Pivoting Season: Be Careful

Introduction

We are entering the Pivoting Season. Some investors will succeed and others won’t. One needs to understand both the successful and unsuccessful pivots in history and at present to be able to pivot successfully in the future.

Current Pivot Attempts

For some time the “Jarrett Administration,” otherwise known as the Obama Government, has been attempting to execute a Pacific Pivot without meaningful success.

Another pivot is the coming “Brexit” referendum with the base arguments shifting away from London-oriented economics toward social and defense concerns. The continent can not progress economically without Britain, but Britain can survive and even progress without Europe, albeit with some near-term difficulty. In my humble opinion, the momentum will be for the UK to leave.

In the run-up to the US Presidential elections we traditionally enter the period of pivoting to the center and escaping from the strident extremes. This year, due to the length of the primary season and the shift away from network news to the Internet, the movement toward the center is going to be much more difficult unless there are surprises.

With this focus on pivoting it is natural for investors to also think deeply about pivoting their portfolio into more winning structures. Based on my study of history and racehorses, my instinct is not to try it unless you use appropriate, professional talent and then restrict the pivoting to only sections of the portfolio. Our goal is to execute a pivot if certain conditions are met (such as those passed on from Lincoln to Generals Grant and Sherman) as described further below.

The Most Successful Pivot

When President Abraham Lincoln changed focus from defeating the Confederate armies in battle to winning the war, he picked different leaders and different battles. He shifted from primarily fighting in Virginia and Pennsylvania to Missouri and Tennessee. His leadership changed from generals who graduated at the top of West Point to those at the bottom of the Class; from officers that were accustomed to riding horses to ones who in Grant’s case, only made a modest living driving mule chains.

Ulysses S. Grant built his campaign from the shores of the Mississippi River down through the tough terrain of Missouri through to the western side of Tennessee. The Confederate high command took this as a continuation of the North pushing southerly with the ultimate political goal of seizing the political center in Alabama.

At this point Grant ordered General Sherman to execute the pivot. Instead of a north to south-oriented drive, Sherman executed from the west in his ‘March to the Sea’ (Atlantic Ocean).  His target was to knock out the logistic center of the Atlanta rail head. The battle shifted from political targets to a war-making capability. 

Because of the speed of execution and the destruction of property along the way, Sherman was able to survive a two front exposure (from the north and the south) when the Confederates reacted with underwhelming force. In the end the pivot brought the US Civil War to an end many years before the old, politically-oriented strategy would have.  In terms of the conditions for a successful pivot, Lincoln had chosen the right leaders, the right time, and the right place.

Both Napoleon and Hitler also made pivots from the west to the east into Russia and failed miserably because they did not have the same right leaders, time, and space.

Is this the Right Time to Pivot?

Are we at a similar point as was Mr. Lincoln, when the top strategists are wrong? Let’s look at the results this year from the standpoint of large stock and bond portfolio investors.

High Quality Corporate Bonds and US Treasuries are meant to be risk absorbers as they no longer can produce income above actuarial assumptions. They are not meant to be performance vehicles. The S&P500 has a Corporate Bond index that seeks to replicate components of the S&P500. Through the first five months of 2016 this bond-only index was up +4.99%, after being the only major asset class to show positive results earlier in the year.  The problem for most investors is they didn’t own enough of this dull instrument during this period because they were not being advocated by the ‘top of the class strategists.’

What is even worse is that most large investors owned the wrong stock sectors. In the five month period ending May 31^st, the S&P 500 stock index gained 2.59%. During the same time period the healthcare sector was down -0.3% and the financials -0.74% of the stocks within the index. These two sectors were heavily owned within institutional portfolios and favored by most strategists. What really hurt the pride of portfolio managers and the pocketbook of investors is that there were three large sectors producing double digit returns: Utilities +12.80%, Telecommunication Services +11.45% and Energy + 10.73%. My guess is that the first two sectors were only slightly owned  by institutional accounts (with the exception of  Verizon and AT&T which was held for yield). The third was shorted by the hedge fund community.

After a period of disappointment with market and performance leadership, performance-addicted investors are ready to switch horses. Should they? Do they currently have the right generals and right locations?

The Lessons from the Track

As my regular readers may know, I have learned many analytical approaches in attempting to analyze the past performance at racetracks. I have previously written that there are “Horses for Courses” and more importantly that the changing conditions of each race should impact the probabilities as to the ultimate results.

