Proving Investment Selection Processes

Clients, critics, and financial media consumers want to understand how other professional investment managers and I select the securities that are found in their portfolios. For me, the starting points are the financial and emotional needs of the account. I believe that one size does not fit every individual account. Using those elements as a base plus an understanding of critical time horizons colored by views as to the current market opportunities, I decide on one or more selection processes for the funds that will be resident in the account.

The purpose of this post is to examine two opposite selection processes, (1) Picking winners and (2) Avoiding losers; as well as to discuss the provability of these or any selection processes before-hand.

Picking only winners

A number of selectors of mutual fund portfolios and some newsletter writers look to near-term performance. In at least one popular case the published pundits select funds with the best available one year performance regardless of investment objective. Under their ministrations the subscriber or account holder will continue to own the fund for a year. At the end of the year the underperforming funds will be replaced with the current year's best performers. This is a momentum approach adapted from the individual stock world to the portfolios of tax-paying mutual fund holders. Early in a long cycle the momentum approach can produce good returns. Often it has the benefit of producing spectacular results near the top of a highly speculative market. The descent from the peak however can be very painful in the first year of a decline.
                                                           
Avoiding big losers

While desirous of gains, many of the clients that have chosen me to manage their investment fund oriented accounts are relatively risk adverse. With that as a filter I turn to the databank now known as Lipper for Investment Management. (I no longer have any direct connection with my old firm, the producers of the data.) I particularly search for down quarters. Because the majority of the money I manage is in large institutional accounts or on behalf of very wealthy families, I restrict my search to funds with current assets of over $100 million.  My accounts are expense-oriented, thus I seek to have total expense ratios below 1.26%.

In this example I focused on three particularly bad quarters since December of 1999 and I was interested only in those funds that declined measurably less than the average in their peer universe. Because of the needs of a particular account I looked at only small capitalization funds. My original sort started with some 400 funds. The resulting roster of funds that passed through my filters was a grand total of five. Three of these were closed to new accounts. I may have to be less stringent in my screens in order to surface a suitable number of funds to examine with current upside potential. Time will tell whether I can come up with winners, but history is on my side. What I am confident in is that when the  periodic down markets occur these kinds of selections will perform better than the momentum driven suggestions from the first approach.

Can you prove it?

I have been recently asked “What do you believe about investing, but know that you could never prove?" Before addressing whether I can prove that my approach of avoiding large losers rather than the approach that is momentum driven, I want to share some of my thoughts as to "proof" of investment decisions.

From my exposure being a Caltech Trustee and my vague memory of my physics classes at both Columbia University and the Staunton Military Academy, the discipline of the "scientific method" makes me question whether anything can be proven about investments before the final trade is tabulated. The basis of the scientific method is that anyone following the same procedures will get the same result. In physics there is no attention to the emotions of the experimenter or the fact that all conditions surrounding the experiment are known. As we don't know why anyone buys or sells a security, we don't know the critical motivation to the trade.

Is the seller making an investment judgment as to the value of a security absolutely or relative to some other security?  Are they putting their portfolio in the desired order or are they meeting a funding need? The buyer may find this particular security attractive in and of itself or may want to increase the portfolio's exposure to the market or sector. The buyer may need to be in a more fully invested position by a report date. Both the buyer and seller may be reacting to competitive pressures from within their organization or beyond. Given the same general economic, political, and announced corporate results but a change in any of the other factors listed above, a different set of results are possible. As Mark Twain said, “History does not repeat itself but it does rhyme.” A good example of this is when Ruth and I go to many of the wonderful concerts of the New Jersey Symphony Orchestra; the program informs us as to what is going to be played, but not how it may sound to us. Guest conductors and soloists as well as different musicians on stage let alone different concert venues and weather can produce startling different levels of appreciation.

Instead of utilizing my academic exposures in getting comfortable with expectations of future results, I fall back on my two real sources of thinking:  the racetrack and the US Marine Corps.

What I try to do is guess what the odds are on a result. I use past experience adjusting for current conditions as well as the persistency of trend. (The longer the trend the less likely it will be continued.)  Like many who are always focused on survival, I accept that my bias for quality will reduce some of my upside potential. Nevertheless I echo “The Long View” column by John Authers in Saturday’s Financial Times, “Numbers add strength to Buffett's law of selection not only for Warren Buffett's focus on quality, but his price discipline.” That discipline can be summed up by "It is better to buy an excellent company at a decent price than a fair company at an excellent price."  I believe the same concepts can be used in selecting fund mangers.

You can have it both ways

One of the nice elements of a portfolio of funds is, when appropriate, one can assemble a portfolio following a number of different approaches. This multi-approach portfolio could make sense for a portfolio that has different time horizons.

Which approach do you use?

Traveling and learning

September will find Ruth and me in London and Budapest. I would be happy to meet with any members of this blog community to share views, particularly from those who will help me learn.

