Recognizing a Professional: Ratings vs Ranking - Weekly Blog # 811

 

Mike Lipper’s Monday Morning Musings

 

Recognizing a Professional: Ratings vs Ranking

 

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

 

 

While we can’t know exactly whether someone is schooled in a subject or just pretending, we can presume a lot from their choice of words. In the world of investment statics there are several tribes of analysts that attempt to predict whether a fixed income instrument will go into bankruptcy. They summarize their learned judgements with letter grades, called ratings. These ratings do not give an opinion as to whether they are good investments, just whether they anticipate them entering bankruptcy. The history of the professional credit raters is pretty good, as bankruptcies are relatively few in number. While they give an opinion as to whether the instrument will enter bankruptcy, they do not indicate how much of the issued principle will be lost.

 

One unfortunate trait of inexperienced people is the use of a term from one subject in another. While the term may have some similarities, it is not identical and may not even have the same utility as the original. This is why I used performance ranks and not ratings when developing the practice of mutual fund analysis, using the performance array of mutual funds we tracked each week. This is where my analytical training kicked in.

 

I pity those who passed through the analytical profession and did not learn as I did at the racetrack. My experience instilled in me a strong aversion to losing money. Analysis at the track is similar to the popular method of selecting investments based on past performance. This approach relies on the belief in the repeatability of events and has led to the development of quantitative systems, both in the investment market and at the track. “Quantitative” investing has periodically been very popular in the investment market, buttressed by “ratings” which are meant to be predictive.

 

 I gained an advantage from my many discussions in the grandstands following each race, where some player complained about the failure of “the system” he/she was following. Because I did not like losing money, I paid attention to the complaints of the failed “systems”. What I discovered was these systems actually worked better than half the time for a period of time, but rarely more than 60-70% of the time.

 

Later in life I heard similar complaints from more senior analysts as the corporations they followed failed to deliver the expected performance. The standard complaint was that someone was lying. It took me a while to connect the similarity of their complaints with those I heard over the weekend at the track.

 

This realization led me to think about the process of predicting the future. Since no systematic thinking produced winners all the time, there must be mistakes in the math. As securities analysis is taught as an adjunct to math, or the certainty of law, the losses had to be a function of mechanical mathematic failure. It eventually occurred to me that it was not the process that failed, but the universe of variables being different than those utilized.

 

At the track, the things that could change were the jockey, the trainer, the exercise rider, what the horses were fed, what drugs were administered, or the competition. Each of these possible changes, and others, could and often did impact results. This is why I believe we should pay more attention to changes of people and their attitudes in the investment world. More so than believing in their statistical record.

 

This week was a good example of changes that largely invalidated the past record of the entire global financial sector. As an analyst, investor, and portfolio manager, I have always had an interest in financial services securities. Stock Exchanges have been at or near the center of the financial sector and thus were always of interest. There have been five Lipper brokerage firms that have been members of the New York Stock Exchange. (Never has a son or younger brother succeeded the founder, and consequently none extended to a second generation.)

 

In most commercially viable countries, there are stock exchanges. Considering all I know about these exchanges; none are making most of their money exchanging securities. At best, most make single digit returns on this revenue. This week I attended a capital markets conference of the 300-year-old London Stock Exchange. While it is interesting looking at their history or past performance, it is of no value predicting their future.

 

Unlike racehorses and most people, some companies can be rejuvenated into something quite different than their past history. In the case of the London Stock Exchange, it has grown into the London Stock Exchange Group (LSEG), primarily through a merger with a Thomson Reuters spin-off. (In 1998 Reuters purchased our fund data business. We and our accounts still own Thomson stock, which has a major position in LSEG.)

 

The spinoff included a number of unintegrated number-crunching entities, labeled Refinitive. It was a comfortable fit because the London Exchange had previously acquired a number of similar unintegrated and under-marketed numbers-companies. To this mix they added “expert” management from various financial and tech companies, including a cooperative agreement with Microsoft based on their plans and/or dreams.

