What is Pending and When - Weekly Blog # 947

 

Mike Lipper’s Monday Morning Musings

 

What is Pending and When

 

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

 

          

 

Who is Foreseeing?

We are entering a new phase at the Federal Reserve Bank where the new chairman wants to look to the unknown future rather than recorded history. He is searching to find a different set of indicators than government collected survey data. I always thought that the lunch discussions presidents of the local reserve banks had with “captains” of local industry were an attempt to gather this data. I believe what he is looking for is the kind of inputs many companies gather daily or weekly. (I knew the number of subscribers for each of our fund data products plus the number of new subscribers each week. Additionally, I knew the number of special individual reports generated, and the amounts of commissions earned each week.) I hope he gets what he wants, it will probably improve the efficiency of what the Fed decides.

 

My big complaint to the members of my securities analysis profession is that most of their reports focus on relatively short-term investment performance: the quarter, the rest of the calendar year, or one year. While that has some value for the media or gatekeepers, it has very little analytical value.

 

In viewing the work produced under the rubric of Securities Analysis, it is important to remember that the original text on the subject was written by Ben Graham, an investment manager and adjunct professor who favored “cheap” stocks. He was assisted by David Dodd, a full professor at Columbia University who taught accounting courses. Their original text was written in the middle of the depression. The key to their writing and financial survival was to avoid losses. Little attention was paid to making money, which came later. This bearish bent was echoed in the SEC’s Investment Company Act of 1940, which was not written by members of the SEC or their staff, but by a bunch of trust lawyers with heavy input from lawyers in Boston, New York, and Philadelphia. For them, the key issue was avoiding large losses and being sued. I took Securities Analysis under Professor Dodd at Columbia.

 

The More Modern Era

One could selectively make money by venturing into the market with new listings trading at a discount. An approach highlighted after WWII when war industries recommitted to the commercial world with new high energy leaders. However, far too many of the new ventures of the late 1940s produced large losses for their investors. By the late 1950s more pragmatic leaders emerged, with the “bull market” of the 60s bringing new generations into the market. The fear of losses ebbed in the late 60s, resulting in  the idea of some leading stocks being held forever. This led to economic decline and a downturn in market enthusiasm which lasted into the mid-1980s. Since then and up to this calendar year the emphasis has been on making money, not avoiding losses.

 

We Have Possibly Entered a New Era

In last week’s blog I suggested that the critical market indicator has shifted from the Dow Jones Industrial Average (DJIA), from the late 1940s through the mid-1980s, to the institutional Standard & Poor’s 500 (S&P 500) from the mid-1980s to until very recently, and in the current period to the NASDAQ Composite. This week the DJIA was up 3 days and the S&P 500 was down 5 days. The NASDAQ was also down 5 days, but by a larger amount each day than the S&P 500 institutional measure. This seems appropriate as it rose more, driven by “AI” and the technology craze. I believe it is sensible to label this a technical correction.

 

More concerning is the market sensing a change in our future. Much of the current leadership comes from the retail side, whose increased numbers were driven by the conversion of retail brokers becoming wealth managers to earn a fee rather than a commission. The significance of this shift is that for the first time investment performance will be measured on the retail side. These new “managers” may panic and be quicker to sell than the institutionally oriented mutual fund portfolio managers. We may already be seeing this in redemption rates and attempts to redeem closed-end target date funds. Institutions have long experience with the cyclical results of below investment grade debt. Is it possible retail investors will lead the whole market in worries about declines?

 

Are There Reasons to be Worried?

I believe it is too early to be categorical about the next major decline, though I do believe it could happen. The following are potential signs of one or more major declines. (Going back to my course with Professor Dodd, I believe we should be prepared for the following pending triggers to generate meaningful declines.)

