Managing Mistakes - Weekly Blog # 652

 

Mike Lipper’s Monday Morning Musings

Managing Mistakes

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

Mistakes are common in all endeavors. That is why we should learn from them and raise the fundamental question as to why we don’t. In the US we have entered a two-month period where almost all the candidates make mistakes due to oversimplification, incomplete statements, over-worked staffs, inexperienced candidates, etc. Some of these unforced errors will cause a few candidates to change their preferences.

The political world should learn from the experiences of both the sports and military worlds. Most of the time the declared winners are the side that makes fewer mistakes at crucial points. On a win-loss ratio, General George Washington lost more battles in the American Revolution than he won, particularly in the earlier years. He won at Yorktown because he benefited from battles won in the South by other generals using fewer European tactics. Additionally, weather in the Atlantic allowed the Allied French fleet to depart from New England and kept the British fleet harbor bound while British politicians in London grew tired of an expensive war.

How does this focus on historic mistakes apply to portfolios? Like most American election choices which are already made up, most portfolio owners are sticking with their plans. Modified only after the election as a result of foreign political changes. 

The Crux of the Problem: Unrealistic Plans

Some individual and institutional investors are unhappy with their portfolio results and are seeking to make small adjustments. There is rarely an almost perfect portfolio than can be converted to complete satisfaction by the change of a single security or fund. The crux of the problem is addressing multiple needs with a single solution. Most often investors have a diversified portfolio in mind, but due to an emotional need to be with the crowd their investment performance is closer to that of the popular indices.

True diversity can only be accomplished long-term by a collection of winners and losers at different points in time. In our everyday lives we are both self-insurers and hedgers, taking on physical risks at home and at work. While we may have fire and auto insurance policies, they are unlikely to pay off enough to totally substitute the new for the old. In effect we accept the shortfall as part of the bargain embedded in the contract. In other words, we chose to tolerate less than complete perfection. Yet in our portfolios we wish to avoid any deficits in actual or relative returns. Understanding how the markets and life rotate disappointments and mistakes hopefully gives us the opportunity to own winners where the gains are much larger than the mistakes.

The so-called mistakes may quite possibly be insurance premiums to be activated in future periods. I therefore favor dividing a single portfolio into parts, first in terms of risks and second in terms of desired delivery time. If one has only a single portfolio then any “mistake” is a negative, whereas a portfolio that addresses different levels of risks or different time periods provides some insurance. Today’s risks include changing tax rates, materially higher inflation, fall of purchasing power due to currency changes, technological changes, management changes, political changes, medical and health conditions, and the unknowns.

Could This Be the Time to Change?

One of the disadvantages in pouring over current data is that whatever occurred recently has little to do with what will occur subsequently. Nevertheless, the performance of equity oriented mutual funds for the week ended last Thursday could be indicative of future directions. In contrast to the slight decline of -0.85% for the average S&P 500 Index fund, 87 fund peer groups did better. The five peer groups averages that did best included: Base Metals Commodity Funds +2.49%, Latin American Funds +2.46%, Financial Services Funds +1.87%, Utilities Funds +1.58%, and Agricultural Funds +1.38%. I know of not a single portfolio that holds all five weekly leaders. The only common denominator is that these groups underperformed the S&P 500 for a considerable period of time, as did most of the other 82 peer groups. 

This is not only a US phenomenon, of 44 markets in local currencies only 15 Ex US markets gained, including 2 European markets (Moscow and Spain). In contrast to many of the pro-inflationary funds groups, the average 6-month money market deposit account interest rate declined to 0.19%, down from 0.22% the prior week and a three year high of 0.72%, signaling that many banks cannot find secure borrowers to lend to.

One additional symptom of a speculative market producing a lot of gains for some nervous holders is the change in trading volume on a year over year basis. NYSE listed stocks +7.84%, DJIA stocks +46.09%, NASDAQ +84.86% and Dow Jones Transport stocks +186.19%. Traders of volatile stocks are likely to look for future volatility.

