The 3 Cs Dangers – Weekly Blog #534

Consultants, Career Risks, and Cash can hurt professional money managers as well as many individual investors who think like “the Pros”

Consultants
A recent Financial Times column by John Authers starts off by recognizing that it is hard, but necessary, to accept the responsibility for mistakes. It is the reason that many investment committees and other fiduciaries hire consultants. The column goes on to describe the results of a ten year study of consultants’ manager selection recommendations. The academic study found that the recommendations underperformed the market and were worse than the performance of the managers that were not recommended. This was also true in the selection of allocations to various sectors. However, the recommended managers’ performance hugged the benchmark better. (Perhaps the consultants recommended closet indexers.) I suspect the buyers of the consultants’ services expected those results. They knew the value of the John Maynard Keynes quote “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” In another quote from Farnam Street discussing Howard Marks’ book, The Most Important Thing, “first-order thinkers look for things that are simple, easy, and defendable.” Howard makes the distinction between first-order and second-order thinkers. First-order thinkers are only interested in the current time period, whereas second-order thinkers are focused on how the present sets up a number of future scenarios.

Disguised Consultants
Many of today’s investment advisers were impacted by the changing economics in the financial community, from being a fixed fee adviser or a commission driven broker to becoming a registered investment adviser charging a management fee. Since many investment advisors have no rigorous training in securities analysis, they focus their client bets on sectors and factors, using statistical measures, current news, and trends. As with manger selection, consultants are often first-order thinkers and produce similarly unappealing results.  One tip off as to their performance is the weekly data from my old firm’s publication of the Lipper Performance Report. During the latest week, all twenty categories of US Diversified Equity funds showed positive results, comprising the management of $8 Trillion in aggregate. In contrast 18 out of the 28 sector equity funds showed losses, comprising only $1 Trillion in aggregate. The difference between the two is that the diversified funds owned some of the best stocks in the sector portfolios and had enough diversification to produce less volatile results.

Nervous Contrarian
With the consultant’s focus on short term results, echoed by a number of investment committees and other insecure fiduciaries, the ability to predict short term market moves is critical (This is not true for long term investors.) The current stock market is being driven much more by changes in sentiment than fundamentals. Most transactions are originating from non-price sensitive transactors and the markets are reacting to changes of sentiment driven by news, fake news, and rumors. To see the rapid changes of sentiment, look in Barron’s for the results of the weekly American Association of Individual Investors (AAII) sample poll shown below:

View Latest Week     2 Weeks Ago   3 Weeks Ago
Bullish                    34.7%                   43.1%                  27.9%
Bearish                   24.9                       29.2                     39.3
Neutral                   40.4                       27.8                     32.6

As a contrarian I get nervous if I find myself betting with the crowd. Thus, if neutral approaches 50% I will be forced to make a decision and not just bet against the bulls or bears. At the moment my short-term inclination is to go to the bearish side and maintain a bullish position for the long term.

Career Risks
The challenge for the professional investor is to play according to the consultants’ rules, or attempt to produce extraordinary performance by being different, which almost guarantees underperformance some of the time.

Is Cash an Asset Class?
Last week I attended a Pershing Conference for Investment Advisers. I was particularly impressed with a discussion that included Rob Sharps, who chairs the growth equity committee at T. Rowe Price and is an important input into their best in class target date funds. (I am biased in the favor of T. Rowe, having known each of their chairman back to Mr. Price himself. We are users of some of their funds both personally and for clients, and also hold a position in our private financial services fund. I took particular note when he said that at the margin they were de-risking for the first time this cycle. In addition, State Street is raising the question of cash, pointing out that the current rates of return on US Treasury Bills are closing in on the Fed’s targeted inflation rate.

Years ago I studied the performance of various mutual funds that raised cash defensively. In major declines only funds that had about 25% of their assets in cash like instruments had a meaningfully smaller decline in the market. The longer term problem with these funds is that do not recommit to the equity market fast enough, so that when the market regains its prior peak they underperform and are meaningfully worse as performers.

