Will Fund Classification Hurt Your Fund Selection?

Introduction

I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases relative performance is very important. My concern is that most benchmarks be they securities or fund indices are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional  “gate keepers” or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the US. According to McGraw-Hill Financial’s survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies’ foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources.  As a matter of fact I found four which had foreign sales of over 75%. Since for many years sales outside of the US have been (in local currency terms) growing faster than in the US, I am willing to bet that a number of funds that are characterized domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher quality small cap funds had a relatively good third quarter performance (see many of the Royce^* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important on this Sunday when the Financial Times reported that the Brookings Institution announced that the global economy is coming back, being led by the richer countries. For the moment the classification of small cap appears to be working. Nevertheless, from a selector’s view point it is a flawed classification.

^* Owned by some of our accounts

Better Classifications

Originally funds were slotted into classifications solely on what the funds’ marketing people claimed they were. Over time this yielded to the language in the prospectus created by the firms’ lawyers. Increasingly their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards as to earnings growth, price to book value, yield, market capitalizations and other measures. The data sources for these were the unadjusted financial statement statistics.

As both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed.  I have already pointed out that higher quality Small Cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors.  Other such measures might have to do with the difference between turnover in dollars vs. turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float and there are others.  Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

Bottom line: Pure performance ranking numbers in one period are not an important selection device today.

What screening devices do you use?  Please let me know.

Readers’ Service

In last week’s post I mentioned that Colin Camerer, a Caltech professor that we supported with help for his post-doc students, had just won a MacArthur fellowship, often called a Genius Award.  He sent me his collaborative article in the Neuron magazine, entitled, “In the Mind of the Market: Theory of Mind Biases Value Computation During Financial Bubbles.”  The work shows that during a bubble, the “smart guys/gals” get caught up playing what we used to call “the bigger fool theory.”  Please let me know if you would like me to email the article to you.

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Am I too Premature?

Popular media pundits are judged on the immediate impacts of their pronouncements. Sell-side analysts are judged on short-term performance. Portfolio managers are judged by their annual performance and consultants on three year views. Sounder investment managers award incentive compensation on four, eight and twelve year periods. As most of the money that I feel responsible for is long-term (in some cases life time and working on my family’s future, multiple generations), I attempt to focus way beyond the known horizons. As one shifts from the terrestrial telescopes to microscopes (all of which I am fortunately exposed to as a trustee at Caltech), one needs to adjust one’s focal length and duration of expectations. As someone who watches markets intensively for signs of longer-term importance, some of my thinking can be premature. I hope the concerns that I am about to express are premature.

New highs in prices, but not in emotions

Capturing the emotions around an event is often critical to understanding the event. The infamous and facetiously untrue question supposedly asked to Mrs. Lincoln after the assassination of her husband, “Other than that, how did you like the play?” was certainly the wrong approach to find out the impact of the murderous act. However, in our media sensitive world, gauging people’s emotions about an event can be an important clue as to the significance of the event. The string of new high readings on the Dow Jones Industrial Average (DJIA) and very close to new high readings on the Standard & Poor’s 500 did not produce wild euphoria on the floors of stock exchanges, in the general press or on Main Street. One could interpret this lack of enthusiasm as a symbol of either disbelief or lack of importance. There are possibly many reasons for these attitudes. I will suggest just two. The first is that many investors or former investors are not participating in the rise. Since the former market peak in 2007, according to the Investment Company Institute there have been net redemptions of $556 billion in domestically-focused equity mutual funds over the period. For the most part this money was diverted into bond funds and some internationally oriented funds. In all likelihood if this is the beginning of a new market expansion, this money and more will come back. The second indicator of disbelief or concern on a global basis is comparing the price of gold at the time of the 2007 peak and today; it has slightly more than doubled though it is down over the last 12 months.  Because of the actions or perhaps more correctly their inactions, investors and some central banks are fundamentally concerned about the intrinsic value of paper money. (This concern seems to be more tied to money’s value than a fear of rampant inflation which could be caused by some of the currency warriors’ actions.)

Did last week’s stock price and volume actions give us a clue?

