Mike
Lipper’s Monday Morning Musings
TIME TO PRUNE?
Editors:
Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Season & Direction
Many
businesspeople and some investors normally consider changing plans in September,
focusing on the ends of December and January. Many will include the results of the
mid-term elections in their timing decision.
Some merchants
will focus on the end of January, which ends the retail trade year. With
possible inventories out of balance and some uncertainty over shipments,
particularly from Asia, there is a premium on having the correct inventories to
sell quickly, utilizing a diminished senior sales staff.
Like Charlie
Munger and Warren Buffett, my preferred holding period is forever. In my humble
experience, there are times when it is wise to consider pruning the portfolio.
Since the earliest investors were farmers, periodic pruning was normal. Even
the best portfolio managers follow professional gardeners and prune their
portfolios. A good portfolio is more than an accidental collection of
securities. A sound portfolio should work well in most non-extreme markets.
As a
contrarian I do not accept we have entered a new “Bull Market”. I believe a new
market cycle begins from a prior market’s beginning point. In this case, from
its prior peak. What we are currently experiencing is a normal rally in a “bear
market”. The main reason for this belief is that we have not even begun to
address many of the causes of the last bull market’s problems, other than
simply prices.
I regularly
admit that I can be wrong. I urge investors to keep their pruning instruments
handy on the chance that I am correct and equity markets decline. Pruning is a
necessary tool for the survival of successful portfolio managers.
The
Need to Prune
The reason
one prunes is that it is an essential first step in repositioning the
portfolio. The timing of the decision is not necessarily dependent on knowing
what to add to the portfolio immediately.
There are
two motivations to prune. The first is to reduce the level of panic when the
market is in freefall. The second, which may not come from the first, is to
build a buying reserve. Opportunities are easier to judge when one does not
have to decide what to sell before you buy.
Voluntary
& Involuntary Pruning
Since we
have established the necessity to prune, the first way to do it is by the
calendar, and the second is by the performance of the market.
I have
already suggested a calendar prompt, which may be particularly apt in this
troubled year. Using September as a month to make financial decisions may make
unusual sense. It is the end of the US federal fiscal year and the beginning of
the fall shopping season.
Some pundits
are saying we have entered a new “bull market”. However, history suggests that
a new bull market is usually led by new groups of stocks. The current leaders appear to once again be large-cap
technology growth stocks. Going back to the old leaders suggests many of the pundits
are failing to look for new leaders, ignoring many fund managers signaling
caution.
One quick
filter that could suggest candidates for pruning is measuring the growth of
operating earnings between pre-COVID 2019 and 2021. If these operating earning
did not rise 10% or more, an analyst should question a replay of old leadership
being conducive to doing well.
There are
other filters such as evaluating whether the management of competitors has
deteriorated or improved, and/or whether price and volume has materially
changed. The key is to find some reason to do what racetrack handicappers do,
which is to throw out a particularly bad race in assessing the future.
I have been
a beneficiary of the involuntary pruning of positions held for some time, which
made me question why they were continued to be attractive. (Please do not treat
these examples as recommendations, which should only be made based on client
needs and temperament.) The following discussion of five occurrences result
from my background in the financial services industry, although the lessons can
be profitably used in other sectors too.
ADP>CDK
Global
I recognize
my investing should be broader than the more familiar targets of mutual fund
management companies and broker/dealers. Automatic Data Processing’s (ADP) historic
basic business was relieving companies of their payroll processing and payment
responsibility. They replaced commercial banks who initially dominated the
field. ADP had superior data skills and a lower cost structure. They also learned
the wonders of “free float” from Warren Buffett. Earning short-term interest on
the payroll account. Since I was convinced the number of payrolls in the US were
in a secular growth pattern, this stock was a good “common denominator” base
position for a financial services fund.
As is often
the case when one buys a good company, there may be a “kicker” in the purchase.
ADP purchased or originated other financial services activities. but As good as
many of these were, they were not as productive as ADP itself. Their usual
approach was to spin-off these companies to their shareholders, and a number of
good ones went public.
One of these
spin-offs was CDK Global, which provides data services to automobile dealers, automating
their sales and service appointments. The number of individual auto dealers has
been dropping and the number of larger multiple brand dealers has been growing.
