Fragments Prior to Fragmentation - Blog 829

 

      

Mike Lipper’s Monday Morning Musings

 

Fragments Prior to Fragmentation

 

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

   

 

 

Historic + Military Learning

Some have said, if you scratch a good security analyst a historian will bleed. If you add in two other variables, learning from military training and exposure to the racetrack, you will understand much of my thinking. In fearing World War III, one should start with the German General Staff study of the American Civil War and the Peace efforts prior to and post WWI. Long periods of relative peace can be achieved most of the time if intelligent leaders continue to plan for economic and military hostilities.

 

Since we don’t know what the future will bring, we should study every fragment of information available and track developments that might lead to dangerous conflicts. Few peacetime leaders are equipped to be successful war leaders, and often they make war inevitable. I believe a lesson from one of the various “war colleges” is that war is another way to conduct political change. Our political leaders increasingly use an “anything goes" approach to cling to power, ignoring the vulnerabilities they are exposing for our adversaries to exploit.   

 

In retrospect, it has become increasingly clear that WWI and WWII were inevitable. The threat of nuclear war and some of our world leadership has held off WWIII, hopefully forever. Due to improvement in tactical nuclear and other weapons, there is greater risk today than in the past. We need to review all fragments as they appear and be watchful of those which could harm us.

 

Dangerous Fragments Past & Present

In the 1920s, the general urban population looked askance at criminal controlled bootlegging but enjoyed the local speakeasies. Today’s version of this attitude is the general disrespect for most members of Congress. Although they continue to support their local representatives, or for the younger set, the local ‘pusher”. We seem reluctant to reform our own process of offering debt forgiveness in the hope of gaining votes. They don’t seem to see these stimulants as bribes, much like the circuses that led to the fall of the Roman empire.  

 

Daily Stock Markets React to Central Banks Words

On Thursday, 27 % of the “Big Board” stocks declined, with 38% falling on the NASDAQ. The next day, 64% of NYSE issues fell, with 63% falling on the NASDAQ. The only difference was many traders finally believed the clues given regarding the possible number of interest rate cuts this year. (They paid no attention to the view that the next rate move by the Fed could be up.) Most of the time investors stay focused on their long-term needs and don’t react to politicians and pundits.

 

Fragmentation Becoming More Popular

On many days more stocks go up than down. This week, 21 of the 28 foreign markets Barron’s tracks rose. However, in the US only the momentum index has gained double digits over the last two months.

 

What is the Remaining Upside Left?

While it is popular for market leaders to mention their gains from the  bottom, the payoff for today’s investor is what is left? Jeremy Grantham, Chair of GMO, has generally held a bearish view but has generated good long-term performance for the funds he supervises. He mentions that if one uses the Shiller P/E, the market is in the top 1% of its history. A more significant observation is that many analysts use both P/E and profit margin, which are linked, so they are double counting. (Profits = Earnings, which is the driver of margins)

 

Today’s Parallels with WWI And WWII

Russia is in fighting a war in Eastern Europe, with Western Europe supporting the locals. The US is in a trade war with China and is constraining trade. Our opposition is getting stronger, although we are having trouble convincing people that they need to fight. This reluctance exposes our current weakness to our adversaries, giving them reason to cheer.

 

The markets generally seem to be ignoring the geopolitical hot spots accumulating around the world. There seems to be a perception that we can ignore these problems as they are occurring in some distant land. However, these problems are now surfacing closer to home and their citizens are increasingly arriving at our borders and making their way into the country. The situation is putting significant strain on resources and budgets, at a time when pet projects are already being funded in the hope of attracting the support of an expectant electorate. This spending is unsustainable in the long-term and creates additional vulnerabilities for our adversaries to exploit.  

 

 

 

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Building Long-Term Investment Portfolios - Weekly Blog # 720

 

Mike Lipper’s Monday Morning Musings

Building Long-Term Investment Portfolios

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

After the Valley

We don’t know what future investment markets hold for us. Nevertheless, we have an obligation to those who rely on us to guide their assets, both currently and when we are no longer around. The nice part of the latter responsibility is, we won’t suffer the consequences.

