2021 Lessons and a New Worry - Weekly Blog # 714

 

Mike Lipper’s Monday Morning Musings

2021 Lessons and a New Worry

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

The Mind Set

Every day is a learning opportunity, although we often don’t view it that way. While we begrudgingly accept some of our investment actions not turning out as planned, we find temporarily culprits for the cause of those mistakes. I cannot continue to blame others for my results, I must accept I contributed to those unhappy results. Over the years I have been forced to recognize that some mistakes in thinking are repeated far too often.

2021 Mistakes

First, is not keeping in mind the one truism about investing and life, that there generally will be mistakes. The only market guaranty is that it creates humility in the survivors.

Second, the appropriate way to think about a collection of futures is to assign some rough odds of being correct. The number is not as important as the recognition that you might be wrong. The general reasons we might be wrong includes the following “3 I’s league”: Incomplete analysis, Inaccurate inputs, and Indefinite time periods of success or failure.

Third, there are other rules of the game which guide our actions:

1. Recognition that the numbers we use are an abstraction of reality, not reality itself, which is full of unpredictable people.
2. In a news centric investment world, we tend to value the latest news above the flow of past information.
3. There is a search for fairness, which has never existed in the real world, particularly among new or amateur investors. In truth, life and investing is not simple or fair.
4. The following unrecognized shortening of decision times has led to much more volatility, which some confuse with risk. 

• Politicians intensely focused on the mid-term elections will try to force more stimulus payments on the portions of society likely to vote for them, not really caring about the induced inflation. Furthermore, they will attempt to raise the taxes of the capital bases in opposition. (Remember, money is the mother’s milk of politics.) 
• The investment industry has also shortened the performance period by introducing wealth management asset-based fees as an alternative to brokerage commissions. This has caused the switch to increase trading in ETFs. The sale of mutual funds, have anti-churning restrictions. 
• In 2021, for the first time, the compounded dollar impact of traded short-term options was greater than the aggregate value of shares traded. (Typical of a contrarian, I have lengthened the period for measuring investment success.) 

5.  Whether we like it or not we are all globalists by circumstance, not by choice. It impacts our lives and investments and will become even more important in the future.

Missing the Significance of Pandemics

In seeing how point 5 is likely to impact our investments, recognize that the two major variants of COVID-19 came out of China and South Africa to infect much or the world. Globalization follows the path of commodity prices, which drive both food and energy prices higher globally. Bottom line, we cannot escape the impact of globalization on our lives and investments.

Just as we used horsepower to measure the influence of internal combustion engines on society, investors are similarly using the incorrect measure to understand the power of globalization.

Last week I mentioned at least one investment manager who focused on the supply side of trade, rather than the much more popular demand side. Carrying this analysis further, China is the largest single importer. I think we should be looking at China’s impact on the exports of other countries. Germany, US, Canada, Australia, and Japan are increasingly dependent on exporting to China.

China’s domestic growth, while still a multiple of the rest of the world, is slowing down. They have been building their financial reserves, which could backstop their export earnings if they were to slow. China’s slowdown is due to their population growth declining, both in terms of the overall birthrate and the movement of rural peasants into cities. Once in the cities, the peasants find work for domestic or foreign owners and the productivity of their labor grows. (One of the issues facing the rest of the world is labor productivity not growing as fast, due to the focus on schools, rather than education and useful learning. This concern is multiplied by the Chinese being savers and soon investors, which our populations are not.)

We are correctly concerned about the Chinese growing militarily, including in space. In their long history, the Chinese have gone to war to protect their borders and critical suppliers perceived to be vulnerable to opposing forces. They, like the Japanese, don’t want to add people to their country, just their goods and services. (In the West, Rome conquered much of the known world to get slaves, which were often freed once acclimated within the Roman Empire. Europeans hope to grow their population base at a lower cost by expansion, rather than through growing their own population.)

Simultaneous slowdowns in China and the rest of the world are not likely to be bullish for the global securities markets.

Question for Subscribers: Are you worried? What Do you intend to do?      

  

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Are Investors Taking Too Much Investment Risk? - Weekly Blog # 713

 

Mike Lipper’s Monday Morning Musings

Are Investors Taking Too Much Investment Risk?