Avoiding Poor Recovery Syndrome
There are two ways to avoid the poor recovery syndrome. The first is not to raise a great deal of cash but instead move heavily into low risk stocks that pay good dividends and a have a shareholder base to support liquidity in the stock price. We used to call them warehouse stocks. The classic one was the old AT&T, not the current stock of the same name. The second approach is to replace the portfolio manager with the next generation, a generation not burdened by the knowledge of what won’t work because it didn’t in the past. In recoveries, the combination of new enthusiasm and momentum will be early stage winners. The trick is then to replace the successful youngster with a more rounded manager.

Bottom Line
Be prepared to move away from the crowd, examine defensive tactics, and don’t fall in love with cash.

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Three Concerns: EPS/Golden Calf, the Next Dip, Indexing is Faulting - Weekly Blog Post # 489

Introduction

Most individual and institutional investors are in essence outer directed. Either consciously or not they follow what others do and have a fundamental belief in “smart money.” For extended periods of time this philosophy has worked. Perhaps, it was my brother’s experience in the US Marine Corps Reconnaissance as the leading point for wartime patrols to avoid walking into an ambush. Or my experiences at the racetrack where betting favorites won only about one-third of the time. I look for instances where the “crowd” is wrong. Not to be just a contrarian, but looking at the profit opportunities when the generally unexpected occurs. Some of these opportunities are just plain random, others can be perceived ahead of time. Each of this week’s concerns has some evidence backing up the views as to future changes. Whether you agree or disagree let me know.

Is EPS our Golden Calf?

Throughout my investment career I have heard earnings, actually reported earnings per share, drives the market. In the 1960s I was told all one needed to know was the growth rate of earnings to determine the appropriate price/earnings ratio. Recently I heard a very well known and respected Portfolio Manager explain in a long cable news interview that “earnings drive the market.” The first thing he said about each of his five buy recommendations was their earnings per share. The analyst in me rebels at this kind of over simplification.

In a period where much of senior managements’ compensation is based on in order, EPS, sales, and market price - do you think that they attempt to show the best possible record? I don’t want to proclaim that they are totally manipulated or are the equivalent of “fake news” but it makes you wonder whether it is a true reflection of the value and future potential of the company. One of the first lessons from my Professor David Dodd, who wrote the five editions of Securities Analysis with Ben Graham, was to reconstruct the financial statements of the company under study. We laboriously went through each line in the income statement and balance sheet adjusting for removal of non-recurring elements and questioned the accounting techniques that produced each item. We were quickly taught that in various cases the results in the press release or Management’s letter did not give a totally accurate picture.

When professionals discuss the valuation of various Merger & Acquisition deals today, comparing them to others, the metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization (what were the write offs?). The drive here is to understand what was the operating earnings of the company. Net Interest is the result of the financial condition  and policies of the company and might not be followed by a new owner. One of the simplest techniques that I learned at a trust bank was to put all the steel companies held in trust accounts on the same tax rate. This deprived some of the companies of their tax management skills, which were often transitory, but would be different under different ownership.

Depreciation charged is a function of the weighted ages of the plant and equipment with no adjustment for critical future expenditures. Amortization could be an orderly way to recognize the deteriorating value of intellectual property purchased and/or other write downs. To some degree I think all of these items plus debt service obligations are more important than reported earnings and so do the “M&A” troops.

Notice that a good portion of some companies “earnings improvement” comes from profit margin expansion. What this really means is that reported earnings are growing faster than sales. This is favorable when the company is increasingly earning more over its fixed cost base. However, it may mean that it is not spending enough on plant and equipment and/or research and development. These considerations are important in an increasingly competing world of relatively slow growth.

In history, when the ancient people felt that the Golden Calf  did not answer their needs, not only did they destroy the statue, there was a period of turmoil and violence until new, and in some cases, better beliefs were established.

