“The Risk to Worry About” - Weekly Blog # 517.

Introduction

Recently I ran into an old friend at a cocktail party who is retired from being the managing editor of a trade newspaper. He expressed concern as to his own investments with the current volatility. I suggested that the time he should have been worrying about risk was during the fourteen months ending in January, after nine years of rising markets! He was much more comfortable with gradual gains and no declines greater than 3%. I said he should have been worried about risk when others were not, which is perhaps the best measure of the reciprocal level of certainty that a large number of pundits proclaim.

You never know about the future, but one can guess what you don’t know. While in the US Marines as an officer, we were instructed when planning for an operation to identify the essential elements of information (EEI). We quickly learned that it was rare to have as much as 70% of the EEI. Applying the same approach to handicapping at the racetrack, I was pleased to find 60% of the EEI. I feel the same today when selecting individual stocks and funds.

I suggest that in each of our attempts to measure risk, the largest single risk is the unknown and it rises when the pundits are more certain.

Is the Public Smarter?

“Americans Hold Off on Spending Extra Tax Dollars” was a page 2 headline in The Wall Street Journal on Friday. In addition, February was the third month that overall retail sales were slightly off from prior months. Consumer spending was up +0.2% compared to a rise in wages of +0.4%. This was not what was expected. I cheered this announcement as it demonstrates consumers are acting rationally. In the end, the article did point out that a number of consumers were using their tax benefit dollars to reduce their high interest loans. (Economists would label this as savings or deferred spending.) 

Consumers should be fearful of increased state and local taxes as well as increased fees paid to government agencies, and for business sales/use taxes. They should be saving and investing to reduce their growing retirement capital deficit. I don’t know whether it has yet entered into the public’s psyche that there is a chance that the purchase prices of their items will bear the costs mentioned and possibly the impact of tariffs.

A Second Example of Consumer Smarts

For the last several years American investors have been net buyers of “non-domestic equity funds.” I am guessing that these buyers are not largely the same fund investors that have been redeeming older domestic equity funds. I believe the redeemers are completing their expected retirement, estate building, and large purchase needs. To the extent that older fund investors are adding foreign stock investments, they are hedging their domestic equity funds. For a number of years the US dollar has been weak compared with other currencies and deservedly so. Despite foreign investors buying US securities for refuge, it makes sense for US investors to invest overseas. Often there are lower valuations in local markets, which makes sense when considering they are also in less liquid markets. They are also unique investments not found within US borders.

Traders are also buying more overseas investments while redeeming domestic ones. Each week my old firm, now a part of Thomson Reuters, measures the net flows of both conventional mutual funds and Exchange Traded Funds and Exchange Traded Notes. For the last week, ending on Wednesday, ETFs had net redemptions of $11.5 Billion in domestic equity vehicles while conventional mutual funds had $2.5 Billion. (Remember the assets of ETFs are much smaller than conventional mutual funds.) It is worth noting that just two ETFs had combined net redemptions of $10.6 Billion in S&P 500 invested portfolios. This suggests to me that the redemptions came from a small group of trading desks and not the general public.

The fallacy of the “risk on/risk off” approach

The financial media has gotten into the habit of describing market movements as either “risk on” or “risk off.” This is simplistic but can be a binary switch for a quantitative portfolio. It assumes that the investor has identified the risks. Perhaps, this in and of itself is a big risk.  Many can produce a roster of risks. Few can weight them. Fewer still can set the time when their impact will be felt.

The fallacy of the “risk on/ risk off” approach is that it is one directional. At all times we should be looking at both the opportunity for risk and reward. In this case those that invest in mutual funds have an advantage over those that use only individual securities. Mutual funds have flows that many individual investments don’t have. Flows drive buy and sell reactions which cause the portfolio to change. (Often a fund in net redemption benefits from pruning the least attractive current holdings and has an additional opportunity to switch into new investments.) 

Regardless of how one’s portfolio is structured, you should always be looking to add opportunity.

Quotes from Berkshire Hathaway’s Annual Report*

While Warren Buffet lays out their thinking about acquisitions of companies, the principles can be applied to selected individual stocks.

•     good returns on net tangible assets and a sensible price

•   “We evaluate acquisitions on an all-equity basis.”

•  “Betting on people can sometimes be more certain than betting on       physical assets” (I would include shown financial assets.)

•  Berkshire’s goal is to substantially increase the earnings of the non-insurance group through a large acquisition.

