Introduction
The
proper function of active portfolio management is to be aware of possible
forthcoming change and to anticipate its arrival. It is this very function that we are least
prepared to accomplish well and therefore the biggest single risk that we and
our investors share. They at least have the benefit of being able to blame
their professional managers, but since they selected the managers this is
self-deception.
Why
are we so unprepared to anticipate and take some advantage of future changes?
In an over-simplification, the description is the differences between Art and
Science. There is a great amount of art in what scientists do, and artists
utilize science, often well. The difference in its simplest form is the
scientist starts with existing formulas and focuses on what is there. Some
artists focus on what is not apparent and perhaps what in their mind should be.
In
the portfolio management world the scientists are guided by specific or at
least implied facts that have repeated themselves enough so that they become
rules, laws, or the current term - factors. All of these are a product of a
mental prison. The prison can be labeled EXPERIENCE. If the timing of these
“portfolio scientists” is propitious they may make relatively small gains.
The
gigantic gains in terms of rewards or avoidance of pains comes from sensing
what is not readily seen by most at the time. In the recent two weeks I became
focused on long-dead geniuses. The first was the Nobel Prize for the efforts
led by professors and laboratories of the Jet Propulsion Lab that Caltech
manages in proving Albert Einstein’s 100 year old theory as to the impacts of
gravitational waves in space. (This achievement only took over 1000 people and
over $ 1 Billion NASA dollars and a strong contrarian view.) Nevertheless
within a few weeks after the beginning of its operations, they were able to
detect a number of collisions of black holes that release a huge amount of
measurable energy.
Last
night my wife Ruth and I enjoyed a magnificent musical performance conducted by
the incomparable Xian Zhang and the New Jersey Symphony Orchestra playing
Beethoven’s Emperor Concerto for Piano and Orchestra. Beethoven is another
example of a genius well ahead of his times. What I didn’t know was when Beethoven composed this piece in
1809 he anticipated the development of the modern piano different from the one
of his day. It would take a half century before the present day piano arrived.
Today
we are the beneficiaries of these geniuses’ work; one and two hundred years ago
they saw what was not seen by the rest
of their professional colleagues. Perhaps for us in the portfolio management
business the lesson is avoiding some of the penalties from using outdated instruments
and thinking.
I
have been concerned as to how to prepare for future changes and how they will
impact future generations of beneficiaries of the art of portfolio management.
Future
Political Changes
In
last
week’s blog I alluded to both the French and
Russian Revolutions and that the early leaders of dramatic changes were
replaced by more radical leaders who appeared to be able to more quickly accomplish
structural changes that were promised. Today on every continent we have leaders
who have sold themselves to the voters and other decision-makers as change
agents that are being bogged down with the lack of sufficient political power
to accomplish their promised goals. At some point, if the inability to make
major structural changes continues, the present crop of change agents will be
replaced either through the voting box or more violent means either from the
Right or the Left. My fear is that due to technology and global economics we
could enter a post-national world that may look like City/States with defense,
military, and economic alliances. In such a world, the force of law on
contracts may be quite different than what we are enjoying today.
I
don’t know whether the changes will be good or bad or more likely both. Neither
do I know who will be the winners and losers. What it does suggest is that it
may be prudent to be widely diversified not only in terms of geographies, but
economies, and perhaps most importantly, the rule of law and taxation.
Financial
Structure Possible Changes
Most
of the readers of this blog and I are much more focused on equity investing
than fixed income investing. The historic reason is that stocks are where we
can profit the most. We tend to forget about the bond market. This is a mistake
for three reasons:
1. The bond market is bigger than the stock
market around the world.
2. Equities are leveraged directly or
indirectly by the borrowings of governments, businesses, and individuals.
3. The basic contractual laws were developed to
establish “fair dealing” between lenders and borrowers which is also the
basis for rules for equity owners.
Today,
the size of unfounded and contingent
obligations question to the lenders that each and every future dollar or
equivalent will be paid on a timely basis without significant increases in
taxes and other transfers.
One
of the tenets of being a contrarian investor is to get increasingly concerned
about one sided markets. In many countries, (including the US) there has been
more money going into bond funds than stock funds. These funds and many
retirement funds are buying bonds pushing their prices up and yields down.
Historically the differences in yields were an indicator of perceived risk.
What are the financial markets saying when the yield on US Treasuries are 2.3%
which is the same yield as the market is placing on emerging market stocks? Now
the best thing that can happen to the owner of Treasury paper is to get paid
the maturity value upon its liquidation, nothing higher. Over the next ten
years the dividends on Emerging Market stocks can rise or fall. Clearly the
Emerging Markets have trade, product, and currency risks that the Treasury
paper does not. The equity market appears to be much more discriminating as
shown in the yield table of equity indices below:
Below 2%
|
2-3%
|
3-4%
|
Above 4%
|
India
|
Japan
|
France
|
Australia
|
S.
Korea
|
Mexico
|
Italy
|
Russia
|
China
|
Germany
|
Sweden
|
|
US
|
Brazil
|
United
Kingdom
|
|
Canada
|
Spain
|
||
South
Africa
|
Each
list starts with the lowest yield, the most favored country in the yield range.
The
stock markets appear to make significant distinctions that bond aggregates do
not. There are some skilled bond investors working in the emerging market
space. One that came to my attention this week has top three holdings in Kenya,
Senegal, and Iraq. For lots of political, social, and religious reasons some
investors might object to investing in these or other countries, their
withdrawal as potential investors could reduce the number of buyers and make higher
yields available to other investors.
As
a contrarian I expect the flow of money into bond funds will be at best
counterproductive, if not producing
meaningful losses. I am also concerned that the brokers and advisors who put
investors into bond funds will lose face and clients for their actions. Much of the flow into these
funds comes from large broker dealers and large registered investment advisors.
As much of the flows have gone into fund companies that also offer stock funds,
hopefully the fund houses will be able to convert a significant portion of the
residual bond investments into stock funds to preserve wealth and give the
investors a chance to recover some of the expected losses. If this exchange happens
now the scenario may work. There is a dreadful chance that the switch will
happen concurrent with an eventual top of the equity market.
Equity
Market Structural Risks
The
European Union in January will put into effect rules that will have the effect
of reducing payments for brokerage delivered research that may impact
institutional trading around the world. From an investor standpoint this will
likely remove the research support for many smaller companies which will lower
their potential market value. This is occurring at the same time that in the US
for various administrative rules and tax implications, the number of publicly
traded stocks has been cut in half from the number of publicly traded stocks of
years ago. It is much too early to tell whether the currently discussed tax
bill and the desire of the Administration to reduce the burden of regulation
will have a positive effect on stock prices. It would not be the first time
that the unintended consequence of changes has the opposite impact to the
government’s desires.
Investment
Policy Considerations
As
we may have entered a world where the historic factor type of rules based
management may produce competitive results, it could be the time to drastically
increase diversification. This is not just adding to the number of securities
in the portfolio. It means having an increase in the number of themes used in
the portfolios. It could well mean to begin a position in some of the currently
worst performing segments such as agricultural commodities. It may mean to
invest in local securities around the world. For us who manage portfolios of
funds we may need to add new managers who think differently than some of our
very successful present managers.
Bottom
Line
We may have entered a period of structural
changes that we need to recognize and begin to take actions to protect the
assets of future generations.
Question
to Dwell on: Can you evolve your thinking ahead of the headlines?
__________
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A.
Michael Lipper, CFA
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