Based on both recorded and geological histories, we expect the future will contain both up and down periods. We often don’t know which type of period we are in or going into. Unlike most others, I am professionally imbued with a need to plan, no matter how wrong the projections may be.

I start with the premise that we are on a winding slope of a market decline. The following are brief abstracts from four highly respected investment leaders, which in total point to a downward slope:

Goldman Sachs - Expect lower returns for market indices

T. Rowe Price - Global growth is primarily dependent on China

GMO Capital - Stocks are expensive and resources are cheap

Merrill Lynch - Late stages of a maturing bull market

Thus, I have started to prepare a portfolio of both stocks and funds that would benefit from a subsequent rise in the global stock market.

Cyclical or Structural Decline?

A cyclical decline essentially corrects for overly enthusiastic valuation measures in earnings multiples and/or the attractiveness of current yields. Most market declines are of a cyclical variety and are quickly corrected. 

The problem with assigning a cyclical label to the expected decline is history vs outlook. Due to excessive government stimulus spending, many corporations have reported unsustainably high earnings growth, with earnings growth much larger than revenue growth. First half 2022 earnings growth rates are going to look puny compared to the first half of 2021. Many companies will show modest growth compared to 2019. 

One should recognize that for ten years or more price/earnings ratios have expanded and have been a meaningful contributor to prices increasing dramatically more than economic growth. Thus, there is a reasonable probability that the coming recession will be a cyclical one. However, there is a historic example of the federal government taking a cyclical recession and turning it into a structural depression, by implementing radical policies to reorient society. The President that did that based on his “brain trust” was FDR, who is a model for the current resident in The White House.

Is there a societal need to reorder our economy and society? I suggest there is a need to reverse the damage done by the school system, which has produced students who cannot find jobs due to both their behavior and lack of educational discipline. Increasingly, the growth in STEM jobs is overseas, a precursor of future relative economic growth. A structural decline is somewhat unlikely, but one should consider it in developing investment portfolios.

Four Portfolio Approaches

Large-Caps

Most individual and institutional investors prefer to invest alongside others. That is why 30.3% of mutual fund investors are invested in Large-Cap funds, with an additional 19.8% invested in S&P 500 Index funds. While the stocks in these portfolios get most media and pundit coverage, there is “decay risk” lurking. Over the last 100 years, not one company on the largest companies list has survived in the Dow Industrials Index. As the old saying goes, success breeds failure. Companies reach their peak relatively quickly and become more interested in maintaining position rather than growing, particularly in new products and services. 

Small-Caps

In many, if not most time periods, small-cap aggregate earnings grow faster than the largest-caps. However, there are four drawbacks to investing in small-caps.

1. They have a higher rate of business failure, with the larger ones being rescued.
2. Some of the better small-caps are bought by larger companies, cutting off their price growth.
3. Lack of media and analyst coverage leads to greater volatility.
4. They have an absence of critical talent at stress times.

“Barbell”

A favorite technique of the investment community is to take two extreme positions and “barbell” a portfolio, e.g., large-caps/index funds with small-caps. The absence of selected mid-caps and internationals, or enough heavily weighted winners, can produce poor relative returns.

Idiosyncratic Selection

Idiosyncratic selection from the entire global marketplace. Many investors who practice this artform kid themselves, as there is great similarity in their selections. The following is a list of characteristics that can be limiting to successful investments at times:

• Best Product/Service
• Top Market Share or Fastest Growing
• Great CEO (Replaceability risk)
• Lack of Debt or Too much Cash
• Institutionally Owned (Liquidity risk)
• High earnings growth (Unsustainable)
• Smart Ownership
• Large customer base (High renewal potential unless market changes)
• Well-connected within industry and government (Things change)
• Estate and other ownership issues
• Speaks ESG language (Plus or minus?)
• Never moved headquarters
• Strong social connections 
• Ownership too concentrated by age and type of investor
• Etc, etc, etc.

Career Investing

Current and future persons making investment decisions should view themselves as career investors. Part of career investing is accepting periodic mistakes and learning from them, but also carefully exploring fields for potential investment, particularly beyond current borders.