 

The CEO believed he had identified all the problems that could delay them. The current management group is investing heavily in new products and services, including the marketing of them. It would not be difficult to improve on the record of its two major founders. LSEG deserves to be ranked highly in its present efforts. I will leave it to others to predict its future.

 

This Week’s Signs of Stagflation

Despite the media and others chanting Good News, there is increasing evidence that smart professionals see an approaching decline in market prices. Whether we are just in stagflation or entering a significant contraction will be determined later. However, it is worth noting the S&P 500 Equal Weighted Index is essentially flat year-to-date.

 

The following announcements have to do with future revenues. The companies making these statements are addressing the second of two measures of their health, their investment performance and the prospect of generating new business, largely from new customers.

• Manulife is laying off 250 employees in its Wealth and Asset Management functions. (Manulife is a Canadian Life Insurance company with significant Hong Kong sales.)
• Wells Fargo is laying off 50 Investment Bankers.
• Burberry issued a sales target warning.
• A 2^nd Hedge Fund is cutting 150 of its 1000 person staff.
• Jim Chanos is closing his short selling hedge fund. (He said the market is changing away from his style.)
• Amazon is cutting several hundred from its Alexa staff.
• Another observation noted in the weekly list of prices in the Weekend WSJ. Only 8% are down, including the US dollar -1.65%.
• Fitch is negative on the investment management sector in 2024.

 

Note From London

At private investment discussions in London during the week, locals were most concerned about the US Presidential election, with differing levels of pessimism. I had two comments.

1. It is incredible considering the size of the US population that the present apparent candidates are such a poor couple. The locals agreed.
2. Much more important to me is that we won’t know the Chairs of key committees until later next year. This is more important on the Republican side, as the Democrats are bound by seniority. According to the intelligent people I talk with, a split Congress is likely, suggesting not much meaningful Legislation will pass, except for emergencies during the first two years of the new term.

 

Share your views with me and let me know what you are watching in terms of markets and votes.

 

 

 

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Mike Lipper's Blog: How to Find the Answer - Weekly Blog # 810

Mike Lipper's Blog: Preparing - Weekly Blog # 809

Mike Lipper's Blog: Indicators as Future Guides - Weekly Blog # 808

 

 

 

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Misunderstanding Mutual Funds, Spain and Goldman Sachs

As an analyst for more than fifty years, I have learned that I will never have enough information to be completely secure in my investment judgments. On average, I receive over one hundred business or investment related emails daily, and in addition, I read numerous trade and general circulation publications. I must admit one of these publications is the New York Times which every now and then gets something right, and almost always has impact on some investors.

The mutual fund myth

Many people, including some who would call themselves sophisticated, knowledgeable investors have an image that the bulk of mutual fund investors are naïve and will buy any fund that has good performance and then jump to the next fund that has better performance. In the Sunday Business section of the New York Times, a statistical table of the fifteen largest mutual funds is published. I find this data particularly instructive, compared to the often exaggerated image of mutual fund buyers as “Ma and Pa Kettle.” First, none of the fifteen largest funds has total expense ratios over 1%, thus a large number of investors own some of the least expensive funds. In the long run, the low expenses provide a performance advantage over the average fund. What is even more instructive is the fund management families that make up the roster of the fifteen largest. Seven are managed by the American Funds group that relies on salespersons to raise assets. The next largest group is the four Vanguard funds, followed by two from Dodge & Cox and one each from Franklin Resource and Fidelity. Six of the funds have no sales charges and two have share classes that have different sales charges. I believe that at least half of the combined assets of these funds are from institutional investors and probably over half represent retirement money. For the most part, the shareholders in these funds maintain their ownership for longer than average holding periods (even though a number of these large funds have not produced “top of the charts” performance for many years). Yet, they fill the needs of their holders. In many cases they have normal redemption rates, as voluntary or involuntary retirements and health issues require funding. New sales are now probably largely sourced from various retirement plans. For some time, more dollars have been leaving than arriving in these coffers. This imbalance may be about to change.

