Investing Your Time for Better Results

Introduction

In my 2008 book MONEYWISE, I suggested that one’s investment results are more a function of how one spends his or her time on investing and giving than the size of the original capital or the initials after one’s name. This week I had reasons to think about what George Soros, Jesse Livermore, Irving Kahn, Warren Buffett, and two bank CEOs have said.  Each of these gentlemen had worthwhile messages for investors, perhaps particularly at this time when so many people are indecisive as to their investment posture.

George Soros and Jesse Livermore on market direction

[While I have met Mr. Soros and supplied his firm fund information in the past, I do not really know him but respect his skills. Jesse Livermore may well have traded a margin account through my Grandfather’s brokerage firm, I did not know him.] The source of the thoughts that I share with you is from a reader who publishes his own personal weekly blog, Teddy Lamade of Brown Advisory. Teddy quotes George Soros as saying, “Markets are constantly in a state of uncertainty and flux. As a result, money is made by discounting the obvious and betting on the unexpected.” This is in effect the motto of those of us who have been called contrarians. On the other hand, Jesse Livermore said, “The public wants to be led, to be instructed, to be told what to do.” He indicated that people will become a mob as they want the comfort of others going in the same direction.

I am not being diplomatic, but analytical when I state that both of these managers are correct. One should recognize that George Soros above all else wished to survive and go on to future paydays. Jesse Livermore was much more interested in the size of his winnings during the game.

My current investment outlook is that for awhile the trading instincts of Livermore will lead us to higher levels of stock prices as the crowd of investors on the sidelines or in broad market index funds and ETFs will become a mob chasing various pundits and politicians in the obvious trends that Mr. Soros feared. This in turn will lead to financial and psychological collapse. This is the psychological underpinning to my +20%/-20% call which could happen sometime soon either this year or next.

The hard search for value

The dichotomy between Soros and Livermore is why finding great investment value is so difficult and is the basis of the lesson that Charlie Munger taught Warren Buffett after Buffett’s training by Benjamin Graham. Livermore was a believer in price momentum as all who participate in the ultimate bullish phase of a market surge. Ben Graham’s point of departure in seeking value was price. When he started his writing as a guide to students at Columbia University, he was ably assisted by Professor David Dodd, who for many years had the difficult task of teaching myself and others Securities Analysis. In addition, Graham had a teaching assistant named Irving Kahn who just passed away at 109 years young. (More on my friend Irving will be found below.)

Dodd had much more of an accounting background than Graham. This is why he instructed us to reconstruct financial statements before we applied any ratio analysis. For example, writing in the Depression Era of the 1930s he wrote down or completely off any inventory, particularly work in process and raw materials. He wanted us to include unfunded pension amounts before determining book value. We then had to do similar exercises on competing firms. Often he had us look at corporate financials from the standpoint of the bond holder. In some cases with proper analysis the stated equity value should have been greatly reduced. With bonds selling at steep discounts from their par value, if one could get enough bonds one could force the corporation into bankruptcy with the bond holders representing the new equity. That practice as is being done today is called “loan to own.” In some ways Graham, Dodd, and Kahn in their Graham Newman fund became the equivalent of today’s activist investors, but often using bonds as their entry point. Max Heine, who later founded the Mutual Shares Fund that eventually Mike Price sold to Franklin Resources, played a similar game. Others had followed similar practices on railroads so much of the rolling stock of America fell into financial hands. Thus, many so-called value investors were essentially adjusted book value investors looking for the ultimate liquidation or sale of their companies. As we came out of the Depression and World War II periods, general prosperity lifted stock prices so it was more difficult to find statistically cheap investments. In recent years it became even more difficult. In the past it might takes months that stretched into quarters of the year to find suitable candidates. Today with almost all the financials available on easy to manipulate data banks and a large number of activists who want to play, the number of statistically cheap investments has shrunk.

As with almost all trends that eventually are played out, newer versions appear. Irving Kahn, Ben Graham’s teaching assistant and founder of Kahn Brothers, was a successful broker/investment adviser who became the prototype of the new Value investor. Irving went beyond the numbers into what was the company’s particular advantage. Often he found some gems through his life-long interest in science and often found some pioneering work at reasonable stock prices. Irving believed in the global professional securities analysis business. While he was an important founder of the New York Society of Securities Analysts, he was also a member of the London Society  and had some successful investments in Japan when few others did. Until recently he traveled extensively and we met his late wife with him on one of his many analysts’ trips.