•   Berkshire has suffered four short-term price declines of 59.1%, 37.1%, 48.9% and 50.7%.

•  “An unsettled mind will not make good decisions.”

• “Charlie and I will focus on investments and capital allocation.”

Perhaps the single most important clue to Berkshire Hathaway’s long-term thinking is the following statement:

• “The Yahoo broadcast of the meetings and interviews will be translated simultaneously into Mandarin.”

*Held in client and personal portfolios

Question of the Week: What are the risks to your portfolio that others don’t see?

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A Good Week for Long-Term Stock Investors - Weekly Blog # 516

Introduction

“Six months ago everything was good you couldn’t find a reason to sell stocks. Now you can’t find a reason to hold them.”  I was delighted to read this quote in The Wall Street Journal. I only hope there are more expressed sentiments of discouragement. As our subscribers have learned, such views and increased volume of transactions are necessary to have a successful test of a bottom. The actual index close can be higher, lower, or equal to the questioned low point, but without a change in sentiment it is just statistics.

Parsing out the quote I found the singular buy and sell driver encapsulated in one word, “a”. Perhaps it is my long training as an analyst and portfolio manager, as well as a racetrack handicapper, or just living through these times. However, I have never not had conflicting reasons to buy or sell or take any other actions. One of the training techniques for salespeople when trying to make a sale is called “The Ben Franklin Close”. Perhaps the wisest of the Founding Fathers, who was essentially a successful businessman, used the approach of listing the plusses and minuses of a proposal in two columns on a single page. As long as the potential buyer accepted the validity of the list and the positives out-numbered the negatives, Ben Franklin closed the deal. To make a final decision, I require the weighting of each listed item not just the number of items. My experience has made me a contrarian. I always have doubts.

Investors make the most money in periods of doubt. These periods of doubt are often ones where the bulk of the “experts” are on one side or the other. For example, the vast group of experts who were against the British leaving the European Union predicted dire results if the foolish people voted for Brexit. They predicted unemployment would rise significantly, the value of the currency would drop, and London would be deserted by the financial community. In a front page article in the weekend WSJ Review section, a British editor indicated that the Brits are doing just fine. Unemployment is the lowest it has been in years and the pound is higher than it has been in some time. Additionally, the number of the financial people being transferred to the Continent appears to be in the hundreds not the thousands predicted.

Recognizing that I can and have been wrong, or at least premature, periods of doubt represent opportunities that “experts” can be wrong. After all, the Western Hemisphere was discovered during a period where many “experts” believed the earth to be flat, because they could not see beyond the horizon. By definition, long term investors must look beyond their current horizons.

An Explanation via Fund Data

Investment Performance

One of the main differences between growth and value fund investors is the time horizon expected to bring gains.

The growth investor is looking to a brighter future for the companies in which they invest. Value investors are betting that there will come a time when the values they perceive become more appreciated. Over time both have produced good results, but at different times. (This is why in many of our fund portfolios there is a sample of each discipline. Due to the long underperformance of value-driven funds, a contrarian might start to nibble. It is quite possible in the next wave of acquisition activity that smart acquirers will recognize the value properties before the market does.)

Currently, while the “popular” media is full of headlines as to problems, successful investors are evidently favoring growth. In the year to March 22nd, most equity funds are down a bit, but there are only eight fund peer group averages that are up 3% or more. Of the US Diversified Equity funds, only the four growth fund categories produced 3% or more. In the Sector fund group, just the Global Science and Technology funds make the grade, and they were higher than the Growth funds. Just two other investment objective categories: Latin American funds and China Region funds made the 3% gainers leaders.

Flows

While exchange traded products are governed by many of the same regulations as conventional mutual funds, the reasons their owners use them are different, therefore they should not all be lumped together in deciding market implications. The vast bulk of the money in ETFs and ETNs is invested in broad Index funds, which are primarily used by trading entities like hedge funds and discretionary advisors. In numerous cases these have replaced more expensive derivatives.

Mutual funds, a much older investment vehicle, were primarily designed for retirement, estate building, and other long-term needs. They are found in individual accounts, defined contribution plans [401k], and individual retirement accounts [IRA]. As the participants fulfill their needs they redeem their existing funds and use the money, or change to more conservative investment options. For many years growth funds were among the most popular funds, performing quite well and above most retirement measures. Because of the lack of growth of new investors, redemptions are not being offset by new sales. To my mind these are “completions” of earlier promises.

