Are We in Boiling Water? And Understanding Value - Weekly Blog # 650

 

Mike Lipper’s Monday Morning Musings

Are We in Boiling Water?  And Understanding Value

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

Where are we (in the market)? Many of us have traveled with impatient children that too frequently ask “are we there yet?” What they should be asking is, where are we and what difference does it make? Plenty. This is where a frog and a pot of water is useful. Placing the frog in a pot of cold water will be greeted by the frog jumping out. Place the frog in mildly heated water that is a comfortable temperature and the frog stays put. If you raise the temperature slowly the frog is not conscious of the slowly rising temperature until it reaches a boiling level, which kills the unfortunate frog.

In terms of the current US stock market expansion measured by the popular indices, is the temperature rising? There is some evidence from the last four weeks that we should be getting ready to jump out of the market indices led market. Over the past four weeks ended October 8th, the average S&P 500 Index fund gained +3.31%. This compares to gains of +4.35% for the average Large-Cap Growth Fund and +5.60% for the average US Diversified Equity Fund, comprised of 7,336 funds. Earlier in 2020 index funds were clearly in the lead, for three reasons:

1. They were fully invested and thus had no retarding cash
2. They had no brokerage and other operating expenses
3. They had a large commitment to information technology stocks

What is causing the change waking up us frogs? Both brokers and the media need investors to transact to meet their commercial needs. Considering that in the current year we had a record decline and recovery in terms of annual rates of change. As this is unusual, it generates nervousness. In September the shrillness of the political campaigns upset some investors, causing them to question whether their current investments will serve them well in the next couple of years. 

Turning to specific concerns, the final publication of the majority report from a House Committee advocated for a new type of anti-trust legislation that would splinter large info-tech corporations. Evidence of these concerns can be found in the short positions of the tech heavy NASDAQ market, which rose 3%. This compares to the short positions on the NYSE, which rose only 0.5 %. Volatility has risen over the last three weeks compared to levels a year ago. The performance of the NASDAQ Composite has led the Dow Jones Industrial Average (DJIA) and the S&P 500 for some time, but it is no longer the clear leader.

Getting Ready to Jump to “Value” Stocks

Advocates of change are reducing exposure to tech in favor of adding to “value”. As with many labels, it covers a wide range of different types of actions and securities and could well be jumping from the “frying pan into the fire”. In terms of the professional academic literature, the earliest text I know about was titled “Security Analysis” by Benjamin Graham and David Dodd, who were professors at Columbia University during the Depression. The book was so successful in academic circles that it went through five editions. I was extremely lucky, as I took David Dodd’s Security Analysis course toward the end of his distinguished career. 

In reading his text in class, it became clear that he was describing value as liquidating value. This was a very good way to make respectable investment returns starting in the depression. Remember, this approach was that of an academic, not a business person, so there was reliance on published financial statements. As students, our first task was to recast the balance sheet by revaluing the assets and liabilities. The critical key to the analysis was to value the preferred shares and debt at their current market value, not their stated value on the balance sheet. Furthermore, assets were revalued to what they could bring in a quick sale. This meant that only finished product inventory had any real value and that was subjected to a discount. Plant and equipment were assigned little to no value. The next step was to augment the balance sheet with undisclosed assets and liabilities, including items such as leases, rights-of-way, and the net value of pensions. This type of analysis led to the conclusion that some bankrupt companies could be worth more than the lackluster common stock price. This type of analysis allowed Graham and Dodd to buy and liquidate companies in their fund.

Max Heine, founder of Mutual Shares, and Ruth Axe, founder with her husband of the Axe Houghton funds, did similar operations of railroads. Axe Houghton at one point controlled the Missouri Pacific Railroad by being the dominant holder of a cumulative preferred issue, which had not been paid dividends for many years and had to be paid off before the railroad could be sold with its attractive right-of-way real estate assets. (In a similar way, as a small investor I participated in a defaulted cumulative preferred, which over time was gaining voter control of the board of Pittsburgh Steel.) The key point of this deeper understanding of “Value” is that one does not rely on published balance sheets, but uses them as a beginning to find other assets and liabilities to recast a more realistic picture.

