A Good Week for Long-Term Stock Investors - Weekly Blog # 516

Introduction

“Six months ago everything was good you couldn’t find a reason to sell stocks. Now you can’t find a reason to hold them.”  I was delighted to read this quote in The Wall Street Journal. I only hope there are more expressed sentiments of discouragement. As our subscribers have learned, such views and increased volume of transactions are necessary to have a successful test of a bottom. The actual index close can be higher, lower, or equal to the questioned low point, but without a change in sentiment it is just statistics.

Parsing out the quote I found the singular buy and sell driver encapsulated in one word, “a”. Perhaps it is my long training as an analyst and portfolio manager, as well as a racetrack handicapper, or just living through these times. However, I have never not had conflicting reasons to buy or sell or take any other actions. One of the training techniques for salespeople when trying to make a sale is called “The Ben Franklin Close”. Perhaps the wisest of the Founding Fathers, who was essentially a successful businessman, used the approach of listing the plusses and minuses of a proposal in two columns on a single page. As long as the potential buyer accepted the validity of the list and the positives out-numbered the negatives, Ben Franklin closed the deal. To make a final decision, I require the weighting of each listed item not just the number of items. My experience has made me a contrarian. I always have doubts.

Investors make the most money in periods of doubt. These periods of doubt are often ones where the bulk of the “experts” are on one side or the other. For example, the vast group of experts who were against the British leaving the European Union predicted dire results if the foolish people voted for Brexit. They predicted unemployment would rise significantly, the value of the currency would drop, and London would be deserted by the financial community. In a front page article in the weekend WSJ Review section, a British editor indicated that the Brits are doing just fine. Unemployment is the lowest it has been in years and the pound is higher than it has been in some time. Additionally, the number of the financial people being transferred to the Continent appears to be in the hundreds not the thousands predicted.

Recognizing that I can and have been wrong, or at least premature, periods of doubt represent opportunities that “experts” can be wrong. After all, the Western Hemisphere was discovered during a period where many “experts” believed the earth to be flat, because they could not see beyond the horizon. By definition, long term investors must look beyond their current horizons.

An Explanation via Fund Data

Investment Performance

One of the main differences between growth and value fund investors is the time horizon expected to bring gains.

The growth investor is looking to a brighter future for the companies in which they invest. Value investors are betting that there will come a time when the values they perceive become more appreciated. Over time both have produced good results, but at different times. (This is why in many of our fund portfolios there is a sample of each discipline. Due to the long underperformance of value-driven funds, a contrarian might start to nibble. It is quite possible in the next wave of acquisition activity that smart acquirers will recognize the value properties before the market does.)

Currently, while the “popular” media is full of headlines as to problems, successful investors are evidently favoring growth. In the year to March 22nd, most equity funds are down a bit, but there are only eight fund peer group averages that are up 3% or more. Of the US Diversified Equity funds, only the four growth fund categories produced 3% or more. In the Sector fund group, just the Global Science and Technology funds make the grade, and they were higher than the Growth funds. Just two other investment objective categories: Latin American funds and China Region funds made the 3% gainers leaders.

Flows

While exchange traded products are governed by many of the same regulations as conventional mutual funds, the reasons their owners use them are different, therefore they should not all be lumped together in deciding market implications. The vast bulk of the money in ETFs and ETNs is invested in broad Index funds, which are primarily used by trading entities like hedge funds and discretionary advisors. In numerous cases these have replaced more expensive derivatives.

Mutual funds, a much older investment vehicle, were primarily designed for retirement, estate building, and other long-term needs. They are found in individual accounts, defined contribution plans [401k], and individual retirement accounts [IRA]. As the participants fulfill their needs they redeem their existing funds and use the money, or change to more conservative investment options. For many years growth funds were among the most popular funds, performing quite well and above most retirement measures. Because of the lack of growth of new investors, redemptions are not being offset by new sales. To my mind these are “completions” of earlier promises.

To respond to the lack of growth in sales of funds at the retail level, brokers in the US and elsewhere have been reducing the number of funds being offered and reducing the number of fund houses with which they are dealing. Funds are not the most profitable products for brokers and some managers. At some point this may change.

On the Horizon

Committees in the US Congress and the Administration are working on a second tax bill. Some of the possible provisions address the need to create more retirement capital in the US. Other countries are also addressing the lack of sufficient retirement capital in an era of extending life spans, expensive health care, and slower to no worker growth. Seniors vote, while often young people don’t.

Conclusions

Despite perceived and perhaps more importantly unperceived problems, equity risk investing is needed by the world and will happen.

The more people sell the more opportunities exist for the patient buyers and their advisors.

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Emerging Market Warnings, Crowds Ahead, Smaller Exit Portals

Ever since the dawn of attention to investment performance, the smart guys figured the way to outperform was to invest outside the general experience of others. Often this technique worked initially until too many others copied the strategy. As with life in general, the unexpected happened and the exits became crowded and were blocked for the late movers. This is a repeat performance of a movie I have seen before.