To respond to the lack of growth in sales of funds at the retail level, brokers in the US and elsewhere have been reducing the number of funds being offered and reducing the number of fund houses with which they are dealing. Funds are not the most profitable products for brokers and some managers. At some point this may change.

On the Horizon

Committees in the US Congress and the Administration are working on a second tax bill. Some of the possible provisions address the need to create more retirement capital in the US. Other countries are also addressing the lack of sufficient retirement capital in an era of extending life spans, expensive health care, and slower to no worker growth. Seniors vote, while often young people don’t.

Conclusions

Despite perceived and perhaps more importantly unperceived problems, equity risk investing is needed by the world and will happen.

The more people sell the more opportunities exist for the patient buyers and their advisors.

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Investors Need to be Wrong to be Right – Weekly Blog # 515

Introduction

Investing is an art not a science. In science the search is for a repeatable answer under every identified condition. As strong as it may seem to many, the search is not in the end the largest performance number. The search is the delivery of the required funds to meet the accepted needs of the beneficiaries; be they institutions or individuals investing within the realms of prudence. Thus, the investment manager’s primary function is to aid in the feeling of the well-being of the beneficiary. According to a recent report on happiness as applied to nations, well-being is based on income, healthy life expectancy, social support, freedom, trust, and generosity. It is far easier to contribute to well-being through sound investing. I believe our clients hire us to provide sound investments for them in order to accomplish their well-being. Thus far I have been able to deliver. But much of this is not based on the certainty of math and science that I learned in school and university, but as a handicapper at the New York racetracks. From an investment standpoint what I learned at the track that is useful can be summarized as follows:

1.  The objective is not to win every race but to finish the day as a winner (including expenses).

2.  Don’t bet on every race, there could even be days when no bets are made as the payoff odds are not appropriate to the probabilities foreseen.

3.  Occasionally the most popular bet is logical in terms of expected results, but the payoffs are too low because it doesn’t take into consideration what can be called “racing luck.” At these times it could make sense to invest in the second or third most logical horse if they are being offered at reasonable odds for second or third place and turn into larger money makers if racing luck overcomes the favorite. This is a good bet as favorites rarely win, even half the time.

4.  After concluding the most logical result, the real analysis begins, which is how much should be bet on this horse in this race? Weighting one’s bets can make the difference of a nice win vs loss record and walking away as a winner for the day.

5.  Accepting that I was wrong an uncomfortable number of times, but learning from the experience by re-examining both my analysis and how I handled my money and to a lesser degree my expenses.

Thus, I believe that, like other investors, I will be wrong in terms of market direction, sectors, “factors” and selections. To defend our beneficiaries’ interests I have adopted a policy of having a number of different bets at the same time, but with the recognition that unlike at the track where races end, the investment process continues through many cyclical periods.

“Goldilocks” May Be Leaving

Liz Ann Sonders of Charles Schwab among others is raising concerns about the future. After all, for at least nine years it has been somewhat easy to ride the secular rise in the US stock market. (Shorter periods for other stock markets.) This issue brings up a number of questions: evidence of impending change and what should be the correct investment policy going forward. In terms of evidence of impending change there are two important elements:  flows into stocks are from traders not investors and credits may be mispriced leading to fixed income not providing stable values. This week some in the press for the first time are heralding significant flows into the equity market from “funds”, which shows the Public is buying the current conditions. The truth, according to Thomson Reuters’ Lipper Inc., is that $20.4 Billion came in net, but $18.7 Billion went into domestic oriented ETFs with $8.2 Billion going into the SPDR S&P 500 and $3.1 Billion into PowerShares (Invesco*) QQQ. Both of these are favorites of hedge funds and other traders. In numerous cases ETFs and ETNs are being used by these players as substitutes for futures which are more expensive. I am noting that a number of investors have sold short some ETFs that represent over 10% of their assets and in at least one case over 100%. What may be more disturbing is that a number of independent investment advisors and a number of advisors working through brokerage firms are managing discretionary accounts exclusively in ETFs/ETNs. Some of these are probably good, but I suspect many do not have any successful background in market trends, sectors, “factors” and the selection of individual securities. They may be, along with others, contributing to a much higher turnover rate in ETF/ETN portfolios than conventional mutual funds.

*Invesco is held in a private Financial services fund and personal accounts that I manage.

