Confession: Numbers Don’t Tell All - Weekly Blog # 768

 

Mike Lipper’s Monday Morning Musings

Confession: Numbers Don’t Tell All

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

 

 

 

As a numbers-oriented person I must confess that numbers don’t reveal all critical information about a situation. For instance, future risks. The bearish financial press is focused on future profit margins shrinking on declining sales in the coming recession.

 

The real likely risk ahead of us is what an economic recession will mean to us personally. As Warren Buffet said, it will be revealed which swimmers are naked when the tide goes out. So too will we find out which companies are overextended when the economic pie shrinks.

 

The problem facing the management of companies, governments, non-profits, and individuals is the reduction of expenses. Rarely are expenses reduced proportionately to the actual decline in revenues, or the expected “top line”.  Expenses are cut either by judgement or happenstance. The cuts can impact the three “S” s on which future relationships are based. Products/services and future sales are based on their perceived Success in use, whereas Service is based on the ease of the relationship and the Safety of the user.

 

To an important degree the way customers feel about the product or service is dependent on the quality and quantity of known or unknown people they deal with at the firm and/or its distribution system.

 

The transaction price of most companies and practices are sold is leveraged over the resale value of its hard assets by its perceived reputation value. This is an attempt by the marketplace or ballot box to determine the sum total of the three “S” s. Thus, the impact on the absolute and relative value of its reputation is critical when it becomes necessary to cut people.

 

During the past holiday shopping season, it was easy to rank the service and inventory levels of various merchants through store visits. It was a little more difficult gauging the service levels provided by these service companies, particularly financial and health services. Much more difficult, but perhaps more important, is gauging the safety for the customer performed by service companies. Banks have announced employee cutbacks, hospitals are having difficulty finding qualified nurses and medical techs, certain military branches are understaffed in critical units, and law firms are reducing staff. These levels of safety should impact a company’s ultimate worth.

 

We don’t know what additional risks we are taking as consumers by relying on formerly reliable service providers whose staff support is shrinking. While I don’t know the risks, I do know that I am my accountant and back-office people are already spending more time reviewing the statements sent to us. I suspect the cost to me is much greater when a professional firm has an error or omission than when the wrong size of a garment is received at a store.

 

The following statistics suggest to me that I need to pay increasing attention to the details of safety than in the past:

 

Possible Warning Signs

1. The decreasing value of the US dollar relative to other currencies. This will likely raise the cost or reduce the quantity of what I buy.
2. There is a dichotomy between the level of transactions in the NYSE and the NASDAQ. Compared to a year ago, NYSE volume is down -14%, while NASDAQ volume is up +2%. Last week NYSE prices rose while NASDAQ prices fell. With many older company stocks generally flat for a year or more, the outlook for making money in these stocks looks limited. Some “growth stocks” are finding their sales more cyclical than in the past and the demographics are not promising.
3. China’s business capital returns are declining. Growth in global trade has been heavily dependent on Chinese export earnings. If they become smaller as the rest of the world slows, it is likely that export earnings will decline and result in lower imports.

 

Self-Appointed Mission

Bernard Baruch, a friend of my grandfather, labeled himself a speculator at a congressional hearing. He then explained to members of the House that the term speculator comes from the Latin term “to see far”. I use a speculative focus on the future for me and my clients. Part of looking at the future is identifying different possibilities. I take my marching orders to spot both “bull” and “bear” cases.  

 

My blogs often warn of problems, as Mr. Baruch did. However, I think the time for a new “bull” market is coming. Hopefully, we will make enough adjustments to our society/economy so that we won’t need to go through stagflation to adjust.

 

I lack the ability to see the future. Hopefully, a few subscribers to these blogs will have some thoughts they are willing to share about the next major “bull” market. (Please don’t focus on inflation and interest rates which are old news, they are attributes, not causes.) Help!!

 

 

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Large Opportunities and Risks - Weekly Blog # 626

Mike Lipper’s Monday Morning Musings

Large Opportunities and Risks

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

Current Picture
Normally the US stock market moves at a pedestrian pace, with annual moves of about 10% (7% to 12%). We have just completed a two-month period that by statistical definition includes the fastest “bear market” in history and a recovery that would qualify as a one month “bull market”. There are some signs the recovery has likely ended, with a rounding or flat top for the three major stock indices. Furthermore, the lack of confirmation by the VIX index and the advance/decline line is casting doubt on the direction of the market. Thus, we have probably entered a confusing period, which until it is resolved will lead to lower volume. It offers an opportunity to reposition for a significantly lower market based on deteriorating economics and politics, as well as an  opportunity to buy into stocks that will be viewed as great bargains in the years ahead.

I am a somewhat risk-aware contrarian long-term investor and advisor. Both the Bulls and Bears could be right. For long-term investors, the bulls have an eventual chance to multiply their capital many times over, whereas unleveraged bears could preserve a portion of their capital. Careful bulls amass more capital over time than bears, although some bears have produced exciting short-term returns.

