Are Investors Taking Too Much Investment Risk? - Weekly Blog # 713

 

Mike Lipper’s Monday Morning Musings

Are Investors Taking Too Much Investment Risk?

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

One can rarely earn investment gains without taking investment risks. Investors often believe they imperil too much for the risk assumed. This view has led Lee Cooperman to comment that he is a fully invested bear. (He is counting on his timing and trading skills to save his capital) I am in a somewhat similar position in my investment account, which excludes my “burn-rate” and personal future generation endowment accounts.

Focusing on my operating investment accounts I wonder if I am taking too much near-term investment risk, as I do not believe I have sufficient trading skills and expect to be premature. The best way for me to escape a major decline might be to reduce the premature gap from “the top”. The way to do that is to recognize the excessive investment performance achieved by others as a precursor to a massive decline. Prior road trips with a young family echo in my mind, “are we there yet?”.

Listed below are an increasing number of signs of excessive investment performance:

1. Most diversified equity mutual funds produced a 20% gain for 2021, with some professionally managed investment accounts producing returns of 30% or better. History suggests that this is unusual and characteristic of an approaching top.
2. The types of stocks generating above average momentum are like those we have seen in the mid to late stages of a bull market. While stock market cycles and economic cycles don’t have to be coincident, the major ones usually are.
3. The pandemic’s economic cycle impact is unknown. In a normal investment cycle, it would either be the equivalent of an investment “bear market”, or as they say at “the track”, an aberration that should be disregarded. There is reason to disregard the impact of the pandemic, but market leadership does not look like the beginning of a new “bull market”. If we are not in a new bull market, we are in an aging expansion approaching ten years. Bull markets are not closely tied to an economic cycle, but there is something of an echo effect.
4. For some time, the predictive power of reported earnings per share has deteriorated, due to changes in accounting and regulatory rules. From a long-term investment perspective, I prefer to focus on aggregate pretax operating net income, which is not marred by non-operating net interest earnings and changes in share counts. I further attempt to back out the impact of changes in accounting rules, including recognition of depreciation and amortization.
5. We have entered a period of accelerating inflation, which needs to be considered when attempting to predict earnings power generation. This is particularly important in companies reporting significantly larger rises in net income than sales. There are many reasons for this, including operating leverage, with most of the gains coming from the exercise of pricing power to offset inflation. Earnings so generated, are not usually the source of future earnings gains.
6. There are lots of good investment managers, but some with “hot performance numbers” appear to have unsound analytical backing and may be generating gains from skilled market analysis. This is difficult to maintain and is what we used to call “racing luck”.

I am not attempting to precisely predict the future. What I am attempting to do as a good pilot is avoid air pockets that can cause a sudden drop in altitude or permanent loss of capital. 

After The Fall

To the best of my knowledge there has never been an active market that did not have intermittent declines. I therefore have a high level of confidence that at some point there will be future declines in all markets I’m invested in. 

There are two causes for wars, underlying and immediate. Analysts are unlikely to identify immediate causes beforehand but should be able to spot many of the underlying causes. Most of the causes are essentially an ongoing change in the perceived level of competition. When enough power has shifts to one side, the situation is fraught with danger. The leader sees an opportunity to further increase its power and the loser fears further loss of power. Either side may choose to react to this growing disequilibrium. I suggest the growing gap in relative safety measures are such that it is reasonable to fear some unplanned explosions.

 Whatever happens, it is our responsibility as fiduciaries to invest before, during, and after the fall. This plays to our preferred method of investing in stocks, which is through portfolios of mutual funds, mostly somewhat diversified. In preparation for this task, I read the diverse views of successful fund managers. The goal is to build focused portfolio of funds that think differently. This holiday week I had more time than usual to read what managers were thinking about the longer-term future. Two long-term very successful managers produced reports that should earn their place in equity fund portfolios, as described below:

The Capital Group published a 2022 Outlook on the “Long-term perspective on markets and economies”, which had the following highlights:

1. Market leadership is currently the same as it was before the pandemic. (This is an indication of a continuing long bull market)
2. Global economic growth is slowing, particularly in China. (Valuations have expanded, particularly under the influence of buybacks and M&A activity.)
3. Inflation should persist longer than expected, due to broken supply chains, shortages of materials, and more importantly of competent employees, particularly at the trained supervisory level.) Nevertheless, Capital believes inflation will not rise to the double-digit levels of the 1970s. In most inflationary periods stock and bond prices rose.
4. A good time to focus on stock selection by looking for pricing power, sustainable growth, and rising dividends.
5. Expect increased volatility in this midterm election year. (Perhaps this view is best expressed in the firm’s Growth Fund of America, ranked 17th of top 25 mutual funds year to date and the single best for the week ended December 23rd, gaining +3.55% vs +1.25% for the Vanguard 500 index fund. (Compared to many other growth funds, this multimanager vehicle is more risk aware.)

The other fund management group that has produced thoughtful pieces is the London based Marathon Asset Management. They are a successful global investor with a sizable sub-advisor and separate account business in the US. What distinguishes their thinking is their focus on the supply side of the equation, whereas almost all the other investment managers first focus on the changing levels of demand for a company’s products and services. This tends to put them earlier in the timing of the investment cycle. Their portfolios tend to look like those of a value investor, making Marathon a good investment diversifier in an otherwise growth-oriented portfolio. The following are some of their investment ideas:

1. Moody’s and S&P Global are viewed as an oligopoly taking fees for assessing credit instruments. (This is not completely accurate as there are a number of smaller credit tracking agencies, both in the US and elsewhere. What makes them attractive businesses is their ability to access a small increase in prices each year, as well as a fluctuating demand level. (At least I hope so, as both are in accounts I manage, and in a somewhat similar position is Fair Isaac, which provides FICO credit ratings on 99% of US credit securitizations.)
2. With a limited number of new copper mines coming on stream and local governments pushing tax collections, the price of copper is rising. It will probably rise much further as auto production moves to battery electric vehicles (BEV) from internal combustion engines. BEVs, which use roughly 80 lbs. vs 20 lbs. of copper per vehicle.
3. “Private equity will face major headwinds in a governance play with little leverage as topping” (This is another set of headwinds as it is an overcrowded area, with entry prices expected to rise and provisions expected to decline.) “Growth valuations are based on visibility, the ability to push out time horizons ten or twenty years into the future with sufficient certainty to justify paying for that outcome, a very difficult call in a new world based on political whims.”
4. Japan has not adopted the US approach to corporate governance and has limited M&A activity and corporate raids. Stock options are evolving, with more shareholder friendly conditions. (A number of global investors, including Lazard, have a long-term favorable view of Japan, despite its recent economic record. Japan is becoming a more needed US ally, both militarily and economically.)

Next week I hope to devote the blog to some things I and other investors have learned (or relearned) in 2021. Please send me an email on what should be included in the list.    

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Short & Long-Term Inputs to Successful Investing - Weekly Blog # 539

Mike Lipper’s Monday Morning Musings

Short & Long-Term Inputs to Successful Investing

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

Last week may have been important to both time frames below.

Short-Term
Followers of the US stock market should recognize that analytically the most important news of the week was not that the Standard & Poor’s 500 rose slightly to a new peak exceeding its January top, but rather that it finally caught up with record highs for the Dow Jones Industrial Average and the NASDAQ Composite. What could be more important to short-term market performance is how equity mutual fund averages performed. Many institutionally oriented investors believe that the S&P 500 with its higher market capitalization is “the market”. However, during the week ended Thursday, the average S&P 500 Index fund underperformed most actively managed mutual funds (13 out of 20 US Diversified investment objectives, 17 out of 28 sector fund averages, and 23 out of 25 global/international fund groups). This view suggests to me that investors are becoming more selective than the capitalization weighted market. If this continues we could see a frothier market, which is characteristic of a late stage stock market.

Long-Term Better Financial Reporting
The President favors higher stock prices and not downside volatility. To him stock prices going up are an indicator of present and future growth. When prices periodically go down, he views it as short sited and an overreaction to the publication of unfavorable earnings reports. To him, if there were fewer reports there would be fewer declines. This is not supported by a review of traded markets around the world in all kinds of instruments, from real estate, to currencies, bonds, and stocks. I am delighted that most investment professionals disagree with the President’s view. One of the earliest was Lee Cooperman of Omega and like me a former president of the New York Society of Security Analysts. Later in the week my old friend Bob Pozen, a former President of Fidelity and former member of the US Government and a Professor at MIT, wrote an Op-Ed piece in The Wall Street Journal which expressed a similar view. The WSJ, on its editorial page, was also against changing to semi-annual reporting.

