Justify Wins, Buffett Looks for New Commitment - Weekly Blog # 522

Introduction

On Saturday there were two useful omens for long-term investors. For the ninth time, one of my sons and I attended the Berkshire Hathaway celebratory annual meeting. I also watched Justify win the Kentucky Derby on television. I detected messages or inputs from both to aid in making long-term investment decisions. Both have already received substantial press reviews. As many of our regular subscribers have come to expect, I see or perceive things differently than most others. I will mix in additional thoughts from my current readings.


Berkshire Hathaway Annual Celebration (Annual Meeting)

For the past nine years we have gone to Omaha to learn more about Berkshire, get general investment lessons from Charlie Munger and Warren Buffett, gain insights into specific areas of the economy, and see many of the great value-oriented managers from around the world.

One of the lessons that I’ve learned from my racetrack handicapping experience is that the way one handles one’s money is in the long run even more valuable than individual selection of specific bets. One of the big advantages that Warren Buffett has is that he is in a position to make selectively big bets through his securities investment accounts and in his insurance risk facilities. In terms of the latter he is willing to accept unusual concentrated risks that could total $400 Billion in aggregate to cover severe storms and extreme crypto risks. His expectation of individual risks is limited to perhaps 3% of global underwritten risks.

Berkshire’s current float is $116 Billion, which is part of the over $325 Billion in its investment accounts. This suggests that if an opportunity appears, Buffet could commit over $200 Billion. He has not totally given up his “cigar butts” training from Ben Graham and is likely to become more aggressive if lower prices or better values appear. However, he does recognize that Ben Graham lived long enough to see many of his views invalidated.

The same occurrence happened to that great Nobel Prize winning scientist Stephen Hawking. This week I read that at his death he no longer believed the universe had no boundaries. He previously believed there were no boundaries.

These realizations are critical for us investors who believe in the immutable power of various investment theories. Charlie Munger’s approach to buying good companies at a fair price produces better results than buying at only cheap prices.

On an operating basis he is encouraging GEICO to expand its share of market, expecting significant initial losses to later translate into substantial profits. In a similar approach, in the near term Buffett does not expect dividend growth to result from growing earnings at the utility operations of the parent company. He also expects to grow their life reinsurance business on a regular basis and the casualty reinsurance business only if he sees favorable prices.

Both the stock market and the global economy are structurally changing. One of the points that Warren Buffett made at the meeting was that the five largest market value companies in the S&P500 are not capital-intensive businesses. At this stage of its development Berkshire-Hathaway does not need external capital. Thus to some degree it has escaped the discipline of the market place. To my mind this makes the policy of indexing into the S&P500 more risky than active portfolio management.

Justify Winning “The Derby” Lessons

During a driving rain storm dropping 3 inches of rain on the track, Justify ran away from the other 19 horses in the race. Justify was the favorite, which proves that occasionally favorites do win, suggesting that current market leaders (as is often the case) won’t disappoint.

From a tactical standpoint there were many horses that were in the second phalanx which could not catch the winner in the homestretch, proving that positioning does not always work well. The winner was unusual in a number of respects. First, Justify did not race as a two year old, which was unusual. From an investment standpoint the most significant factor is was that the winner was bought for $500,000 by a Chinese syndicate. Interestingly, the only foreign language translated at the Berkshire meeting was Mandarin. In addition, there were a large number of Chinese at the meeting and they asked a significant number of questions. This is not so surprising. For sometime, Charlie Munger has felt that there are more opportunities for sound investing in China than in America. Mr. Buffett echoed those thoughts.

Next week’s blog will continue the topic of Investment in China and will come to you via Hong Kong where I am chairing a meeting of the International Stock Exchange Executives Emeriti).

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Danger Ahead, New High Stock Market: Is Capital Preservation with Appreciation the Answer? Weekly Blog # 514

Introduction

At the end of February I was about to suggest that both the high and low for the year 2018 were in place. If either price was violated it would be troublesome. After the first nine days in March I am getting much more concerned about a breakout above the January highs.

Why are Higher Prices Dangerous?

