Investment Dangers from Extrapolating Historical Trends

Last week the expected outgoing US Attorney General began a lawsuit against McGraw-Hill (Standard & Poor’s) for failing to see the future.  S&P is in the somewhat distinguished company of various Presidents, members of Congress, government agencies and Departments; e.g., Treasury, Federal Reserve, SEC, as well as a number of government sponsored mortgage-related companies (GSCs). The private sector has an equally long list of participants which did not see the end of the rising house price trend.

These errors of human judgment are also found in betting that various streaks will continue.

The mortgage mess

The DOJ alleges that the ratings of a small number of credit ratings issued on subprime-related, structured underwritings by S&P were faulty. (Focusing on only the specific issues in question, based on selected internal emails, the fees earned by S&P were on the order of $13 million.)

Disclosure: I have personally owned shares in McGraw-Hill for many years and my fund has a long position in Moody’s. The high price on Moody’s last week was $55.39, and the low $40.67, with a close of $43.37.

US vs. Mc-Graw-Hill

The case against McGraw-Hill has generated heavy news media coverage, which is ironic as the media itself should be considered a contributing factor in this debacle. As Wall Street Journal columnist Holman W. Jenkins, Jr. pointed out on Saturday, “S&P was not responsible for the destruction of underlying housing collateral (caused) by politicians who made it nearly impossible to foreclose on delinquent homeowners.”  Jenkins also reminds us of the Fed chairman’s illuminating quote:  "You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country."

Seven  reasons why I believe the suit is misguided

1.    Within any sizeable organization that deals with opinions such as credit ratings, there is likely to be differing opinions, particularly from those on the lower and middle rungs of the power ladder.

2.    We know that the Federal Reserve Board was not too concerned about housing and subprime loans during the period in question.

3.    There is significant legal risk if a credit rater is early in downgrading ratings without firm facts that seriously contradict past history.

4.    In my work over the years, I generally felt that credit ratings were a lot like performance statistics; i.e., a backward-looking device with not much predictive value if things change.

5.    While the SEC has been mandated to reduce the power of the credit rating agencies, it has not been able to do so yet, and the SEC has not joined in the suits.

6.    I suspect the states who have joined the suit are trying to aid in the defense of their own pension plans who did not do their own credit research.

7.    In most cases of the so-called AAA paper, it was only the top tranche that had that highest rating, and the lower tranches had lower ratings. It was the lower tranches with higher (leveraged) yields that investors bought, ignoring the lessons of the market that higher yields often show a market judgment of potential risk of loss of capital.

There are no innocents

There are no innocents in this train of unwise and intellectually challenged decisions. The list includes both Congress and the administration, the Fed and the SEC, the builders and real estate agents, the public who lied either to themselves or to the mortgage companies, the investment  and commercial banks who couldn't get rid of the paper off their own books quickly enough, insurance companies and pension funds who let their insatiable need for yield override their own sense of fiduciary controls, the media that stoked the desirableness of owning ones' own home and the ease of getting a mortgage and of course the credit raters who relied completely on history and not a fundamental understanding of supply and demand and the dangers of leverage.

In my opinion, there were NO innocents, all of the parties overlooked one or more important signal.

Lessons to be learned from the mortgage mess

There are a number of great lessons from these tragedies. The first is to be wary of sponsored mass movements in any one direction. (In this case, new home ownership based on very large borrowing.)

Second, one needs to anticipate the possibility of a “black swan” effect, of something happening that is beyond our historical context (house prices dropping materially).

Third, when there are too many middlemen in the process there is little discipline (politicians desire to change voting patterns, new builders starting with little experience and less capital, inexperienced buyers, mortgage brokers and loan officers, etc.).

Fourth, we live both individually and collectively in a cyclical world of ups and downs and the longer we go from a key market turn, the more likely that there will be a major change in direction.

Buy the leader and be wary of number two

One of the characteristics of a bear market and many flat markets is the lack of faith in various companies and types of securities. In times like the present when investors believe that despite the globally troubled economies they must invest, they all too often take a historical approach. They look for the single leading company in a sector that is already expanding. They forget two important lessons.

