Avoiding Many Mistakes - Weekly Blog # 834

 

         

Mike Lipper’s Monday Morning Musings

 

Avoiding Many Mistakes

 

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

   

       

Numbers Are Not the Answer, Questions Are

This is the season of the year when investment managers are often chosen. This is particularly true now, with US stock market leadership evolving. There is a debate between the short-term attraction of growth and fundamental long-term concerns over the global economy and political structure. We may have entered the early stage of replacing current leadership in business and in Washington. Because the future appears uncertain, group decisions through committee are more likely. (A historic lesson from military and political history is the larger the group, the less dynamic the decision.)

 

The first step in making an investment discussion is often to gather the easily available numbers. The first problem with gathering numbers is the motivation of the sources. In the investment arena, the major providers are groups who wish to publish data for direct or indirect sale and/or profit. Another source is regulators who wish to provide standards leading to evidence for lawsuits. Neither of these sources try to help others make wise investment decisions.

 

At this point in my professional life and practice, I am trying to make informed and correct investment decisions for specific users, including my family and myself. The following discussion are some of the indicia I use to ask some of the right questions.

 

Critical Questions in Search for Profitable Investments

1. Rarely the first question and more likely the last, is understanding the motivation of important individuals involved on a personal and group basis. Different answers should be expected depending on whether the mindset is one of a publicly traded investor or a sole ownership, and all gradations in between.
2. Obtain quarterly performance since inception for at least ten years, or shorter if there was a significant change of individuals or operating philosophy.
3. Understand the choice of perceived peers and their performance for the period where their critical philosophy and personnel were in place.
4. Get the percentage of time the investment occupies in each quintile. If potential investors are satisfied with mid-quintile performance, eliminate all candidates who don’t have 75% of their results in the 3^rd quintile. If the account is a significant turnaround buyer, focus on managers with 25-50% in the 4^th and 5^th quintile. (This is based on the reaction of many investors to the pain of losing, which is felt twice as much as gaining an equal amount. If the pain multiple is higher e.g. 4x, the loss tolerance level will be lower, perhaps as low as 13% or in the range of only five quarters out of 50.) If the buyer insists on avoiding problems, screen for a manager that has performance primarily in the second quintile, but no more than 25% in top quintile.)
5. Voting members of the committee, are they making choices or reaffirming choices made?
6. How important are inputs from marketing/sales and trading? Who are the top 10 brokers and top 10 marketers for the organization?
7. Recalculate the published turnover of the portfolio to include the greater of sales & purchases. (The SEC mandated measure is based on the smaller, because of their concern for “churning”. Identify the major sources of inflow and withdrawals? From the portfolio perspective, how much of sales is replacement of positions and how much stems from disappointments?
8. What are the management responsibilities of the portfolio manager and who does he/she report to? Can he describe his personal and major family portfolios?

 

Items of Interest you may have missed.

1. Daniel Henninger wrote a column in Thursday’s WSJ titled “The Counter-Revolt Begins”. He lists a number of instances where decidedly left leaning communities have passed local regulations and laws to bring back some safety to their cities and states. These include San Francisco, Los Angeles, the District of Columbia, and the states of Oregon and New York. Wealthy university donors are also insisting on changes.
2. The global financial community is consolidating as intra-industry acquisitions occur. Computershare is buying BNY Trust Company of Canada. Several top financial advisors at JP Morgan also left in a single day.
3. PGIM of Prudential is following the trend and has applied to the SEC for a new class of Exchange Traded Fund shares for their mutual funds. They are following DFA, Morgan Stanley, and Fidelity. (This may bring more money into the ETF industry. It answers one of my concerns for redeeming ETFs in thin markets.  A surge in bond and small-cap redemptions on a crisis day can be helped by accessing the open-end fund’s resources. Until Vanguard’s patent protection expired, it was the only fund group that could do this.
4. All 32 global equity market indices rose this week.
5. AAII publishes bullish, bearish, and neutral indices from a sample survey of their members market views six-months out. They show rare confusion in the retail market this week, where all three numbers were in the 32-33 range.
6. Also, Copper prices are often referred to as Dr Copper because the metal is used in so many products. Copper has been used as a type of currency in some countries with limited or expensive markets for dollars. This week’s copper prices were near an all-time high.

 

As always, I am searching for good thoughts from bright people such as you.   

