While Most Look to this Week, I Look Long-Term

Introduction

The almost exclusive focus of many US citizens and those that have investments or trade with the US is on the results of the Presidential election. Historically this is foolish. Going back through recorded history of elections from around the world, we have learned that even if they want to, politicians do not deliver on what they say. In this particular election this view will be most likely sustained. I am much more focused on who will be the ranking minority member of important Senate committees. That individual's political skills and priorities will give us the most useful clues as to what will pass through the House-Senate reconciliation committees when the two houses pass different pieces of legislation.

The second focus should be on the various strengths of the "K Street" lobbyists on both legislation and executive actions. All of these considerations are short-term and will in all likelihood will be overcome by currently unseen or at least unpredicted events.

With so much focus being paid to the very immediate, as a contrarian I look to the longer term implications of this and the various European elections that will occur within 12-15 months in the future.

The Losers

I don't know who the winners will be despite my personal opinions on who should win. However, it is easier to identify the most likely losers. As an old broadcasting stock analyst in years past, I could count on a surge of political spending on broadcast and print media advertisements during election season. These buys helped the cyclical earnings pictures of the media companies. It also set the need for political organizations to raise substantial amounts of money to pay for these ads. In handicapping an election the candidate that raised the most money would be the betting favorite to win. The election in 2016 is different. One side clearly raised the most money, but as always big money comes with ties. Either because of these ties or other reasons the big contributors may not have bought the election. At any rate they had to pay much more than candidates who used virtually free media exposure who are getting a much smaller cost for exposure and getting a higher return on their investments. The longer term implications of this condition is that the broadcasters and producers of print publications are going to be less valuable in the future. Ultimately the real losers from this switch to sound bites over the internet may well be the voters. There will be a dearth of long form, well researched, unbiased journalism. Unfortunately as of the moment not many people will pay for it. (I hope I am wrong as I personally own a fund that owns media stocks. Luckily they have substantial investments in domestic and international cable and internet investments.)

An Investment Research Parallel

Whenever I speak with CEOs of public companies or fund managers, the older ones complain as to the quality of research being produced. I believe it is the result of a similar economic pattern that will be applied to many media stocks. The market will no longer pay for the time and energy of in depth research. One of my great learning experiences was commuting with Arnold Ganz, my brother's research partner. He regularly produced forty page research reports that were of the quality of legal briefs. The analyses spent a great amount  of time on the motivations of managements as they chose different approaches to the future. There were a handful of pure research firms that did nothing but produce high quality research. None of these independent firms exist today, but I believe there are a few individual analysts with a small market audience working by themselves or very small groups.

Two Statistically Significant Events Happened This Week

After 108 years the Chicago Cubs won a thrilling World Series. The Cubs win is significant for long-term investors for two reasons. The first is the unfortunate need for patience along with continued efforts to improve. As an entrepreneur, investment manager, and investor I have experienced various plans for the future that have not worked out. For example in the third quarter many publicly traded fund management companies reported earnings declined greater than their revenue declines. Instead of operating leverage working for them as usual it worked against them. They elected to keep on spending for talented people and technology rather than cutting back. These managements were practicing what I learned in the US Marines. I was told by a senior officer we never get judged by the success of plan A, because we never get to complete it. We get judged by plans B through Z or some combination of those. The lesson was in combat one needs to be able to adopt to change conditions and execute the best one can. This philosophy rests on intelligent patience of looking for the new opportunities as they evolve. Unfortunately when we teach about dealing with life's investment problems we don't teach patience. The success of the Cubs was based on the patience of their fans, but also adopting a strategy that another successful team previously used in their winning season.

The second political and investment lesson from their victory was that the weight of money doesn't always win. Growing up in New York City it was easy to cheer for the New York Yankees, particularly after the New York Giants were suckered out to move to San Francisco by the transplanting of the Dodgers to Los Angeles. After all, the Yankees had the biggest stadium, largest TV audience and earned the most money. That worked well until some large financial institutions determined that they did not manage their farm teams well enough to produce new superior talent. This year's World Series was between the Chicago Cubs and the Cleveland Indians. Neither team benefited from the bi-coastal television audiences available to the Mets, Dodgers and the Yankees.

