Horses for Courses and Thoughts for Two of Four Time-Span Portfolios

Introduction

I believe whatever my analytical skills are, they got started at the New York racetracks. Thus for years the first Saturday in June was very important to me, even more important than the Chartered Financial Analyst (CFA) exam usually given on that same day.

The Belmont Stakes day is the single most important US thoroughbred race day in determining the future breeding fees for young stallions and in rare cases, mares. At a mile and half which is the longest race for three year-old horses, the winner is usually accorded the title of Best Three Year-old or even Horse of the Year in America. This year the question for the sports-oriented public was whether we would finally have a new Triple Crown winner after 36 years. The answer was no.

Linking these thoughts to what I currently do for a living which is picking the best fund accounts for my clients and other responsibilities, I have learned that it is wise to diversify my bets. I have never found a portfolio that could be the best in each and every time period and change of market conditions. With good horses and good managers there appears to be a finite season for successes; this is what prompted me to use “Horses for Courses” as the title for this post.

One of the questions facing investors every day is whether we are entering a new season or a new track and whether we can extrapolate from past performance records. The majority of the money bet on the Belmont Stakes was attempting to leverage the previous racing success of California Chrome and willing to accept low financial returns if this remarkable horse won. In this case it was not a wining bet and perhaps not even a smart one. Our job is to make smart bets that occasionally win enough to meet various investment needs.

Time Span Fund Portfolios-a recap

1. An Operating Portfolio is for immediate needs.
2. A Replenishment Portfolio is designed to produce the required funding after operational funding has been spent.
3. A Legacy Portfolio is designed to meet needs for those currently alive and/or beyond current management.
4. The Endowment Portfolio is for beyond our own lifetime and for future generations.

Replenishment Portfolio concerns

As regular subscribers to these posts have learned I am concerned about a parabolic rise in market prices followed by a major decline. While there are some early signs of a peak, we have not yet experienced the heady experience of excited enthusiasm which characterizes the run-up to an extended peak. However, each week I see some signs that make me nervous. The latest is work done by Morgan Stanley^*. In this piece the strategist does not see great parallels with past cycles. He postulates that we have entered a "no cycle" phase. His argument is based on comparisons with general economic data. To me he does not focus on the real causes for cycles which are human behavior that goes to extreme excesses from time to time. I see no evidence that we have changed people's behavior.

*Owned by me personally and/or by the private fund I manage

I am reminded that just before the 1929 crash (the real one) a learned economist and market guru said that we had reached a new plateau and in effect there would be no declines. If the recent Morgan Stanley view gets general acceptance I would be worried.

Lessons from history

One of the ways to study history is to identify the underlying causes from wars and other various tragedies. In the case of the First World War it was the assassination of the Archduke Franz Ferdinand and his wife. If my memory is correct one of the immediate causes of the 1987 market break was the inability of a United Airlines labor/management group to be able to use the airline’s gates at O'Hare Airport as collateral to support a buyout. I wonder if the extra large short positions in US Treasuries, copper, West Texas Intermediate (WTI) crude oil and Canadian dollars are issues of collateral for major traders including some hedge funds? Therefore the rumor or the reality of major bank having a new source of loan problems could prove to be quite disruptive.

The Replenishment Portfolio

For the management of the replenishment portfolio which normally has a five year time horizon perhaps the well known view about a glass that is partially filled could be useful. If the liquid is champagne, in addition to its level there will be bubbles, mostly small. The argument will be whether the glass is half full or half empty and as usual the focus will be immediate. I suggest that over time the level will decline due to evaporation. Over the next five years the odds increase that my concerns about a major market break could occur.  Thus these interim portfolios should be sensitive to any signs of market disruptions.