 

 

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Mike Lipper's Blog: News & Reactions - Weekly Blog # 833

Mike Lipper's Blog: Better Investment Thinking - Weekly Blog # 832

Mike Lipper's Blog: Preparing for the Future - Weekly Blog # 831

 

 

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Committing Reserves - Weekly Blog # 547

Mike Lipper’s Monday Morning Musings

Committing Reserves

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

Any student of military history will be presented with the reasons why important battles were won and lost. Often the critical decision was when and how reserves were committed, both in defensive and offensive phases. The same thing can be said for managing portfolios. The standard battle structure used by the US Marines for maneuver units is, two up and one back, plus support units. On offense, reserves are committed to replace the tiring front line units so that fresh troops can pick up the pace of an attack. On defense, if the front line forces are pushed back, troops held in reserve are committed to stop the breakthrough, where enemy's troops are expected to be tired and somewhat disorganized. The keys to committing reserves are the factors of time, surprise, and location.

Applying these military lessons to portfolio management, the following principles come to mind:

1. Reserves need to be of sufficient size to maintain or regain the momentum. The two up and one back suggests that reserves should be in the range of 1/3 of the active forces.
2. Reserves should not be committed piecemeal, as they lack sufficient force to accomplish the main objective.
3. Reserves should not be committed too early, suggesting a 25% decline from the prior peak might give sufficient space to pick up bargains.
4. After committing reserves, be prepared to assign additional assets in order to preserve critical resources.

Husbanding Reserves
This week both Goldman Sachs and Morgan Stanley reported unexpectedly good earnings, which the market treated positively. In carefully reading their release and listening to their conference calls, there were some cautionary notes. Both are watching very closely for any weakness in their credit extensions.

Awaiting Direction
Along with other money managers, flows were slower than earlier periods. Modest earnings gains are expected by various analysts. The biggest gains are expected for the Russell 2000, which may be influencing the proportion of firms becoming profitable.

The average Large-Cap growth fund is up +9.09% YTD and +12.72% for five years, with both exceeding the average S&P 500 Index Fund performance of +4.78% and +11.52% respectively. The period of superior performance for index funds may be over for a while.

Major Commitment
Finally, on Thursday there was the announcement of Mass Mutual selling Oppenheimer Funds to Invesco for approximately $5.7 Billion, largely in stock.

In looking at the price, there are two interesting points. First, the rumored price was $5 billion in cash. This is roughly equivalent to $5.7 Billion in stock, in my opinion. Second, the seller wanted to stay invested in the mutual fund business. I view both as a vote of confidence in the business. Invesco has good distribution capabilities in Europe and Asia, which may be effective in selling the Oppenheimer Funds.

 Mass Mutual as a knowledgeable seller becomes the largest shareholder in the combined company and obtains a board position. They like the outlook for the business but probably don’t like the outlook for Oppenheimer’s retail fund operation. Mass Mutual has retained their ownership of Barings, an institutional player.

My clients and I own positions in a number of their domestic and international fund management companies.

Prudential Needs Smaller Reserves
Prudential Insurance is no longer labeled as a SIFI (Strategically Important Financial Institution) It did not have to contort itself as Metropolitan Life did to shed the title, it just had to be more patient and work Washington well.

Risk Management, not a Perfect Defense
Risk appears to be singular but in reality it encompasses a number of known and unknown risks. This multiplicity of risks makes it difficult to model as a single risk factor. This is particularly true due to a growing list of unknown risks. Thus, there is no such thing as a riskless investment.

Some Portfolio Managers Reduce Market Risks
The following brief comments are derived from reading the quarterly institutional reports from T. Rowe Price and Wasatch Funds, that we and our clients own. They are derived  from portfolio managers who also look at broader issues that may be of interest to our subscribers.

1. In the third quarter and continuing into the fourth quarter, security valuations didn’t seem to matter much. High Price/Earnings ratio stocks outperformed those with lower Price/Earnings ratios.
2. Investors remain complacent to the potential of future shocks.
3. A number of portfolio managers are pruning their portfolios by selling into strength.
4. At least one perceptive portfolio manager is taking advantage of the fall in Chinese stocks prices by broadening and deepening her commitment to non-tech Chinese stocks.
5. Concern for the housing outlook favors beneficiaries of short-term and longer-term lower commodity-priced inputs.
6. Trimming some Software-as-a-Service stocks.

In our private financial services fund I personally own shares in the publicly traded T. Rowe Price stock.



