Risks Found in this Week’s Readings

Introduction

Each week I appear to be a one person research or reconnaissance staff looking through the information clutter trying to avoid Improvised Explosive Devices (“IEDs”).  I hope to dance through the minefield that is out there. Like most destructive forces they are initially hidden and like a wary animal I try to sense dangers before they become clear. My search approach is to look for possible analogies that could reveal dangers to all of our portfolios. This week there were four questions that popped up:

• Possible ties between compulsive gambling and ETFs?
• Are there parallels between the collapse of the Weimar Republic and the US?
• Are there amateur real estate winners?
• Is political arithmetic more important than budget math?

Is using ETFs a form of compulsive gambling?

In The Wall Street Journal’s Review section this weekend, there is an article entitled “The Real Odds On Gambling.” I am pleased that the source of the data for this discouraging article is from scholars in the UK supported by gambling business consultants in the US. The findings showed that the odds on winning big in casinos were stacked against the players 31 to 1, (31 losers to 1 winner).  The scholars also found on average, that gamblers who bet somewhat continuously over a two year period, 31 lost money for every one who made money in casino type games of chance. Poker players playing against other players did better winning about one third of the time. A number of poker players and casino players did win periodically. They kept their winnings by walking away from the tables.   

When I wrote the book Moneywise, I noted that two of my great learning institutions for adult life were the Racetrack and the US Marine Corps. Sorry about that Columbia University, where I joined the professional military through the Naval Reserve Officers Training Corps via a scholarship. Actually a good bit of my racetrack experience was learned while I was enrolled at Columbia full time, with an on campus job and a member of a world famous fencing team. What I learned by doing the math was that it was virtually impossible to walk away a winner for the racing season by betting every race. First there is the issue of racing luck/bad analysis/not picking winners. Second, the state and the track replaced the casino in terms of the take they took out of every bet. Finally, the New York betting crowd (possibly the same Wall Street players or their cousins that I competed with later) were too accurate juggling most of the track odds and the probabilities at winning.

I concluded that I materially improved my chance of walking away a winner by betting few and in some cases no races on a given day. Further I looked for opportunities where most of the attention was focused on predicting the winning horse and the odds on either of the first two or three horses aligned more favorably with my analysis of the probabilities.

What does this have to do with investing in Exchange Trade Funds (ETFs)? I believe a great deal. Over-simplifying, the bettor using ETFs is in for a fast trade, essentially betting against the market’s view of valuation; or else he/she wants to participate for an extended period of time (which is sort of like some of my relatives who wanted to cash a ticket so much that they virtually bet almost every four legged vehicle in the race). Both the short-term and long-term approaches do not have good odds on winning big, particularly when compared with other opportunities.  In truth, I should not be anti ETF as I own shares in publicly traded investment groups that are the sponsors of various ETFs. I have improved my odds by betting on the house rather than with the crowd. I will admit that I have used index funds in various institutional accounts to balance the concentrated investments of some active funds with broader and cheaper passive funds. However, I do not use them personally.

Possible parallels to the Weimar Republic collapse

The inspiration or perhaps more accurately my fear was generated by The Wall Street Journal, in this case a book review of “The Downfall of Money” by Frederick Taylor.  He describes the monetary trap that the German government, the Weimar Republic, found itself in attempting to pay off its high reparations debt calculated in terms of gold. Germany’s answer was to inflate the money supply to such an extent that the internal value of their currency collapsed. (In the week of the French invasion of the Ruhr to seize the coal it was owed, the Germans needed 7,260 deutsche marks for a US dollar. By October the purchase of one US dollar required 65 billion marks and this was not the final quote before the mark became worthless. Under such circumstances one should have seen that a charismatic leader who would fix things and repair the wounded German pride would arise to take over and indeed Hitler did. This part of the story is well known and should be taught in every school in the world.

What is not as nearly well known is the contention of the author that the economic problems actually started in August of 1914. In order to raise the money needed to feed their war machines each of the soon-to-be combatants began to inflate their money supply. By 1920 the purchasing power of the US dollar had declined by 50% since 1914. In reaction to the induced inflation one after another of the major countries returned to a gold standard pushing up the value of gold to offset the purchasing value of the internal currencies, thus wiping out arbitrage opportunities and the competitive advantage of various exporting countries. With this background we can understand the fears of some of the implications of the problems at the periphery of Europe, potential problems in Japan, China and clearly the US with its growing deficit. (At least for now our debt is all dollars based.) We could see at some time in the future a reversal of Franklin Roosevelt’s arbitrarily raising the price of gold behind the US dollar and Richard Nixon’s closing the gold window. (What a strange combination!)

These fears are a good reason that corporations are doing more of their business overseas and in some cases in local currencies. Securities investors should follow remembering that US listed securities represent less than half of the world’s securities.

