Evaluating the Evaluation of Investment Performance

Introduction

I wonder whether my old fencing team has found the best way to evaluate investment performance? (More below).

This possibility seems strange from someone who built a first career on the production of mutual fund data for management organizations and their independent directors. My second career has two sets of masters, the first being the accounts I manage as a fiduciary and the second as a chair or member of various investment or finance committees. What is clear to me is that not only is investing an art form but judging investing is also an art form. I have learned this on the basis of not only my experience but discussions with some of the best investors in the world.

The governance trap

Professional fiduciaries want, above all else, to protect themselves from being sued (or in the case of trusts and estates surcharged). The bait in the trap is the definition laid down by Judge Putnam in his 1830 Prudent Man Rule. The case of  Harvard vs. Amory defined prudence as doing what other men....would do with their own funds. Notice in the introduction that prudence is a function of being allied in actions with peers. Nothing was said as to investment success or avoidance of risks of permanent substantial losses. The trap was sprung by reliance on the difference between US legal thinking and those of the U.K.  Under US law one can do everything one desires as long as it is not specifically prohibited. In the British tradition of a non-written constitution they require actions to be “fit and proper” with the sitting Judge making that decision.  As an outgrowth of these differences, in the US our investment policy statements (IPS) spend most of the words on what is a prohibited transaction and very little on accomplishing the goals of making money without undue risk of permanently losing large amounts of money. This philosophy has led to hurdles to safely jump over in terms of peer performance and fees charged. This is like telling Rembrandt how much paint he can use to create a great masterpiece because that is the amount painters’ use. My experience with investment committees is that those that are dominated by lawyers or salespeople have the bulk of the focus on comparative numbers. Usually the majority of the discussions are about periodic past results.

A number of organizations have recognized that the make-up of the committee will materially impact the long-term result.  Caltech, Atlantic Health Services and at least one major successful US state pension fund requires that only those trustees with significant investment experience sit on investment committees. The greater part of the conversations at these investment-driven groups is about meeting the long-term needs of the account while accepting reasonable risks. This second group is much more focused on the quality of thinking being expressed in the portfolio.  

Mutual funds are appointing accomplished analysts and former portfolio managers to their boards. Just this week, I was happy to learn that a woman who served on the board of the New York Society of Security Analysts has been invited onto the board of a major mutual fund board.

I believe that performance measures are not the way to select funds or managers, but that is the way many investment committees function. I believe that performances over various periods are a good place to begin the series of questions to see whether there is a proper fit. One way to begin the discussion is to look at the individual relative performance over the last forty quarters compared to perceived peers. For funds that are used to intelligently participate in a market segment, I want to see the bulk of the quarters within the middle three relative performance quintiles. When they pop out of the fat part of the bell shaped curve, which is what funds in the mid quintiles inhabit, I want to understand why. When looking for an aggressive manager to fully capture a leadership position, I look at the ratio of leading quintile performance to lagging. Normally, I like to see a ratio of three to one in favor of the leading quintiles. I am very interested in the pattern of the reversals from among the best to among the worst; I want to understand what if anything did the portfolio manager do to correct the fall from grace.  In other words, I try to get into the mind of the manager and determine what behavior modification went on. This is similar to what is happening to my old fencing team.

The stretch or the lunge?

In Saturday’s New York Times there was a rather extensive article entitled “No.1 Columbia Fencers Are Aided by a “Jedi Master.” 

Back in the cave dwelling days when I went to Columbia University, I was a substitute épée fencer on the Varsity Team. In subsequent years as with many Columbia sports teams, performance deteriorated. Luckily a few years ago a former computer software salesman became the head coach for the team. He used his computer orientation to trap all sorts of quantitative information about the members of his teams, opposing teams, possible recruits etc., somewhat like the baseball coach in the book and movie, “Moneyball.”

But to me one of the keys to the success of the Columbia Fencing Team (now Number 1 in the US) is how they go beyond the numbers into the mental framework of the fencers. The head coach was able to retain an 82 year old assistant coach to instruct these athletic fencers to lie down and meditate as part of his instructions in mental discipline. The message that I take from this article for us in dealing with investment committees is that statistics can only capture the past, aiding in mental behavior modification can change the past patterns that would be missed by merely looking at the past record.

In the search for the best

In searching for the best long-term investments I am mindful of expenses, (not their size, but where the money is being spent). If it is being spent wisely on talent, that can lead to good results. This is the sort of judgment that an investment committee full of professional investors can determine. An investment committee not so constituted runs the risk of commodity type pricing, believing that rare talent is easily interchangeable, and in the end getting below-optimum results.