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No “All Time” Growth Stocks ExistIBM: Yesterday’s Apple

Introduction

My blog post of November 1, 2015, was entitled “Rising Earnings Do Not Make a Growth Stock.”  In keeping within the topic of looking for sustainable growth, being a confirmed contrarian is useful at times like this when I search for a contrary value. Sometimes this approach produces good results. At the moment many people are giving up on growth investing in general but chiefly in healthcare, tech (particularly Apple^*), China and other emerging markets and many consumer goods/services companies.

^*Held personally and/or by the private fund I manage

Many of today’s portfolio managers and most individual investors don’t know during my investment lifetime there was one very prominent growth stock that was the Apple of its day, International Business Machines or IBM. In last week’s blog post I suggested that critical investment and business management courses could be focused on Berkshire Hathaway; I believe every investor who is going to devote a significant portion of his/her portfolio should also have a course on IBM. (This thought was triggered by a lengthy article in a Sunday New York newspaper on the company’s attempting to a bring a style focus to its products. As usual with this paper it was an incomplete piece which neglected to track the major shifts in how IBM’s shareholders have viewed its stock over time. The change of their attitudes mirrored many of the changes in the operations of the company.)

A Personal Note 

My Grandfather who led his own brokerage firm for the first twenty or so years of the 20^th century told his grandchildren about being one of the few outsiders other than company executives to attend a dinner with the then CEO Tom Watson and many of his family who were placed at each table. My Grandfather was not a security analyst, (at that time called statistical people), or a technologist of any type. He was impressed with the reported growth of the company and was impressed with Mr. Watson. On the basis of this appreciation and friendship IBM played a prominent role in many investment accounts for my family. When my brother and I became professional investors, we urged with some trepidation that the oversized positions be reduced as the market had placed a higher value on IBM’s growth than we did.  At the present time I don’t directly own any IBM and it is not a prominent position in our much larger investments in mutual funds. Perhaps, as the company evolves to more of a service company we should own the stock, but I hope more of our growth oriented mutual funds take positions in IBM.

I have had three other interactions with IBM that colored my evolving views on the company. The first was that while in the US Marines (as often the case in training as one of the smallest Marines) I was assigned to carry and fire a Browning Automatic Rifle (BAR). It was the only automatic weapon the infantry squads carried. It was considerably heavier than our usual rifles particularly with its ammunition. During World War II IBM converted its factories to war production including BARs.

The second interaction was when I was setting up my performance analysis service, I wanted to have our own in-house computer rather than continuing to rent time on a trucking company’s mainframe. Not surprising  my computer associates talked me into going on the waiting list for the IBM 360 computer. Perhaps as part of the sales effort I was invited to spend close to a week at a school for IBM clients which was very interesting in terms of theory and a tour of its manufacturing line. (I must admit that the most long-term benefit of the school was for me to get to know the soon to be president of a client who was executing a major turnaround of a slowing great old name in the mutual fund business. He succeeded.) After returning from the school I was as usual impatient to move ahead and not wait six months for delivery. So I cancelled the order and had a Wang (which was good for us) operating within a few weeks.

The third interaction was that IBM was using our mutual fund data within their domestic pension operation. The domestic side did not control the retirement activities for the foreign affiliates. The domestic people asked whether we could help with providing statistical guidance for the separate foreign plans. At that time we had too little that we could do to help them, but the request reinforced the need  for non-US fund data in my mind. This in turn led to opening of offices in London and Hong Kong and the eventual sale of the data operations to Reuters Group. All of these interactions demonstrate to me that IBM is a multifaceted jewel that has been evolving for 104 years and like the blind men feeling the elephant, each interaction is informative, but incomplete.

A Brief Financial History

The original people of IBM came out of National Cash Register and formed a punch card reader and related products producer. The company that they formed had more debt than equity when it was publicly traded. Thus IBM started its financial history as what was then called a “watered” stock. We would call it junk. (The term ‘watered stock’ came from the stock yards where cattle were bulked up through large consumptions of water.) One of the functions of the punch card reader that was the company’s initial main product was reading punch cards of employee hours. Thus at one point it is possible that IBM was the largest clock producer in the US. During the Depression era the financial conditions were so stretched that the company paid its clock repair people partly in company stock. Years later some of these workers had multi million dollar portfolios for repairing time clocks. During WW II as much as possible the company’s manufacturing base was converted to war work. During the war some of IBM’s research was on the beginnings of the computer. Initially Tom Watson was not a believer in its commercial development. He is quoted in 1943 as saying, “I think there is a world market for maybe five computers.”