______________________________

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All Rights Reserved.
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The Real Investment Risk is not Changing Your Thinking

In the US Marine Corps and in the long-term investment portfolios that I manage we never lose sight of our final goals of accomplishing the mission and survival. In the Corps, investment portfolios, school lesson plans, and certain other activities it is desirable to move orderly in one direction and with a single set of instructions. Unfortunately that approach is often called the ‘school’ solution, a theoretical plan that does not represent the reality on the ground or in portfolios that must perform. In the real world more often than not we are confronted with challenges and therefore opportunities that take us off the narrow principles-based trajectory we have been schooled to follow. At every given moment, those of us that invest for others must negotiate the differing challenges of:

·       Selecting among tactical vs. strategic considerations

·       Diversification against a laundry lists of risks

·       Incorporating multiple and changing definitions of risks

·       Managing operational considerations both for the client and our own shop

The future starts with the present

While a long journey begins with the first step, our near-term vision can dictate how we approach our long-term goals. One of the traditional problems in using long-term performance is that the jumping off point may be radically different than the first step that built the enviable record. In almost all cases it is better to start when the market prices reflect past poor performance rather than counting on momentum to continue. Intellectually this may be easy, but emotionally tough to do. Luckily peaks and bottoms are relatively rare in terms of frequency. Most of the time we are zigging and zagging within an unclear trend.

One of the advantages of my practice is that I get the great opportunity to have meaningful discussions with smart managers, (there are very few, if any, dumb portfolio managers in the fund business). I am often struck that in this world of supposedly fair disclosure, that the better managers receive very productive insights from conversations with people not directly connected to the corporate or financials worlds. In addition, the better managers have good powers of detailed observations.

I try to learn from the good and great ones and apply their different approaches when I can.

A breakfast at Caltech

Some time ago I spoke to a group of incredibly intelligent students from the California Institute of Technology about financial community opportunities. I must have made some sense because a few weeks ago one student asked whether we could continue the discussion with a few of his fellow grad students. My time on the Caltech campus is always quite limited, so I challenged him to come to an eight o'clock breakfast. (For many students, 8 AM is the middle of their sleep period!)  Four of them attended as did a fellow trustee with three degrees from Caltech, who is also a successful company founder. We were joined by a professor and research project leader in neuroeconomics.  He is developing an understanding as to how the brain makes investment decisions.

The students appear to want to focus their efforts in biotechnology. While still on campus one of the students has already founded his first company.

I don't know what they received out of our discussion, I got an understanding of what their science (and others) can do for mankind. This discussion was followed by another about the development of a potential home machine that could transmit the nature of ailments through sampling body fluids that could be delivered to doctors before the patient arrives.

What does this mean to me?

One of my antecedents was an Elector for Abraham Lincoln, and even though my brother received an appointment as a page from a Democratic senator, I am a believer in much of Republican philosophy.

I had firmly believed that the so-called Obamacare was a mistake for the country economically and socially. While philosophically I am still opposed to government sponsored healthcare, the discussions on the campus of Caltech and reviewing a fund that has been a successful investor in biotech companies of high promise, I am now contemplating that the government's projections are extremely misleading, not because of their socialistic policies, but because of technology. Relatively low cost and widely spread new families of healthcare instruments or appliances as well as new drug therapies could materially lower the costs of healthcare. My purpose of bringing this subject up is to show that as long-term investors, we need to constantly examine our thought patterns. This is just like the Marine Corps had to develop tactics of moving off of ridge lines and moving down into the valleys or cross-compartments to take the "critical terrain" and accomplish its mission.

Our mission is to invest successfully long-term

The first rule of successful investing is to avoid permanent loss of capital. In this weekend's Wall Street Journal 

the inestimable Jason Zweig discusses a book that focuses on risk. To me risk is the penalty for being wrong to the degree that critical terrain is lost in accomplishing long-term investment goals. Jason makes the distinction between shallow risk which he harks back to Ben Graham as "quotational risk" or somewhat temporary price declines. "Deep Risk" is what we should be focusing on, he believes.  Deep risk is created by four elements; according to the column they are:

·       Inflation

·       Deflation

·       Confiscation

·       Devastation

Though bad for our future capital, the four conditions above could be survivable if expected and anticipated in our portfolios.  If we don’t recognize the potential for each of the listed ‘four horseman’ then we are truly in deep .... risk.

Recognition time

I could be wrong about the overall costs of healthcare; certainly I will consider more evidence that may alter my view. However we could change direction on national inflation and the continued confiscation of private bond holders' rights versus the government’s prerogatives.

The truly successful long-term investors don't lock themselves into a strategy. Each day if not each hour represents an opportunity to change.