(Berkshire, Alleghany, and the Washington Post, among others, are aggregators.)
As CDK’s European business was in the process of being sold, its US activities sold
separately at a good price. Thus, we involuntarily had a cash infusion during
the “bear market”.
I kept ADP,
who used its strong connections providing payroll services to assist clients in
their hiring of financial services and other specialist. By the time this pattern
became visible, they were already developing the business of “renting”
employees to their clients and others. Initially it was in the financial services
business but expanded to other fields as well. This “PEO” business made
continued ownership of ADP even more attractive.)
Little
“Berkshire” Joins the Big One
Alleghany
Corp was the old Kirby family holding company with a long history of owning interesting
companies, including IDS the forerunner of today’s Ameriprise. Alleghany is
largely an interesting collection of casualty insurance companies, plus a
collection of minority interests in a wide portfolio of ventures. Alleghany’s
capable CEO recently retired and was replaced by a former CEO of General
Reinsurance, which was acquired by Berkshire Hathaway. Alleghany is very
familiar to Berkshire, so it was an easy decision for Mr. Buffett to make a cash
acquisition offer for Allegheny to close later this year, at a record price.
(No competing bid came in!)
Aetna>CVS
Health and Eaton Vance
Two other
holdings got new owners through a stock deal because they recognized a major
change in the natures of their businesses.
As a newly
married young US Marine Corps officer I purchased a life insurance policy. When
I entered the financial services field, I realized I had bought the wrong
product from Aetna if I didn’t die early. Years later it became clear to me
that the cost of selling insurance was too expensive. Aetna’s management saw
the same thing. They realized the healthcare industry had much better
prospects, as did their competitor Cigna. Aetna bought the larger CVS drug
store chain. By combining its healthcare funding and processing capabilities
with the store fronts. It then put medical professionals in the stores. and They
were better addressing the needs of the public than by serving each of them
separately. (In previous blogs I mentioned three major sectors growing less efficient
and not doing a good job: schooling, defense, and healthcare. CVS health is
addressing some of the issues involved with the latter, which is one of the
many causes of inflation and lack of growth.)
Eaton Vance
is one of the oldest US mutual fund management companies. They have been one of
the more innovative management companies developing new vehicles for
institutional and individual investors. But the game has changed. Their
original base was being one of two Boston based investment advisors dealing
with rich clients and offering funds for the related but less wealthy retail
accounts. They sold their mutual funds and closed-end funds through commissions
salespeople at major brokerage houses. The business changed with individual
brokers restyling themselves as wealth managers, earning annual fees rather
than commissions. These wealth managers have inserted themselves between the
fund complex and the ultimate client. This has had two effects. The wealth
manager feels compelled to prove his/her worth by having an opinion separate
from that expressed by the asset manager at the fund company. All money
management accounts lose money for the provider of investment services on
day-one of the relationships with the client. The client moves into a profit
position with the asset manager over time. There is less effort in managing the
account than getting it. In practice, the money stays with the wealth manager for
less time, so the economic value of the relationship declines. In addition,
Eaton Vance’s competitive strength is in sophisticated fixed income and tax
managed products. With interest rates going lower, their book of business was
becoming less profitable. A merger into Morgan Stanley locked in their largest
wire-house distributor and opened international distribution opportunities.
Thus, each
of these involuntary prunings helped the owners of the accounts I manage.
Weekly
Insights
- The
US Treasury inverted yield curves persist, with the 2-year yield higher
(3.257%) than the 10-year (2.848%) and 30-year (3.117%). The bond
market still sees a recession.
- In
a volatile week, the best performing mutual fund investment objective was
Natural Resources +8.24%, with General US Treasury -2.36% being the worst
for the week ended Thursday.
- The
weekend edition of The Wall Street Journal tracks the prices of 72 stock
indices, and index funds, commodities, and currencies. 93% were higher,
catching Friday’s exuberance. The two that generated losses of 1% or more were
the WSJ Dollar Index -1.05% and the Russian ruble -2.77%. Both could be of
significance.
Did you miss my blog last week? Click here to
read.
https://mikelipper.blogspot.com/2022/08/investors-politicians-other-children.html
https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html
https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.html
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