Adjust Investment Tools for Next Phase - Weekly Blog # 667

 

Mike Lipper’s Monday Morning Musings

Adjust Investment Tools for Next Phase

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

As Rules Change, or are Better Interpreted

For many years to the extent possible, I managed the Defined Contribution Plans for the NFL and the NFL Players Association. At the time of each Super Bowl, when asked which team I was rooting for, I replied “for those in the black and white uniforms”. I hoped the officials would see all the relevant plays and correctly interpret the changing rules of the game. As it turns out, that was good training for watching the constantly unfolding investment games between buyers and sellers, various regulators, shifting weather conditions, injuries, mistakes, and pure luck. None of the results were pre-ordained and would be argued about for many years into the future. I approach each market and market phase with the same weariness in preparing for the next market phase. Part of the preparation is examining the terms used to describe the game, and when appropriate improve definitions. This exercise may be particularly important this year, as it appears we are close to a crossroad.

Enthusiasm vs Crumbling Underlying Structure

Many global stock markets are rising in February, despite the historical odds that after a decline in January there is only a 22% chance that the remaining eleven months will produce a profit. The general media, revealing their political views, interpret the various executive orders and other political pronouncements as accomplishing their goals, and see an economic expansion beyond the release from the lockdowns. It could happen, but the odds of complete success are unlikely. 

The current small-cap +5.03% and emerging market +3.07% leadership in January is like other late stages of the past. Fixed income funds often lead equity funds in terms of direction. For the year through Thursday night, the average S&P 500 Index fund was up +3.16% vs -2.95% for the average General US Treasury mutual fund. Another worrisome note is the size of margin debt, which perhaps due to short squeeze actions has reached record levels.

A good investor should look beyond stock prices to see a different economic view, which I attempt to do. Large futures speculators are increasing their shorts in copper, Eurodollars, S&P 500 minis, emerging markets, and US Treasury bonds. In recent blogs I mentioned the Industrial Price Index rising compared to a year ago and this week it accelerated to a gain of +33.18%. The bond market recognizes these tensions and the yield curve has continued to steepen. Even the Congressional Budget Office sees that inflation will likely be over 2% by 2023. (My guess is that it will be a lot sooner, raising the cost of financing the politically generated deficit.)

Understanding the Tools of Security/Fund Selection

Headline writers and many marketeers prefer short words to describe complex tools, e.g., “growth” and “value”. These create good pictures or charts, with ever rising growth and ever declining value. Would it be so. As with the changing weather at a football game, conditions change, as do the useful definitions of terms. 

Speculators essentially bet on what others will pay for their shares, bonds, or loans in the future and a successful speculator primarily knows his/her markets. An investor is a partial owner of a company that at some point could be purchased by a knowledgeable buyer. It has been the motivation of buyers and sellers in marketplaces around the world since recorded time. Perhaps in response to the “great depression”, securities analysis became a separate academic subject, distinct from older economics courses. 

Benjamin Graham was a successful analyst/portfolio manager/investor. He was also a good writer as an adjunct professor at Columbia University and worked with Professor David Dodd in writing the first textbook on Security Analysis. Graham and Dodd were primarily interested in avoiding unnecessary investment losses in their writings and emphasized the use of financial statements, particularly balance sheets. In early editions of their six-edition book, they emphasized anticipated liquidating value, an issue appropriate during a depression.

While Ben Graham is often erroneously called the “Father of Security Analysis” and the first value investor, this is not where he and his partners in a closed-end fund made most of their money. The fund became a dominant shareholder in an insurance company which had no real equity left on its balance sheet. What it did have in this period of substantial unemployment was a customer base of relatively low wage employed government workers. They saved and ended up controlling Government Employees Insurance Company (GEICO), which Warren Buffett analyzed and eventually bought outright.

Years later I personally had the honor of taking the Security Analysis course under Dave Dodd, but I disagreed with him and believed that growth was an important factor in choosing investments. He  quickly shut me up by indicating how much money they had made on their investments. Years later, as a small entrepreneur, this led me to include growth and more importantly the evaluation of key people in making successful investments. (In evaluating three cases, one had to be closed, another was key to a bigger product, and the third was very successful). As a side matter, I was particularly pleased to receive the Benjamin Graham Award from the analyst’s society in New York for a private matter requiring some investigative skills a few years ago.

