Positive Investment Implications...

I wish to bet in favor of an expansion of returns of investors’ capital, even though this time may be different in that we might be entering a long-term phase of flat to down stock markets. At market turning points there is usually not an over-abundance of evidence of a change in sentiment as to the long-term direction. Thus, to find clues of change I scan all information that passes through my desk and memory. The following are items that I think should be weighed and their implications examined.

Intellectual property and unfunded pension liabilities to be calculated in GDP

In July of this year the US GDP will grow by 3% due to the inclusion of intellectual property in its calculation, recognizing intellectual property as a produced asset rather than an expense-only generator. According to a Financial Times story released on Sunday, this adjustment will be carried back to the initiation of the calculation of national accounts at the Bureau of Economic Analysis in 1929. The size of this addition is roughly equivalent to the size of Belgium’s GDP and the biggest increase since the 1999 addition of software. This change is in response to the international accountants recognizing intangible assets such as research and development expenditures, and royalties on creative works (movies, television shows, books, music and theater). If these are the results of current spending to produce long lasting assets, they need to be identified on accounting statements including the national income accounts that produce our Gross Domestic Product. At the same time the revision will recognize the unfunded liabilities of public and corporate pension plans. There are many investment implications to these changes. The first is that the US economy with its large scale production of intellectual property will widen the gap from most other countries, which may play a role in the on-going deficit production and austerity discussions in the US. Second, intelligent investors have already priced these benefits into some of their judgments regarding the production of intellectual property in the biotech sector (including drug companies), as well as others. If recognized this shift, in addition to published book value, will lower the price/book value ratios that many so-called value investors favor. Also some states like New Mexico will get greater recognition for the large amount of R&D conducted there. Larger in dollar value, but smaller as percentage of total state product, my home state of New Jersey could also benefit. However the various states as well as the nation’s GDP numbers will be marked down due to the size of the underfunding of their pension funds. In most cases knowledgeable investors have understood these conditions and market prices may already be reflective.

Portfolio liquidity

Many institutional investors have been willing to accept in the case of their purchase of “lock-ups” through private equity and many hedge funds that there is a penalty on early redemptions. Recent discussions with investment committees (who are focused on providing operating funds to their institutions) have indicated a stronger than normal push to insure the liquidity of their portfolio.  They are willing to pay a liquidity premium beyond the current year’s needs to feel comfortable in meeting the requirements of their organizations, particularly if business and donor support slows down in the year ahead. At the moment there is less competition for long-term investment opportunities which in turn may lead to better entry prices or terms for lower fees or less onerous exit terms. Thus, now may be a particularly favorable time to be a long-term investor with cash to spend.

Four letter words

From a young age we have been instructed to avoid the use of certain four letter words. In this prohibition, we tend to forget two additional very important words; Love and Like. The world would be a far less attractive place without these words in practice. But there are two other four letter words that now need to be understood. The first is “real.” This term is used in reporting the impact of inflation on income and price performance recognizing that published nominal rates don’t measure the “real” cost or benefit received from a number. My problem with the designation of real is that the number for inflation is increasingly recognized as questionable. There are growing questions as to the price inputs, methodologies applied and the accuracy of each procedure. In my talks with various institutional and individual investor audiences I have yet to find people that perceive the published consumer price index is representative of their experience. I would suggest that it would be prudent to use “real” rates of return as estimated and not certain in the specific situation of the investor or citizen. The second four letter word that should be handled with care is “copy.” Something that bears no resemblance to an original will rarely be compared as a copy. The art and the investment worlds know that a well done copy is not only difficult to spot but also has many similarities to the original and in some aspects could even be better than the original. Copying is the sincerest form of flattery it is said. At the right price a copy could be a useful bargain. In the investment world which follows and mimics performance leaders, I would not necessarily shy away from good followers as long as one identifies that they are followers who could produce better, often more leveraged vehicles, than the original leaders. As long as one recognizes that those who follow are unlikely to either spot the turning points when the period of advantage is over or to be an original leader in subsequent phases. Thus, I would not reject a copy out of hand, but understand as to what one is dealing with and do so at the right price.

Investor confidence

As mentioned a number of times I follow the weekly publication of the Barron’s Confidence Indicator of the ratio of yields of intermediate quality bonds to high grade corporate bonds. When the ratio declines it is meant to be positive for stocks in the future. Most weeks the change is below 1% (100 basis points) which I consider a weekly trading differential. In the past week the decline in the ratio was 1.6% or from 67.9 to 66.3 which is encouraging to those of us that have long positions in stocks.

Markets speak to non-profits and governmental services

One of the hard realities for many non-profit institutions that are serving the public through admissions to various locations is that they are suffering from a falloff in both attendance and donor support. Very harshly, I am increasingly taking the point of view that if these non-profits were commercial businesses with the same secular, not cyclical decline in support, my attitude would be that ‘the market has spoken” and now is the time to consider basic model changes or closing down. Applying the same thinking to the deficit production machine being run by most Western governments, I believe that the situation calls for a significant model change as the public does not wish to pay in full for all of the omnibus services that it receives. The current debate is, “do we want European level of services or Asian types of government spending?” Analytically I reject that simplistic equation. I believe the tool that is called for is the surgeon’s knife not an axe. I believe that if the potential audience for a museum or concert or a government service believed that it wanted the service that was proffered they would show up one way or another in sufficient quantities to effect a re-pricing of the services. We should not close support institutions and governments entirely, but just rescale them to fit today’s demand levels. The investment implication is that there is a third way out of our box, which is to find the level of demand for services that people will fund for themselves in monetary or work terms. If we see more of this new thinking,  the future will be positive for our children and grandchildren.

