Secular Investment Religions - Weekly Blog # 835

 

         

Mike Lipper’s Monday Morning Musings

 

Secular Investment Religions

 

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

   

       

Timing of Views

Apple announced its first calendar report this week, continuing a pattern of declining comparative quarters, albeit with a smaller percentage decline and slower sales of its latest iPhone model. Later in the week Berkshire Hathaway reported its first quarter results showing it sold 13% of Apple, its largest holding. During the Berkshire presentation I became increasingly concerned about the long-term outlook for US large-cap equities.

 

My worries were summarized in a column by Mohamed El-Erian for the Financial Times. He stated “tighter regulation, industrial policy, chronic fiscal looseness and internationally globalization has been giving way to fragmentation” as concerns.

 

Attending Berkshire’s annual shareholder meeting this weekend, I read a slide showing the major sources of the firm’s net operating income after taxes. One of the reasons to go to the meeting is that they report the results of the over 60 wholly owned and majority-owned companies in summary. In aggregate, their growth in earnings has slowed down or fallen. Most of these companies produce products and services used globally. Despite record domestic stock prices, it appears we are probably going to see an economic decline of measurable depth and magnitude. The questions that remain are timing and whether the decline is cyclical or structural. These questions forced me to examine the nature of these two remarkable companies presented this weekend.

 

Share Owners Create the Nature of Ownership

While management of the company largely dictates the nature of most companies, owners of the stock determine the nature of ownership of the stock. As both stocks are within ten percent of their all-time highs, there are very few losers in the stock. Both are multi product companies that provide services to both individuals and wholesale users. The companies have long outgrown their original set of products and services and their reputations allow premium positions within our society. While they have some competitors, they have no overall copycats. Their exact futures are not clear, although many users and owners have a great deal of faith in them, even though they don’t really know what their future will be. Without being sacrilegious, these two stocks have reached the point of being a religion in the secular world. Regardless of the existence of doubters and some heretics, it would take a major violation of the trust that has been established to destroy their faith in these two companies. (This has happened in the past, a couple of generations ago when the “Generals” were the secular religion, as in General Motors and General Electric, and many lesser Generals.)

 

Management Mistakes Admissions Help

Apple finally gave up on Project Titan (their car project). Elimination of their car project will allow Apple to conserve some needed talent. A complete car is a very different business and is not highly valued. Motorola lasted much longer, from its taxi and police car two-way radio in its early days to the semiconductor and early mobile phone years. On Saturday, Warren Buffet admitted he made the decision to sell Berkshire’s losing position in Paramount. While they were a supplier to Amazon, they didn’t buy the stock or another tech company until Apple.

 

Pulling the Thoughts Together Early

Revenue leverage in an inflationary period is unlikely to be maintained as a growth driver with small unit growth. Around the world, unit growth is decelerating. Productivity is also slowing because new hires are not as profitable as the seniors let go, even though juniors are initially paid less. However, lower pay expenses do not last long, as fringe benefits are more expensive, except for retirement. Retirees have not built-up enough savings to cover expenses in a non-work period. Productivity, where it exists, is driven by non-domestic born labor. Birth levels are below replacement needs and the education system is not producing ready, willing, and educated workers. AI gains, if delivered, will probably help the middle class but not the lower classes. The push for fewer working hours will create additional expenses and possibly social problems.

 

We need Berkshire Hathaway, Apple, and others to succeed for a healthy society around the world. Long-term it must be global, let’s hope it happens.       

 

 

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Selections - Weekly Blog # 710

 

Mike Lipper’s Monday Morning Musings

Selections

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

Premise

One might say we make lots of selections each day, consciously or otherwise. One of the reasons I rely on lessons from betting at the racetrack is that it forces selection based on known and unknown criteria. The same can be said of investing.  In both cases there are active and passive decisions, although passive passes the decision making onto others. 

In almost all activities, particularly completive activities that can be measured, I try to improve my results by shading the odds a little in my favor. Experience is the best teacher, but each experience should be analyzed. The easy part of the analysis is the number of active participants, locations, length of time, and rewards. What is not easy to determine is the motivation of each participant. A reasonable attempt to figure out motivation is to examine the history of similar activities by participants.