Nevertheless, I am pleased that the President may focus more attention on financial reporting and analysis. One of the least read documents is the SEC’s 10-Q report, which displays more complete financial statements than those in written press releases and includes the ever-exciting footnotes. Unfortunately, far too many investors look at whether sales and earnings “beat” corporately generated “guidance” or the average of publishing analysts’ estimates. Using any single standard is often wrong, as it is with one size fitting best for clothes or other decisions. To me, the way one should look at results can be broken down into three categories. What happened during the period both internally and externally that was beyond reasonable expectations? What were the results of management’s key performance indicators (KPI)?  What were the time periods that management was focusing on? And what did the balance sheet reveal about capital risk?

What Unexpectedly Happened?
Most investors are aware of headline events and expect management to be able to conduct their business appropriately. What they may not comprehend is how these events directly impact both current results and changes to internal forecasts. This is particularly important for internal events in terms of people, prices and policy changes. It is unrealistic to expect companies and their leaders to be on auto-pilot. To an important degree the future valuation of a company is tied to how it handles unexpected changes. Smart competitors already sense what the competition will do when things change, so it would not hurt a company to give some clues as to the impacts of unexpected changes to their owners.

Key Performance Indicators
Often when I start looking at a new company I try to find out what the more important KPIs are. Whether I agree as to their importance is not germane, what is important is how management thinks. All to often in a digital world the KPIs are shown as numbers in a dashboard setting. However, some of the most critical needs are qualitative assessment of people, including successors, customer development, and product & service quality. Nevertheless, a dashboard approach is useful if it can be kept to a single well-thought-out page and  should be an abstraction of what the great merchants carried around in their heads. As an example, while I like details more than most, there are a few things that I care about everyday, like the quality of reports, levels of service to clients, development of people, the schedule of new product development, and the operating cash in bank accounts. Notice, for me I was primarily focused on operations rather than the direct value of my ownership. In my analysis of some publicly traded companies, CEOs are much more concerned as to the appropriate value for their ownership and options. There is nothing wrong with that, it just addresses the appropriate time periods for investment analysis.

Time Periods for Judgment
While we all dwell on multiple time periods, we tend to manage mostly to a single time-period. There are two lists shown blow to highlight the most logical time periods to make judgements. The first is for companies and the second is for individuals. Reporting should focus on the most important time period that management is using to make their decisions:

Business
Type of Activity              Period                                   Comments
Business Enterprise      Each Day                              # days/size of losses
Fashion Firm Season    More than one a year
Financial Groups           Economic or Market Cycle
Cycle Developers           Maturity or Final Payment

Personal
Type of Activity              Period                                     Comments
Politician                         Next election
Statesman                       Next Two Generations
CEO                                  Planned Retirement             Voluntary
Parent                               Children off family payroll

Risks to Capital
Almost all press releases exclusively discuss revenues and reported earnings, with some attention given to earnings under GAAP. Apart from very occasionally listing book value, there is no identification of capital risk. It is this very concern that the founders of modern security analysis, Graham and Dodd, were most concerned with in security selection. Today’s book value incorporates many of the items that had questionable liquidation value during the depression years. These include raw materials and work in process inventory, goodwill, and intangible assets. If one eliminates these, over values real estate at historic prices, and under depreciates capital equipment, the stated value of equity is in many cases materially reduced. These are not generally a concern in periods of expansion, which likely won’t last forever. I believe we may enter a period where costs will be driven up by cost-push inflation, with slower demand-pull price increases. Thus, margins will be under pressure and balance sheet values may be questioned. At this point in time I can not with certainty predict such a period or the diminution of balance sheet values. However, out of a concern for prudence one should be aware of that possibility. Hopefully future reporting will recognize this need and make us aware of these issues in their quarterly reports.


Questions for the week:
What periods are important to you in your investment decisions?
Do you spend any time looking at the balance sheet and cash flow statements of your investments?
 


Did you miss my blog last week? Click here to read.

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each Monday morning, please subscribe by emailing me directly at
AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.