Diversification - Weekly Blog # 929

 

         

 

Mike Lipper’s Monday Morning Musings

 

Diversification

 

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

 

                                                                        

 

Preface

On a recent trip to London, Ruth and I attended a private fund and friend raising concert for the Academy of St. Martin’s in the Fields (ASMF), where Ruth is the first American trustee. The wonderful music was performed by Joshua Bell, the artistic director, and five other top-notch string musicians from the ASMF. Between the six talented musicians they played three different types of string instruments, alternating between lead and ensemble roles. The result was a successful combination of each of their talents.

 

Even when listening to a magnificent concert performance, I cannot forget my investment responsibilities. As individual musicians alternated from leading to supporting roles, it reminded me of what individual securities should do in a diversified long-term investment portfolio.

 

Application to Portfolio Management

In 1940 the SEC completed their depression-oriented reform rules. Among the last of these was the Investment Company Act of 1940, which unlike the other six regulations was not formed at their SEC headquarters. It was produced at the Mayflower Hotel in Washington by lawyers for the fund industry from Boston, New York (where the industry’s trade association was headquartered), Philadelphia, and Washington. Considering their recent experience of the market falling during the Depression, the mood of the meeting was to try reduce the chance of big future declines. The best model for that were state laws governing trust accounts, using generations of work by Boston and Philadelphia lawyers. (Even as late as the early 1960s a few Boston law firms had professional securities analysts on staff to assist in managing trust accounts.) Note, the main concern of the creators of fund regulation was the avoidance of losses. No word was spoken of making money on investments.

 

They thought the best way to reduce the chance of major losses was to limit an account’s exposure to any single investment. This led to limiting the percentage amount that funds could invest in any one stock, which usually meant no more than 5% of the voting stock at cost (not market). To this very day, most equity funds are labeled as diversified if they adhere to this principal.

 

The Problem with Voting Stock Limits

The biggest penalty paid by investors is not losses, but the absence of profits. Mutual Funds with long histories often make ten, twenty, or even more times as much on some of their holdings, which more than covers a small number of losses. Furthermore, great fortunes have been made, particularly over successive generations, in single stock portfolios or portfolios having a small number of investments.

 

For Professional Investors

The concept of risk management is critical but doing it by name or percentage of voting shares does not reduce risk, it may increase if all investments are exposed to a single concept. In the late nineteenth century professional investors considered concentration to be the best and safest way to invest. My college degree is from Columbia University, which had an endowment fully invested in railroad bonds and stocks, every single one file for bankruptcy. Today there is a risk that some participants in the “AI” surge could produce similar results by investing in too much in a good thing.

 

For publicly traded securities I suggest the biggest risks is with the stock owner and not the issuer, as they will be sellers of the stock before you do. Other risks include countries, technology, politics, and management. These can be identified as short-term and long-term factors. A possible short-term indicator is slightly more participants being bearish than bullish in the latest American Association of Individual Investors (AAII) survey of expectations for the next six months. Interestingly, the long-term indicator was Friday’s announcement by the Supreme Court, which ruled against the President’s authority to set tariffs using the International Emergency Economic Powers Act (IEEPA), which had very little to any impact on the market.

 

Bottom line, watch the musicians play and how well they work together, both with other musicians and staff, but also watch the reaction of the audience.

 

Understanding Going Global

In a recent conversation with a London-based fund manager, who in the past was almost completely invested in the US but now has a growing position in European stocks. While he has the biggest portion of his portfolio in US securities, he is very risk aware and expresses this by augmenting his portfolio with European stocks. Normally, he expects his US positions to outperform his European positions, but not in a declining market. In terms of P/E, Free Cash Flow, Dividend Yield, and other value measures, European stocks are less risky than US holdings.

 

 Another careful investor was Charlie Munger, who listed six principles to be avoided: High Financial Leverage, High Operating Leverage, Negative Cashflow, Poor Governance, High Risk of Obsolescence, No Competitive Advantage vs. a Strong Competitor.

 

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Mike Lipper's Blog: To Win Long-Term, Learn From Great Presidents - Weekly Blog # 928

Mike Lipper's Blog: Strategically, Time to Think Differently - Weekly Blog # 927

Mike Lipper's Blog: Do Current Prices Lead Future Markets? - Weekly Blog # 926

 

 

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Perspectives: Risk, Liquidity, Duration, + Concentration - Weekly Blog # 690

 

Mike Lipper’s Monday Morning Musings

Perspectives: Risk, Liquidity, Duration, + Concentration

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

Risk

Risk is the penalty for being wrong resulting from the loss of financial capital, time spent and the opportunity to improve returns. I believe it is impossible to avoid all risks. I attempt to identify as many risks as possible and manage these risks by addressing them. All assets have imbedded risks, whether we can identify them or not. As I invest internationally and assume some of my perceived obligations will outlive me, I make provisions for addressing these issues with what I leave. These perspectives color my investment thinking.