Goals

The strongest of all goals is survival. Survival first requires the preservation of capital by limiting losses and participating in gains. If one wants to grow capital, lost capital must first be made back up to the starting capital level. Actually, return to the original capital level is insufficient, as there are expenses and taxes which reduce initial capital. In today’s world, the appropriate measure of capital is current spending power vs spending power at the beginning. Thus, changes resulting from inflation and foreign exchange need to be calculated and incorporated.

From a Historical Perspective

All life is cyclical. We know our results probably contain ups and downs. Psychologists tell us we normally feel twice as bad about loses than the pleasure of gains. One smart family financial office measures losses, including purchasing power, vs gains achieved. Their goal, which they have achieved, searches for opportunities that will produce gains twice as large as their real adjusted losses. With those concepts as a guide, I first examine the outlook for losses.

Outlook for Three Levels of Losses

Currently, most global stock market indices are showing year-to-date gains. While down from the peak levels of early spring, the gains are greater than those earned in the last two, three, and five years. These gains have been derived from the even larger gains of a small minority of stocks. My guess is non-indexed accounts produced smaller gains. There have been a significant number of absolute losers. The Financial Times recently published an article with the following headline “Half of this year’s blockbuster IPOs are underwater, despite broad stock rally”. They further note, “Goldman has led on 13 deals that raised more than $1 billion this year, but nine of these are now in the red” … ”Six of the 14 deals led by Morgan Stanley were trading below their IPO prices”. I suspect an important portion of these underwritings were bought by hedge funds and other highly sensitive market players. My guess, to the extent possible, is that none of the underwritten shares are currently owned by today’s “fast money” players.

With the above as background, I believe it is wise to look at the three types of market declines:

1. Corrections - Normally a 10% decline from peak. Through Friday, we are about half-way through a standard correction. I always assume the very next day after I purchase a stock there will be a correction. I can therefore tolerate such a market move. 
2. Cyclical – Declines of around 25% occur within each decade, The problem for an investor who pays capital gains taxes out of this account, is the reduction in the size of the account resulting from taxes paid. This raid on capital must be made up to recover the original capital base and is particularly galling if the stock recovers.
3. Structural – Recession/depression with loses exceeding 50%. These are generally part of the economic realization that something is out of order. They often occur during periods of excess borrowing, where the lenders’ financial stability is threatened.

My View

A correction has already begun, and it is not worth repositioning long-term portfolios. We have not had a cyclical decline for a number of years, and it appears to be long overdue. There are increasing numbers of business and people having difficulty. Odds are, within a five-year period there will be a cyclical market decline. Portfolios should be pruned of weak holdings. Weak holdings are those that would cause irreparable pain if they fell by 25% or more before returning to their current level in five years.

Selections Process

This is the topic of a forthcoming speech to a group of financial institutions and their advisers regarding analytical approaches to selecting individual securities, advisers, and funds. Needless to say, my approach is not the standard pitch.

Selecting Individual Securities

Rarely does a person want to exactly copy another. After reviewing the standard Graham & Dodd financial statistics, I focus on what makes a company different. Unless the stock is very cheap compared to peers, it is usually the non-statistical differences which make a stock attractive. I am suggesting that after securities analysis there should be business analysis. The following is a brief business analysis of five stocks owned in accounts, or by me personally. (These are not recommendations for purchase, as that would only be wise if they fit the needs of each portfolio and were priced attractively.)

Apple is viewed as a growing “annuities producer”. Rarely after a single purchase of an Apple product does the customer switch to another brand. Currently, there is a more than usual risk of delayed new purchases due to supply chain issues, higher prices, and the draw of forthcoming new products. Years ago, many General Motors car brands were in a similar position as people in America replaced their cars in one to three years. As with Apple, GM’s strength was in its distribution system. Apple’s is better, having their own stores and departments within big box stores. The annuity like value of their sales helps with their planning and is an attractive attribute for long-term investors. At some point, when attractive new features stop coming, it is possible the annuity like trend will become similar to the overall growth of the market. However, they will continue to produce good sales in countries with faster growing populations.