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

One can rarely earn investment gains without taking investment risks. Investors often believe they imperil too much for the risk assumed. This view has led Lee Cooperman to comment that he is a fully invested bear. (He is counting on his timing and trading skills to save his capital) I am in a somewhat similar position in my investment account, which excludes my “burn-rate” and personal future generation endowment accounts.

Focusing on my operating investment accounts I wonder if I am taking too much near-term investment risk, as I do not believe I have sufficient trading skills and expect to be premature. The best way for me to escape a major decline might be to reduce the premature gap from “the top”. The way to do that is to recognize the excessive investment performance achieved by others as a precursor to a massive decline. Prior road trips with a young family echo in my mind, “are we there yet?”.

Listed below are an increasing number of signs of excessive investment performance:

1. Most diversified equity mutual funds produced a 20% gain for 2021, with some professionally managed investment accounts producing returns of 30% or better. History suggests that this is unusual and characteristic of an approaching top.
2. The types of stocks generating above average momentum are like those we have seen in the mid to late stages of a bull market. While stock market cycles and economic cycles don’t have to be coincident, the major ones usually are.
3. The pandemic’s economic cycle impact is unknown. In a normal investment cycle, it would either be the equivalent of an investment “bear market”, or as they say at “the track”, an aberration that should be disregarded. There is reason to disregard the impact of the pandemic, but market leadership does not look like the beginning of a new “bull market”. If we are not in a new bull market, we are in an aging expansion approaching ten years. Bull markets are not closely tied to an economic cycle, but there is something of an echo effect.
4. For some time, the predictive power of reported earnings per share has deteriorated, due to changes in accounting and regulatory rules. From a long-term investment perspective, I prefer to focus on aggregate pretax operating net income, which is not marred by non-operating net interest earnings and changes in share counts. I further attempt to back out the impact of changes in accounting rules, including recognition of depreciation and amortization.
5. We have entered a period of accelerating inflation, which needs to be considered when attempting to predict earnings power generation. This is particularly important in companies reporting significantly larger rises in net income than sales. There are many reasons for this, including operating leverage, with most of the gains coming from the exercise of pricing power to offset inflation. Earnings so generated, are not usually the source of future earnings gains.
6. There are lots of good investment managers, but some with “hot performance numbers” appear to have unsound analytical backing and may be generating gains from skilled market analysis. This is difficult to maintain and is what we used to call “racing luck”.

I am not attempting to precisely predict the future. What I am attempting to do as a good pilot is avoid air pockets that can cause a sudden drop in altitude or permanent loss of capital. 

After The Fall

To the best of my knowledge there has never been an active market that did not have intermittent declines. I therefore have a high level of confidence that at some point there will be future declines in all markets I’m invested in. 

There are two causes for wars, underlying and immediate. Analysts are unlikely to identify immediate causes beforehand but should be able to spot many of the underlying causes. Most of the causes are essentially an ongoing change in the perceived level of competition. When enough power has shifts to one side, the situation is fraught with danger. The leader sees an opportunity to further increase its power and the loser fears further loss of power. Either side may choose to react to this growing disequilibrium. I suggest the growing gap in relative safety measures are such that it is reasonable to fear some unplanned explosions.

 Whatever happens, it is our responsibility as fiduciaries to invest before, during, and after the fall. This plays to our preferred method of investing in stocks, which is through portfolios of mutual funds, mostly somewhat diversified. In preparation for this task, I read the diverse views of successful fund managers. The goal is to build focused portfolio of funds that think differently. This holiday week I had more time than usual to read what managers were thinking about the longer-term future. Two long-term very successful managers produced reports that should earn their place in equity fund portfolios, as described below:

The Capital Group published a 2022 Outlook on the “Long-term perspective on markets and economies”, which had the following highlights:

1. Market leadership is currently the same as it was before the pandemic. (This is an indication of a continuing long bull market)
2. Global economic growth is slowing, particularly in China. (Valuations have expanded, particularly under the influence of buybacks and M&A activity.)
3. Inflation should persist longer than expected, due to broken supply chains, shortages of materials, and more importantly of competent employees, particularly at the trained supervisory level.) Nevertheless, Capital believes inflation will not rise to the double-digit levels of the 1970s. In most inflationary periods stock and bond prices rose.
4. A good time to focus on stock selection by looking for pricing power, sustainable growth, and rising dividends.
5. Expect increased volatility in this midterm election year. (Perhaps this view is best expressed in the firm’s Growth Fund of America, ranked 17th of top 25 mutual funds year to date and the single best for the week ended December 23rd, gaining +3.55% vs +1.25% for the Vanguard 500 index fund. (Compared to many other growth funds, this multimanager vehicle is more risk aware.)

