Lack of Confidence in Brexit Era Could be Costly

Introduction

I am a student of long-term investment performance for our accounts and my family. Some of the money entrusted to us is designed to make future payments many, many years into the future. Thus, I study which are successful and unsuccessful investors and their strategies over long periods of time. In that light I mentioned at a recent meeting of the New York Society of Securities Analysts celebrating the thinking of Ben Graham, the father of value investing, why I believed that the “experts” were wrong that the British would vote to remain within the European Union. They violated my rules for avoiding large losses that I derived from Ben Graham and my old professor David Dodd. The rules are:

A.  Overconfidence (Almost universal belief in an outcome)

B.  Faulty, incomplete, and poorly timed assumptions (Economic only

arguments) - Lack of non-financial milestones (Confusing money bets with bookies and number of bets + % undecided)

C.  The frequency of massive overconfidence in financial history is relatively rare; e.g., “Tulip Bulb” Sub-prime mortgages with house prices never declining. Avoiding those losses are critical to the number one rule of successful investing which is to avoid (big) losses along with the second rule, which is not to forget the first rule.

The First Two Rules Are Not Enough

One could have avoided losses from overconfidence by just moving into an all cash position and one would have saved all or the bulk of one’s capital. But if you stayed in cash you would have missed out on the compounding growth that investors have experienced over many years. Using a no-brainer approach of investing in a market index since 1926, one could have compounded at about 9% which doubles money every 8 years. (This is not a prediction of future returns.)

Our objective relative to the risks assumed is to do better than a mechanical index strategy. However, to beat the index one should analyze the performance of the index compared with actively managed investment accounts. In the periodic market declines, the index declines more than the accounts because first it does not have any cash and second most indices are heavily weighted in favor of the most liquid stocks which typically drop the most as they are the easiest to sell. The reverse is true on the way up from the bottom. The indices have no cash to reduce their rate of gains and are in the most liquid stocks that late-comers plow into.

As a student of investment performance of successful managers, I have noted that they have more confidence in what they are doing than others. Often they are lonely in adopting a particular stance or set of securities. Typically they are not positioned defensively in early stages of what proves to be a rising market. Many times this lonely confidence (compared to a market of little confidence) produces a superior compound growth rate. The superior managers don’t always do extremely well, which is why our portfolios have a number of funds that have characteristics that suggest in appropriate markets that they will do well.

Is Brexit an Opportunity?

Caveat emptor or buyer beware: we can not predict the future. My training at the race track is such to wish most of the time to avoid the betting favorites (weight of money) as well as my contrarian nature suggests that Brexit could well represent a major long-term opportunity for investors around the world.

Why?

There are potential parallels between 2016-17 and 1848 as indicated in last week’s post.    There are already eight European elections scheduled plus the re-vote in Austria. Australia finished voting this weekend with the present government weakened. The US will have a new administration and a different makeup of its Senate. There is a likely chance that within Europe there will be Brexit type votes either the in planned elections or in special referenda.

Around the world the existing order is under attack by groups on the right and the left claiming that the politicians and other “experts” have not delivered. Further they claim, governments are too big and therefore expensive and inefficient. Supranational bodies are viewed as even worse, as they are further away from the disgruntled people. In part due to social media, many minorities have expressed unhappiness with majority cultures and are expressing desires for autonomy or even independence. One wonders whether the concept of nationhood will need to change.

The world has changed. Even small companies and to some degree small investors view the world through multinational lenses. In the forthcoming negotiations between the UK and the EC, at the moment the UK has the advantage in that it should not be in any hurry. In the meantime it will be free to develop singular trade deals around the world. At the same time multinational companies and investors will seek out their own best deals. There is a long history of wartime enemies arranging a regular flow of trading between combatants. (I suspect that some in Germany are already at work on this option.) In the eventual final negotiation it would be wise for the UK to have one with the negotiating skills of “The Donald.” This is not a US political judgment, but one that recognizes commercial realities. It would not surprise me if the length of the negotiations is not similar to the twelve-year period between The Declaration of Independence and The Constitution. And that process had the benefit of the Founding Fathers led by Hamilton, Jefferson, Madison, and Monroe.

Perhaps coming out of all this will be a political shift favoring consumption over labor. China is attempting to do this with difficulty. The pro-labor attitude of the existing power structure has not worked. By raising the cost of labor (including benefits), it priced much of labor out of the market to be replaced primarily by automation, if not outsourced production beyond China’s borders. By focusing on consumption the drive will be in terms of price, quality, and safety which can produce a healthier and more satisfied society.

There is Still One Thing Missing.

The two largest economies in the world have been built by risk-takers. In both the US and China, the countries are populated by people who took the risk to move to their present location. Historically in the US, it is important to remember that with the exception of the Native Americans, we all came from someplace else for the past four hundred years. Because we arrived with very little in the way of financial assets, we were, and many of us are still today, risk-takers. This makes us unique among nations at the moment, which will have to be corrected if the Europeans want to catch up to the US.

Pardon a parochial view, but I often view the world through mutual fund glasses. One measure of the risk-taking attitude of investors is the portion of their assets invested in equity funds. On paper, Europe as a whole is the same size as the US economy. As of the end of the first quarter of 2016, the world has invested $16.4 Trillion in equity mutual funds. US registered funds accounted for 60.9%. All of Europe had only 27% in equity funds, including Luxembourg and Ireland which are favored by tax aware global investors outside of the US. Excluding the tax shelter investors, the four European nations with the largest share of the global equity funds were the UK with 4.3%, France 1.9%, Netherlands 1.7% and Germany also 1.7%. The potential of  less expensive and bureaucratic government focus on consumption is great. However, it won’t be achieved if most of the risk-taking comes from US and Chinese sources.