Credit Concerns

Remember that most significant stock market declines begin after a period of fixed income market declines. Through March 15th most bond funds are showing a slightly negative total return, which includes both their income and their market movement. The only domestic groups that are not negative are loan participation funds, some specialized credit vehicles, and ultra short maturity funds. I don’t know when the next recession will commence, but I expect it will be within this first term of the President. I do know that during a recession bankruptcies and other financial difficulties occur and they are not being priced into the market. Institutional term loans are being priced at only 3.2% above prime corporates, compared with 3.1 % before the crisis that began in 2007-8. Further, while banks have much more capital than they did before the last crisis, their book of derivatives is somewhat higher.

In a talk at a Futures conference last week, my old friend Tom Russo, formerly General Counsel to Lehman Brothers, mentioned that when a counter-party believes it was duped, the entire class may be considered illegal as an auditor will have difficulty claiming the asset is worth 100 cents on the dollar. He said, according to the Financial Times, that “when you owe a little bit you call your bank - when you owe a lot you call your lawyer. “A good bit of derivatives are directly or indirectly financed through the credit market.

What Should Investors Be Doing Now?

There is no special reason for long-term investment policy to be changed as long as it contemplates that there will be periodic market declines. This is similar to money that is invested in what we label Legacy and Endowment Timespan L Portfolios®. For those with a shorter focus of at least five years, they should be making two lists of equities and equity managers.

The first list should be of items that at higher prices would become risky if the general stock market rises at a rapid rate. (There is some chance of this happening as new money rushes in on the basis of buy-the-dip or FOMO fear of missing out.) The risk is that such a surge most often leads to a major fall, which could lead to structural changes. The second list should be labeled “Hopefully not to be used, but probably will be.” It is a list of sound companies and managers who may be slightly damaged in a decline but will survive and prosper. Both of these lists should have names and prices scaled to avoid emotional price reactions. Five or ten price points could be prudent.
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Danger Ahead, New High Stock Market: Is Capital Preservation with Appreciation the Answer? Weekly Blog # 514

Introduction

At the end of February I was about to suggest that both the high and low for the year 2018 were in place. If either price was violated it would be troublesome. After the first nine days in March I am getting much more concerned about a breakout above the January highs.

Why are Higher Prices Dangerous?

Perhaps I am jumping to the wrong conclusions, but for many the 400 point rise of the Dow Jones Industrial Average on Friday can be chalked up to volatility, but others may see it as a successful test of the February lows. (I would have preferred a lower test with more volume of trading and statements of discouragements.) But the realist needs to accept reality, not wait for the perfect. There is a good chance that others will see it as a successful test, encouraging buyers with significant power to return and drive the next upward move. Using the very volatile sample by the AAII, 45.2% of their surveyed members are now neutral, which is higher than both their bullish and bearish members. This is a rapid change from just three weeks ago where the neutral tally was 32.6%. In the recent week the top 25 performing mutual funds had gains between +7.77% and +6.07%. All but one of these were growth oriented and or specifically science & tech oriented. 

Thomson Reuters tallies analysts’ earnings estimates and in their latest report the analysts expect the S&P600 Small Caps to have earnings growth for this year of +24.1%  compared with +19.45% for the S&P 500 and +37.67% for the Russell 2000. Both the fund performance leaders and earnings estimates are based on a belief that the future is going to be good, led by positive future developments in terms of technology, politics, and economics. (Perhaps they will be correct.)

After nine years of rising markets, I have been on the lookout for signs of an inevitable market decline. In terms of magnitude of decline a normal cyclical decline is in the range of 25%. These happen normally once within a decade. Not too many people are psychologically wiped out in these declines and usually return to the stock market within a few years after the decline.

A much more serious fall, that is often labeled a collapse, happens infrequently, normally once a generation and is generally in the range of 50% from the peak and has investors leaving the marketplace never to return, This type of fall is in the passing on their distrust of the market to the next generation. The individual and societal losses from these collapses are relatively small compared to the forgone profits from the recoveries, which impacts the rest of their lives and often also the next generation’s. As both a fiduciary and an investor I would like to avoid these results. I attempt to do this with an eye on a number of different market histories.

The major traumatic collapses start with apparently successful investing, that not only turns a small amount of money into a larger amount of money but inflates the investor’s belief in their own investment skills. Often this confidence leads to the use of borrowed money in the forms of margin or derivatives. A speculative fever takes over the crowd, while they recognize there is some risk their confidence is such that they can get out without large losses.