In February, my old firm, Lipper Inc., estimated that $1 billion came into Large-Capitalization Growth funds, and another $700 million came into Multi-Cap Growth funds. (Multi-Cap is a classification for a fund that has assets in different levels of market capitalization. Often Large-Cap is the largest commitment, but not the dominant market-cap.) During February the more speculative group of investors often including hedge funds, put $6.9 billion in Sector Exchange Traded Funds (ETFs) and $5.1 billion in World Equity ETFs. If these speculators prove to be correct, I expect it will ignite the interest in Large-Cap funds.

A survey of international asset managers compared expectations for the US market in January compared to their expectations in December. In January, 62 managers expected a rise versus 53 in December. Only nine were looking for a decline.

Disclosures: Both my private financial services fund and I personally own shares in most mutual fund management company stocks, including one mentioned above. We own a large number of these management company stocks within the US, Canada and the UK as a way to understand our primary investments for clients in their underlying funds. A number of the funds in the largest funds table are owned in our client accounts. I have been annually advising one of these funds as to the appropriateness of the advisory fees since the late 1970s. I believe my multiple involvements with mutual funds and their managers make me a more informed and better analyst. The prices of mutual fund management stocks are leveraged to the market’s expectation as to their growth in assets, which normally leads to increased profit margins.

Other tea leaves

JP Morgan Private Bank has noted that the US Consumer Spending is the largest source of consumer sales in the world by region. However, the US is behind both Europe and Asia in terms of the level of gross investment, and is the only major region that is a net importer. Brazil, Japan and other countries are fighting what they see as competitive devaluations through QE or other interest rate repressions. Until the fears of induced inflation increase and the exhaustion of the excess corporate capital hoard occurs, we are not likely to see meaningfully higher interest rates. As US taxpayers, we should hope that rates remain low for the next ten years as the US is facing the largest single refinancing need of any country or region.

Sam Eisenstadt, the long-time statistical genius behind Value Line is once again expressing a precise bullish view as to the market into August, where he believes the S&P 500 will reach 1520. Market Hulbert translates this in MarketWatch to a DJIA of 14360.

Spain, and its somewhat kissing cousin California, are in deeper trouble than they appear to be on the surface. Both have more complex conditions than are initially apparent. Officially, Spanish sovereign debt is listed as $732 billion and 68.5% of GDP. However, if you add in the bank and other guaranteed debt plus the regional government debt, the total indebtedness rises to $1.1 trillion or 103 % of GDP. What makes this difficult to swallow on the part of the task masters in Germany, is that it is too similar to Ireland, where the biggest part of its debt was the Irish government’s assuming the local banks' real estate debt. The Spanish banks' commercial real estate loans are larger than similarly combined loans in Germany and the UK. (Just as we went to Asia to get a better understanding of China earlier this year, we are trying to plan a visit to Spain to get a view on the ground.)

The connection with California (which has a long tradition of Spanish investment) is that as the EU was being formed, I was urged to invest in Spain as it was ironically touted as the “New California,” providing low cost labor for Europe’s manufacturing needs. Spain would be home for a real estate explosion as the Europeans from less favorable climates would want to vacation and retire there. For awhile it worked, until the production of debts rose faster than income, similar to, you guessed it, California. To bring the parallel up to date, in the annual period ending in February 2012, California tax revenue fell 22.5% due to sharp declines in retail sales as well as use taxes and personal income taxes. A sunny climate is not sufficient to produce prosperity.

