Mike Lipper’s Monday Morning Musings
Four Letter Words to Sounder Investing
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
When I was growing up I was admonished not to blurt out various four-letter emotionally driven words, which had the effect of me not using four-letter words at all. I rarely focused on words such as love or nice. When I now think about communicating sound useful concepts to long-term investing, it strikes me that there are at least five four-letter words that shine a light on critical concepts. These are briefly discussed below in alphabetical order.
Debt
Debt is the temporary transfer of capital from lender to borrower in exchange for periodic interest payments. Both sides benefit from the exchange, the lender receives payment for delaying current spending and the borrower from using someone else’s capital. In a world where debt is growing faster than the growth of the economy, the question arises, is this a wise temporary transfer of capital?
From the borrowers’ viewpoint it should be about the amount of benefit received, be they individuals, businesses, or governments acting as an intermediary for taxpayers. Such as borrowing to invest in long term assets that will produce a stream of income larger than the interest and related costs. A mortgage on a business building is a good example.
Unfortunately, we are seeing more borrowing by both governments and individuals for consumption. One can look at much of the stimulus spending, which politicians hope will benefit them at the next election. Some may call these bribes, like the “bread and circuses” of ancient Rome, which at least built roads and bridges that produced a stream of increased traffic.
When viewing any transaction one can often identify at least one winner, although this is not the case for high-grade debt today. The lender is receiving interest payments that will not fully compensate for the future decline in purchasing power, both in the national and international markets. (The JOC Industrial Price Index is up +108.81% and producer prices are up 12% year over year.) This may be why large commercial bank loans fell in the first quarter, even as deposits grew.
There is currently another problem with debt, the fastest debt growth is being financed outside of regulated banking institutions. The source being brokerage/investment banking firms and other financial companies. Margin loans to support securities transactions have grown 70% year over year. In well-managed brokerage firms, utilizing listed stocks and bonds as collateral is reasonably safe for the lender, who can recover from some of their clients going broke. However, there has recently been a surge of borrowing to leverage non-listed derivatives tied to relatively illiquid stocks listed globally. The question facing the market is, are we approaching a crisis like the Morgan Library Panic of 1907 where the banking community was forced through locked doors to contribute to endangered competitors? The problem would likely be socialized with government bailouts today, adding to the growing deficit by partially financing it with more debt. Bottom-line for most institutions and individuals, debt is not currently priced for the long-term inherent risks.
Risk
Sir Isaac Newton came up with a critical rule, “There is an opposite and equal reaction to every action”. Too bad he did not offer an investment rule for his own considerable fortune, suggesting every investment caries both rewards and risks throughout its existence. There is no such things as a riskless investment. The key to assessing the size of a risk is what a knowledgeable, disinterested, investor would pay for an asset producing an acceptable rate of return relative to all other investments. This may be the reason that on the more actively traded NASDAQ the number of stocks rising was 8.5% vs 5.8% falling, compared to 18.4% rising and 3.2% falling for the NYSE.
Rate
Rates tie streams of numbers together, like miles per hour. Most of the time in the investment world the two streams relate to interest rates, earnings growth, sales, and book values compared to prices. The wise investor adjusts the first stream for the probability of it continuing the current movement. The price may also need to be adjusted for the likely size of the investment. (Remember, quoted prices are for small purchases, take-over prices are normally higher than pre-bid prices.)
Rank
Rank is an orderly display of participants based on criteria such as length of period, size, volatility, etc. One should remember there is nothing that promises the sustainability of completed periods. The winner may have been slowing down or speeding up immediately before the end of a period. Also, first place gives no indication of any negative event impacting one of the participants, which may not reoccur. While repetitive high rankings are assuring, it is not a guarantee of future results. In picking funds or stocks, you need to adjust for the change in skill of each participant. Because conditions change, one should not place too much emphasis on repeated success. Remember, winning streaks almost always end.
Time
By far the single most important variable in choosing an investment is the period to be measured. Unless an investor believes they have superior trading skills, they should focus on one or more time periods. The longer the period, the more likely the return will be smaller. The number of full participants will also decline through acquisition or failure.
The following set of observations may be relevant in applying attention to today’s details:
For the current calendar year through last Thursday, the best mutual fund macro peer group was US Diversified Equity Funds +12.02%, followed by Sector Equity Funds +11.96%, Commodity Funds +11.59%, World Equity Funds +6.82 %, and Alternative Equity Funds +1.84%.
Keep in mind that this data is for almost one-third of a year. The 12% return for US Diversified Equity Funds and the +9.53% return for All-Equity Funds is close to the long-term stock average of +9-10% per year, which excludes fund expenses. This raises the question of whether an investor should stick around for the rest of 2021. If you were to stay invested this year, a contrarian might invest in the average World Equity fund, which has generated roughly half the gain achieved by US focused funds. Of the 25 best performing mutual funds this week, 10 invested in the China Region. A leading broker noted that investors were buying European Equities, inflation-oriented investments, and “value” stocks. They were selling high yield and emerging market securities. (Note that the five largest tech stocks have a combined market value larger than all the emerging market stocks.)
Most large gains by investors result from holding stocks and equity funds for a long time. An example of the effect of compounding is the US Diversified Equity Funds return of 12% doubling in 6 years. (Which assumes an annual return of 12%). If the compounding rate were 9% it would take 8 years and at 6% the doubling would take 12 years.
We rarely live in an average year. Based on history, roughly two-thirds of the years rise and one-third decline. Because of the compounding effect investors have more money in their accounts than simply multiplying decades of average performance. Results can be very satisfactory. Hopefully we will recover from increased “rates, regulation, and redistribution” in the future.
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/04/the-other-side-weekly-blog-677.html
https://mikelipper.blogspot.com/2021/04/mike-lippers-monday-morning-musings.html
https://mikelipper.blogspot.com/2021/04/respecting-opposition-market-weekly-bog.html
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