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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History: Good Lessons & Not Great Predictors - Weekly Blog # 684

 

Mike Lipper’s Monday Morning Musings

History: Good Lessons & Not Great Predictors

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

Human Minds

We are all wagering machines. When we wake up day or night we make a bet, most of the time extrapolating the current trend. We remain on this journey and deviate based on internally accepted historic lessons, modified by predictions of change. Pundits, or so-called teachers, are often the sources of these perceived historic lessons. In the few minutes they have our distracted attention they simplify what initiated the change. These summaries are rarely subjected to evidentiary rules and opposing views, or the mood of the times.  

An example of how the viewing of financial data has evolved from my college days is evident in this weekend’s Bloomberg interview with Josh Friedman, Co-CEO of Canyon Partners, a very successful institutional manager of credit portfolios. He is a fellow trustee of Caltech and former Chair of its Investment Committee. His cogent analysis of the investment market suggests that much of what is happening relates to the sale of assets, not earnings, with institutional prices the result of carried interest/performance fees. The skill sets at Josh’s firm include asset accounting.

In the late 1950s, as an undergraduate taking graduate courses, I had the great honor of taking Securities Analysis under Professor David Dodd. He was the principal writer of the textbook with Benjamin Graham (Graham & Dodd). Showing more guts than brains, I questioned his focus on the proper valuation of assets and liabilities, considering his data started shortly after the trough of the Depression, when the first edition of the textbook was published. I felt it was outmoded in a world that was paying for earnings, particularly earnings growth. Smiling, he divulged how much money an investment in his fund had made by investing in assets selling at a discount. 

Columbia offered two courses in the second year of accounting. Cost accounting, popular with aspiring accountants, and asset accounting, tied to the Graham & Dodd investment practice. Asset accounting, unlike cost accounting, did not focus on the historic cost of assets and liabilities and created a much different valuation, similar to what Canyon Partners practices today. Perhaps the most valuable lesson from that course was the final exam, where 50% of the score was devoted to the critical aspects of a business not captured by the accounting statements.

Both the late David Dodd and I were right. In the 1960s and some of the 1970s, stocks with earnings and earnings growth were the standout investments. Later during that period, Mike Milken spotted Keystone custodian funds having a junk bond fund with significantly superior performance to its stablemate, a high-quality corporate bond fund. Milken, through Drexel Burnham (*), began a very successful sales campaign to sell high-yield or junk bonds to insurance companies and savings institutions. It was so successful that there was soon a shortage of paper to fill high-yield demand during this period of low interest rates. Much later, rising interest rates cratered the market price for “junk” bonds, brought on by increased regulatory pressure and Volcker attacking inflationary pressures. At much lower prices, another era of asset accounting value surfaced.

(*) I was a junior analyst at Burnham in the mid-1960s, still chasing earnings.

Cycle Repeats, Lessons Should Have Been Learned

During the early part of the first Obama term, they created stimulus programs to give cash to consumers, hoping their increased spending would influence the mid-term election. However, a good bit of the money was saved or used to pay off debts, reducing the economic lift. With some of the same people in the White House today as in 2009, they should have learned that excess stimulus will create inflation in the years to come, as recovery from the lockdowns creates expansion.

Lesson of Lessons

Each lesson should be adjusted for historical perspective and given a different weight under different conditions. You should also consider when a particular strategy or tactic won’t work. It is also useful to evaluate what else is happening at the time and consider its influence on the result or the value of the result. Although pundits try to deliver a forceful simple statement that immediately solves problems, life is rarely binary. We need to accept that we are complex people living in a complex world.

Predictability

One reason all investors should pay attention to mutual funds is they reveal what individuals and institutions are doing or not doing. Before delving into fund performance statistics, a few general comments might be useful:

• The main use of mutual funds is to meet retirement or legacy needs.
• Funds, even no-loads, are sold with involvement of an intermediary.
• As long-term investments they are rarely disrupted.
• Most redemptions are completions or reflect changes of needs.
• The former commission broker is now a wealth manager getting an annual advisory fee, making an ETF the likely choice.
• Fund owners have other financial assets.
• Salary savings - 401k, 457, and 403 are pension replacements.
• Funds are being used by a growing number of institutions.

