Improve Your Returns: Watch Short-Term and Learn Long-Term

Introduction

With the passing last week of Andy Grove it seems appropriate for me to consider the breadth of thinking in his book Only the Paranoid Survive. While some can be comfortable following Warren Buffett’s words (not his actions) to buy and hold forever, along with most professional investors, my insecurity does not permit me to buy and forget. We worry all the time and particularly when trends turn and accelerate in our favor. This is one of the reasons why I came up with the four increments in the Timespan L Portfolios^® . These require me to focus on both the short-term to make tactical decisions and to learn what are critical lessons for successful long-term investing.

The Short-Term Operational Portfolio Worries

The timespan model for this portfolio was designed for an endowment that has to feed an operating activity over a two year duration, (in practice we will modify the timespans to meet client needs). While we think of this as a short-term portfolio, a number of individuals and institutions perceive their preferred measurement period for the entire portfolio is one year, thus for some, this is a long-term portfolio.

As longer term readers of these blogs have learned, I find a need for excessive enthusiasm to be in place before I start to prepare for a major decline, possibly of 50%.  I am beginning to see some growing enthusiasm. After all of a five week improved US stock market, and rising Chinese stocks and oil prices, I see shopping at the nearby high end mall getting crowded. Parking spaces are hard to come by, shoppers (mostly women) are carrying three or so shopping bags. Stores were reasonably crowded and both the Apple and the Verizon Communications stores have customers waiting.

As an analyst I search for negative indicators as much as positive ones. As long as there is sufficient uncommitted money to equities I know that there is spare buying power that can push prices higher. This is particularly true if the money is being guided by so-called professional, conservative money managers. In a recent asset allocation study of forty large wealth managers' recommendations, I looked at the five most aggressive wealth managers who were recommending that their clients put 60-70% in equities compared to the average of 51% for the forty. Only one manager would put 10% in Emerging Market equities and another sole manager would put 16% in High Yield debt. In both cases the average for the group was about 4%. This was the same level of group aggressiveness in terms of private equity where the five most aggressive had between 10-14%. The commitment to hedge funds on average was 9% where the leaders had 18-25% in these vehicles. Thus the wealth managers in general haven’t been swept up yet by enthusiasm.

Some of the money in hedge funds and other trading vehicles is finding its way into ETFs either on the long side or short side. For the week ending March 23^rd there was a net inflow into equity ETFs of $2.8 Billion which included $1.1 Billion into Balanced ETFs. (It is important to remember that the institutional community has learned that Index ETFs are a cheaper entry vehicle than futures for their hedging and other trading purposes. I will be discussing the impacts of ETFs on the structure of the market places in early April at a meeting of the International Stock Exchange Executives Emeriti.)

I would not pay a great deal of attention to the net redemptions from conventional mutual funds in terms of future direction of the market. In the latest recorded week $1.5 Billion were redeemed, all of it from Domestic funds, almost all that from Large Cap funds. It is my contention that the bulk of these redemptions are in effect “completions” of long-term investment plans prior to funding other needs. This is an old phenomenon which in the past was offset by new purchases of funds that are not happening because it is more profitable for the distribution systems, including registered investment advisors to deal in other products including hedge funds, private equity funds, and to some extent ETFs.

There are some signs of significant enthusiasm which need to be tracked. In the last week $3 Billion went into Emerging Market equities. Some could be short covering. In a recent survey the second most crowded trade was being short Emerging Market stocks which are less liquid than our domestic stocks.

Other examples of rising enthusiasm are the quarterly hockey stick-like estimates of earnings for the S&P 500: 1^St Quarter ‑6.9%, 2^nd quarter ‑1.9%, 3^rd quarter +5.0%, and 4^th quarter +10.6%%. Certainly part of the gains is earnings from the Energy sector going from a ‑98.9% decline to a gain of +10.6. While these estimates suggest a trailing price/earnings ratio of 17.2x and a forward one of 17.0x, the real action is more towards the large and midsize companies found in the Russell 2000 with a trailing p/e of 24.9x and a forward p/e of 22.5x.

Bottom Line For Short Term Portfolios

With the above list of inputs, I still believe that the short-term portfolios should set up a price grid to begin to reduce their risks as the market moves higher. For longer term portfolios they should continue to invest for the long-term and occasionally buy into some opportunities that the market will serve up, but not attempt to market time.

Longer Term Lessons

As much as I question the perceived wisdom from academic sources, like many analysts I am always a student of our environment. As a practical matter it is more difficult to learn from successes than mistakes. Almost every aspect of a success could be the critical element, if you will, the secret sauce that made the success. Most mistakes come from slavishly following the perceived wisdom of reported successes without looking deeper as to why they worked when they did. Probably the toughest part to learn of the art of investing is timing. There is nothing fundamentally wrong with balanced accounts, all equity accounts, private equity funds, and hedge funds. The keys are when to use each of these, in what mix, and what level of patience should be applied. Generally one should use these tool sets when others are not. Most of the time it is a mistake to follow the crowd.