“History Does Not Repeat Itself, But It Does Rhyme”

In some respects the search for attractive value investments may be similar to the period of Graham & Dodd’s depression analysis, at least in questioning book value as shown on published balance sheets. There have been many accounting rules changes, but a few things remain the same. In most cases land is carried at cost and buildings and equipment are carried at depreciated value. While at this point in our recovery I don’t know what the future will bring from the pandemic, my working assumption is that WFH (work from home) will reduce the number of people in office buildings and will likely impact the value of the buildings. There may also be less value in being in major cities. (I do recognize that some of these properties may be successfully repurposed, usually by private real estate people.) We have already seen a remarkable shift in the use of equipment to produce masks and similar products. Nevertheless, I question whether that will be the case in the new era.

This Week Brought an Example of a New Right of Way Deal.

The Missouri Pacific example of using the right of way real estate value to generate a higher than current market price still works today, but in a different form. This week, Morgan Stanley announced they will acquire Eaton Vance with a combination of stock and cash, at a 40% premium to the price it was selling prior to the surprise announcement. In some respects it was similar to depression type value creation. Eaton Vance is one of the oldest mutual fund management companies, starting life as the principal underwriter for the first publicly traded mutual fund, Massachusetts Investment Trust. It later started its own funds and through a Boston merger entered the investment counsel business. Over the years it raised money through sales to various brokerage firms and investment advisers. In recent years, it was successful in developing imaginative fixed income funds and low-cost index portfolio products. 

These distribution relationships were not on their balance sheet, but was what Morgan Stanley found attractive. (Morgan Stanley itself is the largest brokerage firm using Eaton’s funds.) Morgan Stanley found that 95% of Eaton Vance’s sales were to US and Canadian clients. They were under distributed internationally, which is where Morgan Stanley has considerable strength. There is another element that makes this merger attractive to the acquiree. The CEO of Morgan Stanley publicly announced that he was wrong to have sold Van Kampen, another fund management company with a strong distribution organization. Morgan Stanley also sharply curtailed its capital absorbing fixed income trading a few years ago.  They will be using a limited amount of its accumulated capital for this deal. All companies make mistakes, but few admit to them. I believe a former “sinner” is more likely to be a good partner in the future.

There are a couple of additional personal pluses to this deal. In the development of my own firm, when we generated sufficient capital beyond our operating needs we began investing in our clients. The main purpose was to avail ourselves of a shareholders’ view of our clients. In 1981 I purchased some shares in Eaton Vance for the firm. Luckily, when Reuters acquired our assets in 1998 they did not want our small portfolio, as they did not see the intelligence value of the holdings. Thus, today we are the pleased owners of a few shares that cost under 9 cents a share due to splits. (To demonstrate that it is better to be lucky than smart, over the years we have sold some of these shares for other portfolio operations.) As a member of a number of investment committees, I believe long term ownership of reasonably diversified portfolios of common stocks to be very capital productive over a long period of time.

Concluding Thoughts

We may or may not be at a pivot point in the stock market. If not, it is only a matter of time before performance leadership changes. At that point, some of the leadership will be labeled value. However, I believe future success in terms of stock prices will not be based on published book value. Attractiveness will be the result of finding unrecognized assets and ways to reduce liabilities. So, Professor Dodd will once again be correct.  

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

https://mikelipper.blogspot.com/2020/10/what-is-nasdaq-saying-to-whom-weekly.html

https://mikelipper.blogspot.com/2020/09/there-is-incredible-shortage-weekly.html

https://mikelipper.blogspot.com/2020/09/headlines-excite-dictate-or-respond-not.html

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Are you an Investment Trend Follower or a Selector?

Introduction

Are you an investment trend follower or a selector? The answer to the question will determine the result and the comfort level of your volatility.