The other fund management group that has produced thoughtful pieces is the London based Marathon Asset Management. They are a successful global investor with a sizable sub-advisor and separate account business in the US. What distinguishes their thinking is their focus on the supply side of the equation, whereas almost all the other investment managers first focus on the changing levels of demand for a company’s products and services. This tends to put them earlier in the timing of the investment cycle. Their portfolios tend to look like those of a value investor, making Marathon a good investment diversifier in an otherwise growth-oriented portfolio. The following are some of their investment ideas:

1. Moody’s and S&P Global are viewed as an oligopoly taking fees for assessing credit instruments. (This is not completely accurate as there are a number of smaller credit tracking agencies, both in the US and elsewhere. What makes them attractive businesses is their ability to access a small increase in prices each year, as well as a fluctuating demand level. (At least I hope so, as both are in accounts I manage, and in a somewhat similar position is Fair Isaac, which provides FICO credit ratings on 99% of US credit securitizations.)
2. With a limited number of new copper mines coming on stream and local governments pushing tax collections, the price of copper is rising. It will probably rise much further as auto production moves to battery electric vehicles (BEV) from internal combustion engines. BEVs, which use roughly 80 lbs. vs 20 lbs. of copper per vehicle.
3. “Private equity will face major headwinds in a governance play with little leverage as topping” (This is another set of headwinds as it is an overcrowded area, with entry prices expected to rise and provisions expected to decline.) “Growth valuations are based on visibility, the ability to push out time horizons ten or twenty years into the future with sufficient certainty to justify paying for that outcome, a very difficult call in a new world based on political whims.”
4. Japan has not adopted the US approach to corporate governance and has limited M&A activity and corporate raids. Stock options are evolving, with more shareholder friendly conditions. (A number of global investors, including Lazard, have a long-term favorable view of Japan, despite its recent economic record. Japan is becoming a more needed US ally, both militarily and economically.)

Next week I hope to devote the blog to some things I and other investors have learned (or relearned) in 2021. Please send me an email on what should be included in the list.    

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Questions Without Answers Indicate Uncertainty - Weekly Blog # 712

 

Mike Lipper’s Monday Morning Musings

Questions Without Answers Indicate Uncertainty

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

Searching for Direction

Investors gain confidence when they have a clear sense of direction, particularly regarding short-term market moves. They ask a lot of questions in the hope of finding concrete answers. This is increasingly true as markets move closer to the top of a major phase. Thus, extreme confidence, while generally reassuring, is a warning sign of a nearby top. 

Each week I examine lots of data and articles in the media looking for concrete answers, or at least a guide as to direction. This week I came up with some interesting questions, without any good answers. As many subscribers are professional or insightful individual investors, I will serve up the questions with elements of my indecisive views. I am hopeful some will provide answers as a Christmas present and communicate them to me, either for my personal use or to share.

Are Smarter Investors Calling a Turn?

For some time, I have suggested large investors in the NASDAQ stock market are on average brighter than those invested exclusively or mostly on the New York Stock Exchange (NYSE). This is based on the performance of various small-company mutual fund portfolios trading on the NASDAQ since the March 23, 2020 trough. On average this has been the best performing group based on market capitalization (The other groups are large-caps, multi-caps, and mid-caps.) However, year-to-date smaller caps are running in fourth place. There was possibly a change on Friday with its high volume? The NYSE volume was 5 million shares, split roughly 2 million on the upside and 3 million on the downside. On the NASDAQ, total volume was close to 8 million shares, split 4.6 million shares on the upside and 3.2 million on the downside. The NASDAQ Composite has declined 5.53% from its 2021 peak, the most of the three popular indices and roughly halfway through a classic 10% correction.

Does Friday's market action suggest savvy players picking up bargains at low prices?

Commodity Funds Rising Earlier than Expected

Numerous individual commodities are rising due to shortages. The median commodity fund is up +28.79%, while the weighted average fund is only up +3.92%. The reason for this difference is the extreme performance of Energy funds +71.98% and Precious Metals funds -10.41%. Commodity price cycles typically extend to one or more decades, for example from 1996 to 2016. Professional commodity investors did not expect a general commodity rise for at least another five years, after several new mines became operational. The switch to electric vehicles from internal combustion engine vehicles has accelerated demand for some metals, while the interest in currency coins has simultaneously impacted the demand for numerous commodities.