Next week

We will discuss whether we have experienced a peak to be followed by a major decline. Let me know your thoughts.

_____________________     

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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The Age of Investing

Introduction

Some people believe that age is a common denominator. The great fallacy of Target Date Funds is that age is a shorthand for the level of investment risk an individual should take. There are many other measures and some more important than others in terms of individuals; e.g., assets including intangibles, liabilities including contingencies, mental and physical health as well as others. All of these factors should be viewed through the filter of one’s gene pool. With that thought in mind I learned separately of the recent birthday celebration of a 108 year old matriarch and the death of my senior cousin at 88. The matriarch is of a large family and is the mother of a smart and aggressive woman I knew as the senior director in terms of service of at least one volatile public company. Because of popular governance approaches there was a move to remove her as a director without any real acknowledgement of her remarkable gene pool, which to my mind is concentrating on form over substance and overlooking her contributions to the younger senior executives on the board. The 20 year spread between the live matriarch and my recently passed cousin suggests to me when I counsel 401(k) plans for current employees and their need for retirement funding I also must consider the uncertainty of the length of their life span, medical conditions and end of life medical expenses. I have great respect for actuaries and their ability to reasonably predict length of life of large masses of people for life insurance purposes, however I am extremely skeptical of their ability to predict any specific person’s date of death. 

My cousin was a lawyer and businessman as well as a long-time investor particularly in above-average yielding stocks which he shared with members of the family and others on a pro bono basis. I have a different model, which is to copy or exceed the life of a certain leading name investment manager who was close in age to the matriarch and was actively trading for himself and others paying a fee until a few days before his death. My somewhat facetious thought is that the pros normally outlive the amateurs.

Time horizon investing

Some of the readers of this post are responsible, at least in part, for investing for extremely young children, grandchildren, or great grandchildren. With that responsibility in mind I would suggest that some attention should be paid to time horizons beyond a century, possibly 120 years. (This comes from the trustee of Caltech who recommended the issuance of 100 year bonds because I could see the need for insurance companies and families for this kind of paper. On a historic basis I like to pay, not to receive, low interest rates.) To sharpen the focus on the future, based on lot of current experience, many young people do not get their first professional job with above-substance pay until age 25 and are forced into uneconomic retirement at 65, and then live to 120. The ratio of work-based earnings for 40 years compared to 80 years living off of savings (theirs, or others) including transfer payments is 3/1. I know of very few investment portfolios that can produce triples with certainty.

Three depressions

I am not about to discuss past or future economic depressions. I just want to focus on three rates of change that are currently way below the actuarial norms. In order of sluggishness to normal change, they are: population growth, savings rate and the dividend yields. Except in Islamic and a few other cultures, fewer children are being born. In part this is due to the recognition of improved medical conditions so fewer children die in childbirth. The use of contraceptive devices, and some additional recognition of economic uncertainties also affect birthrates. On the one hand, fewer children mathematically raise average income per person, reduce the size of consumer markets, and could create a shortage of workers or warriors.

The low savings rate is due to two factors. First, the ability to save is being crunched by expenses rising faster than incomes and second, the interest rates available to many are too low to attract their money into the savings system. One of the reasons I pour over the weekly edition of Barron’s is for its statistical section. In this week there is a monthly table of the dividend yield on the Dow Jones Industrial Average for the last ten years. At the end of January 2014, the yield was 2.14% which was the second lowest (2.01% in January of 2004 was lowest). There were other months that were lower, but most of the time the yields were higher. Obviously, the dividend yield is not in and of itself attractive enough to explain the record price for the DJIA. (The high at the beginning of the month was 16530.94 which compares with the monthly low of 6547.05 in March of 2009 when the yield was 4.31 %.) The explanations for this almost 1000 point increase in the averages are three.

• First, dividends have increased because earnings have grown.
• Second, there has been significant repurchases of the shares outstanding for the older companies in the average.
• Third, the stock market should be future focused discounting what the average dollar of investment sees.

Tying age and data together

For those who attempt to provide long-term solutions for individual or institutional investors the measurement process has shifted to a total reinvested return mentality which is the way my old firm started to report to fund boards, management, investors, and the media. This in turn means that we have all become much more price sensitive. With current historically low yields there is little price protection afforded by yields. If a market is dropping a “normal” down market of 20%, I believe a current yield would have to be close to 10% to cut the decline in half.

The rosy future is dependent on smart youth.