Working Conclusions:

Clear investment answers are not likely to be revealed immediately after the US elections. I suspect we will be in for a period of excess volatility that will attract more cash off the sidelines. This uneasy period is not likely to end until most if not all the cash has been consumed. While this frenetic period continues, there will be time to transform a single portfolio into a collection of portfolios based on different needs and risk appetites. All portfolios should have sufficient reserves to absorb the mistakes that will occur without hurting the investment objectives too much.

Question of the Week? Are your ready for Changes?     

 

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2020/10/momentum-is-slowing-under-too-many.html

https://mikelipper.blogspot.com/2020/10/mike-lippers-monday-morning-musings-are.html

https://mikelipper.blogspot.com/2020/10/what-is-nasdaq-saying-to-whom-weekly.html

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July 4th Lesson: Need to Hire Wise, not Just Smart People - Weekly Blog # 636

Mike Lipper’s Monday Morning Musings

July 4th Lesson: Need to Hire Wise, not Just Smart People

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

Bear in mind, many smart people are taught lots of valuable lessons in schools and search for answers that look like test questions in terms of simple (straight line) answers. Wise people are educated through their own experiences and the experiences of others. This is the main reason many smart people do not achieve lasting success in various activities, including investing.

Current Dilemma 
Almost the entire globe is being worn down by the Coronavirus plague. We will probably only exit the current economic and political conditions and enter the “New Normal” when either effective medical treatments or vaccines are in large supply. This is a smart, but not a wise view based on history. The fatality rate currently reported (including the estimate of undiagnosed Covid-19 cases) is undeniably tragic, but is low compared to historic experiences.  Conversely, public reaction has been unprecedented in size and scope.

What are the differences causing all this turmoil? 

1. The rampant fear of the unknown and the uncertainty of the depth and duration of the impact of the pandemic.
2. The stress of the “lockdowns” caused by the shrinking of the economy and changing political conditions.
3. The speed at which it has happened and its continued acceleration. 

In the desperate search for a “New Normal”, people do not remember a quote attributed to Lenin “There are decades where nothing happens; and there are weeks where decades happen.” The revolutions Lenin instigated may have impacted more than half the world at one point.

American Revolution
This blog is being written on the day after the US celebration of July 4th, Declaration of Independence. I believe this 18th century revolution, supported by a fraction of those living in the country at the time, is still impacting the world to an extent even bigger extent than Lenin’s efforts. To a large degree the American Revolution began the New Normal for most of the world. While it is still evolving, a new normal may be entering the globe, potentially impacting commerce and consequently the political sphere. Thus, it makes some sense to grasp how much time it took to complete the first phase of its new normal.

The Boston Massacre and Boston Tea Party were the first skirmishes in 1773. These were reactions to perceived unsuitable taxes and were followed by the first Continental Congress in 1774, leading to a somewhat unpopular war which ended with very appropriate march music by the surrendering British soldiers “The World Turned Upside Down”. The real revolution came to the political sphere in 1781 when the Articles of Confederation were passed, giving an unsatisfying structure to the 13 independent states. To address its deficiencies and to create a central government, the US Constitution was passed in 1788. Perhaps, more important in today’s environment is the  Bill of Rights, passed in 1791. The first major test of the American experiment came in 1797 when George Washington’s second term ended in the peaceful succession to Massachusetts lawyer, John Adams. (George III, and many elsewhere in Europe predicted Washington would be crowned King, or would be replaced by a “strongman”. Similar to what has happened recently in Russia, China, and parts of Africa.)

Thus, the functioning “New Normal” took 24 years before it was viewed as secure and essentially lasted until the Civil War broke out. Most current history written about the Civil War lists slavery as being the cause of the War. This was the same issue that occupied much of the wrangling by the members of Congress in producing both the Declaration of Independence and the US Constitution. In both cases the Members concluded that they could not agree on perfect documents and accepted a compromise. What really broke the impasse was economics in the form of import tariffs, something generally not credited and one of many failures to teach accurate history.

The main source of tax revenue for the US Government until the 20th Century, excluding the federal income tax during the Civil War, was money from tariffs. These were quite favorably supported in the North, as they gave price protection to Northern manufactured goods. Those in the South saw tariffs as hurting the export of their cash crop, cotton. The southerners were already being squeezed by the declining economics of slavery. As is often the case when economics is important, it is hidden under more acceptable social causes.