Are these speculative trends going to continue and cause actual mine and mill openings to accelerate? 

Investors Are Finding Other Markets Attractive 

While the US equity market has gained about 25% year-to-date, three other markets are also up over 20%:  India +22.3%, Taiwan +22.0%, and Canada +21.5%. Many investors now see international diversification as prudent, with political turmoil making US investing difficult for at least the next three years. As the economy recovers from various pandemics and tax/trade uncertainties, declining percentage gains in rising earnings will hurt. 

The Fed is Not Helping 

The Fed is basically defining its role as affirming the current situation by looking forward from its present position.

Critical Question: Do you think you will change your investment strategy materially before the next top?

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Two Contrarian Questions: Next Recession? and Is NASDAQ Leading? - Weekly Blog # 711

Mike Lipper’s Monday Morning Musings

Two Contrarian Questions:

1. Next Recession?

2. Is the NASDAQ Leading?

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

Position in Polite Society

In a global society searching for popularity, anyone posing the two blog questions would be labeled a contrarian. That person first needs standing to voice a view significantly different than the commonly believed view. To understand my occasional contrarian views and questions, one should understand their origin and basis.

The Origin of My Contrarian Questions

As with others, I tend to learn more quickly and deeply when my money is at risk. While in grade school and secondary school I was an indifferent student, particularly in precise subjects. Numbers only took on real meaning when I was introduced to the New York racetracks. Suddenly, the eight or nine races a day focused my adolescent attention on statistics and other factors that would lead to losses and gains. I started out behind, as I charged my expenses (going to the track and lunch) to my at-risk budget. After-all, I was going to the track to make money, not for a day in the country or entertainment.

Below, I briefly outline the aspects of what I learned at the track, which have carryover implications for investing:

1. There are too many variables in terms of the number of horses, races, and conditions to be reasonably expert on all. (Screen opportunities to find the best selections)
2. The most popular bets, if won, would at best pay off an equal sized losing bet. Favorites win less than half the time. (Thus, betting only on favorites is a losing proposition)
3. Most bettors have a narrow selection process heavily focused on the most current information, with a home track bias. (More complete analysis often suggests this race is different than the immediate past)
4. Because of the differences in odds, one can finish the day ahead by winning only one of three races. There are also times where one can win more on the second horse at the end than the first. (The correct handling of money can enhance the results, such as weighting the size of bets and paying attention to the probability of results.)

The Next Recession

As someone with a contrarian bent, I believe the next recession is closer than most expect. During the fourth quarter it is common to see projections for the coming year. Most of what I see suggests 2022 will struggle to produce essentially flat results, partially because of the significantly above trend in 2021. Many forecasts do not even mention a recession or suggest a very low chance of one. From the above discussion this prediction sounds like a bet on a favorite, which would be reasonable. But the absence of a discussion on the lengthy period since the 2013 recession is not prudent. Yes, we may be coming out of a downturn in the economy labeled with COVID headlines, but the downturn experienced was not a standard cyclical decline and is therefore outside the history books. Perhaps future historians will label it a recession and take some of the inevitability of recessions off the table for a while.

Throughout recorded history we have regularly had periods of expansion and contraction generated by external and internal causes. External causes usually result from increases in demand caused by new markets or resources. Contractions are mostly caused by over expansion, usually through excessive debt generation. Military and trade wars may start out as expansions but eventually lead to contractions because of the resources wasted in these battles.

Increasing exposure to non-bonded credit is the current flavor of the month in the institutional and high net worth portion of the markets. A decreasing minority of institutions have yet to increase their exposure to “privates” or alternatives. The initiators of these debts are probably raising entry prices while simultaneously lowering safety covenants. At the very same time the Chicago Federal Reserve Bank and the Bloomberg indices of financial conditions are deteriorating. Politicians around the world and around the corner, in governments of all sizes and shapes, are encouraging increased spending, meaning more debt issuance. 

I cannot predict the time when all these trends will create some combination of a recession and or financial crisis, but prudent investors are not currently being offered enough reward to offset the inflation and currency risks.