Perhaps I am jumping to the wrong conclusions, but for many the 400 point rise of the Dow Jones Industrial Average on Friday can be chalked up to volatility, but others may see it as a successful test of the February lows. (I would have preferred a lower test with more volume of trading and statements of discouragements.) But the realist needs to accept reality, not wait for the perfect. There is a good chance that others will see it as a successful test, encouraging buyers with significant power to return and drive the next upward move. Using the very volatile sample by the AAII, 45.2% of their surveyed members are now neutral, which is higher than both their bullish and bearish members. This is a rapid change from just three weeks ago where the neutral tally was 32.6%. In the recent week the top 25 performing mutual funds had gains between +7.77% and +6.07%. All but one of these were growth oriented and or specifically science & tech oriented. 

Thomson Reuters tallies analysts’ earnings estimates and in their latest report the analysts expect the S&P600 Small Caps to have earnings growth for this year of +24.1%  compared with +19.45% for the S&P 500 and +37.67% for the Russell 2000. Both the fund performance leaders and earnings estimates are based on a belief that the future is going to be good, led by positive future developments in terms of technology, politics, and economics. (Perhaps they will be correct.)

After nine years of rising markets, I have been on the lookout for signs of an inevitable market decline. In terms of magnitude of decline a normal cyclical decline is in the range of 25%. These happen normally once within a decade. Not too many people are psychologically wiped out in these declines and usually return to the stock market within a few years after the decline.

A much more serious fall, that is often labeled a collapse, happens infrequently, normally once a generation and is generally in the range of 50% from the peak and has investors leaving the marketplace never to return, This type of fall is in the passing on their distrust of the market to the next generation. The individual and societal losses from these collapses are relatively small compared to the forgone profits from the recoveries, which impacts the rest of their lives and often also the next generation’s. As both a fiduciary and an investor I would like to avoid these results. I attempt to do this with an eye on a number of different market histories.

The major traumatic collapses start with apparently successful investing, that not only turns a small amount of money into a larger amount of money but inflates the investor’s belief in their own investment skills. Often this confidence leads to the use of borrowed money in the forms of margin or derivatives. A speculative fever takes over the crowd, while they recognize there is some risk their confidence is such that they can get out without large losses.

The driver of these “animal instincts” is based on an unshakeable view of the future. These speculative markets are driven by sentiment, not researched fundamental investing. This is why I am paying more attention to measures of sentiment, along with attention to internal financial calculations.  One of the fuels of a major top is the sucking into the market of all or most of the available cash.

Assuming the US and perhaps other markets pierce their former highs, the various pundits, including non-professionals, will proclaim that those not participating are stupid. They have never studied handicapping at the racetrack where in each race there is likely to be at least one horse with a good, very current record receiving a disproportionate amount of the betting money. This is the favorite of the crowd, no different than the current market where leading funds are heavily invested in a select group of multinational tech companies. At the track, while the favorites do win at short odds, they don’t win enough money to cover the losing bets the majority of the time.

I am concerned that over the next year or so too many investors, including those institutions that are de-risking, will get sucked into the market. My fear is not for them alone after their disappointment of losses from the next peak, but for the opportunity losses in a future recovery. Unfortunately in our society these are the losses that are socialized for the rest of us to pay.

What are the Signs to Watch?

Currently, the most visible largely speculative source of flows into and out of the market are the Exchange Traded Funds (ETFs). Much of the current activity in these securities is by traders, often at hedge funds, who are using ETFs rather than more expensive derivatives. In the last week, while the larger mutual fund industry had a small net inflow due to net purchases of non-domestic funds ($2Billion), ETFs had a net outflow of $12.6 Billion with $10.3 Billion in one ETF invested in the S&P 500. This is a sign of a trading market that has lots of speculation occurring.

The second item to watch for soon is mutual fund advertisements heralding their ten-year performance results, which had been trailing more current periods. It is easy to look good from a bottom in March of 2009.  These market efforts could bring a lot of unsophisticated money into the stock market, which will entice the so called sophisticated players to trade the market on the way up convinced that they can get out in time.

What can a Wise Investor Do?

In an over simplification, portfolio strategies can be divided into two buckets: Capital Preservation and Capital Appreciation. For some of our clients, particularly those who have worked hard for their money, their primary concern is capital preservation. This is particularly difficult today if one is concerned about after inflation and after tax earnings. Around the world, governments in theory are sponsoring inflation as a way to create jobs, by ballooning the income of businesses and individuals. What they are actually doing but not discussing is lowering the purchasing power of the loans that they are repaying. This is a continuation of a trend, as governments since their beginnings have debased their currency as a way to payback less value than what they received. 

