Fundamental Changes Occurring - Weekly Blog # 755

 

Mike Lipper’s Monday Morning Musings

Fundamental Changes Occurring

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

            

 

 

People are changing their attitudes about what they do with their money and investments. Failing to define their changed concerns about the future, they are not happy. They appear to fear more fundament changes than just a relatively simple, shallow and quick, cyclical recession.

Without fully defining the cause of their fears, they are moving their cash and investment around slowly. Third quarter statements for leading commercial banks are showing increased deposits and the purchase of fixed income securities and loans. For their own accounts, leading banks are raising their bad debt reserves.

 

Liquidity

Jaime Dimond, the CEO of JP Morgan Chase, is worried about a possible future stock market decline of 20% due to credit concerns. Concurrent with liquidity concerns in domestic and international markets.

Most non-trading investors are unconcerned about the amount of capital on trading desks. This capital is needed to provide immediate support for transactions resulting from sudden and sizeable events. Last week, a well-known high-quality financial services stock had quite a day. After closing at $98.07 the prior day, it opened at $94.99 after a bad earnings report, then dropped further to $93.53 before rising to $102.66, finally closing at $101.96. Trading volume on the NYSE was higher by 1 million shares for the day. While the earnings report was less than expected, the closing price was roughly in line with prices paid over the past couple of weeks.

The price action of the stock suggests the NYSE market-makers did not have enough uncommitted capital to cushion the opening trade and early morning trading.

An indication market-makers are undercapitalized. This is a worry for all institutional sized investors owning shares listed on the “big board”.

 

Stock Strategy

Most of the time investors select stocks similar to each other, regardless of market capitalization. This is not currently true, with large-capitalization growth stocks leading the way since the June lows. However, smaller caps have been led by “value” stocks. This dichotomy is probably based on the belief that large-caps are more liquid than smaller-caps. Additionally, the average small cap value stock is cheaper in terms of price/earnings ratio.

However, if one sees the next market as essentially a recovery from the decline, you would be attracted to large cap growth, now selling under stock prices of two years ago. International mutual funds on average have three years of poor performance to recover from.

If you believe the next major move is a recovery, then large caps make sense. People currently find the low S&P 500 price of 3583.07 attractive. I am not such a believer.

Odds favor the next “bull market” having a largely different leadership than the last. In part, leadership will come from corporations positioned to be providers of products and services to a restructured world.

 

Public vs. Private Investments

Since the sailing ship days investors have profited from “carried interest” earned by ship captains and others on solid land. They benefitted from the price spread between what the owners of the ship paid for the merchandise and the price the captain negotiated upon landing. Carried interest is the source of wealth for Italian cities and Boston financiers nurturing the owner’s and captain’s wealth.

The same procedure was used by these firms when they invested in private companies. Boston law firms also used the same approach when they began investing in “privates”. (When I started visiting these law firms in the 1960s, they had more money under management in their trust-departments than mutual funds. They also had professional security analysts on their staffs.

Carried interest was used to connect portfolio people and salespeople with their wealthy families. The private equity business was founded through this union and grew significantly to include wealthy individuals and non-profit institutions.

Two other aspects beyond capital gains tax treatment aided their growth. A forty-year bond bull market generated capital to invest in private equity and private debt at very low interest rates. The privates also had a second advantage, their investors were trained to wait three to twelve months to see their investment returns. (By then their poor performance was not as painful as publicly traded investments reported with a one-to-ten-day delay.)

All of this is in the process of changing. There are now many providers of private funds with lots of spreadsheets. Interest rates have risen on leveraged capital. Many private funds are now investing in public securities and an investor or prospect can somewhat triangulate the private fund’s results. Private funds typically launch a new vehicle as soon as they can, often before the prior fund is fully invested.

I believe a handful of these funds will continue to produce good results. However, even these funds will be pressured by higher interest rates, competition for talent, and stronger negotiating people in operating companies. Only a few will produce exciting records.

 

Conclusion: Use dollar cost averaging to invest in good companies not already represented in your portfolio. The slower the better.

 

 

 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2022/10/are-we-there-yet-weekly-blog-754.html

https://mikelipper.blogspot.com/2022/10/begin-to-dollar-cost-average-equity.html

https://mikelipper.blogspot.com/2022/09/if-not-bottom-then-what-weekly-blog-752.html

 

 

 

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History: Good Lessons & Not Great Predictors - Weekly Blog # 684

 

Mike Lipper’s Monday Morning Musings

History: Good Lessons & Not Great Predictors

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

Human Minds

We are all wagering machines. When we wake up day or night we make a bet, most of the time extrapolating the current trend. We remain on this journey and deviate based on internally accepted historic lessons, modified by predictions of change. Pundits, or so-called teachers, are often the sources of these perceived historic lessons. In the few minutes they have our distracted attention they simplify what initiated the change. These summaries are rarely subjected to evidentiary rules and opposing views, or the mood of the times.  

An example of how the viewing of financial data has evolved from my college days is evident in this weekend’s Bloomberg interview with Josh Friedman, Co-CEO of Canyon Partners, a very successful institutional manager of credit portfolios. He is a fellow trustee of Caltech and former Chair of its Investment Committee. His cogent analysis of the investment market suggests that much of what is happening relates to the sale of assets, not earnings, with institutional prices the result of carried interest/performance fees. The skill sets at Josh’s firm include asset accounting.

