Selections - Weekly Blog # 710

 

Mike Lipper’s Monday Morning Musings

Selections

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

Premise

One might say we make lots of selections each day, consciously or otherwise. One of the reasons I rely on lessons from betting at the racetrack is that it forces selection based on known and unknown criteria. The same can be said of investing.  In both cases there are active and passive decisions, although passive passes the decision making onto others. 

In almost all activities, particularly completive activities that can be measured, I try to improve my results by shading the odds a little in my favor. Experience is the best teacher, but each experience should be analyzed. The easy part of the analysis is the number of active participants, locations, length of time, and rewards. What is not easy to determine is the motivation of each participant. A reasonable attempt to figure out motivation is to examine the history of similar activities by participants.

Goals

The strongest of all goals is survival. Survival first requires the preservation of capital by limiting losses and participating in gains. If one wants to grow capital, lost capital must first be made back up to the starting capital level. Actually, return to the original capital level is insufficient, as there are expenses and taxes which reduce initial capital. In today’s world, the appropriate measure of capital is current spending power vs spending power at the beginning. Thus, changes resulting from inflation and foreign exchange need to be calculated and incorporated.

From a Historical Perspective

All life is cyclical. We know our results probably contain ups and downs. Psychologists tell us we normally feel twice as bad about loses than the pleasure of gains. One smart family financial office measures losses, including purchasing power, vs gains achieved. Their goal, which they have achieved, searches for opportunities that will produce gains twice as large as their real adjusted losses. With those concepts as a guide, I first examine the outlook for losses.

Outlook for Three Levels of Losses

Currently, most global stock market indices are showing year-to-date gains. While down from the peak levels of early spring, the gains are greater than those earned in the last two, three, and five years. These gains have been derived from the even larger gains of a small minority of stocks. My guess is non-indexed accounts produced smaller gains. There have been a significant number of absolute losers. The Financial Times recently published an article with the following headline “Half of this year’s blockbuster IPOs are underwater, despite broad stock rally”. They further note, “Goldman has led on 13 deals that raised more than $1 billion this year, but nine of these are now in the red” … ”Six of the 14 deals led by Morgan Stanley were trading below their IPO prices”. I suspect an important portion of these underwritings were bought by hedge funds and other highly sensitive market players. My guess, to the extent possible, is that none of the underwritten shares are currently owned by today’s “fast money” players.

With the above as background, I believe it is wise to look at the three types of market declines:

1. Corrections - Normally a 10% decline from peak. Through Friday, we are about half-way through a standard correction. I always assume the very next day after I purchase a stock there will be a correction. I can therefore tolerate such a market move. 
2. Cyclical – Declines of around 25% occur within each decade, The problem for an investor who pays capital gains taxes out of this account, is the reduction in the size of the account resulting from taxes paid. This raid on capital must be made up to recover the original capital base and is particularly galling if the stock recovers.
3. Structural – Recession/depression with loses exceeding 50%. These are generally part of the economic realization that something is out of order. They often occur during periods of excess borrowing, where the lenders’ financial stability is threatened.

My View

A correction has already begun, and it is not worth repositioning long-term portfolios. We have not had a cyclical decline for a number of years, and it appears to be long overdue. There are increasing numbers of business and people having difficulty. Odds are, within a five-year period there will be a cyclical market decline. Portfolios should be pruned of weak holdings. Weak holdings are those that would cause irreparable pain if they fell by 25% or more before returning to their current level in five years.

Selections Process

This is the topic of a forthcoming speech to a group of financial institutions and their advisers regarding analytical approaches to selecting individual securities, advisers, and funds. Needless to say, my approach is not the standard pitch.

Selecting Individual Securities

Rarely does a person want to exactly copy another. After reviewing the standard Graham & Dodd financial statistics, I focus on what makes a company different. Unless the stock is very cheap compared to peers, it is usually the non-statistical differences which make a stock attractive. I am suggesting that after securities analysis there should be business analysis. The following is a brief business analysis of five stocks owned in accounts, or by me personally. (These are not recommendations for purchase, as that would only be wise if they fit the needs of each portfolio and were priced attractively.)

Apple is viewed as a growing “annuities producer”. Rarely after a single purchase of an Apple product does the customer switch to another brand. Currently, there is a more than usual risk of delayed new purchases due to supply chain issues, higher prices, and the draw of forthcoming new products. Years ago, many General Motors car brands were in a similar position as people in America replaced their cars in one to three years. As with Apple, GM’s strength was in its distribution system. Apple’s is better, having their own stores and departments within big box stores. The annuity like value of their sales helps with their planning and is an attractive attribute for long-term investors. At some point, when attractive new features stop coming, it is possible the annuity like trend will become similar to the overall growth of the market. However, they will continue to produce good sales in countries with faster growing populations.

Berkshire Hathaway is managed for the non-shareholder heirs of current holders. This fits the desires and needs of a large portion of Berkshire’s owners. At some point, I suspect pieces of the operating company will be hived off to shareholders or other operating companies. The book value of these companies starts with their acquisition price, plus earnings less dividends paid to the holding company, which in a number of cases is way below what these activities are worth in an open market. I can envision a day when my grandchildren will receive a growing cash dividend from a smaller, regularly managed company.

Moody’s is a toll collector of fees from most of the world’s fixed income issuing companies, including non-profits and various levels of government. Most of these organizations will grow in an increasingly complex world, where debt is required for progress.

Raymond James Financial has the fastest growing financial services retail distribution network on a per share basis. They aggressively create homes for investment salespeople who find their current employers unattractive.

Goldman Sachs has probably more bright and talented people on a per share basis than any other financial services company. What is intriguing about GS is that it is transitioning from its old model of utilizing borrowed capital to one using capital generated by its own customers. When there is a new profitable game in towns around the world, Goldman will probably be in it. 

Selection of Advisors and Funds

Our history of being an advisor to institutions is one of great length. (We have enjoyed a number of tenures of twenty years or more, which only expired with the change of key members of the investment committee or a desire to go in a different direction). It is disrupting to change critical advisors, so it is done less often. Turnover of a stock portfolio is a more tactical move. With that in mind, the factors to be considered are more about the advisor than the holdings in a portfolio. Portfolios of equity mutual funds change about every 10 years, halfway between the 3-year turnover of a stock manager and the 20 years of a manager of institutional accounts.

In developing approaches to manager selection, one cannot avoid biases. These are thought patterns which at one point had a reasonably good foundation in facts. The intellectually honest advisor consultant or manager should use the current picture to update their biases. The following are my current working biases: 

1. Both highly concentrated portfolios and wide universes can be used successfully.
2. Short investment periods should be examined to find patterns of success.
3. Periods of weaknesses should be discussed in detail to understand humility, blame shifting, and blind spots.
4. Multigenerational team building, by both copying others and new thinking.
5. The reasons for low and high turnover and the difference between turnover of dollars and names.
6. Multiple generations of management in key departments.
7. Business Management skills and controls, analyzing successes and failures.
8. Small vs large losses.
9. Size of boards and executive committees, the smaller the better.

Art Forms

If good investing is an art form, then investment management is a bigger art form. Still larger is the investment management business art form.

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