Fire Drill - Weekly Blog # 782

 

Mike Lipper’s Monday Morning Musings

Fire Drill:

On board ships and in schools, why not in investing?

 

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

 

 

 

Any Smoke?

Implications: US stock index returns are almost normal for the full year if we use the year-to-date performance of the Dow Jones Industrial Average +7.16% and the S&P 500 +8.14%. Even the NASDAQ +18.64% is representative of a good speculative year, perhaps benefitting from short covering. The VIX indicator is almost asleep at 15.76, compared to 30 in past mildly troubling times.

 

There are some whiffs of smoke in the air, including a continuing 2 to 10-year yield inversion spread of 4.08% - 3.45%. Updating one of the oldest technical indicators with a more modern twist. In the latest week the 30-stock DJIA had 20 stocks rising to 10 declining, but the 20 transports split 6/14. (In the original Dow Theory, it was only the rails in the index. Today the number of rails has dropped, and a number of airlines, trucks, and other transportation securities have been added.) This could be significant if the normal buyers of rails, which are freight driven, are looking for future declines. 

Another group that appears to be worried are the CEOs of traditional financial services companies. The latest to announce a 10% layoff from both their investment banking and investment management functions was Lazard. (Mid-market M&A industry revenues hit a 9-year low in the first quarter.)

 

Publishers Note

The popular distinction between a recession and a depression is your neighbor losing his job in a recession and you losing yours in a depression. It can be helpful to explore the possible roads to a depression by focusing on the needs of securities analysts regarding layoffs. In focusing on the way companies handle layoffs, they should first be aware of the lost art of making money from bankruptcies. All too often layoffs are the first act of self-inflicted worsening conditions. Since they don’t teach about surviving bankruptcies today, they are unequipped to adequately analyze layoffs. (I admit the thought came to me in a recent meeting with the Dean of an upcoming Business School, where there are no classes on bankruptcies.) 

While a Columbia College undergraduate I was privileged to take Securities Analysis from Professor David Dodd, who was both an academic and investment partner with Benjamin Graham. David Dodd collaborated in producing the seminal work on Securities Analysis based on their experiences in the 1920s and 30s. It occurred to me that the whole basis for the course was the knowledge necessary for those who’d lived through the depression. This knowledge could be important in the coming era, and I will consequently devote the rest of this blog to the types of things one should look for prior to and during such a period.

 

The Fixed Income World is Different

There are two critical differences between fixed income and equity.

1. The first is the legal relationship. Fixed income is a contractual relationship with an initial investment, periodic payments, maturity, and rank in the order of payments in a bankruptcy.
2. Owners of fixed income securities are expected to be paid a pre-determined amount of interest and pre-payments of principal, as well as a final payment.

If payments are not delivered as promised, the default process is governed by the issuing documents. Things change dramatically when a bankruptcy begins. All debts immediately come due, sourced from the potential sale of all assets. Debts are paid in priority order, as specified in the issuing documents.

 

However, compromises are often made to get agreement from the holders of different classes of claims. This helps expedite payments rather than having to endure long, expensive court hearings. The size of the payments is a function of the price paid for the assets, less the costs of the sale. The cost of the sale includes the cost of highly specialized attorneys, accountants, and other experts.

 

Fixed income securities rights and privileges are senior to common stock rights. Owners of common stock will probably be wiped out, as there is generally no additional money to pay out after the senior debt holders have been paid. However, to avoid long and expensive court battles by equity owners, they will often be awarded a small amount of a subsequent new equity class.

 

What is a Bankruptcy Worth

Up to this time the focus has been on the current appraised value, usually in a quick liquidation. To the extent there is a belief that a “going concern” will survive bankruptcy, a different kind of analysis is needed based on the current use of the assets and their user in the future.

 

Growing up in Manhattan there were neighborhood cigar stores on many commercial street corners. They were good business in the late 1920s and became less good as time went on. By the early 1940s those businesses had effectively died. A chain of these went bankrupt, but their stock went up in price!!! The reason for this was that these stores were on busy corners and had long-term leases. A classic case of being worth more dead than alive.

 

There were a couple of cases of railroads who lost lots of money throughout the depression and went bankrupt. However, a couple of sharp investors saw a similar situation, as the railroads had considerable land along their right-of-way. In the WWII expansion of plants and military camps, these lands and their proximity to the rails became very valuable.