Often in the investment world there is the belief that the largest players can get better results because of their size and presumed talent. This is often called the “weight of money argument.” I first came into contact with this concept when I was leading an around the world mining focused analyst trip for the New York Society of Security Analysts. One night on the trip I got a call from the senior international investment officer of a large US investment group who was inquiring as to what were my trip mates’ reactions to our visits that day with some Australian mining companies in which he held big positions. Considering how deeply his firm did their research, I said I could not imagine that we learned anything that he did not know. That was not his reason for asking me in the middle of the night. He was interested in my guess as to whether the analysts would be likely to recommend the purchase of the stocks in which he was interested. In effect, he was attempting to gauge the future value of those shares based on the weight of money. This approach is not different than those who today are betting on which political campaign will win on the basis of the amount of money they have to expend. With the Cubs’ win this year it may not be an effective strategy to bet on the bigger payrolls of the other teams.

The second statistically noteworthy event of the week was the ninth consecutive day of the S&P500 decline. This has not happened since December of 1980 or before many of today's money managers were in the business. While the aggregate decline over the period was only

­­-3.1%, many of today's more trading-oriented managers are used to being able to trade successfully against a trend. In the commodities world this is called trend following and trading. The importance of this event is not its direct impact, for on October 19th, 1987, the market declined -20.47% and over a two day period in 1929, -22.50%, but rather a signal that we have entered into a different type of market than many of today's investment managers and investors are used to. They may have to exercise some patience as they search in their normal playbook for plans B-Z and adopt to changing conditions. This week could be interesting for them.

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Investment Stimuli: Short-Term, Intermediate-Term and Long-Term

Introduction

Almost every moment we are exposed to various stimuli. Often we are not aware of being exposed to factors that are going to impact us at some point in our lives. One of the reasons that I conceived the Timespan L Portfolios^® is to be able to focus on the known factors that will impact investment success. As we live in a nanosecond world of instant global communication and too many instant communication devices, we are besieged by the very current items, and longer term implications are drowned out. As a defense against this condition I have attempted to assign inputs into different time buckets. While the assignments are undoubtedly imperfect, the pigeon holing helps to clear the plate to give more time to each of our client’s needs that we will attempt to fund through wise investments.

Short-Term Inputs

As an investor I try to read into the current markets for insights to the immediate future. I have found that too few investors examine the changing market structure for clues. These are some of the elements that I am seeing:

• Most people last Friday  afternoon were mesmerized by the announcement that the FBI found additional emails that conceivably will have an impact on the US Presidential election. While that is in the immediate future, to me there was a major signal to all investors. Within a period of about one hour the Dow Jones Industrial Average, the stodgiest of stock indices fell 160 points, approaching 1%. By the end of trading most of the decline was recovered. The key to me is how "thin" the market is. My apprehension is that if we have a serious negative input the rapidity of the fall could be greater. Having just come from an investment committee meeting that was in the process of changing allocations to reduce risk to the orderly payment of needs, I am very conscious that on any particular day or hour when stocks are to be sold to generate a particular sum of money, execution prices may be temporarily lower. If one uses the VIX ratio the current market is trading significantly below its historic average and way below its peak, Thus I believe we need to be prepared for substantially more intraday and daily volatility.

• High quality bond prices have been weak globally. Some point to China as the source of the instability. Spot commodity prices in Shanghai for non precious metals have been moving sharply higher recently, aluminum and zinc in particular. I suspect that the increase in demand is not an increase in likely Chinese industrial production, but a reaction to a government edict. In order to reduce a surge in heavy truck accidents, the government has lowered the size of cargo that can be carried. A further concern longer term is the fact that factory gate prices recently rose for the first time since 2012. Thus, China is no longer exporting deflation. (More on China in the intermediate input section.)

• Often mutual fund net flows can be a reaction to changing conditions. For the last four weeks it has been reported by Lipper, Inc., that there has been positive flows into financial funds. (I am the portfolio manager for a private financial services fund.)

• Once again the so-called experts have been proven to be wrong on the impact of Brexit on the UK economy. A survey of expected UK retail sales predicted a 2% decline. The latest results showed a gain of +21%. Particularly now around important elections, I question the accuracy of various predictions and pools.

Intermediate Inputs

Steve Roach, now teaching at Yale, points out China is directly or indirectly through other nations, producing just about all of the world's growth in GDP. At the moment  China is in the midst of a transition from a heavy industrial exporter to a more consumption  product and services user. While there are lots of opportunities for "hard landings" on the switch, they haven't happened yet.

In reviewing the third calendar quarter reports for brokerage firms, asset managers, and banks there seems to be a trend to reduce some of the high priced customer-facing people and building up the "tech gang." Unless revenues rise dramatically there is a good chance that some of the more expensive tech people will follow some of the investment bankers out the door. Part of the digitalization of the financial community is the awaking interest in Bitcoin, which in theory can reduce back office personnel.