Today, when I review financial statements, particularly the footnotes, I have little confidence they will reveal the “true value” of the company. We live in a litigious world and accounting practices are designed to protect the accountant, the underwriter, or the company itself against lawsuits, rather than to ascertain value. However, there are some very good analysts that are pretty good at finding the range of values for a company. These analysts don’t publish their work, as they are employed by investment bankers, private equity funds, or serial acquirers. While they don’t publish, the price of their bids and deals are known, and this sets the market price for similar deals. If I can’t get enough data, I use the multiple paid for earnings before interest, taxes, depreciation, and amortization on successful bids. 

To understand value investing, one needs to understand where the current market is and what is best indicated by the price of deals. These in turn are influenced by the level of interest rates used to discount future growth and the cost of acquisition.

How to Measure Growth

Many believe that any number larger than the previous number is growth. For valuation purposes however, what is useable are growth comparisons. They should deduct inflation, exclude acquisitions, currency changes, and the impact of changes in regulation or competition. To me, each period may be different, so a long period growth rate can be misleading. 

I like to see the consistency of growth rates. There are times when highly variable growth rates leading to above average long-term trends are valuable and times where a more consistent return is more valuable, particularly for accounts that have finite payments requirements. (For mutual funds, we measure both total return and consistent returns.)

What about both Growth and Value?

In truth many companies go through periods of growth and value. IBM, before it changed its name and was under Tom Watson’s management, had so much debt that it was viewed as an underwater stock. Years later, it became the prime example of a growth stock and later still its growth slowed to the point where at times it was viewed as a value stock. Because of various recent changes I don’t know how to characterize it. What I do know, is that past financial history is not of much use to an outside investor. 

Since many companies go through numerous growth and value changes, I favor looking at many periods. However, it is more important to look at changes within the company, including the people hired at the senior and entry level, changes in product/service/prices, and the reaction to competition/regulation.

Conclusions

1. Look at how things are, don’t overpay for history.

2. Expect surprises!

3. Take partial positions initially.

4. Admit mistakes quickly and serially.

Your Thoughts?

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Time to Change Investment Labels?

The secret is out! The volatility around a flat performance in the second quarter proved that successful investing is difficult for most equity managers. While the quarter was essentially flat, individual months, weeks, and certain days showed wide up and down swings. (Future posts will deal with the mechanical/devoted capital sources for this volatility.) Even before this saw tooth pattern, a number of fund organizations and astute investors were seriously questioning their reliance on labeled strategies.

The label trap

In our work selecting mutual funds for clients, we have detected at least five sizeable fund organizations that are having deep internal discussions as to how to improve the overall performance of their family of funds. I suspect there are many others quietly going through the same exercise. Similarly, various institutional investment committees are asking related questions. A magnetic compass has the comforting aspect that it always points to magnetic north and one can then, with a high degree of certainty, triangulate to where one wants to go.

In these internal fund group discussions there is a sense that possibly they have lost the arrow pointing to magnetic north. All of the groups that are troubled by their recent performance have in the past had good absolute and relative performance, just not now. In many cases this unease has been building over the last several years. Their fundamental question is whether they should throwaway the compass because after all we now live in a “GPS World.”

In the equity world, the compasses that worked well in the past were various labels; e.g., growth, value, growth at a reasonable price (GARP), quality, income, etc. I believe that these supposedly distinctive labels have been proven to be traps for investors and managers. Traps because they did not provide winning results. The dispersion of performance results of portfolios gathered under these labels has been much too wide to be useful. Bad performers on an absolute basis can be found under each label and the top performer rosters include funds that march under different labels.

The need for labels and abbreviations

We live in an abbreviated or sound bite society. Because so much is happening in the various worlds around us, we feel compelled to gather an ever increasing bundle of information. In order for us to store all of the elements of information we need to file in our mind (or on our computer, smart phone, etc.) distinct categories are needed to help us in recovering the relevant information when we need it. Even in our enormously underutilized brains (both physical and digital) there are capacity limits. To be able to cram more information into these spaces we abbreviate the addresses for each element of storage.