Irving got started in the investment business in 1928 and was conscious of my Grandfather’s firm on which he was complimentary. As a future- oriented investor he was aware of periodic market declines which is why he combined what many might have said was aggressive stock picks with half his portfolio in or near cash. Basically what he did was to redefine value to include the corporate advantage that some today call moats on top of his statistical analysis. He and his sons would require managements to keep shareholders first in their deliberations. In many ways he was among the first modern investors.

The lessons that Warren Buffett learned

Like many followers of Berkshire Hathaway, Saturday morning was devoted to reading this year’s letter from Warren Buffett and Charlie Munger. While I could devote a lot of time and space as to what was said and why most investors in the stock will be happy with it, I would like to finish this post with comments about value investing.

In Buffett’s early years he followed Ben Graham’s model of investing in “mediocre companies at bargain prices” which produced gains but with some losses. That changed with the advent of Charlie Munger on the scene who converted Warren to buying great companies at fair prices. This has worked much better than the value-oriented investments in the past. The other general comment that is worthwhile to all investors is the need to be prepared for periodic 50% drops. (I will be happy to discuss my other comments on the Berkshire letter. At some point I may devote a lot of space to it or hold it to report with my impressions of the Berkshire annual meeting weekend.)

What to do?

As Shakespeare would say “to your own self be true,” follow your instinct. If you are a growth investor enjoy the crowd’s surge and ride out periodic dips of 50%. If you are a value investor you will need to practice patience and look for value beyond what is just plain cheap.

The beauty of the L Time Span Portfolios^TM is that either or both growth and value oriented managers can be utilized. In most of our managed accounts we use both in different proportions based on the individual accounts needs.

Question of the Week: Where are you on the Growth-Value spectrum? 

 

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Emerging Market Warnings, Crowds Ahead, Smaller Exit Portals

Ever since the dawn of attention to investment performance, the smart guys figured the way to outperform was to invest outside the general experience of others. Often this technique worked initially until too many others copied the strategy. As with life in general, the unexpected happened and the exits became crowded and were blocked for the late movers. This is a repeat performance of a movie I have seen before.

I am a Believer

I am a believer in investing internationally. As a trainee in my first job after my education in the US Marine Corps, I had a tour of duty within a bank’s vault to count the actual foreign stock certificates that backed up the bank’s issuance of American Depositary Receipts (ADRs). More than 15 years later, when I could start to invest for my own account, I began investing outside of the US. Over the years I have invested in Latin American and Asian closed-end funds, individual equities in Canada, Australia, the United Kingdom, Netherlands, Finland and Japan as well as private equities in the UK and France. In addition, at the time of my sale of the operating assets of Lipper Analytical to Reuters PLC, we had foreign clients buying non US-data from our offices in London and Hong Kong. Thus, I believe I have won my stars as an international investor. So why am I raising the yellow flag of caution now? Simply because it is getting crowded out there.

Petrobras

On Thursday of this last week Petróleo Brasileiro S.A. or Petrobras, sold over $70 billion worth of common stock. This was the world’s largest initial public offering (IPO). According to the Wall Street Journal, options will be available which will expand the common stock offering by 25%, including an undisclosed amount of preferred stock. (It is true that some $43 billion was an exchange with the Brazilian government for the drilling privileges to a potentially huge offshore series of sites. Nevertheless, an enormous amount of cash was invested into Petrobras.)

First Warning Flag

The sheer size of the enthusiasm for this transaction should be enough of a warning to a practiced investor, but there are other danger signs. Petrobras has been a favorite of many well-known global investors. A number of them felt that the terms of this offering were not in favor of the existing outside shareholders but were to the benefit of the government. Among those who are rumored to have sold out are George Soros and the good people at Templeton. One of the risks in any investment is that the government may turn less friendly. (This risk is valid in the US as well.) Based on my experience, foreign investors typically don’t really own foreign securities permanently. They rent them.