The first is from the sports world, be it with human athletes or thoroughbred horses, though I prefer the latter group. Unless there is a premature retirement, winning streaks always end. Often they do not immediately resume, at least that is my experience with a number of portfolio managers. 

As with the lessons from the mortgage mess, investors often do not anticipate the arrival of a black swan. These can be unexpected changes in personalities, government regulations, structures of commercial and financial marketplaces, etc. Often once a market surge is underway the number one company’s stock rockets up to a price that is beyond a fair level. In this case there is a tendency to jump on the number two company in the sector, whose price has not appreciated to the same degree. I have studied this phenomena in the financial services area, and I believe that it is also applicable to some other sectors. 

For years whichever retail brokerage firm had the second largest number of salespeople to Merrill Lynch was favored by some investors in the belief that it was selling at too big a discount to Merrill. Going all the way back to Bache, none of these number two companies did as well as the leader. There is a sound reason why the gap did not materially close. When a firm believes it must compete across all product lines with a leader, it will come to the party late in terms of loyal experienced people. 

Today, Morgan Stanley through acquisition of Citigroup’s sales force, is now the firm with the most active employee salespeople. This is somewhat ironic as its CEO came out of McKinsey and Merrill Lynch is now tucked into Bank of America. We will see what it can accomplish as number one. Judging by the large number of experienced brokers who are leaving it won’t be easy. Morgan Stanley is the original major competitor in the investment banking business though Goldman Sachs remains the “go-to” banker on large, difficult deals.

(We own a much larger position in GS than we do in MS which may be an indication of my concern about betting that a number two can become number one.)

Bottom line

One should understand past history, but be aware that the future, at some point in time, will not look like the past.

_________

 Did you miss Mike Lipper’s Blog last week?  Click here to read.

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 - 2013 A. Michael Lipper, C.F.A.,

All Rights Reserved.

Contact author for limited redistribution permission.

A More Insightful Way to Characterize Funds

Guilty As Charged

I plead guilty. I plead guilty for the crime of characterizing mutual funds and their kissing cousins, hedge funds by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out. We choose to identify people by what they look like, not what they are, or more significantly how they think. I should have known better. I forgot my race track education of calculating my betting choices after examining the characteristics of the jockey, trainer, and breeding as well as the conditions of the race and the racetrack. Shame on me.

The Talents of the Trade

Each of us has a different collection of talents. I have made a living analyzing a mass of data, organizing the data for decision making, and using that data for making decisions applying the disciplines that I learned from my educational institutions, the US Marine Corps and the aforementioned racetracks. I should have looked at the primary thought patterns of the principal decision maker for each fund. Most of the time this is the portfolio manager, but it can be the most forcible member of the investment committee, a determined marketer, or extremely rarely, the fund’s board of directors. The following are some of the ways that I identify the dominant personality of a fund and how the fund can be used most effectively in a portfolio of funds. (I manage or advise on the use of funds in a multi-fund portfolio where each fund has a separate function in contributing to the whole over the long-term.)

The Discoverer

This portfolio is full of names that are not common to most other portfolios. More often than not these names are of smaller, often newer companies. Sometimes the names are from rarely explored foreign markets. Occasionally the names are different types of securities which more often than not come from the extremes of the fixed income world. All of these securities lack significant research coverage from the usual sources of research. As an analyst I used to delight in finding companies whose president has not talked to an analyst in years. As he or she explained the company to me, I explained how analysts like me operated. Some of the most rewarding investments were in companies that had a policy of not speaking to analysts. In almost all cases the names in a Discoverer’s portfolio are difficult to analyze. When these stocks move, it is usually not due to an asset class’s popularity or the general trend of the market. Most often a Discoverer will have more strike outs than home runs. The investment results will look more like those of a venture capital portfolio, but have the advantage of offering daily liquidity. In the hands of someone with a great deal of industrial experience and a proclivity in recognizing management’s abilities, this kind of investing can be rewarding for the truly long term investor. Wealthy individuals who have a multi-generational outlook or a structured endowment for long term horizons can find a Discoverer a non-political “fellow traveler” and a good strategic fit.