The Dangers of Buying the Next Dip

This past week there was an extremely sharp jump in the portion of the American Association of Individual Investors views on the market. In one week 41% are bullish, a gain of 12 percentage point from the week before with a concomitant decline in bearish beliefs and neutral holding about even. Both the Dow Jones Industrial Average and the S&P 500 went to new highs, not immediately echoed by the NASDAQ Composite. It is quite possible that the two senior averages need to catch up with the NASDAQ. The year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88% and NASDAQ + 22.96%.

Could this be the key missing element to a race to the top? While a number of highly respected market analysts expect a minor pull back, as there are a few price gaps that should be filled in before a major new top is reached. This could be accomplished by a 5 to10% correction. The Goldman Sachs^* view is that there won’t be a dip as too many people are expecting it. (Remember the humility production function of the market.) This focus on sentiment over financials is a concern of Professor Robert Shiller as expressed in The Sunday New York Times when he refers to John Maynard Keynes’ belief that market participants were not making their own investment decisions, but were guessing what others were doing, in other words, trying to follow “smart money.”

^*Held in the private financial services fund I manage

My concern is that this trading attitude may actually succeed. The risk is that the successful traders and later their acolytes will have faith that it is a repeatable result, and they are truly skilled. My concern is that when the next “Big One” occurs it will be quite different than managing through normal drops and even minor corrections. The difference is the size of the trading capital in the marketplace having to provide liquidity to non-price sensitive ETFs and margin-called players. There is little to no capital on the floor of the exchanges. Dealers have capital constraints and banks are limited by various regulations in a global marketplace connected in less than nano-seconds.

I don’t worry about trading losses, they come within the territory of investing. What I do worry about is the potential of future revulsions to investing and a generation that will decide “never again.” This will be tragic for themselves and their families. But also the rest of us taxpayers who are likely going to have to pick up some of their missing retirement capital.

More Evidence Indexing is Faulting

You have to excuse me for looking at the world with lenses that start with mutual funds which I have been following for more than fifty years.

Each week I look at the funds’ performance for varying time periods. For the week ending last Thursday I saw an interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks close to 100 different fund peer groups. The largest equity group is the $ 1.2 Trillion S&P 500 Index funds. I compared its results for three periods and counted the number of peer groups that beat the large Index funds as shown below:

Type of Fund	# of Fund Types Surpassing Index Funds
	YTD	52 Weeks	5 Years
US Diversified funds	4	3	2
Sector funds	12	7	5

There were four fund types that beat the index in all three periods, 2 diversified and two sector fund types. The key point is more active managers are beating the Index. It is not because they switched from dumb pills to smart pills. It is due to greater variability of performance within the 500. Mathematically this splitting is called less correlation and greater dispersion. Within the Index there are some big winners and a few big losers which is meat to active managers, and in theory to long/short managers (hedge funds and the like).

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Be Vigilant when Relying on Patterns

Introduction

In last week’s post I discussed that many investors are only interested in outcomes and not the causes of the outcomes. These investors search for repeated results and expect the same patterns to be continued into the future. For the last two weeks I have been drawing lessons from California Chrome’s losing the Belmont Stakes, and stated that it was a bad bet. Those who wagered on that result were betting that the colt’s past pattern would continue in this most difficult race for three year olds.

Those who follow history of sports, politics (Eric Cantor), theater, and human emotions all have experienced disappointment when the winning streak is not continued. The reason I said that the bet on California Chrome was a bad bet was that the betting odds were odds on, putting up more ($5) to win less ($4). This assumed a much higher degree of certainty than warranted on a young, head strong colt in the spring of the year.

Keynes lost several fortunes following patterns

In the June edition of the Financial Advisor Magazine there is a good article on John Maynard Keynes and his investment experience. There is no question that this Cambridge University don was exceedingly bright and had all kinds of ambitions. As an economist he was also a researcher and looked for patterns in commodities and currencies as well as US and UK common stocks. Each failed to produce a winning result every year and also led to large, (but less than market) losses in 1931. He did beat the UK market in 12 out of 18 years, which is exactly the ratio one would normally expect from a very good professional investor. The sad part of this experience in terms of the rest of the world is that various governments took his economic theories to be unassailable laws. If people only would have used the concept of applying a winning percentage to absolute belief in his economic laws, the world would have been a better place. Instead we had a Republican President of the United States intoning “We are all Keynesian Now.” This was almost exactly at the very moment of history when the US allowed its budget to get out of hand and began peace time deficits that continue to this day, which has led to a relative decline in the US standard of living.

