People Make the Difference – Weekly Blog # 538

Mike Lipper’s Monday Morning Musings

People Make the Difference – Weekly Blog # 538

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

Factor Investing

I have often been told that given an earnings growth rate a bright investor can tell the appropriate price/earnings ratio, leading to a prediction of the right future price of a stock. In only a slightly more complex approach there are a number of investment products or funds being offered that are driven by an identified factor or a collection of factors. As these are new vehicles they are being pitched as something brand new and superior to the traditional methods of security analysis. Investors have for a number of generations used various statistical measures as a filter to determine better than average choices for additional investment analysis.

Modern Portfolio Theory (MPT)

There is very little that is brand-new in investment analysis. Nevertheless, we periodically receive marketing messages that extoll these new methods as a better way to make money. This reminds me that a number of years ago, based on now recognized faulty academic research, we learned about Modern Portfolio Theory (MPT), which actually was not modern in identifying different rates of change in stock price momentum. MPT was identified hundreds of years ago and had very little to do with portfolio construction and management, other than stock selection. The theory before and after its publication did not regularly produce investment success, but did generate marketing success.

Better Tools for Investment Success

What then are better tools for investment success?  A continuing study of successful investors suggests that the biggest help is the analysis of people at three or more very different levels. Behavior of market participants, buyers and sellers of specific products and services, and finally important portfolio managers, which can improve investment success. In each case the study of these areas has been helpful in the past and I suspect will be so in the future.

Market Transactions

There are a group of market analysts and their followers that focus intently on stock transactions to identify recognized patterns of past movements being repeated currently. For these so-called technical analysts the key to success is the improved chance of being right. They are not interested in the known or unknown motivations of the buyers and sellers, just that their actions follow past trends. This type of analysis is more popular when there are fewer new factors or information introduced.

Looking back to Friday August 10^th, the three major stock price indices - the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 and the NASDAQ Composite, all opened below the last price of the previous day and over at least the next four trading days did not bridge the price gap. Most of the time a price gap needs to be closed before the dominant trend can continue. Some of the price gap of the DJIA was probably filled last Friday, but the gaps in the S&P 500 and the NASDAQ Composite remain open. The continued existence of gaps suggests that the forward price movement for the bulk of the US stock market will be limited and will only rise through their past peak at some point in the future. 

From my vantage point, the predictability of gap filling is measured by the quality of the analysis of the market technicians.

Customer Analysis

Successful investors often place their bets on their perception of future changes. My wife and I had the pleasure of spending time this week with Ralph Wanger and his wife Monique. Ralph for many years was the portfolio manager of the very successful Acorn Fund. The fund initially invested in smaller companies that in numerous cases became mid-cap leaders. In discussing a number of his very successful investments it became clear that in addition to studying a great amount of relevant financial data, Ralph had a deep understanding of the people at various companies.

In one example, he noticed that a company’s logo had become a body tattoo, establishing a body of trust with its customers that might give the company enough time to execute a well-founded turnaround plan coming out of bankruptcy. Many sound turnaround plans take too long to reach fruition as existing and potential customers’ patience is worn out waiting for the new and improved products. In this particular case with the tattooed bodies, the present customers and the potential customers waited for a couple of years for Harley Davidson’s new and significantly improved motorcycles. Ralph recognized the potential power of the relationship that the tattoo created,  buying the needed time for recovery. He also had a similar population of patient investors in his Acorn Fund, I was one of them. A number or factor driven investors would not have participated in the stock rise, which multiplied its worth many times over.

Earlier in the week I met with the CEO of a statistically driven company experiencing some disappointing results. While not close to bankruptcy, it is in a multiple year plan to evolve with its big company clients into an enhanced relationship. They perceive, along with a number of their leading manufacturing clients, that many of them are becoming service companies. An auto manufacturer is in the after-sale service business as well as in the financial services businesses.  It is their successes in these businesses that is becoming equal to or more important than the success of their new exciting models coming off the production line. These are some of the required elements being implement in order to increase customer loyalty and market share. They are mission critical for both the manufacturer and its statistically driven suppler, for both the auto company and other companies too. I am withholding my investment judgement as to whether they will succeed in a major way, but I am looking for changes rather than extrapolations.

Need for Tolerance

At any given time the investment process produces winners and losers. I am comfortable with this result from learning basic securities analysis at the racetrack. There I learned that if you bet prudently you can walk away at the end of the day by properly selecting only a few races, varying betting procedures so that you can afford to lose more races than you win. You walk away a winner overall because the money won was larger than the money lost. I apply the same philosophy to investing, particularly with the use of mutual funds. But perhaps more important than the money earned was the knowledge acquired. When something turned out differently than expected, the key knowledge gained was the analysis of what happened. There was a growing recognition that all the actors, either on two legs or four are not perfect and can make mistakes, some surprising on the upside. The key to future racing and investment success is to learn what happens unexpectedly. This allows us to tolerate the unexpected and most importantly to tolerate our own and others’ mistakes while learning to manage our expectations.