What are your thoughts 

  

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https://mikelipper.blogspot.com/2022/01/things-are-seldom-what-they-seem-weekly.html

https://mikelipper.blogspot.com/2022/01/two-critical-questions-weekly-blog-717.html

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The Wisdom of 3 Wise Men - Weekly Blog # 663

 

Mike Lipper’s Monday Morning Musings

The Wisdom of 3 Wise Men

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

                   

Those who spend a great deal of time, energy, and emotion investing are truly “career” investors, whether they do it for a fee as a professional agent or as a personal investor. The successful ones focus on areas beyond security selection, including policy decisions. They are scouts leading away from capital destruction and toward capital appreciation. To do this, their natural position in the march of time is to be way ahead of the parade of followers of current trends. Successful investors are often lonely, fearful of falling into an avoidable trap, often searching for clues that others have found.

US investors will suffer a new government beginning in ten days, made up mostly of career politicians who participate in a former government producing slow, uncertain growth and loss of relative strategic power. Asia, particularly China and to a lesser degree India, plus the Middle East and Africa, represent challenges and opportunities likely to drive higher investment returns relative to those in Continental Europe. Under these circumstances, as a contrarian, I am paying attention to three investment wise men.

Jason Zweig wrote in this Weekend WSJ, “In theory investing is all about markets: in practice it is more about marketing.” Jason was addressing the old tale that stocks and funds are not bought but are sold, largely based on the marketing of past performance. The easy approach for salespeople and others is to extrapolate the immediate past. In the commodities markets, which often exhibits long trends, there is the motto “the trend is your friend”. My study of sports, economies, politics, and markets is that all trends either end disrupted or exhausted. The longer the trend, the more competitive forces will seek to replace the presumed longevity of the trend.

Jeremy Grantham of GMO points to the career risks of being too premature about future drastic changes in direction. He was admittedly three years early before the Japanese market topped out. In another instant, he lost half his clients in one strategy by being premature. The lesson here is to gradually withdraw and add to various sectors or philosophies. While it may be emotionally satisfying to go “all in” or “all out”, it is extremely arrogant in terms of career risk. We should also remember that the prime function of markets is to create humility. We can be wrong.

Benjamin Graham has been called the Father of Security Analysis and was a successful fund manager with both wins and losses. He said “Never mingle your speculative and investment operations in the same account, nor in any part of your thinking”. I don’t remember when I came up with the idea of creating sub portfolios for different purposes, but earlier he was focusing on different approaches for different investment purposes. At the racetrack it is called “different horses for different courses”. 

I often advocate sub-portfolios for different time periods to meet spending needs. As the weakest securities disappear in terms of impact over time, the longer a portfolio functions the greater the odds of success. Almost all the accounts we have held for twenty years or more are profitable. Under today’s conditions of increased uncertainty, I wonder whether two new sub portfolios should be set up. 

• The first would have a four-year duration based on the probability that much of what the incoming administration accomplishes will be reversed by a new administration in 2024. I am particularly focused on tax rates and regulations. 
• The second trading portfolio would have a one-year focus based on the effective timing of new legislation and executive order implementation. It would trade on the rumors of the progress of various political actions. 

Despite the financial media focus, the bulk of equity investments are long-term, both for retirement and estate building purposes. We have just finished an above average ten-year period where US Diversified Equity Mutual funds averaged an annual gain of +12.69%, with the median fund rising +11.71%. To do better than these results one needed to be invested in growth-oriented funds, which were more volatile than other stock portfolio peer groups. I have doubts that the next ten years will be as good as those in the past. Considering my outlook for interest rates, inflation, the value of the dollar, demographics, and technology, performance of no more than half the level of the last ten years might be viewed as heroic. One might even predict a lower return. (Interestingly, if we did experience a low ten-year growth rate, the following ten-year rate would probably be much higher.)

