Contrarian Stock and Bond Fund Choices - Weekly Blog # 604

Mike Lipper’s Monday Morning Musings

Contrarian Stock and Bond Fund Choices

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

WHY DON’T WE FEEL BETTER?
During the week the three major stock indices reached peak levels and finished less than 1% from their top closing prices. However, last week’s Dow Jones list of weekly price changes indicated that most prices declined for the first time in my memory, with 68% of the prices falling. During past peak periods stock prices generated enthusiasm, something not prevalent today.

General attitudes toward the market are often better expressed by the performance of selected mutual fund portfolios than the precepts of some publishers. The average performance of the 7,539 mutual funds in the Lipper US Diversified Equity Funds universe reflects real expenses, flows, and cash reserves. Through last Thursday’s close the average year-to-date gain was +23.05%, almost three times the normal +8.36% average annual long-term growth of capital for the past five years.

One would have to believe that we have entered a magical era where past experiences are not relevant for this to continue. Even the most optimistic long-term pundits are not suggesting that future sales, earnings and dividends can command stock prices to rise and produce future gains of 20%. Any significant increase from the low to mid-single digit numbers currently being produced creates an unusual level of price risk.

I am sensing a bifurcation of market prices as popular stock indices benefit from the rising prices of an increasingly smaller number of stocks, with few stocks gaining 20% or more. Many stocks are only generating gains that match their single digit earnings, assuming they are growing at all, despite a remarkably strong economy.

I am concerned that analysts are jumping to favorable conclusions without thinking about how our economic system works. This week a long discussed potential merger between Charles Schwab and TD Ameritrade was announced. Charles Schwab is a holding in our private Financial Services Fund and TD Ameritrade is the second largest discount broker after Schwab.

Pundits calculated what Schwab’s’ earnings would be if the merged companies saved only half of the acquired firm’s expenses (called a “one and done” deal), but it does not take into consideration the competitive and market reaction to a potential deal. Furthermore, you might see lower pricing in the profitable arena of wealth management services, particularly through investment advisors. Lower net fees have contributed to the profit squeeze in the investment business.

WHAT TO DO?
Financial history is replete with tales of supposedly bright people fleeing a falling market and failing to come back in to benefit from a subsequent rising market. To prevent falling into this apparent safety trap, I among others have developed a practice of always keeping some money in so-called risky assets.

There are two primary ways to maintain exposure to a risk portfolio.

1. Shed most, if not all, low growth stocks/funds in favor of reserve building. Some with enough market experience can do this well, but not many, as committing cash in a down or even a flat market takes internal fortitude. Cash becomes too comfortable, making it is easy to postpone re-entry while you wait for some event, which may or may not happen.
2. A second approach also divides the portfolio into two sub-portfolios. The first sub-portfolio contains securities of extreme faith, or stocks that might crater by 50% or more in reaction to unfavorable news. To make it worthwhile being a long-term holder of such former wonders requires raiding reserves or selling other assets. The second sub-portfolio contains underperforming assets expected to perform better with a change in conditions, which is not unreasonable to believe.

The following example illustrates the principle. Currently, there are many investment categories that are underperforming the “market” gains of 20% or more. Many investors owning US domiciled earnings have benefited due to the strength of the US dollar, largely due to relative political conditions. While I do not know how long this will last, I understand math and markets and know that extreme imbalances don’t last forever. Thus, in this example I am suggesting a significant portion of the second sub-portfolio be devoted to non-US centric holdings. As foreign securities can be administratively difficult, most of our non-US holdings are in funds, mostly but not all in SEC registered funds or fund management company stocks.

The following is a list of country or regional fund investment categories with average returns below the Lipper US Diversified Equity Funds average, in spite of unfavorable currency comparisons:

China             +19.58%
European Region   +18.65%
Japan             +18.31%
Pacific Region    +14.65%
Emerging Markets  +13.45%
Latin America     +13.25%

For those investing in legacy long-term oriented accounts may wish to consider Frontier Markets +8.63% or India Region +2.27%

WHAT SHOULD CONTRARIANS DO ABOUT BONDS?
If you own individual high-quality bonds with a maturity date that fits a detailed financial plan you are exposed to the risk of market forces. Contrarians are always worried when they see excess flows into any asset. Bonds have become too attractive for many investors, particularly those advised by former brokers, now classified as investment advisors.

