Investors Focus on the Wrong Elements - Weekly Blog # 853

 

Mike Lipper’s Monday Morning Musings

 

Investors Focus on the Wrong Elements

 

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

 

 

 

Combing Mr. Buffett with Albert Einstein

Compound interest, the eighth wonder of the world, is wrongly attributed to Einstein according to the people at Caltech. Nevertheless, Warren Buffet stated, “He who understands it (compound interest) earns it. He who doesn’t pays it.” The better long-term investor understands it and uses it in drawing up his/her long-term strategy.

 

I have tended to use a long-term lens in my lifetime focus on mutual funds. My particular focus is the long-term, the ten-year record of the average performance of 30 equity fund indices for the last 10 years through August. Of the 30 only 7 had double digit returns, the highest being Health/Biotech which rose 15.67%. I also looked at the 25 largest stock mutual funds for 5 years, 17 of which produced double digit returns, with only one reaching the twenty percent level. It was Invesco QQQ Trust, which gained 21.30%.

 

This research reminds me of one pension plan a number of years ago which sold all its equities when the portfolio was up 20%. It was one of the best performing pension funds. Strange for me considering my background to suggest that superior performance could well be a signal to reduce investment. I say this knowing that every few years there is a period when one or more funds gain 100%. Strangely, none of these wonders makes the best performing list for the five or ten-year period.

The Media and Frequent Statements by Pundits

Traditionally, media outlets get more attention when the news is bad.   However, in covering the market and economy there is much space devoted to “happy news”. What seems particularly true is headline editors, correspondents, and allocators of space/minutes seem to share a single political view. It is occasionally worth reading to the end of an article where the other point of view gets some exposure. Operating margins for news distributors are under pressure, which has led to surveys where the number of people polled is only between 1,000 and 1,500. This might be okay, except that many people on the right don’t trust polls and media related agencies and thus do not participate in polls, often causing the prediction of incorrect election results.

 

What Should We Be Following

• Unlike the current situation in the US, many nations are seeing younger people move up. This is particularly true in the Middle East, Africa, and Asia.
• China is exporting surplus steel, which amounts to half of what they produce
• Our Presidential election on both sides exaggerates
• their commitment to integrity
• The pouring of money into small company start-ups will curtail the future of small business capital formation. The odds of repaying these loans and other bribes will probably be similar to the repayment of student debts. The unstated purpose of these programs is to hurt the families and friends of the would-be entrepreneur.

 

What elements are you watching to help make decisions about the two apparently unrelated games, equity markets and economy? How will global problems impact them?

 

 

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Gravitational Waves & Investing - Weekly Blog # 791

 

Mike Lipper’s Monday Morning Musings

Gravitational Waves & Investing

 

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

 

 

 

 Living & Investing within Uncertainty

We unconsciously make bets about a collection of futures at every moment. Scientists and other Seers have been doing this since the beginning of human time. The terms of our world have been evaluated, as well as how to gain, grow, preserve, and distribute wealth. I have come to a point in both my professional and personal life where I hope to find a systematic way to make investment decisions regarding money and the expenditure of time and effort in acquiring it.

 

This week, by mere coincidence, scientific teams in Europe, India, Australia, China, and the US, released their astronomical observations on what they perceive happening in deep space. Their observations are the result of 15 years of study using both land and satellite based large telescopes. (This knowledge is also being shared by nations building military applications.)

 

The research follows the theoretical work Albert Einstein did over 100 years ago. (Historical note, Einstein was a frequent guest and lectured at Caltech where I am a Senior Trustee.) The current work supports his theory that we are traveling through an undulating sea of intensity and are being attracted by the gravitational pull of large, dead, dark stars. At this point, we cannot predict how these intense, undulating pressures will direct our earth.

 

Coming back to earth and the subscribers of this investment blog. We should accept uncertainty as one of the undulating governors of future investment opportunities and risk. I am starting to corral a number of thoughts as part of a toolkit to develop appropriate investment policies tailored to particular situations.

 

3^rd Quarter Risks for Money Managers

The bulk of dollars under management may have entered a period leading to the termination of trusted relationships, both contractual and/or personal. Relatively few formal or informal investment committees execute management changes during the summer, but they likely will after the third quarter when decision makers receive second quarter reports. These reports will not be happy readings in more cases than not. It is estimated that the earnings per share of the stocks in the S&P 500 index will fall by -5.7%. Combining this news with another bit of analysis, it may cause fiduciaries to question the reason they are paying fees to their existing managers.