I used the expression “GPS World” above. All of the travelers out there know what GPS is and what it does. Many may not immediately recall that GPS stands for global positioning system. Fewer will remember that it is based on signals from satellites in the sky. These satellites were put in place initially to help our space probes. (Much of this pioneering effort was conducted at the Jet Propulsion Laboratory of Caltech where I am lucky enough to be a trustee and sit on their investment and other committees.)

Notice how the combination of labeling and abbreviated addresses has replaced relying on magnetic north to guide us. I wonder whether we have adjusted our philosophy due to this switch. This change is very similar to the quandary facing many investment organizations and investors today.

Labels are investment commands

As we grew up our parents and other authority figures reinforced their observations and directions by the label “good boy” or “good girl.” Years later we hardly remember what the original issue was, but we do remember the label of being good.

Often our first serious investing class is taught by an academic, with or without a CFA. In an enlightening period of roughly fifty minutes the instructor wants to present an investment concept often with complex graphics and tables. The clear message is that if one follows the concept, “good” things will happen. Perhaps the professor briefly discusses the data, rarely pointing out the holes in the data or periods when the concept did not work. Unfortunately, these courses are not taught from the vantage point of handicapping horses at a race track. Horse racing data always has holes in it because most histories are quite short and conditions of the track, the race, and the nature of the competitors change. From a gambler’s (or if you prefer, an investor’s) standpoint, the odds or perceptions in the marketplace are a measure of the reliability/ predictability of the data. For a numbers junkie like me, the data does not show the direct impact of personalities of the jockey, trainer, owner, groom, and racing officials. Thus, the appellation that a horse is a sprinter, or comes from behind, has beaten worse horses, or similar moving up in quality labels should be taken in with skepticism. The terms “growth,” “value,” and “good quality” should be received with some doubt, as periodically they are not predictive of investment results.

While the academics and other pundits are the initial broadcasters of these labels, investment sales people are major users of labels as they have an even a shorter period of time to convince an investment committee or an individual investor the wisdom (predictability) of a concept. If in the first five minutes of the encounter positive interest and possible excitement is not raised, the odds are that it will be a tough sale. The marketing force behind the salesperson is also a heavy user of recognizable labels as it tries to find the right existing products to fit its perception of the quick reaction marketplace. Within many investment organizations the political power structure is driven by sales and marketing people and the labels that they have been taught.

New labels are needed

Coming out of the Great Depression of the 1930s most investors were focused on preservation of their equity capital with heavy emphasis on price-to-balance sheet factors. These concepts were generated by Benjamin Graham in his portfolios and taught by him and Professor David Dodd at Columbia University. Professor David Dodd then taught me. They were the authors of the seminal book, “Security Analysis” which many investors (including CFA candidates) use as their Bible.

Their focus was what on the assets could be turned into cash quickly. They did not value inventories highly and paid no attention to intellectual property or franchise value. Nevertheless, these precepts are often the basis of so-called value investing today. A few years later, but still in the 1930s, an investment counselor in Baltimore, among a few others, favored investing in the stocks of companies that were regularly growing their earnings. Thus, Mr. T. Rowe Price was one of the very first investors to invest for growth. Well into the 1950s and early 1960s growth was not a popular label for stock portfolios.

In recognition of the needs to come up with new investment strategies, Investment & Pension Europe in June published a special report on Risk and Portfolio Construction which showed that in Europe, investment people are looking to find better ways to construct successful portfolios. As with US based consultants, they have noted that there has been “style drift” in portfolios. Instead of treating this as a violation of a mandate, I would suggest that either market conditions or specific security conditions changed or the manager is groping his/her way to a perceived better investment dictum. Another factor, (discussed in last week’s post) are the impacts of flows. In the short-term, large in or outflows can dramatically change the performance characteristics of a portfolio’s performance which to the untrained eye might be seen as a violation of some label.