Translating to Our Search for a New Normal

1. I believe the various medical solutions for COVID-19 and its aftermath will take longer than expected to reach a reasonably affordable conclusion. 
2. The trend to work at home will evolve, but we will not see the same number of people working every day in large offices.
3. There will be continued growth in shopping over the internet.
4. Education will increasingly be delivered over the internet, with some necessary exceptions. Furthermore, schooling will be focused on current and particularly future employment needs.
5. The military will be focused on a combination of raids and electronic warfare.
6. Supply chains will be rationalized, both for security and economic advantages.
7. Travel will be streamlined and made medically safer.
8. Politics will revert to the former House Speaker Tip O’Neill’s view, that all politics is local.
9. We will live longer and more expensively.
10. My strongest view of all is that I will both be wrong and surprised.

What to Do?
What is taught in most business, finance, management, and economics classes, success is based on formulated planning. I have been both a reasonably successful private company entrepreneur and an investor in competitive fields. It is my belief that success is based on finding the right people and having them evolve in the right jobs.

In terms of picking successful funds to invest in over long periods of time, the skills and culture of management has been crucial to the result. One of the better ways to guess whether management will make the profitable decision is to look at how they handle the myriad of short-term details that surround any activity. Most companies have reasonably good management in particular portions of their business; however, going beyond the borders of that expertise adds to risk without the addition of new talent.

As fund investors we are believers in well-diversified portfolios of concentrated funds, when they can be found. When they cannot be found we invest in low cost broadly invested portfolios.

Where are We Now?
Short-term, until at least the election or longer if there are meaningful changes. One should recognize that in terms of stocks and stock funds the attention of the market has become more speculative, as shown below:

1. In the first half of 2020, mostly in the second quarter, there have been 64 IPOs on the NASDAQ raising $19.11 billion and 33 on the NYSE raising $15.44 billion.
2. While both the DJIA and S&P 500 are still below their former highs, the NASDAQ Composite has gained +13.76% year to date, including dividends.
3. Precious Metals funds for the first half are up +21.76%, Global Tech funds +19.74%, Tech funds +15.56%, and Large-Cap Growth funds +11.92%. There are 21 peer groups positive for the year.
4. As a contrarian indicator, this last week was the third week in a row that the AAII sample survey had a bearish reading over 40%.

Fixed Income Funds

1. Europeans expect mid-term inflation.
2. Mortgage applications are at their highest level since 2008.
3. The default rate for speculative issues is 12.5%. Credit defaults are expected to rise in a prolonged recession.
4. The Big Fear – a trifecta of Democratic victories. Based on history it is unlikely. If it happens, except in the case of the current administration, when has a politician delivered on campaign promises?

Conclusion
Long-term investors should maintain equity holdings and look to add selectively overseas. Shorten up durations on fixed income.

 

Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings-new.html

https://mikelipper.blogspot.com/2020/06/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/06/data-driven-reactions-dangerous-weekly.html



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Investment Losses Can Be Profits - Weekly Blog # 616

Mike Lipper’s Monday Morning Musings

Investment Losses Can Be Profits 

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

Losses from investments can, and often should be, counted as profits. This is not from my normal contrarian side, but from my lifelong attempt to learn something from most occasions, every day. Losses materialize when our portfolios are out of sync with the markets. In terms of results, there is no difference in being premature or being wrong.

Why Now? 
One should rarely delay in acting on a mistake. This may be a particularly appropriate time to accept the “wisdom” of the market. This week we witnessed the S&P 500 and the NASDAQ Composite going to new highs, with the Dow Jones Industrial Average close behind. The American Association of Individual Investors sample survey rose to an often unsustainable level of 41% bullish. Depending on one’s historical measure, the US stock market has been rising for over one or ten years. In this latest week WSJ chart 85% of the weekly prices rose, of 72 stock price indices, currencies, commodities, and ETFs. This is the highest percentage gain I have seen for the 72 elements and I therefore don’t expected it to continue.

During this period of generally higher stock and high-quality bond prices, it is a good time to review one’s portfolio. Any stocks that are currently being held at double-digit, absolute percentage losses or are selling at significant losses relative to their benchmarks, should be considered candidates for “capital liberation” or complete/partial disposal.

