Reality is Different than Economic/Financial Models - Weekly Blog # 878

 

 

 

Mike Lipper’s Monday Morning Musings

 

Reality is Different than

Economic/Financial Models

 

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

 

 

Purposes of Models

Models are designed to portray complex relationships in a simple way. However, all too often models leave out contrary relationships. In so doing their utility as decision-makers is greatly lessened. Academics love models as teaching instruments, especially during time consuming classes. Rarely do the publishers of models give the odds on their exceptions. One drawback of blind use models is the lack of discussion on exceptions. To be a successful portfolio manager I believe we should consider exceptions to “normal” expectations.

 

For example, the current administration is trying to grow the US economy by creating measures to help manufacturing and housing. This might have worked well in the past but may not work well this time. Why?

 

The top 10% of the population owns almost half the assets and is responsible for an even larger portion of current spending. I believe most high spenders are not generating their gains from manufacturing and probably already own their own homes. With approximately 2/3rds of the population classified as part of the services sector, direct aid to the manufacturing sector will not make the spenders spend more.

 

Some of the big spenders are already cutting back on spending and are selling some of their higher earnings assets. In the latest American Association of Individual Investors (AAII) weekly sample survey, only 19% are bullish vs 61% bearish for the next six-months. Some of the wealthiest families are selling some of their best performing assets. (Exor*, the family holding company for the Agnelli family, is selling 4% of Ferrari.)

*Personally owned

 

In the US and possibly other economies some sense that part of the problem lies in education at the primary level and higher. In the US I believe 40% of grade school students can’t pass a basic math test. In Estonia they are going to begin teaching AI in their high schools.

 

This week we saw attention being paid to the importance of importing selected metals. On a broader scale, people in the commodity markets are expecting 6% inflation for “Doctor” copper.

“Happy Talk” is still driving much of the media who are celebrating 2-year Treasury yields dropping below 4% (3.99%) and 30-year Treasury yields dropping to 4.5% this week.

 

None of the popular models are currently pointing to a recession, which would give a more complete total outlook. However, I remind investors that throughout history there have always been periodic recessions, usually due to excess use of debt and/or government action. We have an abundance of both currently.

 

Take Care    

 

 

 

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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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Michael Lipper, CFA

 

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Contact author for limited redistribution permission.

 

 

 

Beyond Near Term Investing: How Much For Brains?

Luckily for me and I hope for you, thoughts once launched continue under development as people react and additional information becomes available. I am very blessed as I am regularly in receipt of many stimulating investment papers and articles of importance.

Last week’s blog post focused on the relative value of my personal accounts' 40%+ investment allocation outside the US and the expenditures to support education for various members of my family.

This week I was privileged to read three articles and a personal email that contributed considerably more depth to these thoughts.

Top Test Scores From Shanghai Surprise Educators

The above was the headline in an attachment to the always interesting, thought provoking and occasionally correct “Ten Surprises” by Byron Wien of Blackstone. (Disclosure: I have known Byron for the more than 50 years and have served on boards with him.) One of the reasons Byron was pessimistic long term as to the future of the US was the poor test scores earned by 15 year-olds in the US relative to others around the world in 2009. The tests were given in Science, Reading and Math. In each case, the United States was far from a leader, above average in Science and Reading but below average in Math. There were thirteen countries that did better than the US students in all three tests. In order of their Math rank they were: China, Singapore, Hong Kong, Korea, Finland, Switzerland, Japan, Canada, Netherlands, New Zealand, Belgium, Australia, and Estonia. (I will be happy to supply my work sheet on these results if you contact me.)

Why Chinese Mothers Are Superior

Amy Chua, a professor at the Yale Law School wrote the above titled article for the Wall Street Journal. The article stressed the very rigorous discipline Ms. Chua applies to her two daughters, not allowing any outside activities and focusing all of their attention on repeated or rote work. For the daughters and their Mother the long focused practice sessions seem to have worked.

Rereading the list of superior test-taking countries, I can not avoid the recognition that the first four locations had strong Asian mothers present. One can add the seventh place Japan to this list of enforcers of scholastic discipline. There were a number of western countries that also did well, at least three of these have long winters which are good for long study hours. I must admit as a “civilian Marine,” (the newly coined term for those who no longer wear the uniform), the use of rigorous discipline and working during dark hours rings true to me.

Over the years I have had successful investment experiences in practically every one of the thirteen high test-scoring countries. Byron Wien was concerned that in the long run, test scores could undermine the intellectual leadership of the US. Three of our family’s college students, attending good universities, report that often the leaders in their various classes come from Asian homes. I hope many of them stay here and produce for this society. As a Trustee of Caltech, I am conscious of the number of brilliant students who come here on student visas and are forced by our immigration policies to return home with the extensive knowledge that they learned here.

I wonder whether we need to put a higher value on those companies that can attract the brightest on a global basis. The ability to get young brains may be of more value than the companies’ current cost of capital and resources.

The Next Decade : Where We’ve Been…And Where We’re Going

George Friedman has recently published his latest book with the above title. I have been privileged to see his author’s note. I can not wait to read the whole book. However, he is focusing on the tensions within the US between our global, if you will, empire roles versus the roles as a republic. In the drive to produce higher test scores and the creation of a “brainy” society, the simplest way to do it is by enforced discipline that eliminates alternative actions. The risk, according to Friedman, is that we unconsciously replicate ancient Rome or other rigid societies at the expense of the sound alternatives which are the basis of our own Republic.

Perhaps our portfolios should be balanced between the most efficient producers and those who practice creative destruction or alternatives to the present order. These are some of the critical issues that long term endowments and family fortunes need to examine and balance.

Maybe education does work

My youngest son sent me an email which stated, “On January 8th 1835, the national debt was $0.00 (the only time this has happened). Makes you think what would have happened if we kept that balance.” This is from a child of the inflationary 1960s. Maybe either education or age is finally kicking into focus the challenges that will face him and his children’s lives.

In conclusion

There is a lot more to think about in setting investment policy than near term interest rates and forthcoming earnings per share.

What do you think?

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