At least weekly, if not daily, I examine fund performance. From an investment policy standpoint, I pay particular attention to two mega collections of funds encompassing most of the equity assets of mutual funds. There are 18 peer groups of US Diversified Equity Funds (USDEF) and 13 Sector Equity Funds. (At times I pay attention to global, international, commodity, and mixed asset funds as well.) After the end of each month, I look at a report that portrays total return performance for 8 periods, from one week to ten years. One screen I use for some accounts is to see which investment objective peer groups perform better than the average of all S&P 500 Index Funds. The analysis to the end of May shows two important elements.

1. For the year-to-date period, 10 of 18 USDEF and 8 of 18 Sector Groups beat the S&P 500 Index Funds’ average. This is unusual because index funds have lower fees, less turnover, and less cash. This is a trend that has been happening since the bottom of the market and may not last a long-time.
2. Contrasting the YTD figures with 10-year performance, one can see the difficulty in beating “the market”. Only 3 of the 18 US Diversified Fund Groups and 4 of 13 Sector Fund Groups beat the S&P 500 Index Funds’ averages.

What was the frequency of various peer group averages beating the market during the 8 periods? Small-Cap Value, Multi-Cap Growth, and Tech Funds each did it 5 times. Large-Cap Growth and Natural Resources did it 4 times.

This suggests that superior investment selection is difficult and possibly should not be an appropriate goal. A subject for a later blog. For those that are interested, I recommend two articles in the Saturday Financial Times on selection difficulties. They are titled “Racing Industry Looks to Epson Derby for Galileo Heir” and “Tiger Cubs on Prowl after Robertson built dynasty in hedge fund jungle”.

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Short & Long-Term Inputs to Successful Investing - Weekly Blog # 539

Mike Lipper’s Monday Morning Musings

Short & Long-Term Inputs to Successful Investing

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

Last week may have been important to both time frames below.

Short-Term
Followers of the US stock market should recognize that analytically the most important news of the week was not that the Standard & Poor’s 500 rose slightly to a new peak exceeding its January top, but rather that it finally caught up with record highs for the Dow Jones Industrial Average and the NASDAQ Composite. What could be more important to short-term market performance is how equity mutual fund averages performed. Many institutionally oriented investors believe that the S&P 500 with its higher market capitalization is “the market”. However, during the week ended Thursday, the average S&P 500 Index fund underperformed most actively managed mutual funds (13 out of 20 US Diversified investment objectives, 17 out of 28 sector fund averages, and 23 out of 25 global/international fund groups). This view suggests to me that investors are becoming more selective than the capitalization weighted market. If this continues we could see a frothier market, which is characteristic of a late stage stock market.

Long-Term Better Financial Reporting
The President favors higher stock prices and not downside volatility. To him stock prices going up are an indicator of present and future growth. When prices periodically go down, he views it as short sited and an overreaction to the publication of unfavorable earnings reports. To him, if there were fewer reports there would be fewer declines. This is not supported by a review of traded markets around the world in all kinds of instruments, from real estate, to currencies, bonds, and stocks. I am delighted that most investment professionals disagree with the President’s view. One of the earliest was Lee Cooperman of Omega and like me a former president of the New York Society of Security Analysts. Later in the week my old friend Bob Pozen, a former President of Fidelity and former member of the US Government and a Professor at MIT, wrote an Op-Ed piece in The Wall Street Journal which expressed a similar view. The WSJ, on its editorial page, was also against changing to semi-annual reporting.

Nevertheless, I am pleased that the President may focus more attention on financial reporting and analysis. One of the least read documents is the SEC’s 10-Q report, which displays more complete financial statements than those in written press releases and includes the ever-exciting footnotes. Unfortunately, far too many investors look at whether sales and earnings “beat” corporately generated “guidance” or the average of publishing analysts’ estimates. Using any single standard is often wrong, as it is with one size fitting best for clothes or other decisions. To me, the way one should look at results can be broken down into three categories. What happened during the period both internally and externally that was beyond reasonable expectations? What were the results of management’s key performance indicators (KPI)?  What were the time periods that management was focusing on? And what did the balance sheet reveal about capital risk?

What Unexpectedly Happened?
Most investors are aware of headline events and expect management to be able to conduct their business appropriately. What they may not comprehend is how these events directly impact both current results and changes to internal forecasts. This is particularly important for internal events in terms of people, prices and policy changes. It is unrealistic to expect companies and their leaders to be on auto-pilot. To an important degree the future valuation of a company is tied to how it handles unexpected changes. Smart competitors already sense what the competition will do when things change, so it would not hurt a company to give some clues as to the impacts of unexpected changes to their owners.

