The Art of Portfolio Construction - Weekly Blog # 615

Mike Lipper’s Monday Morning Musings

The Art of Portfolio Construction 

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

This week had attention getting headlines that might be important to prudent investors.

1. The Barron’s Confidence Index dropped by an unusually large 2 points as high quality bond yields rose less than intermediate credit yields.
2. The 30-year yield to 3-month yield spread narrowed. 
3. The Baltic Dry Cargo Index was down 30% from a year ago (negative for world trade). 
4. SoftBank failed to raise the capital anticipated.

Despite all the news that has made headlines this week, we professional managers and serious investors must continue to manage the portfolios entrusted to us. Many professional journals are full of articles about Artificial Intelligence (AI), suggesting the management of investment portfolios can be done entirely “by the numbers”. Contrary to that view, I believe that portfolio management is an artform, similar to life in general.

That is not to say that math and related science has no place in portfolio management. The great artists of the world, either consciously or not, use mathematical principles in producing their art. It is the same with portfolio managers. Just as a painter looking at a blank canvas needs to contemplate the organization of the space, selecting the right colors to convey his/her point of view, so too do portfolio managers, particularly the successful ones.

One of the first choices the portfolio manager must make is whether to utilize many choices or just a few. Some portfolio “artists” will fill the space with many details, while others only use a few, concentrating on a limited number of opportunities. As someone studying investment portfolios for most of my life, I have come to some working observations.

1. The need to quickly convert some of the portfolio assets into cash in order to meet responsibilities focuses attention on liquidity. In markets of limited liquidity and occasional sharp price moves, owning a large number of securities often suggests the portfolio has a good amount of liquidity. This is not always true, but many portfolios do not need a great deal of liquidity.
2. The next consideration for portfolio strategists is career risk, as portfolio managers are rarely employed under long-term contracts. This is particularly true in the mutual fund industry, my preferred research laboratory. Termination is often triggered in one of two performance directions, up or down, depending on which is the greater fear. By definition, there are a limited number of individual securities that will be up significantly in any given period. If that is your goal, the best portfolio structure is to own only the big winners. On the other hand, career risks could be triggered by falling more than peers or the market and/or exhibiting an unnerving level of volatility. In that case, portfolios might include a large number of individual issues in order to generate returns similar to peers or market indices.

As a manager of portfolios of mutual funds, we utilize both extremes in some combination to meet the expressed or perceived needs of the account. Where possible, we want to use concentrated portfolios to give us better than average performance, accepting some additional downside risk. We offset these concentrated funds with a selection of portfolios that have numerous securities. They often look similar to market indices or are actual index funds.

I have great empathy for the managers of concentrated portfolios, as I for many years have managed a private concentrated portfolio investing in global financial services stocks and funds. I am not soliciting new members, nor am I recommending the purchase of any of the financial securities I will mention shortly. I am using a brief discussion of my experience to highlight some of the attributes of one particular concentrated portfolio, which might apply to other concentrated portfolios. The following are elements that may be found in concentrated portfolios:

1. During a recent period of positive performance for the portfolio and negative results for the benchmark/peers, only 7 of the 19 positions rose. The portfolio outperformed in part due to the two largest positions being the two best performing stocks and totaling 25% of the portfolio. The use of weighting is an important tool.
2. More important than what we own, might be what we don’t own, life insurance and large commercial banks.
3. Financial services can be used effectively beyond brokerage commissions and deposits to address other needs or fears. For example:  
1. Using ADP and Berkshire Hathaway to participate in GDP growth
2. Using Franklin Resources and Invesco to hedge the value of the US dollar.
3. Using NASDAQ for a general level of speculation.
4. Using Allegheny Corp. and Berkshire to participate in rising casualty insurance premiums.
5. Using the London Stock Exchange through Thomson Reuters to participate in the evolution of global stock exchanges.
6. Some of these options could also be considered hedges in a financial services portfolio.

Conclusion: Concentrated portfolios can work both offensively or defensively when appropriately structured, but need to have better security selection than portfolios with a larger number of issues.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/01/is-it-always-brains-over-flexible.html



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Searching for and Suffering Great Funds - Weekly Blog # 545

Mike Lipper’s Monday Morning Musings

Searching for and Suffering Great Funds

Tied to Columbus Day Image Control

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

My Perspective
Commercially for the most part, I manage mutual fund only long-term accounts for both institutions and wealthy individuals. In general, I and my associate Hylton Phillips-Page attempt to construct equity portfolios that contain Good Funds and Great Funds. The dividing line between the two is the long-term fear and greed ratio. In some cases this can be translated into the tolerance for embarrassment. To paraphrase what Warren Buffett has said, he would prefer an investment whose path is an uneven compound growth of 12 % over a more even 10%.

Our Three Bucket Tasks
Exercising experience, judgement, and a lot of performance and portfolio data, we divide the fund universe into three buckets.

• The first bucket are possible candidates for the great fund managers, which is a small group. 

• The second bucket are the good funds that most of the time produce satisfactory results. 

• The third and largest bucket are the other funds, which should be studied to identify characteristics to be avoided. These observations require long records to be reviewed and entail visits to managers, their staff, competitors, and clients.