What Do You Think?

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Three Bullish Presents for Investors

This is the holiday season of giving presents. I have three ideas as presents for long-term, fiduciary oriented investors. These ideas are both presents for those who may need them as well as thoughts that should have presence in an investor’s mind while looking into the future.

1.       Waiting for the big drop

At a recent dinner with a knowledgeable member of a charity’s investment committee, he indicated that he was out of equities for his personal account which is to fund his living expenses for the next twenty years. Yet he was perfectly comfortable with our use of equity funds for the charity. In terms of estimating future returns, I believe my actuarial friends will see little difference in a twenty year and a theoretical perpetual return for the charity. While I recognize and expect the past price patterns to continue, this suggests that in any ten year period, there will be three 25% declines from peak levels. Further, once a generation there is likely to be a drop of 50%. Having experienced these in the over fifty years I have been an investor as well as serving other investors, I know very few market participants that totally side-stepped these declines. I have found it to be more difficult to accurately guess how big a drop will occur once a decline is underway. I have looked over my notes and recollections of my judgments at or near past bottoms. In every case I convinced myself that a deeper bottom was required to bring the market to a bargain basement level. There were always lower estimates of earnings, unfounded rumors of firms, institutions, or well-known individuals that were in dire straits which would become known soon. As difficult as it is timing a bottom price, the decision to buy early on the way up is even more difficult. Because at the time of the sharp decline there was no market-clearing event which would signify the end of the bear market, most lacked sufficient courage to be an early participant on the rise. Often this rise was described contemporarily as a rise in a bear market caused by successful short covering, not the beginning of a new bull market, or at least a sustained stock market rise.

While some may have all the skills of identifying a major decline in advance, recognizing a bottom, and being an early participant in the recovery rally, along with most other professional investors, I do not have these capabilities.  As with many extreme sports, and other dangerous pursuits, I choose not to engage in market timing strategies.

Perhaps more importantly, there are a number of positive features I see on the investment horizon which can be summarized as follows:

A)      The largest gains come from investing into opportunities when others retreat from challenges.

B)      A careful listening to the press conference given by the Federal Reserve Chairman will reveal his view that the monetary policies being followed have not lowered unemployment (and underemployment by those seeking full time work or discouraged workers). I would suggest other countries’ quantitative easing also has not produced significantly positive results. I believe that market and credit rating declines will eventually curtail the need to sell more government bonds to the central and commercial banks. As usual the private sectors, including individuals, are ahead of the government sectors. While governments are issuing more bonds, the private sectors are deleveraging. In the future we may see the private sectors expanding while the government sectors begin to contract. One of the lessons for an equity investor is to look to the bond market for clues to the future.  Each week Barron’s publishes a confidence indicator that measures the ratio between the yields of mid-quality bonds versus high-quality bonds. The index normally moves 1% or less in a week. When the index goes up, which means mid-quality bonds are going up, it is bullish for stocks. In the last week the indicator rose by +1.4%. Bottom line: I would be leaving cash for equity.

2.       Economic bears like stocks

As is often the case, Jason Zweig in his Wall Street Journal columns, reports on thoughtful pieces he has read. This week he reviewed the opinions of two astute thinkers on the economy who see that the US progress will labor to grow at half our historical rate since the Civil War. Nevertheless, both are investing in high quality US stocks. One of them, Jeremy Grantham of GMO believes that such a portfolio will grow for the next seven to ten years at an annual rate of 5% plus inflation. This is a very satisfactory rate as it exceeds many institutional and endowment minimum spending rates. Many conservatively managed pension funds will be able to meet their needs with such returns.

3.       The biggest potential present from Singapore

One of the investment managers that we use for our accounts is Matthews Asia. As one would expect, they are long-term bullish on Asia. In their well-reasoned November Asia Insight letter, entitled “Emerging Asia’s Rising Productivity,” they focus on the smart way to use labor rather than the initial low wages, which are now rising. Part of the reason for the rising labor productivity is the attitudes of the local governments. The Singapore Department of Manpower has a vision statement which states the department “embodies the aspirations of lifelong learning and the need of Singaporeans to adapt, learn and re-learn skills, attitudes and competencies for lifelong competitiveness.”  Now compare this view to that of the US Department of Labor’s mission statement: “To foster, promote and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights.” While we can understand the historical political development of each institution, the US Department of Labor raises lots of hurdles to generating high productivity in the US labor force. Indonesia, which has a population that is much larger than Singapore’s, has a similarly charged Department of Manpower. Some of the US Department of Labor activities are good for labor (and in the long-term, capital), but many are anti-competitive. Maybe we will make some future progress by following the emerging market leaders as we recede.

Investment Implications

·        Don’t attempt to time the market.

·        For the long-term, equities are better than cash.

·        Some of the emerging markets understand how to produce long-term value and selectively belong in many portfolios.

Please share your views.   

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