One should be aware of the following statement by the market analysis  group of Bank of America’s brokerage affiliate, Merrill Lynch “We stay irrationally bullish....We expect peak positioning along with peak liquidity(need) in the second quarter, triggering a “Big Top” in risk assets.” Why accept market prices that could be wrong?

Considering general stock market prices have risen beyond being fairly-priced (having as much upside as downside) to being fully-priced (having more risk of a decline than upside). If a position’s price has not risen with the market or it’s appropriate benchmark, it is a serious candidate for sale.

What is the Benefit of Selling Now? 
All of life should be treated as a learning experience. Outside of purchases used as part of a hedge strategy, investment losses are not additive to accomplishing one’s investment goals. (Often in a hedging strategy, one leg will produce an actual or relative loss while the other produces gains. In assessing whether the strategy is succeeding, the entire hedged investment must be reviewed to see if they are doing their job.) Almost everything life follows some cyclical pattern, such as investment opportunities in the present often being similar to those in the past. This is because people usually follow similar patterns when exposed to similar situations. Hopefully, after recognizing a losing situation, we can identify some of its characteristics. Remember the old market saying, fool me once and it is your gain, fool me twice and it is my loss. Winning the investment game calls for escaping avoidable losses. 

One of the benefits of selling a loser is to redeploy the money into other investments or leave it in cash for future deployment, either at lower prices or when better opportunities arise. For the taxable investor, the loss can be used to shield gains. It is not unusual to have long-term gains as well as losses. Some of the gains are quite large and are in securities that are not performing to expectations. Some investors make the mistake of letting “the taxman” be their portfolio manager and avoid taking profits. Losses can be used to offset some of these gains. Thus, the size of the capital available for redeployment doubles when an equal amount of the loss is used to free up some mothballed gains.

For Americans, this is a Good Weekend to Think About Losses 
On Monday, the nation celebrates Presidents Day, a combined vacation and shopping day replacing the birthday celebration of our two greatest presidents, George Washington and Abraham Lincoln. You could spend a lifetime studying these two great men. Of interest to me is that both Presidents started their position of power with significant military losses, based on poor strategy and key leadership gaps. In each case they learned from their mistakes and found the better leaders that were needed. Washington stopped attacking the British in New England and the Mid-Atlantic States, as did Lincoln in Virginia.

Washington opted for better training in his winter camps in New Jersey and Pennsylvania. He also had good leadership in the South with the local militia. Lincoln finally found the right generals and shifted the campaign to the Midwest, recognizing the strategic value of the east-west railroads after Lee had almost accomplished his mission of disrupting the east-west railroad through Pennsylvania. Grant and Sherman captured the east-west railroad through Atlanta, logistically crippling the South. While there are many reasons to celebrate these two Presidents, their ability to learn from mistakes were traits few others demonstrated. For us as investors, I hope we all learn from our mistakes.

Applying the Lessons 
I am undecided when to recognize the only loss vs purchase in one account. It is a fund management company that used to have some noteworthy performance and an unusual distribution pattern. While it could recover its former glory, that would take both time and talent. Based on history, the obvious solution is for it to merge into a larger and hopefully stronger investment group. This has been true for a couple of years, but it hasn’t happened yet. This may be because management wants to stay in control and has convinced the funds’ boards of directors and the key distribution people that they can rebuild the company. Possibly, the existing management wants too high a price. This stalemate has gone on for too long and I should probably recognize my relatively small loss. On occasion, something new happens. This week my old firm, now a part of Refinitiv, calculated that the mutual funds and ETFs included in the Lipper Financial Services Funds segment are attracting sizable net inflows. These positive net flows followed substantial net redemptions in the last two years, which about equaled the net inflows in the 2013-2017 period.

My quandary is, should I show a little more patience and see whether the new flows result in a terminal price high enough to get management to sell out? Any thoughts?   