Current Updates

• For the first week of 2021, the average S&P 500 Index fund gained +1.30% vs +2.59% for the average US Diversified Equity fund, continuing the pattern of underperformance delivered in the last half of 2020.
• The AAII weekly sample survey of its members’ views for the next six months is 54% bullish and 26.6% bearish. Market analysts treat this as a contrarian indicator. 
• An interesting mathematical insight is that these ratios are approximately 2 to 1. They are in the extreme range and I would not be surprised if they reversed, with the S&P Index funds doing better and the six-month trajectory of the market doing worse.
• The JOC-ECRI Industrial Price Index remains stubbornly high, generating a +26.6% gain year over year.
• Truck tonnage carried is moderating an early spike.
• The S&P 500 was up for the first five days of 2021 and more often than not that heralds a positive year. The full month of January is a stronger predictor.

Critical Question:

Do you regularly examine your investment policies or is most of your attention spent on security selection?

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https://mikelipper.blogspot.com/2020/12/stud-poker-new-swamp-game-weekly-blog.html

https://mikelipper.blogspot.com/2020/12/mike-lippers-monday-morning-musings.html

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Implications of China vs. US Timespans

Introduction

A number of years ago a good friend attended a Chinese Embassy party where a very senior member of the government commented that while the West owned the watches, the Chinese owned the time. This critical distinction has stayed with me in terms of looking at investment horizons.

One Belt One Road

While there has been some US coverage of the “One Belt One Road” meeting in Beijing this Sunday hosted by Xi Jinping with Vladimir Putin in attendance, most of the US attention has been focused on the dismissal of one employee at the discretion of the President. As a long-term investor, I believe this is a misplaced focus. On the Chinese side the implications of the massive One Belt One Road Initiative may have implications into the next century. The US focus appears to be on the electoral contests in 2017-2020.

I find it is interesting that China is using a staging investment philosophy somewhat similar to our TIMESPAN L Portfolios^®. China announced some of the outlines to this the One Belt One Road Initiative in 2013. From an economic vantage point it was a brilliant way to export its excess steel and cement capacity in building long line railroads and some internal subway systems. It also would reduce shipping costs of Chinese manufactured products that potentially could be exported to 60 countries, part of the land and sea bridges.  This is somewhat like President Eisenhower's US interstate highway building program that required new federal highways to be built with the ability to handle the transportation of heavy tanks.  As the rail and port facilities are built, China (even without moving its military) will have strengthened its ability to influence all of the surrounding countries. Some have called this drive as "Globalization 2.0.” Compared to the Russian leader in attendance, the US is sending a senior director for Asia at the National Security Council. While there is definitely a military threat in this initiative, by far the bigger threats are economic and political.

The One Belt One Road Initiative is not without substantial  risks. The planned funding requires a series of public/private partnerships. Every analyst and most investors should have knowledge and respect for past histories. Around the world in the last half of the 19^th Century, there was a surge of railroad building. The British were particularly active in South America. I suspect that almost every railroad company started during this period eventually went bankrupt. In one case the largest and most powerful UK merchant bank almost went under because of its Latin American exposure. I can not think of a long line US railroad that did not enter or threatened to enter bankruptcy. Some of the same problems exist today. One of the Chinese-backed African rail lines is not expected to reach breakeven for the first eleven years, and we all know how reliable the predictions of breakeven have been. 

If we of short memory fail to remember the global distribution of less-than- healthy US residential mortgages, we could have a replay with global distribution of private partnerships through the growing power of Chinese financial services companies. Thus, for the global investor there is both downside and upside as this initiative grows. I maintain that no matter what you invest in; stocks, bonds, commodities, real estate, currencies, or intellectual property, your returns could pivot on what is happening or rumored to be happening in China.

What are the US Markets Focused On?

Investors into the US market are focused on the very short-term to intermediate future while China is exercising its long-term options.

The following are briefs tidbits that have crossed my computer screens this week:

1.  Dow Jones Industrial Average - A minuscule decline closed on of the two price gaps in its current chart. The other two major stock indices, S&P 500 and NASDAQ, still have price caps. (One wise market analyst suggests that we need a 5% decline before we can resume a meaningful upturn.)

