Preventing Investment Mistakes - Weekly Blog # 533

Confirmation and Anchoring

Confirmation and anchoring, according to a recent survey, are the two most popular biases of investment advisors. I suspect these are largely the biases of their clients. While these biases tend to drive investors at all levels into the most popular strategies and investments, they imply that the crowd is normally right, or at least it is safer when wrong to go down with a crowded ship than try to swim in lonely waters.


The Favorites

Those that search for popularity did not attend my first class in analysis of securities and people. The class was held on most days, including Saturday, in an open-air setting at various New York racetracks. The most popular horses had the smallest betting odds. These were called the favorites, as if they were like the most popular high school dates. The problem with chasing favorites is that on average they only win between 30 and 40% of the time.

More importantly, when they win, after deducting the portion of the winning pool that went to the track and state taxes, they do not generate sufficient winnings to cover the 60-70% of the time when they lose. (Like many investors, the winners do not recognize that they owe income tax on their winnings.)


Useful Information

Many investors believe that they are smarter or have more useful information than those on the other side of the bet or transaction. They quickly confuse temporary winning with greater mental capabilities. Just as various political leaders, central bankers, and pundits of all types view an errant morsel of information.

A new breed of binary judges is being marketed to investors as factor funds, which ranks and chooses securities by various statistical measures, such as revenues (Fortune), Market Capitalization (Standard & Poor’s and Russell), Earnings Per share Growth, Price/Earnings Ratio, Free Cash Flow, Current Yield, and others. Sometimes single factors are brought together into multi-factor portfolios. The problem with this approach is that if it were that easy various printers of financial statements would be the richest people in the world.

One of the early lessons from the track, security analysis, and topographical maps/photos is that these are given to all who can afford them. The key to more victories is what is missing, often in plain sight but not recorded for publication or correctly understanding the value of a corporation’s inventories, fixed assets, patents, and customers.

There are other occasions when both the buyer and seller are correct or wrong, one being an expected time span in ownership ranging from one moment to almost infinity. Another is completing a portfolio structuring or restructuring. A third might be the value of a shareholders’ vote.


Avoid Arrogance

Thus, to avoid unforced mistakes avoid the arrogance of assuming the party on the other side of the trade is dumb. Make a serious attempt to guess the motivation on the other side. They may know something that might be helpful.

The professors at Caltech believe that what we commonly call thinking is reaching back into our memory banks. There is a growing gap between those that have experienced either a bond bear market, deflation, or even a 1987 style stock market. Therefore, many investors make mistakes that seniors avoid. If you don’t know something it is easy to be arrogant and not look to understand the other-side of a trade.


Cross Winds

One of the big mistakes that far too many investors are guilty of is not examining a large enough set of inputs. Rare insights are often in plain sight but ignored by most. With that thought in mind, the following are some factoids that I saw this week which could impact some short to very long-term investment decisions:


Possible short-term inputs

The top three global market weekly advances were - Nikkei 225 +3.71%, Shanghai Composite +3.06% and S&P BSF Sensex (India) +2.48%. (Asians must believe that they won’t be hurt significantly by the trade politics, or there is massive short covering.)

Somewhat linked to the above is that the next two index risers were the NASDAQ 100 and the S&P 500 Info Tech Index. This was supported by the 18 of the best 25 performing mutual funds for the week, which likely held those types of securities.

Both the S&P500 and NASDAQ Composite were at record price levels this week, but their trailing price/earnings ratios were not higher than year ago readings. (This suggests that higher prices are being driven by reported earnings, not changes in valuation levels.) However, margin debt is continuing to grow at record levels. My guess is that margin debt is supporting speculative holdings of bonds and/or stocks.


Intermediate Term

Over the last year the average Taxable Long-term Bond fund’s total reinvested return was less than the average coupon on the bonds in the portfolio. This suggests that those investors spending their distributions are eroding their capital. To a lesser degree this has been happening for the last five years. Even though nominal inflation has been historically low, on a “real” return basis, they are eating into their spending power and are certainly doing so if they are tax payers.

With the global aging of developed nation populations, the result of longevity expansion and healthcare becoming more extensive, the underfunding of pensions is growing. This does not take into consideration the self-funding that many are or should be doing.

We may have entered into a world where the money cycle is more important than the trade or product cycle. One of the indications of the impact of technology on jobs can be seen in the oil patch, particularly for those involved with fracking. The number of employees used in extraction is flat to declining and the number used in energy service is growing and is larger than those used in extracting. It would be even higher if the service companies could find a sufficient number of truck drivers.


Longer-Term Considerations

In about twenty years, just 8 US states will comprise 49.5% of the expected population. Adding another 8 states raises the total to about 70%. These states are mostly on the east coast, California, Texas, and Colorado, although they are still unlikely to control the US Senate.

Nigeria will replace India as the home of the most poor people. While this is good for India, it suggests that Africa will likely be the home of most conflicts for many years. While I have been suggesting that the bottom performing commodity funds should be looked at for long-term investing, it may require too much patience as commodity players and farmers remind me that commodity cycles typically take 30 years.

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Are We at a Turning Point or at a Vantage Point?

Shortly we will be receiving first quarter reports from various funds, investment managers and the media. Most will mark that we have passed the one year anniversary of the agreed bottom on March 9th, 2009. The reports will boast of the 40-70% gains off the bottom. Few will focus on the fact that most accounts have not shown a positive return for the last two or three years unless they were significantly in domestic fixed income securities. Almost none will reference their performance high water mark that was reached often in the fall of 2007. As we receive this happy news, the critical question before us is, “So what?”