New labels on the horizon

Goldman Sachs has also recognized the problems with the existing popular labels. In their analysis of the performance of the S&P500 they have introduced a large number of filters. My favorites from their long list are: 

• EBITDA growth
• Sales Growth
• Enterprise Value to EBITDA
• Enterprise Value to Free cash flow
• Profit margins
• Return on equity
• International Sales (also by region)
• Leverage
• Tax rate
• Balance Sheet strength.

I would add a few others:

• Franchise value
• Replacement value
• Ability to successfully disrupt
• Major changes in management attitude and capability
• Institutional ownership
• Media sensitivity.

Bottom line

Since I am not confident that I can predict the future with any degree of certainty, like a good general I want to learn quickly what killed my troops (investment positions) and avoid those types of losses in the future. One of the lessons undoubtedly will be not to put too much emphasis on labels. For those beneficiaries that I have responsibility toward, I hope to make new mistakes not to hold labeled errors.  

Which investment label do you feel is most dangerous?        

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Faulty Tools May Lead to Faulty Investments

Construction of a sound portfolio of stocks or portfolios of funds is accomplished through the use of effective tools used properly. One of the many tools discussed in Graham and Dodd’s basic investment primer Security Analysis is the P/E ratio, the price divided by earnings per share.  I suspect that this measure, or similar tools, has been used by professional investors ever since financial disclosures were available.

As with any tool, one first must examine how the tool is constructed and when it can be used propitiously. Otherwise, to the amateur carpenter (investor) with a hammer, everything looks like a nail to drive into a surface. If there are lots of hammers around and everyone is using them chaotically, not many houses (portfolios) will be built that will give the eventual owners a competitive advantage.

These concerns surfaced to me after this weekend reading “Dissecting the Variety of Price-Earnings Ratios” by Liz Ann Sonders of Charles Schwab. She raises concerns about three approaches; 12 month Forward P/E, Trailing 12 month P/E and Robert Shiller’s Cyclically Adjusted P/E (CAPE). I share her concerns with all three approaches, but particularly CAPE. All of them are the product of statistics, not analysis. In each case the data used is as reported, with the good professor using it ten times regardless of the lengths of the business or market cycles. Most of the time most markets seem to be more selective in utilizing published results in terms of stated and unstated non-recurring events, including tax and accounting changes. Further, none of these measures as used by commentators take into consideration non-recurring events as to the competitors. I agree with her when she quotes the esteemed Howard Marks of Oaktree Capital who prefers to use the inverse of the P/E or earnings yield, which is often used in the UK. The advantages of the earnings yield is that it is easy to attempt to get a real return by deducting an inflation rate and them comparing it to yields available in the bond market.

The whole concept of using the level of earnings in a valuation model is to be able to compare over time whether a stock, market, or fund is more highly valued or less, compared to the past. In his attempt to give a longer term view of earnings, Professor Shiller used a passage out of the before-mentioned Security Analysis authored by Benjamin Graham and my old professor, David Dodd when they were attempting to use history as a guide to the present. When they wrote their seminal text they focused on the average business cycle which by 1934 was running at least 6-10 years. (In more modern times the average business cycle has gotten shorter.) Perhaps more importantly is that market cycles play a significant role in valuations. As regular readers of this blog know, the statistics one of the more astute mutual fund managers uses for incentive compensation is four years. In general investors in the stock markets should pay more attention to the market cycles while remaining conscious of the business cycles.

The proper use of earnings yields when building portfolios

In putting together investments to be purchased or repurchased today, I am more concerned about future valuations than selling opportunities. First as an analyst I attempt to copy the great John Neff’s approach of estimating the earnings power of a company. (Actually, it would be wise to estimate a range of earnings power in both good and bad years.) In the current environment, operating earnings is a better starting point than reported earnings.

When constructing portfolios, I believe they should be focused on different time horizons. A trading portfolio would have a time horizon of perhaps one year and in some cases the remaining portion of a calendar year. A portfolio designed to meet certain cash income needs should possess a time horizon to meet the next two years’ funding. A third portfolio designed to replenish the cash, needs a portfolio that might have a time horizon of five years. A longer term, almost an endowment approach would have a minimum of a ten year focus, or more appropriately it would be tied to a life expectancy or until the next major capital campaign is fully funded. Ms. Sonders is appropriately skeptical; but long-term focused investment professionals should be skeptical. A liberal use of discounting future earnings may help participants to sleep better. With this kind of thinking the endowment and other long-term accounts will be growth-oriented. To the extent that dividend and interest income is generated, the key analytic question is:  “What will be the future yields on this income that is not consumed?”

