Flat Earth Wrong Again

Introduction

Because most people in the Fifteenth Century were focused on the difficulties of their lives, it was easy for them to believe that they and their neighbors were the center of the world. Their view of the world was limited by the height of the tallest mountain and the depth of the deepest valley. Thus it was easy to believe in boundaries that they could see. From this vantage point it was simple to believe that the earth was flat and was the center of the universe. To some degree investors and political leaders have the same view today. We have been trapped in a flat general stock market that experiences significant daily to weekly volatility before reversing to attempt to breakthrough either on the up or downside.

Low Volume Trading

These movements use up a lot of energy in expressing hopes and despairs. Having grown tired of this dance to nowhere, many investors have shut down their transacting activity. At most the low trading volume absorbs the net additions to investors’ cash flow or provides a trading arena for those who believe that they possess superior trading skills. Thus, we have created an investment audience who believe that not much will dramatically change until they perceive a major and probably unknown stimulus. They have returned to the flat earth view.

Open Your Eyes

One of the jobs for the long-term strategic investor in companies, securities, and people is to examine daily inputs of change to discern what could change and what are the odds on that change would occur.   One of the lessons that I learned through handicapping thoroughbred horses for a specific race was to deal with absolute uncertainty by assigning relative odds on each potential bet and comparing my personal-generated odds compared with other players/investors to find where I saw a better than normal opportunity that others did not see. Therefore I learned to look for early indicators of transformative disruption that others did not take into consideration. Like some of those in the Fifteenth Century, I looked far wider than others. I looked beyond the statistical measures such as reported earnings, present yields and last transaction prices. The following items are what I am now seeing.

The Downside

The first thing any investor should do is to look at the odds on losing money. In every transaction there is a buyer and a seller. Each side has his or her own motivation for the trade, but both are forcing themselves to do this trade at this time and at this agreed on price. Both could be correct for themselves because they have different time frames for their judgments and/or different plans for their money.

Lots of Great Sales, Few Great Buys

Having both bought and sold securities and financial service companies I sense the buyer of companies is more long-term oriented particularly if the buyer believes he or she can dramatically improve the profitability of the seller’s merchandise. The seller is more currently oriented, feeling that the price offered more than adequately pays for the present risk and rewards available. As someone who has been following the financial services business for more than fifty years it is my impression that there have been relatively few great buys and a lot of good sales. Today there is an increase in the number of insurance-related and data services providers that are selling out, often for cash and some stock. Broadly speaking, financial services is only about one-quarter of the available stocks, however the business of financial services is critical to the workings of all economies. Therefore, to me the odds of a security price downturn in the near to intermediate term is going up. This is reinforced in the fact that the number of business start-ups is way below what would have been expected after a six year economic expansion.  Should you care?

This focus on the time of judgment combined with operating conditions that are funded by investments is why I have trademarked the name Lipper Time Span Portfolios. The concept rests on four portfolios of stocks, funds, and managers. The first or Operational Portfolio is designed to fund current operating needs for a period of a couple of years. As a downturn may not recover within this period, concerns about a downturn are very important. The normal hiding places today like short-term high quality paper unfortunately do not pay enough to cover at least my perceived level of inflation, particularly after all taxes. Thus, some level of equities should be included, but with a manager or investor that will quickly liquidate once a downturn has begun. We will focus on the other three portfolios as part of the upside discussion that follows.

The Coming Upside

History suggests that for America, there will always be an upside. The only question is when will it occur and will it happen as a breakthrough of the upper limit of the current flat market or will we experience a once in a  generation breakdown first. I remain optimistic and reasonably fully invested in equities and equity funds. I have four reasons for my optimism.

The first is based on all the exciting research technology on and off the campus at Caltech as well as what I hear about Carnegie Mellon. The marriage of technology with the biotech world will lead to faster and better treatments for many of the world’s debilitating illnesses and untimely deaths.

The second reason which is very short-term is based on data from the American Association of Individual Investors, which surveys its members frequently. The latest AAII survey displayed in Barron’s shows only 21.1% Bullish and 40.7% Bearish. These kinds of readings often occur at reversal turning points.