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/the-art-of-portfolio-construction.html

https://mikelipper.blogspot.com/2020/02/significant-turnaround-two-fearful.html

https://mikelipper.blogspot.com/2020/01/mike-lippers-monday-morning-musings.html



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Winning Investment Strategies Shrinking - Weekly Blog # 608

Mike Lipper’s Monday Morning Musings

Winning Investment Strategies Shrinking

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

Premise: Winners are not Good Teachers
In the Northern Hemisphere this is the season where sports fans look forward to identifying the best team to crown as champion of their league. They celebrate the stars that did exceptionally well, but because we don’t like to pick on those that are down, we avoid focusing on the players that performed badly. This highlights the difference between a good sports or investment analyst and one likely to perform poorly in the future. As a contrarian I believe I learn far more from the mistakes of previously competent players than the exceptional winners.

Matter of fact, most winners owe their success to the mistakes made by others, something that is certainly true in military history. Many competitors try to model themselves after recently crowned champions,  but more often than not those who study a broader list of mistakes made by individuals, and their managements will be on the way to becoming future champions. (General George Washington was one who learned from early battle losses.)

Applying Lessons to Professional Investment Battles
Since every investor starts with some cash and perhaps some borrowing capability, all investments and investors are in competition. Most choose to stay in the middle of the pack rather than venturing out to the extremes. Nevertheless, it is not what a single investor or a single investment does, it is what others do that determines the absolute and relative profitability of the decision.

Why is this? It has to do with what is called the weight of money. (A lesson I learned from the real investment professionals at Fidelity.) Prices don’t move on the basis of brain power or information, but on the size of the flows into and out of investments. (This is the fundamental basis behind technical or market analysis.)

Flows follow Performance
Brains don’t move prices, conviction as measured by the size or the weight of money behind the flows do. No one is required to sign an affidavit as to why we do anything, it’s what we do and with what size or force. In viewing different asset classes we can see that the lack of  money going into commodities and some elements of real estate has led to flows into some equities and somewhat indiscriminately to fixed income.

Excessive Flows are Often Late
As with most investment rules and policies they can be taken to an extreme, which might be viewed as an antidote to the weight of money argument. One critical element of flows is who the sellers are at various prices, or for fixed income securities, yields. In many cases the sellers are more disciplined than the buyers. Owners of fixed income products are initially interested in current yield, but those like pension plans are also focused on the reinvestment of their interest payment receipts. When rates are too low they may decide to exit the fixed income asset class with their profits and explore total return vehicles, largely equity-oriented investments.

In the third quarter, worldwide equity funds had net redemptions of $3 billion, bond funds net inflows of $271 billion, and money-market funds net inflows of $311 billion. The smarter sellers may be speaking, especially if you consider that interest rates are among the lowest in 500 years, before the inflation caused by the discovery of South American gold. Even though rates are low, the yield curve is becoming a bit steeper. Currently, the thirty-year US Treasury yield is 2.35%, which may be the “market’s” guess of the long-term inflation rate. Some escapees from high-quality fixed income and some nervous equity investors are congregating in high yield paper/funds. Moody’s (*) has expressed their concern after rising prices in this category, fearing an increase in problems for future issuers.

(*) A position in our Private Financial Services Fund)

All is not Great in the Domestic Equity Arena

1. The US dollar’s rate of exchange is softening, making foreign investments more attractive. 
2. Too much attention is being paid to the S&P 500, which year-to-date is producing a return north of 30%, including reinvested dividends. What is not being noticed is the significant number of stocks producing lower returns, particularly the value-oriented and industrial company stocks found in many portfolios. The latter dealing with lackluster sales and weakening prices. 
3. Low interest rates are allowing companies that should close to limp along and depress prices. 
4. The very volatile American Association of Individual Investors sample survey, a contrarian indicator, showed 44% of investors being bullish vs. 20.5% bearish. (Most readings are in a 20-40% range.)
5. The oldest Central Bank in the world has given up using negative interest rates. Sweden, a very respected central bank, is now no longer one of the few negative interest rate users. I suspect some central banks and investment people with a knowledge of history see higher rates in their future, perhaps much higher.

A useful set of indicators
The New York Stock Exchange (NYSE) currently trades 3,099 issues and the NASDAQ 3,466. Historically the NYSE had more stringent listing standards, so on balance it has older and higher perceived quality. Both had 47 issues that were unchanged last week. The NYSE had 2.6% of its stocks hit new lows, whereas the NASDAQ had 20% hit new lows. The NASDAQ Composite has gained +38% this year and the DJIA +25%. On average the NASDAQ attracts more active traders than the senior exchange and thus may better reflect sentiment.