As shown in last week’s post on Berkshire Hathaway, analysts need to pay attention to legal, accounting and tax elements. IBM conducted its foreign activities in IBM World Trade which for a number of years was not consolidated fully into the company’s financial reports. Many of us analysts performed this task, including calculating the overall tax rate. One of the mistakes many early analysts made is that they thought of IBM as a manufacturer. In truth most of its revenues after the War until relatively recently were from leasing computers directly to ultimate users or third-party leases. Due to length of the leases one could project with a high level of certainty what future revenues would be. The leasing activities were helped greatly soon after the War ended.  Prudential loaned IBM at that time a very large $100 million for at least one hundred years. Thus IBM which was in effect a finance company, but was viewed as a leading institutional growth stock with a high multiple.

By the time I came to Wall Street in 1960, IBM was probably the single largest holding in most trust-quality portfolios. (Hence my family’s over commitment to the stock.) The company had competitors including Sperry Rand which had major support from General MacArthur for use in re-building Japan. None of the other competitors had IBM’s installed base of leasing revenues so they competed on both price and technology. Often the competition came down to IBM’s image, financing, and a good sales force against lower prices and faster machines. In addition, IBM’s sales force included sales engineers, think of Ross Perot. In response to the competitive pressure, the firm bet its future on a new computer system the 370 which eventually succeeded, but with lots of additional expense which hurt the relative stock price. Over time the fall in the stock price was halted by the dividend yield.

Thus over its history the IBM stock was viewed as an extremely leveraged speculation, an essential business manufacturer, a high quality growth stock, an income stock, and a turnaround candidate.

What Makes a Growth Stock

In essence a growth stock is a stock that many market participants will trade higher into the future. This is usually expressed as earnings per share growing faster than the market.  I take a different point of view as follows:

1.  All growth is cyclical and for some future periods each item will under-perform.

2.  I am not interested primarily in statistical measures. I am primarily interested in growth...of my capital.

3.  Combining the first two points I want to own value stocks that become growth stocks and growth stocks that become value stocks.

4.  To accomplish these goals I have two valuation metrics. The first is the long-term prospect of dividend growth. (The only reason for buy backs is to benefit management with their short-term employment contracts and remove some of the takeover target value.) The second metric is the strategic value of the company to a knowledgeable buyer.

Why is Growth Important Now?

In these posts we have introduced the Timespan L Portfolios^®. We will need to populate at least half of the Endowment Portfolio with Growth investments, and even more in the Legacy Portfolio. As of the twelfth of November the only major mutual investment objectives both US and non-US showing positive performance are growth funds of varying market capitalizations; Large-Cap Growth +4.9%, International Small/Mid-Cap Growth 4.34%.

Globally the current job imbalance is reinforcing the focus on the lack of qualified workers to fill existing jobs. This indicates that there is a growing replacement of labor with capital, in part evidenced by machines. According to a recent advertisement by Fidelity, 80% of global GDP comes from non-US countries and only 26% of the world’s publicly traded companies are based in the US. Further a Bank of England economist suggests that up to 50% of the existing jobs in the UK could be replaced by smart robots in the future.

As a global society we need to support growth as a way to solve our growing employment problems. I wonder if the murderers involved in the dastardly attacks in Paris would have chosen a different approach to life and death if they were employed in a growth sector. 

_________   

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Is There Enough Left on the Upside?

Introduction

One of the many necessary elements for a peak to occur is the belief that the current market rise will continue. This belief is nurtured by cheerleaders and there were two highly respected ones sharing their views with us this week. The first was in Mark Hulbert’s column, where Sam Eisenstadt, the former statistical genius of Value Line stated that he believes in the next six months the stock market will rise 8% as the leadership will shift to higher quality companies rather than the lower ones which have been the leaders. 

The second was an observation from U.S. Global Investors’ Investor Alert which quoted a study by BCA Research which examined the 30 years since 1870 when the market was up 25% or more. They found that in 23 years following the big gain that the market had an average gain of 12%. A number of Wall Street types are now hoping to split the difference and are looking for a 10% gain.

Is 8, 10, or 12% good enough?