• The biggest potential trigger is that we have not experienced a depression since the election of FDR in 1933, which did not end until 1942 because of his mismanagement. Skipping several cyclical recessions, the prior depression globally was in 1873. Thus, it has been 93 years since the beginning of the last depression or 84 years since it ended. (Depressions are caused by mismanagement and too much debt in the financial system.) The present administration, by personality, not policies, is very similar to FDR’s.
• The surprise to the leaderships of attacks on Bahrain’s US Naval Base and Ukraine’s attack on Crimea. The nations hurt were thought by their people to be prepared for these attacks. Both nations have people worried about their country’s intelligence and governance.
• Changes in Federal Reserve governance may be destabilizing.
• ACA Insurance healthcare payments showed unexpected reductions.
• Lack of progress on addressing Social Security solvency
• Focus on innovation, but only on the mechanical side. In the US innovation typically has a bigger impact on sales size and structure.
• Quality of schooling and home life vs. education retards growth and military preparedness. Probably negatively impacting marriage and childbearing.
• Legal immigration

 

For the last 10 years only the average Large Cap Growth and domestic global Science and tech funds have beaten the S&P 500 Index fund average. For the current year-to-date period, 57 sector averages did better out of 104 equity sectors. The game has changed.  

  

What are Your Thoughts About?

• A possible Depression?
• What are we not prepared for?
• Will the 2026 election decide anything?
• What will the 2028 election decide?
• Any other thoughts or comments?

                                         

 

 

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Mike Lipper's Blog: Too Many Short-Term Worries To Pick Long-Term Winners - Weekly Blog # 946

Mike Lipper's Blog: Is This the Last Hurrah? - Weekly Blog # 945

Mike Lipper's Blog: New Era? - Weekly Blog # 944

 

 

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The Inevitable Recession - Weekly Blog # 914

 

 

 

Mike Lipper’s Monday Morning Musings

 

The Inevitable Recession

 

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

 

 

 

Loses Are Needed

Securities analysts, portfolio managers, investors, politicians, and others, need the fear and reality of recessions. Both written and geological history record meaningful and painful declines. Since they happen with some regularity there must be a repetitive set of reasons, with the lure of a gain sucking us into overexpansion and other error-making decisions.

 

Humans evolved from hunters and/or gathers, who periodically generated supplies beyond their immediate need, beyond a limited reserve for emergencies. When they gathered too much, costs grew and quality suffered. In the financial world we hoard and or borrow too much in the way of financial assets. This became increasingly clear as conditions changed.

 

These adverse conditions are clear in recorded history, in Babylon, China, and other places. Thus, the history of weather, business, and political cycles were written, becoming critical drivers of financial markets.

 

The Rise of Financial Analysis

Trading markets began soon after communities were established. Over time, it became clear that some successful traders achieved periodic, large returns on their use of trading capital. A number of these people gained reputations as good traders and found other people who recognized they did not have the same skills, contacts, and capital. These traders could borrow money at attractive rates and could charge fees to manage portfolios for selected outsiders. A number of these traders evolved into investment banks, who had both skilled traders and statisticians, some of whom became analysts.

 

US and UK Governments vs. Fraud

When markets fall, investors don't blame themselves for the losses they sustain. They claim fraud on the part of the "system", which includes issuers, exchanges, underwriters, and salespeople. Generally, the public investor does not understand business and financial cycles or chooses to forget the warnings that were given before they placed purchase orders. To protect the "public", disclosure and other laws were passed. While no law or regulation can prevent bad judgement, disclosures can ensure investors receive what is required to be transmitted to them. Unfortunately, accounting and legal disclosures use terms that the public does not understand.

 

As a result of large losses sustained by US public investors in the 1930s, there were seven reform laws passed, including the Securities & Exchange Act and a similar set of regulations in the UK.