An effective time horizon strategy

Rarely market prices, yields, and other investment ratios reach long-term peaks or bottoms. Most of the time we are zigging or zagging from a past major top or bottom. We just don't know which is the terminal point of a trend. Therefore a mechanical process of adding to or subtracting cash to an investment portfolio makes sense. The trick to do this effectively is to keep the time horizon in mind for each portion of the portfolio. 

Current needs

For the portion of the portfolio that needs to provide current levels of money to meet operating needs, US law has changed. Under modern law the distinction between income and capital has been removed. Thus the general level of acceptable current yield is augmented by trading results. In today's markets, I suggest that trading of stocks and bonds will be a greater source of cash needs than yields. The ability to convert principal to meet needs suggests that current requirements will be met by what we used to call "wasting assets" similar to investing in a mine with a known life. Eventually the funds will be needed to support current cash needs.

Intermediate-term

The next time horizon bucket is the intermediate bucket or perhaps buckets. The purpose of this intermediate portfolio is to regenerate enough cash in a timely fashion to provide for current needs when the first portfolio is exhausted. This portfolio requires less trading skills and in today's environment more equity type risk taking which can include some so-called high yield product.

Long-term

The four "horsemen" of deep risk should be the main focus of the long-term portfolio with sufficient upside potential to offset the pains delivered by the deep risk elements. Based on my own recognition from this last week, I will look as to what makes sense in biotech investing either in the public market or through intelligent and not too greedy private equity vehicles.

Questions for today

1. Share with me privately what were the "aha moments" in your portfolios.

2. How are you positioning your portfolio responsibilities for this dynamic world?

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Government Debt vs. Tough Love

Introduction

Introspection is forcing many managers and investors to privately reconsider the basic premises of their long-term investment strategies. With the popular US stock indexes at or near all time highs, why don't they feel better?  The relative investment performance of many high quality value-focused managers is lackluster. The companies they own are doing well and for the most part they are sitting on lots of cash earned overseas from faster growing markets than their own home market.

One of the sectors which is doing very well for many portfolios is financial services securities. In terms of market value this sector is the second largest in the S&P 500. Further, in most other markets, the financials are the largest high quality names. Our own private financial services fund is having a good year producing returns at least twice a "normal" year would produce. And that dear reader may be a symptom of the deep problem.

The two drunks structure

When two people who have had too much to drink and are marching down the street supporting each other, there is a symbiotic mutual support system at work. In most countries, governments are thought to be the guarantors of at least the banks’ depositors, if not the majority of its creditors. In most societies, the largest owners of the governments' debts (those that are not a government entity like social security) are the banks. The drunks are into each of their pockets in a major way.

The reason and the costs of financial dependence

We all know the historic reasons for these relationships. In the past each side was feared to be in danger of failing. Under these circumstances heads, some of them innocent, would roll. There would be disruption of “normal” activities and many things would grind to a halt. That is until replacements came into being with new leadership and fresh capital. Order would be restored with the absence of some wonderfully historic nameplates such as Bear Stearns, Lehman, Washington Mutual, Countrywide and Merrill Lynch; as well as, at least initially, more assorted spending and investing. In a parallel example, think about some function or people who were let go and not replaced. In all likelihood they were not earning their cost of capital and in the past were a drag on all who were.

No bailouts plus “tough love”

In a somewhat simplistic view the bottom line of corporate, bank, and government failures is that they run out of money. This was probably due to the fact that they did not earn enough to pay their debts (including to their own people), and because their clients and citizens did not value their services highly enough to meet their obligations. As an independent investment advisor and private citizen, no one is holding a safety net beneath me to meet my obligations. Recognizing that I am not likely to get some form of bailout, and that with the specter of tough love, I have to manage my affairs to pay off my legal and more importantly for me, my family and charitable obligations.

What would the world look like under tough love?

Governments would rely on their taxing authority to meet much more limited needs. Some of present expenditures would be taken over by the private sector; this would include the postal system, Medicare, Social Security, Patent Office, Library of Congress, mortgage companies, student and farm loans, many government facilities and more.  At the same time the private marketplace would determine what would be the minimum level of capital required for a bank to be considered sound and safe. This probably would mean that banks would keep very little of their capital in medium to long-term bonds.

Do I expect this to actually happen?

No, but I think there is some chance that we will haltingly move in this direction.

If there is any chance, how should this be played?

In a conceptual sense we are already seeing replacements for traditional banks. You can't tell this from midtown Manhattan or in many wealthy suburban communities, but the number of bank branches is dropping. The financial agents for college age kids are credit cards, student loans and the “Bank of Mom” or other relatives. In some respects Google, Alibaba, Amazon and undoubtedly others including financial services web-based brokers, large family offices, gatherers and distributors such as BlackRock, Blackstone, KKR and T Rowe Price* will play roles that banks have played in the past. Not all of these stocks will be successful, but some exposure in portfolios will be warranted
          *Held by my private financial services fund.

A question

Who is providing financial services for your children and how will this impact your plans in the future?

___________________

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



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


Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.