This dichotomy produced the first modern hedge fund, which was housed in the same 74 Trinity Place building in which I spent 25 years. A.W. Jones, a former magazine writer, came up with the concept of always being 50% long and 50% short. This produced good but not spectacular results over the years, often due to declining less in down markets. Unfortunately, he moved out of the building before we established our office there, but I did study his results. From that study and analyzing the success of a number of mutual fund and other managers, I concluded that long-term investing on the long side produced satisfactory returns. My lifetime’s work leads me to briefly outline the case for increasing equity investments now, although I should first clear up the one reason media pundits have led the investing public into a confused state.

What is in a name?
Our ability to name something or someone is critical to organizing our internal filing system, otherwise called memory. But it is also the source of much confusion if the name is not specific enough, such as with a company’s name. A name can mean different things to actual or potential customers, employees, competitors, lenders, and various types of owners. Much like blind people feeling different parts of an elephant.

Some of the abovementioned people are interested in what the company can do for them today and that becomes the company’s image, although it’s quite different for those who own the company’s debt or equity. They are vitally interested in the future securities price of what they own or are contemplating buying and need to guess the price of the securities at future dates of importance to them. The price will be determined by the current owners selling for some unidentified reason, while potential buyers compare similar investment opportunities. Today, most companies are experiencing falling sales and increasing prices, so things look temporarily bad. However, the securities buyer is looking at pent-up demand, which could return to 2019 levels, more or less.

The Optimistic Case
As is often the case, buying largely rests on demand in the short, intermediate and long-term. In the short-term, the $4 trillion in Money Market funds is earning next to nothing relative the real inflation being generated by the COVID-19 stimulus. At Bank of America (Merrill Lynch), 14 % of the average account is allocated to cash. In the intermediate term, when both businesses and other consumers get more comfortable, pent-up demand will generate sales of products and services.

In the long term, the main purpose of most money in institutional and individual accounts is to create future payments for specific retirements and/or legacies. If one amalgamates the retained earnings from 2018 through the present time, my guess is that in general it did not earn an actuarial rate of return sufficient to meet future payout desires. As my Grandfather’s friend Bernard Baruch explained to congress, the Latin derivation of the word speculate is to see into the future. I expect to see changes in how we live and think about the future coming from demographic trends, the march of technology, and the impetus from the current Coronavirus and future COVID plagues. As a global society we will be paying more for longer and more expensive retirements, particularly in the end.

An example of a little noticed change with larger implications is the following small notice on page 2 of The Wall Street Journal. 

“Notice to readers, Wall Street Journal staff members are
   working remotely during the pandemic. For the
   foreseeable future, please send reader comments only by
   email or phone using the contacts below, not U.S. Mail.”   

Considering President Trump wants the Postal Service to charge much more for packages, while rural members of Congress remain unwilling to change the schedule for mail delivery, future communications from various governments are likely to change. We are already seeing a smaller quantity of mail, which is not altogether negative, but is a lost sales opportunity for some.

The biggest long-term change I see is the possible reduction in our real estate footprint. Not only in our homes, but hospitals, schools/universities, and entertainment locations. I became more convinced of this threat when I read an article on the latest Gallup Poll survey, where individuals favored real estate over securities as an investment. As a contrarian I hope they are right but think their view will change as real estate becomes more difficult to sell, due in part to mortgage rates rising and state/local taxes going up.

What to Buy?
As usual, there are investment performance arenas from which to choose current winners and laggards. One advantage our clients have is that I look over the performance of all US and over 26,000 offshore funds each week. In the latest week, measuring from March 23rd which I am using as a bottom, the three leading mutual fund peer group averages were Precious Metals +47.40%, Equity Leverage +46.36%, and Energy MLP +43.16%. These are narrow-based funds enjoying a large recovery, which should probably not be a large part of a long-term mutual fund portfolio. The best performing diversified equity funds for the same one-month period were: Mid-Cap Growth +27.14%, Multi-Cap Growth +25.54%, and Large-Cap Growth +25.31%. Clearly, in this recovery growth has been favored in part due to its positions in the health/biotech sector, which gained +30.12%.  What may be significant is that performance leadership is no longer the sole property of large-cap funds, suggesting the overriding need for liquidity is shrinking.

Future performance leaders often come from the bottom of the performance ladder, which in this case are a few well-managed Value funds. However, one needs to be particularly careful looking for Value today. Far too many base their analysis on the spread between book value and price, which was a scholastic task assigned at Columbia University by Professor David Dodd while I was there.

This was a relatively easy job because we had the published financial statements, which had some relevance back then. This was not the way he and his partner Ben Graham (*), at the closed end leveraged Graham Newman fund, produce his great performance. Book value, according to their student Warren Buffett, is today misleading. It is an accounting number based on the historic cost of assets, which can only be changed by impairments, not improvements.

The task in the class I took was to identify companies that should be liquidated, not purchased as a going concern. There are relatively few of these companies today, as they are usually prey to private funds who specialize in this art form. There are however a reasonable number of companies whose financial statements do not fully reflect their improving value in the right hands. Careful and patient analysis can uncover their true value, the trick is identifying what or who will recognize their true value and change investor’s perceptions.