Berkshire Hathaway is managed for the non-shareholder heirs of current holders. This fits the desires and needs of a large portion of Berkshire’s owners. At some point, I suspect pieces of the operating company will be hived off to shareholders or other operating companies. The book value of these companies starts with their acquisition price, plus earnings less dividends paid to the holding company, which in a number of cases is way below what these activities are worth in an open market. I can envision a day when my grandchildren will receive a growing cash dividend from a smaller, regularly managed company.

Moody’s is a toll collector of fees from most of the world’s fixed income issuing companies, including non-profits and various levels of government. Most of these organizations will grow in an increasingly complex world, where debt is required for progress.

Raymond James Financial has the fastest growing financial services retail distribution network on a per share basis. They aggressively create homes for investment salespeople who find their current employers unattractive.

Goldman Sachs has probably more bright and talented people on a per share basis than any other financial services company. What is intriguing about GS is that it is transitioning from its old model of utilizing borrowed capital to one using capital generated by its own customers. When there is a new profitable game in towns around the world, Goldman will probably be in it. 

Selection of Advisors and Funds

Our history of being an advisor to institutions is one of great length. (We have enjoyed a number of tenures of twenty years or more, which only expired with the change of key members of the investment committee or a desire to go in a different direction). It is disrupting to change critical advisors, so it is done less often. Turnover of a stock portfolio is a more tactical move. With that in mind, the factors to be considered are more about the advisor than the holdings in a portfolio. Portfolios of equity mutual funds change about every 10 years, halfway between the 3-year turnover of a stock manager and the 20 years of a manager of institutional accounts.

In developing approaches to manager selection, one cannot avoid biases. These are thought patterns which at one point had a reasonably good foundation in facts. The intellectually honest advisor consultant or manager should use the current picture to update their biases. The following are my current working biases: 

1. Both highly concentrated portfolios and wide universes can be used successfully.
2. Short investment periods should be examined to find patterns of success.
3. Periods of weaknesses should be discussed in detail to understand humility, blame shifting, and blind spots.
4. Multigenerational team building, by both copying others and new thinking.
5. The reasons for low and high turnover and the difference between turnover of dollars and names.
6. Multiple generations of management in key departments.
7. Business Management skills and controls, analyzing successes and failures.
8. Small vs large losses.
9. Size of boards and executive committees, the smaller the better.

Art Forms

If good investing is an art form, then investment management is a bigger art form. Still larger is the investment management business art form.

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Can China Be Hedged?

There is a difference between people and markets. While both have histories, they are portrayed differently. The experience of people is recorded with lots of emotions, thought processes and personalities. We record market movements whether they are for securities, commodities, real estate or objets d’art in two dimensions, up or down. I believe the study of both are essential for any successful investor. However, the study of people should serve as alerts to those who focus on the history of markets.

Calamities Travel

Once in a while the single tree falling in a forest or an insect flapping her wings could be the start of a world-wide calamity. There are two relatively recent examples that I saw early, but did not fully comprehend until much later, to my accounts’ disadvantage. The first was the collapse of a Greenwich, Connecticut based hedge fund firm called Long Term Capital Management (LTCM). Actually before the founding of LTCM, I was exposed to one of its widely proclaimed “geniuses.” This learned academic gentleman believed that market-based statistics could be used to predict future market prices. He was correct in many instances, but not in each and every instance. He and his associates applied their mathematical skills to foreign treasury instruments with considerable leverage. They were totally “blindsided” when the Russians defaulted on their treasury issues. My mistake was I did not fully understand the implications of this collapse, after all none of my accounts were exposed to Russian paper. Initially I missed two knock on relationships. The first was the contagion effect. LTCM and other leveraged players (more on this shortly) needed to quickly restore their capital base. They quickly sold their other emerging market positions. (I did not foresee how a Russian default would be the cause of Mexican market decline.)

