"Things are Seldom what they Seem" - Weekly Blog # 599

Mike Lipper’s Monday Morning Musings

"Things are Seldom what they Seem"

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

Premise 
Things are seldom what they seem is an appropriate maxim for military reconnaissance, home buyers, merger & acquisition specialists, political and security analysts, and most importantly long-term surviving investors. When surface observations prove to be accurate, popular rewards tend to be small and when they are wrong the penalties can be large. This week I share three instances where a deeper understanding of what is popularly "known" are examined more broadly.

"Informed Prices" 
On Friday the Dow Jones Industrial average fell 255 points, with 67 of those points in the last half hour. Before using these "knowns", one should examine the makeup of the numbers and their implications. First, almost two-thirds of the decline was caused by just two stocks, Boeing and Johnson & Johnson. Boeing's fall is particularly significant because the DJIA is a price weighted average and it’s fall disproportionately impacted the result, as it is the highest price stock in the index.

As an analyst/portfolio manager, the larger implication lies in reviewing the investment selection criteria. Statistically oriented pundits and marketers generally want to sum up the company's results using factors such as changes in earnings, returns on equity or capital, revenues, or book values etc.

Both the price declines of Boeing and J&J were responses to internal disclosures. In Boeing's case it was a reaction to emails from the chief pilot expressing doubts on the Max 737. In J&J's case it was the discovery of a single batch of contaminated product. Neither of these disclosures were or could have been captured by any known factors. Ever since investors have compared investments and managers they have utilized screens to highlight and understand differences. Rarely was success the result of one management being smarter than others, it was often due to comprehending what was not captured in the statics, i.e. patents, customers, locations etc.

In the following market factors for the week I found issues of future importance, which I would be happy to discuss further with subscribers:

1. There were price gaps from earlier in October in all three major stock indices.
2. There were differences in the patterns of the high/low ratios for stocks on the two stock exchanges - NYSE 303/101 and NASDAQ 197/230
3. On the NYSE the volume of shares going up was very close to the number of shares going down.

"Plain English" can be Plain Wrong 
Jason Zweig, in an always interesting column in The Wall Street Journal, described attempts by a member of Congress and the SEC to force mutual funds to issue a new four-page document in "Plain English". Ironically, this is an effort to correct errors of judgement by both the Congress and the SEC. A generation or two ago there used to be an active retail market for investments in most cities and towns in ground floor stock brokerage offices. Their longevity was a testament to the value they were providing. They existed because busy people who recognized their lack investment knowledge needed help, the situation is no different today. In many cases the customers', man or woman, provided good service to the investing public and many of their recommendations proved to be profitable for both the investors and the brokerage firms. I believe the average retail investor's returns were superior to those of today, in part due to lower interest rates. Perhaps unconsciously, the SEC destroyed this setup by removing fixed commission rates. (That is not to say that there weren’t some abuses and bad judgments made.)

The SEC has faith in the disclosure of "facts", and numbers are even better. For a while it considered requiring funds to publish their beta numbers, urged on by the late and sometimes great Jack Bogel. Luckily, the requirement was dropped after being ignored and considered something of questionable utility. (It could have had some value as an annual or market phase measures.) Digital representation are an attempt to capture reality. While most critical decisions are reached through analog searches and comparisons, JP Morgan himself said that he did not lend based on collateral, but on character. The new document cannot correct for a poor education. Many successful investors learned early about budgeting their time and resources, without which no four pager or four thousand pager will produce on average, winnings.

When someone asks for my help with their investments, the first thing I should ask is how much time they intend to devote to investing. For those devoting "twenty minutes or less", I suggest that they either find someone they trust to manage their money or just accept one or more fixed rate investments. For the remaining few, I would be happy to introduce you to the multi-level set of investments arts.

"Follow the Leader" is Chasing one's Tail or Worse
As someone, with the help of a great staff, who probably created more lists of leaders and laggards than perhaps any other person, I can appreciate the media and spectators knowing who are at the "tops of the pops". Unfortunately, people don’t evaluate all the short to long-term time periods, or how quickly a name rotates from the leaders lists to the laggard roster. That is a mistake, but it is even worse to not notice the change in market conditions.

As an outsourced chief investment officer and a member of non-profit investment committees, I have seen a growing share of assets devoted to private equity and debt. In a recent article in FT WEALTH devoted to Family offices, a survey showed that over 80% are using private equity investments through funds or fund of funds. They are following the lead of certain Ivy League universities which have been investing in private equity for two generations. In the early years these schools produced results superior to the public market. At one of these investment committee meetings the members were presented with a book authored by one of the in-house chief investment officers, highlighting his success in investing in privates. That was then, today most of the former leaders have completed a year where in aggregate they underperformed the public market measures. What happened? The structure of the market was changed dramatically by the SEC’s efforts to make investing easier.