 

The Development of Securities Analysis

While there were numerous books written about investing prior to the 1929 crash, they were not read by many investors. In the early 1930s Benjamin Graham and David Dodd wrote a Securities Analysis textbook for a Columbia University course. (Ben was a portfolio manager and Dave Dodd was a professor, who was still teaching in the late 1950s when I took the course from him.) Their main lesson was how to think about investing in securities while minimizing losing money. The course was taught as a supplement to a number of accounting and business law courses. They largely used the reconstruction of financial statements to assist patient investors. (While useful in minimizing investment losses, creating language to allow people to understand the thinking of others and the politics of an industry or client would have been more valuable.)

 

Recession Analysis

I believe most of those in the market are assessing the probability of an oncoming recession by focusing on published economic data. The stock market is focused on the future, not the past, and in that way it’s ahead of the economics releases. For example, the election results of last Tuesday suggest Louis XIV’s building of Versailles, even though no one else is saying it. The King was always at war, usually with England, and ran up big debts. He destroyed the local power of the nobility and insisted they spend most of their time attending to him in the Palace. (Is the reaction to larger than expected Democratic margins of victory in New Jersey and Virginia and the destruction of part of the White House for a big ballroom similar to what Louis XIV set in motion before the French Revolution and Napolean?)

 

Other market indicators last week included decliners on both the NYSE and NASDAQ being larger than gainers, with the NASDAQ losing twice as much as the gainers. NASDAQ's volume over the last year increased 38.21% vs the NYSE volume gaining 22.98%. (One of the clues to identifying a peak and then a decline is a decline in "quality", which is better evidenced on the balance sheet than through earnings.)

 

On Friday, the best performing mutual fund categories in rank order were Currency funds, Precious Metals Funds, Real Estate Funds, Natural Resource Funds, and Materials Producers. All are not heavily held by funds and other institutional holders. On a year-to-date basis, the only fund categories that beat the S&P 500 Funds Index category were Science & Tech, Precious Metals, Global Science & Tech, and Large-Cap Growth. (There is considerable overlap in the names in their portfolios). Barron's weekly list of foreign market indices showed 5 Asian markets up, with only 1 rising in Europe.

 

Identifying the date when a recession begins is officially only determined after it ends. As a practical matter you might use the purchasing managers' index, which has been in contraction for the last 8 months and is now showing only 42.3% rising. While it is foolish- to name both a market direction and a date, it may be useful to be aware that the market generally rises at least 80% of the time. Considering the 5-year average length of time CEOs remain in their chair, it suggests a market decline once every five years, which somewhat parallels the 4-year length of a US President's term. (I don't know how to adjust the number for the current President but possibly averaging all Presidents it may be around five years.)

 

Working Conclusion:

The odds of a recession before the next Presidential election is probably 67%, with a depression at 50%. (The latter would require some mismanagement during the recession to raise the odds of a depression above 50%.)

 

 

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Mike Lipper's Blog: Biggest Investment Hurdle: Complexity - Weekly Blog # 913

Mike Lipper's Blog: Signals of Change in Historic Patterns - Weekly Blog # 912

Mike Lipper's Blog: Where Are US Stock Prices Going? - Weekly Blog # 911

 

 

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Confessions & Confusion of a “Numbers Nerd” - Weekly Blog # 867

 

 

 

Mike Lipper’s Monday Morning Musings

 

Confessions & Confusion of a “Numbers Nerd”

 

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

 

 

 

Numbers Tell The Story

 My education at Columbia University, the USMC, and taking the CFA taught me that numbers tell the story. My brother and I created a company that sold mutual fund data for some of the largest fund organizations in the world. The problem is it was the wrong story. I fell into a trap common on the numbers loving Wall Street.  The trap is using numbers as a tool for many applications for which they were not intended.

 

The original sin was using the changing price level to make investment decisions, +10% or -8%. This leads to being happy with +10% and unhappy with -8%. Raw numbers can be misleading, until you understand the usage of numbers and their appropriate comparison.

