Improve Your Returns: Watch Short-Term and Learn Long-Term

Introduction

With the passing last week of Andy Grove it seems appropriate for me to consider the breadth of thinking in his book Only the Paranoid Survive. While some can be comfortable following Warren Buffett’s words (not his actions) to buy and hold forever, along with most professional investors, my insecurity does not permit me to buy and forget. We worry all the time and particularly when trends turn and accelerate in our favor. This is one of the reasons why I came up with the four increments in the Timespan L Portfolios^® . These require me to focus on both the short-term to make tactical decisions and to learn what are critical lessons for successful long-term investing.

The Short-Term Operational Portfolio Worries

The timespan model for this portfolio was designed for an endowment that has to feed an operating activity over a two year duration, (in practice we will modify the timespans to meet client needs). While we think of this as a short-term portfolio, a number of individuals and institutions perceive their preferred measurement period for the entire portfolio is one year, thus for some, this is a long-term portfolio.

As longer term readers of these blogs have learned, I find a need for excessive enthusiasm to be in place before I start to prepare for a major decline, possibly of 50%.  I am beginning to see some growing enthusiasm. After all of a five week improved US stock market, and rising Chinese stocks and oil prices, I see shopping at the nearby high end mall getting crowded. Parking spaces are hard to come by, shoppers (mostly women) are carrying three or so shopping bags. Stores were reasonably crowded and both the Apple and the Verizon Communications stores have customers waiting.

As an analyst I search for negative indicators as much as positive ones. As long as there is sufficient uncommitted money to equities I know that there is spare buying power that can push prices higher. This is particularly true if the money is being guided by so-called professional, conservative money managers. In a recent asset allocation study of forty large wealth managers' recommendations, I looked at the five most aggressive wealth managers who were recommending that their clients put 60-70% in equities compared to the average of 51% for the forty. Only one manager would put 10% in Emerging Market equities and another sole manager would put 16% in High Yield debt. In both cases the average for the group was about 4%. This was the same level of group aggressiveness in terms of private equity where the five most aggressive had between 10-14%. The commitment to hedge funds on average was 9% where the leaders had 18-25% in these vehicles. Thus the wealth managers in general haven’t been swept up yet by enthusiasm.

Some of the money in hedge funds and other trading vehicles is finding its way into ETFs either on the long side or short side. For the week ending March 23^rd there was a net inflow into equity ETFs of $2.8 Billion which included $1.1 Billion into Balanced ETFs. (It is important to remember that the institutional community has learned that Index ETFs are a cheaper entry vehicle than futures for their hedging and other trading purposes. I will be discussing the impacts of ETFs on the structure of the market places in early April at a meeting of the International Stock Exchange Executives Emeriti.)

I would not pay a great deal of attention to the net redemptions from conventional mutual funds in terms of future direction of the market. In the latest recorded week $1.5 Billion were redeemed, all of it from Domestic funds, almost all that from Large Cap funds. It is my contention that the bulk of these redemptions are in effect “completions” of long-term investment plans prior to funding other needs. This is an old phenomenon which in the past was offset by new purchases of funds that are not happening because it is more profitable for the distribution systems, including registered investment advisors to deal in other products including hedge funds, private equity funds, and to some extent ETFs.

There are some signs of significant enthusiasm which need to be tracked. In the last week $3 Billion went into Emerging Market equities. Some could be short covering. In a recent survey the second most crowded trade was being short Emerging Market stocks which are less liquid than our domestic stocks.

Other examples of rising enthusiasm are the quarterly hockey stick-like estimates of earnings for the S&P 500: 1^St Quarter ‑6.9%, 2^nd quarter ‑1.9%, 3^rd quarter +5.0%, and 4^th quarter +10.6%%. Certainly part of the gains is earnings from the Energy sector going from a ‑98.9% decline to a gain of +10.6. While these estimates suggest a trailing price/earnings ratio of 17.2x and a forward one of 17.0x, the real action is more towards the large and midsize companies found in the Russell 2000 with a trailing p/e of 24.9x and a forward p/e of 22.5x.

Bottom Line For Short Term Portfolios

With the above list of inputs, I still believe that the short-term portfolios should set up a price grid to begin to reduce their risks as the market moves higher. For longer term portfolios they should continue to invest for the long-term and occasionally buy into some opportunities that the market will serve up, but not attempt to market time.

Longer Term Lessons

As much as I question the perceived wisdom from academic sources, like many analysts I am always a student of our environment. As a practical matter it is more difficult to learn from successes than mistakes. Almost every aspect of a success could be the critical element, if you will, the secret sauce that made the success. Most mistakes come from slavishly following the perceived wisdom of reported successes without looking deeper as to why they worked when they did. Probably the toughest part to learn of the art of investing is timing. There is nothing fundamentally wrong with balanced accounts, all equity accounts, private equity funds, and hedge funds. The keys are when to use each of these, in what mix, and what level of patience should be applied. Generally one should use these tool sets when others are not. Most of the time it is a mistake to follow the crowd.

