Three Concerns: EPS/Golden Calf, the Next Dip, Indexing is Faulting - Weekly Blog Post # 489

Introduction

Most individual and institutional investors are in essence outer directed. Either consciously or not they follow what others do and have a fundamental belief in “smart money.” For extended periods of time this philosophy has worked. Perhaps, it was my brother’s experience in the US Marine Corps Reconnaissance as the leading point for wartime patrols to avoid walking into an ambush. Or my experiences at the racetrack where betting favorites won only about one-third of the time. I look for instances where the “crowd” is wrong. Not to be just a contrarian, but looking at the profit opportunities when the generally unexpected occurs. Some of these opportunities are just plain random, others can be perceived ahead of time. Each of this week’s concerns has some evidence backing up the views as to future changes. Whether you agree or disagree let me know.

Is EPS our Golden Calf?

Throughout my investment career I have heard earnings, actually reported earnings per share, drives the market. In the 1960s I was told all one needed to know was the growth rate of earnings to determine the appropriate price/earnings ratio. Recently I heard a very well known and respected Portfolio Manager explain in a long cable news interview that “earnings drive the market.” The first thing he said about each of his five buy recommendations was their earnings per share. The analyst in me rebels at this kind of over simplification.

In a period where much of senior managements’ compensation is based on in order, EPS, sales, and market price - do you think that they attempt to show the best possible record? I don’t want to proclaim that they are totally manipulated or are the equivalent of “fake news” but it makes you wonder whether it is a true reflection of the value and future potential of the company. One of the first lessons from my Professor David Dodd, who wrote the five editions of Securities Analysis with Ben Graham, was to reconstruct the financial statements of the company under study. We laboriously went through each line in the income statement and balance sheet adjusting for removal of non-recurring elements and questioned the accounting techniques that produced each item. We were quickly taught that in various cases the results in the press release or Management’s letter did not give a totally accurate picture.

When professionals discuss the valuation of various Merger & Acquisition deals today, comparing them to others, the metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization (what were the write offs?). The drive here is to understand what was the operating earnings of the company. Net Interest is the result of the financial condition  and policies of the company and might not be followed by a new owner. One of the simplest techniques that I learned at a trust bank was to put all the steel companies held in trust accounts on the same tax rate. This deprived some of the companies of their tax management skills, which were often transitory, but would be different under different ownership.

Depreciation charged is a function of the weighted ages of the plant and equipment with no adjustment for critical future expenditures. Amortization could be an orderly way to recognize the deteriorating value of intellectual property purchased and/or other write downs. To some degree I think all of these items plus debt service obligations are more important than reported earnings and so do the “M&A” troops.

Notice that a good portion of some companies “earnings improvement” comes from profit margin expansion. What this really means is that reported earnings are growing faster than sales. This is favorable when the company is increasingly earning more over its fixed cost base. However, it may mean that it is not spending enough on plant and equipment and/or research and development. These considerations are important in an increasingly competing world of relatively slow growth.

In history, when the ancient people felt that the Golden Calf  did not answer their needs, not only did they destroy the statue, there was a period of turmoil and violence until new, and in some cases, better beliefs were established.

The Dangers of Buying the Next Dip

This past week there was an extremely sharp jump in the portion of the American Association of Individual Investors views on the market. In one week 41% are bullish, a gain of 12 percentage point from the week before with a concomitant decline in bearish beliefs and neutral holding about even. Both the Dow Jones Industrial Average and the S&P 500 went to new highs, not immediately echoed by the NASDAQ Composite. It is quite possible that the two senior averages need to catch up with the NASDAQ. The year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88% and NASDAQ + 22.96%.

Could this be the key missing element to a race to the top? While a number of highly respected market analysts expect a minor pull back, as there are a few price gaps that should be filled in before a major new top is reached. This could be accomplished by a 5 to10% correction. The Goldman Sachs^* view is that there won’t be a dip as too many people are expecting it. (Remember the humility production function of the market.) This focus on sentiment over financials is a concern of Professor Robert Shiller as expressed in The Sunday New York Times when he refers to John Maynard Keynes’ belief that market participants were not making their own investment decisions, but were guessing what others were doing, in other words, trying to follow “smart money.”