 

Early in my career I called on the partner and treasurer of a management company who informed me he didn’t need our service because he had found something better. I asked to see this remarkable comparison. He showed the performance of all funds, regardless of mission, in his city! He was using the hometown comparison to set the wages of his workers. (Luckily, an outside lawyer working with the independent fund directors immediately recognized that what I was peddling would be essential for the directors.)

 

This experience brought home that there were at least two different needs in the same shop. The treasurer had an operational need to gage the competitive availability of labor needed for the fund’s work, while the lawyer wanted the directors to know how each of their funds were doing competitively.

 

Numbers in the right context are critical. An example of this is the +10% -8% example. The +10% is quite poor in a league averaging +20%, with the best at +30%. The -8% could be superior when the competitive average is -20% and the worst fund is down -30%.

 

Some psychologists believe losses are twice as painful as the pleasure of gains of similar magnitude. This probably averages out, with losses happening in one of four years in the US, but more frequently in other countries. I believe this pain level should also be addressed in terms of age. The older the individual, the less time they have to fully recover. Many of us rely on gains from investments that have been successful in the past, and our faith in them builds over time, so when they fail it is more destructive.

 

This is one of many reasons that relatively little money flowed into SEC registered “China Funds” this week, even though 13 of them were in the 25 best performing mutual funds. Small-caps pulled ahead of mid-caps for the week, which had performed better this year.

 

Before treating the above as purchase suggestions, I quote from Jaime Dimon “Past Performance is not indictive of future results.” However, I regularly look at investments that have done poorly for a long period of time.

 

Current Environment

Most democracies are unpopular and are favored by a decreasing number of supporters. Even in the US the Ex-President won a narrow victory, benefitting from a significant number of non-voting Americans.

 

With long-term productivity adjusted for inflation, higher than normal interest rates, a decline in the dollar, the near-term outlook is not good. This is perhaps the reason many smart companies are laying people off.

 

Please share your views with me, particularly when you feel I am wrong. I need your help.

 

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Mike Lipper's Blog: It Doesn’t Feel Like a Bull Market - Weekly Blog # 866

Mike Lipper's Blog: Professional Worry Time vs Amateurs’ - Weekly Blog # 865

Mike Lipper's Blog: SPORTS FANS SELECT CABINET & OTHER PROBLEMS - Weekly Blog # 864

 

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Searching For Answers - Weekly Blog # 815

 

Mike Lipper’s Monday Morning Musings

 

Searching For Answers

 

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

 

Neural Basis for Preferences

In one of the laboratories in the Humanities and Social Sciences Division of Caltech, a former post-doc led a paper showing a neural basis for making aesthetic preferences like qualities-contrast, hues, dynamics, and concreteness. (Kiyohito Iigaya, is now an assistant professor of neurobiology at Columbia University’s Irving Medical Center.) A similar type of pattern recognition is what successful investors use in selecting investments, such as relative price, operating free cash flow generation, management process, investment sponsorship, competitive position, and future changes in these and other qualities.

I am a senior trustee at Caltech and a member of the board of Advisors of CUIMC

 

Painters, like Picasso, were successful investors in both art and other investments. However, the tracking of investment qualities is insufficient to produce a record of continued investment success.

 

At least two additional qualities need to be tracked.

1. Analyzing changes in the structure of the investment market, in terms of flows and after-tax profits.
2. The perceived multiple needs of the investor.

 

The eternal job of the investor is to evaluate these and other qualities relative to each other. There is no precise ranking information on these qualities, which makes it difficult for quants to use.

 

It is with this as a background I look at elements each week. The remainder of this week’s blog is devoted to some of the highlights that guided me in making multiple investment decisions. I am interested in which factors are important to you, and whether you disagree with my reactions.

 

More Information Does Not Appear to Help

More information should reduce the number and magnitude of investment surprises. But it does not seem to help. The problem could be that the information is distributed unequally. Those with an information delivery advantage, but without sufficient capital or ownership, can have limited impact on price gaps. In accessing the situation, one difficulty may be understanding the veracity of the information at the moment of discovery. In highly speculative markets and issues, there are often more false rumors than real, actionable information. (In terms of the current market information regarding the next interest rate change, it could be wrong 6 times in a row.)