Many institutional and individual high net worth investors inherently believe in the comfort of being gathered into the current central tendency of the market. They fundamentally believe in the phrase “the trend is your friend.” Others with some exposure to the sports and/or political world are very aware that there is an end to every trend which can be surprising and dramatic. Other investors practice a diversion from the central tendency by being selective.

The “H” and “T” Choices

While each of us think we can easily make rational choices between trend following and selectivity, to go against the trend you may have to identify whether you are more “H” or “T.”  Briefly “H” stands for Herodotus and the “T” for Thucydides. Both were historians  of ancient Greece. The first has been called “The Father of History” and by some “The Father of Lies.” He was among the first to write down the combination of what he saw and what we would call oral history without much authentication. He put these stories into a continuum in order to show a developing trend.

Thucydides  has been called the father of scientific history. Unlike his predecessor he did not often express an opinion and required hard evidence in the experiences beyond his own. In effect, he was a collector of incidents including the motivation and expertise of the main players. I must admit to a leaning in his direction as he was a general in addition to be being a historian. His history is required reading in the US Naval War College.

Why are so Many People Wired to be Trend Followers?

Which way we have been taught may very well have to do with a political decision made by the Communist Party in the US and probably elsewhere in the 1920s. The party saw that it needed to convince people as to the inevitability that communism would triumph eventually. They were clever in getting educators at various universities, high schools and even grammar schools to accept these so-called trends as the way the world will go, thus building the belief in the inevitable march through the left to socialism and then communism after a number of generations. Many, if not most of us have been schooled in trend identification and following. Once this becomes our main thought process toward political history it is difficult not to apply it to our investing.

Trends Don’t Last

A careful study of the history of almost any topic will show that the human genius often comes up with intelligent breaks of emplaced trends, be it fashion, art, music, politics, sports or investing. While there are some risks in being too early in deviating from the existing trends, the loss of capital opportunity of getting on sound future trends is much more expensive than being too early.

The Job of a Professional Analyst

The most important job of professional analysts is to act as Thucydides would to examine what is actually happening and apply the lessons prudently. This is what I attempt to do every day for the benefit of my accounts. I do this with the comfort of knowing that most investors will be trend following. This will help in keeping my losses relatively small when I am too premature and have the pleasure of selling into the crowd when the new trend becomes acceptable.   

This Week’s Historical Implications for Possible Trend Disrupters

Last week the Chief Investment Officer of Matthews Asia with his forty strong investment group had a breakfast meeting at a midtown Manhattan hotel. He is betting on rising wages within Asia led by China and India to create massive consumer spending. (Interesting that the government of China recognizes that its hold on power is dependent upon job creation funding a rising standard of living.) He expects that China’s former role as the driver of demand for many industrial commodities will be filled by India with announced major infrastructure projects. To accomplish these goals India will need (as in China) to pay attention to the level and grasp of corruption. Asian stocks while not relatively cheap in terms of price/earnings ratios, appear to be relatively cheap on a price/sales ratio. I would be focusing on the spread between return on invested capital and return on equity to focus on the risks of over-leverage. As these countries move from low wages to higher, I find operating earnings per person is a trend of particular interest to me.  

Much of my focus on deeper financial ratios comes from almost a year solely devoted to getting my arms around General Electric in the mid 1960s. Interesting from my seat at the breakfast last week I could see across Lexington Avenue to the entrance of what used to be the General Electric headquarters building. One of the reasons I question lots of trends is that while the numbers proceed, the way they have been generated has changed to such a degree that past comparisons are less meaningful. My analysis of GE was that the company was essentially a manufacturer which had various financial and insurance activities to support the manufacture and sale of its products.  That started to change as the CEOs changed. GE moved its headquarters to lower-taxed Connecticut and started to grow GE Capital into an independent, financially aggressive series of unrelated activities. The move to southern Connecticut cut the taxes for the most senior executives living in that state, and detached itself from the New York financial community. Initially this helped GE overcome an aging plant and employment base, but it also fundamentally changed the corporation into a materially slower operating growth company on the industrial side and increasingly dependent on, in my opinion, lower quality earnings from GE Capital. Thus while GE is probably the only stock in the Dow Jones Industrial Average stock for the last 100 years, its long-term trend is not particularly useful in predicting its future stock price.