 

The unfortunate attitude of too many of today’s analysts and portfolio managers is that “value” is found on the published financial statements. To them, stock selling at a discount to book value is a bargain. In truth, book value is a collection of unamortized assets not written off. Because of changes in the market for a company’s products, the use of their facilities is less than their original purpose. For example, strip shopping malls in poor locations today.

 

What is not reflected in the financial reports are the developed new products, self-generated patents, a good sales force, key employees, etc. These are the types of assets we look for as investments.

 

The items mentioned in the last paragraph are critical in evaluating various layoffs. To the extent the layoff managers husband these types of assets I am not concerned, but if they are shedding valuable assets I am.

 

 

How Do You Evaluate Layoffs of Owned Stocks?

 

 

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

Mike Lipper's Blog: Early Stages of a New Grand Cycle? - Weekly Blog # 781

Mike Lipper's Blog: Pre, Premature Wish - Weekly Blog # 780

Mike Lipper's Blog: 3 PROBLEM TOPICS: Current Market, Portfolios, and Ukraine- Weekly Blog # 779

 

 

 

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

 

Copyright © 2008 – 2023

Michael Lipper, CFA

 

All rights reserved.

 

Contact author for limited redistribution permission.

Lessons from London: Mistakes Repeated - Weekly Blog # 707

 

Mike Lipper’s Monday Morning Musings

Lessons from London: Mistakes Repeated

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

The Learning Process 

For thousands of years human bodies and emotions have not changed. One should therefore not be surprised we repeatedly make the same mistakes. Too bad because most of the time we only learn from our mistakes, and possibly those of others. One of the great advantages of visiting London and friends/colleagues of fifty years or more is the opportunity to ponder past mistakes. It is a particularly good time now, as the financial community is being forced to play a role in governing human behavior through directing corporate and market behaviors. My recent visit to London this week has brought me to this task. 

Humans often want more than they currently enjoy and search for things beyond their current condition e.g., defense. The search starts with the extended family, community, tribe, state, nation, alliances, supranational organizations, and corporations (particularly utilities and financial communities). Why is the list so long? 

The answer rests on the reliance of top-down thinking. A review of top-down mandate disappointments demonstrates that without well thought out bottom-up practical thinking, the desired grand idea fails to be carried out successfully. A couple of examples will illustrate the point. 

In the UK, wisdom is apparently equated with investment success and that is why most CEOs are replaced in their sixties. Independent directors also have limited terms. An extreme example is the likelihood that no chief investment officer or investment CEO has lived through a bond "bear market". It is now very popular for incoming CEOs/Chairs to be female or minority. Many are qualified, but one wonders whether they are the most qualified. Much of what is done today is done to obtain a high ESG numerical rating. In the future, as in the past, clients and shareholders could suffer from the single-minded thinking of graduates from elite universities, military regiments, or clubs. 

There are at least three Investment Trusts (Closed-End Funds) that are over 100 years old, and they can teach us two useful lessons. Each was a narrow sector fund investing in American Railroads, Texas Oilfields, Mortgages, and Rubber Plantations in Malaysia. Today we have many open end and closed end specialty funds. Some perform very well during a particular period of time but underperform more diversified portfolios over longer-term periods. The second lesson to be learned from these old sector funds is that when one invests in a narrow-based fund it may evolve into something quite different. The managers often recognize the need to invest in another type of business when the original one is no longer attractive. 

I am always looking for different ways to analyze investments and other activities. One successful multi-generation family uses an additional measure to gauge success, believing losing money is much worse than not optimizing the upside. In their relatively small number of losses, they measure the multiple that gross gains represent of gross losses. This approach appeals to me for endowment and multi-generational types of accounts. 

This week there is a dichotomy between a highly valued US stock market and the slightly negative performance of the generally lackluster major stock indices. A contrarian or good analyst might look at the US data for the week and notice the often inverse 6-month prediction reflecting the American Association of Individual Investors (AAII) sample forecast. The bullish forecast jumped to 48% from 42% the prior week. Additionally, 6.9% of the NASDAQ stocks traded hit new lows, while only 3.2% of the NYSE shares hit new lows.

In walking around the non-financial districts and shopping centers there were very few working ATMs to get cash. When commenting about this to veteran investors they commented that their children don’t use cash. Local bank branch sites are increasingly being used for restaurants or stores. (Similar trends are seen in the US.)

While traveling there is a risk of not reading financial news thoroughly. One article had the headline “Berkshire earnings tumble by two-thirds”. Only in reading the small print did one discover the comparison was versus the prior quarter, which had a very large investment gain. More importantly, third quarter operating earnings rose quarter to quarter.