Changing my focal length from the distant time horizon to the last four or five days is an attempt to mine from the current events to the future, with all the hazards of any market focused prediction. Please bear in mind the source of the data used is from the New York Stock Exchange, in an era where the exchange has lost market share to other trading sites, but its data may well be representative. Allow me to focus on financials not just because of my private financial services fund, but during the week the financial sector was the best performing of the ten large sectors in the marketplace. Paying attention to the price and volume statistics of three stocks can be useful when viewing the potential excitement of additional DJIA new highs.

On Tuesday, Moody’s¹  traded 3.7 million shares, closing at $50.06; by the end of the week it worked higher to a $50.95 close, but its volume dropped  more than half to 1.7 million shares. One could interpret this result as higher prices did not increase the amount of stock for sale, perhaps a bullish sign. A more normal result was in the action of T. Rowe Price² which on Tuesday traded 1.35 million shares with a closing price of $73.93; by Friday the closing price had crept up to $75.20 with volume of 1.35 million shares traded, which suggests that the size of the buyers and sellers were equally matched and at these levels price changes were not causing significant changes in the level of transactions. However, in contrast to these two rather placid pictures, what was happening in JPMorgan Chase³ was quite different. The week started with the stock closing at $49.10 on 17.7 million shares. While the stock rose to a peak on Thursday it closed on Friday at $50.20 on 32.3 million shares traded. (On Friday the Federal Reserve announced its stress test results for the 18 largest banks, which is likely to suggest that the Fed will approve most if not all of the bank’s request in terms of dividends and stock buybacks.) The significant increase in the volume on Friday suggests to me that there is an increase in the minds of potential sellers that the current level is an appropriate exit level. In the coming week and going forward, new elements are likely to enter the minds of buyers and sellers of these three financial leaders. Relative to the rest of the market, I would suggest some new impetus is likely to be needed to drive these stocks higher in the short term.

What is happening and important in the broader market and economy?

The earnings of the companies within the S&P500 parallel the earnings of corporate America. For some time we have gotten used to these numbers rising. They did not grow in the fourth quarter. If growth continues to slow, earnings could decline which if sustained could hurt the general level of the market. Rates of change are often unstable, shrinking and then expanding. One impetus to an expansion of earnings could well come from a major increase in US domiciled companies’ capital expenditures. In their periodic reports the Royce Funds⁴ noted that ISI reports that in the US the average age of industrial equipment is 5.8 years and the average age of plants is 15.5 years. These represent the oldest conditions since 1965. Royce uses this to buttress their argument for sizeable investments within the industrial sector. While I agree that at some point there will be a need to replace some industrial capacity, I question whether they will be replaced with the same products and plants that now exist. What will be replaced domestically will be with more technologically-driven products and plants. With rising wages in the developing world, there will be some new plants brought on stream in the US, but with most of them in Right to Work states with attractive business incentives. Nevertheless, at some point, industrial America will commit with courage and global prudence to US production.

Disclosures:

^{1 & 2}   Owned by my private financial services fund 

³        Owned personally

⁴        Some of our managed accounts own Royce funds

Currencies vs. GDP 

In my opinion, one of the best parts of the Economist magazine is its two final pages of comparative statistics. In the current edition it has GDP estimates for 2013 as well as changes relative to the US dollar of the same countries’ currencies. Compared to most, the US’s tepid 2% GDP estimate is quite high with only eleven countries with a larger GDP estimate. (Readers can request the list by emailing or calling me.) Almost all of these countries have seen the value of their currencies decline relative to the US dollar. For those of us who invest for dollar focused investors, the lower valuation of the local currencies translates into lower performance results of International funds. To the extent that the undeclared, but significant currency wars escalate, our performance reports will suffer; even though in many cases the earnings of the companies that we invest in directly or in funds will grow better than those in the US. Further, in numerous cases the outlook for many multi-national and local companies is very attractive as they meet the rising needs of various populations.

How do you put these concerns into portfolios?

As is my nature, I am probably premature and possibly too premature. Thus I am not an advocate of raising cash today through disinvestment in equities. What I am suggesting is that until the next major bottom is reached to reduce commitments to ETFs and most quant strategies that do not permit the use of cash as an investment vehicle. In my selection of active equity managers I will be searching for those rare managers that can raise significant amounts of cash at the right inflection point. These are rare skills particularly when combined with reasonably full equity commitments.

Share with me your views as to whether or not I am too premature.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,

All Rights Reserved.

Contact author for limited redistribution permission.