The second relationship, or if you prefer the second order problem that I missed, was the nature of the trading community. LTCM was one of the largest customers of many fixed income trading desks on “The Street.” Initially these desks merely filled the order of their customer rapidly, perhaps in some cases they sold short the securities as part of filling the order. Soon they saw how successful LTCM was and they followed its trading patterns and in some cases put money into LTCM’s funds. The size of these actual or potential losses would have been very large for the trading community if all of The Street’s trading positions had to be liquidated quickly when LTCM problems became known. Unlike the more recent cases of Bear Stearns and Merrill Lynch, the government recognized the problem early, but the Fed did not ride to the rescue of LTCM with saddle bags full of money. The Federal Reserve Bank of New York convened a meeting of all the principal players including a very reluctant Bear Stearns and would not let the participants out of the meeting until they agreed to loan enough money to LTCM so it could be prudently liquidated. Thus Wall Street was saved from its own potential collapse. (In this instance the FRB of New York played the role of J.P. Morgan when he helped end the “Money Panic of 1907,” before the Federal Reserve was created.) Thus, the tree falling in Moscow almost took down the entire trading market in the US and probably elsewhere as well.

The Sub Prime Calamity

While I recognized that far too many people were speculating in real estate and that amateurs often lose to professionals in the market place, I did not appreciate who the real losers would be. (The providers of credit all the way along the line were the losers.) Initially, people began writing about the ballooning sub prime and the “Alt A” mortgages and that they would lead to bankruptcies and a slowdown on the building of new homes. While this was serious, at the time it was not of monumental importance, as new house construction is a small part of our expanding economy. Once again I was not sufficiently conscious of significant changes and how the market place was operating. I did not fully comprehend that the major investment banking houses had become the center of the mortgage origination casino to feed their securitization sales forces. This process was replicated in the UK, Australia, and elsewhere and the resulting production of mortgage slices were owned throughout the world, including places as distant as Norway and China. While in the case of LTCM the infusion of leverage was at the so-called professional level, at almost every stage of the housing chain leverage was induced so there were many more losers, including those living on fixed income from these mortgage tranches. When the various governments started to get inklings as to the size of the looming debt on the way to non-payment status, the governments rode to the rescue to save at least their financial communities, if not their economies. (We can debate whether the rescue attempt was ham-handed and whether the private sector should have been let to sort out the problem, as Mr. Morgan forced in 1907.)

Is China A Potential Calamity?

Recently I spent time thinking about conventional asset allocation strategies. In almost all cases, institutions are attempting to broadly diversify their assets. Often the categories they use are as follows:

• emerging market equity and debt
  
• developed market equity and debt
  
• domestic equity and debt
  
• commodities including timber
  
• domestic and foreign real estate
  

My unanswered concern is that these diversification attempts are making a common bet and therefore do not have the diversification against a major risk, which suggests there exists a potential for a major dislocation. All of these classes are exposed to China in one way or another. Most emerging markets are increasing their trade with China. General Motors sells more cars in China than the US. Proctor & Gamble, Coca Cola, Microsoft and soon Apple, have important sales and/or facilities in China. “The Middle Kingdom” is the swing buyer or seller of most non-agricultural commodities in the world. Almost all bonds are priced in relationship to US Treasury issues of similar maturities. The Chinese convert much of their trade surplus with the US into the purchase of US bonds, which helps to absorb our increasing deficits. A significant slowdown in China’s purchases, let alone its absence from the market, could send most bond prices down around the world.

I am not an expert on China. I have a great deal of respect for its economic leadership so far. Perhaps these “experts” will continue to manage the population’s needs and desires as they have done in the past, but each year it becomes more difficult. China has replaced the US as the locomotive for global growth. This is not a prediction but an observation that at some point it is conceivable that the engine will perceptively slow down or even temporarily go off its planned track. With so much of the world dependent on the continued growth of the Chinese economy, a slight flicker or a rumor of an unexpected result could cause all markets to react.

How Does One Hedge The Chinese Risk?

Granted we don’t know for sure that there is such a risk, but we should have learned from the LTCM and sub prime examples that calamities can happen. As a professional investor I would like to identify a satisfactory hedge against the possibility of a Chinese calamity. I would like to do this on two counts. First, I am in the market for some insurance. Second, if there was a recognized hedge, its price action could be a clue to a the current market’s perception of the risk.