One of the conundrums in dealing with the growing deficit of retirement capital globally is the individual savings rate. The FT points out that in the aggregate, the savings years are on average between 25 and 65. The periods before and after the savings years are the consuming years. While most of the developed world is experiencing little or no workforce growth, the average lifespan is growing and there is an increase in healthcare spending as we get older. Many believe that the "new normal" will include low productivity and increase costs. (I believe that there is a chance that through technology we will partly address these concerns.) However, people are worried. In a recent survey people were asked what was their single biggest worry. Of the respondents,  61% indicated that they were most worried about "Corruption of Government Officials." My guess is that people are particularly concerned about their healthcare expenditures in their retirement. I am not suggesting that the level of corruption is any worse than in other parts of our society. Just that people feel increasingly vulnerable at the end of their lives to regulation that deprives them of deemed care.    

Long Term Inputs

Often I find that a concept or thought pattern from one area in my life can have  application to other portions. For example, I have just returned from a three day offsite annual meeting of the Caltech board of Trustees. As you might expect, much of the discussion was on what the senior management of Caltech thought about what they should be doing about their future. Below are some of their topics which I have translated into our investment world:

Concentrated Excellence - Assemble only the best investments and talent, others won't do. Don't accept average.

Fearlessness & Reinvention - Don't be afraid of challenging conventional thinking and imaginatively reworking old problems. (The final proving the correctness of Einstein's 100 year old theory took 50 years of study that started with disbelief in the ability to prove it.)

Intersection of Disciplines - combine knowledge and instincts of fundamentals, price/volume studies, trading inputs and techniques with international market patterns.

Pick important hard problems - Seek large volume solutions

Heisenberg Uncertainty Principle - The mere focus on a problem changes the nature and extent of the challenge.

Committing to a funded Space Based Solar Power Initiative which will beam back to earth solar power from space could in time be a major input to our needs for energy

In summary wise investors in securities and investment organizations should strive to lead and not follow through concentrated "smarts."

Question for all of us: How do we apply these and other inputs to our portfolios and investment work?   

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My Investment Views in 3 Periods

Introduction

As part of my work in designing specific portfolio elements for our Timespan L Portfolios^® , I have begun to separate my thoughts about future inputs into specific time horizons. Please let me know what you think about this approach.

Limited Term Horizon

I have little to add to the vast majority of investment chatter other than a few facts and beliefs:

1.  With the bulk of the purchasers of ETFs being investment advisors, hedge funds and other traders there is a belief the average holding period for them is two years or less as compared with between four and five years for equity mutual funds. This leads me to believe that these are more price rather than investment merit-oriented and are short-term focused. In the latest week the two ETFs that had the biggest inflows were invested in the Russell 2000 and the S&P500. My guess is that these were not sole positions, but were probably hedging concentrated short positions.

2.  Alluding to short positions at least for one stock, it is said every available security that could be loaned out has been. This could be just a prelude to a short squeeze which could spike the stock. It could also lead to a corner being declared. This translates to many transactions being cancelled. Is this an indication of our speculative times?

3.  I believe there is a major misconception that the money being redeemed from mutual funds is going into ETFs or passive funds. The two actions are in my opinion not completely related. My guess is that a large portion of mutual fund redemptions are in effect "completions." That is, they were purchased to fund a particular need and the time has come to meet that need. Many redemptions of funds are investor initiated whereas ETF purchases are coming from investment advisors or trading type organizations.

4.  There are three indicators that make me worried about high quality fixed income investing now. First, in the latest week only fixed income funds, including ETFs  saw inflows and all other asset classes saw outflows. As mentioned in last week's post, my early analytical training was at the racetrack where favorites win only about a third of the time.   

More importantly the size of the winnings for the bettor is insufficient to cover losses on other races. One of the reasons for that is the difference between mathematical probabilities and track odds.  The first is the calculated chances of winning based on lots of conditions. The second is calculated on the amount of money relative to all the money bet less payments to the tracks and state/local taxes. Probabilities are based on judgments whereas odds are based on the needs of the track and governments plus the distribution of opinions, some better than others.

There are two other interest rates concerns which are present. Short-term rates with maturities five years and under are higher now than a year ago, but not so for longer maturities, which is often a sign of instability. In addition, published money market accounts at banks have been moving up and are near the high point for the year. Banks raise deposit rates to attract new money or when they need to retain existing deposits. As usual it appears that the Fed is behind the real market.