^*Held in the private financial services fund I manage

My concern is that this trading attitude may actually succeed. The risk is that the successful traders and later their acolytes will have faith that it is a repeatable result, and they are truly skilled. My concern is that when the next “Big One” occurs it will be quite different than managing through normal drops and even minor corrections. The difference is the size of the trading capital in the marketplace having to provide liquidity to non-price sensitive ETFs and margin-called players. There is little to no capital on the floor of the exchanges. Dealers have capital constraints and banks are limited by various regulations in a global marketplace connected in less than nano-seconds.

I don’t worry about trading losses, they come within the territory of investing. What I do worry about is the potential of future revulsions to investing and a generation that will decide “never again.” This will be tragic for themselves and their families. But also the rest of us taxpayers who are likely going to have to pick up some of their missing retirement capital.

More Evidence Indexing is Faulting

You have to excuse me for looking at the world with lenses that start with mutual funds which I have been following for more than fifty years.

Each week I look at the funds’ performance for varying time periods. For the week ending last Thursday I saw an interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks close to 100 different fund peer groups. The largest equity group is the $ 1.2 Trillion S&P 500 Index funds. I compared its results for three periods and counted the number of peer groups that beat the large Index funds as shown below:

Type of Fund	# of Fund Types Surpassing Index Funds
	YTD	52 Weeks	5 Years
US Diversified funds	4	3	2
Sector funds	12	7	5

There were four fund types that beat the index in all three periods, 2 diversified and two sector fund types. The key point is more active managers are beating the Index. It is not because they switched from dumb pills to smart pills. It is due to greater variability of performance within the 500. Mathematically this splitting is called less correlation and greater dispersion. Within the Index there are some big winners and a few big losers which is meat to active managers, and in theory to long/short managers (hedge funds and the like).

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Investment Survival Lessons

Introduction

In an accelerating world, I find it necessary to always be learning. I hope to learn from almost every exposure I have. This week’s post is based on three inputs to my investment survival orientation:

1. Future vs. History

2. Markets vs. Economies/Governments

3. Levels of Patience Required

Future vs. History

In an always insightful column in The Wall Street Journal, Jason Zweig interviewed Professor Robert Shiller, the Nobel laureate in economics and the developer of the “cyclically adjusted price/earnings ratio” or CAPE. In the interview there is a particular bit of wisdom for all of us who are condemned one way or another to predict the future. Professor Shiller stated while the current level of CAPE “might be high relative to history, but how do we know that history hasn’t changed?” Asking the question is the wisdom not my answers. There are at least two reasons to believe the certainty of a top of a market.

The first reason is that we live in a very dynamically changing financial world. This is not the first time that governments and their central bank servants have been manipulating interest rates or modern day money; from the ancient times kings reduced the amount of gold and silver in coinage. Add to this that the trading markets have changed due to the use of capital restrictions, markets fragmentation, increased use of lightly capitalized derivatives and the communication of investment methods.

The second reason to question the utility of C.A.P.E. or any Price/earnings ratio measure is my training at the race track. When asked, the wagers who were putting enough of their money on a particular horse that would make the horse the favorite they would focus on one statistic almost to the exclusion of any others. (Favorites typically win only about 1/3 of the time.) With this as a background, you can sense my apprehension when entering the analytical business where the need was to quickly convey brief reasons to make an investment decision through the use of some term or label with the caveat that people would fully understand the limitations, construction, and the past record of misapplication.

 

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax “pre-other” income growth. In addition, I look at net cash generation after debt service as comparative measures before focusing on an evaluation of management to handle future opportunities and problems. Further, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different than today’s version. The calculators of C.A.P.E. use reported data for the S&P 500 companies which is just not good enough for me in the fight for investment survival.