 

In a second bit of analysis, if one subtracts the performance of the 28 stocks in the S&P 500 which gained during the first half, the remaining stocks lost money. For the six-month period, gains for the 28 stocks were larger than those in the first quarter. Many more had positive gains in June, as the number of winning stocks expanded significantly. However, the June 30^th report may also reveal that there were losses for more than two years, as mentioned in last week’s blog.

 

Portfolio managers, anticipating the results of the 2^nd quarter, may have plowed money into the six to ten global tech-oriented leaders of the first quarter. It is my impression that the Price/Earnings ratios of many of these companies expanded more than their underlying earnings growth, perhaps pushing them to over-valued levels.

 

My concern is that we could see a repeat of a lesson from the late 1960s, when two leading Boston based mutual funds with the rest of the market fell. At the time my brother’s firm was selling fund performance data for brokerage commissions. Our trading desk was in communication with both of these competitors, among others. Up to that time both funds had similar portfolios but following the decline the two managers followed different defensive paths. One sold its most over-valued stocks. The other, perhaps learning from his mother who was a broker on the Shanghai exchange, sold his largest and most liquid positions.

 

After the decline ended, the second manager was hailed in the press as a brilliant manager. So much so that he was featured on the cover of a well-known business magazine. This propelled him to start his own fund management company, which raised a lot of money but didn’t perform particularly well and merged out. The other portfolio manager had retired earlier.

 

Using performance records can only lead to unfortunate choices. At the racetrack, some bettors select the horse with the most winning races or a high win vs loss ratio. I have often found this to be a trap. The wins were over cheaper horses or those competing at less competitive tracks. Whenever trainers enter a horse in a race which had a number of higher quality horses with less of track record, the horse often does not live up to its win/loss ratio.

 

As a provider of performance analyses, we addressed this issue by creating a peer group under the rubric “Capital Appreciation”. The peer group housed funds essentially based on their win/loss ratio, not what was in their portfolio, like growth or growth and income stocks. Over time, fund marketing people and lawyers convinced us to give them the widest range of portfolio choices in their prospectus. Many ended up saying their funds sought capital appreciation and secondarily provided income. The delineation of the peer groups were too broad and was consequently dropped.

 

As a manager of accounts and a member of investment committees I seek to be invested in funds that meet the intermediate (5 year) and long-term total return needs of the account, not shorter-term results. I am anxious for my responsibilities to accomplish their planned distribution to finance their purpose.

 

Work in Progress

There is much more that needs to be discussed including responding to inputs from subscribers. Two additional topics require more space and your time. I am working on the tension between economics and the impact of China and the rest of the world. I would appreciate any comments on what I have produced as well as on the two topics that I am developing.

 

 

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Reading What is There and What Isn’t

Introduction

We are all information junkies. I am always questioning trying to find out what might be important. Thus I am absorbing both hard and soft data in my investment diet. I never know what can turn out to be a good source of facts, knowledge, or perspective; for instance my dentist, who is something of a data hound about his practice. While I was a captive in his chair and being a bit upset he was not streaming the daily programs from Bloomberg TV as usual, we were instead discussing the importance of data. He then gave me a bit of insight. On the cover of his data notebook there was  the following quotation:

“Everything that can be counted does not necessarily count; and everything that counts cannot necessarily be counted.” -Albert Einstein

Not only did this make sense but I am a bit addicted to Dr. Einstein as a great mathematical physicist. My wife Ruth and I have stayed in the rooms that were used by the good doctor at the Athenaeum, the faculty club at Caltech where he visited regularly. In thinking about what Albert Einstein contributed it occurred to me it was not new data that he discovered, and not only to recognize the meaning of what was known, but also what was not captured in the data. He identified what was missing.

If only the pundits who were wrong about the outcome of both the BREXIT referendum and the last US election knew how to look at the data that was and wasn’t, they wouldn't have been so embarrassingly wrong.

I am going to review a set of investment inputs which cross my desktop screen to seek to extract both their meaning and what is missing.

China

To my mind there is no more important topic for long-term investors to track than China. Many believe that it is only a matter of time before China will become the largest economy in the world and all that occurrence implies. We would be badly misled if we applied the lessons from our own history to China. First, we come from political cultures where our leaders for the most part were trained in law, military, or farming. Most of the current leadership in China spent time learning engineering. As part of that experience they were indoctrinated into rigorous planning as a dominant discipline. While there may be periodic disruptions there, their life is much more orderly than is what is experienced in the developed economies. 