Question of the week: When was the last time you looked at your fixed income investments with the same scrutiny as you do your stock investments?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/faulty-decision-processes-at-change.html

https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html



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Critical Lessons from Two of the Smartest Investors

Introduction

Trying to escape reliance solely on experience, I rely on my student skills for this post. I have indicated numerous times that the Neuro-economics professors/scientists at Caltech have shown most people use their cumulative experience as the main or sole basis for making judgments. I try to study current and past history as an important source of additional experiences.

This week I have turned to two of what many have called in their time the smartest men around, Sir Isaac Newton and Warren Buffett. The latter's annual letter came out Saturday morning and I read it before we drove to Mount Vernon to celebrate General George Washington's 285th birthday. While the letter was signed by Warren, it clearly contained some of Charlie Munger's insightful views and was probably edited by the incomparable Carol Loomis.

Sir Isaac Newton

Sir Isaac is acclaimed as  the identifier of the laws of gravity. For many of us market followers this is often translated to what goes up, comes down. We always hope that our particular investment will either continuously rise or we get off the back of the market tiger successfully before he runs in the other direction.

At this particular point I have been focusing on Sir Isaac's investment activities to guide my clients' and family's investment accounts. For almost any gathering of people who are involved with the market the question comes up, “Should we sell after this remarkable rise we have had in many stock markets around the world?” I should not claim forecasting skills, but I can serve up lessons from history.

The South Sea Company was what we would call today an unusually clever public-private partnership that was founded in 1711. The company was awarded a commercial trading monopoly with the lands in the South Seas (South America) and for this the company would assume the war debt coming out of the War of Spanish Succession which ended with the Peace Treaty of Utrecht in 1713. Originally the promise of the company was a 6% yield, but as the government offloaded more of its debt on the company, the promised yield was dropped first to 5% and then 4%. In the Peace Treaty the monopoly was translated to mean one ship a year and there were some restrictions as to the commodities to be traded, but with the fabled gold and silver production in South America the ownership of this team of wealth was deemed to be very valuable. In January of 1720, not quite 400 years ago, the stock was trading at £128, in February £175, March £330 and £550 in May. Somewhere in this parabolic price rise, Sir Isaac (being well trained in mathematics) sold out. Well and good for our hero.

The only problem was that on the way to its ultimate peak of 1000, Sir Isaac got sucked back in, and when it collapsed to 100, he had lost £20,000. According to one account that the loss would be worth £268 million today.

(For those who are interested I would be happy to discuss this bit of history and the roles of the government, the main bank, and other bubbles.)

One of the risks of using the past as a measuring device is that occasionally one can be premature and in some cases quite premature. It is not too bad missing the last opportunity at or near the top. The real penalty is borne by those who get sacked back in by envy and the belief that they can identify the top and go back in and stay in during an unconscionable decline.  I guess the best defense system is the willingness to accept both the loss of presumably large opportunity and actual realized losses during one's hasty parachute exits. 

With the lesson from Sir Isaac Newton's experience in my mind I am paying increasing attention  to expressed sentiments triggering actions. For example, according to one report, Renminbi transactions accounted for over 95% of total Bitcoin exchanges. I am seeing what I believe to be similar activities in some commodities as many Chinese are desperate to get some of their wealth out of their own currency. Further, I see some signs of potential large disruptions in  currencies and treasuries. My concerns are based on the fact that these markets are bigger than the stock markets and through margin and derivatives  heavily committed traders could quickly come into insolvency. This would be too bad for them and their investors. However, it could be very unfortunate to their counter-parties. Often these very same organizations supply credit and facilities to other market participants which could cause a disruption in the stock markets no matter what their level, but particularly if stock prices reflect an increase in speculation.

The Buffett Letter

I suspect that the lead item in Monday's financial press will be about his shareholder's letter released early Saturday morning.  Most of the focus will be about  the value of Berkshire Hathaway shares. As usual I will not compete, but focus as to broader implications on the report as if both Warren and I were back at Columbia.