Two observations that could have major long-term implications became known this week: 

1. Morningstar believes that a safe withdrawal rate of 3.3% from a 50/50 balanced retirement account would preserve capital through retirement. (I have my doubts considering government inflationary policies and demographic trends producing fewer productive laborers.)
2. Apparently, the Central Committee meeting of the Chinese Communist Party (CCP) did nothing to slow Chairman Xi’s goal of being in power to at least age 83.

Question of the Week: Any changes in your thinking?

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

https://mikelipper.blogspot.com/2021/11/do-you-believe-congratulations-are-in.html

https://mikelipper.blogspot.com/2021/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Three Portfolio Political Risks - Weekly Blog # 491

Introduction

What should be normal for an investor and particularly for a portfolio manager of other people’s money after a particularly good investment performance, one should question what can go wrong. Traditionally, September is the worst performing month of the year. Not only was it a positive month in 2017, but most of our advised accounts produced better than their individual performance benchmarks.  Since we utilize fixed income funds, both bond and money market funds as buffers to equity fund performance, most of our accounts are benchmarked against the Lipper Balanced Fund Index which is reported daily in The Wall Street Journal. The long-term record of that index is to produce returns between 5% and 10% with most of the time in the 7%-8% range and these are the normalized expectations for this benchmark.  We need to keep in mind that that past performance is no indication of future performance, and that investing includes the possibility of loss of principal.

Some of our clients’ investments were in mutual funds that gained over 20% and a few in the 30% range. These funds were invested internationally and/or invested in the top five stocks in the S&P 500 or their international equivalents. As we manage diversified portfolios we also own funds that did not do as well as the top performers.

I mention these results as a prelude to my natural caution; I am casting around as to what can go wrong.

What should be normal for an investor and particularly for a portfolio manager of other people’s money after a particularly good investment performance, one should question what can go wrong. Traditionally, September is the worst performing month of the year. Not only was it a positive month in 2017, but most of our advised accounts produced better than their individual performance benchmarks. In the first 9 months of 2017 we are producing returns at two to three times normal long-term annual expectations. We have invested some of our clients’ money in mutual funds that have gains of over 20% and a few in the 30% range. Following what should be the normal reaction after such results I am casting around as to what can go wrong.

A lot can go wrong. At the moment the three most prominent concerns all have a political base. As a classically trained securities analyst,  I normally ignore the political world, in part I have observed that contrary to most people’s logic, news follows the market rather than the other way around. For example the so-called Trump Bump actually started in July of 2016,  not at the election time. One reason for generally ignoring the shifting currents of the political world is that I am a securities analyst, more comfortable with financial statements and operating conditions than attempting to be a political analyst.

Nevertheless the three biggest risks to stock portfolios emanate from political decisions. Remember that Bernie Baruch when testifying before the US Congress was defending himself and his transactions that were labeled speculative. Reminding the Members of the derivation of the verb ‘to speculate’ was to see far (into the future). Recognizing that I may be wrong about any one or all three political risks, I will discuss each in order. The order chosen is in the probability of happening and the inverse order of magnitude of potential risk.

Risk #1:  Top Potential Casualties

Politicians strive much more for power than policy. In a capitalistic society there is almost always conflict between political power and the power of money. Often it is hidden but rarely is it not present. The battleground between the opposing forces is public awareness which is in control of selecting the levers that make our society progress. The following is an incomplete list of industries that the federal government curtailed through various measures since the aftermath of our very destructive Civil War, in roughly historical order. After identifying the industry or company in parenthesis are the government actions.

Railroads (Interstate Commerce Commission on tariffs); Life Insurance (licensing by individual states); Banking (Federal Reserve and Federal Deposit Insurance Corp.); Steel (tariffs and labor disputes); Standard Oil (trust busting); AT&T (breakup) and commercial airlines (deregulation). I am not suggesting that some of these actions weren’t in response to public concerns, but in these cases the net results were to force the companies to drastically change their ways which may or may not have helped the public more than it hurt them.

As a very powerful Speaker of the US House of Representatives once stated, “All politics is local.” In most communities the movers and shakers typically are a small group with a lead the following sectors: Banking, Newspapers, Auto or Farm Equipment dealers, Doctors, Insurance Agents, Retail trade and Real Estate. If a number of these feel threatened by new types of competition, they have an easy access to their political leaders in Washington - particularly when their regular political campaign contributions are remembered.