I would be happy to discuss your expectations and suggest some things that you may wish to consider. Please contact me, as we both might gain from this learning experience. We would be glad to help with the selection and management of funds to fulfill your needs.

Did you miss my blog last week?  Click here to read.

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A. Michael Lipper, CFA

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Get Ready for: Declines, Recoveries, and Growth – Blog # 537

Mike Lipper’s Monday Morning Musings

Get Ready for: Declines, Recoveries, and Growth – Blog # 537

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

One of the prior major stock market declines was signaled when the O’Hare airport authorities would not let United Airlines sell its gate positions to reduce its debt. We may be approaching a similar signal. Media reports that after 31 years of owning the management company for Oppenheimer Funds, Mass Mutual Insurance is considering putting it up for sale at around 2% of assets under management. While this may be a fair price, many professionals would treat this result as negative because it is below full bull market valuation. At the same time the much respected T. Rowe Price (*) is reducing its commitment to large-cap in favor of small caps and international on the basis of valuations. Both of these elements are good reasons to prepare for future declines, recoveries, and growth as discussed in this blog.

As a long term investor in search of other long term investors we are confident that we collectively will experience declines, recoveries and growth. So much for recorded history, but the value of history is primarily the recognition that these types of events happen. Far too many look for history to be repeated exactly, without adjusting for the dynamic changes of the past. My task is not only to understand history, but to also understand the changes that will modify future paths.

We know that declines, recoveries and growth will happen because greed and fear exaggerate the natural cyclicality of nature. Successful predictors can use this for future events or dates, but should never predict both. That is why I can envisage the three events mentioned, but I clearly don’t know when they will occur or their magnitude. However, what I can do is prepare my thinking for each of these inevitabilities.

Declines
There is no question that there will be future declines in both the stock market and the global economy, which are often related, but not always.

As with most wars there are underlying causes of critical imbalances which can be readily observed, but there are also unpredictable flash points e.g. the assassination of the Arch Duke. Populations and their governments can manage through declines reasonably safely, or they can overreact and try to correct both the imbalances and the bad actors. Based on the historical record in this country, overreactions can lengthen and deepen declines. Many of those who lost lots of money in the stock market crash” of 1929-1932 and 1937 discounted their prior gains on paper then swore they would never return to investing in stocks. They and their families missed out on participating in the benefits of the long bull markets of the 1960s and post 1980s.

Strategies and Tactics
Essentially there are two  strategic approaches: abandon or ride through. Neither works particularly well if they are followed minimally. The abandon strategy promotes a misplaced sense of safety  because it does not recognize inflation.  As long as governments spend more than they take in we will have inflation eroding currency values.

The ride through the crisis approach assumes more than a full recovery, including perhaps some inherent gains for the loss of income during the period.  Clearly, even under the best of circumstances not all commercial entities will survive, but most will. However, it may take time. One of the high flyers in the excitement of the radio era (read mobile phones or the Cloud) was the old Radio Corporation of America (RCA). The stock price of RCA did not reach its pre-depression price until the 1960s, on the back of the promise of color television. Also, many farmers lost their lands to foreclosure due to leveraged borrowing.

Few investors fully subscribe to the two strategies of abandon or stay put,  utilizing tactics that address some of the concerns and opportunities of each. Some build up cash reserves, but there are two drawbacks to that approach. Firstly, a study of mutual fund portfolios and performance suggests that unless cash reserves exceed 25% of the portfolio near the top, it will only satisfactorily cushion a typical cyclical decline of 25% or less, not a secular decline of 50% or more. The second drawback, which a study of portfolio manager behavior reveals, is that there is too much comfort in cash and these portfolio managers miss out on buying cheap bargains.

There is another approach that probably works better for long-term investors, that is to gradually move equity portfolios into more defensive stocks. These stocks are generally absent in most market commentary and are often found by examining the rosters of relatively underperforming sectors and stocks lagging near the peak of the market. To me, two of the better hunting grounds for these searches are international and dividend paying “value” stocks.

International
There are two long term reasons to invest internationally. First, it is a hedge against the larger domestically traded stocks/funds in your portfolio. If one looks at our rank in terms of standard of living in the US compared to other countries, we have been slipping for sometime. The main reason for the relative strength in the dollar is that we are living in a period where almost every other country has threatening dissident groups, whereas our currency is perceived as safer than others.

Using mutual fund performance averages based on their investment objectives, of the 18 global and international fund objectives versus their US focused peers, only in real estate is the foreign fund better. I suspect that at least half the performance superiority in the first seven months of 2018 is the direct impact of the strength of the US dollar, which is unlikely to continue forever.