This week I read about an endowment that fired its poorer performing managers after the first seven months of its fiscal year which occurred through the horrible January performance. The group couldn’t take that it was down ‑8.5% and the S&P 500 was off ‑6.6%. The endowment fired their hedge funds and moved into private equity funds. We don’t know what the future will bring but I have serious reservations on the basis of the little bit that we do know. The endowment:

• Probably picked its managers largely on the basis of past performance
• Accepted a popular asset allocation
• Did not understand the cyclical nature of performance
• Did not have sufficient patience
• Elected to do a dramatic change all at once 
  
• Chose to go into the currently most popular asset class with the proceeds of transactions.

I will attempt to follow the organization's future progress because I am always looking for decision makers who have a high percentage of mistakes. These rare negative indicators hopefully will help me and my accounts from making similar mistakes.

Secret Sauces

Far too many investors follow successful other investors and try to mimic what “the experts” do. They don’t focus on the tools the experts applied to their art.  Classic examples are Warren Buffett and Charlie Munger at Berkshire Hathaway, who we will visit this spring. In many ways the tools, not the judgments that they bring to investing is in their annual report. The report contains 67 pages of notes and supplements to their financial statements. I do not claim to fully understand all the nuances that could be found in these pages. To fully grasp the tools that they have used, one would need individual courses in accounting, corporate finance, tax accounting/management, insurance accounting, treaties, various state/federal/foreign legal codes, and various forms of investing. Unless you have a firm understanding of these arts, don’t attempt to play their game. I benefit from both their skills and tools as a long-term share holder.

Other users of secret sauces were the late Sir John Templeton ably assisted by the late Tom Hansberger, both of who were my long-term data and consulting clients. In many respects Sir John was the leading expert on tax code differentials which he applied brilliantly to his personal and company benefit. Tom acted as symphony conductor skillfully managing different personalities as portfolio managers and analysts with global offices and people always on the move. Both understood the sales process and more importantly the sales people as well as how to motivate and control them.

Both of these pairs of artists were much more than stock pickers. Each brought much more to the process of building wealth for themselves and their companies.

Question of the Week: What are the secret sauces that you have seen?
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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Comment or email me a question to MikeLipper@Gmail.com.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

 

No Guarantees in Fiat Currencies or Retirement

One of our younger relatives told my wife and me years ago that he couldn’t settle down because he had “too many questions in his head.”  Unknowingly he repeated what market sages for years have stated, that the market needs “certainty.”  Thus both the young and the wise are grappling with an unknown and perhaps more correctly, an unknowable future.

To answer our basic concerns, the strongest human marketing powers in business, government, science, and religion have repeatedly provided generally accepted guarantees that answer our concerns. During the current period of global neurotic economic stress, one wonders whether the title of Andy Grove’s book, “Only the Paranoid Survive”  is relevant. I am suggesting that as with all well-marketed messages, guarantees provide necessary comfort, but they may not be complete in each individual case. Given the uncertainties facing the modern world, the backing behind each guaranty needs to be understood.

Briefly this blog will touch on some of the accepted guarantees involved with retirement income and the value of money. As usual at the end of this blog I will suggest investment implications to these views. (Many of the views expressed will be provocative and will hopefully generate feedback.) 

The Promise

The heart or essence of any guaranty is the promise that under specifically-stated events or occurrences a predetermined reaction will automatically be triggered. In effect, the promise is a contract, often ill-defined or in some cases not even written down. As time passes, what is remembered is what someone believes to be the promise, without any review of the contract. In typical wedding vows, the only exit is by death. There is no mention of actions and attitudes that lead to today’s large number of divorces. In Europe and elsewhere, the fear of either the marriage contract or divorce has led to a large portion of the population living together for extended periods of time rather than marrying.

Retirement Income

Rational people for ages have been saving money, in part to meet a future period where they will no longer be sufficiently economically active to provide for their own needs. For centuries hoarders have converted much of their stash of wealth into savings. In turn some or all of their savings have been entrusted to various financial instruments and institutions. Since the 19^th century and that great “humanitarian” Otto van Bismarck, people have increasingly relied on taxing authorities to supply retirement income.  (Bismarck created the first social security system which would pay retirement income starting at age 65. He picked that age because he believed that very few would reach that age.) In a more modern era, recognizing that most employees would not have enough discipline to save for themselves, companies would defer some current compensation to be paid out later in retirement. Unfortunately, these two sources, the government and various employers, represent the bulk of the expected retirement income for those that had a career of working. For the most part these people are not worried now and don’t expect to be worried in the future because they believe that they have been guaranteed these payments.