The driver of these “animal instincts” is based on an unshakeable view of the future. These speculative markets are driven by sentiment, not researched fundamental investing. This is why I am paying more attention to measures of sentiment, along with attention to internal financial calculations.  One of the fuels of a major top is the sucking into the market of all or most of the available cash.

Assuming the US and perhaps other markets pierce their former highs, the various pundits, including non-professionals, will proclaim that those not participating are stupid. They have never studied handicapping at the racetrack where in each race there is likely to be at least one horse with a good, very current record receiving a disproportionate amount of the betting money. This is the favorite of the crowd, no different than the current market where leading funds are heavily invested in a select group of multinational tech companies. At the track, while the favorites do win at short odds, they don’t win enough money to cover the losing bets the majority of the time.

I am concerned that over the next year or so too many investors, including those institutions that are de-risking, will get sucked into the market. My fear is not for them alone after their disappointment of losses from the next peak, but for the opportunity losses in a future recovery. Unfortunately in our society these are the losses that are socialized for the rest of us to pay.

What are the Signs to Watch?

Currently, the most visible largely speculative source of flows into and out of the market are the Exchange Traded Funds (ETFs). Much of the current activity in these securities is by traders, often at hedge funds, who are using ETFs rather than more expensive derivatives. In the last week, while the larger mutual fund industry had a small net inflow due to net purchases of non-domestic funds ($2Billion), ETFs had a net outflow of $12.6 Billion with $10.3 Billion in one ETF invested in the S&P 500. This is a sign of a trading market that has lots of speculation occurring.

The second item to watch for soon is mutual fund advertisements heralding their ten-year performance results, which had been trailing more current periods. It is easy to look good from a bottom in March of 2009.  These market efforts could bring a lot of unsophisticated money into the stock market, which will entice the so called sophisticated players to trade the market on the way up convinced that they can get out in time.

What can a Wise Investor Do?

In an over simplification, portfolio strategies can be divided into two buckets: Capital Preservation and Capital Appreciation. For some of our clients, particularly those who have worked hard for their money, their primary concern is capital preservation. This is particularly difficult today if one is concerned about after inflation and after tax earnings. Around the world, governments in theory are sponsoring inflation as a way to create jobs, by ballooning the income of businesses and individuals. What they are actually doing but not discussing is lowering the purchasing power of the loans that they are repaying. This is a continuation of a trend, as governments since their beginnings have debased their currency as a way to payback less value than what they received. 

To the capital owner and the individual, inflation is another form of taxation. In the current environment income taxes are not the only source of pain. Because of the recent changes in the US tax code, I believe we will see an aggregate increase in fees, tariffs, sales and use taxes, as well as various forms of value added taxes. If the job of capital preservation is to maintain the purchasing power of capital, it must earn more than inflation, all taxes, and other distributions. I suggest that in the current market, high quality bonds can’t produce the necessary income. (That is why in our TIMESPAN L Portfolios® we should only have fixed income in the Operational Portfolio.)

At this juncture, until we see much higher real interest rates, the best suggestion is high quality stocks whose yields are in the range of the ten year treasury and have a history of periodically raising dividends roughly in line with inflation. One would like to find dividend payout ratios below 50% of earnings, if possible. In truth that is going to be difficult to do with appropriate diversification.

As a practical matter many accounts are going to have to dip into the capital appreciation bucket. In selecting funds or stocks I would array them based on a guess of how many years into the future the particular issuer will pay a dividend that would qualify for inclusion in the capital preservation bucket. In some cases this may be in only a few years. In others, like with Berkshire Hathaway* and Amazon, the indefinite future may be too short. In these cases the willingness to periodically sell off some of the appreciation to fund the preservation bucket could allow the position to be in the portfolio.

* Owned in both a financial sector fund and personal accounts that I manage

<b>Questions of the week:

What portions of your portfolio do you consider Capital Preservation and Capital Appreciation? Do you expect to change these based on market cycles?  

Investors Should Use Microscopes – Weekly Blog # 513

Introduction

Learning experiences occur everyday for investors with an active, searching mindset. We can see their importance more clearly if we utilize a number of tools. At this point in the market’s evolution from a combination of volatility and no forward progress for many stocks, we should be searching for some guides for both our investment emotions and our considered actions. I am suggesting there may be some valuable insights being offered by looking through a microscope as to very recent investment performance for equities and fixed income.