The Second Warning Flag

One of the better international money managers that I had the pleasure of knowing taught me the importance of the flows of money into a security. In the 1970’s, he focused on foreign money coming into the Japanese markets. He believed that the “weight of money” would lift Japanese stock prices that were clearly not bargains. He focused a good bit of his attention on mutual fund data and that was why he contacted me. His clue to exit an overpriced market was when there was a slow down in the gusher of money coming into the market.

As is commonly acknowledged, mutual fund redemptions have been larger than the rather lackluster sales of US Equity mutual funds. As of the end of August, according to my old firm now called Lipper, total net assets are approximately $4.7 trillion dollars, with only $3 trillion devoted to US diversified investing. The fifth largest collection of assets is in Emerging Market Equity funds ($253 billion). This excludes $112 billion of the more narrowly focused funds that invest outside of the US and Europe. The two collections together have total net assets of $365 billion as of the end of August, which is somewhat larger than the money invested in S&P 500 Index funds. Clearly, emerging markets are not undiscovered territory. The cautionary flags go up with US Diversified Equity funds shedding $ 10 billion in August, with $2.3 billion going in one month to Emerging Market funds. This shows a significant shift in investors’ opinion. A more dramatic indication is that in the same month $3.8 billion went into Emerging Market exchange traded funds (ETFs). I believe this latter inflow is much more speculative in nature. If you will, they are more like daily renters than annual leasers.

The growth in demand of ETFs is particularly ominous. Money can flow in and out of these funds on a daily basis. When the money moves, the managers must transact as nearly as possible to mirror an individual stock’s proportional ownership in the index. If some negative news event causes a redemption run on an ETF, they will have to sell some of each position. The history of international investing, particularly in small markets, is that when we come in we buy from the locals who feel that our valuations are wrong. When we sell under duress they understand that any price is a good price from the pressured seller’s point of view. The losses can be dramatic under those circumstances.

To put the ETF risk in perspective, each week I look at the twenty-five largest SEC registered open-end funds. On that list are five ETFs, two of which invest in emerging markets. On a combined basis these two funds have $70 billion in assets. They promise their large shareholders instant liquidity during US trading hours.

The Third Warning Flag

The next set of concerns is one of personal exposure. Over the last two weeks I have had three discussions about emerging markets. The first was with a marketing executive of a major broad line fund group who was commenting that its International/Emerging Market funds were selling very well. The second conversation was with a retired international investor who was being pitched to go back in business, focusing on the frontier markets which are exciting many people. I am hearing a great deal about investing in Nigeria and Ghana. (Memories of the “South Sea Bubble” of the 18th Century come to mind.) The final conversation was with a fund president who has been away from the market for some time and is being asked to develop a country-specific infrastructure fund as well as other frontier investments. (The Nineteenth and early Twentieth century investments by the Scottish trusts and Barings also come to mind.)

Warning

Despite HSBC’s ten point pitch to invest in the emerging markets and Western Asset’s belief in the attractiveness of the debt side of the emerging markets, I would be particularly careful now. If you are lucky enough to have been there already, cap your exposure at sometime. If you are not invested in emerging markets directly, you can gain some exposure through US companies that export or have operations in the area. As a contrarian bet I would look to large US Growth funds, they have lots of attractive companies in their portfolios at reasonable prices. They should do well enough on a relative basis over the next four years.

What do you think?
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Winning Calls

Life rarely presents us with celebratory events sponsored by others for us. Thus, occasionally we need to create our own in the fashion of Lewis Carroll’s wonderful invention of the “Unbirthday.” With this as a premise, I am indulgently going to celebrate the recent successful calls in our blog. If I don’t, who will?

The first correct call was the recognition that the month of October, 2009, had specific characteristics; which this year resulted in a negative bias to equity performance for the month. I also pointed out that mutual funds end their tax reporting year in October. While most funds have accumulated large realized losses created in ’08 and ’09, it would be possible (and perhaps prudent) to recognize some gains. The gains would not trigger a tax payment because the gains would offset the losses. Since there are no “wash sales” rules on gains, the smart thing to do is sell some of this year’s winners and either repurchase the same stocks, or perhaps to use Sir John Templeton’s phrase, search for “better bargains.” As the SEC no longer requires funds to disclose transactions on a quarterly basis, we no longer see a list of transactions made by the funds, thus I do not know what happened.* However, during the last three weeks of October, a significant number of the best performing stocks for the year were met with selling. On an overall basis, the month of October was down. My supposition is, that with the removal of the incremental mutual fund selling, the short term performance (at least in early November) would be up. This actually happened. I call it a win.

