Entrepreneur vs. Investment Thinking

Singular vs. Diversified Investing

Charlie Munger reminds us that the great fortunes that have been made come from entrepreneurs who focus on one product or service and do it very well.

In maximizing their sound bites or column inches, the talking heads of the news media often focus on a single concept or instrument. While this specific input may be helpful if someone is looking to add to his or her portfolio, following the advice is verging on the irresponsible in terms of how it affects the whole portfolio and the total financial condition of the investor.

Recently I have been researching the impact of ETFs and other pre-packaged instruments and I found that many of the holders of these instruments don't understand the changes in the market mechanisms about trading in and through ETFs. Further they are confusing the difference between individual and team performance.

The Analysis of Picking Winners

As my readers know, I learned much about analysis by handicapping at the racetrack. In order to cash winning tickets it is not enough to find the fastest horse based on its prior races, work outs, breeding, jockey and trainer capabilities. One also needs to guess how the other horses are likely to run in this particular race. If the fastest horse in the race is your choice you would be better off if the horse is not blocked by a crowd of horses running similarly. Some horses with early speed that soon tire could help the ‘come from behind’ horse. Thus, in picking an instrument it is important to have some idea what the other major securities are likely going to be doing. Therefore the length of the race is important. In short races the ability to rapidly accelerate and maintain the acceleration until the finish line is critical to winning. In much longer races stamina is a good deal more important.

Picking Your Measurement Time

When a prospective investor asks me for a recommendation, I ask “What is the period of preferred measurement?” This is like asking the length of the race. To aid the investor, I introduced the concept of the four Timespan L Portfolios^TM, which stretch from the near-term to the long-term. I find this approach useful in contrast to almost all of the popular commentators, who appear to be focused only on periods of under twelve months. To use a military analogy, this is like firing a single rocket compared to a longer range guided missile with bigger and multiple payloads.

Index Funds are Different than Managed Mutual Funds

For long-term accounts, let’s compare an index-tracking ETF with a fully discretionary managed fund. The index tracking portfolio is like a rocket that once fired can not be re-directed to new and better targets of opportunity. The managed account can shift its portfolio composition to address a new or different investment opportunity.  It can change its risks assumptions. As a matter of fact that is one of the reasons managed funds have underperformed since 1987 and particularly since 2008; because of fears that periodic down markets would bring on the need for cash to meet redemptions, which has happened to US domestic-oriented funds for more than a year.

A managed portfolio needs to pass a prudence screen, e.g., avoiding bankruptcies as well as perhaps some social screens, individual stock limits to share of portfolio, shares outstanding and liquidity concerns.

A index tracker does not have similar constraints. Often its portfolio is constructed to represent the central tendency of stock prices along a particular axis such as market capitalization, sales, earnings, etc., that the publisher of the index selects as the single most vital indicator. In the extreme a managed fund manager can face a judge or regulator as to the prudence of the assembled portfolio; the index publisher has no such constraints.*  

*I hold the record for creating the largest number of indices, in this case for mutual funds, which are now published by Lipper, Inc.

Managed Funds Out-performed Indices During Turmoil

Recently S&P/Dow Jones Indices, a subsidiary of McGraw-Hill Financial reported that relatively few mutual funds beat the various indices, regardless of whether that was their goal. In an article in FT Money, Merrryn Somerset Webb of MoneyWeek pointed out that many fund averages lost less than the security averages from April 13th through August 24th. Her astute comment was not that the funds did better, but that the indices did worse. I would suggest that the absence of cash explains much of the sub-par performance of the indices.

Securities indices were never designed to be prudent portfolios and follow normal managed portfolio constraints, therefore it is not really useful to compare managed accounts to indices and ETF tracking vehicles. Each has its place in tool kits of investing.

Conclusion

Some of us like watching individual performers in the sports arena or on the theatrical stage. Others like to view a team of talented individuals working together scoring points or producing great symphonies. We should not confuse the attributes of each to select one over the other.

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Lessons from 2011 for Earning in 2012

The year 2011 was not a good year for many stock markets, investors and advisors, (I count myself among them). However, there are useful lessons to be learned for 2012 and beyond. One rationalization is that we did not pay sufficient attention to “the Risk on/Risk off” dance. These rapid fire flip-flops were focused almost exclusively on macro factors. Macro factors included the overall levels of interest rates and currencies plus political changes. As these changes occurred or were rumored, the markets moved violently. The rapid fire changes were triggered by syllogisms. If you don’t remember your plane geometry, a syllogism is a form of reasoning with two propositions leading to a conclusion, e.g., “If factor ‘A’ is true and factor ‘B’ is true, there is only one possible conclusion.” A contemporary example might be that (a) the US is in a political deadlock, (b) a major credit rating agency lowers the US credit rating, therefore (c) the US dollar, Treasuries, and its stock market will decline. (Those of us trained as analysts of individual securities require a large number of factors to make a decision. We rarely feel absolute certainty about our conclusions, as all the facts never line up on one side.) The “Risk on/Risk off” switches created the volatility that so unnerved individual investors in 2011.