In many ways the more hopeful and sounder reason is that selectively there are many more opportunities outside the US than in it. There are world leading companies beyond our borders in technology and natural resources. Occasionally these stocks are priced more attractively and their younger populations create an attractive market opportunity. Educational standards and wealth are rising both in Asia and Africa, which should be fertile for investments long term. Thus for defensive (hedging) and aggressive (demographic) reasons, investing internationally makes sense, particularly if one uses select funds for administrative and liquidity reasons.

Value
In utilizing value for diversification purposes I am excluding “deep value”, which requires corporate actions, mostly mergers or acquisitions (M&A) to work out. Most M&A occurs during expansionist periods, not declines, so it may not provide much downside protection. For diversification purposes, the ideal value stock must have a history of paying dividends with an average payout ratio of about 50%- 75%, with a history of raising the dividend rate at least as much as recognized inflation. “Trust quality” or above BBB credit rating would also be good. Some strong institutional ownership would be a plus, as would a reasonably liquid stock. Some and all of these characteristics are found in average in some mutual fund portfolios.

Recovery Candidates
Product or service providers that are likely to be considered essential in the future include those that have sufficient management depth beyond the CEO to be the next generation of sound leadership. Also attractive are those companies that have surplus borrowing power to take advantage of product and corporate opportunities which may occur in troubled times.

Growth Candidates
Growing target markets rather than growth in market share is an important growth criteria. A multi-generational attitude also helps in the selection for legacy investment accounts. Sufficient internal research & development open to external sources would be best.

Fund/Manager Selection Tips
If the bulk of one’s assets and dreams are tied up in one asset, diversification should lean toward a couple of portfolios with a reasonably large number of securities, with the portfolios different in investment style. For the asset owner that is more liquid,  a portfolio of concentrated funds that complement each other rather than compete for attention is preferable.

We would be glad to help with the selection and management of funds to fulfill your needs.

Did you miss my blog last week?  Click here to read.

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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.

Apple’s $1 Trillion Lesson and Benefits - Weekly Blog # 536

Mike Lipper’s Monday Morning Musings Blog

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

Lesson for All Investors
The biggest benefit to all stock investors is what the piercing of the $1 trillion level didn’t do! Often such a press event generates a follow through.  That the Apple $1 trillion event did not immediately trigger a speculative surge probably means that there is more time until the top, which is often the result of a great amount of speculation.

In a speculative surge one can imagine commentary on the next one to five companies reaching that level, or when Apple (*) reaches $2 Trillion. These types of comments generally lead to a speculative surge, causing the next stock market decline. The absence of large scale speculation suggests that the next decline will likely be one that’s more cyclical in nature, about 25%. If on the other hand we are cursed with a speculative surge sucking in more of the public as well as undisciplined institutions, it may lead to losses of half the invested capital. As bad as that would be, what would be worse for the economy and society would be a wave of punishing regulation and legislation, because that would curtail the eventual recovery and the return to a growing economy. Thus, the biggest benefit is that with less than a catastrophic decline, we can hold for the longer term and subsequent market recoveries.

(*) I have been a long-term investor in Apple for personal accounts

Investment Executive Wake-Up Call
Contrary to what many believe, Apple is not primarily a cell phone company. It is a champion supply chain manager. Also, it is a marketing channel leader, a capital-lite massive capital generator, and a post-integrator. Post-integrator refers to organizing activities that are not primarily integrated along horizontal or vertical business lines. Other companies have done one or more of these things, but Apple has become the poster case for doing these things differently in the new world of stock investing and political management.

In the 1950s we learned in college about integration, not so much racial integration, but business structure integration. Corporate leaders were vertically integrated by building all the critical inputs to their product lines or horizontally integrated by selling everything essential to the customer. I remember being a guest in a few corporate dining rooms where my hosts were very proud of their internally produced ice cream (an insurance company), or a prized omelet chef (a brokerage house). The executive dinning rooms were believed to be a source of competitive strength.

As a junior securities analyst I was assigned to follow the eight major steel companies using only annual reports and brokerage reports. I found that each of the companies was reporting differently from each other. I also learned the major differences between the largest steel companies and the next tier was their degree of integration. The largest steel producer was also the world's largest cement producer, which had its own transportation system and produced a good bit of the electrical power it consumed. When it needed to get additional capital, the chief financial officer walked across the street from their financial office in Manhattan to a Wall Street investment or commercial bank to get the money. (This was the same pattern for the world's largest auto producer, as well as for the world's leading oil company.)

Contrast this with the $1 Trillion Apple (*) of today. While not completely like Nike, which has no manufacturing efforts, Apple makes very few of the components used in its products in its own factories. Its factories are essentially the final assemblers of the completed products, with sub-assembly work done by others. This is the supply chain task that Steve Jobs assigned to Tim Cook, who built the modern global Apple. In so doing the company transcended governmental and cultural borders. Thus, national political leaders have been out-flanked, and taxes and other trade barriers have become multi-national competitive fields of play.