This week I read about an endowment that fired its poorer performing managers after the first seven months of its fiscal year which occurred through the horrible January performance. The group couldn’t take that it was down ‑8.5% and the S&P 500 was off ‑6.6%. The endowment fired their hedge funds and moved into private equity funds. We don’t know what the future will bring but I have serious reservations on the basis of the little bit that we do know. The endowment:

• Probably picked its managers largely on the basis of past performance
• Accepted a popular asset allocation
• Did not understand the cyclical nature of performance
• Did not have sufficient patience
• Elected to do a dramatic change all at once 
  
• Chose to go into the currently most popular asset class with the proceeds of transactions.

I will attempt to follow the organization's future progress because I am always looking for decision makers who have a high percentage of mistakes. These rare negative indicators hopefully will help me and my accounts from making similar mistakes.

Secret Sauces

Far too many investors follow successful other investors and try to mimic what “the experts” do. They don’t focus on the tools the experts applied to their art.  Classic examples are Warren Buffett and Charlie Munger at Berkshire Hathaway, who we will visit this spring. In many ways the tools, not the judgments that they bring to investing is in their annual report. The report contains 67 pages of notes and supplements to their financial statements. I do not claim to fully understand all the nuances that could be found in these pages. To fully grasp the tools that they have used, one would need individual courses in accounting, corporate finance, tax accounting/management, insurance accounting, treaties, various state/federal/foreign legal codes, and various forms of investing. Unless you have a firm understanding of these arts, don’t attempt to play their game. I benefit from both their skills and tools as a long-term share holder.

Other users of secret sauces were the late Sir John Templeton ably assisted by the late Tom Hansberger, both of who were my long-term data and consulting clients. In many respects Sir John was the leading expert on tax code differentials which he applied brilliantly to his personal and company benefit. Tom acted as symphony conductor skillfully managing different personalities as portfolio managers and analysts with global offices and people always on the move. Both understood the sales process and more importantly the sales people as well as how to motivate and control them.

Both of these pairs of artists were much more than stock pickers. Each brought much more to the process of building wealth for themselves and their companies.

Question of the Week: What are the secret sauces that you have seen?
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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Comment or email me a question to MikeLipper@Gmail.com.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

 

Going Global is No Escape from Investment Problems

• Too Much Correlation
  
• Four Letter Word: Jobs
  
• Fragmented Markets = Less Liquidity
  
• SEC’s Other Unintended Consequences
  
• A Father’s Day Focus For Wealthy Investors
  

Too Much Correlation

You would think after suffering through 2008, when almost all investments went down, we would pick equity investments that were not extremely correlated. Many US investors, particularly those who have had long term exposures to the economy and the stock markets, are unhappy with the current situation of a lackluster economy combined with an excessive US government intervention/manipulation into the financial structures of the economy. There are two fears at work; first there are growing signs of stagflation. (A flat economy with an increase in recognized inflation.) The second fear is the uncertainty of the structure and rates of various taxes. To escape these increasingly perceived problems, many investors are opting to go global.

The ever adaptive mutual fund business has generated a large number of Global funds to fill the needs of investors. These funds, unlike International funds, allow the portfolio managers to select the best available investments whether they are traded in the US or elsewhere. The problem is that this enlarged hunting ground has not produced materially better results. As a matter of fact, the list of fund indexes of various global fund categories has produced somewhat poorer results in the first five months of 2011 than the domestic funds. (Some domestic funds can invest up to 25% in international securities and there is no limit to their investment in multinational companies.)

Out of a larger list, I selected six pairs of fund indices to compare. The first index listed is the global group, comparing with the second group, a similarly focused domestic fund index:

• Global Multi-Cap Growth = 6.30% vs. Multi-Cap Growth = 8.61%
  
• Global Multi-Cap Value = 6.28% vs. Multi-Cap Value = 8.23%
  
• Global Multi-Cap Core = 6.71% vs. Multi-Cap Core = 7.98%
  
• Global Health/Biotech = 16.54% vs. Health/Biotech = 17.90%
  
• Global Sci. & Tech = 7.93% vs. Sci. & Tech = 8.56%
  
• Global Real Estate = 8.35% vs. Real Estate = 12.75%

Source: Lipper, Inc.

Four Letter Word: Jobs

One of the main reasons that “going global” is not working is that in most developed countries, and in a great many developing countries, there is widespread unemployment (as well as underemployment in the US). Globalization has worked too well. Capital has poured into companies and industries that could improve their productivity through the increased use of global technology. Thus we are producing more with fewer people. An important global issue is that we are not creating jobs. The way both China and Brazil are addressing these pressing problems is by raising wage levels, particularly at the entry levels. They are, in effect, inducing inflation that will create later problems for many and opportunities for some. Over-population is not a new problem. Historically, one answer was to wage wars on neighbors, particularly for their land, and in some cases their women. Also life expectancy was limited until the impact of modern medicine and modern agricultural processes became widespread. There is one crying need for vastly under-funded investment in almost every country: infrastructure. Once again China is in the clear lead here. Infrastructure funding historically comes with three problems. The first is the displacement of people from their homes and farms without adequate replacement. The second is that succeeding governments use cutting infrastructure spending as a way to avoid raising taxes. The third is that the very nature of infrastructure spending is that, at some level, it is a cash business which makes it more susceptible to corrupt practices (particularly with low level local politicians). Despite these real drawbacks, if various societies are going to prosper in the future, our global infrastructure needs must be met. At this point I would prefer not to invest in various infrastructure funds, but in more broadly based funds that can move into and out of infrastructure investments as price and circumstances dictate.