2.  JP Morgan has noted that 37% of NYSE volume is executed in the last half hour of the trading day as Index funds rebalance.

3.  There is some justification in the adage “Sell in May and Go Away.” Since 1950, the period November through April does better than the other six months, 71.64% of the time.

4.  According to its inventor, the CAPE ratio, used as a valuation measure, explained about 1/3 of the variation in the ten year returns. (Surprisingly this is roughly the same chances of a favorite winning in most horse races.)

5.  Ray Dalio, who manages one of the largest hedge funds, sees no major economic risk in the next year or two. (This could be an important cautionary flag.)

6.  The highly respected GMO seven year prediction for real return on stocks is -3.8%

7.  Vanguard believes we are in a period of slow growth; e.g., a 60/40 asset allocation will produce a return between +3% and +4.5%. (If they are correct, which I doubt, the average foundation will be liquidating its base each year if it has a mandated 5% pay out.)

8.  Turning to the increasingly popular European investing, there are two points worth considering: (a) the current price of the Stoxx 600 Index is where past rallies have peaked out, and (b) over half of the ETF flows into non-domestic funds came into three Index funds and these were somewhat smaller than the ETF redemptions in two domestic Index funds. (These suggest to me that main players in the ETF market are trading-oriented, and may not be patient during surprises.)

Investment Conclusions

Despite the reputation of highly speculative retail Chinese investors, the Chinese government is playing a long game.

The US market is increasingly short-term focused. This may, over time, give us longer term investors a bigger barrel to fish in.

As we structure various markets I am wondering whether our assorted valuation measures need to be adjusted due to fundamental changes in supply and demand.

Any thoughts? 

__________

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Another Victim of FICC Groups

• Where the Past Problems Generated Profits and Troubles
  
• Seven Immutable Laws of Investing
  
• The Currency Game
  
• The Interactions of Man and God
  
• Paper Money, Deficits and Hyperinflation
  
• We Are All Players-The Best Defense is a Good Offense

Where the Past Problems Generated Profits and Troubles

In an earlier era there was, in theory, a sharp distinction between brokers who were meant to act as un-conflicted agents and investment bankers and other dealers who were viewed as principals using their capital to enrich themselves. This theoretical distinction disappeared years ago, and its disappearance was reinforced by the combining of commercial banking activities with those of underwriting and market making. Out of this stew came the last financial crisis, through the sale and securitization of mortgages and similar debt instruments. The groups within the large financial conglomerates are labeled “FICC,” which stands for fixed income, currencies and commodities. Past blog posts have mentioned the growing attraction of the commodities segment to “investors” (really speculators) and the firms that service them. My concern with this blog are the $4 trillion dollar a day currency markets.

Seven Immutable Laws of Investing

This weekend I read an excellent piece by James Montier of GMO which many of us knew as Grantham, Mayo, Van Otterloo & Co. The seven laws are the following:

1. Always insist on a margin of safety
   
2. This time is never different
   
3. Be patient and wait for the fat pitch
   
4. Be contrarian
   
5. Risk is a permanent loss of capital, never a number
   
6. Be leery of leverage
   
7. Never invest in something you don’t understand

While we all should obey these seven laws all the time, for many of us this could lead to very little investing on our part. However, I urge all to apply these rules to their thinking when addressing the investment in currencies as an asset class.

Currencies can be traded by themselves in original form or through derivatives. This week, Barron’s published two articles that focused on currencies. The first piece focused on the growth of the market, some of the reasons for the growth and the use of ETFs to play the game. (An interesting point was made that it was better to short a currency ETF than to buy a bear-focused currency fund.) What the article did not stress was how much of the FX trade was leveraged by the use of various forms of derivatives or “margin” purchases. The second article was an interview with Ray Dalio of Bridgewater Associates, which has $90 billion under management. This interview focused on the difference between large deficit producing countries/currencies and those that have small deficits. Dalio favors the latter. I would suggest that unless you are in the FX markets everyday because you are hedging a stream of operating transactions, that currencies as a separate asset class fails the Seven Immutable Laws of Investing. Future exchange rates are not guaranteed or even have the same sense of reliability as do the maturity value of high quality bonds. Money has been traded around the world since the beginning of recorded time as noted in the Bible. Therefore, this time is not different.