The way investments are taught in most places focuses almost entirely or totally on the issuer of the securities. However, the company is only one of five forces on the price and utility of investing in the security. The others are the needs of the customer, the compensation for marketing, the profitability of the firms that provide investment management, investment banking and trading, the changing nature of the exchanges, and the attitudes of the reviewers/critics.

The combination of generally declining profitability caused by the SEC’s elimination of fixed rate commissions and the long-term decline in real interest rates altered the commercial needs of the players other than the issuer and dramatically changed the market for privates. For over two generations brokerage firm equity/agency commissions were unprofitable. Their profits came from net interest on margin loans, dealing spreads, underwriting, financial advisory activities and investing for their own accounts.

This led the institutional sales force and eventually the retail sales force to shift to the sale of private securities, either individually or in packaged products of funds. In order to supply their sales forces, many firms got into the business of underwriting or offering private securities. They were often directly or indirectly paid in shares of the products they were selling. While a couple generations ago there were only a few in these markets, now almost all the firms that have survived are there.

At the same time successful managers of private venture funds were regularly coming to market with new merchandise. Owners of private companies therefore had many underwriters and investors competing for an interest in their companies, leading to higher prices. That was sustainable if these companies went public at sufficiently high prices to create profits for all who participated in the build up to the sale. It all worked as long as the IPOs rose in price long enough for all the willing restricted stock to be sold. In 2019 we have seen some IPOs break below the offer price and some have been withdrawn.

I have witnessed first-hand the success that Caltech's investment staff and appropriate consultants have generally had with their privates. They have worked long, hard and smart. I am convinced that there are few groups that have a similar dedication to this effort.

One of the general lessons in investing is that it is difficult to make meaningful gains in crowded trades and they can be very unprofitable if the crowd attempts to stampede out.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2019/10/contrarian-bets-and-other-risks-weekly.html

https://mikelipper.blogspot.com/2019/09/mixed-near-term-after-recession.html



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To Avoid Moral Hazard: Buy Asian Equities, Hold Cash for Redeployment and Sell High Quality Bonds

This week’s blog is based on thinking about the signs shown for “Occupy Wall Street,” seeing the video rendition of “Too Big to Fail,” remembering the insight of a blind leader, looking at extreme numbers and watching the NY Jets beat a better team. Part of the intellectual handicap we all have is that our views of history are shaped by commentators who lack full understanding of what they thought they saw or heard.

D/F + TBTF + OWS = Bigger failures - - bigger opportunities

By now the media savvy recognize "OWS" stands for Occupy Wall Street which has gone global as sites of anger, frustration, and the willingness to break laws. "TBTF" abbreviates the title of the book entitled Too Big to Fail, which was made into a movie which was rebroadcast last night. "D/F" is my symbol for the Dodd Frank law that is being imposed on the US financial and economic community, which has implications to financial communities around the world. This witches’ brew of maladies will, in my opinion, lead to bigger failures and greater disruptions to global progress and at the same time open up new opportunities for the wise to make money.

The complaints

Two of the complaints coming from the inhabitants of the various “rescue encampments” are first, the banks got bailed out of their problems and we “ordinary people” did not; and second, we have selected various financial institutions to receive future bail outs whenever they get into trouble. I do not expect the strident to allow me to share my personal historical perspective from both fifty years of professional investment experience and having listened to other professionals who went through the changes in the financial community for over one hundred years.

Ever since the “Money Panic of 1907,” (if not before), financial people have been concerned about the potential damage that a concerted “run on the banks” could do to individuals, themselves and the community as a whole. In its simplest form, banks collect deposits and loan most of their deposits back out to the community in the form of demand loans or term loans. Banks require interest income from these loans to pay for deposits, other expenses and to build reserves to cover for periodic credit losses. No bank keeps enough cash on hand to meet redemptions of all its deposits. Thus, if there was a “run on the bank,” the bank would attempt to call all its demand loans and as much of its term loans as possible. The news of a run on one bank is likely to cause a run on other banks. This fear is what led to the founding of various government financial agencies like the Federal Deposit Insurance Corporation (FDIC) in the 1930s. Those of us who have spent our lives in the mutual fund world have harbored the same fear about “money funds.” As a matter of fact, Jack Bogel, the first president of the Vanguard Funds, has told of his fear of one day turning on a Philadelphia television news program and seeing a helicopter reporting on a long line of people formed around Vanguard’s Malvern offices who want back the billions in their money market funds. Both the current US administration and its immediate predecessor felt that they had to “do something” to prevent harm to ordinary citizens. In the government’s eyes, it was bailing out individuals and small businesses. One could argue that the government and financial community leaders should have let various banks fail, and individuals lose the value of some of their deposits. Such inaction could well have led to a lack of confidence in the financial community that supports the government’s funding requirements. Bank failures and government defaults have been going on since their creation without total loss of economic progress.