Liquidity

Liquidity is the ability to buy or sell any asset at any given time. One can easily rank the salability of any asset, from cash in home currencies to the sale of heavily-indebted unique real estate. For the small securities investor size is not normally a problem, as long as practices and regulations don’t change. However, for the very large investor liquidity can be a hurdle that delays action. It can be costly or in rare cases prohibited. While this is not the case for the average investor, the liquidity price for a large investor can temporarily impact the price for all investors. Take the mandatory quick sale of large assets. They could scare the other market participants into withdrawing from the market or participating only at a substantial discount. If all the gold in Fort Knox or all the assets of gigantic investor had to be sold in the next 24 hours, the price would not resemble the previous day’s price. While these are extreme and unlikely events, last week’s average performance of US diversified mutual funds shows the importance of size, as shown below:

Average Total Return Performance US Diversified Funds

For the week ended July 15, 2021

        Large-Cap    +0.74%

        Multi-Cap    +0.18%

        Mid-Cap      -0.31%

        Small-Cap    -0.68%

Thus, in one week the transaction value of small-caps fell 1.42% compared to large-caps. One might call the difference a liquidity preference or discount. Why does it exist? Many institutional investors prefer to invest in a relatively smaller number of large-cap stocks rather than investing in many more small-caps. Most passive funds are heavily invested in large-caps. Additionally, I suspect the shift from brokerage-commissioned retail accounts to wealth management discretionary-fee accounts have increased the use of large cap securities. 

This phenomenon is not inevitably bad for the small cap investor. Small cap stocks are more plentiful on the NASDAQ than on the “Big Board”. For some time I have suggested the NASDAQ is a savvier market, it went up the most and is currently declining the most of the three main stock indices. I often find more attractive investments in stocks having fewer institutional holders. These days institutions tend to move more like a heard than investments in less popular stocks.

Duration

Duration is a concept applied by bond investors focusing on the yield and maturity of bonds. I believe a somewhat similar concept should be used in selecting equities. A common analytical technique is to divide stocks into “growth” and “value”, leaving perhaps 1/3 of the universe with two horses in their stable. Over an extended period, this may produce a more satisfying and less volatile result. The key metric for “growth” companies is an expectation of growing faster than the economy. For value, the metric is expected share price movement. These two metrics are quite different, the only concept they should share is how long it takes to reach their goal. 

For “growth” stocks the critical question is, will future earnings justify today’s often over inflated price. Today there is a belief you are buying at a bargain price because future earnings will be so large. For example, if a stock is selling for 40 times current earnings, it could be conceived as selling at 10 times future earnings, if they are five to ten times current levels. This makes paying a high price today acceptable if future earnings are expected to deliver. The key to this assumption is the level of earnings and how long it takes to reach that required level. The second factor is a length of time or a duration.

The analysis supporting a “value” recommendation is far less patient. A stock represents value today if and when the market recognizes the value. Value recognition is most often caused by outside forces, such as economic growth, changes of input/output prices, market share changes, acceptance of new products and/or management. Sentiment can change much quicker than actual fundamentals. After long periods of lagging stock performance, a change in sentiment can bring dramatic price performance. Thus, the history of value stocks is that they can be volatile, producing sharp gains and quick declines once value is recognized. Therefore, in our mathematical analysis value stocks have a shorter duration. This is appropriate because a substantial portion of the gain is not internally generated compared to growth stocks.

Should one invest in growth or value? In examining eleven time periods the average growth fund did better than the average value fund eight out of eleven periods. (Please contact me if you want to see the details.) What is perhaps most significant is that since the trough on March 23, 2020, both growth and value funds gained 69%. This suggests to me that the bulk of a risk-aware long-term portfolio should be growth oriented, both domestic and international. Some well-chosen value driven funds should also be included, with particular emphasis on small and mid-cap funds.

Concentration

Examining the long-term performance of mutual funds and less-public portfolios, the better ones tend to be more concentrated. This is easy to understand, the wining positions get bigger and the losers get smaller or disappear. A classic example is one $75 billion growth fund. It has 46.9% of its portfolio in its ten largest positions, with 35.9% in the top five and no cash. In eight periods, from one month to fifteen years, it has beaten the S&P 500 all eight times and the Russell 1000 Growth six times. What I find of interest is that in no period did it beat its index comparisons by three percent or more. This suggests to me that it produced this record with the managers using largely the same stocks as the indices, exercising not only stock selection capabilities but also portfolio manager skills, demonstrating both are needed to produce good results. (Their report is available to subscribers. We have a small position in our managed accounts.)

Working Conclusion

If the equity market in the US is envisioned as a long race for humans or horses, I would say leadership is changing as the newer leaders pass tiring racers. The current low volume in the market appears to be the lull before a storm. Maybe we are hearing the early notes from The William Tell Overture as the storm gathers.

Any thoughts you would like to share?    

        

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

https://mikelipper.blogspot.com/2021/07/sentiment-appears-to-be-changing-weekly.html

https://mikelipper.blogspot.com/2021/07/independence-day-3-investor-lenses.html

https://mikelipper.blogspot.com/2021/06/what-did-fridays-market-political.html

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Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Concentrate or Diversify, 2 Questions with 3 Answers - Weekly Blog # 594

Mike Lipper’s Monday Morning Musings

Concentrate or Diversify, 2 Questions with 3 Answers

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

I have been asked to respond to two intellectual investment questions that parallel real word actions. The first question comes from a long-term subscriber of these blogs. The second comes from my preparatory work for a potential investment management client.