Investing in residential housing has worked

In an article from the Financial Times it was noted that the UK wealth gap grows as homeowners save more but renters suffer. The article focuses on first time, but well off buyers of residences. They are intelligently reacting to some remaining softness in home prices, low mortgage rates and rising rentals. The same pattern appears to be happening not only in the UK but other countries including the US. There may well be a political as well as economic implications to this as more people begin to think of themselves as a “little bit wealthy” and change their spending, investing, and possibly their political habits.

The real arithmetic of the partial Shut Down

Both the trade press and the general circulation news media are focusing on the size of the current US deficit and the ability to pay the incurred debts. On the surface these are important, but are not the motivating drivers of the politicians leading the battle. For them the key numbers are 17 swing seats in the House of Representatives and 5 seats in the US Senate. If the elections bring additional cover for the Administration more socialistic laws and regulations should be expected. If the reverse happens there will be a stalemate on the legislative side leaving the actions to take place mostly on the regulatory front. The battle is being fought through various press releases and interviews on or off the record to influence the relatively small number of swing voters who will make up their minds in terms of local choices one year from now. Largely the long-term economic impact of what is finally decided in 2013 will have limited dollar impact by October of 2014. Thus the keys to watch are the growing changes of perceptions as to which specific local candidates will be considered less bad than the other person to fight for a better share of rewards for the swing voter. At this point delivery will be more important than wisdom

The Benjamin Graham Award

Earlier this week, I received the Benjamin Graham Award for Distinguished Service to the New York Society of Security Analysts. I have been active in the Society for more than fifty years serving the leadership with energy and advice. In a very brief acceptance speech I stated that I was delighted to get an award named after Ben Graham who was the spiritual godfather of the society. Having taken Security Analysis under his writing partner David Dodd, I was able to say that Ben taught us (including Warren Buffett) that one could lay out various principles but in the heat of the day do something different. (I believe this is an important realization for all who participate in the market at any level.) I also thanked the audience for the ability to give back to a business that has given so much to me.

How are you looking at the investment world now?        

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Financial Illiteracy: Too Many Are Not Ready For Retirement

This week my thoughts have turned to retirement for others, including my children and grandchildren as well as many others that I know. The concept of a voluntary cessation of producing an economic income and relaxing comfortably at leisure is shaping up to be one of the great myths. They simply won’t have the money to be only mild spenders and not earners at hard work. If we think the current debt structures and deficits are troublesome, we only need to look at the future. Unless we dramatically change the savings, investing, and living practices, the size of the population that will need help to retire with any sort of comfort will be huge. In my view the only long-term answer to the crushing problem is practical education. Of the three parts to the solution: saving, investing and life style, my only expertise is in investing. Nevertheless, I recognize the other learned skills of budgeting (controlled spending) and leading a healthy life are equally important.

Investment is an art that begins with reading

While almost all could benefit from reading Wealth of Nations by Adam Smith, Securities Analysis by Benjamin Graham and David Dodd or even to a much smaller degree my book MoneyWise, these are not what I am talking about. The kind of reading that I am alluding to is reading the situations around the world by observing every single day. Particularly now in these stressed times we watch conspicuous consumption with some awe. We do not pay enough attention to those who are not currently spending because they can’t and those who choose to spend less. Both groups are important to observe. Those with little resources and living moment to moment didn’t follow (or found it too difficult to follow) their few successful classmates, teammates, fellow workers, neighbors, etc. There are always some that took advantage of the opportunities to move up and out. Luck was not the source of their ascendency, but rather they recognized opportunity and the willingness to do the difficult. The second group of curtailed spenders may well be future-oriented as distinct from living moment to moment. The second group has internalized the fact that limiting current spending is transferring resources (no matter how small) to a future period. This transfer can earn additional awards through investing. Other places to read the economy are the gas stations (gas prices and level of maintenance and repair work), supermarkets (changing prices, excess inventories, the shifting to store brands from nationally advertised brands, quality of produce, etc), and shopping malls with high turnover stores (promotional and everyday prices, inventory of your size, stock liquidations, imports vs. locally produced merchandise).

There are too many financial illiterates

At the last board meeting for the Museum of American Finance where I sit as a Trustee, there was mention of a study by Annamaria Lusardi (George Washington School of Business) and Olivia S. Mitchell (Wharton School, University of Pennsylvania) entitled “Financial Literacy and Retirement Planning in the United States.” In a survey of 1200 responding Americans, the study asked three very simple questions; (1) understanding that interest rates can add to the value of savings, (2) understanding that inflation can reduce spending power in the future, and (3) whether some form of diversification lowers the risk of loss. Only 35% of the respondents got all three answers correct. What is even more discouraging is when the respondents were divided between those that are planning for retirement and those who were not, 47% of the planners got all three correct and the non-planners 23.9% got all three correct.