Is the NASDAQ Leading?

As there are “horses for courses”, there are market conditions favoring one kind of bettor or investor. Part of the problem we analysts face in determining what may happen, is not knowing the individual or institution motivation in buying or selling a security. At best we have “circumstantial evidence”, which can lead us in one direction or the other. 

One of the factors in understanding the strength of various bets at the track is how much they are influenced by hometown biases and similar tie-ins. To some degree I can play a similar game by looking at the differences in trading on the New York Stock Exchange (NYSE) and NASDAQ. Thus far in 2021, the stocks listed on the NASDAQ have produced a higher return than those on the NYSE and Dow Jones Industrial Average. The NASDAQ stocks also led the decline this autumn. 

This Friday was an up day for the market, which highlighted the following similarities and differences in the NYSE and NASDAQ:

                                                                                                   NYSE        NASDAQ

Up Volume                   2.07 mil    2.09 mil

Down Volume                 1.74 mil    2.26 mil

New Lows (% stocks traded)  6.7%        17.1%

Stocks on the NYSE are on average older, larger, and more cyclical than those on the more junior exchange. To my mind there is a meaningful difference in the mix of active traders on the two exchanges. The NYSE is almost completely the home of passive stock index investors, including institutions and investors taking advice from brokers, now styled as wealth managers. By contrast, much of the volume on the NASDAQ is generated by active professional traders. (One of the regular rumors at the racetrack is that the “smart money” is betting on a specific horse, causing the betting odds to drop due to unexpected inflows.) Since NASDAQ prices led on the way up and down, I am wondering whether it is the current home of the “smart money”.

The Value of a Contrarian

I believe the smartest thing I did as Chair of a non-profit investment committee was to mostly limit the membership of the committee to active professional investors. I searched for a bearish investor and was able to get one with a long record of shorting stocks. In most years he was quite successful. He was a great addition to the committee in two ways. First, he questioned many of the buy recommendations from other members of the committee, including its chairman. The questioning led to some recommendations being withdrawn. He also contributed one of our big winners, a company trafficking in a little followed area that was not held in high repute, defaulted residential mortgages. It worked out very well and was a very good diversifier.

A contrarian’s value is enhancing the investment discussion and process. Contrarians do not count their ratio of gains vs loses, but the aggregate sums of money earned vs loses.

Question of the week: Are you getting sufficient contrarian views to help with your decision process?    

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Selections - Weekly Blog # 710

 

Mike Lipper’s Monday Morning Musings

Selections

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

Premise

One might say we make lots of selections each day, consciously or otherwise. One of the reasons I rely on lessons from betting at the racetrack is that it forces selection based on known and unknown criteria. The same can be said of investing.  In both cases there are active and passive decisions, although passive passes the decision making onto others. 

In almost all activities, particularly completive activities that can be measured, I try to improve my results by shading the odds a little in my favor. Experience is the best teacher, but each experience should be analyzed. The easy part of the analysis is the number of active participants, locations, length of time, and rewards. What is not easy to determine is the motivation of each participant. A reasonable attempt to figure out motivation is to examine the history of similar activities by participants.

Goals

The strongest of all goals is survival. Survival first requires the preservation of capital by limiting losses and participating in gains. If one wants to grow capital, lost capital must first be made back up to the starting capital level. Actually, return to the original capital level is insufficient, as there are expenses and taxes which reduce initial capital. In today’s world, the appropriate measure of capital is current spending power vs spending power at the beginning. Thus, changes resulting from inflation and foreign exchange need to be calculated and incorporated.

From a Historical Perspective

All life is cyclical. We know our results probably contain ups and downs. Psychologists tell us we normally feel twice as bad about loses than the pleasure of gains. One smart family financial office measures losses, including purchasing power, vs gains achieved. Their goal, which they have achieved, searches for opportunities that will produce gains twice as large as their real adjusted losses. With those concepts as a guide, I first examine the outlook for losses.

Outlook for Three Levels of Losses

Currently, most global stock market indices are showing year-to-date gains. While down from the peak levels of early spring, the gains are greater than those earned in the last two, three, and five years. These gains have been derived from the even larger gains of a small minority of stocks. My guess is non-indexed accounts produced smaller gains. There have been a significant number of absolute losers. The Financial Times recently published an article with the following headline “Half of this year’s blockbuster IPOs are underwater, despite broad stock rally”. They further note, “Goldman has led on 13 deals that raised more than $1 billion this year, but nine of these are now in the red” … ”Six of the 14 deals led by Morgan Stanley were trading below their IPO prices”. I suspect an important portion of these underwritings were bought by hedge funds and other highly sensitive market players. My guess, to the extent possible, is that none of the underwritten shares are currently owned by today’s “fast money” players.