The Endowment Portfolio

In previous posts I have suggested that an important part of this portfolio class be invested in disruptive companies. A long-term subscriber asked whether this was just a collection of opportunistic investments. Not in my mind; the key to opportunistic investing is entering at a particularly attractive price at a good time. In contrast the investments that I believe should be in these portfolios will be companies that will profitably benefit from important if not major changes to the global economy. These will not be evolutionary or innovative changes. They will introduce radically different ways of thinking similar to the impacts of cell phones, sulphur drugs and steam engines.

 
In The Wall Street Journal, Jason Zweig discusses James Anderson, a successful portfolio manager for Vanguard and Baillie Gifford. As indicated in the article he is attempting to put together a portfolio, possibly for the next one hundred years, of technologically elite companies and similar leaders which have been recognized and currently sell at high valuations.  Anderson believes great innovative companies will continue to be great and innovative. While some of these well known stocks might be represented in my preferred fund portfolio, there will be other names of smaller, perhaps tiny companies.

Why I disagree

There are three reasons for my departure from the views reported above. The first reason is based on a discussion in Nantucket with Dr. Phil Neches who has three degrees from Caltech and is a fellow Trustee with me. Phil's commercial experience has been in disruptive companies as a founder, chief technical/scientific officer and venture capitalist. In Phil’s opinion, with rare exception disruptive companies can maintain their ability to be disruptive for only two generations. This view makes sense to me as an investor. Thus there will be a need to prune the portfolio of what our British friends call "the worthies."

The second reason is that disruption from start-up to commercial viability usually takes time. During this gestation period the market usually does not put high valuations on these companies, which gives the knowledgeable investor a chance for a relative bargain.

The third reason is that all company investments run the risk that successive managements do what turns out to be dumb things. Thus, even long-term, future-oriented portfolios should not follow a complete buy and hold strategy. I like to see understandable selling.

Which time spans concern you most?

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Copyright © 2008 - 2014

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

Premature Selling Is Tough but Beneficial

Introduction

The vast majority of investment literature for professionals is about smart buying. Most professional investors pride themselves on their timing of purchases and thus focus on current conditions. While nothing in the art form of investing is easy, buying correctly is much easier than selling. But as active investment managers we should feel responsible for doing the difficult tasks to earn our premium pay over the mechanics, extrapolators and closet indexers.

From a career standpoint, unfortunately there is little difference from selling too soon and being considered wrong. However, any who have experienced the emotional trial of selling into a declining market have learned that it is even more difficult. All too often what appears to be a market break is a hesitation in a continuing bull market. Nevertheless, I believe I have an obligation to protect against significant capital losses for both my paying clients and the non-profit institutions I serve as a volunteer.

As many of my readers have learned I believe that my two great learning experiences were learning to handicap (analyze) at the race track and taking responsibility for my troops as an officer in the US Marine Corps. Thus I approach my current responsibilities today. Based on past analyses of recorded stock market bubbles, I believe that the odds are that some time over the next five years we could experience a major global decline in many stock and bond markets. While as Marines we would prefer to attack than defend, we have learned to capture an advantage after a hard fight. After more than doubling from the bottom of March of 2009, we should prepare our defensive positions. The enemies, or if you will the losers, that we won our advantage from will try to recapture their lost ground.

Excessive enthusiasm is not currently present, but momentum is growing

At the peaks of classic market tops, both professionals and the general investing public often plan lifestyle changes to take advantage of the wonderful new era that the markets appear to be promising. People pull cash out of savings and all too often the equity in their homes to put into the market. I remember commuting on the train with an acquaintance who announced that he would no longer be going to a well paid job at a major company. He was going to say home and day trade one stock from the Dot Com Bubble that was sweeping the country and much of the developed world.

As we examine the current US equity market, bear in mind that the NASDAQ 100 Index (the 101 largest non-financial stocks traded on the NASDAQ^* market) is selling at its highest price since September of 2000. Also the short interest ratio in these stocks has moved up to 5.02 days from 4.66 days just two weeks earlier. 