Salary savings plans: 401(k), 457, 403b come to the rescue

These savings plans increasingly require all the new, and in many cases present, employees to participate in defined contribution plans which are replacing defined benefit plans where and when possible. These plans are usually funded by employer and employee contributions. These contributions are invested at the discretion of the employee into various options including default options if they fail to make a choice. Open end mutual funds are the single most popular choice for managing this money according to the funds' trade association, the Investment Company Institute (ICI). Last week I contributed a brief column to Reuters on how I select the various options to be offered within a plan. In addition to the nine alternatives, I suggested that a managed account offered through the 401(k) could adjust the investments to changing market conditions and outlooks.

There are two dangers lurking in these plans

Both of the dangers lurking in these plans stem from some of the participants (beneficiaries) of the plan and an occasional sponsor of the plan not grasping that these are fiduciary accounts whose sole purpose is to build retirement capital. Another survey by Transamerica Center for Retirement Studies found that 63% of those who had participated in a 401(k) plan drew cash out when they became unemployed, and 34% of the underemployed did as well. Not only is there a tax penalty for a premature withdrawal, they are in effect robbing their own retirement money and/or benefits that could go to their family or heirs. I suspect that many who withdrew would have been part of the 65% who did not correctly answer the three basic questions in the other survey. Also they did not read (or see) the poor and struggling retirees around them. In the long run they and the rest of society who will give them some support will have suffered from their financial illiteracy and their inability to observe others around them. The contribution to our future deficits will be caused by this failure to educate our people.

The second risk, which is much smaller, but still a risk in some relatively small plans of privately held employers, is an attempt to replicate the senior executive's personal investment account. Even in the smallest of plans with just one owner and one employee, the sponsor has a fiduciary responsibility to the sole non-owner employee that the money is being invested in a prudent fashion. Also the executive who presumably has a significant personal account would be better off investing in potential capital gain earners in their personal account where, under current US tax regulations, they will pay fewer taxes when they liquidate.

What has me worried is when I see sector-oriented indexed exchange traded funds (ETFs) in retirement plans. These are narrowly focused portfolios designed to replicate a fixed list of stocks in one sector or industry. My concern is that these are good trading vehicles particularly when combined with short sales of some stocks within the industry. But the flows in and out of these ETFs are much more volatile than the underlying stocks. According to the ICI, the gross redemptions for all sector/industry funds through August, 2012 was $146 billion and the total assets in these funds was $246 billion. To be fair, the gross redemptions were somewhat offset by some inflows. Nevertheless, the gross redemption total indicates to me the speculation that is going on within these kinds of vehicles. This is just one of the types of investments that may be wonderfully appropriate in a personal account, but should not be found in a fiduciary account for all employees in a plan. Luckily, instances of these hyper-aggressive strategies in retirement plans are rare.

Opportunities

I speak with bias, in that I manage a small, private financial services fund that has positions in a number of investment management stocks. Despite the problem with financial literacy, I believe that defined contribution plans will continue to grow at rates faster than employment and the economy in general. Investment management company stocks should benefit from this perceived trend.

Are you reviewing your retirement planning?

My next blog will come from London.

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Does Wealth Equal Freedom or Independence?

In my book MONEYWISE, I equate wealth to freedom. Freedom to do what you want to do (within the laws of the land), and freedom to make active decisions. This weekend a more mature series of thoughts became clear to me. My good wife, Ruth, had surgery on her left hand and wrist, temporarily reducing her ability to dress herself, prepare meals and drive. She is a very dynamic person who is highly independent by nature. She will be partially constrained for a period of up to eight weeks and will be dependent on her sisters, various friends, some of our office staff and her klutz of a husband. Her life over the next several weeks however, will be much easier than most others that have limited support available to them. Nevertheless, she will involuntarily give up some of her prized independence for dependence on others.

Whether we like it or not we are all aging, some fighting it along the way. What is clear by observation is that all of us will be giving up some independence over time. As an investment animal, the need for significant resources to pay for dependence is becoming graphically clear. The kind of temporary, or more frightening, permanent help with life’s functions and some remaining pleasures, will be expensive in both monetary and perhaps family terms. Those with limited means may become dependent on various government transfer payments to senior citizen aid programs. However, these will be limited by budgets, the availability of trained and compassionate home health care aides, and the baby boom population echo. Bottom line, the public funds will be inadequate to meet the personal needs of those without any resources. But it is the larger middle class who will be in the worst shape. They don’t have the resources to independently fund all of their needs and will have too many resources to fully qualify for forms of government aid without disposing of most of their tangible assets.