My third reason is based on recent developments in the commodity markets. The performance of many commodity managers for the period ending in June and extending into July has been extremely poor. Many investors are fleeing these funds with a number of the funds closing. Commodities are priced based on their scarcity value. With many commodity producers withdrawing their capital from the production of various commodities, and large numbers of skilled and semi-skilled labor being laid off, eventually supply will sink below demand - especially when global demand picks up. At the racetrack occasionally a long shot surprises and comes in first. In some races it makes sense to look for long shots when the crowd has driven the odds down below their reasonable probability on their favorites.  A few, well chosen long shots become logical small bets. Commodities will likely be such a bet in the future. More importantly, the future rise in their prices will signal a rise in general global demand which should be good for the rest of the portfolio of stocks, bonds, and real estate. I can not guess the timing, but it is probably closer than those who are fleeing commodities today believe.

The fourth reason for my optimism is because informally I have managed portions of my portfolio in the mode of the Lipper Time Span Portfolios. As in the example above, I have some money to meet current spending needs for a couple of years. Eventually this portion will be spent. The next portfolio concept is the Replenishment Portfolio to create the new Operational Portfolio. This portfolio is structured so that it can remain reasonably fully invested through the next major downturn seeking to avoid the risk of being too late.

The next portion of the my Timespan Portfolio money is the Endowment Portfolio, which should see my younger wife through her expected long life spending needs. The securities and managers used are similar to what are in the Endowments Portfolio that I see or manage. The final portfolio or the Legacy Portfolio is designed to meet the needs of the family and charities.

Conclusion

The earth is not flat, nor for that matter round as more popularly portrayed, but spheroid with bulges around the equator and a bit flat at the poles. The flat earth believers were wrong, but the common belief today is not quite accurate which gives to some an information advantage. It is often a point of view based on more thorough information that leads to good long-term investing.

Question of the Week: How have you segmented your long-term investments?   

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The Age of Investing

Introduction

Some people believe that age is a common denominator. The great fallacy of Target Date Funds is that age is a shorthand for the level of investment risk an individual should take. There are many other measures and some more important than others in terms of individuals; e.g., assets including intangibles, liabilities including contingencies, mental and physical health as well as others. All of these factors should be viewed through the filter of one’s gene pool. With that thought in mind I learned separately of the recent birthday celebration of a 108 year old matriarch and the death of my senior cousin at 88. The matriarch is of a large family and is the mother of a smart and aggressive woman I knew as the senior director in terms of service of at least one volatile public company. Because of popular governance approaches there was a move to remove her as a director without any real acknowledgement of her remarkable gene pool, which to my mind is concentrating on form over substance and overlooking her contributions to the younger senior executives on the board. The 20 year spread between the live matriarch and my recently passed cousin suggests to me when I counsel 401(k) plans for current employees and their need for retirement funding I also must consider the uncertainty of the length of their life span, medical conditions and end of life medical expenses. I have great respect for actuaries and their ability to reasonably predict length of life of large masses of people for life insurance purposes, however I am extremely skeptical of their ability to predict any specific person’s date of death. 

My cousin was a lawyer and businessman as well as a long-time investor particularly in above-average yielding stocks which he shared with members of the family and others on a pro bono basis. I have a different model, which is to copy or exceed the life of a certain leading name investment manager who was close in age to the matriarch and was actively trading for himself and others paying a fee until a few days before his death. My somewhat facetious thought is that the pros normally outlive the amateurs.

Time horizon investing

Some of the readers of this post are responsible, at least in part, for investing for extremely young children, grandchildren, or great grandchildren. With that responsibility in mind I would suggest that some attention should be paid to time horizons beyond a century, possibly 120 years. (This comes from the trustee of Caltech who recommended the issuance of 100 year bonds because I could see the need for insurance companies and families for this kind of paper. On a historic basis I like to pay, not to receive, low interest rates.) To sharpen the focus on the future, based on lot of current experience, many young people do not get their first professional job with above-substance pay until age 25 and are forced into uneconomic retirement at 65, and then live to 120. The ratio of work-based earnings for 40 years compared to 80 years living off of savings (theirs, or others) including transfer payments is 3/1. I know of very few investment portfolios that can produce triples with certainty.