Goldman Sachs

Last week was “The Week that Was” for the firm. Too much has been written about the reactions to a disgruntled employee. Much of this verbiage is in the so-called “popular press,” as distinct from the professional or trade press. I do not want to add to the collection other than to make two points. First, many amateurs do not understand the concept of agency where an agent is working exclusively at the time for a client. On the other hand, a principal is involved on the opposite side of the trade. A couple of generations ago there were separate brokers (agents) and dealers. Over time, driven by economics, these two functions were combined in the same firm. Most of the time people, (whether they recognize it or not) deal with Goldman as a dealer not as an agent. Clearly both some clients and a small number of employees of the firm do not appreciate the distinction. The popular press does not. The second point I feel compelled to disclose is that we are no longer clearing through an affiliate of the firm, as we did not provide sufficient revenue to them, but this has no effect as to our long-term holding of Goldman Sachs.

Investment conclusion

Read as many tea leaves as you can. Look for deeper implications from factoids because they are often visible before the full picture becomes clear. As many of these thoughts are not without controversy I would like to hear from you.

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The Temptation to Go Short

There appears to be general agreement that a bottom in the stock market indexes was achieved on or about March 9, 2009. April was a strong month, and in some cases showed the kind of progress one sees in what we used to think was a “normal" year. May, and the first few weeks in June, showed additional progress, but at a slower rate. The penultimate week in June showed some weakness. Now we have just two days to see whether we will have a trading rally for the late institutions trying to get rid of too much cash, and trading desks attempting to square their positions.

The popular press (if that term is meaningful anymore), is developing an expectation gap. Very few new jobs have been created by the government’s stimulus. Auto sales have not picked up since the intervention. Interest rates are low, which in many respects shows the lack of solid loan demand. Though somewhat counter-intuitive, many would consider moderately rising rates a plus.

Could we see another test of the recent lows? The answer is yes. But that is not the right question. The correct question is, “What are the odds that we have seen the bottom for most stocks in 2009?” My guess is that there is a better than a 75% chance that we have seen the bottom for most stocks. There is a new symbol for this bottom, “VL.” This suggests that we have already seen something of a “V” bottom coming off the March lows, to be followed by dull, relatively flat movements of most prices. (Within the horizontal portion of the “L” there is plenty of opportunity for trading successes.) Some believe this flat, range bound, market could last for a long time. One might say “VL” stands for very long.

In the face of these observations, why do I believe, in general, shorting it is now unwise for most investors? Often, the study of mutual funds provides answers to larger investment questions. The mutual fund industry is competitive always within its own market, but has grown by entering other providers’ markets; money market, tax exempts, and bank loans are just three examples. Many in the fund business feared the “retailization” of hedge funds (the decline of hedge fund minimum investment requirements) might cause mutual funds to lose customers. The counter attack by the fund industry was led by the so-called 130/30 funds. These funds invest 100% of their assets on the long side and with the use of leverage (often margin) allocate 30% on the short side. Other funds, also willing to bet on declines at least of the markets, if not civilizations, are available.

My old firm, once Lipper Analytical Services, now known as Lipper, Inc., created an investment classification called “Dedicated Short Bias Funds” as a peer group for the 130/30 and other funds betting, at least in part, on a decline. Setting up this peer group worked well. In 2008, and again in the first quarter of 2009, Dedicated Short Biased funds were the best performers (and often the only profitable funds on average) in the diversified US equity fund super-group. As I have often stated, fund performance is cyclical, driven by the highest mathematical power, within a large universe, of reversion to the mean. (Both the leaders and the laggards move in the direction of the middle of the array, often way beyond the point of becoming the new leader or laggard).

I doubt that there will be a meaningful reversal of the performance and rank of the average Dedicated Short Biased fund for the first half and second quarter of 2009. In both periods, these funds are the only classification within the U.S. Diversified Fund super group which shows negative results. Their current fund declines of over -20%, is larger than any other fund in the super group on the upside. (A number are getting close to a 20% gain for the first half.) Further, I believe it is too early to see a counter-reversal for the short sellers.

Thus my considered judgment for investors, not traders, is: this is not the time to go short.