I am told that interest rates around the world are at levels last seen 500 years ago. Many bonds and bond funds have risen to levels where they have market price risk at the valuations they are currently selling. The table below shows the average total return for various bond fund categories, year-to-date through last Thursday:

Corporate Bond-BBB              +12.53%  
Flexible Income                 +12.22%
Corporate Bond-A                +11.13%
High Yield                      +10.88%
Emerging Market Hard Currency   +10.38%
Global High Yield               +10.34%



Question: Do you have a contingency plan for a slump?     


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Thanksgiving and Investment Performance

Introduction

Most cultures have a harvest festival where people give thanks for what they have gathered. I am particularly blessed by the opportunity to communicate with such intelligent people globally through both this blog as well as through my investment responsibilities. One of my investment blessings is uncertainty as to the future. Contrary to many people’s belief, uncertainty is the arena where most investment gains are made; as various elements sort themselves out prices will react appropriately. However once things become crystal clear the vast majority of the price movement has been achieved. Thus I am thankful for levels of uncertainty as I attempt to deal intelligently with expectations.

Expectations

Faithful readers of these posts know that I visit the nearby Mall at Short Hills each Thanksgiving weekend. My report this year is mixed. By far the biggest attraction with long lines of grandparents, parents, and children was an expansive display of products and photos based on Disney’s “Frozen.” I marvel as how successful the “House of Mickey” has been with a product that was in public domain that they didn’t invent, but brilliantly promoted. The other big winner was apparently the iPhone and related merchandise. The large Apple^* store was jammed, but did not have outside lines. A much smaller Verizon store was quite crowded. AT&T’s much too large store had a sprinkling of people within it. While this mall ranges from mid price points to high prices, the high-end stores looked quite empty. My walking conclusion is that it will be a good season for Apple and not so good for high-end shops. I do not have a big feel for the purchases over the Internet. Some retail groups have jumped on to it, Macy’s claims that it is the fifth largest seller on the net.

^*Owned by me personally and/or by the financial services fund I manage

From an economic viewpoint the absence of many “must have” purchases may mean that the savings (not spending) ratio will not retreat from its current 5% level. The use of debit cards is probably not going to soar.

Liquidity concerns

One set of expectations on the part of members of the SEC is the rapid redemptions in bond funds and ETFs when interest rates begin their “inevitable” rise. Quietly they are asking leading fund groups and their independent boards about plans to handle the expected tidal wave. Curious to me they do not appear to be as concerned about equity liquidity which I believe under the present shortage of trading desk capital could react just as quickly. In terms of investment performance in both the debt and equity markets, it has paid off to invest in large, but illiquid positions. We will be watching intently as to how those portfolios that have been more illiquid than others handle any significant squeeze on liquidity. (More on this relating to performance below.)

Longer term economic expectations

Pensions & Investments magazine (P&I) and Aberdeen Research conducted a poll on Macroeconomic expectations over the next ten years by region. The majority of respondents would improve as shown in the following ratios of improvement vs. decline:              

                  

Market Location	Ratio Improve vs. decline
Emerging Markets	47% vs.13%
Frontier Markets	36% vs. 18%
Brazil	33% vs. 17%
China	31% vs. 31%
Japan	16% vs. 11%
non-US dev.	11% vs. 7%
Canada	9% vs. 4%

Other major regions including US, UK, and Europe were expected to have deteriorating macroeconomics over the ten year period. I have little confidence that these projections will work out as expected. However, I believe that they are useful in understanding current price/earnings ratios in these markets.

Performance analysis

One of the elements that I am thankful for this holiday is that we are in deep discussion about managing one particular new account’s money. A vital key to a high level of satisfaction is to agree as to what is important to be measured. I have difficulty determining a worse measure to make decisions as to hiring or firing a manager than raw absolute performance or even relative performance to some securities index. These are not the primary tools we use in selecting funds for a portfolio of funds. As J.P. Morgan himself stated, he only loaned money on the basis of the borrower’s character. Thus we want to understand the managers as individuals.

We also recognize the need to be patient and that is why we look at long-term developments.

There have always been some spectacularly performing managers often with very successful sales people attached that I do not believe. Many times when I dig into their records I find a particular, undisclosed relationship that is the main engine of their success. Some of these engines can keep functioning for a number of years until they are found to be wanting. One of the keys to our analysis is to try to determine where the good and bad performance come from. In some cases all of the extreme performance comes from a limited number of securities. I remember one quite ordinary fund with a skilled portfolio manager salesman touting its good performance. When I looked further into the fund’s performance I noticed that all of the truly great performance was coming from a single analyst. I suspected that he would quickly find better employment elsewhere. When that happened the air was let out of the fund’s good numbers which eventually led to the sale of the management company.

