Investment Committee/Investors Prepare for Mistakes - Weekly Blog # 570

Mike Lipper’s Monday Morning Musings

Investment Committee/Investors Prepare for Mistakes

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

     
                               

Bright People Are Sometimes Wrong

I have assembled and often chaired investment committees of bright, experienced investors. I have been curious as to why these bright investors make unexpectedly bad judgements. Individually, they have a history of making good choices in terms of securities and the timing of their transactions. I bring this up as we approach a general market turning point. I am totally convinced that we will see record high prices for the major indices and I also have confidence that we will experience both recessions and substantial market declines. The order, timing, and magnitude of these are unclear to me. What I am sure of is that many investment committees and most investors will get their timing absolutely wrong!!!.

Why?

We are social people who mostly prefer to agree with others than to express a strident minority view. The group dynamic in most investment committees is to move to a unanimous decision. Unless we have very deep-seated opinions there is a tendency to go along with the sensed majority view, despite our own private opinion which may be better. This tendency has been labeled the “Abilene Paradox”. I suspect that this is one of the reasons that political pools have proven to be inaccurate. One can often sense the answer the questioner wants to hear and we have sympathy for those who ask.

Current Factors

Double digit gains were achieved by the major stock market indices despite the global slowing of economies. The gains if repeated would result in record price levels, led quiet possibly by the NASDAQ Composite, the most volatile of the major stock indices. This volatility could be driven by the larger tech companies or less capital being committed to over-the-counter market making.

The latest Atlanta Fed Real GDP fan chart estimate ranges from under 2.5% to under 1%, reflecting market fears.

China appears to be the most important driver of global economic growth. Some believe changes in Chinese policies are having a bigger impact than the Fed. In part this is true because interest rates driven by the Fed are currently in the mid-range. They have not gone high enough to attract savings (4%) or low enough to spur a declining economy.

One large fund of funds manager has re-juggled its list of managers in favor of concentrated “high-conviction” managers. Others are adding leverage to their portfolios to overcome low returns. From a market viewpoint the combination of leverage + volatility = dynamite.

Helpful Hints from Mutual Funds

Mutual funds are now required to show their best and worst quarters. These are often next to or close to each other. Often the magnitude of the gains and losses when linked together almost cancel each other out, although sometimes it may take two up quarters to recover the losses from the bad quarter. If the percentage gains and losses are large, it is an indicator that the fund is volatile.

The coverage of mutual funds can be misleading, as media and sales efforts focus almost exclusively on the best performers in relatively short time periods. The leaders and laggards are often highly concentrated in terms of the number of issues held, giving the impression that these mutual funds are bought for speculation, although that is not always the case.  

The vast majority of the equity funds are in just four investment objective categories and are listed below in descending order of assets, which also appears to be at increasing levels of perceived risks as you work your way down the list: 

Growth & Income    $4.27 Billion  

Growth              3.84                 

International       2.48                 

S&P Index           2.19                 

The first three investment objectives carry cash to meet extreme redemption needs and opportunity reserves. The biggest use for these funds is to meet retirement and for estate building purposes. Most redemptions are caused by life changes. Index funds always have no cash and buy the most popular stocks.

Turning Point Reactions Produce Relatively Small Gains and Large Losses

Historically, momentum becomes the enemy of capital preservation when we near peaks and troughs, unless an investor possesses trading skill. Investment committees at this juncture become captives of the “Abilene Paradox”.

Don’t say that you weren’t warned, but good luck and stick to your convictions.

  

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/03/the-actively-worrying-classpassively.html

https://mikelipper.blogspot.com/2019/03/long-term-trends-may-not-be-friend.html

https://mikelipper.blogspot.com/2019/03/the-top-before-big-top-weekly-blog-567.html

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Critical Decisions: Successors, Appreciation and Preservation - Weekly Blog # 523

Introduction

The combination of long flights and attendance at the Berkshire Hathaway* Revival meeting has led me to think more prominently about the structure of successful investment processes. I have often said that if one slashes the wrist of a securities analyst (even before they become portfolio managers), a historian will bleed.

I have been thinking about the failure of the conqueror of the ancient world Alexander the Great, whose key lieutenants were for the most part bad successors. In contrast, I compared that result with today’s most profitable company, Apple* and the succession of Tim Cook to the product/service genius Steve Jobs. (This not a prediction as to the future of Apple or its shareholders.) Currently we are in the public succession disclosure phase of the distinctive leaders of two companies: JPMorgan Chase* and the aforementioned Berkshire Hathaway. I believe both successful and less successful command changes should be studied in terms of responsibilities for our families and non-profits we care about.
*Held in client and/or personal portfolios

The Wrong Instincts

I have sat on a number of non-profit boards officially or observed them as their external investment manager. I have noted a number of habits that usually led to long-term sub par results. Choices are made by committee which tends to favor the politically skilled candidates. Frequently it is deemed important that the new leader get along well with the existing staff. Often what is needed for optimum survival  is to either seriously remove staff or materially change their way of thinking and executing. This is particularly true for academic groups where the new person is meant to solve the single biggest short-term problem facing the institution without upsetting too many of the existing “warhorses.”