Brokers are Sharing the Disappointment

The pre-Tax Return on Equity in 2014 was 9.2% compared with 25.1 % in 2000 and 40.3% in 2009 for the aggregated NYSE reporting firms according to SIFMA, the industry trade association. Revenues are less than half their peak levels of 2007 and have been essentially flat at $165 Billion between 2008 and 2014. The number of registered representatives for FINRA has not varied much since 2009 and is now 637,000.  The average annual turnover rate of shares traded on the NYSE is the lowest it has been in the last 15 years.

What has gone up and shows the change in the structure of the market is total margin credit (borrowing); in 2014 it reached $456 Billion compared to $187 Billion in 2008. The growth in margin credits is a mirror of the growth in hedge funds and other trading vehicles. Another growth element through 2014 and probably reversed (at least temporarily) is the portion of the Global Equity Market Capitalization that is now 23% which is double its 1995 level of 11%. When Emerging Markets return to favor there is a good chance that the 42% invested in the US will drop. (Any investor that has more than 50% invested in the US is betting against the rising standard of living outside of the US.) This is a major change in the structure for the long-term demand for US stocks.  For those who have a portfolio structure similar to our TIMESPAN L PORTFOLIOS^®, I would recommend to have significantly greater international holdings in their Endowment and Legacy Portfolios than their Operating and Replenishment Portfolios. Charles Schwab’s next 12 months earnings growth is 2% higher for the Eurozone at 15%, and 5% higher for Emerging Markets.

Bulls Could be Disappointed

Readers of my blog know that I don’t like being in crowded trades, viewing that often one’s co-venturers in a security are potentially a greater source of price risk than the issuer itself. Further, I have often identified that I manage a private Financial Services fund. In this week’s Barron’s nine investment strategists were asked to pick their favored sectors. Eight had financials in their selections. The saving grace for me is that I believe our stock selection is quite different than the bulk of others, without significant holdings in commercial banks, credit card networks or life insurance companies. Nevertheless, I get concerned when new money is coming into my neighborhood.

All is Not Clear Sailing Ahead

The Third Avenue Focused Credit Fund has had too many redemptions so has suspended the ability to redeem from the fund. This is particularly instructive on a number of levels. For some time the yield spread between high yield paper and US Treasuries has widened considerably. At the same time the credit rating agencies have raised their year ahead estimate of the percentage of high yield paper that is likely to default. The combination of low sales growth, falling energy prices, rising interest rates and maturing debt schedules are some of the market’s apprehensions.

What is fascinating to me is that the management company was founded by Marty Whitman, a 91 year old  very successful distressed securities player who made a lot of money for me. As part of my research on closed end funds that we were tracking I bought some shares in a West Coast fund that was being managed by a trust bank, but was selling at a big discount. Mr. Whitman bought control of the fund and converted its portfolio into a distressed securities portfolio with particular focus on firms that had large tax loss  carry forwards. He then merged operating companies into those with large losses and thus freed them of a tax burden. This was a wonderful investment particularly as it was not an open end fund that had to meet redemptions. To me this is the appropriate place for investing in similar merchandise, not like the Third Avenue open-end fund.

Fund pioneer and value investor Max Heine with his associate Mike Price at Mutual Shares did the same thing on a smaller scale in their open end funds which always carried large cash reserves plus a portfolio of very liquid stocks. There is nothing wrong with selectively owning distressed securities if you know what you are doing and do not need liquidity in a market with shrinking risk-oriented liquidity. (If anyone is interested I will share what I did with cumulative shares in arrears as a another distressed securities play.)

The final possible storm warning is the interest rates that many banks are offering for deposits. Just this week the average dropped to 0.26 basis points from 0.28 the week before and 0.44% earlier in the year. There is a demand for loans, but banks may be so constrained by bank capital requirements they would prefer to keep their money with the Fed or in the highest quality corporate bonds whose yields according to Barron’s are averaging, 3.74% which is more popular this week than last.