To some degree the competitive advantage that Apple has developed is channel management, with intense focus on the level of completed product inventory, for what is probably the world’s largest grossing store change. Interestingly, Apple built the stores at the very time that large department store chains were closing unproductive stores. There is a major difference in Apple stores, both from the general department store and the stores of other mobile phone manufacturers. The difference is the sales floor and the sales force. Not only is the sales force knowledgeable and caring, but they reflect similar demographics as their expected customer base. The network of Apple stores in most major cities of the world supports both the local market and travelers with some critical in-person tech support, which is most appreciated by the traveling and spending population.

Apple’s profit margins and their low but growing dividend payout produces a prodigious amount of excess capital, which means that the company is not dependent on Warren Buffett, as he’s mentioned, and most of Wall Street.

The $1 Trillion lesson for the directors of research of investment groups is that they have been assigning the wrong analysts to follow Apple. They have had primarily technology analysts follow the stock. These analysts have focused on the technical specifications of Apple’s products relative to other manufacturers. What they’ve found is that current Apple specifications are not as impressive as others, but they charge more. Thus, they join the large number of professional Apple haters that have been successful in creating periods when Apple’s stock price has declined absolutely and relative to competitors.

What the technology analysts miss is that Apple customers will pay a premium price for products and services that effectively communicate with them. Customers want solutions to their problems. Some of these problems are new to the customers but address important needs. If I were running a major securities research effort I would assign Apple to a team of fashion retail analysts, bank analysts, demographers, and field analysts covering the use of office supplies. This approach would have identified Apple’s strengths sooner than those focusing on technical statistics.

The future is unlikely to be an extrapolation of the past, thus different analytical and investment approaches will be needed to survive and prosper.  In the future we will be presented with various opportunities and risks.

Indirect Apple Winners
The second largest equity owner of Apple shares is Berkshire Hathaway (**), which probably owns close to $50 Billion of the stock. The company announced its second quarter earnings on Saturday. From a long term investor's standpoint, while it was nice that the company’s investments rose, including their derivative positions, it is much more important to investors that the operating earnings rose beyond the lower income taxes paid. Casualty insurance operations recovered largely through an increase in the premiums generated. In addition, the railroad gained as there was more freight moved, and earnings from utilities rose because more capacity was brought on line.  In brief, Berkshire’s results reinforce other data that US business is getting better and the reduction in income taxes at almost all levels helped.

(**) I have been a long-term investor in Berkshire Hathaway for personal accounts

The careful investor should always look at what could go wrong. This could possibly be summed up in one word, CHINA. A good bit of the freight being moved on the railroad is to and from China. If the level of threatened trade with China is not replaced, earnings could fall. The US stock market is beginning to worry about that. Five out of the ten worst performing mutual funds this week, as published in Barron’s, were primarily invested in China.

Conclusion
Investors can learn a lot by studying two of the most successful companies in the world as they focus on the future.


Due to travel schedules during the next two weeks, blogs may be delayed in reaching you


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Tribute to Frank Harrison - Weekly Blog # 535

We have lost our very good friend and the first editor of these blogs, Frank Harrison. He suddenly passed on to a place of less pain on Saturday night, July 21st. In the last week of his too short life he contributed to blog 533. At the request of his husband and partner of 40 years Mr. Maurice Lane, we delayed this announcement to his many friends and admirers.

Frank was an essential part of our old firm, Lipper Analytical. As our Chief Operating Officer he made things work for our valued clients and colleagues. Early in his career he was a school teacher for disadvantaged children in Newark, New Jersey. He used the same deep concern and patience with all our people. Frank played an important role in establishing our offices in Summit, NJ; London, England; and Hong Kong, where he developed lasting friendships. He also played a critical role in our original office in New York City and our data center and main product office in Denver. In many ways I either didn't know or fully appreciate how much he made my job in managing the firm easier and better. While he was working in NYC during the week he was commuting back to Massachusetts on the weekends. That became too arduous and feeling we could do without him, he found employment closer to what was now his home state of Massachusetts. We never could replace him.

About ten years after I sold the operating assets of the firm to Reuters, I started to write this weekly blog and asked Frank to edit and operationally manage it. He did a great job for ten years, both in his new "part-time" role and his former role as Chief Operations Officer. He was an excellent media ambassador for us, both domestically and overseas.

With Frank's wide circle of friends and admirers here in the US and overseas, my wife Ruth and I would like to celebrate his life and accomplishments. As Frank liked a party, we are planning one in his honor at the Princeton Club in New York, sometime in the early fall. If you and others that share our high regard for Frank would like details of the party, please email me at aml@lipperadvising.com.

Link to Frank's obituary https://www.currentobituary.com/obit/222721

As Frank would have wanted us to do, we must now turn to the primary mission of these blogs, which is to share various thoughts as inputs to our subscribers’ thinking as they address their investment responsibilities. I will share a few of the questions in my mind.


