MEMORY TRAPS JUDGEMENT - Weekly Blog # 578

Mike Lipper’s Monday Morning Musings

MEMORY TRAPS JUDGEMENT

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

In the US it is the season to remember and celebrate the past. For more than 150 years we have had Memorial Days to honor those who served and died in the defense of their country. It is also the time for college commencements. (Like many other families we proudly celebrated multiple college and high school graduations this month) Victors write the published history and exploits are summarized and simply told. It is the simplified and often enhanced versions that are remembered in succeeding years.

This habit is harmless unless it becomes the basis of judgement in dealing with the likelihood of future events. I have often said that if one cuts an analyst, a historian will bleed. Caltech(*) professors have determined that the part of the brain that deals with making judgments is the portion that stores memory. I feel that comparisons of the past with the present or perceived future, unadjusted, can lead to significant errors of judgement. Errors of judgement can be costly in all elements of life, but is particularly noticeable with investments, where it can result in both unnecessary losses and forgone gains. A very perceptive reader of these blogs, while discussing the current investment scene, quoted a bunch of statistics to me from the past. I responded that the current picture is different from the past because so much has changed. He then suggested that I blog about the crucial differences, which led to this blog.

Major Changes
One can categorize the major changes in two buckets. The first are the less visible changes that have and are a continuing influence on the markets for investments. The second are the changes that are driving the broader world. While both sets of changes have their origin many years ago, their importance has been accelerating over the last ten years.

Less Visible Changes in Investment Markets Structure
One of the techniques I learned in the Marine Corps was that when planning an attack, start by looking at it from the defender’s perspective and plot your attack from the enemy’s position rather than from your own. I have utilized the same approach of reversing direction to the art of investing. Thus, I start with the profitability of the agents, intermediaries and principals, recognizing that  return on equity, profit margins, and capital turnover have all suffered since 2007, if not earlier. Because of the generational growth of cash capital, revenues have grown. When I was an analyst at a retail-oriented brokerage house trying to build an institutional business, the return on partners capital was about 25% in normal years. Better firms probably did even better. Today, after an extended period of concentration in the industry, many firms utilizing a lot of leverage have return on equity in the single digits. Moreover, that return is earned on selling private equity and debt rather than publicly traded investments. Private sales are growing at twice the pace of publicly traded sales, although the market is much bigger.

From a customers’ vantage point the lower profitability has led to a much smaller cadre of research analysts and less readily available liquidity in stressful situations. Smaller companies have lost analyst coverage, including many stocks that don’t even have an analyst regularly reporting on them. Part of this decline is the result of regulation FD, which curtailed what analysts could learn from private meetings with corporate executives. With less in-depth analysis and increased media attention on reported earnings, published earnings have become a less reliable guide to what is happening. Previously it was a clue to future results.

Due to the competition for effective salespeople, those that are better get a higher percentage of the revenues they generate. This has led to a switch from selling load mutual funds to selling private equity and debt, plus the occasional initial public offering. These were less frequent occurrences in the past, as private firms remained private for longer or were acquired.

In the past some firms would accommodate good customers by absorbing the stress merchandise they held or sold. Any losses sustained were repaid in future transaction business. This kind of facility is not generally available today. Liquidity concerns may be heightened when we move out of the relatively low volatility market we have been enjoying.

Regulations addressing the late 2007 mortgage credit collapse in the US  penalized the participants rather than dealing with the imbalances that were partially created by politically sponsored government subsidies. In Europe, MiFid II is already reducing both research and liquidity support for European investors.

External to the Market Changes
Central Banks have evolved from being the bank of last resort in financial crises, to stimulating economies within the term of the current political leadership. Unfortunately, they rely on government data that does not capture the reality of inflation and does not fully understand the deflationary impact of technology.

The changing structure of the banking world is not fully appreciated, financial tech providers are viewed as an aid to existing institutions. Fintech has morphed into new competition for established banks through items like electronic payment systems, electronic trading of currencies and personal loans.

Demographic changes have been identified for a long time, but not their implications. The developed world needs more workers, productive workers. Our educational system, from pre-school through the granting of Ph Ds, is not producing enough employable workers with the right knowledge and personal attitudes to fill present and future jobs. Combined, these trends along with the advances of expensive medical science and the inadequacies of social security and pension systems, will not be able to support retirement.

We have a transnational problem. Both consumers and producers have become global, but they are dealing with national laws, taxes, and regulations. To an important degree, elements of consumption and production can and will move beyond local political mandates.

Are Past Lessons Worthless? 
Absolutely not, they just need to be adjusted to fit the current context. We can learn from past motivations and they should be studied, not the various statistical ratios, frequencies and measures. The statement that history doesn’t repeat, but rhymes, is more accurate than a statistical cookbook.