Incomplete/misleading headlines

If one totally believed the flash news, one could complete the syllogism and react quickly. Unfortunately, all too often the headlines do not include enough information to properly evaluate the news. The following are three examples of news articles premised with too-shallow thinking:

1. “A World with Too Much Debt,” * based on data from the Organization for Economic Co-operation and Development (OECD), examines unfunded liabilities and official government debt as a % of GDP. The US ranks sixth, with a figure of 620% (98% of official debt + 522% of unfunded liabilities). This is pretty scary when Spain, Italy, and Ireland have lower numbers, indicating that the US is in deep trouble, enough to hit the “Risk on” button. That is, unless you look at the details, as micro analysts do. First the unfunded liabilities are the difference between the projected cost of continuing current government programs and net expected tax revenues. Note that the figures do not take into consideration any dedicated assets to these programs. Second and much more importantly, is that liabilities are shown without any calculation as to a nation’s assets, even if it were just the government’s assets. One of the reasons for this mismatch is that the US government does not publish a balance sheet, even an unaudited one. (As regular readers of this blog have learned, I believe our credit rating should be lowered to the mid-investment grade level, not because we don’t have the assets/earnings power to pay off our debts. The downgrade is warranted due to the political unwillingness to materially reduce the US deficit production.) Bottom line, in my opinion: the US debt picture is unhealthy, but does not have to be fatal. Thus, I would delay hitting the “risk on” button.
   
   *This chart was brought to my attention by John Maudlin of Millennium Wave Advisors
   
   
2. “There is significant evidence that the economic growth in China is slowing.” The expressed fear is that to head off a slowdown in China, wages will rise. As we buy so much from China, we will be introducing additional inflation into the US that will hit the Wal-Mart shoppers hard. There are three reasons that this is interesting but not significant. First, a substantial portion of Wal-Mart sales are grocery items, of which very few are imported from China. Second, my guess is that the actual dollar value of imports is approximately matched by the combination of transportation costs, including fuel, and Wal-Mart operating costs. (This company along with a number of other US companies has been very good at finding ways to reduce costs while preserving quality.) Third, we have already seen some production has shifted out of China to lower cost sites, including back to the US, due to increased automation. An important part of the fear of a slowdown in China is that they will no longer buy US dollars and debt, and will begin to be sellers that will lower the world value of the dollar and drive US interest rates higher. One should remember that the largest single owner of US Treasury debt is the US government. In various trust funds, the US government holds about 40% of US debt. Also, the combination of Japan and the UK actually own more of the US debt than the Chinese. Perhaps most importantly, one needs to understand that the Chinese government is not trying to do us a favor by owning our debt, they are solving their own problem. Chinese producers sell their goods all over the world, often being paid in US dollars. To keep the local currency stable and reduce the impact of imported inflation, the Chinese government requires all those that internally hold dollars to turn them into the Chinese banking system in exchange for local currency. With the dollars so corralled, they buy US Government paper. As the trade surplus with the US grew over time, the Chinese became involuntary holders of our paper and very much interested in preserving its purchasing power.
   
   Like most investors and analysts I do not know what is likely to happen to the Chinese economy in the near or far term. I hope to learn more from a trip to Hong Kong, Singapore, and Shanghai beginning the last week of this new month. I would appreciate your suggestions as to investment people I should meet.
   
   
3. “The November decline of Exchange Traded Funds’ Net Issuance”
   Some market pundits have raised an alarm about the decline in the net issuance of Exchange Traded Funds (ETFs). In November, the net dollar issuance was only $5 billion, down from $20 billion in October and $99 billion year-to-date. For some, this was another reason to go for the “Risk on” button. Net issuance is the difference between purchases and redemptions. If one disaggregates the data, the biggest decline comes from a drop of $23 billion in issuance of index ETFs. I do not know with certainty the cause of this decline, however I suspect that various hedge funds and others have regular “short book” purchases, less index funds, to offset some of their short positions. My guess is that once we see the 2011 data from the Investment Company Institute, the December numbers will go back to their former trends.

The Trend is Your Friend, Go with the Flow, and 1987

In the ever-present attempt to simplify investment assertions, the two expressions “The Trend is Your Friend” and “Go with the Flow” get great market currency in a “Risk on/Risk off” market. There is a lot of evidence that these attitudes can work well for traders who can and do reverse their opinions rapidly during the trading day. Now that we know that the S&P500 for all of 2011 produced a zero return on a price basis, and the Dow Jones Industrial Average on the same basis gained about 5% , we can determine how many of these hyperactive traders actually added value to their accounts. In some respect the year 2011 is similar to the flat performance earned in 1987. Both were the third year of a US presidential cycle and both had significant foreign inputs, but with a difference. In 2011, fears of European problems held the US market in check but did not prevent many companies from producing solid earnings. In 1987, the US domestic economy had growing problems, but in this case was bailed out by its growing exports. While finishing flat, both years had sharp market breaks as well as recoveries. One can take the point of view that 1987 was the required preparatory period that would usher in the market boom of the 1990s. With the current market finishing over thirteen years of no forward movement in the averages, we are ready for a longer term explosive upside that we can explain at the current time.

My bottom line

While we need to examine macro factors closely, we also must keep focus on the micro factors and be in a position to benefit early from the next rise.

My best wishes

My wish to all the members of this blog community is that 2012 brings a happy, healthy, and prosperous year; and that we are able to increase the level of our personal and professional communications.
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