Favorable patterns that may not hold up.

All humans look for patterns in everything they do. Even well-trained analysts look for what they hope for is certainty in patterns. Being a contrarian by nature I look for a reversal of trends, but currently markets are accepting the following patterns:

1.  On a year to date performance basis the Dow Jones Industrial Average is up +2.2% and its Utility average is up + 15.5%. This suggests that focusing on sectors is more important than the level of markets.

2.  Many portfolios are centered on various market capitalization levels which S&P provides. However the best performing S&P level is its 500 Index up +6.2%, and its worst is its Small Cap Index +2.1%. This suggests that market caps are relatively insignificant. We will see if this is true in the next major moves, particularly on the down side.

3.  Low perceived quality as measured by those stocks listed on the American Stock Exchange gained + 16.3% compared with those of the New York Stock Exchange + 5.5%. In 2014 (and for the last several years) higher quality, particularly of balance sheets has hurt relative performance. I doubt this trend will continue in an economic downturn. (Keep an eye on the default rate in high yield bonds.)

4.  Enthusiasm for various political leaders’ statements as to the future of their economies going through restructuring has driven their markets to possibly unsustainable comparisons. The Indian Sensex index is up +18.6% and the Japan’s Nikkei is down -3.5%.

5.  David Herro in his search for economic trends noted that the old indicator, an increase in lipstick sales, is being replaced by an increase in nail polish as an indicator.

6.  The trouble with following patterns slavishly is there is no room for a “black swan” occurrence.

Pattern Analysis can be useful

In a recent report Standard & Poor’s compared the performance of Large-Cap mutual funds to their respective S&P Benchmarks, showing in each of the last six years that the majority of funds beat the indices. The range of beats goes from 81% in 2011 to 51% in 2009. I found this data set interesting in that it shows actively managed funds can perform as well as the benchmarks. More significant to me is the extremes of performance. The low number occurred in a sharply rising market and the high number in a market that was declining in many sectors. My explanation for this result is that the indexes do not hold cash reserves where mutual funds do. Coming off a bottom, “cash is trash” and hurts performance, whereas in a falling market cash acts as a cushion. As I believe that this pattern will continue in our managed accounts, I have been cutting back on our use of index funds as a preparatory move for a future decline. (The impact of this move is to slightly raise our overall expense ratio.)

Moody’s^*  believes “Exceptionally thin spreads typically credit cycle slumps.” As the yield spread is historically small between low credit instruments and high quality ones, I believe that this is a pattern worth noting. This is particularly true as we are seeing a concerted push on the part of both mutual fund houses and brokers to invest in unconstrained fixed- income funds. Even various government agencies are concerned and have discussed an idea of trying to put some redemption constraints on bond funds, which I do not believe will happen politically. Further to the discussion is a comment by a former Federal Reserve Governor in referring to bond fund redemptions as “liquid claims on illiquid assets.”

^*Owned by me personally and/or by the private financial services fund I manage

Perhaps, my searching for the top of the stock market that precedes a major decline is misplaced, possibly the top will be caused by a malfunctioning fixed-income market. After all, the last major decline was caused by Lehman’s inability to fund itself in the short-term market. 

What patterns do you use?  

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A Stock Market Peak Is Coming, What Should an Investor Do?

Introduction

While a somewhat premature warning of an on-coming market peak may be upon us, we need to think about the implications for our various portfolios.  I believe a sound investment advisor attempts with difficulty to anticipate major problems rather than being forced to react.