Key Performance Indicators
Often when I start looking at a new company I try to find out what the more important KPIs are. Whether I agree as to their importance is not germane, what is important is how management thinks. All to often in a digital world the KPIs are shown as numbers in a dashboard setting. However, some of the most critical needs are qualitative assessment of people, including successors, customer development, and product & service quality. Nevertheless, a dashboard approach is useful if it can be kept to a single well-thought-out page and  should be an abstraction of what the great merchants carried around in their heads. As an example, while I like details more than most, there are a few things that I care about everyday, like the quality of reports, levels of service to clients, development of people, the schedule of new product development, and the operating cash in bank accounts. Notice, for me I was primarily focused on operations rather than the direct value of my ownership. In my analysis of some publicly traded companies, CEOs are much more concerned as to the appropriate value for their ownership and options. There is nothing wrong with that, it just addresses the appropriate time periods for investment analysis.

Time Periods for Judgment
While we all dwell on multiple time periods, we tend to manage mostly to a single time-period. There are two lists shown blow to highlight the most logical time periods to make judgements. The first is for companies and the second is for individuals. Reporting should focus on the most important time period that management is using to make their decisions:

Business
Type of Activity              Period                                   Comments
Business Enterprise      Each Day                              # days/size of losses
Fashion Firm Season    More than one a year
Financial Groups           Economic or Market Cycle
Cycle Developers           Maturity or Final Payment

Personal
Type of Activity              Period                                     Comments
Politician                         Next election
Statesman                       Next Two Generations
CEO                                  Planned Retirement             Voluntary
Parent                               Children off family payroll

Risks to Capital
Almost all press releases exclusively discuss revenues and reported earnings, with some attention given to earnings under GAAP. Apart from very occasionally listing book value, there is no identification of capital risk. It is this very concern that the founders of modern security analysis, Graham and Dodd, were most concerned with in security selection. Today’s book value incorporates many of the items that had questionable liquidation value during the depression years. These include raw materials and work in process inventory, goodwill, and intangible assets. If one eliminates these, over values real estate at historic prices, and under depreciates capital equipment, the stated value of equity is in many cases materially reduced. These are not generally a concern in periods of expansion, which likely won’t last forever. I believe we may enter a period where costs will be driven up by cost-push inflation, with slower demand-pull price increases. Thus, margins will be under pressure and balance sheet values may be questioned. At this point in time I can not with certainty predict such a period or the diminution of balance sheet values. However, out of a concern for prudence one should be aware of that possibility. Hopefully future reporting will recognize this need and make us aware of these issues in their quarterly reports.


Questions for the week:
What periods are important to you in your investment decisions?
Do you spend any time looking at the balance sheet and cash flow statements of your investments?
 


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Can You Blame Your Investment Model?

Introduction

Every moment of every trading day we are confronted with the question, “Do we buy, or sell, or just rearrange?” While one does not know exactly when the next major investment peak or bottom will be, almost all of my time should be spent on how to function between these extremes. Nonetheless, since the actual future turning points are not known, I probably should not expend a great deal of intellectual energy or emotion focusing on the search. If I have this discipline it puts me in a minority of those who make statements about the market. Perhaps my investment accounts and I are benefiting from this redirection of my emotion and mindset. Nevertheless, most of us operate in a relative performance world, my performance will be judged as how it compares with how others perform. Thus, I need to grasp how other investors, particularly institutional investors, view the market. As Hylton Phillips-Page, our firm’s VP of fund selection and I have frequent discussions with both mutual fund portfolio managers and some of their investors, I am struck that most of these chats revolve around  “the market” in general, or the price of a particular stock is expressed as a ratio of the current price to some other variable. Most of the time the managers believe they are buying and owning at some attractive discount to the larger variable. In other words they have a model which is generating a distinct benefit for their investors.

Experience as The Model

What I have learned from the Neuro-economics professors at Caltech, (where I serve as a senior trustee) is that when most are forced to make a judgment, the brain reviews its experiences. If the experiences generated pleasure it was good and thus similar situations will also be judged as good. Having been essentially a student of investing not only through my life but also of others over history where I can get some historical insight, I see a particular pattern emerging.