The significance of turnover and fund flows

A rapid turnover producing a good record is not as valuable to me as one whose portfolio is turned over more slowly. The first fund may possess trading skills which are often relatively transitory while the second one may have real selection skills. As even the best investment managers have periods of significant underperformance, we need to understand both the causes of the underperformance and what the manager does about it. The impact of cash flows and how they impact the portfolio has a distinct implication to evaluating the result. Often a surge of money coming in can overwhelm either the position size or the number of holdings. (An important corollary of the surge is what the organization does with its increased profitability. Does it change the life style of the key investment personnel?) Withdrawals or redemptions can reverse some of the behavior changes. However, we are not disturbed by the outflows. I have never seen a portfolio that couldn’t benefit from some pruning.

The question that I am currently grappling with is how to introduce sound judgment into the investment performance question. With the large group of very intelligent investment professionals and sound investors reading these words, I appeal to you for help. Your assistance will give my accounts and me something to be thankful for.

__________    

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Beware of Future Crowding in US, Emerging and Frontier Markets

Introduction

The purpose of my blogs is to share musings as how to grapple with long-term investing as distinct from shorter-term trading. Most of the time my focus is endowment-type thinking, be it for my family or supposedly perpetual institutions that have some near-term funding requirements but whose main focus is to maintain the organization forever.

Bearing the above preamble, instead of my normal optimistic views, on a longer-term basis I am getting nervous. This anxiety could be caused by the fact that I am finding too many thoughtful investors have parallel views.

The US Markets

As regular readers of these blogs have learned, I have believed that there was more upside potential than downside risk. Since the beginning of the year we have seen currencies, bonds and stock prices rise. As somewhat expected, the general rise has been led by financials and smaller companies. Much of these moves are recoveries from past declines, nevertheless the following three facts are unnerving for someone not used to so much good market news all at once:

• The S & P SmallCap 600 index reached an all time new high.
  
  
• The NASDAQ index is at a 11 year high. (Still way below its former peak.)
  
  
• The Dow Jones Industrial Average has risen more than it has in the last 4 years.
  
  

These price movements are beginning to attract volume and many politically motivated people are becoming bullish. My problem with all of this is if one extrapolates the January gains achieved in some portfolios, one could start to hear about certain managers delivering at a 100%+ rate! My instinct is that this enthusiastic response will be met with a sudden and sharp decline. If the decline reaches 10% or more, it may allow the late-comers to participate.

Emerging Markets/Frontier Markets

Over the last couple weeks I have been focused on Emerging Markets and Frontier Markets, talking with a number of portfolio managers that have successfully invested in these two markets for many years. What is disconcerting to me is that I am hearing the same comments about various markets which can be summarized below:

• It will take a long time for corruption in India to subside to the level of other Asian counties.
  
  
• China is a mixed picture of large long-term consumer demand, but with near-term infrastructure hurdles and capital flight, some earned through corrupt practices. The two unanswered questions are when will there be sufficient east-west road and rail traffic to bring a rise in the standard of living to the hinterland cities, and whether the all-controlling government will continue to succeed.
  
  
• Smaller markets are attracting a good bit of interest; e.g., Indonesia is coming into its own with Western firms establishing offices there. The lowering of the high interest rates and the return to investment grade after many years of "junk" grade has been a big boost. There appears to be a short supply of stocks relative to demand.
  
  
• Africa is definitely of interest, with investments going into Ghana and Nigeria. Even local banks are of interest.
  

The fuel for these markets is coming from Europeans trying to escape the euro and the wealthy Chinese who are quite desperate to get money out of China. There are also negative reasons to invest in these markets; beware that exiting can be more difficult than entering. With all this enthusiasm, caution should be exercised.

Except for the real long-term investor, I would wait for better entry points that are less crowded.