 

Banks & Brokers Cut Staff

State Street is the latest company to announce the layoff of 1500 employees. These actions do not instill near-term confidence in investors in the overall market.

 

Is Value Investing Essentially a Trade?

The fundamental principle of value investing is the current price being substantially less than the current or projected future price. In the mind of the investor this value gap is temporary, because if it is not closed there is no benefit to the purchase. Value investing is therefore a trading strategy, or a two-step move. Contrast this with investing for growth, which does not require a terminal sale except for a change in investor circumstances. This distinction has a definite impact on the timing of the purchase.

 

“Happy Talk” Motivation is Critical (Viewpoint)

Years ago, when each town had a thriving local newspaper, its publisher/CEO was a powerful person locally. Recognizing that elections create advertising demand; a lot of editorial space was devoted to newsprint.  Locally owned papers eventually disappeared and were replaced by chains, and increasingly by broadcast media. They were the beneficiaries of centrally controlled advertising revenue. The media provided much airtime to elections, with the most focus on presidential elections. In many cases, profits from presidential election-year advertising helped carry them through the other three years. Because the majority of listeners were lower income, Democratic Party spending was higher. The owners were conscious of this phenomenon, and it impacted their actions, with the bulk of the coverage/advertising focusing on economic “happy talk”. That is why “news” coverage today is more positive, and often wrong.

 

Interpreting a Signal Can Be the Opposite

The acquisition of one company by another for stock could signify that the board of the purchaser believes owning the acquired stock is better than investing in their own. An interest rate cut by the Fed could also signal a concern about the direction of the economy, or a shift in the importance of the second mandate, full employment. In other words, be careful what some wish for.

 

Personal Tax Rates Are Important

Similar to the selection of art purchases helping make security selections, foreigners can remind us of the importance of US personal tax rates. Shohei Ohtani signed a baseball contract with a gross value of $700 million. In the early part of the ten-year contract, he will be paid just $2 million per year. (He expects substantial product endorsements and other income during that period.) He will receive the other $68 million per year, without interest, when he is 50 years old. (I assume without the burden of US taxes). I wonder if he’s available as a tax consultant, as he came up with this approach.

 

“Long-Term” Different Meanings

Reliability is a characteristic many investors look for in their selection process. In the US, most investment intervals have more gaining than losing periods. The sizes of the gains are also larger than the majority of the sizes of the losses.

 

All markets move in cycles. Thus, a five-year period usually has one complete cycle and parts of another, if not two. With only 20 quarters or just 5 annual numbers, I find the number of observations too limited. The SEC in its wisdom requires mutual funds to show year by year results, overall period performance, and the best and worst quarter. Numbers nerds note that the public is given 12 slices of data. I would prefer to have quarterly data for the life of the fund, which would be 40 slices for ten years.

 

The economy has generally grown since the end of WWII, which might not continue in the future. Consequently, I am much more interested in seeing what actions, if any, were taken in negative periods. Particularly, what portfolio holdings were reduced or eliminated and how much that cost the fund in recovery periods.

 

There is one medium-sized fund group which indicates it invests for the long term, which they define as 3-5 years. We would not use this fund for most taxable investors if over that short a period it replaced almost all its starting portfolio.

 

15-Year-Olds Will Rule

At some point the 15-year-olds youths of 2021 will be part of the ruling class in many, if not most, countries. In 2021, thirty-seven countries took standardized tests in math, reading, and science. Three countries tested top three in the three subjects: Canada, Estonia, and Japan. Due in some part to the pandemic the US dropped 13 ranking spaces in the three tests, or roughly three-quarters of a year, to finish sixth on an overall basis.