Most of the time prices move gradually. Often at the final run up or collapse one can divide professional investors/traders in general by age categories. Whatever driving enthusiasm is largely supported by the young, who view the then current offering as new, different, and wonderful will be the opposite of their older brethren that distrust the surge as it looks suspiciously like past problem-producing situations. Thus the more experienced players don’t participate until the parabolic price move that comes just before the turning point. Some of the more experienced players can’t stand missing out these “goodies” and need to defend themselves against the arrogance of the newly rich. (The same pattern occurs on accelerating declines to a bottom when the twin views that the world is coming to an end and/or prices fail to reflect the survival realities.)

I have noticed throughout my career that many formerly successful investors miss out on “the new thing” because the load of their experiences reminds them of past failures from over-excited enthusiasm. One of the advantages of investing through medium to large mutual fund management groups is that they often have bright analysts and portfolio managers, some with a great deal of successful experience and often, younger ones that perceive greater futures. In assembling a portfolio of mutual funds we choose some of each.

Which Past is Relevant?

To choose as the statistical base for a predictive model we have recorded human history, derived history from scientific sources in addition to yesterday’s news. I suspect we could do far worse than being guided by The Bible. It tells of seven fat years followed by seven learn years, currency manipulation by rulers, collectible and uncollectible taxes, famines, wars, disease, population growth and immigration, etc. While no one has proven that these lessons are not still applicable, we have chosen to shift to statistical measures. Most often we rely on government produced statistics. Since I have met some of the tabulators and understand how they gather data,  I have always had a jaundiced eye on their product. That is even before today’s fully expected (by me) article in the New York Times about groups of government employees developing “slow walking” strategies showing their opposition to the new Administration.

We measure our deficit, that will undoubtedly grow, as a % of our GDP which is an output measure not a wealth measure. As a matter of fact the government’s main view of the population is derived largely from aggregating tax returns. I ask how many of our readers attempt to show the largest income and the least expenses?! Further, often as people get older their wealth grows and in retirement it is their wealth not their income that motivates them.

Another source of questionable value is reported earnings of public companies. When evaluating a possible acquisition of a public company the excess assets and the operating business are separately evaluated. (I sold a data business’s operating assets, not the company and its balance sheet.)

One of the more popular valuation metrics is averaging the last ten year’s reported earnings. This is in contrast to my first lesson from Professor David Dodd, of Graham & Dodd, which was to restructure both the balance sheet and income statement to put them on a comparable basis with other companies that could have been investment candidates. Many models are based on industrial sectors as defined by either the government or a major credit rater. Over the years both IBM and Apple^* among others have been shifted from sector to sector. I suggest that if one wishes to be long or short either of these securities, it will not be because of different statistical ratios with whatever industrial sector someone places them.

^*Held personally.

We are in a New World

I am well aware the typical reason given to buy a security that is historically over-priced is, according to the salesperson, “This time is different.” To some extent that could be right today in that we have entered essentially a new phase. In the past the leading countries were growing in population and wealth. Often they were clearly technological leaders. In the United States, China, Japan, and developed Europe, the size of the work force is declining relative to their total populations and all are experiencing growth in seniors. (This may inhibit the new Administration’s ability to grow the US labor participation.)

Interesting that some have looked askance of my announcing our firm’s smallest new commitment to a fund that invests in the Middle East and Africa, because of favorable demographics, savings rates, and progress in their educational institutions. Based on current trends it is only a matter of time that Africa will house one quarter of the world’s population.

We are now living in a world where farming and manufacturing are becoming smaller relative to the growth of the service sector. (Service sector includes financial services which is experiencing growth from traditional sources but also new entrants and technologies. Unschooled farmers in Africa are daily monitoring the price of their commodities on cell phones. The fastest growth in the financial sector is in mobile finance and banking.)

The world is facing the integration of currencies, taxes, trade and military policies. One should expect that in the future we will understand the difference between schooling and useful education.

Do I Have a Model?

The simple answer is no. But I have a process to benefit and protect my investment responsibilities. First, I attempt to get our accounts to utilize the TIMEPSAN L Portfolio^® approach which addresses the importance of getting the future right. The shorter term portfolios live in the world of the present whereas the longer term portfolios are more future oriented. Since we use funds from a number of the leading investment organizations each has their own views of the future, they will change over time.

My model essentially leans on the investment lessons that have been learned over the millennia and watching what smart commercial and investment professionals do with their long-term money.

Question of the Week (or perhaps the year): What Model Drives Your Investments?  

__________

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