Fragmented Markets = Less Liquidity

One of the reasons that the global markets have become much more correlated is that with the exception of some Asian markets and to a lesser extent the UK market, the main driving forces in the marketplace are institutional investors. Many of these are managed by people who have been educated and/or had training in a limited number of universities or major firms. This somewhat limited exposure has produced generally accepted ways of thinking aided by instant global communications. In the search for meaningful competitive advantage, the players have to find more restrictive card games (markets) where only a few serious (big money) players are at the table. This has led to the creation of numerous places to trade. In effect, this move destroyed the knowledge capital of the formerly central marketplace. As no one knows for sure what transactions are currently occurring, there is a reluctance to provide liquidity to the marketplace. In turn, the lack of identifiable liquidity leads to increased volatility. Increased volatility scares many retail investors, so they retire from the marketplace. In the past, at the time of investment, individual investors were looking to the long term for their gains. The focus of too many institutional investors was defending against career risk, i.e., they needed superior performance in the present quarter. Markets work best when investors with different time horizons meet. Thus, one investor could be focused primarily on today’s price and another on some future price. That way both could be right. The absence of longer term-oriented investors in the marketplace hurts finding equilibrium prices, which promote future investment.

SEC’s Other Unintended Consequences

The fragmentation of the US market is a direct consequence of the SEC’s belief that “better” prices could be achieved through competing marketplaces which would aid the individual investor. As is often the case with government intervention, the unintended and unanticipated consequences have led to harming the very people who the changes were meant to help. I am not attempting to change these market structures through this blog community. I am just suggesting that the impact of what was designed to help investors, I believe hurt them. Another example tied to the fund index data shown above is the term global. The SEC cannot directly dictate a fund’s investment objective, but it can dictate as to its name under the concept of Truth in Advertising. At an earlier time, when US investors were pouring money into funds, the commission was concerned that investors could wind up in a non-diversified fund in terms of exposure to various foreign markets. That is why they insisted that for a fund to be called “global” it had to be invested in at least three different countries. In truth many of these funds invested in many countries and from my standpoint, too many countries. (When I used to counsel new funds, I suggested that they should not put a geographical or investment term in their name.) One of the reasons for the closeness of the performance data shown above is that too many of these funds are too broadly diversified, thus they will hug the middle of the market and not attempt to do extremely well. When examining a fund, investors should look at the fund’s portfolio to get their own view as to what the fund holds, and therefore how it should be measured to meet their own needs. If an investor cannot, or chooses not to perform this analysis, then the use of a competent investment adviser is warranted.

A Fathers’ Day Focus For Wealthy Investors

This blog was written on a day that is celebrated as Father’s Day in several countries of the world. For many, this was a day of family gatherings, exchanging cards/electronic messages, and gifts. When thinking about the upsurge in communicating with one’s family, there is a natural tendency to think about both the past as well as the future. Anyone who has children is wealthy beyond any commercial successes derived. Thinking back to one’s own father and grandfather, there has to be recognition that in many cases they are no longer with us. Turning to the future, we need to absorb the fact that at some point in the future our children will probably be looking back to a father or grandfather who is not with them on some future Father’s Day. All fathers (and mothers) try to pass on to their children their values and perhaps their talents. If you can do this, you are indeed wealthy.

For those who have financial assets, particularly sizeable assets, there is an added task, which is to pass on to children, grandchildren and great grandchildren not only financial assets, but the moral and investment values that have the best chances to make them happy and productive people. There are many models and devices to accomplish these goals, however there is no single plan for each and every beneficiary. When we lived in a much simpler world where our main asset was a farm or a local business, often the heirs had to share in the ownership and management of the family asset. There was very little one could do wisely for one heir compared to another except in terms of decision making. Today most wealth is, or can be, converted into liquid form. In many cases the assets of the heirs can and should be handled differently. One way to start the process, while you can change it, is to create separate portfolios with different rules for each of the heirs. Working with your accountant and trust/estates lawyer in the early stage of this process, I would use mutual funds because of their relative transparency and flexibility. Once policy portfolios feel right, then they can easily be memorialized in wills and trusts. To start the process, give some thought to the use of investing outside of your home country. In all likelihood one should start small, and as experience and confidence grow, take bigger steps. Don’t you wish your parents or grand-parents did this for you? This effort can be a gift to your children and grandchildren in addition to passing them your values and talents.

Perhaps we can help a limited number of fathers and mothers out there.

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