 

As a grandfather and great-grandfather of 5 young ones, I am worried about the future we are leaving them. Our current educational system is the result of a deteriorating educational process that has been in decline for some time. Recently, a teacher on maternity leave at a “good school” revealed that she had decided not to return to the public school system. A real-life casualty of the dysfunctional system she worked under.

 

What scares me is the US has the most expensive educational and health systems in the world but does not lead the educational rankings in the world. A long-term oriented society that prizes excellence is necessary for world leadership. For the protection of our young people, we must on a long-term basis increase our exposure to the best minds and culture in the world.

 

Investment Conclusions

1. Portfolios should be broken into sub portfolios based on needed investment periods and risk tolerance.
2. The portfolio segment with an expected near-term payout should focus on trading rather than investing. Fixed income holdings should have a maturity range within the allocated payout period and only be invested in the highest quality non-US government paper. Equity should be invested in listed 2-4% yield common stocks or funds. The one exception would be Berkshire Hathaway, which is building a portfolio for the heirs of its shareholders.
3. The next portfolio segment builds a retirement portfolio with high quality, low cash dividend payors, and no fixed income except for payment reserves.
4. The estate portfolio segment should be invested in high quality equity modest compounders, avoiding above average yields. Use an appropriate equity strategy in an unleveraged ETF rather than a mutual fund if it makes sense, but only for one-half of your fund investments.

 

Share Your Thoughts

Do these topics and format make sense for you and how should it be improved?

 

 

 

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Mike Lipper's Blog: Reactions from a Contrarian - Weekly Blog # 814

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Mike Lipper's Blog: A Cyclical World + Consistent Results - Weekly Blog # 812

 

 

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

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Investors Can Learn from History, If Diligent - Weekly Blog # 631

Mike Lipper’s Monday Morning Musings

Investors Can Learn from History, If Diligent

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

Most memories are summaries of what people think happened and these memories over an extended period become enshrined as facts that are used for future investment decision making. Current investors are under the impression that “history” favors “value” and “Goodbye Globalization”, without being fully conscious of the history that created these impressions. Upon further study, one would realize that the underlying history is more nuanced and complex.

Value vs. Growth
We like to use short labels to cover complex situations. For example, we use the same label for both a company and its stock price, which often go in different directions. A company’s growth is essentially dependent on increasing sales and possibly its earnings, whereas stock prices are the result of buyers and sellers, often evaluating the stock in relation to other investments. Daily stock prices make them easy to rank from best to worst performance for each time period, which probably has little predictive power for long-term investing. Nevertheless, some investors search through the poorer performers looking for turnarounds, fitting with a part of the American psyche that likes to cheer for the underdog. Many investors who have missed being heavily invested in different forms of growth are now cheering the long-awaited trend of “value” beating “growth”, at least for a period.

I believe the first textbook publishing of Security Analysis by Ben Graham and David Dodd was written during the Depression in the 1930s. (The first was an adjunct professor and the second a full professor at Columbia University, which twenty years later suffered having me in his class.) Their approach, both in class and to some extent in their practice at a successful closed-end fund, was to find a security selling at a substantial discount to their analysis of value. What worked for them and others like Ruth Axe and Max Heine, was looking at distressed bonds and preferred shares using this approach.

The first thing the good professor taught us was to reconstruct the balance sheet by discounting finished inventory by 50%, work in progress by 100%, and raw materials by 75%. In the same fashion we reduced the value of physical assets to our estimate of quick resale prices. We wrote off all intangible assets and what was left of the underlying equity (more on this later). Comparing our new estimate against the depressed price of the senior securities became our initial estimate of value. During the 1930s and into the war years, this led to some very successful investments in railroad bonds and preferred shares. In effect, what we were taught was the rapid liquidating value.