In the late 1950s, as an undergraduate taking graduate courses, I had the great honor of taking Securities Analysis under Professor David Dodd. He was the principal writer of the textbook with Benjamin Graham (Graham & Dodd). Showing more guts than brains, I questioned his focus on the proper valuation of assets and liabilities, considering his data started shortly after the trough of the Depression, when the first edition of the textbook was published. I felt it was outmoded in a world that was paying for earnings, particularly earnings growth. Smiling, he divulged how much money an investment in his fund had made by investing in assets selling at a discount. 

Columbia offered two courses in the second year of accounting. Cost accounting, popular with aspiring accountants, and asset accounting, tied to the Graham & Dodd investment practice. Asset accounting, unlike cost accounting, did not focus on the historic cost of assets and liabilities and created a much different valuation, similar to what Canyon Partners practices today. Perhaps the most valuable lesson from that course was the final exam, where 50% of the score was devoted to the critical aspects of a business not captured by the accounting statements.

Both the late David Dodd and I were right. In the 1960s and some of the 1970s, stocks with earnings and earnings growth were the standout investments. Later during that period, Mike Milken spotted Keystone custodian funds having a junk bond fund with significantly superior performance to its stablemate, a high-quality corporate bond fund. Milken, through Drexel Burnham (*), began a very successful sales campaign to sell high-yield or junk bonds to insurance companies and savings institutions. It was so successful that there was soon a shortage of paper to fill high-yield demand during this period of low interest rates. Much later, rising interest rates cratered the market price for “junk” bonds, brought on by increased regulatory pressure and Volcker attacking inflationary pressures. At much lower prices, another era of asset accounting value surfaced.

(*) I was a junior analyst at Burnham in the mid-1960s, still chasing earnings.

Cycle Repeats, Lessons Should Have Been Learned

During the early part of the first Obama term, they created stimulus programs to give cash to consumers, hoping their increased spending would influence the mid-term election. However, a good bit of the money was saved or used to pay off debts, reducing the economic lift. With some of the same people in the White House today as in 2009, they should have learned that excess stimulus will create inflation in the years to come, as recovery from the lockdowns creates expansion.

Lesson of Lessons

Each lesson should be adjusted for historical perspective and given a different weight under different conditions. You should also consider when a particular strategy or tactic won’t work. It is also useful to evaluate what else is happening at the time and consider its influence on the result or the value of the result. Although pundits try to deliver a forceful simple statement that immediately solves problems, life is rarely binary. We need to accept that we are complex people living in a complex world.

Predictability

One reason all investors should pay attention to mutual funds is they reveal what individuals and institutions are doing or not doing. Before delving into fund performance statistics, a few general comments might be useful:

• The main use of mutual funds is to meet retirement or legacy needs.
• Funds, even no-loads, are sold with involvement of an intermediary.
• As long-term investments they are rarely disrupted.
• Most redemptions are completions or reflect changes of needs.
• The former commission broker is now a wealth manager getting an annual advisory fee, making an ETF the likely choice.
• Fund owners have other financial assets.
• Salary savings - 401k, 457, and 403 are pension replacements.
• Funds are being used by a growing number of institutions.

At least weekly, if not daily, I examine fund performance. From an investment policy standpoint, I pay particular attention to two mega collections of funds encompassing most of the equity assets of mutual funds. There are 18 peer groups of US Diversified Equity Funds (USDEF) and 13 Sector Equity Funds. (At times I pay attention to global, international, commodity, and mixed asset funds as well.) After the end of each month, I look at a report that portrays total return performance for 8 periods, from one week to ten years. One screen I use for some accounts is to see which investment objective peer groups perform better than the average of all S&P 500 Index Funds. The analysis to the end of May shows two important elements.

1. For the year-to-date period, 10 of 18 USDEF and 8 of 18 Sector Groups beat the S&P 500 Index Funds’ average. This is unusual because index funds have lower fees, less turnover, and less cash. This is a trend that has been happening since the bottom of the market and may not last a long-time.
2. Contrasting the YTD figures with 10-year performance, one can see the difficulty in beating “the market”. Only 3 of the 18 US Diversified Fund Groups and 4 of 13 Sector Fund Groups beat the S&P 500 Index Funds’ averages.

What was the frequency of various peer group averages beating the market during the 8 periods? Small-Cap Value, Multi-Cap Growth, and Tech Funds each did it 5 times. Large-Cap Growth and Natural Resources did it 4 times.

This suggests that superior investment selection is difficult and possibly should not be an appropriate goal. A subject for a later blog. For those that are interested, I recommend two articles in the Saturday Financial Times on selection difficulties. They are titled “Racing Industry Looks to Epson Derby for Galileo Heir” and “Tiger Cubs on Prowl after Robertson built dynasty in hedge fund jungle”.

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Did you miss my blog last week? Click here to read.

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https://mikelipper.blogspot.com/2021/05/faulty-comparisons-weekly-blog-682.html

https://mikelipper.blogspot.com/2021/05/extreme-views-can-be-good-lessons.html

Did someone forward you this blog? 

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.