I am a Believer

I am a believer in investing internationally. As a trainee in my first job after my education in the US Marine Corps, I had a tour of duty within a bank’s vault to count the actual foreign stock certificates that backed up the bank’s issuance of American Depositary Receipts (ADRs). More than 15 years later, when I could start to invest for my own account, I began investing outside of the US. Over the years I have invested in Latin American and Asian closed-end funds, individual equities in Canada, Australia, the United Kingdom, Netherlands, Finland and Japan as well as private equities in the UK and France. In addition, at the time of my sale of the operating assets of Lipper Analytical to Reuters PLC, we had foreign clients buying non US-data from our offices in London and Hong Kong. Thus, I believe I have won my stars as an international investor. So why am I raising the yellow flag of caution now? Simply because it is getting crowded out there.

Petrobras

On Thursday of this last week Petróleo Brasileiro S.A. or Petrobras, sold over $70 billion worth of common stock. This was the world’s largest initial public offering (IPO). According to the Wall Street Journal, options will be available which will expand the common stock offering by 25%, including an undisclosed amount of preferred stock. (It is true that some $43 billion was an exchange with the Brazilian government for the drilling privileges to a potentially huge offshore series of sites. Nevertheless, an enormous amount of cash was invested into Petrobras.)

First Warning Flag

The sheer size of the enthusiasm for this transaction should be enough of a warning to a practiced investor, but there are other danger signs. Petrobras has been a favorite of many well-known global investors. A number of them felt that the terms of this offering were not in favor of the existing outside shareholders but were to the benefit of the government. Among those who are rumored to have sold out are George Soros and the good people at Templeton. One of the risks in any investment is that the government may turn less friendly. (This risk is valid in the US as well.) Based on my experience, foreign investors typically don’t really own foreign securities permanently. They rent them.

The Second Warning Flag

One of the better international money managers that I had the pleasure of knowing taught me the importance of the flows of money into a security. In the 1970’s, he focused on foreign money coming into the Japanese markets. He believed that the “weight of money” would lift Japanese stock prices that were clearly not bargains. He focused a good bit of his attention on mutual fund data and that was why he contacted me. His clue to exit an overpriced market was when there was a slow down in the gusher of money coming into the market.

As is commonly acknowledged, mutual fund redemptions have been larger than the rather lackluster sales of US Equity mutual funds. As of the end of August, according to my old firm now called Lipper, total net assets are approximately $4.7 trillion dollars, with only $3 trillion devoted to US diversified investing. The fifth largest collection of assets is in Emerging Market Equity funds ($253 billion). This excludes $112 billion of the more narrowly focused funds that invest outside of the US and Europe. The two collections together have total net assets of $365 billion as of the end of August, which is somewhat larger than the money invested in S&P 500 Index funds. Clearly, emerging markets are not undiscovered territory. The cautionary flags go up with US Diversified Equity funds shedding $ 10 billion in August, with $2.3 billion going in one month to Emerging Market funds. This shows a significant shift in investors’ opinion. A more dramatic indication is that in the same month $3.8 billion went into Emerging Market exchange traded funds (ETFs). I believe this latter inflow is much more speculative in nature. If you will, they are more like daily renters than annual leasers.

The growth in demand of ETFs is particularly ominous. Money can flow in and out of these funds on a daily basis. When the money moves, the managers must transact as nearly as possible to mirror an individual stock’s proportional ownership in the index. If some negative news event causes a redemption run on an ETF, they will have to sell some of each position. The history of international investing, particularly in small markets, is that when we come in we buy from the locals who feel that our valuations are wrong. When we sell under duress they understand that any price is a good price from the pressured seller’s point of view. The losses can be dramatic under those circumstances.

To put the ETF risk in perspective, each week I look at the twenty-five largest SEC registered open-end funds. On that list are five ETFs, two of which invest in emerging markets. On a combined basis these two funds have $70 billion in assets. They promise their large shareholders instant liquidity during US trading hours.

The Third Warning Flag

The next set of concerns is one of personal exposure. Over the last two weeks I have had three discussions about emerging markets. The first was with a marketing executive of a major broad line fund group who was commenting that its International/Emerging Market funds were selling very well. The second conversation was with a retired international investor who was being pitched to go back in business, focusing on the frontier markets which are exciting many people. I am hearing a great deal about investing in Nigeria and Ghana. (Memories of the “South Sea Bubble” of the 18th Century come to mind.) The final conversation was with a fund president who has been away from the market for some time and is being asked to develop a country-specific infrastructure fund as well as other frontier investments. (The Nineteenth and early Twentieth century investments by the Scottish trusts and Barings also come to mind.)

Warning

Despite HSBC’s ten point pitch to invest in the emerging markets and Western Asset’s belief in the attractiveness of the debt side of the emerging markets, I would be particularly careful now. If you are lucky enough to have been there already, cap your exposure at sometime. If you are not invested in emerging markets directly, you can gain some exposure through US companies that export or have operations in the area. As a contrarian bet I would look to large US Growth funds, they have lots of attractive companies in their portfolios at reasonable prices. They should do well enough on a relative basis over the next four years.

What do you think?
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