Today, Merger & Acquisition activity has become the main determiner of value. Instead of determining the liquidating value, the acquirer is interested in what accountants call the going concern value. However, the acquirer often writes off some of the assets, adds the cost of expected layoffs, and determines an estimated increase in earnings based on “better” management and new opportunities from existing assets. I suspect that in the acquirers view of the future there is no estimate for a down period or the reactions from competitors.

M&A driven prices create an accounting problem, because after accepting the remaining costs of fixed assets transferred to the new balance sheet, an amount must still go to the consolidated balance sheet. Some of this gap can be labeled as the value of intangibles, such as customer lists and patents. However, even with these additions there is typically still a gap labeled “goodwill”. (I was the beneficiary of this math when I sold the operating assets of my data business, a service business who’s price was substantially above the value of the physical assets sold.) This is where the fictional portrayal of balance sheets and  book value come into the picture.

For publicly traded companies, “goodwill” and other assets cannot be written up but can be written down if there is clear evidence of loss of value (a non-cash charge which lowers reported earnings). The CFA Institute notes that private companies can write off goodwill over ten years and there is a movement to allow publicly traded companies the same privilege. In an article they pointed out that there are 25 corporations that have between $28-$146 billion of goodwill on their balance sheets, including Berkshire Hathaway, CVS Health, and JP Morgan Chase. In my case it would be difficult to write off the goodwill from the transaction, as they continue to use the name and basic calculations for the statistics. As the acquirer continues to have many of the same clients after a sale 22 years ago.

I believe too many investors lump “value” stocks with cyclical stocks, which is why they have been greeted by poor performance for over ten years. Most of the world’s economies have grown during this period due to increasing services revenue growth. Over the same period there have been relatively few goods and materials shortages. Prices of goods, particularly manufactured or natural resources, have not kept up with inflation.

In our fund selection process we like to find true value stocks that show substantial discounts from their intrinsic value. These tend not be economically sensitive and are found infrequently. Most of what others call value, are cyclical stocks selling at the low point in their cycle. Typically, their stock prices rise when shortages appear, often when large competitors drop out or the demand level shifts in their favor.

There is a difference in when to sell a true “value” stock versus a cyclical stock. One completes a trade when the discount disappears in the value stock price. Cyclical stocks should be sold when the investor believes the demand for a company’s product or service is peaking. My own way of timing this is to watch commodity prices and commodity fund performance. We could be entering a more favorable period for cyclicals as 66 of the 72 weekly prices tracked by the WSJ were up, but most commodity funds did not rise, except for those invested in energy.

“Goodbye Globalization”
Goodbye Globalization is the headline in a recent edition of The Economist. This magazine is in the running to replace Time and Fortune magazines as excellent negative indicators. They do not know their history, countries and companies that build fortresses by gathering all needed resources within their walls have proven to be builders of self-inflicted prisons, with high costs and lowered productivity. History suggests that even during wars, opponents trade with each other through third parties. In WWII, the relatively easily conquered Sweden and Switzerland were left unoccupied to serve that purpose. Even when the US was clamping down on an increase in Japanese car imports, they still came in through factories in Mexico and Canada.

But the real historical lesson happened in the 15th Century, within those one hundred years created the “new normal” that guided economic and political trends until the late 18th century. During the 1400s the new young Emperor of China decided to recall its very powerful ships from the Mediterranean, India, Africa, and possibly America, before destroying them. At the time, China was the most advanced country in terms of science, gun power, and business structures. China has still not recovered from that decision and this is one of the reasons for China’s leadership moves today.

By mid-century the Ottoman Turks captured Orthodox Constantinople, turning it into the Moslem dominated Istanbul, enabling them to challenge Eastern Europe. An event that has effects even up to today.

Finally, by the end of the century there was the discovery of the misnamed America. This led to the extraction of Latin American gold which turned the European economy positive and the investment opportunity that the US proved to be.