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Yellow Alert: Second Supply Cycle Growing

As an analyst rather than a statistical extrapolator, my mind searches for what can go wrong thus forcing a meaningful deviation from the current trend. In last week’s blog I headlined the twin concerns of “blood in the streets” and the impact of possible contagion as an aftermath of the civil unrest in Egypt. In terms of the markets in the developed world, the impact of last week has not yet been felt in general. The markets, at least for now, seem to be more insightful than the politicians and the English speaking, liberal-tinged press. What we may be seeing in Tahrir Square in Cairo is no more than 250,000 actors in a manipulated intramural contest between the President and the military establishment to bring about a reasonably orderly succession. Thus far, my initial concerns were at least premature or possibly inaccurate. I recognize that these events can well escalate into more meaningful dangers if new actors are released on to the scene.

As part of my functional worrying about the future, last week’s exercise was useful in highlighting what could go wrong. In the same vein I see significant potential market problems arising beyond the near term investment horizon.

The Two Supply Cycles

Many economists disguised as securities analysts or portfolio managers focus on the national generation of economic data. When the data turns positive they become bullish, even though well functioning markets have discounted these turns and have moved prices from the fundamentally cheap levels into the fairly priced levels that are only attractive relative to past valuations and/or other markets. At this point in time, the number of truly cheap investments has shrunk. Investments are cheap when their entire market capitalization can be acquired at a substantial discount from a readily available price, which includes quickly liquidating the company. The cheapest of the cheap are those that can be liquidated at a profit by just converting their current liquid assets against all of their liabilities. These situations are known as “net-nets.” Net-nets are always difficult to find, but can be discovered in all market environments. There are more of them to be found before the published data on the economies turn positive. As the economic data becomes more robust, confidence returns and people and businesses increase their spending and consumption. This increase in supply of good news meets with the demand driven by investors to make up for lost time in the recession. First, they want to restore their capital base to their former peak loads and second, they recognize the need to grow their insufficient retirement capital funds. The frenzy created by this “ever- growing” supply and demand convinces these economists masquerading as portfolio managers and strategists that they have entered into a long lasting bull market, thus they adjust their policies to take on more risk (which they believe is mispriced in their favor).

There is also a second supply cycle. While dependent upon the first cycle to get started, in modern times this second cycle becomes larger than the first at its peak. When it falls, it produces more financial pain than periodic declines in the first cycle. The second cycle deals with the production of securities, funds of various types, and derivatives to give investors and speculators ways of participating in the primary first cycle. One well known example of this is gold. The size of the “paper gold” market is considerably larger than not only annual gold production and “consumption,” it may well be approaching the amount of gold held by all the central banks. We find paper gold in derivatives like futures, gold backed bonds and now bullion or coin owned by exchange traded funds (ETFs). I am excluding the funds that own shares in gold mining companies which is, in effect, a derivative of the price of gold.

The Current Increase in the Second Supply Cycle

For several months I have been dealing with an accelerating number of private fund offerings in my capacities as a member or chair of institutional investment committees, a professional portfolio manager and private investor. Each of these offerings is focused on emerging or frontier market (a frontier market is less economically developed than an emerging market) opportunities in general or in specific countries. The level of enthusiasm of the promoters and their sales forces is matched with high fees and expenses. These costs are for the privilege of locking our money away for some period of time without addressing a fear of the return of redemption gates beyond the lockup period. We have not yet seen much in leveraged plays being offered through the use of borrowed capital. This would be a possible future sign of a top in the cycle.

At some point, the sheer size of the second form of supply cycle may impact the primary supply cycle. This week we saw larger net dollar redemptions from Emerging Market ETFs than from managed mutual funds of the same sector. The ETF owner is fundamentally a price speculator and/or hedger. Many mutual fund owners expect to invest for the long term, on average beyond three years, to benefit from the perceived longer primary supply cycle. In my book, MONEYWISE, and previous blogs, I have written about the risks created by co-investors. The risk is that they want to get out of an investment at precisely the same time that you do. The rush to the exit (if you can get out at all) will be met with lower prices. The nature of the fund-raising for these new private funds is very performance oriented. Long-term investors like us need to be aware of the co-investor risk from the new players.

What do you Do Now?

• I suggest that one stay with present sound investments and continue to deploy cash reserves.
  
  
• Despite my relative bullishness, one should expect some “air pockets” with sudden sharp declines followed by a general, but not specific return to the upward pressure to get more heavily invested.
  
  
• We should be alert to signs of peaking. If a peak does not occur before, I would expect one by 2013 which will be a politically difficult year for investors. The appropriate mix of strategies for the next three years should include both strategic as well as tactical considerations which is a difficult prescription for many investors.

What do you think?

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