Another road to failure is setting up a competitive horse race. Not to say that the best person not often wins, but all too often some of the better people leave in disappointment, which weakens the firm even if the best person wins. Unfortunately, we have seen this approach in financial organizations. Just think of the number of CEOs that have come out of GE and a number of leading brokerage firms. The same thing happens with both non-profits as well as families.

Successful Patterns

When Steve Jobs recognized that his deteriorating health would lead to the need for a new leader he chose Tim Cook. He was not a “product guy” like Jobs, but was the master of the supply chain manufacturing and selling all the wonderful new products that were dreamed up by Jobs and his tight design crew. Further, Jobs told his appointed successor not to do things they way he (Jobs) would do them, but the way that made sense for Tim Cook. Under the successor, the shareholders (and I presume the Job’s estate) have seen their assets multiply a number of times. I suspect that Steve Jobs’ thinking was in part shaped by having been fired from Apple in 1985 to avoid taking it into bankruptcy. Luckily he learned a lot with new responsibilities and was better prepared to be Apple’s CEO the second time.   

Selecting Two American Generals

We have benefited from two US Presidents making controversial decisions to lead our Army at critical points. President Abraham Lincoln chose a cashiered Ulysses S. Grant to lead the Union forces through a brutal campaign, first in the Midwest and then the South. Grant who graduated from the US Military Academy at the bottom of his class, accepted the surrender of Robert E. Lee who graduated at the top of his West Point class and is generally believed to have been the best general of the Civil War era. Lincoln’s selection of Grant was key to the eventual Union victory.

When it came to choosing the commanding general for the US-led invasion of Europe, President Franklin Roosevelt turned down the highly respected, most senior Army officer General George Marshall

(later a brilliant Secretary of State) in favor a much younger and junior officer, Dwight Eisenhower. I suspect FDR’s thinking was shaped by the fact that for a number of peacetime years Eisenhower was on the staff of the very difficult, but brilliant General Douglas MacArthur, who not only graduated at the top of his West Point class but also returned to the Academy as superintendent.  I believe that the President felt that if Eisenhower could get along with MacArthur he could work with the difficult British Field Marshal Bernard Montgomery. Being a politician himself, Roosevelt recognized the importance and skills of another politician.

People Skills Part of Asset Allocation

Warren Buffett believes his greatest contribution to the success of Berkshire Hathaway is making major asset allocation judgments. Beyond the required investment skill to make these decisions, he has the ability to “sell” his decision both internally within the firm, and also to his outside audience which he does very well. In looking at these decisions, with the help of Charlie Munger, he uses both capital appreciation and capital preservation strategies in building Berkshire Hathaway for the next generations of owners. While Buffett likes to portray Berkshire as a long-term thinker, he can afford to do that as long as he has a bountiful supply of cash or short-term paper.

With Warren Buffett and Charlie Munger as models, the approach that we recommend to prospective clients is based on our Lipper TIMESPAN Portfolios^®. For illustrative purposes only we have divided an institution’s or individual’s portfolio into four unequal timespan sub-portfolios. Each portfolio is assigned a portion of both capital appreciation and capital preservation securities and strategies which can be modified if conditions and specific needs dictate. The following table is illustrative and can be modified when required:

Lipper TIMESPAN Portfolio®	% Capital Appreciation	% Capital Preservation
Operational (Short-term)	25%	75%
Replenishment (Cyclical)	50%	50%
Endowment (Present lives)	60%	40%
Legacy (Future Lives)	80%	20%

Source: Lipper Advisory Services, Inc.

Please let me know how you would allocate resources for which you feel responsible.

N.B. One of our long-term subscribers who is both an accomplished mathematician and a successful money manager properly called to my attention that I gave the late Stephen Hawking a Nobel Prize that was not awarded to him. Further he reminds me that his theories were never confirmed by measurement. I plead guilty of being in awe of him as a person and the work he did at Caltech.

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A. Michael Lipper, CFA

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Leaders vs. Managers

Introduction

In building a portfolio of funds for clients, essentially the choices are to choose leaders, managers or a mix.

Leaders

This last weekend may show my inclination. We spent the weekend with our enlarged family group of forty-seven, some or all participated in visits to George Washington's home in Mount Vernon, the US Marine Corps oldest base at 8th and I street in Washington for the sunset parade and silent drill team demonstration, and the National Museum of the Marine Corps.