There are other factors that should also be considered. These start with the racing history of the particular horse and those of its family, including the sire, the dam, and their families. Plus a similar review is required of the past success of the jockeys, trainers, and stables. The challenge for both the track and security investor is that there are very few winning teams that have a good record under all conditions. Under the pressure of the laws of economics, most of the better teams are under contract to rich players. In our investment account world, this often means high-fee hedge or private funds.

While we look to find consistently superior teams and horses, they are hard to find. Thus, we tend to match the available talent to the expected conditions.

Right Battlefield Locations

One the first major distinctions a good handicapper or track analyst focuses on is the length of the race. The length often determines the racing strategy and betting (or if you prefer, allocation strategy). In short races opening speed is very important as there is little opportunity to recover from a slow start. In longer races there is both the opportunity and risk of recovery. Stamina and the ability to handle change in leadership becomes important.

It was the thinking expressed above that was a critical element in our development of the TIMESPAN L PORTFOLIOS^®. In this structure we divide the portfolio responsibility into at least four different timespans.

The first or Operational Portfolio is to fund the cash needs for the next two years. From a manager, fund, or security selection standpoint, capital risk is paramount.

The next three of the portfolios should have different representations of investment styles (growth, GARP and value) and talents (technological, turnaround and management assessment). This is a real mix and match effort, which is based on the individual needs of the account.

The second or Replenishment Portfolio is designed to recapitalize the Operational Portfolio. Often the duration of this portfolio is five years or a capital cycle. From a selector’s viewpoint the cycle is presumed to have at least one down year and some recovery.  In the first two portfolios liquidity is very important and expensive however is less important in the final two portfolios.

The third portfolio (Endowment Portfolio) is designed to meet the longer term funding needs often tied to the expected length of service of the CEO, Investment Committee Chair or Chief Investment Officer. This portfolio is expected to last through a few cycles and can accept some risk of loss capital if it has a positive cash flow.

The final portfolio or Legacy Portfolio is the funding vehicle meant to endure beyond the current sets of management and is designed to successfully tolerate a number of disruptions while still provide funding to meet very long-term needs.

Where Are The Generals?

In the US Marines I attained the rank of Captain, however I have devoted my adult life to studying various generals, both investment as well as military.

As a General, U.S. Grant handled numerous setbacks just as a competent securities selector is able to survive the unexpected and not lock into positions where there is little prospect of recovery.

Question of the Month:

Do you have or want the right generals?

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The Shapes and Shadows of Things to Come

As I have stated numerous times in these posts, it is the job of a good analyst to explore impossible thoughts. Too much of the focus of the media and the politicians is on the immediate future. Good analysts, particularly those like me who try to divine future secular trends, need to look to the furthest time horizons that are visible and to understand what might be beyond the horizon. With these thoughts in mind, the following topics are presenting themselves for recognition, interpretation, and investment implications:

1.     The Bernanke-labeled “fiscal cliff” is an income statement problem not a balance sheet problem. We must all recognize that this is a multigenerational challenge.

2.     There is no consumer strike, just a lot of caution.

3.     Multinationals think globally as to where to store up cash and borrow money.

4.     Problem solving by attempts to change the laws and not behaviors is illogical.

5.     Two illuminating front page articles in the Sunday New York Times next to each other, “Clinton’s Countless Choices Hinge on One: 2016” and “Tax Arithmetic Shows Top Rate Is Just a Starter.”  

Fiscal Cliff:  Income statement vs. balance sheet

All of the current focus in Washington on the “fiscal cliff” is focused on changes to current tax rates vs. ten years of budgeted expenditures. This is governmental math. We have never seen a balance sheet for the federal government and for that matter most governments. The expenditure for payrolls is treated the same as for buildings and equipment that may have some value after the money is spent, as distinct from payroll spending. If the government was a business there would be charges to depreciation and amortization accounts. Further the government does not recognize future liabilities, particularly contingent liabilities; e.g., replacement of existing facilities, impacts of changing health expense inflation, technological obsolescence. To be fair we have not seen even a list, let alone a valuation of governmental buildings, lands, mineral rights, and what intrigues me the most, intellectual property. Because of these assets I am not now worried that the US government will be forced to default on any of its loans. Nevertheless, I believe that its practice of being a slow payer will continue and accelerate. Please bear in mind our possible forerunner in terms of debt repayments, Greece, is having difficulty in selling some of its assets, but at the right price the Greek government will trade. I believe that the US has better quality assets and could raise substantial capital through sale or lease programs. The rating agencies have threatened another round of credit rating chops if there is not a discernible political willingness to address the spread between US revenues and expenditures.  I am guessing that the global bond market has already discounted on the prospect of another rating cut.