 Current Views through a Microscope – Equities

One of the basic beliefs supporting market analysis is that from time to time the ownership of stocks rotates from “strong” sound, long- term holders to short-term oriented momentum trading “weak” players. Strong and weak are applied loyally to their current holdings. In theory the market’s purpose for periodic meaningful declines is to shake out the weak holders selling at indiscriminate prices; e.g., offering bargain prices to strong buyers who foresee longer term value at these depressed prices. Historically, after a low price is followed by a rally, the question comes up whether the low price is actually the bottom of the move. Often a second or even a third down move “test” is required to convince some strong investors to be buyers. These tests can be at or somewhat near the prior low price. For me it is not only the price move that is critical in declaring a bottom. What I look for is a dramatic change in attitude on the part of the sellers who are exhausted from the emotions of the decline and proclaim they are leaving the game, often calling it “fixed.” At the moment I am not hearing this lament from the sellers. Thus, I believe the February bottom to be a weak bottom. Most of the time weak bottoms are not when the base for subsequent, substantially new highs are generated.

With the above thoughts in mind I wonder whether the stock market, not individual stocks has seen its high in January, which would fit the pattern of post performance from a prior good year.

For Those Committed to Equities for the Long-Term

Many of us have responsibilities to be largely invested in stocks or stock funds because the history of successful large macro bets is poor for many that have tried. Getting three successive correct decisions (Buy-Sell-Buy) in a row has proved to be difficult for most who try. Thus for the rest of us professionals we try to produce the best returns that we can within our prescribed market.

One of the reasons that all institutional investors should pay attention to the results of mutual funds is in aggregate they are the best contemporaneous record of institutional money. (Bear in mind many of the mutual fund management shops manage a great deal of money in non-mutual fund accounts, but use many of the same securities and strategies.) By using a microscope on the very small number of average mutual fund performance through March 1st, one can see some useful patterns. The average US oriented diversified fund declined only -0.31% where the average sector fund fell -3.13 % and the average world equity fund gained +0.11%. What these numbers suggest to me is that during periods of volatility liquidity is important. Further, that an important part of short-term global investing are the inputs from currencies.

There are some other lessons from this study. The best diversified US oriented fund category was the Large-cap Growth funds, which gained +4.02%. (Part of the gain is probably due to investments in a small number of globally oriented tech companies; the average Global Science & Tech fund rose +6.36%) What is significant about the leading performance of the Large Cap Growth funds is that in most weeks it has the largest redemptions. Contrary to the popular view that redemptions are a sign of disappointment in returns, (as these are often the oldest funds many investors own) the redemptions are the completion of particular phases in an investor’s life cycle; e.g., retirement.

Fixed Income through the Microscope

Utilizing the mutual fund data through March 1st, the average domestic fixed income fund was down -0.91%. Not particularly helpful to balanced accounts that were looking to fixed income gains for stability to offset equity losses. Institutional investors and some retail investors did find better investments than the general bond market in Loan Participation funds (Bank Loans) +0.97% and Emerging Market Debt funds in local currencies +2.65%. To emphasize, the importance of currency in Emerging Market Debt fund investing, bonds traded in dollars were down -0.63%.

In reading the annual reports of fixed income funds that our clients own, I found the following statement, “Credit sector is less compelling.” This particular fund has a long history of providing slightly above average income with less downside than most of its peers. Currently, they are sitting with shorter duration bonds or higher quality.

I have written in the past of my unease with the growth of credit funds, both in the US and globally. The leading bank distributing syndicated loans is Bank of America, not one of the leaders that I know of in credit research. The search for yield has been a trap in the past.
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Investment Lessons from “The Phil,” “The General” and Warren - Weekly Blog # 512

Introduction

I look for valuable investment lessons from exposure rather than only from annual reports, company statements, and the financial media. I often find lessons learned from beyond the investment arena as more meaningful. Over the last weekend I was blessed to have three exposures which gave me valuable insights. The three were: The Vienna Philharmonic Orchestra, General George Washington, and Warren Buffett.

Investment Lessons from “The Vienna Phil” Friday Night

               

They played an all Brahms Program beautifully.  I will let others in the packed audience comment on his Academic Overture (university drinking songs), eight variations on Haydn’s masterful work, and his long delayed symphony No 1. But sitting in Carnegie Hall Friday night, two important observations came to me. The first with the aid of The Playbill was that it was very difficult to produce high quality music in very different musical formats. In particular, it was said at the time no one liked his first symphony, except that over time it became viewed as the best first symphony ever written. Further, Brahms was considered the best composer of his era and the best successor to Beethoven’s crown.

