Mike Lipper’s Monday Morning Musings
Adjust Investment Tools for Next Phase
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
As Rules Change, or are Better Interpreted
For many years to the extent possible, I managed the Defined Contribution Plans for the NFL and the NFL Players Association. At the time of each Super Bowl, when asked which team I was rooting for, I replied “for those in the black and white uniforms”. I hoped the officials would see all the relevant plays and correctly interpret the changing rules of the game. As it turns out, that was good training for watching the constantly unfolding investment games between buyers and sellers, various regulators, shifting weather conditions, injuries, mistakes, and pure luck. None of the results were pre-ordained and would be argued about for many years into the future. I approach each market and market phase with the same weariness in preparing for the next market phase. Part of the preparation is examining the terms used to describe the game, and when appropriate improve definitions. This exercise may be particularly important this year, as it appears we are close to a crossroad.
Enthusiasm vs Crumbling Underlying Structure
Many global stock markets are rising in February, despite the historical odds that after a decline in January there is only a 22% chance that the remaining eleven months will produce a profit. The general media, revealing their political views, interpret the various executive orders and other political pronouncements as accomplishing their goals, and see an economic expansion beyond the release from the lockdowns. It could happen, but the odds of complete success are unlikely.
The current small-cap +5.03% and emerging market +3.07% leadership in January is like other late stages of the past. Fixed income funds often lead equity funds in terms of direction. For the year through Thursday night, the average S&P 500 Index fund was up +3.16% vs -2.95% for the average General US Treasury mutual fund. Another worrisome note is the size of margin debt, which perhaps due to short squeeze actions has reached record levels.
A good investor should look beyond stock prices to see a different economic view, which I attempt to do. Large futures speculators are increasing their shorts in copper, Eurodollars, S&P 500 minis, emerging markets, and US Treasury bonds. In recent blogs I mentioned the Industrial Price Index rising compared to a year ago and this week it accelerated to a gain of +33.18%. The bond market recognizes these tensions and the yield curve has continued to steepen. Even the Congressional Budget Office sees that inflation will likely be over 2% by 2023. (My guess is that it will be a lot sooner, raising the cost of financing the politically generated deficit.)
Understanding the Tools of Security/Fund Selection
Headline writers and many marketeers prefer short words to describe complex tools, e.g., “growth” and “value”. These create good pictures or charts, with ever rising growth and ever declining value. Would it be so. As with the changing weather at a football game, conditions change, as do the useful definitions of terms.
Speculators essentially bet on what others will pay for their shares, bonds, or loans in the future and a successful speculator primarily knows his/her markets. An investor is a partial owner of a company that at some point could be purchased by a knowledgeable buyer. It has been the motivation of buyers and sellers in marketplaces around the world since recorded time. Perhaps in response to the “great depression”, securities analysis became a separate academic subject, distinct from older economics courses.
Benjamin Graham was a successful analyst/portfolio manager/investor. He was also a good writer as an adjunct professor at Columbia University and worked with Professor David Dodd in writing the first textbook on Security Analysis. Graham and Dodd were primarily interested in avoiding unnecessary investment losses in their writings and emphasized the use of financial statements, particularly balance sheets. In early editions of their six-edition book, they emphasized anticipated liquidating value, an issue appropriate during a depression.
While Ben Graham is often erroneously called the “Father of Security Analysis” and the first value investor, this is not where he and his partners in a closed-end fund made most of their money. The fund became a dominant shareholder in an insurance company which had no real equity left on its balance sheet. What it did have in this period of substantial unemployment was a customer base of relatively low wage employed government workers. They saved and ended up controlling Government Employees Insurance Company (GEICO), which Warren Buffett analyzed and eventually bought outright.
Years later I personally had the honor of taking the Security Analysis course under Dave Dodd, but I disagreed with him and believed that growth was an important factor in choosing investments. He quickly shut me up by indicating how much money they had made on their investments. Years later, as a small entrepreneur, this led me to include growth and more importantly the evaluation of key people in making successful investments. (In evaluating three cases, one had to be closed, another was key to a bigger product, and the third was very successful). As a side matter, I was particularly pleased to receive the Benjamin Graham Award from the analyst’s society in New York for a private matter requiring some investigative skills a few years ago.
Today, when I review financial statements, particularly the footnotes, I have little confidence they will reveal the “true value” of the company. We live in a litigious world and accounting practices are designed to protect the accountant, the underwriter, or the company itself against lawsuits, rather than to ascertain value. However, there are some very good analysts that are pretty good at finding the range of values for a company. These analysts don’t publish their work, as they are employed by investment bankers, private equity funds, or serial acquirers. While they don’t publish, the price of their bids and deals are known, and this sets the market price for similar deals. If I can’t get enough data, I use the multiple paid for earnings before interest, taxes, depreciation, and amortization on successful bids.
To understand value investing, one needs to understand where the current market is and what is best indicated by the price of deals. These in turn are influenced by the level of interest rates used to discount future growth and the cost of acquisition.
How to Measure Growth
Many believe that any number larger than the previous number is growth. For valuation purposes however, what is useable are growth comparisons. They should deduct inflation, exclude acquisitions, currency changes, and the impact of changes in regulation or competition. To me, each period may be different, so a long period growth rate can be misleading.
I like to see the consistency of growth rates. There are times when highly variable growth rates leading to above average long-term trends are valuable and times where a more consistent return is more valuable, particularly for accounts that have finite payments requirements. (For mutual funds, we measure both total return and consistent returns.)
What about both Growth and Value?
In truth many companies go through periods of growth and value. IBM, before it changed its name and was under Tom Watson’s management, had so much debt that it was viewed as an underwater stock. Years later, it became the prime example of a growth stock and later still its growth slowed to the point where at times it was viewed as a value stock. Because of various recent changes I don’t know how to characterize it. What I do know, is that past financial history is not of much use to an outside investor.
Since many companies go through numerous growth and value changes, I favor looking at many periods. However, it is more important to look at changes within the company, including the people hired at the senior and entry level, changes in product/service/prices, and the reaction to competition/regulation.
Conclusions
1. Look at how things are, don’t overpay for history.
2. Expect surprises!
3. Take partial positions initially.
4. Admit mistakes quickly and serially.
Your Thoughts?
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html
https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html
https://mikelipper.blogspot.com/2021/01/contra-messages-weekly-blog-664.html
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A. Michael Lipper, CFA
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