Last week a panel of Caltech trustees met with approximately 100 graduate and undergraduate students out of perhaps a total student body of under 2500 who were interested in exploring entering the financial community with firms like Goldman Sachs recruiting on campus. As one might expect, my fellow trustees (all who are active within the financial sector) were encouraging, I raised issues for them to think about. (I am willing to discuss my view or send my notes to our subscribers.) The key question for some of the Ph.D. students is should they continue with their efforts on developing new products with a seven-to-ten year time horizon for a possible big pay off or go into the financial community for more near-term rewards? I am finding that this is a question that my nephew at Carnegie Mellon is dealing with; he is a bright young man who already has patents registered and is attracting the attention of some leading professors. Somewhat younger, I also have a grandson at Bucknell who is an engineering major and is trying to get the right internship to learn how productive engineering is. As long as the youth of the world are attempting to make things that will help our progress, we have good reason to be positive for long-term investing for the next 100 years.

Filling the age gap

Tonight was the Super Bowl XLVIII. For the first time our National Anthem was sung by a world famous opera singer, Renee Fleming. I am very proud to report that she engaged the New Jersey Symphony Orchestra to accompany her. (Ruth, my wife, is the Co-Chair of the NJSO.) She is addressing the chronic problem of classic musical audiences, that they are aging and orchestras are working very hard to bring in more of the young to invest their time and eventually their hard-earned money in support of classical music. From an investment point of view this can be important. There is a clear relationship between math, science, and therefore investing, and perhaps improving each with an understanding and appreciation of classical music.

I think Ms. Fleming sang wonderfully!

_____________________     

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Copyright © 2008 - 2014

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

Current Investment Traps

Introduction

To use a term from tennis, a trap is an unforced error. In our arena of investments a trap is a concept/thought that leads us to significant losses of capital, or worse, opportunities to make sound productive investments.

Last week I had the opportunity to address ASCOSIM, an organization of Italian investment advisors. My talk in Milan included a brief list of ten concepts in structuring portfolios of collections of mutual funds. Email me at MikeLipper@Gmail.com, and I will send you a copy of the ten slides which might promote useful conversations with investors.

I mention this journey to highlight one of the advantages of spending sixteen hours in an airplane over the course of two days, the ability to have ample time to read, think and to write.

In the world that I inhabit of professional investors and their competent advisors, there are many opportunities for mistakes of judgment. During my flight home from Milan, I kept wondering why these smart people make dumb, unforced mistakes. In thinking about the mistakes that I and others have made, I realized that we all fell into traps. Most of these traps first started with the principles we utilized. We use tools for the impatient. Instead of celebrating data diversity, we use labels as a way to bunch information so we can quickly narrow our focus to making a selection from a pre-sorted list of alternatives. We believe that we can reasonably predict the relative outcome of the labeled alternatives. For example “growth,” “value,” stocks, bonds, developing markets and a whole bunch of other classifications. Our problem is the comfort brought by these and other navigation skills. One example is the ability to predict with a high degree of certainty our arrival time on an airplane trip covering more than five thousand miles with greater precision than our arrival time in our daily land-based commuting. In math and physics we are taught by problem-solving and experiments that there is only one correct answer, and to get it all one needs is to follow the prescribed formula. 

The focus of this post is the current traps that I see smart and perhaps very smart people falling into. They are examples of using labels that can lead to traps. They are not listed in any particular order. Pick your own trap as we all do.

Value

We all enjoy the warm feeling when we believe that we have bought a bargain. We want to pay a price at a significant discount from its true value. There are two traps here. The first is that we can mathematically determine the exact true value of something, including securities. The second is not being concerned with the seller’s motivations which could well change our evaluations and results.

One of the ideas that I hope to get over to the incredibly smart Caltech students (including Doctoral candidates as well as post-docs) that I will be addressing this week is that the person on the other side of the trade may be even smarter and may have better information.

Successful young investors

Having grown up in the investment business I have experienced and benefited from the battle for investment thinking supremacy between young analysts, portfolio managers, and investors and those who are older. Wisdom is not chronologically based, but the work being done at Caltech and elsewhere indicates that memory plays an important role in judgments. The cyclicality of markets and investment themes over time reinforces the need to avoid obvious risks. It has been many years since the general stock market has risen significantly above previous peak levels, thus many of today’s enthusiastic investors have only had the experience of the decline and recovery phases of the last five and ten years; they think a bull market is a new phenomenon. They don’t see that within every surge of higher prices and volume that there are built in time bombs of future problems. Some of these rises will produce spectacular results. Enjoy them, perhaps participate, but don’t count on today’s gainers getting you out ahead of time of their collapse, it will be new to them. In other words it could be a trap.