With the above as background, I believe it is wise to look at the three types of market declines:

1. Corrections - Normally a 10% decline from peak. Through Friday, we are about half-way through a standard correction. I always assume the very next day after I purchase a stock there will be a correction. I can therefore tolerate such a market move. 
2. Cyclical – Declines of around 25% occur within each decade, The problem for an investor who pays capital gains taxes out of this account, is the reduction in the size of the account resulting from taxes paid. This raid on capital must be made up to recover the original capital base and is particularly galling if the stock recovers.
3. Structural – Recession/depression with loses exceeding 50%. These are generally part of the economic realization that something is out of order. They often occur during periods of excess borrowing, where the lenders’ financial stability is threatened.

My View

A correction has already begun, and it is not worth repositioning long-term portfolios. We have not had a cyclical decline for a number of years, and it appears to be long overdue. There are increasing numbers of business and people having difficulty. Odds are, within a five-year period there will be a cyclical market decline. Portfolios should be pruned of weak holdings. Weak holdings are those that would cause irreparable pain if they fell by 25% or more before returning to their current level in five years.

Selections Process

This is the topic of a forthcoming speech to a group of financial institutions and their advisers regarding analytical approaches to selecting individual securities, advisers, and funds. Needless to say, my approach is not the standard pitch.

Selecting Individual Securities

Rarely does a person want to exactly copy another. After reviewing the standard Graham & Dodd financial statistics, I focus on what makes a company different. Unless the stock is very cheap compared to peers, it is usually the non-statistical differences which make a stock attractive. I am suggesting that after securities analysis there should be business analysis. The following is a brief business analysis of five stocks owned in accounts, or by me personally. (These are not recommendations for purchase, as that would only be wise if they fit the needs of each portfolio and were priced attractively.)

Apple is viewed as a growing “annuities producer”. Rarely after a single purchase of an Apple product does the customer switch to another brand. Currently, there is a more than usual risk of delayed new purchases due to supply chain issues, higher prices, and the draw of forthcoming new products. Years ago, many General Motors car brands were in a similar position as people in America replaced their cars in one to three years. As with Apple, GM’s strength was in its distribution system. Apple’s is better, having their own stores and departments within big box stores. The annuity like value of their sales helps with their planning and is an attractive attribute for long-term investors. At some point, when attractive new features stop coming, it is possible the annuity like trend will become similar to the overall growth of the market. However, they will continue to produce good sales in countries with faster growing populations.

Berkshire Hathaway is managed for the non-shareholder heirs of current holders. This fits the desires and needs of a large portion of Berkshire’s owners. At some point, I suspect pieces of the operating company will be hived off to shareholders or other operating companies. The book value of these companies starts with their acquisition price, plus earnings less dividends paid to the holding company, which in a number of cases is way below what these activities are worth in an open market. I can envision a day when my grandchildren will receive a growing cash dividend from a smaller, regularly managed company.

Moody’s is a toll collector of fees from most of the world’s fixed income issuing companies, including non-profits and various levels of government. Most of these organizations will grow in an increasingly complex world, where debt is required for progress.

Raymond James Financial has the fastest growing financial services retail distribution network on a per share basis. They aggressively create homes for investment salespeople who find their current employers unattractive.

Goldman Sachs has probably more bright and talented people on a per share basis than any other financial services company. What is intriguing about GS is that it is transitioning from its old model of utilizing borrowed capital to one using capital generated by its own customers. When there is a new profitable game in towns around the world, Goldman will probably be in it. 

Selection of Advisors and Funds

Our history of being an advisor to institutions is one of great length. (We have enjoyed a number of tenures of twenty years or more, which only expired with the change of key members of the investment committee or a desire to go in a different direction). It is disrupting to change critical advisors, so it is done less often. Turnover of a stock portfolio is a more tactical move. With that in mind, the factors to be considered are more about the advisor than the holdings in a portfolio. Portfolios of equity mutual funds change about every 10 years, halfway between the 3-year turnover of a stock manager and the 20 years of a manager of institutional accounts.