To the capital owner and the individual, inflation is another form of taxation. In the current environment income taxes are not the only source of pain. Because of the recent changes in the US tax code, I believe we will see an aggregate increase in fees, tariffs, sales and use taxes, as well as various forms of value added taxes. If the job of capital preservation is to maintain the purchasing power of capital, it must earn more than inflation, all taxes, and other distributions. I suggest that in the current market, high quality bonds can’t produce the necessary income. (That is why in our TIMESPAN L Portfolios® we should only have fixed income in the Operational Portfolio.)

At this juncture, until we see much higher real interest rates, the best suggestion is high quality stocks whose yields are in the range of the ten year treasury and have a history of periodically raising dividends roughly in line with inflation. One would like to find dividend payout ratios below 50% of earnings, if possible. In truth that is going to be difficult to do with appropriate diversification.

As a practical matter many accounts are going to have to dip into the capital appreciation bucket. In selecting funds or stocks I would array them based on a guess of how many years into the future the particular issuer will pay a dividend that would qualify for inclusion in the capital preservation bucket. In some cases this may be in only a few years. In others, like with Berkshire Hathaway* and Amazon, the indefinite future may be too short. In these cases the willingness to periodically sell off some of the appreciation to fund the preservation bucket could allow the position to be in the portfolio.

* Owned in both a financial sector fund and personal accounts that I manage

<b>Questions of the week:

What portions of your portfolio do you consider Capital Preservation and Capital Appreciation? Do you expect to change these based on market cycles?  

Price Trends, Clues and Concerns - Weekly Blog # 506

Introduction

Bonds, stocks, and commodity prices are sending different clues while the pundits proclaim synthesized global economic growth. After thirty-six years of rising returns for fixed income, almost a decade of stock market gains, and commodity prices entering a new cycle, thoughtful market participants are confused. The one common impetus is growing confidence in decision-making. With more confidence investors are consciously or not accepting more risk because they are getting a somewhat clearer view of the future. As a contrarian, and often allergic to popular views, I have my doubts. I am not totally alone. Ian Bremmer of the Eurasia Group has said, “2018 feels ripe for a big unexpected crisis." My concern is that the growing confidence is crowding out a reserve for surprises, good or bad.

Inverted Yield Curve Fear

While it is true that the last seven fixed income prices declines came after the 2-10 year US Treasury yield curve inverted, I do not believe it is an immutable law of investment science. Nevertheless, it is a proper place for study. There is a similar pattern in the futures market when near-term investments are more expensive (higher yield) than long-term ones. What is important is that the market view is that the near-term future has more risk than the longer-term. Often this is right, but not always. Remember the surprise factor. In my opinion an inverted yield curve if and when it happens is more descriptive of current fears than predictive of long-term prices. Fixed income prices are set by supply and demand and are similar to the odds posted by book makers which are not the result of careful analysis but prices that will bring new bets into balance to keep the bookmakers’ capital risk into reasonable balance. The bookies and the bond market will lose out only if there are too many surprises.

The fears that there are oncoming inverted yield curves or other causes for bond prices to decline have been operating for the last few years. The biggest concern is not credit losses, but inflation. To service those who are concerned that inflation will rise above current levels, the US Treasury and others have created TIPS (Treasury Inflation Protected Securities) funds which are issued in roughly the same maturities as the other treasury paper. For more than the last three years the total return investment performance of the average TIPS fund is slightly better than the average intermediate US Government Securities fund. For longer periods the reverse is true. One wonders what the relative performance results would be when the reported inflation rate finally reaches or exceeds the Fed desired 2% level. It is possible that our and others are from time to time paying premiums to buy inflation protection and this is why the TIPS funds perform better rather than their pricing mechanism?

If one is managing retirement capital accounts for those that are currently working, I would substitute 30 year treasury yield for the 10 year. (More on this later.) 

Individuals investing in fixed income securities or funds should separate the total return numbers between income (interest) payments and market prices. Inflation will not nominally impact the income stream, but may have significant impacts on both the prices of the bonds and the purchasing power of the proceeds.