Markets vs. Economies/Governments

While I am very sympathetic to Professor Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey and London using individual tools and data that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed a rapid rise led by the late stage large-cap stocks. Nevertheless, one analyst has supplied some S&P500 benchmarks in terms of downside risks as shown:

a) 200 day moving average: 1905, breaking down from this level could bring more selling;

b) Down 10% from recent top: 1810;

c) Down 20% from top similar to 2011 or a cyclical decline: 1610;

d) Down 33% a la 1987 crash: 1350.

As frightening as these numbers are, they do not include a once in a generation decline of 50% which could take us below 1000 as compared with today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets; e.g., German DAX is down -12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the Emperor is marching naked. 

Current moods of business people and investors are much more cautious than national statistics would indicate. One example may be helpful, Large Cap Growth stocks were up +2.21 % in the quarter vs. -6.39% for the much more economically sensitive Small Cap Value stocks. To show the importance of volume, on October 6^th the stock of T.Rowe Price^* closed at $78.14 on NYSE volume of 872,860 shares. At the end of the week the stock closed at $75.35 on volume of 2,643,245 or close to 3X the earlier day. The interpretation is that the firm’s income will suffer from lower assets under management due to market decline and fewer net sales.

In terms of investment survival I pay attention to the market analysts and have adjusted most portfolios that have a five year or less time horizon to be more cautious. However, each of these bright market analysts see that we are setting up in the long run a major expansion of stock prices and somewhat higher interest rates to which I agree. But this could be delayed by the political forces utilizing inaccurate data trying to create a recovery rather than seeing that they are a main cause of the current malaise. We may need new global leadership.

Levels of Patience

An advantage that I have is owning a large number of stocks of financial services companies either personally or in a private financial services fund that I manage. Thus this week I attended an Investors Day for Jefferies, which is now owned by Leucadia^*, and is owned in our fund. In one way this has been a good holding in that it is up 143% since purchase years ago. In another way it has been a disappointing holding for the last 18 months with the merged stock just about where it was on the day of the merger. Luckily other holdings did better. However, in terms of lessons it may be worth a great deal.  My reason to continue to hold the stock is that I saw it as a unique player in a rapidly changing investment banking and institutional brokerage business with a largely attractive merchant banking portfolio, a significant net operating loss carry forward and new capital resources.

^*Owned by me personally and/or by the financial services fund I manage

What I was counting on was the continued regulatory pressure on the major banks and their investment banking activities in terms of their use of their capital. I was further counting on a significant a number of successful investment bankers and other highly trained technical people seeking employment with an organization that could materially increase its market share through their efforts. Where my analysis was faulty was that these changes would have effect much more quickly. What I should have recognized is that it often takes two to three years for the investment bankers to bring in more revenues than their cost.

Judging by their underwriting and deals success many of the Jefferies bankers are on the verge of becoming profitable to the firm. I should have been more patient to see the expected improvement. It was easy to recognize the pressures on the majors and the deteriorating service levels throughout many of the organizations. This is why I suggested that currently one might not open new bank relationships due to pressures throughout the organization. I thought these pressures would immediately translate to more and profitable business to the non-bank competitors. It didn’t happen on my schedule thus I am reluctant to suggest purchase at this time. I will have to see not only operating earnings coming through, but also a steady decline in Jefferies compensation ratio.

PS: Last week’s suggestion that some of the money planning to leave PIMCO should consider reducing its allocation to bonds may be happening in that the flows this week into money market funds were unusually high. I would hope as equity ratios decline because of falling prices and other disappointments that new capital can be prudently introduced into expanded equity holdings.

Perhaps, once again I need to be more patient.

PPS:  Bloomberg Television Sunday night is showing a weak opening in Asian markets which followed a report from Business Insider that the Dubai Stock Market index fell 6.5%. Be cautious and do not try to catch a falling knife.

Question of the week: Do you have plans to increase your investments in stocks?