Three depressions

I am not about to discuss past or future economic depressions. I just want to focus on three rates of change that are currently way below the actuarial norms. In order of sluggishness to normal change, they are: population growth, savings rate and the dividend yields. Except in Islamic and a few other cultures, fewer children are being born. In part this is due to the recognition of improved medical conditions so fewer children die in childbirth. The use of contraceptive devices, and some additional recognition of economic uncertainties also affect birthrates. On the one hand, fewer children mathematically raise average income per person, reduce the size of consumer markets, and could create a shortage of workers or warriors.

The low savings rate is due to two factors. First, the ability to save is being crunched by expenses rising faster than incomes and second, the interest rates available to many are too low to attract their money into the savings system. One of the reasons I pour over the weekly edition of Barron’s is for its statistical section. In this week there is a monthly table of the dividend yield on the Dow Jones Industrial Average for the last ten years. At the end of January 2014, the yield was 2.14% which was the second lowest (2.01% in January of 2004 was lowest). There were other months that were lower, but most of the time the yields were higher. Obviously, the dividend yield is not in and of itself attractive enough to explain the record price for the DJIA. (The high at the beginning of the month was 16530.94 which compares with the monthly low of 6547.05 in March of 2009 when the yield was 4.31 %.) The explanations for this almost 1000 point increase in the averages are three.

• First, dividends have increased because earnings have grown.
• Second, there has been significant repurchases of the shares outstanding for the older companies in the average.
• Third, the stock market should be future focused discounting what the average dollar of investment sees.

Tying age and data together

For those who attempt to provide long-term solutions for individual or institutional investors the measurement process has shifted to a total reinvested return mentality which is the way my old firm started to report to fund boards, management, investors, and the media. This in turn means that we have all become much more price sensitive. With current historically low yields there is little price protection afforded by yields. If a market is dropping a “normal” down market of 20%, I believe a current yield would have to be close to 10% to cut the decline in half.

The rosy future is dependent on smart youth.

Last week a panel of Caltech trustees met with approximately 100 graduate and undergraduate students out of perhaps a total student body of under 2500 who were interested in exploring entering the financial community with firms like Goldman Sachs recruiting on campus. As one might expect, my fellow trustees (all who are active within the financial sector) were encouraging, I raised issues for them to think about. (I am willing to discuss my view or send my notes to our subscribers.) The key question for some of the Ph.D. students is should they continue with their efforts on developing new products with a seven-to-ten year time horizon for a possible big pay off or go into the financial community for more near-term rewards? I am finding that this is a question that my nephew at Carnegie Mellon is dealing with; he is a bright young man who already has patents registered and is attracting the attention of some leading professors. Somewhat younger, I also have a grandson at Bucknell who is an engineering major and is trying to get the right internship to learn how productive engineering is. As long as the youth of the world are attempting to make things that will help our progress, we have good reason to be positive for long-term investing for the next 100 years.

Filling the age gap

Tonight was the Super Bowl XLVIII. For the first time our National Anthem was sung by a world famous opera singer, Renee Fleming. I am very proud to report that she engaged the New Jersey Symphony Orchestra to accompany her. (Ruth, my wife, is the Co-Chair of the NJSO.) She is addressing the chronic problem of classic musical audiences, that they are aging and orchestras are working very hard to bring in more of the young to invest their time and eventually their hard-earned money in support of classical music. From an investment point of view this can be important. There is a clear relationship between math, science, and therefore investing, and perhaps improving each with an understanding and appreciation of classical music.

I think Ms. Fleming sang wonderfully!

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Frustration is Widespread and Normal

OWS

As almost everything in the modern telecommunications world is abbreviated, for those who have just landed on the planet OWS stands for Occupy Wall Street. Similar to the “Arab Spring” or the various color revolutions, OWS activities were spread through social media, in this case to a reported 868 cities around the world. The apparent rationale for crowding a large number of young people and some older into a constrained space easily accessible to the media, is to vent their frustration as to the lack of jobs and other grievances. (This Saturday when we were briefly visiting Carnegie Mellon University, I noticed a sign on a very crowded bulletin board advocating to bring OWS to Pittsburgh to “occupy” Mellon Square in the middle of the financial district. No one appeared to be taking any notice of the signs; this group of very smart students appeared to be focused on their difficult studies and other normal university activities.) From what I read, the crowd which does not appear to have a leader, is frustrated with their joblessness, as we are for them, but also upset about the distribution of wealth in their communities. They seem to believe that the financial services companies have deprived them of what is, in their opinion, their rightful share of the wealth of the community. They may fear that the coming cutback in government spending will reduce their lot in life even further.