Question of the Week: What portion of your portfolio do you consider significantly different than mainstream thinking?

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Investment Selections Improve with Adjustments Before Eliminations

Too many mutual fund and separate account managers are selected by bracket rankings as used in basketball, World Cup football (“soccer” as we call it in America) and tennis, unlike golf and horse racing. In the first three sports, the winner and other high ranking finishers are derived from their last bracket victory without the recognition that some losing competitors are materially better than some of the winners of weaker brackets. In other sports analysis, sophisticated watchers adjust the results for many variables such as the conditions of the competitors and the conditions of the competition itself. Intense followers of sports are not the only ones to adjust their thinking and actions before their rooting begins.

MUSICAL AND INVESTMENT ADJUSTMENTS

This weekend Ruth and I had the pleasure of listening to the Boston Symphony Orchestra (BSO) and the Boston Pops, both in concert and in rehearsal. Each of the overlapping groups was made up of very talented professional musicians probably at the heights of their musical careers. Nevertheless their equally talented conductors clearly modified how each piece of classical music was played. In watching and listening to the maestros one could detect adjustments they wanted the performers to make in well known pieces that have been played, in some cases, for hundreds of years. I am not a music critic, but I recognized that some of the adjustments made during the performances were similar to the adjustments that I believe should be made when examining the performance records of various equally talented investment managers.

Looking at the parallel adjustments between the two very different art forms can be instructive. In each case the conductor knows that while past performances can be illustrative of the desired future performance, today’s conditions (known and unknown) are different.

Pieces of music and individual stocks, bonds, or commodities were originated to stand on their own. In the real world they are going to be used in conjunction with others, e.g. a Beethoven program, overtures to great operas, love themes through the ages, the development of the American musical, etc. An individual security may be only one component of a concentrated portfolio with a singular focus, or a broadly based portfolio to participate in a general market movement, or an asset allocation portfolio, etc.

A great concert is not just a collection of individual pieces of music, it should be one with a point of view. Similarly, a successful investment portfolio is not just a collection of currently highly performing positions. Thus, I look beyond the aggregate performance of a fund to see how many securities contributed meaningfully to the overall performance. To my mind, a fund with one or two spectacular winners, (particularly if they are initial public offerings or from one segment of the market) is very different than a diversified portfolio producing similar results.

PERFORMANCE FACTORS

While the great maestros can get better results from each of their players on any given day, there will be a range of skills delivered, just as a portfolio manager needs to recognize the different level of research that he/she is utilizing. Some fund managers rely on a deep culture of professional research analysts within their shops, such as the American Funds (Capital Group is their manager), T. Rowe Price, and Janus. They will give an investor a steady result different than a brilliant solo performer like Fairholme. Good orchestra leaders vary their programs and interpretations to a lesser degree. Portfolio managers are selected by the turnover of their audience (shareholders) which are often a demonstration of time horizons. CGM Focus has attracted short term investors by its volatile and sporadically good performance but has a very good long term record. Other funds with solid long term records who are able to buy bargains in down markets because they raised cash in high markets attract long term investors; good examples of these are the various Mutual Shares funds, the Dodge & Cox equity fund, Longleaf, plus some of the Ariel and Marsico funds.

COMMUNITY OF INVESTORS

Many (if not most) of the members of this blog community are serious professional investors. You manage money for yourselves and for your clients. What distinctions do you apply when looking at fund records? What eliminations do you make from the leader lists? What filters are you using and will you share any with us?

COMMUNITY OF CONTRIBUTORS

Before leaving the BSO and the Boston Pops there is another important contributor to their beautiful music that I should acknowledge. Over many years the BSO has built a very large community of contributors. As a contributor and investment advisor to numerous non-profits, I am envious of the size and composition of their program book’s advertisements and endorsements. As with portfolio management organizations, producing good results over time is rewarded with capital that promotes successes in future generations.
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