In thinking about the comments on his work, it is somewhat parallel to what we and many others do in assembling a portfolio of managers or securities. At any given point in time one or more managers or securities fail to do well in the period and we are deemed to be less good investors to those highly concentrated portfolios of only the most winning holdings in the period. From a career risk standpoint we get penalized for this underperformance, yet similar to Brahms, taken overtime the complete work through multiple market cycles can produce much more credible “lifetime” results. The lessons are that diversification can hurt results, particularly in short time periods, and we should therefore pick clients more carefully as to their time frame focus.

In addition, there was another critical observation that came to me Friday night at Carnegie Hall. When I was a college student sitting in the cheap seats in the highest balcony, the audience below looked a bit like a bunch of fury animals, with women and some men encased in full length furs.  Friday night, at one of the highlights of this season’s top concerts, I did not see one human draped in furs. Clearly there has been a major change in the audience’s thinking. It was an important reversal. Sitting there, I started to look for a similar reversal from today’s investment fashion. I began to wonder whether in a number of years “intelligent” portfolios will own index vehicles or even this year’s model of ETF/ETNs? The lesson for all of us is to think what will be different when our children or grandchildren have our investment responsibilities.

“The General” Speaks and Too Few Listen

Each February my wife Ruth and I attend a birthday celebration for President George Washington. This year I had the pleasure to spend some time with a young but noted historian. I asked him about the “Whiskey Rebellion” where President Washington had the task of dealing with an organized bunch of angry western Pennsylvanian farmers. At the urging of Alexander Hamilton, the largest American army formed since the Revolution was raised to deal with the rebellious farmers. I asked the bright historian what was really going on in this rebellion. I knew that the excise tax being levied was a small six to nine cents a gallon. He agreed with me it was not the size of the tax, but the resentment of the western farmers to the easterner’s wealth. (Sounds somewhat familiar to the resentments between the blue and red states today.) Hamilton’s solution through negotiation was to have the central government assume all of the war debts of the various states, which lowered the tax burden of many and led to a sound national debt policy.

The reason for my question is that I am seeing the potential for a surge in indirect taxes. These are sales, use taxes and fees paid to the government. Once these indirect supports to a government are in place they are difficult to reverse, except with enormous popular demand. I am told that today in Egypt they are still collecting an excise tax that that ancient Pharos initiated! My concern is that Federal, State, and Local politicians will gravitate to increased use taxes to reduce any shortfall created by changes in the income tax. For some jurisdictions indirect taxes equal about half of corporate income tax payments.

Many years ago the late chair of the US House of Representatives Ways and Means Committee asked me about his favorite tax raising approach, the Value Added Tax. I replied, did he want to convert US citizens to French citizens who at that time had made an art form of not paying their share of taxes? It did not go forward then, but is being raised again now. I hope we don’t as a nation have to go back to The Boston Tea Party and the Whiskey Rebellion to express our concerns for these sly ways to take more money from us. We need to be on watch.

Warren’s Investment Policy Lesson

As most every investor knows, on Saturday morning Warren Buffett issued his annual letter portion of Berkshire Hathaway’s annual report. I believe very few of the media pundits caught what I believe is a very important affirmation to his and Charlie Munger’s thinking. The letter revealed that Berkshire began a slow but deliberate program to eventually buy 80% of Pilot Flying J (PFJ), which has about 750 locations that we used to call truck stops. I am sure that it is a good business, but to me it reinforces what has become a major tenet of their thinking in terms of many of the operations. They seem to be drawn to products that need to be shipped by trucks, trains, or pipelines. While they do own some service companies beyond insurance and finance companies, it seems that goods production and transportation tend to be rather unique vehicles which are often built and owned by entrepreneurial families, which at their current stage are producing excess cash flow to their growing needs. Most of these are domestically located. The greater volume they do, the more closely their results will parallel the Gross Domestic Product, but they will grow faster because of smarter use of leverage and freedom from normal corporate disciplines.

In Conclusion

From a long term investor’s viewpoint there are a lot of positive factors. I am not too concerned that the recent recovery appears to me to be a weak test of the recent lows. I wonder for 2018 whether we have seen both the highs and lows for the year or possibly neither, but in the long run it may not be important either way.

Question: What do you think?