The Anticipator

I use to hear this term used more frequently than now. The term was applied to managers who felt they had well-defined skills at anticipating major interest rate moves. There is still at least one fund that invests either in very short term treasuries or thirty year treasury bonds. The Anticipator has a defined view of the future and is waiting for the rest of the investing community to catch up. The trick for a successful Anticipator is not to be the first Anticipator but near to the last, just before the take off of the expected trend. At times, Bill Gross and others at PIMCO are Anticipators. To some degree this a necessity, due to its size relative to the size of the available merchandise at an inflection point. This may be a requirement for PIMCO as the world’s largest bond fund manager. Some patience is required to be a successful holder of a fund that anticipates. One can appropriately call my faith in the benefits of technology as anticipatory and not often rewarded.

The Immediate Reactor

The financial press believes that the market is full of those traders/investors who immediately react to a bit of news. They are looking for the proverbial one-handed economist who has a singular view on an event. Even the rapid-fire “macro” hedge funds don’t put their money on a single roll of the dice. Most often a substantial buy is offset by a sale or short sale, perhaps through derivatives or ETFs. Nevertheless, the Immediate Reactor does make dramatic moves quickly. The closing of the liquidity pool around a security or currency is viewed as an opportunity to get in before the bulk of the move is underway. Funds that do react well have suburb trading skills and they know how to use their size to get the best advantage. In many ways these are trading artists. Outside of occasional outsized gains, these funds can be used as an early warning device, a canary in a mine if you will.

Trend Identifier

These managers are constantly searching for minor deviations from immediate past experiences; to be one of the earlier identifiers of a change in an investible trend. For example, these trends can focus on elements of consumer spending at various price points, the popularity of products ( e.g. Blackberries and iPads), or the daily movement of a currency. In the fund arena, the rate of inflows and redemptions can be interpreted as meaningful trends. Often large funds use identification of trends to shift a small amount of their portfolio in the direction of the trend on a daily basis and more as the trend becomes more pronounced.

Trend Follower

Some managers, particularly in the commodities world, are Trend Followers. They need to separate market volatility from important market trends. These stock, bond, and commodity managers focus on large aggregates in the market place. A more modern example of this age-old technique is the use of Exchange Traded Funds. Currently there are portfolios that only own ETFs or Exchange Traded Notes (ETNs), a fixed income equivalent. Increasingly these portfolios are being used for commodities like gold and silver. Trend Followers have more faith that the trend will continue for some period of time than recent history suggests. Also aggregate trends do not allow for the investment opportunity differences among various industries, sectors and other components of the aggregates. If one does not have much faith in individual selection skills and the direction of “the market” becomes all important, Trend Following is an attractive approach.

The Resurrection Believers in Recovering Prices

As all life seems to be cyclical in terms of up and down phases, hopefully around a recognizable trend, some managers look at investments that are currently priced well below their peak levels. Excluding from this universe those stocks that were substantially over-priced given their best expectations, the resulting list of large discounts from peak can be a happy hunting ground for some investors. These investors are different from value investors who believe that today’s price represents a good value relative to today’s reality. Those that believe in recoveries believe that conditions will change. Whatever caused the unfavorable conditions, e.g. commodity prices, unpopular styles or product failures, will change. The argument goes something like this: if oil was priced at either $150 or $36 a barrel, certain properties would be perceived to be more valuable. Another variant of this strategy is when the new production comes on line, such and such will happen that will significantly change the valuation of a security. This may be considered as betting on the return of the Black Swan from Australia. History is on the side of those who believe in cycles of prices and other forms of human behavior. What is more difficult is identifying which particular cycle will change the soonest. To some degree distressed securities buyers believe in a form of financial resurrection.

Final Note

To be a good investor, one needs to know more about the intellectual motivations behind various portfolios.

____________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.