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

We are not there yet. Confidence is improving both in the US and elsewhere, particularly in Europe and India with both Italy and India’s stock market showing 14% gains. Stock and bond prices are moving up with little in the way of earnings, dividends, interest income, or economic support. If this momentum accelerates and the gap between market prices and fundamentals gets to be too wide, a sharp fall could occur. Jason Zweig in the weekend edition of The Wall Street Journal summed it up well; “Those with unrealistic expectations are the first to panic after the slightest disappointment.” Unfortunately too many won’t panic as they will believe that it is just a temporary disappointment which will be reversed shortly. When the second or third disappointment happens, assets will be dumped at whatever the available prices are. The term complacency is being used frequently which indicates that investors currently are not worried. Also the same lack of immediate fear is shown in the CBOE’s VIX measure that is at its lowest level in more than a year.

Six items to consider when disposing of funds or managers

Our investment practice is to invest in funds, mostly open-end mutual funds. Recently we were asked in a formal Request For Proposal (RFP) to manage an institutional account what would cause us to sell or redeem a fund. This is an on-going process, but is taking on additional importance now that we are preparing for a peak and subsequent decline.

1. The first consideration is when a client’s needs change. We work with the client to anticipate changes both internal and external. Often in poor economic times various non-profits believe that they should increase their spending. We need to be able to support this change in planned spending rates. For corporate accounts poor economic conditions can cause lay offs which will affect retirement payouts. Also during poor periods some surviving companies see opportunities to make attractive purchases and thus cash is needed.
2. The second consideration I learned from the phrase used by the late Sir John Templeton which is that there are better bargains outside of the portfolio than in it. This is an easy choice when the client only pays excise taxes or none. For a tax paying client including in the switching costs are tax estimates including state taxes as well as federal.
3. The third consideration is when a portfolio manager or key analyst who is deemed to be critical to the investment results leaves or has significantly less time to devote to the fund. One needs to quickly assess the team around the manager who at least temporarily will manage the portfolio.
4. The fourth consideration is one of too much success. Can the existing portfolio manager handle a sharp increase in assets?  A related consideration is whether the very success of the fund has brought in more high quality competition that will make the job of the portfolio manager more difficult.
5. The fifth consideration is unexplained performance both on the upside as well as on the downside. Is the fund changing and why?
6. The sixth consideration is if the management company undergoes a significant change in ownership or organizational structure. This is of particular importance if it affects the fees and expenses of the fund and the financial/psychic income of the key portfolio managers, analysts, and traders.

Note that performance ranking is not a direct consideration. If we do our job correctly and particularly understand the underlying portfolio, the performance over time will take care of itself.

Please share with me publicly or in private communications what are your rules for switching investments and how are you preparing for the next bear market?  

_________________

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Copyright © 2008 - 2014

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

Fears of Buyers and Sellers

Introduction

Often the price battle between buyers and sellers is described as the battle between fear and greed. Currently I see the conflict as being between two vastly different sets of fears with very little greed motivation being shown. The focus is on not whether the proverbial glass is half full but rather, what will be the forces that change the water level? What is interesting is that both sides are being driven by fears.

Buyers’ fears

Today’s buyers are afraid of 2013. They are fearful that the near-term stock and bond markets will accelerate and once again they will be shut out of producing index-like returns. One can label this as a competitive threat that another period of underperformance will cause investor accounts to move. On a personal level the fear is the absence of bragging rights at the next gathering of smart people.

While in reality hedge funds are not a separate asset class, the popular image is that they represent highly sophisticated, smart, aggressive managers. In some cases this is an accurate description of managers who have richly rewarded good long-term records. The above average gains of the general markets in 2013 surprised many who significantly under performed. They don’t want this to happen to them again in 2014. This year the markets have incrementally advanced. Last week the S&P500 for the first time closed above 1900. To avoid a competitive repeat of 2013, certain managers are increasing their use of historically low interest rate leverage. We see this in the different directions of net flows in Exchange Traded Funds (ETFs) and similar portfolios of mutual funds. In April, equity ETFs attracted 17.6 billion compared to 12.6 in March, all of the gain was in World Equity ETFs.  

