We Are in a Training Exercise - Weekly Blog # 548

Mike Lipper’s Monday Morning Musings

We Are in a Training Exercise

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

         

We are Never too Old or too Rich Not to Learn
After almost ten years of a one-way domestic stock market we are experiencing some discomfort. Fixed income markets have been falling for some time and most commodities and currencies, ex the US dollar, are in bear markets. One might say that many investors in the US stock market over the last ten years have learned little and forgotten much.

Some of the realities we have forgotten:

1. Change is always present, but it becomes noticeable at different rates and times. From a portfolio standpoint, the time of maximum risk is often when each position is profitable.  The current prices of many positions are two to one hundred times their original cost. The danger herein lies in the belief that the size of these gains is permanent. Any detailed study of wealth over the years will show that it fluctuates and the only way to lose a lot money is to make a lot before one loses some or all.

One way to see the power of change is to examine the ten largest market capitalization companies in a series of ten-year intervals,1998-2008-2018. (See the footnote as to why the three periods were selected.) Only Microsoft and Exxon made the list in all three periods. Thus, there was an 80% failure to maintain relative market capitalization. One might say that any long-term investor who does not own these two for the next ten or twenty years is betting that they don’t survive at the top of the relative peak in market cap.

2. Perhaps, the most creative part of human nature is the ability to circumnavigate around an accepted standard. At one point in financial history the most important measure was yield, which was replaced with book value, which gave way to size and then to earnings per share. Now it is non-GAAP earnings. Usually, sellers of securities favor the old popular measure, where buyers prefer a newer version. Because of changes in accounting standards, tax rates, and regulations, private equity participants often use EBITDA (Earnings Before Interest, Depreciation, and Amortization). I prefer operating earnings adjusted for debt service. The one thing I am confident of is that in ten years the transaction price battle between buyers and sellers will utilize other analytical measures. The art of selling well and buying wisely demands nothing less.

3. One of the most valuable lessons that Charlie Munger taught Warren Buffett was that it was better to buy a good company than a good business. With the cycle of disrupting the old and replacing it with the new, there is a risk of buying into a copycat model based on the financial ratios of some currently successful company or venture. At one point there were some 300 US automotive companies, semiconductor manufacturers, restaurants, banks, insurance companies, and universities. According to Mr. Buffett, a good business is one that any fool could run and often does.

Defining a good company is not a mathematical or a historic exercise. The focus of the search is not on the “C” suite exclusively, it’s on the bulk of the people. Can they do the next important job? Do they have the trust of their clients and suppliers? Will they generate many of the new ideas and procedures that make both large and small differences. While too many annual reports state that their employees are their best asset, some do make that condition happen.

4. Market price liquidity is not important until it becomes critical. Most of the time price sensitive buyers and sellers keep prices and the spreads between them in check. During periods of stress the urgent price insensitive buyer or seller dominates the market and is a heavy user of the liquidity pool. As their insistent need to trade uses up much of the present liquidity, it frightens away some potential liquidity providers, leading to both greater than normal dispersion of prices and spreads between bid and offer levels. Often the price insensitive player is motivated by a need to meet an obligation. This could be an Authorized Participant or a Market-Maker keeping his book in balance. The biggest destabilizer is an owner meeting an immediate margin call.

There are some that say the unusually severe drop in the Chinese “A” share market was caused by the government’s concern about the quantity of  debt in China. They put pressure on the four major government-controlled banks to reduce the size of their loans. They in-turn called part or all of the loans to various entrepreneurs who pledged shares in their company. To meet the call they liquidated enough of their holdings to meet the banks’ demands.

Maybe one of the reasons  many NASDAQ stocks with good earnings and prospects fell more than other stocks is that large portions of their shares were owned by hedge funds, private equity funds, and senior employees who were meeting margin calls. This is the kind of market action that has been periodically happening ever since there have been collateralized loans.

At times, the size of the liquidity pool is more sensitive to sudden changes in sentiment than financial and economic numbers. Periodically, changes in political trends can cause driven investors and speculators to become price insensitive, causing liquidity providers to reduce their commitments or retire from the game.

Perhaps investors have learned enough from last week’s training exercise. Enough to know that when the real market reversal comes they will recognize what to do, before, during, and after a future “big one”. I hope so.

Footnote
2018 is ten years from the last major market decline and 31 years from the biggest single day decline, which was much more a market phenomenon than an economic one.

2008 was the first year of the great financial crises. This was the result of excess leverage by the private sector in response to a series of governments attempts to postpone a crisis in the economy, although they made future crises worse.

1998 was the year I sold the operating assets of Lipper Analytical to Reuters Group Ltd. It was a good company because we had good people who were dedicated to helping both our direct and indirect clients. 


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