The 52 year record of performance of Berkshire-Hathaway is truly remarkable. What struck me was over this period there were eleven years when the market value of Berkshire's shares went down and eleven years when the S&P 500 went down. What was interesting is that in eight out of eleven they were different years. This suggests to me while both time series produced good results (20.8% for Berkshire and 9.7% for the S&P 500), they are not good tracking devices for each other. Thus they are not well correlated to each other. One of the reasons I suspect that many accounts that are broad market index centered will be underperforming is that the correlations in today's market is widening. This theme was repeated in a couple of examples from the letter.

Every year since 2002 the operating income, including interest and dividends has produced more for the shareholders than capital gains. These results are the product of a relatively low turnover of its securities investments and the increasing shift to buying companies rather than securities.

The preference of Buffett and Munger to buy whole companies is producing better long-term results than buying publicly traded securities.  This is due to trading, when appropriate, the absence of dividend requirement and the ability to leverage. Other corporate investors have seen this as well which in turn has led to an absolute shrinkage in the number of US publicly traded companies. Further, there are fewer mega cap companies that can profitably use the ministrations applied by Berkshire and ValueAct.  Thus, I suspect that there will be more acquisitions made and there will be some medium cap deals that show larger potentials will be acquired. 

Berkshire reports the earnings of Clayton Homes under Financial and Financial Products rather in their manufacturing complex. While the bulk of the revenues for Clayton comes from manufacturing homes the bulk of the earnings comes from its mortgage operations. There are many public companies and their subsidiaries are similarly misclassified  compared to the better security analysis exercised by Berkshire. In a similar vein, many sector and industry index funds  have  been characterized improperly. Again this may come back to haunt certain sector and industry index ETFs.

All investors and their managers should be indebted to Warren Buffett's page 22 where he shows the almost ten year record of Protege Partners choice of five fund of funds,  which include some 100 individual hedge funds' annual performance from 2008 compared with an S&P 500 index fund. For the nine completed years, the S&P fund was the best in five years. The best of the fund of funds beat the Index fund four times and the others one to two times. What I take out of this are the following:

1.  It is difficult to the beat the market .

2.  The market indicator does not win in each year.

3.  In its best year the index was up +32.3% and worst was off -37.0%, both of more are reasonable expectations for some future years.

4.  It is quite possible that the funds suffered from over-diversification and this is true particularly true versus Berkshire itself.        

In Conclusion

One wag has suggested that the only thing the markets are guaranteed to create is humility. Thus, as a never-too-old student I hope to learn from others, so I make fewer investment mistakes and hope you do as well.

__________

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Avoid Incomplete Data + Overconfidence

Introduction

Far too many investment mistakes can be blamed on incomplete data and overconfidence. In the real as distinct from the theoretical or academic world it is difficult to avoid these traps that have hurt us from time to time. The best that we can do is to be aware of the traps and to avoid putting too much confidence as to “what we know.”

Focusing on the Wrong Measurement Gaps

Perhaps Larry Summers was reading my blog post when we I was questioning the validity and perhaps the utility of building government and financial policies on Gross Domestic Product. My concern is that there is little or any attempt to include unreported income within GDP. The former President of Harvard, Secretary of Treasury, and frequent pundit stated that he wished to abolish large denomination currency bills, for instance the $ 100 dollar bill and similar sized notes in other currencies. His view is that these pieces of paper are mainly used by those involved within the higher echelons of the underworld. At least with that projection I believe he is largely accurate. But he is missing a far more important set of facts published by his own organization. The Harvard Kennedy School found that the US Tax Gap on unreported income was 14.5% of reported tax liabilities in 2006. Other countries have different degrees of shortfalls: UK 6.4%, South Africa 23%, Bangladesh 36%, Thailand 53% and Pakistan 70%. On a global basis someone at the UN felt that the global tax gap was $2.1 trillion.

As far as I know, no one has taken these tax gaps and other less than complete estimates to adjust various GDP figures. Any student of high end purchases should question the sources of the money spent and saved. I have felt that observing the inhabitants of leading countries might be a more valid factor than what one could derive from government statistics. Since ancient times as soon as many people became wealthy in their own eyes and after fulfilling the needs for conspicuous consumption they found acceptable ways to both invest and to hide some of their wealth. They have been doing this long before there were paper currencies. Abolish paper and there will be substitutes, physical and perhaps electronic.