One rarely sees a “fat pitch” (a perfect, or “too good to be true” pitch) that is advertised; note the FX dealer ads on the financial networks or popular press articles. The reason I mentioned shorting an ETF that is long a currency, is that is a contrarian move. From my own viewpoint, the short interest on the ETFs that hold Canadian and Australian dollars suggest that these may not be contrarian enough to be safe. Many of the academically trained participants in the market will look at the past movement of a currency and calculate the standard deviation around a 36 month trend line, and label this volatility as risk. Whereas risk is the permanent loss of capital, occurring when a government dramatically changes what its currency is tied to.

The second derivative of risk is not just the loss of capital, but the loss of the productive use of the capital. The problem with leverage, either through direct borrowing or through the use of derivatives, is that there is always a payment date that can be extremely inconvenient. Unless one clearly understands the real political pressures on the various central banks and how they in-turn apply pressure to their principal dealers, I would suggest that there is a lack of understanding that makes currency trading problematic.

The Interactions of Man and God

There are two old sayings that are worth remembering: “Man plans and God laughs” and “Man proposes and God disposes.” As long term investors, we try to think about the future, matching future streams of income with spending needs. In the past, many employers and their employees felt secure in terms of retirement on the basis of an average compound earnings rate on their capital of 8% or higher, with an inflation rate of 2%. That is not the world we live in today nor for the last several years. Not only were the forecasts very wrong, most investors did not have strategic reserves that could be applied to adjust the returns to meet some or most of their spending needs. The problem with reserves are that they don’t earn much money; effectively zero today, adjusting for published inflation. Even if we were smart enough to build strategic reserves, the removal of this capital from the higher earnings pools will reduce the overall return on the entire capital base and therefore a cut in spending plans will be required. That is an extremely difficult message for us to get accepted by various investment committees and wealthy families.

Paper Money, Deficits and Hyperinflation

One of the attractions of using currencies as an asset class is to escape too much reliance on any one currency, read US dollars. As most currencies today are not convertible into hard assets by their individual owners, the name of the game is to gravitate to those other paper currencies that have substantial excess earnings power that the issuing government is not spending. The current trends are not favorable either for the US or the UK, and many feel most of Europe, beyond Germany and Switzerland, is beyond hope. The US deficit is approaching the tipping point of 20% of federal government spending. Beyond 20% there is a very strong historic trend to go into hyperinflation, which will make most fixed income investments unsalable. (Thus, one can see why the FICC groups are building up their sales forces in the commodities and currency arenas.) If there is some chance of hyperinflation, one can see the investing public as reluctant to commit to what is probably a fairly priced, large capital equity market.

We Are All Players- The Best Defense is a Good Offense

In this blog, my intention is to cast doubt on adding to one’s present investments, suggesting the need for strategic reserves and altered planned spending. I further recognize that the earnings on today's strategic reserves don’t help the unavoidable spending needs. In response to these dilemmas, my training from the US Marine Corps makes me search for a good offense as a best defense. While I have some ideas to be shared at a later date with my clients first, I am not comfortable that these are the best or perhaps not even good moves on the offense.

I appeal to this blog community to suggest currently good long-term investments or sound strategic reserve elements that can be used for a narrow base of clients or shared with this entire blog community.

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Why Some Individual Investors Produce Better Results than Investment Committees