The way the potential run on the banks was headed off was to force Federal government or Federal Reserve Bank loans on the banks, which led to the belief that certain financial institutions were so important that the society could not afford to let them fail financially. In other words, they were too big to be allowed to fail. There is a term for this which is “moral hazard,” which means that the government will permit these groups to make significant financial mistakes and they will still be bailed out. This concept goes directly against the wisdom of a very successful regional brokerage firm. On the occasion of the annual meeting of its partners, I was paid to give a speech on how I saw the brokerage business evolving. This was in the early days of Power Point graphics which I used in my slides to support my conclusions. To my horror, no one told me the chairman of the firm (who was sitting next to me) was totally blind. Trying to recover in my conversation with him, I recognized he did not have to see the charts, he intuitively knew what I was talking about. We then discussed what his firm should do in the face of the increasing market share that larger brokerage firms and banks were taking out of his market. I inquired why his very successful firm had a small capital base, (where the substantial profits were paid out at the end of each year). He replied that he did not want to accumulate firm capital, for he feared that his partners would invest it poorly. Too much capital would lead to putting undue pressure on the firm.
Today, I wonder whether firms that get into financial trouble should be bailed out. The FDIC has a model that a failed bank’s deposits and sound loans get auctioned off to a competent nearby bank, and the losses to be absorbed by the bond and shareholders of the failed bank. In the UK, the banking authorities are trying to “ring fence” or separate the retail deposits and loans from the business loans and investment activities of the bank. (In some ways they are trying to put back in place the Glass–Steagall Act in the United States.) This weekend in Europe, the powerful countries are trying to determine how to help their national banks with faulty sovereign debt and underwater loans, either through a materially stronger bailout fund backed by a central bank, or a facility that would insure some of the value of the loans. To me, the insurance scheme has less moral hazard.

All governments need to be careful about changing established ways of conducting business. In the US, we have merged investment banking with commercial banking rather than keeping them separate and in some cases, competitive. Almost all of the losses suffered by the large investment banks were in their investments, particularly illiquid real estate. Similarly the Savings & Loan scandal of the 1980s was caused by pulling down the interest rate advantage the S&Ls had in attracting deposits for making local home mortgage loans. Once there were level interest rates, many S&Ls went into commercial lending that they were ill-equipped to do, and commercial banks built up their home mortgage business without the requisite local and personal knowledge of hometown people and properties. Further, when the SEC introduced price competition in brokerage commissions (as distinct from service and research competition), it changed the game which led to the need for capital to facilitate trades. The SEC compounded the problem when it encouraged multiple sites for trading, executions, and reporting. To some degree, the fragmentation of the market has led to increased volatility.

Many investors believe that the increase in volatility is a sign of increased economic risk. I think you have to look at volatility as any time series, and dissect it to derive meaning. In Saturday’s WSJ, which is what they are labeling the Saturday edition of The Wall Street Journal, there were two items that address volatility. “The S&P 500 would be up 16% for 2011 if the three biggest declines were excluded and it would be down 13% if the three biggest daily gains were excluded.” The message that I get from this data is that we have been in trading range markets with periodic extremes. For the technical or chart analysts, this pattern is either of a distribution where stocks move from strong (in theory, “bright”) sellers to weak (presumably dumb) buyers, or it is an accumulation by bright investors picking up bargains from tired or discouraged speculators. Only time will tell which is correct when a significant move breaks out of this trading range. My long term bet is for a breakout on the upside. In a contest, the bright or better team doesn’t always win. We just returned from seeing the New York Jets, with their home in New Jersey, play football against the San Diego Chargers. While I was cheering for the Jets for “hometown” and other reasons, I had to admit that most of the time the Chargers played a better game, except for two pass interceptions which led to a Jets victory. Thus, it is often better to be lucky than smart; and I hope that while I understand the negatives facing us, I hope to be lucky on the upside.

To put my neck out further, I was a member of an investment panel addressing a group of Caltech alumni and scholars. Our final question was what would we buy, hold, and sell. We ran out of time before I could answer, but as some of that audience are also members of this blog community, I thought I should very briefly give my answer which we can discuss in future posts. I would buy Asian equities, hold cash for redeployment, and sell high quality bonds.

What would you do?
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