On the one hand (as the economist would say) these gains are 2-4x the recovery high on the US Treasury 10 year note at just over the 3% yield achieved this Friday. On the other hand someone trained on using the odds of meaningful success would start to get cautious. Just five years ago the percentage decline in the market offered a potential recovery to the prior peak of 2-3x what is now being offered. This is not counting on going on to new highs. The question now is, are we about to enter Sir Isaac Newton’s “greater fool theory” trap? Remember he participated early in the run up of the infamous South Sea Bubble. He got out early, but got sucked back in when his friends were making more money faster than he did. When the bubble did break he lost all of his gains and more. What we have learned from the recent studies at Caltech is that some people don’t retreat when they sense danger, but stay involved believing that their sense of timing will take them out of danger. As I mentioned in prior posts, I learned about this as a junior analyst and it was called the greater fool theory. To believe that future big gains are possible after large gains are achieved does not show the level of caution that many successful long-term investors use.

I used to question why we researched bonds when I was studying Security Analysis at Columbia with Professor David Dodd.  The name of the class was the same as the title of the book that he co-wrote with Ben Graham. What became clear to them and reinforced in the recent mortgage market collapse beginning in 2005 and culminating in 2008, that at times the fixed-income markets are much more sensitive to credit conditions and therefore the eventual health of the economy than my fellow stock jockeys.

As mentioned above on Friday the ten year US Treasury bond’s yield rose to a psychologically important 3% from a low of 1.63%. This in turn caused bond prices to decline in absolute terms. I look at historic 10-year yields the following way:

• I view the normal yield for the ten year to be about 4%. 
• During abnormal times rates would be in the 6-8% range, which should meet the relatively few defined benefit pension funds' actuarial requirements.
• Under economically stressed periods one could see yields in the 9-12% range if not higher. 

The higher current yields would occur when there is greater demand for capital than what is immediately available, usually with both the private and public sectors needing money to meet their immediate and longer-term needs. We are currently far from these conditions now, but sound equity investors should be alert to credit conditions as both the private and public sectors are short of capital for long-term productive investments.

Is there too much asset allocation?

For far too long investment pundits and those who direct the construction of long-term portfolios have found comfort in diversification into many different asset classes; e.g., domestic stocks, international stocks, emerging market stocks and bonds and now stocks from frontier countries as well as similar fixed-income asset classes going from the most to the least secure. To these lists add private equity, commodities of different types, real estate, timber, and elements from the art worlds plus intellectual property. While not a separate asset class, hedge funds owning one or multiples of these classes are included in the array for diversified investing. Many of these types of investments have badly trailed the simple stock market and some for 2013 are likely to show negative results, such as commodities and volatility measures. I would suggest there are three lessons one should consider before deploying asset allocation.

The first is that in declining markets and particularly sharply declining markets, correlations will increase. Wherever there are pools of liquidity they will be drawn down. Assets that can be sold quickly will be. Second, when there are choices to be made and particularly in the early phases of a rally, selectivity will be important. Along with the skills of the selector it is important to understand the relative sizes of compensation of the intermediaries. Isn’t it strange the highly compensated products and intermediaries get the first mover advantage? The third clue (the most difficult one for those of us who are trained in complexity) is to keep the strategy simple where most of the time is spent on selectivity.  In his weekend column in The Wall Street Journal, Brent Arends quoted a study by Andrew Smithers, a well-known and highly respected British investment thinker, who in a study for the investment committee of a college at Cambridge University recommended that it should have only two asset classes, stocks and cash. Stocks could range from 60% to 100% based on the level of the market, utilizing some long-term ratios. In today’s world this simple but effective approach is making a lot of sense, at least until reset approaches coming off the next major bottom.

What is increasingly missing from our command structure?

As a US Marine Corps officer, we never really retire, we just change uniforms. Over the weekend I enjoyed an interview with Camille Paglia  where she is quoted as saying. “The entire elite class, now in finance, in politics and so on, none of them have military service, hardly anyone. These people don’t think in military ways. The politicians lack practical skills of analysis and construction.” She finds “no models of manhood except on Sports Radio.” (My friends at the National Football League and the NFL Players’ Association will be glad to hear that they are her models of manhood.) However, they are not alone seeing the benefits of military thinking, conditioning, focus, and street smarts for returning service men and women. Prudential Insurance and JP Morgan Chase are among the leaders in seeking out these returning heroes and heroines with job opportunities. I am guessing some of these people will rise to the top of our leading organizations. On a global basis the benefits of a well-spent military life could, and I believe should, give the US an advantage in our international competition. This alone may be a reason to be long-term bullish on America.

What are your thoughts?

Drop me a line.

I hope all of the members of this community will have a Healthy , Happy, and Prosperous 2014.     

_______________________

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Contact author for limited redistribution permission.