Large Opportunities and Risks - Weekly Blog # 626

Mike Lipper’s Monday Morning Musings

Large Opportunities and Risks

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

Current Picture
Normally the US stock market moves at a pedestrian pace, with annual moves of about 10% (7% to 12%). We have just completed a two-month period that by statistical definition includes the fastest “bear market” in history and a recovery that would qualify as a one month “bull market”. There are some signs the recovery has likely ended, with a rounding or flat top for the three major stock indices. Furthermore, the lack of confirmation by the VIX index and the advance/decline line is casting doubt on the direction of the market. Thus, we have probably entered a confusing period, which until it is resolved will lead to lower volume. It offers an opportunity to reposition for a significantly lower market based on deteriorating economics and politics, as well as an  opportunity to buy into stocks that will be viewed as great bargains in the years ahead.

I am a somewhat risk-aware contrarian long-term investor and advisor. Both the Bulls and Bears could be right. For long-term investors, the bulls have an eventual chance to multiply their capital many times over, whereas unleveraged bears could preserve a portion of their capital. Careful bulls amass more capital over time than bears, although some bears have produced exciting short-term returns.

This dichotomy produced the first modern hedge fund, which was housed in the same 74 Trinity Place building in which I spent 25 years. A.W. Jones, a former magazine writer, came up with the concept of always being 50% long and 50% short. This produced good but not spectacular results over the years, often due to declining less in down markets. Unfortunately, he moved out of the building before we established our office there, but I did study his results. From that study and analyzing the success of a number of mutual fund and other managers, I concluded that long-term investing on the long side produced satisfactory returns. My lifetime’s work leads me to briefly outline the case for increasing equity investments now, although I should first clear up the one reason media pundits have led the investing public into a confused state.

What is in a name?
Our ability to name something or someone is critical to organizing our internal filing system, otherwise called memory. But it is also the source of much confusion if the name is not specific enough, such as with a company’s name. A name can mean different things to actual or potential customers, employees, competitors, lenders, and various types of owners. Much like blind people feeling different parts of an elephant.

Some of the abovementioned people are interested in what the company can do for them today and that becomes the company’s image, although it’s quite different for those who own the company’s debt or equity. They are vitally interested in the future securities price of what they own or are contemplating buying and need to guess the price of the securities at future dates of importance to them. The price will be determined by the current owners selling for some unidentified reason, while potential buyers compare similar investment opportunities. Today, most companies are experiencing falling sales and increasing prices, so things look temporarily bad. However, the securities buyer is looking at pent-up demand, which could return to 2019 levels, more or less.

The Optimistic Case
As is often the case, buying largely rests on demand in the short, intermediate and long-term. In the short-term, the $4 trillion in Money Market funds is earning next to nothing relative the real inflation being generated by the COVID-19 stimulus. At Bank of America (Merrill Lynch), 14 % of the average account is allocated to cash. In the intermediate term, when both businesses and other consumers get more comfortable, pent-up demand will generate sales of products and services.

In the long term, the main purpose of most money in institutional and individual accounts is to create future payments for specific retirements and/or legacies. If one amalgamates the retained earnings from 2018 through the present time, my guess is that in general it did not earn an actuarial rate of return sufficient to meet future payout desires. As my Grandfather’s friend Bernard Baruch explained to congress, the Latin derivation of the word speculate is to see into the future. I expect to see changes in how we live and think about the future coming from demographic trends, the march of technology, and the impetus from the current Coronavirus and future COVID plagues. As a global society we will be paying more for longer and more expensive retirements, particularly in the end.

An example of a little noticed change with larger implications is the following small notice on page 2 of The Wall Street Journal. 

“Notice to readers, Wall Street Journal staff members are
   working remotely during the pandemic. For the
   foreseeable future, please send reader comments only by
   email or phone using the contacts below, not U.S. Mail.”   

Considering President Trump wants the Postal Service to charge much more for packages, while rural members of Congress remain unwilling to change the schedule for mail delivery, future communications from various governments are likely to change. We are already seeing a smaller quantity of mail, which is not altogether negative, but is a lost sales opportunity for some.

The biggest long-term change I see is the possible reduction in our real estate footprint. Not only in our homes, but hospitals, schools/universities, and entertainment locations. I became more convinced of this threat when I read an article on the latest Gallup Poll survey, where individuals favored real estate over securities as an investment. As a contrarian I hope they are right but think their view will change as real estate becomes more difficult to sell, due in part to mortgage rates rising and state/local taxes going up.

What to Buy?
As usual, there are investment performance arenas from which to choose current winners and laggards. One advantage our clients have is that I look over the performance of all US and over 26,000 offshore funds each week. In the latest week, measuring from March 23rd which I am using as a bottom, the three leading mutual fund peer group averages were Precious Metals +47.40%, Equity Leverage +46.36%, and Energy MLP +43.16%. These are narrow-based funds enjoying a large recovery, which should probably not be a large part of a long-term mutual fund portfolio. The best performing diversified equity funds for the same one-month period were: Mid-Cap Growth +27.14%, Multi-Cap Growth +25.54%, and Large-Cap Growth +25.31%. Clearly, in this recovery growth has been favored in part due to its positions in the health/biotech sector, which gained +30.12%.  What may be significant is that performance leadership is no longer the sole property of large-cap funds, suggesting the overriding need for liquidity is shrinking.

Future performance leaders often come from the bottom of the performance ladder, which in this case are a few well-managed Value funds. However, one needs to be particularly careful looking for Value today. Far too many base their analysis on the spread between book value and price, which was a scholastic task assigned at Columbia University by Professor David Dodd while I was there.

This was a relatively easy job because we had the published financial statements, which had some relevance back then. This was not the way he and his partner Ben Graham (*), at the closed end leveraged Graham Newman fund, produce his great performance. Book value, according to their student Warren Buffett, is today misleading. It is an accounting number based on the historic cost of assets, which can only be changed by impairments, not improvements.

The task in the class I took was to identify companies that should be liquidated, not purchased as a going concern. There are relatively few of these companies today, as they are usually prey to private funds who specialize in this art form. There are however a reasonable number of companies whose financial statements do not fully reflect their improving value in the right hands. Careful and patient analysis can uncover their true value, the trick is identifying what or who will recognize their true value and change investor’s perceptions.

Conclusion:
Successful investing is much more an art form than a quantitative exercise. It requires patience and luck to make one’s investments profitable. 


(*) I am the recipient of the New York Society of Securities Analysts Benjamin Graham award



Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/04/long-term-investors-mistakes-ahead.html

https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html



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