I have reviewed all of the current asset allocation categories and have found to varying degrees each is dependent on developments within China. At the moment I can not find an independent hedge. Perhaps you will share your thoughts with me on such a hedge or at least your leading indicator of Chinese problems.


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The Art Form of Selection for a Portfolio of Funds

As has been noted on this blog and my book, MONEY WISE, which is about to go into paperback, I believe that each major investment need should have a separate set of investments. The end game for all investing is to produce capital for eventual spending. In many cases, the time frame for charitable institutions and wealthy families is infinite. Investing through mutual funds and hedge funds is not necessarily the best single way to invest, but it is far from the worst. Due to my background of studying funds for the last 50 years or so, funds are the first choice in my investment tool set.

To accomplish the goal of providing for future spending needs, one is essentially dependent on the current spending rate and the growth of capital as they pass through the filters of inflation and taxes. Like most all other investors, I am predisposed to the term “growth.” One of the ways to grow capital is to invest in growth stocks, often found in growth funds.

As someone who has probably created more fund classifications than any other individual, I recognize that turning fund classifications into investment objectives was never designed primarily to help in fund selection. The beneficiaries of classifying funds into peer groups include fund portfolio managers, independent directors of fund groups, owners of fund management organizations and the fund marketing systems. In essence, fund classification produces bragging rights. Particularly in the developed world’s competitive focus, ranking against peers becomes the title requirement for ownership of bragging rights. This is exactly where a dichotomy lies between the needs of a fund investor and the above-mentioned beneficiaries of fund classifications’ bragging rights.

To keep the reward game honest, a set of rules are needed which should be based on empirical evidence. For example, my old organization, now known as Lipper, Inc., defines a growth fund as a fund that has a price/earnings ratio greater than the S&P 500, and a three year average growth rate of sales per share that is above the same broad market indicator. Others use some variation of high price sensitivity and historic trend analysis. Note that all of these measures are backward looking because they are known and are usually not adjusted for post-period recognitions of material differences.

One of the sound arguments against using any broad market securities index is that you are paying for past successes. Remember the SEC requirement that is meant to go with any performance advertising: that past performance is no guaranty of future performance. As a matter of fact, after prolonged periods of specific progress, the mathematical pull of regression to the mean becomes overpowering. Leaders give up the performance leadership and often become laggards, while laggards become leaders. Usually at some point in a sales pitch for a fund, reliance is placed on the fund classification bragging rights mentioned above.

Extrapolation is easy, particularly if one sees no imminent signs of major reversals. Instead, I am addicted to anticipation. I think about the uncertain future. I have a preference for managers who are also searching the future to find stocks that do not represent an extrapolation of the past. This is much more difficult. In the mid- 1960’s a very good analyst caught the shift from a cyclical valuation to an expected growth valuation for a, now much smaller, company named General Motors. His market call worked for a while until it became accepted word near its cyclical peak. Think about IBM, which started life with more water in its balance sheet than assets. For many years, IBM was considered a growth company; then it became an income stock and now is a consulting services company. Imagine the problems of keeping IBM within any giving index as a predictor of future price behavior.

After a long period of declining prices, the best relative performances are held by those funds that exert a tight price discipline and/or have used cash as a significant investment. Many of the best, well known, investors have used this type of “value” oriented approach. For investment needs where the spending rate is high relative to the earnings rate, these price disciplined investments should play a major role. However for some needs (particularly in the early stages of many portfolios), the growth of the long term capital is of greater importance than the annual total return generation. Growth of capital is also a primary driver for many wealthy families, who believe the current level of capital is insufficient to meet future generational and /or philanthropical needs.

By dividing one’s resources into need-focused portfolios, one may have the best of both worlds (value + growth). Periodic rebalancing between the portfolios should be driven by the changing levels of needs. As the late Sir John Templeton would direct, changes to the individual portfolios should be made on the basis of focusing on better bargains. These bargains can be in future growth stocks or funds.

The successful selection of future growers is difficult, at best. In my case it is achieved by listening to smart managers that have different points of view based on their own research methods. As noted previously, I am willing to own funds that have different, and in some cases conflicting points of view.

Do you agree?