1. European Portfolio Manager response to Sub-Zero Interest Rates?
2. Appropriate Structure for a Long-Term Charitable Account?

In my mind both questions revolve around the same risk management question. Is it better to concentrate one’s assets and energy or spread the risk by diversifying? Too often investment people view their problems as special and quite separate from the real-world problems of others. We do this at the risk of not seeing the universality of problems.

Perpetuation of the family/species is at the core of human and animal creation. Due to potential violence, insufficient food, and medical risks, some produce multiple offspring with the hope that some will survive. Others choose to produce a limited number of descendants and protect them carefully. This is the very same quandary that investors face, particularly those with responsibly for others.

One approach to a decision process with two alternatives is to create a barbell type solution by combining the two extremes of diversification and concentration. To be prudent we should not use this barbell decision model. The third element to consider is the presence of other factors, which often determines the appropriate decision.

Reactions to Negative Interest Rates
On the surface, paying a financial institution for the privilege of letting them hold your money, which they then lend out without sharing the proceeds with you, appears to violate Newton’s laws of physics. It suggests a collapsing universe rather than an expanding one, raising the question of why an investor would contribute to such a scam?

Jim Grant, one of the best columnists on fixed income, called for the end of the 38-year bond bull market in this week’s Barron’s. In his column he quoted from a 1981 article by Parker Hall, a deceased but old friend who heralded the beginnings of the bond bull market. Today’s question is somewhat more complex than just betting on a cyclical turnaround in bond prices. It has been made more complicated by the policy dictates of various governments for political purposes. Although interest rates are expressed in their local currency, e.g. euros, they are compared to rates in other currencies and are exposed to different inflation rates. Governments, officially or unofficially, direct their central banks to induce low interest rates to create and preserve jobs, often through problematic loans which create additional market distortions.

Most large fixed income portfolios are managed through or for the political establishment, making it difficult for many managers in Europe to meaningfully exit from negative interest rate paper. However, I am seeing some increased diversification into both high-quality corporate bonds and very long-term government bonds, including century bonds. The latter is interesting in that they’re betting they can, over the long-term of possibly 100 years, reinvest the low yielding coupons at higher expected interest rates. (It is worth noting that the biggest return in long-term bond investing is through the reinvestment of payments at current rates).

If European fixed income managers can get out of the euro they generally will, often by buying US paper. Most cannot and are therefore effectively corralled into the euro and forced to extend their maturities. However, there is a limit as to how much they can lengthen their maturity structure, as many portfolios are designed to pay pension benefits. In most European countries the retirement ages are lower than in the US, thereby limiting maturity elongations.

Portfolio Structure for a Charitable Investment Account
The payout needs for any account requires current cash to make payments. There are two main ways to achieve this. The traditional way is to let the gross income earned on the entire account make the required payments, but due to market price fluctuations the available cash will fluctuate. To the extent that current income is insufficient, proceeds from sales can supplement the cash generated from dividend and interest payments.

We are advocates of another approach which divides expected payment responsibilities into specific timespan portfolio sub-accounts. The most current timespan portfolio should generate the funding necessary to make required payments. This portfolio could be structured in a way where cash or short-term investments satisfy the payment obligations before being replaced with the next timespan tranche. The advantage of this approach is that it makes certain that current bills are paid, regardless of market volatility. It also allows the rest of the portfolio to be invested for longer term horizons.

Charities, even private ones, are fiduciary accounts that are distinct from personal accounts. No one must know how well or poorly one’s personal account performs. Most fiduciary accounts make reports as to the success of their investment program from time to time and the frequency of this reporting can influence how a portfolio is managed. Financial markets are by their nature volatile. Over very long periods a fully invested portfolio of reasonably selected securities or funds should produce a higher return than a portfolio that has frequent changes.

To some degree, in dealing with fiduciaries it is more difficult to manage their expectations than manage the performance of the funds and/or securities. Using a rough rule of thumb, the potential peak to bottom declines are as follows:

     A 10% decline - Three times in a ten-year period
     A 25% decline - Some time over a ten-year period
     A 50% decline - Once in a generation of approximately 25 years

Many investors do not achieve the general returns available in the market because of timing their moves in and out of the market.

Diversification reduces specific risks of individual securities. However, it also reduces the opportunity for doing much better or worse than the market average. Over an extended time period, wise concentration in a small number of choices produces the highest returns, but the results can be volatile.

Pulling these thoughts together the following structure may be appropriate for a charitable account, assuming a ten-year horizon:

     10% in Money Market funds and short-term US Treasuries
     40% in growth funds of various sizes, most in mid/small-cap funds
     30% in international funds, with 2/3rds in Asia
     20% in value funds

The selection of individual funds will be guided by risk tolerance, size of the account, operating procedures, and special factors. The higher the risk tolerance the greater the commitment to a concentrated portfolio of funds.

If you need help in constructing or reviewing your portfolio, please contact me.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/09/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/09/excess-capital-less-equity.html

https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.