In developing approaches to manager selection, one cannot avoid biases. These are thought patterns which at one point had a reasonably good foundation in facts. The intellectually honest advisor consultant or manager should use the current picture to update their biases. The following are my current working biases: 

1. Both highly concentrated portfolios and wide universes can be used successfully.
2. Short investment periods should be examined to find patterns of success.
3. Periods of weaknesses should be discussed in detail to understand humility, blame shifting, and blind spots.
4. Multigenerational team building, by both copying others and new thinking.
5. The reasons for low and high turnover and the difference between turnover of dollars and names.
6. Multiple generations of management in key departments.
7. Business Management skills and controls, analyzing successes and failures.
8. Small vs large losses.
9. Size of boards and executive committees, the smaller the better.

Art Forms

If good investing is an art form, then investment management is a bigger art form. Still larger is the investment management business art form.

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Investors Be Alert to November’s Risk Lessons - Weekly Blog # 709

 

Mike Lipper’s Monday Morning Musings

Investors Be Alert to November’s Risk Lessons

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

In the US we have just celebrated Thanksgiving. Other countries also have typical harvest festivals where they are publicly thankful for personal good harvests. As a perpetual student of investing, I am thankful for the investment mistakes I and others have made, for they represent learning opportunities. We have an opportunity to not repeat mistakes by learning from them. Both George Washington in the American Revolution and Abraham Lincoln in the Civil War started off by losing battles. They came close to losing their wars, but learned well and changed their tactics/strategies. 

In my discussions with successful investors, I usually probe their mistakes, asking what they learned from them. They often mention that there was a factor in clear view that they did not fully appreciate. In general, these factors were not standard securities analysis issues, but some critical element that would have significantly changed the valuation of a security or market.

The month of November could be such a period where changes unfold that make a major difference. In most developed countries with active securities markets stocks sold at near or above normal valuations, with high-quality bonds selling at depressed prices. In most countries COVID-19 was highlighted as the major cause of supply chain shortages leading to rising rates of inflation, although they were usually the result of economies being stimulated with wide-spread grants. These excesses were tolerated, but they made owners of capital nervous. 

Political leaders recognized the best way to win the next election was to continue contributing to inflation, providing more money than the amount of goods and services available. In the US, the latest census will shift seats from urban centers to southern states in the 2022 election. Texas will get two additional house seats and Florida one. Both have strong Republican governors and legislatures, which probably means these three new seats will go to Republicans, with Democrats losing three seats at a minimum. Historically, the party that wins the prior Presidential election loses the next mid-term election in Congress, particularly in “The House”. Based on history, it is logical to expect Republicans to gain enough House seats to prevent the continuation of Democrat spending and taxation policies.

During early November it was rumored within political circles that President Biden wanted a second term, even while his approval rating was simultaneously dropping. At the same time anti-energy moves were pushed by the Administration, most impacting Texas the leading petroleum producing state. The attack on the energy industry continued this week with the tapping the Strategic Petroleum Reserve and the raising of the royalty rate for drilling on government land. (The Strategic Reserve was set up so the military would have a source of energy should foreign countries prohibit sales to the US). It is a bit ironic for this President to make these moves while seeing himself as FDR like. FDR prohibited US oil companies from selling their oil from Indonesia to Japan, giving Japan a reason to expand its drive further South in the Pacific.

In the second week in November portions of the US and European markets topped out, while China’s market was already in decline. This week a new COVID variant, Omnicron (B.1.1.529), from Africa emerged. It is growing very fast and has caused the suspension of an increasing number of international flights. While some may feel this is just bad luck (racing luck), the medical profession has expected new variants for some time.   

On Friday most of the World’s stock markets fell materially. In the US the popular stock indices declined between 2% and 3%. Some sectors were worse, with Health/Biotech falling 4%. A number of individual stocks also declined materially, with at least one falling by 20%. 

Does the abbreviated US stock market session on Friday give us a clue as to its future movement? Possibly, both the New York Stock Exchange and the NASDAQ traded 3.4 million shares on Friday. Ninety percent of the NYSE volume was in declining prices, with only 71% for the NASDAQ. However, the number of new lows on the NYSE was 9.5% vs. 17.2% for the NASDAQ. This suggests to me that further declines are needed for the NYSE to bring stock investors back into the market. It is possible buyers were purchasing options instead of stock and if that happens broker/dealers may buy additional underlying shares.