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Copyright © 2008 - 2014

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All Rights Reserved.
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Institutional Investing in Uncertain Times

Uncertainties

Negatives: Parallels to WWI and II, Inefficient redistribution through wages and taxes, Disappointing earnings, Global economies to lag market declines, Faulty analysis.

Positives: Private sector growth, Nuveen purchase, Boston Marathon, Boom ahead.

Instruments of Success: Time Horizon Portfolios

Introduction

For three of the great religions of the world this was an important week of cherished celebrations. As each of these institutions needs to look after its flock now and in the future, financial capital investment for all should be thought of as a group of coordinated portfolios. In my work with various non-profit organizations I have been an advocate of at least four such portfolios. 

The first is the expected next two year expenditure pool or the operating subsidy beyond current donations and earned revenues. 

The next portfolio is the replenishment portfolio which is designed to replenish the operating subsidy over a relatively short period of five years. It is this pool that is at most risk to a market decline as it may not have enough time to recover from its former peak.(Depending on the likely term of current leadership there may be greater sensitivity to leaving the organization as strong as when the current team came into its responsibilities.) 

The third portfolio or legacy pool is designed to provide funding for the foreseeable future of at least the next leadership team. They need to be concerned for paying for the physical and human upkeep of existing facilities. The legacy portfolio can recover from periodic market declines. 

The fourth portfolio, or endowment pool, is to recognize that institutions will need to provide services beyond their current framework which may well mean a major desired expansion. The endowment portfolio needs to provide the necessary capital for expansion and thus must grow faster than its surrounding economy. Often, this can most readily be accomplished by taking advantage of periodic opportunities offered in declining markets.

Addressing the needs of the four portfolios is what I attempt to do for various long-term focused institutions and wealthy families which want to provide funding for three or more generations. Today my focus is on what changes may be needed for the second or replenishment portfolio. If the other three are well structured, current problems and opportunities do not require much in the way of changes.

The issue today is the appropriate weightings of the negatives and positives that are lurking just below the horizon that most investment commentary is focused.

Negatives discussed

I have often commented that if one scratches the wrist of an analyst, a historian will bleed. In that vein, the work being conducted at Caltech and elsewhere shows some work that passes for thinking and judgment is essentially memory. Not only because of my history lessons from the US Marine Corps, but my study of financial and therefore political history I am struck with the increasing parallels with the political actions that led up to World War I and II. In each case initially the eventual protagonists did not seek armed conflict. They were indoctrinated by their general staffs on von Clausewitz’s principle that war is another way to accomplish policy goals. Both sides felt that they were under economic attack from the other side and the integrity of their promises to their allies was threatened. In both cases the US was intent on not getting militarily involved and applied economic sanctions to slow down or prevent further expansions of the other side. In each case the US strategy failed. I am very hopeful that the parallels do not complete a triple disaster.

If external problems are not enough, the US is in the process of hollowing itself out by adopting a very inefficient way to redistribute wealth through increases in minimum wages in the reported economy and changes in tax rates and regulations. The issue is very simple from a geometric point of view. Those currently in power look at a pie chart of wealth and want to change how it is allocated. The real way to put more money in people’s hands is to grow the pie to larger sizes. If we are going to focus on redrawing the slices, our attention must be focused on the trade-offs between the slices. Unfortunately, those with less capital are more at risk to diminished purchasing power due to government sponsored inflation and the relative destruction of small local businesses. On the other hand if the pie is growing through providing more goods and services to both internal and export markets there will be more income at all levels for those who wanted to work.

So far, the reported earning season has been disappointing. This is particularly true when compared to a very robust fourth quarter in 2013. A careful analysis of operating margins (pre net interest income) is showing a minor contraction in many cases. As we progress through the year the quarterly comparisons with those of 2013 will probably look less healthy. Outside of absolutely needed capital expenditures in the US, an expansion in spending here is not expected unless the results of the 2014 election and the prospects for the 2016 election look favorable to both corporate and individual investors. Even in the case where domestic production is cheaper and more efficient than outside the US, there is little headway in bringing more work and capital back into the US.