Well, smart guy investment animal, what are you going to do about it? My book, MONEYWISE, does start to answer the problem. In the book, I advocate the drawing up of a personal balance sheet that recognizes the reserve, or if you prefer the debt, for one’s own retirement. Hopefully the debt includes looking after one’s spouse or significant other. After my experience this weekend, as well as the observations of others, a commercially purchased or self-funded long-term care medical plan is likely to be insufficient to cover all of the needs of incapacitated people. I am not to the point of identifying the need for round-the-clock nursing, however, I recognize the need for a daily visitor to minister to the non-medical needs. Depending on the length of the visit, from one or more hours to a full day’s tour of duty, today’s cost would be well into five figures and perhaps into six figures, multiplied by the number of remaining years. Most people have not set aside money for this need in addition to their long term medical needs. Each person, perhaps aided by their trusted lawyer, accountant, and/or investment adviser or other elder care expert, should determine the amount of capital needed to be assigned to the retirement reserve.

The investment of the retirement reserve puts the investor in a very uncomfortable position. We are led to believe that the higher the potential return from investing the likelier the risk of permanent loss of capital. By adding this uncertainty to the uncertainties of quality of life (as well as length of life), leads to difficult decisions for each of us. Despite the difficulty in making these decisions, we have no choice. Not making a choice is no choice, and losses the benefits of compound interest rates to grow capital.

The realization of the need to add to our own retirement capital base is going to force us to invest more and to spend less. On a worldwide basis, retirement capital is way below the level needed to produce the retirement spending that we may feel is essential. The problem won’t go away and just gets bigger every day. This recognition is why I believe that more and more money will go into the investment channels on a secular basis around the world. Thus, I am long term bullish on security prices.

As these thoughts are being written on Mother’s Day in the US, we should start to help our Mothers and the Mothers of our children and grandchildren.


p.s. Ruth is getting better if for no other reason than self defense.

Could the “Stress Test” be a Big Trap?

Beginning Monday and perhaps lasting for a week, savers and investors will look forward to the publication of the results of a series of stress tests on the 19 largest domestic financial institutions as to their safety and soundness of their capital. While I do not know the details of the measurement of these tests, the absolute reliance on them seems to me like a dance at the “Mad Hatter’s Tea Party.” In my book MONEYWISE, I identify one of the causes of risk of loss of permanent capital is unanticipated events. These warnings were written in 2007 before both the recognition of the sub-prime mortgage collapse and the recognition of various Ponzi schemes, most of all Bernie Madoff’s. In these cases there were numbers trending in the expected direction and the future was expected to follow predicted patterns.

I hope that I am wrong about the statistical stress tests being applied by the government and that in the near term future, all of the financial institutions tested with their present or augmented capital prove to be safe and sound. As humans, as well as many animals, are conscious (or more likely unconscious) odds makers, the odds on the outcome of the tests are somewhat less than completely perfect.

The intent of the tests is to supposedly give us comfort in continuing to leave our capital with these institutions and perhaps more importantly be willing to advance additional capital in the form of deposits, loans, various forms of equity, and counter-party risk assumptions. This exercise is similar to, but not identical, with an acquisition study. In one way or another I have participated on both sides of the acquisition mating dance. Only at the first level of these discussions are the various numbers significant. Additional scenarios are often produced as variants of the original data. These are similar to the stress tests we are all awaiting. However, in an acquisition exercise there are many other analyses performed. Perhaps the single most important analysis is to evaluate management, to determine how much of the past was created by the leadership rather than the environment, and what is management’s expected roles in the future. The 19 financial institutions are all in competitive businesses among themselves as well as other domestic and global competitors. As an odds-maker, I put the probability of significant changes of price and other terms of trade as almost a certainty. (Unless the government will attempt to put into place monopolistic pricing discipline, under some other name, to protect its investment in these financial institutions.) There are many other elements to a good acquisition analysis. There remains one more critical screen and that is trust.

Both financial and intellectual frauds often start as business in the late stages of expansion to make up for earlier, smaller losses. The frauds are expected to be short lived by the perpetrators until assets are returned in full with interest, or when various market share or sales targets are met. Most frauds are begun by previously honest individuals or organizations. I am not suggesting any of the 19 institutions are doing anything fraudulent. However, I wonder if the stress test is leaving enough of a cushion to keep each of the 19 in a safe and sound condition if there has been undiscovered fraud committed by employees or customers/counter-parties. The odds of such occurrences are favorable; the frauds have not been discovered yet, and the people committing the fraud in some aspects may have superior data systems knowledge and capabilities than each of the 19.

The bottom line as a manager of a financial services fund: I look forward to the coming week and the enthusiasm generated by the expected results. However, I am willing to bet a year to three years from now that we will discover that the stress test failed to identify the specific stress that one or more of the financial institutions will go through. For the others that are addicted to investing in stocks and bonds of financial service companies, they may wish to widen their selections and include both large and smaller companies.

Let the games begin this week.