5.  Over the next fifteen months there are a number of national elections. Some entrepreneurs and other investors will be disappointed in the results. This may lead to an increase in the number of private businesses and other assets being offered for sale. Often the buyers will be publicly owned companies. This is worrisome. The sellers appreciate the complexity of operating their assets on a daily basis. The buyers believe that they can produce better results than the prior owners because the new managers can put into place uniform principles and more complete solutions. Thus we could be entering another period where the buyers will disappoint their investors.

Intermediate Influences

1.  For years the front cover picture of a couple of magazines were wonderfully negative indicators. They were actually correct at the time the accompanying article was produced, they were just wrong as a predictive device. A Wall Street Journal article entitled “The Dying Business of Picking Stocks” could be a good example. The first line in the article went further and said, "Investors are giving up on stock picking." Other articles seem to be in support of that contention showing in the Large Cap mutual fund arena, that over ten years the percentage of actively managed funds dropped from 84% to 66%. 

I have mixed feelings about these views. As a contrarian I am delighted that there will be fewer competitors when I am trying to buy a bargain. Further, when I choose to sell a position I am pleased that a more supposedly successful stock will have more buyers at higher prices than passive funds. On the other hand fewer people adding significantly to their retirement capital means that my tax burden will go up. My guess is that when the equity market produces 2-3 times what the ten year current interest rate will, then be there will be a rush into the market and many people will become stock pickers for the ride as long as it lasts.

2.  One current market observer has commented that almost everything is going up a bit; in my mind this lack of successful selection skills will be only a temporary phenomenon.

3.  One of the current fads is factor investing where a single investment is used as a singular screen. In many ways the first factor was bonds and the second was stocks. These were combined into a balanced account for trusts. Thus the very first mutual funds in the US were Balanced funds. I have been exposed to balanced accounts and Balanced funds since the 1950s. Over time I have noticed that some performed better than others. Several managers, actually economists in training, varied the ratio of stocks to bonds. This explained a number of the differences in performance but not enough. When I looked into the portfolio at first I saw that perceived quality made a significant contribution to both the stock and bond returns. But that did not explain enough. Clearly the prices paid for the securities made a big difference. Trading competence and clout, particularly on the bond side was important. Some funds were close to frozen and others had high turnover of their portfolio. On the equity side whether they were growth, GARP (growth at a reasonable price), value or dividend-oriented also made a difference. Further, whether there was there just one portfolio manager or multiple managers eventually also produced different results. Over time Balanced funds became less attractive to investors as many wanted more distinct performance compared with a more level result when stocks and bonds were going in different directions (which was the original intent).

To the extent that the more modern factor funds can learn from the analysis of Balanced funds would be useful. Further the sooner they move away from analyzing only the published financials the better. This week Goldman Sachs* reported its third quarter results. Going back to my early experience of taking Securities Analysis under Professor David Dodd of Graham and Dodd fame, I reconstructed elements of the balance sheet and income statement. While the reported results were significantly better than the "street" expectation, the stock rose only slightly. In my analysis I noted the shift in the investment banking line to more advisory and a smaller amount of underwriting. In addition, I was conscious that non-compensation expenses were sharply curtailed, plus I saw a shift in the number of employees involved in investment banking and technology (investment banking was reduced, IT was increased). All of these observations added up to the conclusion that the firm is changing and the past record and ratios are of less value today than in the past. Yet many algorithms based on the pure reported results would not have picked up these changes as used by factor funds.

*Held in the private financial services fund I manage.

Longer Term Observations

The number of US publicly traded companies has declined by half over the last 20 years, but the average size of companies is now six times larger. To some degree this means there is less of a need for a large corps of analysts, particularly covering small companies. But this may well be a chicken and egg argument, for over time the level of commissions has shrunk as has spreads between the bid and asked. I suspect that many of the small company analysts that I grew up with are still delving into small companies for their own account, but are not sharing their work with clients. This could work out well for those of us who do not like crowds.

One of the reasons that there are fewer companies could be that the global development cycle has been shortened. Thus lower cost entrepreneurs with reasonable to better technology can quickly enter a market for new products and can rapidly capture market share that would not have been possible twenty years ago. So our protective umbrella has been pulled down.

Perhaps linked to this thought is that, according to recent surveys, 82% of parents in China today believe that their children will be better off in the future than the parents are now. In the US only 32% of the parents felt the same way. My guess is that these expectations will narrow, in part because the US will continue to disproportionately attract some of the best and brightest.

Question for the week: Do you separate your investment views by time periods?         

 

_________________

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Copyright © 2008 - 2016

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