Consumers vs. governments

As regular readers of these posts may remember, my good wife Ruth and I regularly walk and observe in the very glitzy Mall at Short Hills. Today it was raining and parking was directed by security people. By far the biggest line was for pictures to be taken with Santa. Some stores had reasonable crowds, including the Apple store. Others were quite empty. When a clerk at J. Crew was asked about some out of stock merchandise, he volunteered that we should try the website. Internet shopping is filling many FedEx, UPS, and US Postal trucks. These observations suggest to me that consumers are not on strike but are being cautious. Whether they are buying now because they feel that their after-tax income will shrink next year or that prices will rise because of some scarcities, including the need for price relief from higher taxes, I don’t know. We will be watching for trends in early 2013.

Global vs. national

During the week there was news about Emerson Electric borrowing in the US to pay dividends, possibly special dividends, while they had significant cash sitting overseas. The history of Emerson Electric is that it is a prudent Midwestern US company who has a major share of the world market for small motors which drive many machines and equipment. The media commented that this was a strange act to borrow when it had a pile of cash. I believe that the press reaction is also mirrored by this Administration, members of Congress, and the Fed. They all miss the point; that business, consumers, and increasingly investors live in a global world rather than a national location. While I am not privy to the thinking of Emerson Electric, it appears to be rational. The company made money overseas and probably sees opportunities to make more by investing outside of the US. Emerson’s own treasury may feel that the interest deduction is worth more in a high tax state like the US, particularly when they may feel that the Fed has guaranteed inflation so they can repay the debt with less valuable dollars. In setting our economic policies, the leaders of this country should be thinking globally, particularly recognizing the economic problems of other governments and peoples,

“Raise the bridge or lower the water” won’t always work

There is an old saying from Venice, Italy when it was one of the leading city-states of the world, and a leader in financial transactions, that when an overloaded barge could not fit under a bridge they could either raise the bridge or lower the water. Modern governments are attempting to change the rules of commerce to accomplish the same goals of forcing a solution to problems. Many times the solutions are short-term until they come up to a bridge that can not be raised or the water lowered. The only way to move the vessel, or if you will the government, is to off-load some of the burden. While that might help navigate a particular obstacle, it will have no lasting impact without a change in behavior. In order to lower the tonnage that the government is carrying, we must ask the government to carry less and shift some of the perceived necessary burden back on to the people. As with any meaningful behavior modification, it won’t be quick or easy, just look at the attempts to eradicate cigarette smoking; a difficult task, but not an impossible accomplishment to achieve.

Is the front page editor of the New York Times a political prophet?

As mentioned earlier, Sunday’s New York Times had two timely articles next to each other on the front page. The first and somewhat expected article due to the newspaper’s political orientation, explored the possibilities of what will occupy Hilary Clinton’s time  when she steps down from a somewhat impotent position as US Secretary of State. In her next phase she will be able to espouse policies that she has personally developed whatever they happen to be. Even those who have opposed her in the past are very conscious of her own political skills as well as those of her husband.

The Clintons are pragmatists and are good at making political judgments. Whether we will vote for Hillary or not, her attention (or lack of) to the fiscal problems in the run-up to the 2016 is something we should watch.

The second article, somewhat surprising in the New York Times,  deals with the need for substantially more revenue than would be generated by the President’s proposal to tax the wealthy. This is the beginning of an analysis of how difficult it will be to quickly and meaningfully reduce the size of the deficit. In my opinion, our deficit as well as those of many other countries began two or three generations ago. We collectively wanted more from the government than we were willing to pay for in taxes or user fees. My guess is that if it took two or three generations to build these deficits in relatively low interest rate environments, it will take at least as long to eradicate the deficits.

Implications

As investors are reading of these shapes and/or shadows, they should recognize that these conditions drive longer-term portfolio choices. At this point while pure US stocks, if there are any, may be cheaper than similar issues overseas, significant global holdings make sense. While European opportunities are enticing trades, selective Asian and Latin American companies are more appealing. Both Mexico and Canada could make sense for some portfolios. In all cases, unless you have specific expertise, I prefer to use funds or management company securities.

Please share your views.  

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