What to do in an aging market

We are four years from the last major stock market bottom, with the apprehension that we are more likely to suffer a meaningful decline than any time in the last four years. Today, there is a new seasonal factor that some traders and market technicians fear.  They are questioning whether the current April is replacing the normal May when they hear the old chant “Sell in May and Go Away.” This is a seasonal pattern that appears to have worked in the London markets since 1694, according to Mark Hulbert.  

 However the period between the beginning of May until Halloween (October 31) is typically most negative for manufacturers with little harm done to stocks of consumer goods, financial services, technology and telecom.

For most investors I would accept the periodic dips we have in the market particularly for the longer-term endowment type accounts. For the shorter-focused accounts I would gravitate to the highest available quality in each of the appropriate investment universes.

Make sure you are not using faulty tools, particularly as we head into more difficult markets.

What do you think?

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Growth & Value: Buyers and Sellers Disagree

In my periodic conversations with formerly successful fund managers, I am struck with a comparison to that wonderfully broad comic television program from the 1970s,“Fawlty Towers.” The essence of the program was a depiction of the “Peter Principle” at work in a small seaside hotel. The somewhat disdainful employees who filled the roles of hotel manager, desk manager, and chef all graduated, perhaps too quickly, from entry level jobs. In their roles they assumed the attitudes of what they perceived to be the deportment of professional hotel personnel, with some very humorous (but sad) results.

The formerly successful portfolio managers that I speak with mouth the same platitudes that they attribute to Warren Buffett and others, as well as their own statements of years ago. While these antics are amusing on the screen, they are tragic for the investors in the formerly successful funds.

Repetition doesn’t make it true today

Almost all of these managers vehemently proclaim that they are growth or value or somewhere in-between investors. These are wonderful banners that masses of investors march under, but have little practical meaning today. While all investors want to grow their capital, particularly after inflation and taxes, the original concept of growth investing as articulated by Thomas Rowe Price, Jr., and others in the 1930s was to invest in companies which produced earnings that grew faster than the economy (market). As no one wants to invest in securities that have questionable worth, value investing is buying something at a discount to a readily identifiable value. Contemporaries with Mr. Price, Ben Graham and Dave Dodd (my old Security Analysis professor) focused on securities with large discounts from current values. At its base level, they were speaking of liquidating value, which is why their initial focus was on buying bonds priced way below their value in liquidation. Warren Buffett, a student of Ben Graham, evolved these two approaches to look for investments that were selling well below their future or intrinsic value.

The apparent message from “The Market”

These formerly successful managers are trumpeting how “cheap” current prices are. The principal suppliers of this ammunition come from the sell-side brokers, academics trapped in the past, and talking heads desperate to find encouragement in an effort to hold on to their shrinking audiences. Why don’t the dumb investors and professional buy-side institutional investors accept the “cheap” argument and commit to current prices? As usual the answer is reflected in the numbers. Buyers are not accepting that stocks have as low price/earnings ratios and price/book values as the sales-side trumpets.

Why not?

There are two main reasons for this buyers’ strike. The first is faulty math. One of the very first things that Professor Dodd taught was not to accept published financial statements as a sole basis for making judgments. We spent hours on reconstructing these statements before applying any valuation issues. First, we focused on removing from the balance sheet any asset that was not readily saleable at the stated value. These would include inventories, real estate, goodwill, and intellectual property. In addition, we learned that liabilities are often understated, particularly in what could go wrong. Warren Buffett would add to the balance sheet the brand name value and the deepness of “the moat” that protects the proprietary value. (While these are not easy to calculate, some attempt is needed. Often this is called acquisition analysis which sub-divides into two categories; one for financial buyers and one for operating buyers.) The whole area of real estate utilization requires careful analysis. One needs to look at not only the current value reflected on the books, but also to ask, “are there any sweetheart arrangements with controlling interests that are giving the company a break on costs; or the other way around, with the company in effect paying a selective dividend by overpaying for the use of some property owned by insiders?” In addition, for many organizations with a large number of branches or offices, some of their leases are a competitive advantage in terms of key locations; some were signed during higher rent periods. In many companies this is too important an area not to be carefully examined.