The second call was on the relative value of the dollar, which I felt was bottoming. This appears to be happening. Please note that I phrased my comment in relative terms. I agree with many of the views of the dollar’s detractors, that the buck should be worth less due to the present deficit, the almost certainty of a larger deficit, and the strong odds of a pick-up in inflation, probably induced. Why then should the dollar stop falling? World trade currencies are priced relative to other currencies. From a managed trade point of view, the decline in the US dollar is an increase in the value of the counter currencies. In many countries exporters are politically important. They see a rising price of their own money as an inhibitor to their export sales. Thus, I believe that other countries will buy some dollars to prevent their own money from being priced out of the world market. I have great respect for George Soros and his investment accomplishments over the years, even though I rarely am in agreement with his political views and actions. When he was recently asked about the worth of the US dollar, he replied that it was over-valued, except in comparison with other currencies. Today, I do not see a better value in other paper currencies, even though personally I own some other currencies to support my foreign equity investments.

From the standpoint of those who are focused on the absolute value of the dollar, that is to spend rather than trade, the price of gold (and to a lesser extent prices of some other commodities) is instructive. The nominal price of gold is at record levels, about $1100 a troy ounce. However when translated into today’s dollars, the old record price of over $800** an ounce in 1980 would be at least a thousand dollars higher. One reason for the recent strength in the gold price is that several central banks have made it known that they will not be carrying out their previous plans to sell gold. In addition, both India and China are buyers. I will claim this call as a winner in light that the other side is not winning.

On a tactical side, my recent calls for long term investing for growth, and particularly technology-driven innovation, appears to be winning relative to bets on value, and to some degree on industrials. I will claim these as short term winners, even though they were meant for long term investment.

Emotionally, the final two words in last week’s blog, “Go Yankees,” (written by the ‘born in Manhattan boy’ in me) proved to be the week’s biggest win. Please remember that there are legions of New York haters who resent the swagger generated by this culture of winning. Thus while I am very pleased, after eight long years of lack of fulfillment, my guard is up to defend against those who wish to punish New York. New York is a state of mind and not just a place. The biggest threat we face is a repeat event as severe to our economy and the financial markets as we experienced last year. We will retain our “license” to be central to the progress of the world only if we have learned something and we change our thinking.

I believe that we must change our thinking, thus next week’s blog will be devoted to my attempts to become more aware of the shape of future problems before they overwhelm us.

Any contributions from readers will be appreciated.

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* Years ago, the SEC required mutual funds to report their transactions quarterly, allowing a deeper dimension to the analysis of funds than is now available. The SEC caved-in to the funds in abolishing this report, reasoning that the SEC and its staff could get the specific information anytime they needed it. Fund owners and their analysts no longer have access to that insight.

** A very valued former associate of mine, the late Alling Woodruff, of Greenwich, CT, did sell his physical gold position above $800. He was an independent director of what was then the largest US gold fund and was going to South Africa to visit some mines, thus out of touch with the market for a couple of weeks.

The Next Big One - FX

The Madoff scandal and other similar grand thefts come as a complete surprise to people, but they shouldn’t. Why? Bad behavior is part of the human condition. Large scandals happen because they can happen. Investors believe first in people, and second in their own understanding of the perpetrator’s personality. In the back of these investors’ minds is a belief that there are effective, long-established controls that would prevent any large frauds to take place. Often the mind of an outright criminal, or more likely someone who “temporarily borrows money” from the unsuspecting, is smarter than the best of the designers of financial/trading controls. Most of the large losses experienced over the last ten years grew because the perpetrator(s) understood “the back office” systems better than those in charge of various compliance functions. Some may have actually been motivated by the battle of man vs. machine, where the lone mind can beat the machines and their watchdogs. I will let the lawyers and the forensic accountants supply the blueprints to the Madoff scandal, if they can. I am attempting to spot the next big, unexpected fraud.

One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.

Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.

Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.

The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.

Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.

The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.

My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.