The financial community is always looking for an easy way to express an abstract thought. We love numbers because we can arbitrage against these numerical trends by purchasing below trend and selling and/or shorting above trend. This approach can last for a long time, way beyond its analytical usefulness. I am very concerned that in two cases these mathematical extrapolations are going to be increasingly found wanting. The first is the very popular CAPE (Cyclically Adjusted Price to Earnings ratio) developed by Robert Shiller of Yale University. In his model he uses the reported ten rolling year’s earnings per share compared with current prices to determine whether a market is under or over priced. As an analyst one of my frustrations is that the quality of reported earnings is evolving. Accounting rules have been changed to favor the use of financial statements for the benefit of lenders not investors. Further, almost every year there are substantive modifications in federal and state taxes. The plain truth is that long past results are not much use for investment these days by strategic or ordinary buyers. I suggest that these simplistic calculations can lead investors to believing that there is not a valuation risk in today’s markets. 

The second questionable measure is a purported measure of risk, called from its symbol, VIX. S&P reported that various ETFs that were meant to go up when volatility increased, did not. As a matter of fact the inverse instruments did. More importantly, we believe that risk of large losses is not effectively measured by volatility. Over the last twenty or more trading days numerous biotech and Internet-oriented retailers suffered significant price declines that they had not experienced before. This suggests to me risk of large losses is more likely a function on the rate of past price gains and excessive current valuations.

Positives

When one strips out the impact of governments at various levels, there is considerable evidence that the private sector is somewhat haltingly growing in many countries. Interestingly, the UK, with a somewhat more orthodox economic policy, is leading the way. This is very much worth watching for global investors as the FTSE 100 price chart appears to have created a triple top going back to the 2000 year. If it were to decisively go through the 2000 peak, a chart pattern would be created that the market technicians would believe becomes a base for a massive expansion.

One sign that a long-term focused financial institution believes that there will be more money flowing into financial management is the purchase of Nuveen by TIAA-CREF. The intention is to keep the acquisition separate and under present management. This is important because the buyer recognizes the value of the existing management and projects that the individual and institutional markets will grow faster than the general stock market. With its resources TIAA-CREF could have hired a bunch of people to do the same jobs as the Nuveen people do. 

On Monday the Boston Marathon will be run. A year ago it was disrupted by terrorists’ bombs. Like New York after the 9/11/2001 attacks, Boston is coming back showing the resilience of the American people just as we showed once our political leaders fumbled us into the two world wars.

In looking beyond a period when the markets lead our economies down, there is an increasing belief that a major boom is ahead for us. The applications of technology and energy production and use will change the structure of how we live and I suspect, invest.

Applying Time Horizon Portfolios

While I will be happy to discuss specifics with our readers, let me briefly outline my suggestions.

Operating Portfolio - An Operating Portfolio to cover at least two years of planned expenditures should be kept in high quality short-term instruments of limited duration.

Replenishment Portfolio - A Replenishment Portfolio, which normally would look like a sound Balanced fund, reduces its risk portion by going into somewhat limited in duration, high quality Fixed-Income with high quality, (probably Large Cap) equities in equal proportions. If the market gives an opportunity to buy high quality securities at significantly lower than today’s prices, I would be willing to dramatically raise the stock portion.

Legacy Portfolio - Outside of a small trading reserve, a Legacy Portfolio should be equity focused. This could include some high yield bonds or even bankruptcy paper, but not at today’s prices. Entrepreneurial companies that are dealing with expanding markets would find a natural home in this portfolio.

Endowment Portfolio - An Endowment Portfolio should be focused on companies that are currently disruptive and smart. They are currently disruptive by dramatically changing pricing due to technology. Many small companies may fit within this portfolio.

In our investment practice we intend to fill these four Time Horizon Portfolios with mutual funds and similar SMAs.

Question of the week:

Which negatives and positives do you agree/disagree with? Please let me know.    

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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.