Growing evidence

Though no two market peaks are identical, many of them have similar characteristics. Expectations become elevated beyond normal valuations and knowledgeable bright people get sucked in with the belief that they can exit the burning movie theater before the mob behind them. With the benefit of their history (particularly of financial matters) and a cooler disposition, we Americans have a hard time believing our British cousins would get caught up into theses speculative surges. However, Sir Isaac Newton, Sir Winston Churchill and the famed British economist John Maynard Keynes all suffered major financial losses from the collapse of markets. Today the current versions of these “worthies,” many in the investment management business, are imploring us to get fully invested in equities. This is despite the combination of lackluster corporate sales growth and peak profit margins and the increasing prospect of higher taxes on the so-called wealthy.

In this last week both the Dow Jones Industrial Average and the Standard & Poor’s 500 reached new high points. We have come a long way from the bottom reached in March of 2009. Many of the pundits are looking for materially higher prices often with a “2 Handle” or 20,000 or 2,000 points respectively for the popular averages.

What are the signs of a peak?

Margin debt is at an all time high. With trading volume low, there is a presumption that those who are borrowing against their securities are institutions or sophisticated investors who are acting like hedge funds or other aggressive investors. While there is no public disclosure as to which security owned or to be purchased is the beneficiary of the borrowing of margin, I suspect that a good bit of it is to support being long or short Exchange Traded Funds (ETFs) or similar vehicles. In addition there is some borrowing to support “carry trades” where one borrows money cheaply and buys higher yielding securities.

What set my particular concerns off is when a retired CFO and CEO mentioned to me he was arbitraging interest rates by using low cost margin money. He probably does not need to do this, but it appears to be a sophisticated trade for a retiree to do. Some of the carry trade is in buying high yielding stocks and bonds globally. My concern is from a recent headline describing the frenzy as a “dash for trash.” More such evidence is needed before one can definitively call a top or peak.

If there is a peak, what should an investor do?

Before one initially invests in stocks, one should understand that 25% declines from peaks happen regularly, perhaps three times in every ten years. Once a generation, the drop has been 50%. After such a calamity, if companies don’t go bankrupt, their stock prices recover. I will share an extreme example of this. As a junior analyst I was doing work on the Radio Corporation of America (RCA). There was something of a celebration during the 1960s when the stock finally surmounted its 1928-29 high. In the 1920s RCA enjoyed the enthusiasm that the “Dot Coms” had in 1997-2000 era.  While this fact is of interest it should not be a mantra for investing. A better strategy has to do with time horizons.

Time horizon investing

Most institutions and individuals have multiple purposes for the proceeds from their account, but they think in terms of a single portfolio. I have been urging them to break up their investment portfolio into time horizons or Time Frame Portfolios. This principle works for wealthy investors as well as sophisticated institutional investors.

The first slice is the amount of money needed to meet current or near current obligations. Ideally the size of this portfolio will cover up to two years worth of expenses. Highly liquid, high quality, near cash investments should make up this portfolio. When the first slice is exhausted through payouts, it needs to be reconstituted out of the second Time Frame Portfolio which should be made up of intermediate high quality bonds and good stocks.

One way to look at these time horizon slices is the first is for the treasurer or controller.  The second slice should have an expected duration similar to the current CEOs career or the principal wage earner’s life. The third slice should have long-term duration similar to the way Warren Buffett buys operating companies and most of his selected major stock positions which he often says is “forever.”

Application of time horizons to peaks

Fears of peaks should eliminate securities with meaningful downsides from the first portfolio. Some small amount could be tolerated in the second portfolio. Not only could the third portfolio tolerate a declining price investment, it could look for an opportunity to add more.

Harvest time celebrations

This is the time of year in many cultures in the Northern Hemispheres we gather to celebrate the accumulated harvest. In the US we celebrate this coming week as Thanksgiving. My family and I have a lot to be thankful for our blessings. What I am particularly thankful is for an ability to convert some of our problems into opportunities for others as well as ourselves.

Please write and let me know about your:  Peaks/tops, time-horizon investing, and thankful opportunities this year.

_______________________

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.