(*) I am a senior trustee of Caltech and a member of its investment committee, among other committees.
 
   
     

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/05/probable-view-of-next-decline-weekly_19.html

https://mikelipper.blogspot.com/2019/05/probable-view-of-next-decline-weekly.html

https://mikelipper.blogspot.com/2019/05/2nd-of-mays-good-lessons-weekly-blog-575.html



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Look to London When Seeking Global Views

Introduction

Too many American investors and managers do not search for investment wisdom beyond their national borders. For years Byron Wien wrote about "the world's smartest investor who has passed away.”

 I do not have the skill to identify the smartest investor. For decades I have been calling on some very smart investors in London. Some of these were clients of various fund data services and resulting consulting. Others were leading investment shops or investment trusts. I continue this journey.

This last week I accompanied my wife Ruth to London to hear our New Jersey Symphony Orchestra's wonderful music director, Xian Zhang conduct a superb concert at The Proms, held in the Royal Albert Hall. I took a ‘busman’s holiday’ and spent the rest of the week speaking with a number of great money managers, corporate leaders, old friends and former associates. As usual our far ranging conversations covered both the current global investment environment through to multi-generational investing.

Shakedown Cruise

Most of my British friends don't know what to make of President Trump. He is a definite interruption of the past policies and trends that they had become accustomed. The only way I could help them with their concerns was to explain that the current occupants of the White House have embarked on what the US Navy does immediately after it launches a ship. The Navy conducts a "shakedown cruise" where the crew learns how to handle as many of the problems that might occur in carrying out their missions. From a training viewpoint, the more problems the better. Over time they learn to solve most of the problems. At the beginning of the cruise the crew does not know how long the shakedown effort will last.

I reminded my hosts that the President learned command at military school. He is a product of a Queens County, New York real estate family. Using his threatening negotiating skills, he successfully attacked other New York City boroughs and regulators to accomplish his business goals.  

President Trump is going to be different. The intramural battles in Washington are what the founding fathers expected. They did not want an imperial king. We all are going to have to learn the new dance steps to unfamiliar music.

International Investors and the US Markets

For international investors putting money into the US, it is a double bet on the dollar and local stock prices. In the past these moved in the same direction which increased their total returns. More recently while share prices were rising, the value of the dollar was dropping. (One good technical market analyst believes the dollar is "bottoming" and will rise to new highs.) Due to a left leaning press, many in London tie it to Mr. Trump. I see it very differently.

To me the dollar should not have been strong for a number of years, which in part was a contributor to the 2016 Republican electoral wave, all the way down to state legislatures and counties. The reason the dollar was strong until recently was that almost all other currencies were weak in view of their own problems. The prospects in many of these countries are sufficiently improving to a point that the locals are reducing their conversions into dollars. (I have not yet seen a reversal where there is significant selling, just less buying.) This phenomenon is being recognized by US investors who have been replacing some of their domestically-oriented mutual funds with international funds, a trend that has been going on for many years. We are also participating in this trend for our accounts.

When I see very successful multi-generational families, I look at their investment portfolios and philosophies. Most of the positions in the trust-quality portfolios are not likely to be top performers, near term.  Thus, they won’t make the lists, to use a British expression, of the “Tops of the Pops.”  As it is almost impossible to always be in the most popular successful stocks, there will be times when these former leaders will under-perform. Thus their records will appear to be more cyclical than the somewhat slower moving secular growers.

Harking back to my first professional investment job at a trust bank, the multi-generational families opted for quality of management and products. Today the long-term concerns of multi-generational investors remain focused on quality and selectivity. We seek to answer these issues in the Endowment and Legacy segments of  TIMESPAN L Portfolios^®, though these portfolios may contain other instruments that are more price-sensitive as well.

Interesting enough, the striving for quality has a place in their portfolio investing in under-served markets and these exist in all societies. The keys to these investments is to be providing uplifting services to the underserved.

The new European regulations coming into effect in January, MiFid II will raise the costs of both investors and brokers, which will lead to a reduction of investment industry capacity and is likely in the short-term to reduce the support for smaller and many mid-sized stocks.

There is recognition of the large and growing global retirement capital deficit, but at the moment no one is addressing it in a major way.

Short-Term Concern

While we focus long-term, we do not ignore short-term. One of the short-term factors that we look at is the relative yield dispersion, what Barron’s calls Best Bond and Intermediate Bonds, based on credit quality ratings.  In the last week, the demand for Best Bonds drove their yields down by 12 basis points, and prices up,  whereas the Intermediate Bonds’ yields dropped by 5bps.  The increase in price of the Best Bonds relative to the Intermediates is viewed by some as a bearish signal for stocks.  

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.