Large ETF positions in hedge funds include those that invest in emerging markets, gold and long-term bond indexes. (During the same periods Small Cap mutual funds saw over $2 billion in net redemptions as compared with net sales in March. Normally small caps are favored by some institutional investors, including hedge funds because it takes less money to move these stocks.) In the past the hedging method favored by some funds fearing price slumps in the S&P500 was the purchase of VIX contracts. In the latest week these contracts hit their low for the year, clearly indicating little fears of declines.

Adding to buyers’ fears, Germany’s DAX Index reached an all time high on the Monday holiday when the US markets were closed.

Sellers’ concerns

Normally buyers are more future-oriented than sellers. After all, since the beginning of the history of the Dow Jones Industrial Average the market has gone up two years out of three.  Thus for the buyers, when the future came it was positive. Today the sellers look at the future and see the past. They see many of the elements that led to the 2007-2009 financial markets crisis. They can be persuaded to slowly sell some of their long-term positions as market prices rotate upward.

Manipulation by governments and central banks

Once again we see activist governments and their central banks attempting to offset slowdowns in their general economies by pushing up the demand for housing. Just recently US federal agencies have been urging the lowering of the underwriting standards for residential mortgages. Combine this with artificially low interest rates and the result is the residential housing market getting injected with venom that can be dangerous to the markets as well as the whole society. Based on past experience it is reasonable to expect that an increasing number of these mortgages will default. When faced with large unpaid debts the past practice of these activist governments was to socialize the losses through various forms of bailouts financed through higher tax realizations. (They ignore past financial history that finds that after a collapse new and/or sounder financial organizations come into being to provide the necessary functions that lead to the overburdened debtors’ collapse.)

The fundamental problem with artificially low interest rates is that it underprices both credit and inflation risks. Within the payment of interest there should be, in effect, an insurance payment for slow to non-payment of the loan and interest. At the current low rates, credit risk premiums are not being effectively paid. They can get away with this for awhile as the huge underfunding of global retirement needs is driving savers into chasing for yield. (CCC-rated paper and bonds are being urgently sought after.) This is a long term problem with only an estimated one quarter of Americans saving for retirement.

Investors appear to be fearful that the central banks will eventually succeed in creating enough inflation that their nominal economies will expand at an acceptable rate. The goal of many central banks is to have a 2% or higher rate of inflation. To protect themselves, institutional and individual investors are plowing into TIPS (Treasury Inflation Protected Securities) to such a degree that the price on the 10 year TIPS is now yielding 0.297%. Clearly current interest rates are not covering credit and inflation concerns.

A Time Span Portfolio Solution

My favored approach is to divide the investment responsibilities into four time-spans based on funding needs and goals.

Under the current “new normal” interest rate environment, the shortest duration portfolio (the ‘Operating Portfolio’) will run out of money sooner than expected. The second portfolio, (the ‘Replenishment Portfolio’) has to carefully trade off liquidity for current yield. This could mean lengthening duration from three to five years. I recommend investors search for reasonably well protected and growing dividend streams. The third Time Span Portfolio,  (the ‘Legacy Portfolio’) should be all equity that can survive a normal recession and still build purchasing power in excess of spending. The fourth portfolio or (the ‘Endowment Portfolio’) should be positioned to recognize and take advantage of commercial disruptions that can lead to outsized returns after inflation, expense creep, and relevant taxes.

A question facing all of us

What are we going to do with the capital liberated by selling that won’t be sucked into either spending or chasing prices?

Memorial Day

This blog post has been delayed one day due to the Memorial Day weekend. 

On this day we are thankful for all of those who sacrificed their lives so that we may be free.

__________________

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

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

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

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