Numbers Filters
Analyze the fund’s record under the same portfolio manager, pretty much the same staff, senior management, and the same investment and commercial goals. Some minor adjustments can be made, but if there are too many we need to begin the analysis at the point where these inputs are reasonably stable. Thus, a stable universe is created.

The next step is to compare the manager’s relative quarterly performance quintile among the appropriate peer group over 40 quarters. A good manager’s performance will be in the mid quintile and the next highest performance quintile between 24 and 30 times during the 40 quarters. In the remaining quarters the preponderance of the quarters should favor the top quintile over the bottom quintile.

Great managers will spend most of their time in the best quintile. However, the second most likely placement will be in the bottom quintile. Those quarters need to be examined carefully. Great managers are often out of phase with the current market and give up current market opportunity for capital preservation. Thus, the worst quintile performance is often a small absolute gain or loss. Large losses need special explanation. It would help if a bad quarter is followed by a top quintile performance.

The Human Filter
Investments are an art form based on a mix of personalities operating at the same time. Too often investors treat the short hand of numbers as reality. The interaction of the various personalities throughout the ecosystem of the fund drives the results. In discussions with the various participants, total intellectual honesty should not be expected. I have learned to group responses into categories in order to build a more complete picture from the various fragments. The following is an example of this approach:

Good Fund Managers limit their cash to 5-10% of assets and are politically sensitive in their organizations to clients. They try to avoid excess volatility and are often top-down thinkers, motivated by the long-term prospects of promotion translated into money.

Great Managers will use cash as a residual, primarily when they can’t find attractive holdings. Thus, cash holdings in extreme cases could rise to 50%. They are very individualistic in many of the things they do. They will occupy the best and worst quintiles more frequently than the more controlled good managers. Great managers are very bottoms-up and are detail oriented in their thinking. Their preferred time-period is a lifetime, but they will sell when disappointed. These are “rare ducks” who are quite introspective and may not provide the best interviews. Rarely will they enter crowded stocks and are contrarian by nature. They are hard-working and would probably fit in with the current Chinese work effort of 12-hour days, six days a week. When focused, they are good observers of people and consumer trends. They feel deeply when they make mistakes and try to learn from them, even though they often repeat the same types of mistakes. When they are early into a stock they can hold the position for a long period of time. These can produce what Peter Lynch called “ten baggers”, or gains of ten times or more the original investment.

Image Control/ Columbus Day Perspective
Most successful professional investors are by nature private people and don’t like to discuss their current investment thinking. Several r of them overcome their shyness, driven by commercial needs, to bring new money under their management. Often, others have the responsibility to use the successful investor’s record and skills to make them both rich. One of the fears of the successful manager is that the public relations machine will exaggerate the investor’s accomplishment.

Monday in the US we have a national holiday, Columbus Day, to celebrate the popular view of his discovery of America. In truth, he never landed on the North American continent. Prior to his voyage, at least two other explorers landed here. Nevertheless, there are aspects of his life that some of the Great Managers have paralleled in their own careers. These are:

1. A man of great conviction [right in concept and wrong in details]
2. Could not raise the money for the exploration at home and went abroad to Spain.
3. Leveraged the Queens’ jewels to get the needed cash.
4. Diversified risks by having three ships, tow returned.
5. Lost control of the theme upon completion of his successful voyage.
6. His discovery was an excuse for US politicians to grant an important urban political group of union workers a national holiday. No similar holiday exists in either Spain or Italy.

Thus, an investor’s success becomes a commercial vehicle for the greater success of others.

Where to Hunt?
As every single day is a day to think about the search for great managers, what does last week possibly signal?

1. For the week, six of the seven biggest market performance leaders tracked commodities. 
2. Five of the seven worst performers were stock indices.
3. While most funds declined, there were some winners that gained more than 1% for the week - Base Metals Funds, Agricultural Commodity Funds, Precious Metals (Gold) Funds, Natural Resources and Energy Funds. DOES THIS MEAN THAT THE MARKET IS MORE CONCERNED ABOUT INFLATION THAN GROWTH?
4. Longer-term targets of future opportunity: Longevity Care and Management, Food allocations, Disruptions to come from AI/VR, TIPS.

Conclusions:

• The world is changing in both identifiable and unidentifiable ways.

• Good equity managers perform credibly well most of the time.

• The rare great managers will find ways to make a lot of money, but it won’t be a comfortable ride unless one builds that likelihood into ones’ expectations.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

Winning Investors’ Super Bowl

1.  Too Much Correlation/Pity the Shorts Near-Term

2.  Dynasties Need to Win Everyday

3.  Defense and Discipline Over Speed

4.  The Long Ball Could be the Ultimate Winner

Special Note: I have some investment credentials and years of experience with winners and losers which I share with you and my investment advisory clients.  Over the same period I have been following both sports and politics as an amateur, and do not claim any expertise.