At the moment, these masses of people can be properly called a crowd, not a mob. Mobs have leaders, often self-appointed. Mobs led on by their leaders can express their anger in non-violent activities. All too often, non-violent activities in the eyes of some, impinge on the rights/privileges of others. To protect both sides, the forces of “law and order” try to keep each group separated and calm. Unfortunately, all too often one side or the other, often the original protesters, lash out against “the authorities,” creating a series of violent eruptions, which can be taken to its extreme: open rebellion. Historically, some of these rebellions can lead to bloody revolutions, which in the end defeats both sides, for example the French and Russian revolutions. This risk is why it is wise for global investors to keep a wary eye on these crowds.

OWS concerns

Some of us are also frustrated. We are frustrated with the current generation of protesters who in many instances have not prepared themselves to find work in a changing world and often appear so self-centered that they are not helping out with their extended families or charities. Most importantly, they do not recognize that they themselves, their parents, and their grandparents have benefited from a society that has been willing to give us more services than we have been asked to pay for in taxes, fees, or volunteer work. In the US we have allowed a number of our school systems to cease teaching either civics or geography. Civics, properly taught, would have emphasized the individual’s responsibility to the community and the society in general. Geography is essential to economics. One quickly learns that land, water, and other resources are not equitably distributed. Some elements are better than others and are worth more. The fights to gain these basics shape our world’s history. Any reasonable students of geography and therefore economic/military history, would focus on the incipient power of China. They would be able to explain that except for about the last two hundred years, China has been the leading economic (and in some ways, intellectual) power in the world. With this knowledge, one would be wise not to play the “China Card” with the political crowd.

My own frustrations

The people in the milling crowds are frustrated because they do not have the appropriate tools to solve their problems. In a very much less important way, I am frustrated in my inability to answer a mutual fund search question. I was asked by a very savvy investor to come up with one or more “deep value” mutual funds. As with most terms in the world of funds, there are not complete definitions, but a series of concepts. One would think with the ability to tap into my old firm’s ninety-odd fund classifications, I could easily find a couple of “deep value” funds. This is not the case; so I must rely on artistic instincts to complete the search. In the past, poorly performing funds would excuse their poor performance by saying they were holding securities that were priced with big discounts to their intrinsic value or even better future prices. Over long periods of time they never get into a market that recognizes the values they perceive. To avoid waiting for the market to recognize these managers’ brilliance, I am looking for funds which base their choices on three attributes.

The first attribute is a massive change in the supply/demand equation for the products or services of the company. Often this kind of search puts one into commodity types of companies. The risk of getting a massive change on the upside is that it can also go the other way. Further, often changes in government regulations can cause significant alterations in the supply/demand balance. Because of the sources that cause change, the successful investor has to have deep contacts with the users and regulators of these products and services.

The second attribute is simply price changes. Not the kind of changes that emanate from the first attribute, for that is a given. The second attribute focuses on a relative price of a company and/or a sector relative to the larger universe of investments. There are times when the relative value spread gets to be too large between what is considered to be the best investment and second or third or possibly the tenth best investment. The skill required here by the portfolio manager is to pick up the changes in momentum between the current leaders and the others too far behind. Trading skills are very important for this kind of manager, both in stocks and other financial instruments.

The third attribute is usually an abrupt change in management which comes with radical changes in policies and how the company is run. There are activist managers who try to force these kinds of changes. Sometimes they are successful, sometimes not. Change is not always good for the investor. Occasionally a management change in one company makes other stocks more attractive.

All three of these attributes require a great amount of patience on the part of both the fund manager and the fund investor. A successful deep value fund(there have been some) should not be the only fund in one’s portfolio. As a manager of accounts devoted to a portfolio of mutual fund investments, we would normally own funds that have a variety of characteristics.

I am developing my list of “deep value” candidates; I would appreciate suggestions from any member of this blog community.
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