The lessons to be learned from the 15th century was:

1. Adam Smith in his book titled "The Wealth of Nations" showed the benefit of countries/companies specializing to get economic advantage through world trade.
2. Fortresses become prisons, eventually.
3. Often, new critical stimulus come from outside the recognized ecosystem.

It would be difficult not to be a global consumer and investor today, it would deprive us of a better life.

Good News
In April we saw some individual mutual funds and mutual fund management companies having positive net inflows. The winners had particular selection skills rather than being focused on sector section. Much of the inflows came from institutional or retirement investors. In brief discussions we heard that the trends seen in April continued in May. Nevertheless, on an overall basis equity products had net outflows, but larger amounts went into fixed income investments. Being a contrarian suggests to me that once the risks of higher interest rates and inflation rates become more pronounced, we are likely to see substantial equity inflows that can absorb the actuarially driven outflows.

Any thoughts? Please Communicate.



Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html

https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html

https://mikelipper.blogspot.com/2020/05/top-down-sells-bottom-up-pays-weekly.html



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A. Michael Lipper, CFA
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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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2nd of May’s Good Lessons - Weekly Blog # 575

Mike Lipper’s Monday Morning Musings

2nd of May’s Good Lessons

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

The inestimable Charlie Munger has labeled Warren Buffett a learning machine, someone who is always learning from his own and other’s mistakes. This is a good model to follow. The first couple days of May provided some good classrooms, the Berkshire Hathaway annual meeting and The Kentucky Derby, both on Saturday, May 4th.

The Annual Meeting/ Investment School

While many attended the meeting to gather bits of information to help guide their views as to Berkshire’s earnings and/or near-term stock price, I view it as an opportunity to learn about the art of investing. For me this is a linear progression from my Introduction to Securities Analysis course under Professor David Dodd at Columbia University. Dave Dodd was both a teaching and investment partner with Ben Graham, Warren Buffett’s first mentor. The following are the nuggets gathered from the meeting which can be applied to investing in general:

1. Paying too much makes it very tough to make money on an investment. (They did for Kraft.)
2. Intrinsic value is a range not a specific point. This range could be 10% plus or minus. (This is the fulcrum point for their buybacks.)
3. Individual Investors are their preferred owners rather than bureaucratic institutions.
4. They have a desire that their heirs hold onto their shares long after Charlie and Warren are gone. That is why they are developing the next tier of management, which will be different and better.
5. A large opportunity reserve has two values, it cushions periodic declines and creates bargain opportunities.
6. The allocation of resources allows them to shift capital to where it is most productive long-term.

The Kentucky Derby 

I have written about “racing luck” or surprises in the past. At this year’s running of “The Derby” we witnessed a classic example of “racing luck”. With far too many horses on a rain-soaked track there was at least one bumping incident, which the three racing stewards felt impacted the order of the finish. After reviewing many films of the race and a call to the two leading jockeys, they disqualified the winner and gave the victory to the horse that came in second. The level of surprise can be gleaned from the betting odds. The first horse to finish was the second favorite at $9 to $2. The declared winner was a $63 to $1 long-shot. This is the first time in the history of this race that they have disqualified the winner for an on-track violation.

The investment lesson from this experience is to avoid putting too much faith in the “inevitable conclusions”. Surprises do happen, even those that are the first in more than one hundred years.

The Mixed Current Picture

Change Signs?

1. While the NASDAQ composite has gained the most since its January low, +26% compared to +17% for the Dow Jones Industrial Average and +20% for the S&P 500, this past week the 420 new highs on the NYSE exceeded the 305 new highs on the NASDAQ. Have traders shifted their focus to more industrial and  seasoned companies from growth and tech?
2. Of the 72 price indicators tracked by the WSJ covering securities, commodities and currencies, only 30 are rising, Recently, the number of gainers were in the majority.
3. Both High quality bonds and intermediate quality bonds gained in price, showing some shift in demand away from stocks. 

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/04/value-investing-will-be-superior-but-it.html

https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html 

https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.