experiences. We clearly have been in an exceptional time. History suggests that past exceptional periods eventually coalesce into some form of repetitive patterns that become the new normal. I am not sure what these new relationships will be. PIMCO believes that they have found the new normal, which produces more subdued growth. I am not sure. In view of the fact that, in general, equity returns for the last ten years have been flat, I am of the view that over a longer period we will see growth. My feeling is that at least we will see high single digit growth with some years, like 2009, showing double-digit gains. Further, I believe some form of the old “normal” rules will work for investors, perhaps when we least expect it to work. In other words, this is not like saying to hold on to your Confederate Dollars. But rather, it is a recognition that the South did recover eventually, and is now often a growth leader.
Keep an eye on formerly successful managers, for some of them may be future leaders again, particularly if they do not chase the new normal.
Sunday, October 18, 2009
Are We Selling the US Too Short?
Almost everyday the global financial headlines discuss the decline in the value of the US dollar relative to other currencies. Many economists and others talk about a slow recovery here, and faster in Asia. Because of the difficulty in obtaining student visas for university students since 9-11-01, there is wide-spread concern that we are no longer attracting the brightest minds to study and work in the United States.
Sunday, October 11, 2009
On Building Effective
Investment Committees
Investment committees are the heart and soul of many non-profit organizations. The deliberations of these groups determine the near term and perhaps the long term ability of the organizations to accomplish their missions. Combined with the organizations’ Development (fund-raising) efforts, the scope of near term activities is determined. In an ideal world, investment should focus on the long term. In the real world, from a pure investment viewpoint, the pressure of near term funding needs often get more attention than warranted.
Currently, I have multi-faceted relations with several investment committees. I chair two very different investment committees, act as a consultant to some and an investment manager to others. Thus, I read with great interest an excellent seventeen page piece on investment committees by Michael Mauboussin of Legg Mason Capital Management. In his summary, he highlights twenty-one thoughts broken down into general findings, advice for committee members, and advice for committee chairs. With due regard for the patience of blog readers I will not discuss each of his excellent points, but will focus only on a handful.
The best committees are made up of members who bring different points of view from their varied experiences and thought patterns. In effect, intense discussions are the mother’s milk of a successful committee. As distinct from a reporting function which dwells on the past that can not be changed, the committee should focus on the future. Important in the deliberations should be the recognition that after exceptional performance, good or bad, the odds favor a reversal of relative, if not absolute performance. Along this line of thinking, the committee should challenge the obvious. One way to do this is for each member of the group to come to the meeting with thoughts that they share about what could go wrong. Before one can properly come to an assessment of investment risk, one should identify what could go wrong. Up to two years ago, there was no discussion of “hundred year storms,” which actually happen much more frequently. ( For those who are interested, I would be happy to discuss the similarities between the market collapse of 1987 and the defeat of the Spanish Armada.)
Perhaps the biggest contribution to increasing the success of investment committees is to record the essence of the discussions that lead to decisions. Subtly, these records can lead to a shift from an exclusive focus on outcomes to lessons gained from the process. We need to recognize that many outcomes are more a function of luck than skilled judgments. However, if our process allows for luck, or if you prefer the unexpected, we are more likely to be the beneficiary of change than those that have a high degree of certainty.
In applying the last thoughts, maybe we should spend time looking at funds that are currently performing badly, particularly those with managers that have been successful a number of times in the past. Will their successes be repeated?
What do you think?
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