Does the recovery mean that we can go back to investing as we did in the middle of the “aught,” the philosophies of 2005? Or does the recovery give us the opportunities to modify our investment approaches? In other words, have we reached a turning point to embark on a new strategy? Or are we at a vantage point, able to look both backwards and forwards to make slight mid-point corrections to our trajectories?

I recognize that most of us have difficulty identifying turning points as they occur. With that in mind, I do not see that we are at a turning point. However, I see we are at a vantage point; that a number of trends are changing within the markets. For this kind of analysis, price charts are of value. The following briefs summarize what I see:

1. The near term weakness in the Euro is probably over for awhile. (The structural weaknesses will probably not be addressed until the political will becomes stronger.) In effect I am covering the bet of my view earlier in the year that the dollar would rally.

2. A number of national stock market indexes appear to be ready to change direction. The most prescient of these is the Hang Seng. Perhaps in sympathy, Brazil’s Bovespa is also looking like it is having trouble making progress. Surprisingly, and in contradiction to those trends, the Jakarta Composite is breaking out on the upside. The two major Japanese stock indexes, the Nikkei 225 and the Tokyo Stock Price Index, (commonly known as TOPIX), seem ready to follow suit.

3. In our US market, the industrial group which has led the stock price recovery is the financials. For sometime, further attempts to rally these prices have failed in spite of the recent strength in both Citi and JP Morgan. I find it difficult to believe that a sustained economic recovery won’t be good for the financials. The structure of financial markets is rapidly changing, which may make past history less relevant in thinking about the future. For example the venerable New York Stock Exchange, where I was a member, will produce more revenues from derivatives than the cash markets this year. Leading firms are also making more money out of trading these derivatives, commodities and currencies, suggesting that we are in a different world.

I am not paid to be an observer, but an investment advisor. Each of our accounts has significant differences in terms of its time horizons and ability to assume market price risk of loss. Due to these differences, I find that I am executing different accounts in very different ways. For the first time in a number of years, I have taken a little off the equity allocation of the most aggressive of the accounts. For those more conservative accounts with a low tolerance for yields close to zero, I am selectively adding to their long term equity positions with the belief that over the next several years they will benefit from increasing dividends.

These different tactics are an example of what I believe to be different horses for different courses. The clients’ needs should dictate how an account is managed, not the same house opinion for all accounts.

What do you think?


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Twenty, Forty, Sixty: We are Going Global

In a space of just about one week I have been presented with three different examples of people thinking out of their comfort zone. The most remarkable of these is from a freshman at a liberal arts university whose email asked three questions:

1. Describe the growth of international business, and how this growth will impact multinational corporations and national economies in the future.

2. How will companies in the U.S. compete with companies in China, India and other emerging markets in the future?

3. You are the Vice President of International Business Development for Evergreen Solar. How can you use the resources of the international financial institutions to support your projects in India?

None of these questions were asked of me by my Ivy League University. I took many years, with help of the US Marine Corps and some basic analysis work to acquire the background to answer the questions that are preparing this student for the commercial world when she graduates. What is wonderful is that she is comfortable being asked these questions and recognizes how important the answers are to her future.

My reply to her starts with the fact that individual consumers and investors have already become transnational in their outlook and action. Few of the academic world and almost no governments have made the jump over the border into different time zones and customs. While Coca-Cola might be able to meet its debt service requirement without relying on non-US sales, I doubt that it can continue to pay its dividend out of purely domestic operating income.

We received our game plan for success in this global transnational world on or about our first birthday. There were two documents produced in 1776 that shaped our world. The first is our Declaration of Independence, which is a model for a lot of the world. The second and conceivably more important was the publication of The Wealth of Nations, which preached the development of comparative advantage. Author Adam Smith, a canny Scot, figures out if each person could do something better (read cheaper in many cases), we could trade with each other to fulfill many of our basic needs. Merchants became rich being the connectors of this system. One of my rules in looking to get and keep customers is being prepared to do things that make my clients richer. This precept works around the world.

The question as to “Evergreen Solar” is of interest to me in that we have energy technology stocks in our otherwise financial services portfolio. We need to do more work to find whether they are good investments. In general, I shy away from companies that require good connections with the government. So I would look eventually to commercial financing.

Forty

One of my sons has been asked to develop an Internet-based sales pitch to be used by mutual fund wholesalers distributing to retail brokers or advisors. As this was his first specific effort along this line, he asked for suggestions on what he should focus. I suggested Global funds. I believe everyone is impacted by overseas prices and trends, be they farmers, local retail merchants and just about every other economic activity in the US. Global investing is not exclusively investing in foreign companies. As a matter of fact, some of the very best global companies are US based. The critical difference is that as a global investor you are looking for the most rewarding investments, wherever they are.

Sixty

As it is my nature to be generous, “Sixty” could be the average age of a combined Executive and Investment Committee which will meet early this week. Some of the time may be spent on investment guidelines which I feel are outmoded in a number of aspects. One issue of concern regards the asset allocation buckets for US Equities, Non-US Equities and Emerging Markets. These are artificial separations which have nothing to do with the risks and rewards in various securities. Whether we like it or not, almost all our large companies manage their currency risks, some do it well, others do not. Because China is going to be the second largest economy in the world at some point, the allocations system should accommodate it in a large bucket. I am also very concerned by the non- investor friendly court systems in China, India, Japan and California, etc. These factors should be taken into consideration by the managers we hire and not be the purview of a corporate governance document.

Eighty

I only hope that in 80 years our preferred measure of account is the US dollar and that smart kids in our colleges are making fewer mistakes than we have.

What are your thoughts?

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To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com .