At Caltech and other places studying how the brain makes decisions, they have found that most humans make decisions on finding past memories that coincide with current conditions. Every now and then, the occasional winner will see the current situations as sufficiently different than the past that they opt for a new strategy. In other words the preferred algorithms will give way to new thinking and actions.

Stocks Are a Confidence Game

Almost every prognostication from brokers, advisors, and commentators in terms of the stock market were expansive. Two recent examples display the enthusiasm for the stock market are as follows:

Extrapolating the first full trading week suggests that the S&P500 will triple this year.

Goldman Sachs believes that the Bull market should run for another 3 years.

“Investors Intelligence” tracks letter writers in its latest report in Barron’s; 64.4% are bullish and only 13.5% are bearish. In approximately the same period the AAII weekly survey showed a significant reversal in their volatile report with the bulls declining to 48.7% from the prior week’s 59.8% and more significantly the bears gained to 25.1% from 15.8% the prior week. The AAII sample shifts each week which could have caused the changes and this week some were more worried about the impact of the bond market or were reaching to political news.

Commodities are Active

Based on perceived increasing demand from China and rising demand from US manufacturers, industrial metal prices are rising. In a classic example of a surprise, the price of oil touched $70 a barrel this week and there is a press story that some expect the price to reach $80 this year. In response, over the last four weeks the best performing mutual fund investment average is the Natural Resources funds, up 12.66%. As a contrarian and a long-term investor I am wondering when the increasing population and shrinking farming land will be seen in rising prices for grains. This hasn’t happened in a long time.

Very Long-Term Outlook

The latest available estimate of the global retirement savings gap in 2015 was $70 trillion and by 2050 it is estimated to be $400 trillion. Thus, in only 35 years there is a need for over five times more capital to be invested for retirement. (This is why I suggested using the 30 year yield for the spread calculation.) How should one invest to meet this long-term need? I do not believe that today one can evolve a consistent investment policy to meet these needs. My contrarian nature suggests that it may be easier to identify what not to do. The average S&P500 mutual fund beat 90 out 96 mutual fund investment averages for the last five years and 84 for the last ten years. I don’t think that will continue. The best performing hedge funds in 2017 were invested in large caps and securities driven by momentum (FAANG + 2 from China).  Different strategies at different times will be needed to avoid losses and achieve gains. This is why I believe that a portfolio of different funds or managers is the most prudent for the long-term.

Question of the week: What are the most prudent strategies for the long term?

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Reluctant Excuses: TINA to FOMO; Good News: Historical Trends to Apple Store; Accelerating Momentum: Incomplete - Weekly Blog # 505

Introduction to FOMO

Changing sentiment appears to be a much stronger force than earnings taking the stock market higher. A couple of years ago, investors reluctantly were buying equities in the face of expected rising interest rates, relatively slow earnings growth, and expected political turmoil. Their excuse for this questionable decision was TINA, There Is No Alternative. Over the last fourteen months this excuse has given way to another symbolic abbreviation FOMO, Fear Of Missing Out. During these last fourteen months and the first week of January, 2018, the S&P 500 has not had a single month decline. Momentum has become the mantra for the buyers as well as the larger audience of holders. In the last calendar year the leading investment performance factor within the S&P 500 universe has been the momentum stocks that gained 28.27%.

Will it Continue?

This week we had two very insightful experts publish their views of the year ahead with clues beyond. Byron Wien published his annual ten surprises that he believes have at least a 50% chance of happening and that his wide circle of global contacts believe have less than a 33% of happening. One of his surprises is that the market will take a 10% correction during the year. He thinks that a recession will not surprise us until at least 2019.  Further he recognizes that there may well be other surprises during the year that none are expecting. Nevertheless, one could interpret his views that stocks markets in general will be well behaved.

The second very worthwhile piece published this week was by Jeremy Grantham of GMO. Jeremy by nature tends to be on the bearish side. Thus it is a bit surprising that he entitles his piece “Bracing Yourself for a Possible Near-Term Melt-Up.” While he does acknowledge that we could have a 20% decline that he believes would be helpful, he also does not see a near-term recession. Like Byron he sees the S&P 500 as going well into the 3000 territory. B/t/w, his firm has an equity fund that is among the leaders in the institutional league.