Thoughts to Ponder

1. Most people are focused on the economic (trade, non-trade barriers, taxes and currencies) plus defense positioning between China and the US. They may not have noticed that perhaps the real immediate battlefield is Europe, particularly with its alignment with Japan. As trade may become more restrictive between China and the US, there will be a shift to increase trade with Europe. As is often the case with increases in trade, it will be disruptive to the local market because some of the import prices will substantially impact locally produced goods and services. It is quite possible that the ensuing negotiated prices and arrangements will evolve into a framework for a series of agreements between the trade war belligerents. This may take some time and thus a series of quick agreements before the US mid-term elections may not be in the cards.

Those that have to agree to trade agreements are managed quite differently e.g. command/control, multi-decision power groups ( i.e. legislatures), and multi-national business and consumer parties (supply chains and marketing/distribution channels). In the end these commercial interests will determine the depth and quality of execution. These are big picture questions.

2. Because of what we buy and use we have become unwilling, multi-national participants. As an individual how do you protect yourself from the decisions that will be made above “one’s paygrade”. How do you profit? What preparation is needed for your children and grandchildren’s generation?


3. What are the penalties of downside and upside expansion of risk assets in your portfolio? I suggest that the penalty for the downside is withdrawing from planned future equity investments and the penalty on the upside is taking on more risk assets.

4. Will technology continue to be a disruptive and deflationary force through much lower prices?

__________
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The 3 Cs Dangers – Weekly Blog #534

Consultants, Career Risks, and Cash can hurt professional money managers as well as many individual investors who think like “the Pros”

Consultants
A recent Financial Times column by John Authers starts off by recognizing that it is hard, but necessary, to accept the responsibility for mistakes. It is the reason that many investment committees and other fiduciaries hire consultants. The column goes on to describe the results of a ten year study of consultants’ manager selection recommendations. The academic study found that the recommendations underperformed the market and were worse than the performance of the managers that were not recommended. This was also true in the selection of allocations to various sectors. However, the recommended managers’ performance hugged the benchmark better. (Perhaps the consultants recommended closet indexers.) I suspect the buyers of the consultants’ services expected those results. They knew the value of the John Maynard Keynes quote “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” In another quote from Farnam Street discussing Howard Marks’ book, The Most Important Thing, “first-order thinkers look for things that are simple, easy, and defendable.” Howard makes the distinction between first-order and second-order thinkers. First-order thinkers are only interested in the current time period, whereas second-order thinkers are focused on how the present sets up a number of future scenarios.

Disguised Consultants
Many of today’s investment advisers were impacted by the changing economics in the financial community, from being a fixed fee adviser or a commission driven broker to becoming a registered investment adviser charging a management fee. Since many investment advisors have no rigorous training in securities analysis, they focus their client bets on sectors and factors, using statistical measures, current news, and trends. As with manger selection, consultants are often first-order thinkers and produce similarly unappealing results.  One tip off as to their performance is the weekly data from my old firm’s publication of the Lipper Performance Report. During the latest week, all twenty categories of US Diversified Equity funds showed positive results, comprising the management of $8 Trillion in aggregate. In contrast 18 out of the 28 sector equity funds showed losses, comprising only $1 Trillion in aggregate. The difference between the two is that the diversified funds owned some of the best stocks in the sector portfolios and had enough diversification to produce less volatile results.

Nervous Contrarian
With the consultant’s focus on short term results, echoed by a number of investment committees and other insecure fiduciaries, the ability to predict short term market moves is critical (This is not true for long term investors.) The current stock market is being driven much more by changes in sentiment than fundamentals. Most transactions are originating from non-price sensitive transactors and the markets are reacting to changes of sentiment driven by news, fake news, and rumors. To see the rapid changes of sentiment, look in Barron’s for the results of the weekly American Association of Individual Investors (AAII) sample poll shown below:

View Latest Week     2 Weeks Ago   3 Weeks Ago
Bullish                    34.7%                   43.1%                  27.9%
Bearish                   24.9                       29.2                     39.3
Neutral                   40.4                       27.8                     32.6

As a contrarian I get nervous if I find myself betting with the crowd. Thus, if neutral approaches 50% I will be forced to make a decision and not just bet against the bulls or bears. At the moment my short-term inclination is to go to the bearish side and maintain a bullish position for the long term.

Career Risks
The challenge for the professional investor is to play according to the consultants’ rules, or attempt to produce extraordinary performance by being different, which almost guarantees underperformance some of the time.

Is Cash an Asset Class?
Last week I attended a Pershing Conference for Investment Advisers. I was particularly impressed with a discussion that included Rob Sharps, who chairs the growth equity committee at T. Rowe Price and is an important input into their best in class target date funds. (I am biased in the favor of T. Rowe, having known each of their chairman back to Mr. Price himself. We are users of some of their funds both personally and for clients, and also hold a position in our private financial services fund. I took particular note when he said that at the margin they were de-risking for the first time this cycle. In addition, State Street is raising the question of cash, pointing out that the current rates of return on US Treasury Bills are closing in on the Fed’s targeted inflation rate.