At this point I do not see anything that would turn sentiment for trading in the week ahead positive. Only skilled traders should try to ride the various bounces that could occur. Initially, US investors will likely follow the path of Asian and European investors, which appear to be muted. Patience may be rewarded.

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Best Bet: More Sweaters and Parkas vs Overcoats - Weekly Blog # 708

 

Mike Lipper’s Monday Morning Musings

Best Bet: More Sweaters and Parkas vs Overcoats

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

I don’t like to lose bets, especially investments bets. That being said, I am highly confident those in the northern hemisphere will suffer a colder winter than expected. The streams of cold weather from Asia which flow over North America and Europe are moving south this year and will bring a colder winter to the US. (This contradicts “global warming” or climate change predictions.) The second and preventable driver is the need for politicians to be re-elected.

The only game that counts in Washington DC is getting elected, which importantly is based on money deployed from all sources. Despite food prices reflecting rising transportation costs, the central government is determined to hurt the states supplying energy for heating. Three states in particular are being targeted: Wyoming, West Virginia, and Texas. The first two are the leading exporters of coal to the rest of the nation, with Texas being the leading exporter of oil and gas. (Natural Gas is a major source of heating for much of the northern portions of the country.) These three states have significant Republican majorities, both in terms of votes and more importantly political contributions.) 

The game of war often relies on misleading the enemy regarding your intensions. In Washington this is done by a friendly media focusing on stimulus, even though it is a major contributor to inflation. While inflation is the cruelest tax on the poor, those in power believe the loss of some votes in the city districts won’t endanger the city progressives.

There are already a lot of predictions regarding the sharp rise in the cost of heating this winter. Landlords, already having difficulty collecting rents, may cut the amount of heat. Non-profits, including government bodies without actual or equivalent “rainy-day” funds, may face similar problems. Schools in low-income areas may similarly have shortages of students, teachers, and administrators.

Many of the aggrieved or their representatives will appeal to the media for help in sweaters (inside) or parkas (outside). Those appearing in overcoats will be considered tone-deaf, no matter how well intentioned.

Faulty Responses

Many of the shivering responders shown on television will emphasize the spike in heating costs causing an increase in “common colds”. The number of non-workers will be blamed on “acts of God”, due to shifts in northern wind blasts. They will not likely admit that part of the problem was self-administered, either out of The White House or Capitol Hill. By curtailing the capital generation of energy producing industries the government has caused the US to be an energy importer. It is no longer the net energy producer and exporter it was two years ago. They did this by causing pipelines to close, or not be built at all. Furthermore, in a stretched global market for oil, bureaucrats are increasing the industry’s burden by holding price investigations.

Multiple Year Transitory

As is often the case, economists look at the top-down government numbers of goods produced or shipped for problems, not the services or labor required. In their calculation of supply chain shortages, they fail to recognize the nature of the labor shortage. Not only are entry level workers missing, skilled workers and competent/trustworthy supervisory employees in service functions are also in short supply. (A good bit of these absences can be attributed to "educational" sector unions from pre-nursery through PhD programs.) These issues will not be addressed in the coming cold winter.

Long-Term, the Federal Reserve is Trapped

The favorite tactic of those in Washington is to change the rules if they are losing. Members of Congress are trying to make various economic/government financial agencies into social arbiters, including the Fed. Neither the Fed nor their supervised banks are equipped or authorized to perform these functions.

To the extent central governments want to spend a lot of others’ capital on controlling climate conditions, they will sponsor increased spending. This will result in both the Fed and the debt market increasing global debt massively. One wonders whether present low interest rates will become generational lows. Will higher rates drastically change the allocation of credit to the detriment of consumers at the low end?

Causes of Inflation

Inflation is caused by having too much money and borrowing power relative to the level of goods and services on offer. By itself it would be self-correcting through changes in price, including foreign exchange. However, when central banks create more money than their economies can immediately use, it leads to inflation. This is exactly what has been happening, so much of the current inflation has been caused by stimulus (bribes) payments. Thus, governments are a source of inflation.

Investing Choices

Perhaps the only wise reason to own securities today is the belief that the managers of some companies will be able to grow dividends above average inflation after taxes. 

If you have other reasons let us know. 

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