These guarantees are increasingly being issued by some  entities  that are having their own financial difficulties. Most federal and some state and municipal governments around the world are operating at a deficit. We, the citizens, consciously or involuntarily are consuming more from the government than is being taxed. Almost all now recognize that this deficit production cannot continue forever. The two standard solutions are to cut expenses or raise taxes. Somewhere in between these two difficult choices there is a stop-gap measure of changing the payment schedule assumed by the government.  Delaying debt repayment to foreign borrowers can lead to materially higher borrowing costs in the future. One can see the possibility that the government could materially change the net effective payment of social security payments. After all, it is difficult or almost impossible to sue the US government without its permission. Most beneficiaries may not realize it, but social security payments are already effectively means tested. The amount of the payment which becomes reportable as taxable income is based on the level of other income received. Remember that half of the benefit received came from your employer or you as self-employed. Changing the date of full retirement is another way of changing the shape of the government debt. For some time I have warned all of my young employees that they should view that FICA (social security) taxes withheld from their pay and matched by their employer are tax payments and they will be unlikely to receive any real retirement income from their tax payments.

What is probably a larger problem for some is the so-called Pension Guaranty Corp, a government body that is meant to guaranty some pension payments for corporate pension plans of bankrupt US corporations. With the government proclivity to bailout pre-packaged bankruptcies of companies with large union member work forces, the guarantor will run out of money and will have to raise fees on those declining number of defined benefit plans or get an infusion from the US Treasury through an act of Congress. Both are uncertain.

Other ways to save are through various financial instruments directly or thru financial institutions. These are only as good as their continuing credit conditions.

Bottom line:  the various sources of retirement income are not perfectly secure under all conditions. The prudent saver needs to be aware that the expressed guarantees have some limits.  

The Value of Money

In the US, much of life’s activities are ultimately measured by colored pieces of paper approximately 6 by 2 ½ inches called the dollar. The pretty paper which circulates around the world in various denominations has little face value, but has substantial spending and trading value based on the belief that there is some almost universally accepted value because of a series of ill-defined guarantees.  Thanks to President Nixon,  the US dollar no longer has direct backing of gold or even now a fixed basket of currencies. As long as others will exchange goods and services for these painted pieces of paper, the dollar and other fiat currencies have value. Around the world the dollar trades against other currencies 24/7. In theory the Federal Reserve currency  has the vastly expanded Fed balance sheet as backing. These are supported by various issues of  US Treasuries that are the debt of the US government. What makes this curious to a financial analyst is that we have never seen a published balance sheet for the US government. We can speculate as to the enormous value of the government’s real and intellectual property. Most of us don’t know the size of the debt against these assets, particularly the future contingent debt. Value-oriented investors regularly arbitrage the difference between a quoted price and its intrinsic value. I cannot perform this equation as I lack any sort of precise knowledge as to the value of the dollar other than what is trading for now versus other currencies, including gold. Thus, I do not recognize fiat currencies such as the dollar have a guaranteed conversion price.

The Terrible Link

Both the value of future retirement income and the value of the dollar are linked to the rate of future inflation, which itself has no guaranty. The value of the current dollar, euro, pound, yen, and Renminbi is exclusively based on what they can buy today in the way of goods and services. If one isn’t going to spend currency today, one must be concerned as to its future value. Often its future value will be dependent on the path of relative prices. This is particularly true for the retired when an expenditure is likely to draw down retirement income or capital. As these are unknown or probably unknowable, I seriously question the certainty of both currencies and retirement capital that people are using.

 Investment Strategies in a World of Questionable Guarantees

First is my guaranty. My guaranty is that I won’t guaranty any specific future scenario or strategy that will produce only winners.

Second, in a period of increasing uncertainty, excessive concentration is dangerous. 

Third, as I believe significant inflation is eventually probable, I believe up to a quarter of one’s portfolio should be in an inflation defensive mode to include TIPS and selected foreign treasuries of up to five year maturities issued by  small population/commodity rich governments with small to no deficits.

Fourth, all equities should have a global orientation. These companies should have some of these characteristics: exporters, foreign operations, net royalty recipients and managements that think beyond their local borders.

Fifth, technology developers and users should play dominant roles.

Sixth, put at least 25% of your or your clients’ portfolio into stocks of companies that are more flexible than their large competitors. This puts one into smaller capitalization securities.

Seventh, as only a few mutual funds are constructed exactly along these lines, a portfolio of funds that appropriately counterbalance their portfolios will be needed and selected carefully.

Feedback Sought

Please share with me your thoughts on the guarantees discussed and or how one should construct a portfolio for such uncertain times.

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