Years ago I studied the performance of various mutual funds that raised cash defensively. In major declines only funds that had about 25% of their assets in cash like instruments had a meaningfully smaller decline in the market. The longer term problem with these funds is that do not recommit to the equity market fast enough, so that when the market regains its prior peak they underperform and are meaningfully worse as performers.

Avoiding Poor Recovery Syndrome
There are two ways to avoid the poor recovery syndrome. The first is not to raise a great deal of cash but instead move heavily into low risk stocks that pay good dividends and a have a shareholder base to support liquidity in the stock price. We used to call them warehouse stocks. The classic one was the old AT&T, not the current stock of the same name. The second approach is to replace the portfolio manager with the next generation, a generation not burdened by the knowledge of what won’t work because it didn’t in the past. In recoveries, the combination of new enthusiasm and momentum will be early stage winners. The trick is then to replace the successful youngster with a more rounded manager.

Bottom Line
Be prepared to move away from the crowd, examine defensive tactics, and don’t fall in love with cash.

__________
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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.

Preventing Investment Mistakes - Weekly Blog # 533

Confirmation and Anchoring

Confirmation and anchoring, according to a recent survey, are the two most popular biases of investment advisors. I suspect these are largely the biases of their clients. While these biases tend to drive investors at all levels into the most popular strategies and investments, they imply that the crowd is normally right, or at least it is safer when wrong to go down with a crowded ship than try to swim in lonely waters.


The Favorites

Those that search for popularity did not attend my first class in analysis of securities and people. The class was held on most days, including Saturday, in an open-air setting at various New York racetracks. The most popular horses had the smallest betting odds. These were called the favorites, as if they were like the most popular high school dates. The problem with chasing favorites is that on average they only win between 30 and 40% of the time.

More importantly, when they win, after deducting the portion of the winning pool that went to the track and state taxes, they do not generate sufficient winnings to cover the 60-70% of the time when they lose. (Like many investors, the winners do not recognize that they owe income tax on their winnings.)


Useful Information

Many investors believe that they are smarter or have more useful information than those on the other side of the bet or transaction. They quickly confuse temporary winning with greater mental capabilities. Just as various political leaders, central bankers, and pundits of all types view an errant morsel of information.

A new breed of binary judges is being marketed to investors as factor funds, which ranks and chooses securities by various statistical measures, such as revenues (Fortune), Market Capitalization (Standard & Poor’s and Russell), Earnings Per share Growth, Price/Earnings Ratio, Free Cash Flow, Current Yield, and others. Sometimes single factors are brought together into multi-factor portfolios. The problem with this approach is that if it were that easy various printers of financial statements would be the richest people in the world.

One of the early lessons from the track, security analysis, and topographical maps/photos is that these are given to all who can afford them. The key to more victories is what is missing, often in plain sight but not recorded for publication or correctly understanding the value of a corporation’s inventories, fixed assets, patents, and customers.

There are other occasions when both the buyer and seller are correct or wrong, one being an expected time span in ownership ranging from one moment to almost infinity. Another is completing a portfolio structuring or restructuring. A third might be the value of a shareholders’ vote.


Avoid Arrogance

Thus, to avoid unforced mistakes avoid the arrogance of assuming the party on the other side of the trade is dumb. Make a serious attempt to guess the motivation on the other side. They may know something that might be helpful.

The professors at Caltech believe that what we commonly call thinking is reaching back into our memory banks. There is a growing gap between those that have experienced either a bond bear market, deflation, or even a 1987 style stock market. Therefore, many investors make mistakes that seniors avoid. If you don’t know something it is easy to be arrogant and not look to understand the other-side of a trade.


Cross Winds

One of the big mistakes that far too many investors are guilty of is not examining a large enough set of inputs. Rare insights are often in plain sight but ignored by most. With that thought in mind, the following are some factoids that I saw this week which could impact some short to very long-term investment decisions:


Possible short-term inputs

The top three global market weekly advances were - Nikkei 225 +3.71%, Shanghai Composite +3.06% and S&P BSF Sensex (India) +2.48%. (Asians must believe that they won’t be hurt significantly by the trade politics, or there is massive short covering.)

Somewhat linked to the above is that the next two index risers were the NASDAQ 100 and the S&P 500 Info Tech Index. This was supported by the 18 of the best 25 performing mutual funds for the week, which likely held those types of securities.

Both the S&P500 and NASDAQ Composite were at record price levels this week, but their trailing price/earnings ratios were not higher than year ago readings. (This suggests that higher prices are being driven by reported earnings, not changes in valuation levels.) However, margin debt is continuing to grow at record levels. My guess is that margin debt is supporting speculative holdings of bonds and/or stocks.