My real concern is that the growing size of the hordes of large currency is probably the best clue as to the size and growth of unreported income. One expert believes that some small businesses and trades people could approximate 50% of their activities as transacting below the tax radar. As a student of both history and human behavior I do not expect radical changes in behavior. What I am concerned about is almost every top/down pontification by political and financial pundits starts with a verdantly express view as to what GDP will do in the immediate future, and therefore various proposed actions are appropriate. Yet the statistical base of their argument is inaccurate and possibly seriously flawed.

Thus until governments around the world massively increase the money they spend on gathering and analyzing their data, Professor Summers please do not now take away an important source of the growth of real world wealth just yet.

Overconfidence

Just as I believe that high confidence in GDP and many other government statistics is unwise, our uncritical confidence in future actions should be avoided. This is very tough to do. In our very busy lives we do not have time to cognate about future implications of present or past actions. One of the characteristics of the human race is the ability to convince others. Those that are better at this than others are our marketers. They often start with given themes for their targets to choose. The salespeople have learned to keep their pitches compact, or in their language “Keep It Simple, Stupid” or the KISS principle. That doesn’t always work out well. As a professional investor or perhaps a surviving professional skeptic, I need to always guard against the exhilaration of an enthusiastic pitch.

Washington’s Mistakes

We can always learn from properly portrayed history. Saturday night my wife Ruth and I attended the birthday celebration for General George Washington at his Mount Vernon home as we try to do each year. Saturday night’s principal speaker was Nathaniel Philbrick, who talked about his forthcoming book Valiant Ambition, on the implications of the interactions between General Washington and Major General Benedict Arnold, an eventual traitor to America who could have caused the US to be militarily defeated. The interesting part of the discussion was the author’s contention of Washington’s ability to learn from his many mistakes. He changed his strategy from one of highly confident and occasionally well-executed battles in my home state of New Jersey and less successful battles elsewhere, to an eventually successful war of attrition that was increasingly unpopular in England.

Our Own Historical Experiences

I am always trying to learn. As a long-term investor with a fiduciary responsibility I need to be on guard as to the power of our own historical experiences. We should look well beyond our own experience to those of others in different times and places. At some point in the past, based on their experience, too many home buyers, underwriters, and mortgage owners thought that house prices would only periodically stay flat or rise, never decline. (I have not read the book or seen the film “The Big Short, which I am told is excellent. I have been reluctant to see it for it does not place the original cause for the collapse at the feet of the US Congress.) Obviously, with 20/20 hindsight it is clear all the way along the chain there was overconfidence. Part of the KISS principle in selling this paper was the growing population and their supposed growing wealth. Often one heard “Demographics is Destiny.”

Some of the same argument has been put forth for investing in Emerging and Frontier markets particularly in securities of consumer discretionary companies. In many cases these pitches drove the valuations for these securities way above those of somewhat similar companies in the developed world before they recently corrected. This is not to say that they may now be more realistically priced. (Some of these stocks are found in some of the mutual funds that we own for clients and ourselves.) The vastly reduced level of confidence and increased level of investment research improves the long-term odds for those that are patient.

At the moment I am wondering whether there is a nexus of incomplete data and recently-experienced overconfidence. There is a well documented rush to own passive index funds either through mutual funds or through companion Exchange Traded Funds (ETFs). For those who own these securities there is a high level of confidence that history will repeat itself and these vehicles will perform relatively well. The incomplete data part of the picture deals with off board trades, the aggregate size of the intraday trading long and short, the financial condition of the market makers and authorized participants that can create and contract the size of an ETF. Further correlations within markets are widening with very few large cap stocks rising and pushing major indices higher whereas the majority of stocks within the S&P 500 declined in 2015. Other signs of changing demand include an increase in the level of the VIX. Further, over the last sixteen years bonds out- performed stocks, while some believe that for the next sixteen years stocks are expected to outperform bonds.

Change in the structures of demand for securities is likely to cause a change in the structure of the market that was not anticipated.

Question for the week if not the year: What changes in the structure of the market are you prepared for?

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