Conclusion:
Successful investing is much more an art form than a quantitative exercise. It requires patience and luck to make one’s investments profitable. 


(*) I am the recipient of the New York Society of Securities Analysts Benjamin Graham award



Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/04/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/04/long-term-investors-mistakes-ahead.html

https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html



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Worry Short-Term, Focus Long-Term

Introduction

“The world is too much with us” is the title and first line of a famous sonnet by William Wordsworth.  One of the truisms of the media world since the first regular competitive publication is that bad news sells. If one scans the front pages of daily papers as far back as possible, one may see that bad news gets a bigger play than good news and normal news is relegated to the less important sections. Now that we live in a social media/electronic world look at all the bad news that we are bombarded with everyday. Also notice that the world, the country, most businesses and individuals have not come to an end.

While a few can make some money with short-term trading approaches, most who attempt to do it on a day in/day out basis contribute to the wealth of various agents until their capital or personality is exhausted. When Bernie Baruch was testifying before the US Congress about the trading that preceded “The Market Crash,” members of the committee were eagerly waiting to pounce on anyone who made money in the market. They were pleased when he announced to them that he was a speculator. Then they were downhearted when he explained the Latin derivation of the word meant to see far ahead. (As I have observed in the past, subsequent to the hearings he chatted with my grandfather on a familiar park bench and also counseled various US Presidents.)

Using the passage of time

Taking a leaf from Speculator Mr. Baruch, I worry about the current conditions, but try to focus on the long-term. One way I do this is with the development of the four Timespan Portfolios^* that I am developing for clients. The first or Operational Portfolio is very much currently-oriented, with the need to pay for the next two years of expenses to meet the crucial needs of the account. Any unexpected shortfall will starve some important need. Nevertheless, over a reasonably short period of time the operational capital will be all consumed. To meet the continuing needs of the account it must be replaced. That is the function of the Replenishment Portfolio which over the next five years must replace the Operational Portfolio. While there is nothing magic in five years it does represent a political period from leadership elections, the minimum expected presidency of corporate CEOs, some turnover of critical middle management and certain voting blocks. Some may prefer the four year US presidential cycle up to a Biblical 7 year period. 

^* Timespan L Portfolios^TM

In any case, based on past history one should expect a market decline during this period of about 25%. (If one does not see it in that period, be particularly weary because a bigger decline is likely.) During this timespan the markets are likely to be somewhat balanced between cyclical and secular trends with each playing a predominant role for part of the time. During this phase price-disciplined value buyers as well as those market players seeing expanding growth have a place in these portfolios.

Personal and institutional endowments

Even my friends who feel that they are already ancient are likely to need to use a part of the Endowment Portfolio which should have a focus between five and fifteen years. These portfolios ought to be largely invested in reasonably consistent growers of sales, operating earnings and dividends. This period is long enough to recover from periodic declines. Rarely there is an equity portfolio that has produced a negative result over fifteen years.

The Legacy Portfolio

The final Timespan Portfolio is the Legacy Portfolio which should be loaded with lots of emerging growth opportunities, recognizing that a number of these will fail as businesses but the survivors will more than make up for the failures. The focus of this portfolio is beyond the current horizon and will be largely dictated as to how technology acts on our world. Thus smart users of technology as well as their producers should be important investments in this prudent portfolio.

Worries

If I am primarily focused on the long-term in selecting investments for the Endowment and Legacy type investors, I cannot avoid occasional short-term losses caused by relative changes of marketplace popularity. What I worry about is too much enthusiasm in an up market. This is not a major concern today in the equity market. Excess enthusiasm however is very prevalent in the fixed income market. The owners of various fixed income instruments have convinced themselves that they know the future levels of interest rates and how they will evolve. This certainty is a worry.

A major decline occurs when there is a sudden shift in sentiment. One of the very reasons some fixed income investors have done very well is that the dealing community has shrunk. With fewer well-capitalized dealers, price trends become exaggerated beyond their appropriate value levels. This has helped on the upside and will hurt materially when the eventual decline hits fixed income.

My first worry is equity market capital will be drawn into the fixed income market to replace the missing levels of liquidity, the withdrawal of capital from the equity market could trigger a stock market sell-off of significant dimensions.

My second worry is in stock markets that are experiencing higher than currently customary volatility. We are seeing the 2015 leadership shift to more growth companies, particularly of smaller market capitalization. Biotech funds are producing year to date performance twice to three times Growth Stock funds and this is a global trend. Part of this excitement is due to very highly valued acquisitions.  A number of these stocks are gyrating well above many consumer and industrial stocks that are suffering from mixed to mediocre sales and limited opportunities for margin improvement. I can not guess how high this move will be, but I remember from years ago that I used to track funds that were up more than 100%.  As a matter of fact I had to explain to a board of directors that the poorest performing Tech fund was doing a good job being only up 100% with others producing almost double those returns.

My real focus is to avoid big declines that are likely to come from very extended stock market prices. I am not sure about that likelihood for fixed income prices.

Question of the week:


What are you worried about long-term?
__________    

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