Book value’s trap

Many purveyors of investment products use a corporation’s book value as a measure of investment value. People tend to forget the calculation of book value is a balance sheet measure of subtracting the liabilities from the assets found on the balance sheet to get the equity and translating that to a book value of a corporation. This may be like choosing a new friend solely based on their precise phone number. Remember that the assets are shown on the basis of the cost to acquire them if they are demonstrably below their current market value. The liabilities are based on the size of known obligations. People tend to forget that the book value they were taught in college or graduate school as well as the CFA exams is a teaching device not a measure of reality.

A better way

As someone who has both bought and sold intellectual property companies and have advised others to do so, I have found book value is only of use in comparing other transactions when their true value is unknown. When one is privileged, or perhaps burdened, to get into the mind of the driver of the transaction, one sees an entirely different set of algebraic calculations. The first is what would be the cost to recreate that portion of the subject company’s customer relations and sales? This is then compared with the potential buyer’s estimate as to what it would cost to build the desired value itself and how long would it take.

The trap of overlooking human factors

All businesses have inherent problems usually involved with human relations. What will be the costs and bother to deal with these?  Most importantly can the buyer supply the talent needed to solve these issues? With those questions what are the balance sheet assets really worth to a particular buyer? One of the more difficult imponderables in evaluating an acquisition or disposal is the reactions to the announcement. What will the customers think and long-term what will they do?  What will the “good” employees do, what will the various regulators and communities attitudes be, what affect will the acquisition have on the acquiring company, will the combination lead to enhanced talents or to a talent drain? These are just some of the questions that should be determined.

Moving to the liabilities; do they reflect all the reasonable contingent costs including retention bonuses, possible adverse law suits and tax consequences, costs to shut down and move facilities and people, unmet needs for research and development and other elements of essential research? As one can see there are real differences between the real value of a company and stated book value. This is not to say that book value is meaningless.  If one can make the tentative judgment that the sum total of the missing factors are similar to the same or related questions of other transactions, the relative multiple of book value of other transactions is a somewhat useful guide as to the trend of deal pricing. (When I know more I prefer to use the metric of price times sales. Stratifying companies that are worth one half of their sales, or even better one times, two times, three times, and more is a good measure of what buyers believe the future value of an acquisition is.) My bottom line is that present valuation is a good current guess of future valuations, but you should not rely on book value as a sole measure.

Predictability of VIX

S&P Dow Jones Indices publishes monthly comments on various indices. In its latest commentary the first point was as follows:

  “The VIX is down over the past month and the current reading of 12.84 suggests that the potential for significant moves lies only to the upside…..The Australian, Hong Kong, and Canadian VIX equivalents are also down, a pattern repeated elsewhere across developed markets.” 

In its simplest terms the VIX is a measure of the implied volatility of S&P 500 Index options.  Often market professionals view the level of the VIX as a measure of fear operating within the market place. Considering the absolute closing high for the VIX was 80 in late 2008, one can see that currently there is not a great deal of price pessimism in the marketplaces around the world. As a contrarian this is exactly when a negative surprise could be its most potent. The sell off thus far in January, which appears to be worldwide, may be the trap that was sprung on those that use immediate market movements to predict future trends including turning points.

The failure of stock investors to pay attention to bonds

Stocks can surprise both positively and negatively. In most cases the best thing that can happen to owners of bonds is that they receive timely payment of interest and principal. Thus bond prices are more sensitive to potential bad news than the stock market. As a stock investor, I am aware that bond prices can be a useful warning device for me. Changes in credit ratings are often a coincident indicator of bond price movements. Nevertheless, they can be leading indicators for the general stock market prices. Moody’s^* has published a schedule of quarterly down grades and upgrades. For the 4^th quarter of 2013 there were 78 high yield downgrades (68 upgrades) and 21 downgrades of investment grade issuers (12 upgrades). The extreme downgrade readings were 303 for high yield and 93 for investment grade. 

^*Owned by me personally and/or by the private financial services fund I manage.

The current preponderance of downgrades in an economy that is meant to be recovering is a cause for one to be cautious about committing new money to the stock market.

Please share with me the traps that you have avoided and which ones are you wary about now.      

_____________________     

Did you miss Mike Lipper’s Blog last week?  Click here to read.

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Copyright © 2008 - 2014

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