	Assets in Equity funds: as of 3/31/2016
All Equity Mutual funds	100%
US-registered funds	60.9 %
All of Europe? (including Lux & Ireland)	27.0 %
UK	4.3 %
France	1.9 %
Netherlands	1.7 %
Germany	1.7 %

Source:  ICI

How should one invest in the Brexit Opportunity?

This will undoubtedly be a long and laborious task. In a time-segmented portfolio as in our TIMESPAN L Portfolios^®, I would begin with small commitments to International funds which have 40% in Europe and buy more during periodic setbacks. The small fund participation rate in Europe may be an opportunity for financial services investing. I will be happy to discuss privately how we do it in our private financial services fund.    

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The Fork in the Road to your Investment Policies

The fork to the left is pinpointed by real world observations, the fork to the right deals with possible negatives.

As many of the members of this blog community know, one of my critical investment laboratories is Ruth’s and my walks through The Mall at Short Hills. For those of the community who are not familiar with our annual rite, the day and the weekend after Thanksgiving each year find us at this very upscale mall looking at the size and intensity of the crowd as well as the number of labeled shopping bags they are carrying. Another clue to the robustness of the Holiday sales is how far away we have to park compared to our normal spot.

POSITIVE SIGN: HIGH-END SHOPPING

We have just returned from a visit to the mall on a very pleasant sunny Sunday. We had to go to the less convenient level to find a parking place. There were more than the normal numbers of intense shoppers, not walkers. The Apple store (NASDAQ: AAPL) in particular looked busy and the Verizon store (NYSE: VZ) appeared to have a good crowd within. In the past I have commented on the depressing number of vacant store sites. Today there are fewer vacancies and there are a number of large stores advertising their future openings and upscale merchandise. Bottom line: people were buying, merchants were expanding, and mall operators were showing signs of success in filling their sites (perhaps at discounted leases).

RESIDENTIAL REAL ESTATE

In this part of the country, dinners and cocktail parties' participants spend some time on our “local sport.” To my grandson’s dismay, this is not soccer but residential real estate. Increasingly we are hearing about bids being hit or exceeded, but with contingencies for mortgages or prior sale of the buyers’ current homes. Months ago there were little or no such conversations.

INVESTMENT IMPLICATIONS

The investment implications of this left fork are that the economy is in a state of uneven recovery and some hope has returned. From a portfolio standpoint, investment in depressed consumer discretionary items as well as some ties to home improvements appears to make sense. These moves are based on the return some form of normality, even if it’s the “new normal” of lower returns.

SOBERING SIGNS FROM EUROPE

The right fork is more difficult to elucidate. Last week one of the questions that my blog dealt with was, "Why didn’t a number of investors jump in at what appeared to be bargain prices?" As mentioned, sharp market movements in retrospect often are found to be inflection points, marking changes of direction in investment thinking. The immediate concern in the first week of May was the clumsy way the European Community was dealing with the Greek problems. The bounce-back sustained in this past week focused on multi-tiered funding approaches by the EC and the IMF. There were some austerity measures announced for Greece, Portugal, Spain and Ireland. I suspect that these will not be sufficient in the long run. At this point a much bigger potential funding deficit in Italy is not being publicly addressed. A number of commentators have compared the deficit tracks of Greece and the US, which is sobering. What has one concerned is the pattern of governments to socialize, if not nationalize, what in the past has been private responsibilities. As families became clans, then tribes and morphed into nations, the primary need assigned to government was defense from without.

GOVERNMENT SERVICES OR PRIVATE JOBS?

To pay for services by government, taxes were introduced which led to government sponsored coinage and building roads. Over time, provisions for education and retirement became government obligation in some societies. In Europe and now in the US, the provision of health care is being socialized. What is not written in our, or other countries’ constitutions, is the creation and preservation of jobs.

Almost inevitably when a service that has been or could be provided by the private sector is turned over to the government, inefficiency and corruption occur at some levels. These are additional transfers from the private sector to the public sector, not dissimilar to declared taxes. There are differences caused by these inefficiencies and corruptions which build rigidities into the economic systems. Over time these elements act as an additional tax on the provision of these services to the community. Countries, states and cities with higher net effective tax will inevitably lose economic opportunities and therefore jobs to more efficient locations.

MANAGING EXPECTATIONS

Are the problems of just about every country which borders the Mediterranean akin to a flock of canaries in the mine? Did some investors perceive the problem without seeing any significant attempt to structurally reform our own economy? If that is their growing perception, they should start to discount more heavily what they expect to be normalized or peak recovery earnings. In other words, do stocks in the future, not have the same potential capital appreciation that they delivered to us in the past century? (Not counting the last ten years of little to no real growth.)

MY OUTLOOK

For those that are looking down the right fork, they should consider using significant recovery rallies, including new highs, as selling opportunities. As long term bonds are already unattractive in terms of income and inflation, they are unlikely to be a long term attractive alternative for equity money freed from the domestic market. What is worthwhile, starting today, is the search for governments that are being more responsible to their citizens and investors. Those that are doing so today are more likely to continue to do so rather than the countries that recover from too much government spending.

The choice of which fork is up to you and for awhile one could attempt to do both, but that will require an alert investment manager. Keep us informed.

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