One of the repeated fallacies that I hear from formerly successful managers and pitching analysts, is that if one deducts the cash on the balance sheet, the stock is selling at a very low ratio to its historic price/earnings ratio. This is doubly naïve. First, in many cases 80% of the cash is overseas and there could be lots of taxes to be paid on repatriation. In addition, a good bit of the cash hoard is a requirement of various lenders, buyers, and suppliers. The second naïveté is that when the cash is brought back to the home country, there would be a measurable benefit to the common shareholder. Unfortunately this is not always the case. The current fad with managements is to use the cash to buy back their own stock, disagreeing about the value of their stock with the market. The big advantages of the buyback are to help the management. First, it reduces the float of somewhat disgruntled shareholders, making a raid on the company more difficult. Second, by reducing the balance sheet equity, the management’s ‘incentive’ contracts, (based on return on equity) become easier to achieve. The third “tout” point is that the money could be used for acquisitions. Because so many acquisitions fail, both entrepreneurs and investor should ask, “will the deal ultimately build or destroy value?"

After unfortunately determining that they can not use all their excess cash, the more responsible managements increase their cash dividends, which often are tax effective and useful for the endowment-type shareholders who have grant responsibilities. (We manage the investments of several grant-making foundations where dividends are important.)

Turning to the income statement, a lot more work is needed before one should accept the bottom line net income number. Starting with the revenue components, it is important to understand how and when revenues are recognized. (There is a lot more leeway than many investors realize and there are differences in how competitors report.) Often the next quarter after the annual statement is full of changes from the last annual report, particularly on revenue recognition and the use and value of inventories. The whole topic of “other income” requires study as to the changing nature of its components, particularly if a portion of this revenue comes from lending money to clients either directly or through leases. The value of other income revenue may be different than the value that careful analysts put on sales. On the expense side, the largest single element is often compensation. Is compensation reflected correctly, i.e., what does it really cost to get these people to work for the shareholders? Balance sheet footnotes and proxy statements often give a different or at least an expanded picture on compensation. In my experience as CEO, the cost to continue or terminate employment is often very much higher than the last year’s compensation line on the income statement. Other expenses also need to be reviewed as to their reasonableness from an owners’ point of view.

After all of this work one can get a good approximation of current realistic book value and current earnings power. This is another place where the bulls get it wrong.

The future is not the past retold

Your past travels are not a sound predictor of all of your future travels. The same can be said as to the value of a stock, a portfolio of stocks, and the gauge of a manager’s skills. I manage a separate account investing in financial services stocks for my family and a few selected other clients; in doing so I look at the world through the eyes of the interaction between the financial services segments and the “real world.” The financial service sectors are the roads where capital changes hands and through very careful use of operating and financial leverage, that capital should grow. One of the problems facing investors in general is that the financial sector is shrinking. Due to the combination of operating losses from the use of unwise leverage and increased rearward-looking regulations, the earnings power of the sector has been reduced. This translates to fewer salespeople raising capital for new needs or capital transfers. Until the financial sector leaders figure out new ways to grow, one would expect that the general level of market valuation may well suffer. Further, bank leaders must deal with the realization that the many former ways they earned significant returns are no longer possible. Outside of the financials, other sectors have also changed dramatically, e.g., book publishing and selling.

What does this all mean?

One should not expect to find good investments by applying unexamined financial ratios to historical data.

What I am looking for in managers?

The first thing that I am looking for in a manager is a discipline of detailed, current security analysis, not a record of parroting the past. Normally too much turnover of stock positions leads to poor long-term performance, particularly on an after-tax basis. Today however, I would favor managers that increased turnover to repopulate their portfolios. I would like to see new names, with new stories based on new field work. Like other investors, I want to see new, sound merchandise.

Note: I would also like to replace “growth” and “value” with more accurate terms.
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