When Premier Li, states that there will not be a hard landing as their economy shifts to fulfilling internal demand for goods and services from being export driven, I am reasonably confident that the record, as published, will show that the Premier was correct. His was not an idle boast. The Chinese political school attempts to study every conceivable possibility. They want to be good generals that are never surprised (or defeated) like Julius Caesar who claimed a great victory in what is today's France and then spent the next three days burying his dead. Also as Steve  Roach from Yale University has written from his long experience in China, the leaders know that shifts in global leadership are gradual not abrupt. Their planning doctrine allows them to be patient as long as they are making progress every day.

In the real world not everything goes as planned. For instance the public traded price of Huishan Dairy  dropped 85% in one day. From what I have been reading, many successful entrepreneurs are involved with many different activities. These men and women, are often highly leveraged, possibly with bank loans from friendly local/regional banks which they have significant stock positions.

What was not there? First disclosure, in this case the entrepreneur was missing for at least one day. Second, there was no market mechanism to slow or halt the decline, (nothing exists in China and other places like the old US specialists on the floor of the New York Stock Exchange) or in this case similar to other markets after a ten or fifteen percent drop, trading is suspended. Third, there is no equivalent to the Glass Steagall and similar Acts to avoid commercial interests affecting loans and stock purchases of banks. I suspect in a still planned central economy we will see these holes filled. Nevertheless, Western investors need to recognize the practical differences between their home markets and the newer markets in China. (This is why my accounts prefer to use mutual funds that are managed by specialists who have been trained locally.)

While in the US we are still waiting on the surge in infrastructure spending to repair our railroads, roads, bridges, tunnels, and airports, China is well ahead in its construction phase. What is quite different is that in their drive for the "One Belt, One Road" strategy they see it as a way to export their overcapacity in steel and related industries. They want to do this for trading purposes and bringing other nations and markets closer to them. Perhaps more importantly it would somewhat lessen the reduction in heavy industry jobs. I also believe like with the Eisenhower Interstate Highway system in the US, the "one road" program would aid the shifting of military people and goods where needed quickly both internally and to the borders.  All of this is dependent upon detailed planning and a high level of engineering.

United States

Applying Dr. Einstein's approach to two US focused factoids may give us some pause for thought:

Credit Suisse notes that the number of publicly traded stocks in the US has dropped in half from 1996 to the present, 7300 to 3600. (I think that is an over-simplification and could be those stocks just listed on the exchange; nevertheless there is not doubt that the number of public companies has declined.) Whatever the actual number except in industries where there is significant capital risk (technology and consumer demand for fashions) entrepreneurs are preferring to stay private until they receive an appropriate bid for the company. I know that was my idea. Not only are investors disadvantaged by this trend, it is quite possibly the economy will suffer also, as private companies with less debt will tend to be smaller in terms of revenues and job creation. The current Administration wants to reduce regulation to address this problem. I suggest they also need to focus on death taxes on private companies. There have been too many family farms and businesses that had to be sold to pay death taxes. This was a concern for me.

Combined with the reduction of the number of publicly traded companies there has been a twenty-fold growth in the number of CFA^® Charterholders (Chartered Financial Analysts) which did not serve as a barrier to entry that some may have wished. If the number of eligible securities is down and the number of analysts is rising, the odds of analysts discovering new worthwhile investments is declining.

One of the results of the difficulty of finding a lot of new worthwhile investments is the growth in popularity of Exchange Traded Funds and Products. Some analysts, portfolio managers, and security salespeople have gravitated to ETFs and ETPs.

The theory behind this was that the markets move in broad trends and the prices of ETFs would mirror the performance of the underlying stocks. Increasingly this is not exactly the case. Starting with July 8th 2016, my birthday and the birthday of the Dow Jones Industrial Average, the yield on the 30 year US Treasury went up 48%.  An ETF that was meant to mirror  the move in the 30 year Treasuries was up only 43%. The 5% difference was attributed to fees, interest expense, volatile derivatives, and a shorter bond life. Admittedly this is an extreme occurrence.  If there is an increase in volatility, as expected by some, it may be difficult for the ETF managers to exactly mirror the index they are meant to be tracking closely. All of life is cyclical. At times market prices will track very closely to the center of their universe and this is called concentration. At other times the target universe experiences more diversity. I think we have entered such a phase and we will see an increase that various passive products are not tracking  the performance of their universe because they don't own enough of the winners and too many of the relative losers.

Question: What are sensible investors missing?