Introduction

The commonality of statistics, emotions, and luck are present in viewing investments, politics, and sports. In the US they converge on the Super Bowl. The commonality is not due to the statistical side which will be quoted ad nauseam, but the emotions which will guide future actions and lessons learned and not learned. Being one who has been formally trained as a security analyst I start with the numerical relationships but with a bit of suspicion that some of these pairs are coincidental and not causal. The one advantage the long-term investor has is that long-term relations normally hold until broken by some event. As distinct from sports (and to somewhat lesser frequency, politics) pure random luck plays a lesser role than investing for the long-term.

In our discussion I  look at various inputs with the same timespan approach I used in constructing the TIMESPAN L Portfolios^®.

The Immediate

Often many Super Bowl fans feel the ultimate result of the game becomes clear after the first series of plays. In a similar way, if one uses the first five investment trading weeks of 2017, there is one overriding statistical impression. That is, most securities are being traded within a tight correlation. We are in an era of increased interest in selling short either through individual securities or hedge funds/exchange traded funds. Investment theory holds that one sells securities short to make money or as a hedge against an otherwise long portfolio. As of February 2^nd,  out of 120  SEC registered taxable fund categories only 9 showed losses on average for the year-to-date. Most of these losses were small and only 2 were worse than -2%, led by the -4.74% decline in the Dedicated Short Bias category. With the exception of a +17.38% gain for the average Precious Metals Equity fund, none of the other equity funds were up over 10%. A further manifestation of this condition is that recently the CBOE VIX ratio traded at its ten year low. Some may call this a Goldilocks market. I call it a statistical aberration driven by political judgments. The  market bulls are extending the campaign speeches to actual pieces of government regulation or passed legislation without recognizing that the Administration is in what the Navy calls a shakedown cruise to get to know how the ship and crew will act under trial conditions. The lack of new constructive specific criticism by the opposition party is giving the Administration a free pass. Under these conditions one can understand the lack of interest in shorting securities. Instead of pitying the short sellers, we should keep an eye on them, for at some point there will be more dispersion in prices and selling short will return to its traditional role as a hedging device.

Just Before the Start

Today's Super Bowl started with a formal coin toss as to which team will receive first. This formal ceremony was supervised by former President George H.W. Bush and Barbara Bush. The Bushes are a remarkable political family which has ties to three US Presidents, two governors, one senator and is a political factor in Texas, Florida, Connecticut, Missouri and Maine.

In many ways Barbara Bush was the quintessential First Lady who was respected throughout the country. Even with this proud tradition of national service, Jeb Bush was not prepared for the new style of social media campaign that produced the current resident of the White House.

Even in politics, credentials and streaks don't always win under changed conditions. On paper the New England Patriots should have won this year’s Super Bowl. To some extent the contest highlighted their defensive skills and precision passing versus the Falcon's speed and height.

From an investment point of view, the winner will be the one that has the right combination of both defense and offense. Without skills in both, a leader can be worn down to becoming a loser. The winner most likely will demonstrate some successful new skills not shown before. In managing your money you will need to use intelligent defensive and offensive plays and from time to time show some new ways of doing things.

After the Game

One of the responsibilities that we accept in managing money for clients is to appropriately invest for long periods, often beyond our lifetime. The owners of today's Super Bowl teams will have generated the capital that he or she has wisely invested in the past for use today. In the same light I look for long-term investments that can make a huge difference. I am very conscious that the US Defense Department through DARPA funded the creation of the internet as a way research could be transmitted to various institutes and universities.  Little did anyone then conceive how the internet would drive our recent election and is changing the delivery system to consumers worldwide. I am beginning to wonder whether Artificial Intelligence (AI) could have the same impact as the internet. Just as the internet was created to assist the Defense Department, the development of AI is of critical military importance as China appears to be gaining on the US lead with the help of returning Chinese scientists and executives. From a military standpoint, AI technology could be used to assist our guided missiles to avoid defenses and aid in targeting decisions. The implication to me is that conceptually the same or similar technology can be used both in the commercial and investment worlds. Avoiding some strong defenses could make today's winner and  also tomorrow's successful investor.

   

The Recap

In reality, we saw three great football games, the first was the dominance of the young Atlanta Falcons into the third quarter, the last half of the third quarter through the fourth quarter where the Patriots acted like their American forefathers recovering from adversity, and the first overtime in Super Bowl history that displayed the mastery of the training on the details of winning. Many other teams would have "phoned in" their plays being so far behind. The Patriots never lost their confidence and their controls.

From an investors standpoint this great game was similar to the investor's year of 2016. The first six weeks were painful, it was not until immediately after the BREXIT vote did US interest rates start to rise as the demand for money improved; the final seven weeks of the year saw enthusiasm for the future drive stock prices higher. The investors who came out of the year with their investment discipline intact and were able to take advantage of the opportunities offered were the winners.

Statistically there is only one drawback to the Patriots win. The Falcons can trace their historical lineage to the original conference which was the senior member of the merger that created the modern NFL. For some unexplained reason when teams representing the older conference wins, the stock market usually goes up and when they don't, the market goes down. There is no logic to the result but it has worked out this way for fifty years, 80% of the time. I would not change any investment strategies because of this, but be prepared for the chance of a down market, but maybe you have a Tom Brady as your investment quarterback who in the end produces a winning result.

__________

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