Intermediate Term

Over the last year the average Taxable Long-term Bond fund’s total reinvested return was less than the average coupon on the bonds in the portfolio. This suggests that those investors spending their distributions are eroding their capital. To a lesser degree this has been happening for the last five years. Even though nominal inflation has been historically low, on a “real” return basis, they are eating into their spending power and are certainly doing so if they are tax payers.

With the global aging of developed nation populations, the result of longevity expansion and healthcare becoming more extensive, the underfunding of pensions is growing. This does not take into consideration the self-funding that many are or should be doing.

We may have entered into a world where the money cycle is more important than the trade or product cycle. One of the indications of the impact of technology on jobs can be seen in the oil patch, particularly for those involved with fracking. The number of employees used in extraction is flat to declining and the number used in energy service is growing and is larger than those used in extracting. It would be even higher if the service companies could find a sufficient number of truck drivers.


Longer-Term Considerations

In about twenty years, just 8 US states will comprise 49.5% of the expected population. Adding another 8 states raises the total to about 70%. These states are mostly on the east coast, California, Texas, and Colorado, although they are still unlikely to control the US Senate.

Nigeria will replace India as the home of the most poor people. While this is good for India, it suggests that Africa will likely be the home of most conflicts for many years. While I have been suggesting that the bottom performing commodity funds should be looked at for long-term investing, it may require too much patience as commodity players and farmers remind me that commodity cycles typically take 30 years.

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A. Michael Lipper, CFA
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Risks of Diversification - Weekly Blog 532

While many major fortunes have been made through the aggressive devotion to a single investment, most risk aware investors rely on diversification as an important defense mechanism. These investors believe that they are diversified by allocating their portfolio into domestic equities, international equities, domestic and foreign debt, commodities, and cash. I believe that this allocation schedule does not fully take into consideration the risks that we are exposed to as people and investors for ourselves and others.

Three Biggest Risks

The largest single risk is the lack of recognition of the existence of the “unknown unknowns.” Another way to label this is surprise risk. We are regularly surprised, not only by events but also by the long-term significance of the events. The best defense against this primary risk is to array our financial and intellectual assets and liabilities in terms of their flexibility. We should be able to quickly redeploy some of our assets and liabilities. As we get older and have grater responsibilities it gets harder to pivot to new threats and opportunities.

The second biggest risk is the supposed need for a perfect plan for the future. Recognizing surprise risk, we should be able to devote some of our most precious time and investment capital to explore areas that are unknown and probably uncomfortable. In the US Marines we call this recon, short for reconnaissance. (It was Robert E. Lee’s discovery of the sunken road that led to an important victory in the first US war with Mexico. (“From The Halls of Montezuma to the Shores of Tripoli” are the beginnings of The Marine Corps Hymn.)

The perfect investment plan belies the only guaranteed product of investing, humility. When interviewing potential portfolio managers to invest our clients’ money, we want to know about their mistakes. If one has a very short list or none at all it becomes a very short interview. One of the refreshing points in listening to Warren Buffett and Charlie Munger is their frank discussion of their past mistakes. One of Charlie’s biggest compliments of Warren is that he is always learning. Charlie himself is anxious to learn every day, as am I. Being wrong comes with the territory, hopefully it does not have to be repeated, but often it requires multiple lessons to change behavior.

Derived from the first two big risks is a third. The risk of lack of thoughtful assessment can be a hazard to our survival and growth. We learn little from pats on the back and much more from hits to the gut. While the pain of an acknowledged mistake in our thinking is useful, the real reward for making mistakes is the eventual recognition and adoption of new thinking. The more defensive we are, the more difficult it will be to derive the full benefit of our mistakes. Thus, the mistakes will become more expensive and frequent.

Comfort from Popularity Risk

As all humans are insecure, whether they admit it or not, they look for comfort in quick solutions. To cater to our insecurities we are drawn to what others are doing. This is particularly true when we are under great stress. If we believe others are collectively doing something, how can that be a mistake? That is unless one looks at the dissatisfaction of the majority of voters at the end of a politician’s term, or spend pleasant afternoons at the local racetrack where favorites on balance win only 30-40% of the time. More importantly, the winnings are relatively small and do not equal the money bet on the other favorites that did not win.

Currently, one of the big pushes by some investment advisors, particularly those that are addicted to building portfolios of only ETFs, is factor investing. There are many different factor options for investing, from statistical sorting to sector investing. I suggest looking at the latest five year record of the average mutual fund separated by investment objective. The following data is from my old firm, now part of Thomson Reuters:

Investment Objective      Av. Annual Performance     # of Funds
US Diversif. Equity            +  10.71                             8,385
All Equity                                     9.01                            15,116
World Equity                               6.88                              4,456
Mixed Asset                                 6.28                             5,916
Sector Equity                               6.16                              2,275
Domestic LT Fixed Inc        2.38                              4,174
World Income                              1.43                                750

Sector investing is difficult in the long run, but can be narrowly successful. The best sector for the five years ended July 5th 2018 was Global Science/Technology +22.07%. Some of those stocks are also in the US Diversified Equity leader, Large-Cap Growth +15.23%. They are among the most heavily redeemed group of funds as investors complete their risk exposure investing. The critical question is whether performance is the best guide for the next five years. I doubt it. Much more difficult is to guess where the new performance leadership will come from. In the future it may be a good bet that some or all of the seven different commodity fund investment objectives will become leaders. Since commodity cycles are typically long, five years may be too short a period of time.