__________

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Awareness Risks and Opportunities: The Search for Outliers

Introduction

After stock prices slumped last week, particularly Thursday and Friday, we should be aware that our judgments are far from perfect. To help us in our deliberations, I am calling up our top strategy team, RT&E. Let me introduce the team: they are more formally known as Donald Rumsfeld, Mark Twain, and Albert Einstein. Rumsfeld divided knowledge into “Known Knowns,” “Known Unknowns,” and “Unknown Unknowns.” Mark Twain cautioned us as to what we “know” that is just not true. Einstein, a three-time visiting professor at Caltech, told us “Everyone sits in the prison of his own ideas, he must burst it open.” He suggested that we must think differently to produce different results. We should always be aware of risks and opportunities including those that we create by our own narrow thinking.

Known Knowns

1.      In the modern era, where the leading academic institutions teach the unsuspecting students a top/down view of the world in order to put the academics near the top of the power structure, they teach that markets are primarily driven by monetary policies implemented by the Fed and other central banks.

2.      The best examples are China and Russia, both are command economies and therefore the governments can totally deliver what they want.

3.      Price momentum leads to further price momentum for stock prices.

(see table below).

Known Unknowns

Each of the “knowns” are macro trends, or if you prefer, gross understandings that can be transmitted to the audience in sound bites up to 40 minutes of class time.  These averaging or actuarial approaches to human behavior lead to surprises or counter developments that are derived from the study of micro trends which when netted against the gross trends cause periodic reversals. This may well have been what happened last week with the gross beliefs being carried beyond their “sell date.”

For some time it has been reported that most publicly traded stocks in the US were falling, but the popular market averages were being held up by a couple handfuls of favored shares. Many of these favored stocks prices in one day fell into a correction (10%) or a full bear market (20%).

Filtering the largest dollar volume declines on NASDAQ the following names could lead a major price trend change list:

Priceline	(-67%)
Google	(-45%)
Amazon	(-37%)
Netflix	(-19%)
Tesla	(-12%)
Baidu	(-11%)
GoPro	(-10%)
Gilead	(-10%)
Apple	(-10%)

These stocks have preformed very well in the past, but the unknown element is when would they give some back, and how quickly would it occur.

(I am not commenting on the attractiveness of these names, but the surprising rapidity of their decline in high dollar volume which up to last week was unknown.) 

Unknown Unknowns

The “knowns” are premised on “all other things being equal.” We live in a world of small and occasionally large changes daily. Strange as it may seem, each day we grow older and perhaps wiser, but not definitively different than the day before in terms of our attitudes and mental and physical health. Not only are we changing, but we are experiencing the never-ending changes caused by technology.   Because of cell phones, billions of people are now aware almost instantaneously of any important news item, interesting rumor, or critical price change. Markets move with the speed of electronics; in many respects for major “chunks” of money no market is closed.

Teenagers’ buying habits and other consumer demand swings occur rapidly, responding to perceived models can lead to major changes in distribution chains globally, with much unsold inventory.

The Known is Untrue

While I am a professional analyst and money manager at my core I am also a student. Thus each day I am aware that some of my rock-solid facts are going to be challenged. Many of these “facts” come from respected sources. The best of which are my own experiences and yet some of these are extrapolated too far to be general cases and not just specific relationships. For example, for many years I have been following the weekly Barron’s Confidence Index which measures selected Intermediate-rated bond yields compared to a selection of High Grade yields. When the yields of the High Grades go down relative to the Intermediate Grade, which means that high grade prices are raising at a faster rate than the lesser quality is a measure of risk coming off for bonds, which often is indicative of current attitudes toward stocks. Most weeks the change in relative yields is under 1%. This week the move itself was 3.7 percentage points which is the most dramatic change I can remember and signifies a major risk aversion. Whenever some ratio goes to a historic level most people believe it is a confirmation of a trend. My training from the racetrack is to either doubt the mechanics or believe it is less reliable in terms of the future because it represents an extreme. At the moment I am being cautious and doubting the validity of the ratio, but I can be wrong.

Dr. Einstein’s Prison Breakout

We all like the past because we know what happens. The future is uncertain and we need to learn when to jump off the comfort of extrapolating the past. One of the advantages of my practice is that regularly I can examine extreme performance both good and bad. I would be a poor analyst if I assumed that these extremes would continue. The odds are that there will be some reversals where a poor performing fund will do much better than average in some future period. Often this happens because the portfolio manager or the CEO of a company sees something in a different light than the rest of the pack. My job is to find these rare reversal types and get enough confidence in their approach to follow them. The nice part of our portfolios is that almost always there can be room for an unusual approach as they breakout of the conventional prisons.

Question of the week:

Which managers are doing unconventional things that we should study?

__________   

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