The odds are that these two gentlemen will prove to be correct and I hope so. However, when I mention odds I am force to think of the lessons that my experience bought at the major New York racetracks which can be briefly summarized as follows:

1.  Past performance is good to organize one’s memory, but can be less useful in predicting the future.

2.  Each race (Market) is different with different horses and conditions.

3.  Different odds lead to different earnings.

4.  It is not the number of wins that counts, but the size of winnings taken away.

 5.  As a contrarian one can win more money by occasionally betting against the crowd.

Good News: Historical Trends to Apple Store

One of the reasons to own rather than loan is that over long periods of time human life is generally getting better. Most of the time we don’t get this message from our political leaders and their supporting pundits. If there weren’t problems to be addressed we might not tolerate governments and their expenses. Thus, we do not see a lot of publicity about the long-term progress we have made some of which from an article by Max Roser can be shown below:

·       Since 1990 there have been 130,000 people fewer in extreme poverty every day.

·       Globally in 1800 there were fewer than 100 million that could read. Today 4.6 Billion can read.

·       In 1800, 43% of the newborns didn’t see their fifth birthday. In 2015 child mortality was down to 4.3%. Improved health and nutrition has made us taller and smarter.

·       These and other positive trends are continuing and accelerating.

Part of the reasons for this progress is due to technology which marches to its own drummer. Technology itself is driven by the desire for increased profit. I refer to profit not in an accounting or monetary sense, but a desire to improve one’s own life, often to improve the lives of ones for which the individual cares.

This thought occurred to me this weekend when I accompanied my wife to the Apple Store at The Mall at Short Hills. It was by far the busiest store in the mall with both customers, salespeople, support staff, and in effect, trainers. It only took a little more than an hour to exchange her watch for a different model and synchronized it with her iPhone. During that time I had a chance to look at a very diversified group of customers waiting patiently to be served and an equally diverse sales and service group on a packed sales floor. 

What occurred to me is that we were experiencing an ecosystem which is building loyalty and a knowledge base both for customers and a helpful, well-trained sales force. In many ways each person in the store was looking for ways to improve his or her condition in a personally profitable way. (The visit made me happy that I have been a very long-term shareholder in Apple and reinforced my faith in their eco-system in spite of periodic hardware and software glitches.) 

The potential of Apple and its good competitors to deliver very useful products and services addressing many of our unmet needs suggests to me the rate of human progress will accelerate in the years ahead and will probably benefit my grandchildren, great grandchildren and their children.

  

Accelerating Momentum: Incomplete

In a market that relies on sentiment to drive its momentum, one can not wait on published financial and economic results. One should be paying attention to what consumers at all levels and investors are doing as well as saying. Recently I have been commenting on the AAII weekly survey of a sample of its members. As I have said previously, a normal distribution of the individuals' opinion is roughly 40% bullish and 30% each for neutral and bearish. This week the bullish reading exceeded 59% and the bearish number was about 15%.Two weeks ago the numbers were 50% and 25% respectively. Clearly a symptom of accelerating momentum

The siren of the rising stock market has not sucked in all the available money that is fearful of missing out. The banks (particularly the small and regional banks) have not lost cash deposits to the stock market. As a matter of fact, this week the average money market account dropped its rate to 0.30% from 0.33% the week before. The drop may be caused by less demand for loans or possibly that some banks were bulking up their cash items for year-end statement purposes.

Some market observers and I are carefully watching the yields on treasuries. Each major stock market decline had rising yields as money sought safety away from actual or perceived credit risks. Some feel a ten year yield above 2.50% could be alarming.

What to Do?

If economist Jeremy Grantham is correct that we are in a “melt-up” and there will be a 20% decline before the eventual recession which could trigger a bigger decline one may want to shift some of one’s equity positions into highest available quality. That would not have hurt you too badly in 2017 when the quality component in the S&P 500 gained 19.51%.

At this time large market caps with reasonable balance sheets yield above the ten year treasury. Not a great deal of actively managed investors and high market liquidity can be used as bond substitutes. Because we can always be surprised I would own a bunch of these. They may include AT&T, GM and GE plus a few others. If one becomes addicted to investing in quality stocks for the long run, there are more in the small cap arena than elsewhere, but these are for investing not cyclical trading.

Question of the Week: Do you agree or disagree with my analysis?     

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