One could build an entire leadership course based on George Washington's life and pursuits. While much has already been written on these topics, for us involved with investing, two themes merit our review. The first is aggressiveness. Before and after his military battles during the American Revolution Washington was an aggressive investor in land. At the time of his death he owned some 70,000 acres all the way into the Ohio Valley. Many of the land parcels he had surveyed years before, but some were virgin territory for him. Unfortunately while he believed in both physical as well as financial planning, he died with lots of land and some debts and very little cash, thus much of his assets had to be liquidated without further development in order to meet his debts. As with most leaders he was ahead of his time focusing on the potential of future development. (He could have used a more competent cash manager.)

Discipline

I have often written about the second important aspect of Washington’s leadership, discipline, which I have learned from my active duty service in the US Marine Corps. On this trip the skills and bravery of the individual Marine was an important focus. The National Museum of the Marine Corps in their displays depicted the bravery and fighting skills of individual Marines. In addition to listening to the very talented Marine Band and the Drum & Bugle Corps, one of the highlights was watching the silent drill team's parade. This  platoon of perfectly selected young Marines go through their routines with no audio commands issued. Their memory of endless rehearsals and the discipline to follow ingrown procedures produced a striking tableau. In addition to the Marine Corps Commandant, the honored guests included  a sizable number of members of Congress who one point wore the US Marine uniform. Perhaps it was no accident that the current Commandant, General Joseph Dunford has been nominated to be the Chairman of the Joint Chiefs of Staff  pending the approval of the US Senate. In that role he will become the chief military advisor to the US President.

At the end of the evening the Commissioned Officers marched away and were replaced by the leading Non-Commissioned Officers to march off the troops returning to the barracks. These NCOs are the real managers of the infantry. They get the job done accomplishing the officers’ orders.


Do you want Leaders or Managers Managing Your Portfolio?

I sit on a number of investment committees as well as managing discretionary accounts of portfolios of funds. One of the characteristics of investment committees is that there is a strong desire for them to reach unanimous decisions. Often there are official or unofficial benchmarks that become performance targets. All too many investment committees react politically by agreeing to the least aggressive strategy, with emphasis on beating a benchmark regardless of the nature of the account or composition and management of the benchmark. By adopting this strategy they are really making the decision in favor of managers who will be graded on how close they come over time to the benchmark. As all too often the benchmark is of individual securities that are assembled without management and trading expenses they are also without the auditing standards normally used by professional organizations. In addition, not much attention is paid to component weights and methodology and the timing of additions and deletions. The drags caused by expenses and the desirability for some operating cash makes it quite difficult for most managers over time to beat securities benchmarks.

If you wish to have superior results from specific portfolios which do not have the low expense ability and/or the need for operational cash, one should take the risks of going with leaders. Leaders are managers doing some things differently than the normal (not currently the best) performers. Because of their relative isolation, leaders can often be strong personalities with some missionary zeal. A complicating factor in choosing  a potential future leader is that often they are not the smooth presenting managers that garner so much of the institutional money. Further, most of the time they have little or uneven performance records. The key to their selection rests on their well thought-out, but different investment approaches.

What Do We Do?

We build a mix of managers and leaders. The managers are selected on the basis of their expense control and their ability to reasonably hug the benchmark. These are then combined with managers that we believe will have a good chance to be future performance leaders.

Question of the week:  Can we discuss our approach with you as applied to your investments?

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Are Too Many Long-Term Investors Too Short-Term?

Many of us who claim to be long-term investors (LTI) worship at the feet of Warren Buffett and actually own shares in Berkshire Hathaway as I do both personally and in the private financial services fund that I manage. While “the Sage of Omaha” claims his favored investment period is forever, as noted in a recent column  by Chuck Jaffe, a study of his actual publicly-traded portfolio transactions suggests a holding period of four to five years. I suspect his two relatively new portfolio managers (who like Mr. Buffet have a background in managing hedge funds) have a shorter period of satisfaction with their holdings.

Corporate CEOs have little true confidence in the steadfastness of their institutional shareholders, with the possible exception of index fund holders if the companies are cursed or blessed by being found within one or more indexes or ETFs. Assuming no large earnings or other shortfalls, most particularly large corporations have the same CEOs for five years. In terms of transformational investments, ten years is a reasonable planning period to examine the success of many companies. For those businesses that make large capital expenditures in fixed plants or ground-breaking R&D, particularly in pharmaceuticals, twenty years or even longer is a reasonable measurement period.

Those of us who are investing for the education and future of our grandchildren will take our money to the ultimate fulfillment. For those of us like me that serve on boards and investment committees of large tax-exempt groups that are responsible for universities and hospitals, the time horizons are even longer. Think about granting tenure to a forty year old professor who could be teaching for forty or more years voluntarily and an administration without an easy ability to either improve the quality of the teaching or cutting the expenditures. As far as hospitals are concerned, the outer skins of the buildings are likely to hold up for fifty to one hundred years, that is if they weren't built to federal government specifications and by low-bid contractors. However, with the marches of science and regulations many if not all of the physical plants will have to be reworked rather frequently due to perceived obsolescence.