Investment Instrument Limitation

Not wanting to rely on investment judgment, regulators have limited the options available for investment. For example, many trusts and some mutual funds are not able to invest directly in commodities themselves. Other restrictions require only publicly traded securities or Investment Grade bonds. Most brokerage firms can not act as custodian for the securities traded out of their home country. There are other restrictions too; some caused by limited scope of the investment advisor’s administrative support mechanism. Almost as with the US experiment with the Prohibition of liquor, adventures beyond the walls of limitations become attractive in and of themselves. We sense that the games only a selected few can play are more exciting than the ones we are allowed to play ourselves. For some investors it may be worthwhile to find advisors or banks that can facilitate narrower investment opportunities with some lack of legal support.


Two Personal Limitations

The first limitation is the mind set of the investment advisor who wishes for sound business reasons to keep all accounts invested in the same products and allocations. Some gatekeepers object to great dispersion among a manager’s portfolio. Life would be much easier for the gatekeeper if he or she can be reassured that a new account will look exactly like the others. I am sure that you have visited museums where every picture is the same. I haven’t and don’t want to. Good investors are painters who evolve over time. Clearly, limitations faced by investors is the unwillingness for tax and emotional reasons to accept gains for tax purposes and losses for emotional reasons. Actually, the limitation may be at the advisor level, not wanting to see assets decline for fear of failing to meet tax obligations.

The final set of limitations to diversifying a portfolio broadly are our own biases. Our brains are memory devices and we find comfort in what we know or think we understand. Even with my Caltech trustee exposure I don’t really understand the science behind most biotech ideas and companies. Thus, I don’t own any biotech stocks...directly. I have chosen to use a couple of mutual funds that have medical doctors as part of their portfolio management teams. This is the way I deal with this limitation.


The Final Limitation

We only have so much time left and luckily we don’t know exactly how much. So we hope that we can learn every single day, as do Charlie Munger and Warren Buffett


Noise, Direction, and Premature Action

Liz Ann Sonders of Charles Schwab put out a piece on July 7th entitled “Just Noise or Something More.” She focuses on the ratio of noise to importance. Last week I ventured that nothing of significance would happen on July 6th. While the US and China raised tariffs, I believe these were firecrackers not artillery. The Chinese President surrounds himself with engineers who think long-term, whereas the US President is more comfortable with generals and others that have served in the military. Combine this with the upcoming NATO and Helsinki meetings and the real game is revealed. President Trump is using an imbalance of merchandise trade as a fulcrum to address a weakened US Defense position. The President sees a shift in balance in terms of technology, a sub scale Navy to fight a two ocean war, insufficient troops and the will to defend Europe, the Middle East and African proxy wars. His major strength is that the US is the single most profitable market in the world. He is attempting to force others to give him the room and time to correct for the imbalances. His great trading advantage is to make the US market less profitable. Almost none of these views will be found in the noise of the popular press or through their politicians and therefore may be more right than wrong.

I suspect many of these thoughts and concerns will become clearer by the Fall, although they’ll not necessarily be solved. Barron’s, writing about the trade war, believes that new index highs are unlikely until things become clearer. From a market analysis standpoint we appear to be in a transition. The question is whether we are seeing accumulation by smart investors or distribution of their holdings to less smart investors. I don’t know the answer, but to me the odds are that investing in global equities is not an unusually high risk currently. This might be translated into a cyclical decline in the vicinity of 25%, but not a secular fall of 50% or more. On the basis of those downsides I am looking for opportunities to buy long-term bargains.

Recognizing that I am probably premature, there are two asset classes that should be considered. The first is World Equity Funds.
I am particularly drawn to the list in Barron’s of the poorest performers in the latest quarter. A number of these funds have a history of being good performers. Some of the poor performance is due to the rise of the US dollar relative to other currencies. This is particularly true up to July 3rd in the Yuan. In addition, the Chinese market in local terms has been weak, in spite of its rising long-term prospects. The second asset class that deserves appropriate study is commodities and commodity funds. For the last five years commodity funds are just about the only group to show negative results. Commodity prices move up because of shortages, more so than an increase in demand. While many old commodity players believe they move in twenty year cycles, it is possible that the longevity of their decline will be shortened, with growing demand and the lack of capital expanding capacity.

Questions: What are your reactions to some or all of these controversial views? Please let me know privately.
 
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A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.