This statement seems counter intuitive to the practice followed by most of our great non-profit institutions. I am going to use as my point of departure a talk given by Jeremy Grantham, a very original and thoughtful thinker who is the CEO of GMO, a Boston-based investment management group. Jeremy’s October 7th, 2009 talk was entitled “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” The talk focused on the potential disadvantages of Graham and Dodd-type investing. A little background may well be helpful for the members of this blog community who are not professional investors and/ or securities analysts. Columbia University is extremely proud that both Benjamin (Ben) Graham and David Dodd taught at Columbia and wrote the fundamental bible for analysts, not surprisingly titled “Security Analysis.” I had the great experience of taking the course under Professor Dodd when Ben Graham had fully returned to his investment management activities. The essence to the text and the course was to seek out value as the basis for investing in both bonds and stocks. This task was to be done by professional analysts using financial statements to find stocks and/or bonds selling below their current value. I remember arguing with the good professor, that while finding price disparity was nice, it was likely to produce a lower return than by finding prices that did not adequately reflect future value. While Professor Dodd did not totally disagree with me; he felt that there was less risk of loss by pursuing value than by following a future-focused growth approach. (At the time I was not conscious of the investment career of one of Ben Graham’s students, Warren Buffett. When Buffett looked at an underlying business, he created sensible measures of quality not found in financial statements, thus adding immensely to the valuation equation.)

Grantham's Criticism

Jeremy’s main criticism of the value-oriented investors is that they are not sensitive to the extremes in the marketplace. The value investor conducts his or her investment search the same way in up and down markets, always looking for the cheap jewels in the expensive weeds. This practice can lead to many years of gains which leads to value investors focusing exclusively on the search for value, as defined by low price/book value. Jeremy points out that when cataclysmic changes occur in the market, these investors are not prepared. At the 1932 bottom, 41 years of previous gains were lost. Ben Graham lost 70% in that market collapse, in part because he was on margin (using borrowed money). Among the others who lost a bundle earlier in currency speculation were Lord Keynes, also a user of margin. Some more trading-oriented investors recognized the extremes, like Roy Neuberger, who was short (selling shares that he did not own, but borrowed) going into the crash.

Two Critical Questions

Two critical questions came out of this experience. The first is to question the effectiveness of diversification, an accepted part of investment dogma today. The goal is to hold many assets that don’t go down at the same time, thus preserving capital. The only problem with this principle is 2008, when practically every asset class around the world rolled over into a decline of mammoth proportions. There were some, very few, investors who did not suffer substantially. I personally know of no investment committee-led institution that avoided the decline, but I do know of a few individuals who appeared to have escaped the onslaught. This realization leads us to the second critical question: Why did so many investment committees, made up of honest, hard working, investment professionals (our British friends call them “worthies”) have such bad performances?

"Prudence"

There are two parts to the answer. The first is that the legal charge to fiduciaries is to act prudently. The guiding principle comes down from the ruling by Judge Putnam in 1830 in Harvard vs. Amory, where Harvard lost the case because it did not act prudently. “Prudently” was defined as how other men of intelligence and prudence would have acted in their own accounts. In effect this set up peer-focused comparisons. This was the intellectual foundation of the Lipper Mutual Fund Performance Analysis, which made money by creating appropriate fund peer groups and measuring performance for mutual fund directors. Thus, a fiduciary that is doing approximately the same thing as his/her peers, is being prudent whether the account is going up or down in value. While this prudence fulfills the minimum requirements and answers the career-risk issue for trustees and investment managers, it does nothing to fulfill the desires of the client. The non-profit needs to pay operating expenses and occasionally capital expenses, therefore it may not be well-served by “prudently” losing money. Why then are some individuals better able to produce results than the combined brain power of a group of the worthies?

The second answer is best summed up in a quote that Jeremy uses from Warren Buffet. “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.” The very function of an investment committee leads to prudent actions. I am currently chair of three different investment committees. I find that after an informed, polite discussion, a consensus is formed which rarely calls for taking an extreme action. Members of all of my committees are well-meaning people who have volunteered their time (and quite often their capital) to the institution. We almost never have the sharp disagreements that often occur within corporate or family partnerships. I wonder whether the pleasant decisions are of the same quality as the more intense discussions?

Individual vs. Group Decisions

I believe that Warren Buffet would suggest that at critical turning points, an individual’s decision-making is better than even an intelligent group decision process. Buffett might even favor a strong personality over an agreeable one. I know that trustees that do not ask the tough questions are not acting in the long term best interest of their institutions. They should find their friends elsewhere.

One of my sons and I will see whether Warren comments on this topic while we attend his annual meeting next Saturday. Stay tuned.

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