Faulty starting points of too many LTIs

Too often we become captives of both history and the headlines of the day. Any study of past investment mistakes shows that over-confidence in our wisdom and our ability to foretell the future leads to disastrous results. I have learned through meetings with existing and potential investment managers and investment consultants that many confuse the difference between a book report and a book review. The report form abbreviates the history of their investments both statistically and thematically. A review has to do with the ability of the managers to successfully negotiate the future, or more importantly futures. I am in the continuous process of meeting with existing managers that we use and candidates for future use. To the extent that the portfolio managers and their chief investment officers (CIOs) think deeply about the future or futures, I will be probing them with some of the questions shown below and other items they or I think are important.  In addition, I ask the readers of this post to react to these queries publicly or privately.


For the sake of the future, "Are profit margins too high?"

This is not a mirrored concern of my good friend Byron Wien and others that are worried that margins will surprise many by coming down in the second half of the year. My concern is different and perhaps deeper. As an entrepreneur I know that profit margins are not just a result, but to some extent are the outcomes of a very important series of operating asset allocations. Final operating margins are the consequence of a series of simultaneous equations between personnel management, development spending, foreign exchange management, balance sheet concerns and the mix of interest received and paid. Often margins are the beneficiaries of past acquisitions bringing the acquired margins up to the level of the new corporate parent. The simple statistic of profit margin does not reveal enough about its present and future composition for wise investors to properly evaluate the investment's long-term attractiveness.

Why can margins be too high?

I am not a socialist, but I raise the question, “As a society, outside of government, are we paying too little to employees?”

Because of the prior demands of individuals and organized labor, plus government intervention, we have encouraged the substitution of technology and to a lesser extent foreign workers, for domestic workers. My concerns are two. The first concern is the actual and implied replacement of domestic workers. One example is that we are not getting enough useful new ideas from our senior and professional staffs. There are untold numbers of instances where a relatively low paid worker on the factory floor or in the mail room recognized something of value to the process that was missed by the executives.

The second concern comes from Henry Ford, certainly no radical labor leader. Ford raised wages to an unheard of $5 per day. The history books record that his decision to raise his workers' pay was so they could afford to buy the increasingly mass produced Model T automobile. The growth of high corporate revenues needs strong consumer demand.

Currently one of the concerns of investors is that while earnings progress is surprisingly good, domestically produced revenues are flat with the gains attributed to record profit margins. The news from the job front is at best misleading. While the number of new hires is marginally good, the quality of the jobs being filled is at lower levels of pay and satisfaction. Two of the indicators to watch are short-term sales in stores that cater to the middle class and the purchase of new homes.

Will the current wave of M&A lead to tears?

As pointed out by London's respected Marathon Asset Management, one of the reasons for the good margins has been bringing an acquired company's margins up to the new parent's levels. However this is a one time occurrence accomplished by tighter financial management and bigger discounts from bulkier corporate buying.

However, there are longer-term negative impacts of these deals. Often the senior management of the acquired company is locked into the acquirer as an indentured servant for a specified period of years. After their Liberation Day most of the original people are gone including, perhaps those at above-scale wages. At this very point it will become clear whether the combined company has the breadth of management needed to make this work out well in the long-term. One of the historic problems for companies like General Electric is the belief that a good manager can manage anything well. In a more complex world it doesn’t happen all the time. Rarely do we see the practice that I followed with some tiny acquisitions: while I liked the products the acquired firm produced, what I really wanted was the new management to join us and play a bigger role in the overall growth of the firm. This is not happening today.

The big risk for the acquirers is that not only do the former senior managers leave the "Mother Ship" but they bring along with them or attract the bright young and entrepreneurial people that will develop the new leading edge competition.  As a partial answer to these concerns  I believe, along with others, that we will see more spin-outs or strategic sales. To accomplish this well and to keep the loyalty of the former parent company's workers will require skills only a few firms have.

Are you prepared for the next bubble?

In our economy we normally don't fix the inflating force that created the bubble, we just remove the flow of the assets that created the bubble. But the assets go somewhere. Most of the time investors still search for above-normal yields and because of their confidence in their own selection skills or those of their managers, dealers or brokers, they remain speculative. We are at the point of looking at mutual fund flows worldwide to suggest that the High Yield Bond fund bubble is deflating. Where is this money going to go? Wherever it goes eventually, it will likely prove to be disruptive.

What to do?

Try to look to the next visible time horizon and beyond to what may be large mistakes that in some future time periods can be corrected. Do not have too much confidence in the correctness of your present, firmly held investment beliefs. As they say, many roads to Rome (investment success).  One should be on multiple routes, the more the better.

Please share your thoughts.   

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