Today the five largest market capitalization stocks in the Standard & Pours’ 500 are increasingly being looked at as threats to the established  commercial and therefore political order. The five are Apple^*, Facebook, Amazon, and the two classes of  Alphabet (Google). Their combined market cap is $ 2.9 Trillion or in the same region as the annual incremental addition to the US national deficit. Clearly their very market successes create envy, both in the financial markets and public sentiment. Much more important in my mind is each of the leaders can be seen as an unintended threat to the cabal that runs our political structures on both sides of the aisle. I will very briefly identify the threats that can be conceived: 

^*Held personally

Apple is encouraging communications at numerous different levels which is destroying land line phone companies, local newspapers, and local financial institutions. Facebook in the last US election was the source of both valuable and manipulated news.

Alphabet (Google) is the ultimate supplier of “authoritative” information putting our teachers and professors to shame.

Amazon has just about destroyed the local book store and is seriously hurting the retail trade. Its very success has driven its stock prices up at a greater rate than the rest of the stocks in the S&P500, accounting for perhaps 25% of this year’s gains in some measures. It also is one of the reasons that active managers who own more of these and similar stocks are outperforming the identified indexers as well as the closet indexers. European governments have been among the first to try and corral these companies and could reduce their residents’ use of these products (which has happened in China.)

I don’t know how the political power class will attempt to rein in the power of the new uses of technology, but they may only be as successful as the Luddites in delaying the march of automation. While at the moment I am worried and expect the rumors or actual governmental moves to force a give up of some of the large stock price gains, I am betting that these companies’ lobbying and other efforts will blunt any serious moves.  However, my tolerance is perhaps at the 33% level. If your level of tolerance is less, be aware of the perceived risk.

Risk # 2:  Repatriation: Pandora’s Box

Be prepared for disappointing results from the temporary repatriation tax holiday. Politicians and to some degree central bankers are steps behind investors and corporations in their recognition that we are in a post-national world. A good bit of the foreign earnings of US corporations has been generated from sales of products and services to non-US residents. To the extent that the foreign branches and subsidiaries have paid for their US capital and research services, the foreign activities represent potential spin off candidates. This is the case for a number of multi-nationals.

If they fall for the tax trap and bring all of the foreign earned capital back to the US, they are probably good candidates for sale as they don’t believe in their own future particularly if the bulk of the repatriation goes to buy-backs which helps the existing management and hurts future owners.

Often when we invest in a foreign to the US fund, we are investing in foreign multi-nationals. This is similar to when non-US residents invest in our funds. In truth all over the world, most large financial institutions invest in large caps globally. They assume that the companies will be managed to achieve the highest prudent return long-term, not to solve local tax issues to reduce the size of unwise deficits. It may take awhile for the politicians to recognize that investors have felt the need to defend themselves from their own local governments, at least by diversifying into different legal and tax jurisdictions. Whether we like it or not we have entered a post-national world. One can expect the politicians to fight it and try to refocus investors on their home market, but it won’t work unless they encourage the locals to make their market the most attractive in the world. This probably won’t happen, unless we drastically shrink the size of government and regulation. 

The risk is that when repatriation for sound reasons does not produce the flow of money into the US that the politicians were expecting, the politicians won’t see that they are the crux of the problem. Most likely they will wish to penalize international investing, which will be counterproductive and hopefully won’t last too long.

Risk # 3:  Lessons from French and Russian Revolutions

The overall theme of recent elections in India, Great Brittan, US, France, Germany, and possibly Japan and Catalonia is that voters are angry as to their current position and want change. Many, if not most, of the current leaders were seen as change agents to solve the perceived deep problems. However, the problems are indeed deep and have been growing for forty to eighty years, Thus, they won’t be solved quickly in all likelihood. That is where the risk comes to the surface and the fearful lessons from the French and Russian revolutions. In each case the initial uprooting was led by a middle class leader who was attempting to fix the old system. It didn’t happen fast enough and there was some mismanagement of resources due to inexperience. In a short time the awakened masses lost patience. The mob or perhaps an organized crowd consumed the change agents and became enthralled with more radical leaders. For forty years I have been expecting a wave of change agents which could have come from either the right or left. If they can’t produce quickly, they will be replaced. The replacement can come from either extreme, but almost certainly will be extreme. This threat can only be headed off if the change agents get some quick early victories and start to come up with some extreme approaches themselves to head off more extreme approaches of the new radicals.

Question:

What are the three political risks ahead of us?        

__________

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

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.