Separating: Present, Renewals, & Fulfilment - Weekly Blog # 879

 

 

 

Mike Lipper’s Monday Morning Musings

 

Separating: Present, Renewals, & Fulfilment

 

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

 

 

 

 First Priority

Determining the motivation of the client and the account’s heirs is key to understanding the performance of most investment accounts. When asking the real investment account decision-maker about the driving motivation, it is often singular even though multiple other motivations are listed. (It often takes many discussions to reach the effective truth. Over time and changing situations the driving motivations may change.)

 

With most individuals, critical decisions are based on selected discussions with highly respected individuals, which may change over time due to changing circumstances. Most often these individual decision advisers are not revealed to the “hired hands” of the portfolio manager. All too often the unofficial managers express their opinions based on their own experience, which may have little relevance to the long-term needs of the account. These accounts are effectively managed by people known and unknown to the professional manager. Thus, the crucial job for the professional is to communicate effectively with those having meaningful influence on the account. Not an easy job.

 

The Second Motivation

The owner of the account should understand that there is a second motivation operating in practically all situations. The prime motivation of the investment manager is to continue the relationship with the present controller of the account, which includes the periodic renewal of the relationship. The relationship rests primarily on the communication skills of the manager in reaching the expected satisfaction level. This is a two-part job, where the first task is setting and updating expectations. The second task is delivering the expected return and communicating the proper expectation. This is again a two-fold job, with the first task satisfying the adjusted needs of the account in absolute return terms. The next part is where many managers fall down, the artform of selecting appropriate comparisons. This is where my biases enter. I do not believe a managed account should be compared to a list of securities selected by a manager. It should instead be compared to a fund portfolio with real expenses and diversification requirements, similar to the account itself.

 

The Most Important Motivation

Most of the money in the United States is managed directly or indirectly for “retirement needs”, which has lengthened over time. “Retirement” can include the institutional needs of academic, medical, and cultural institutions. What makes these accounts challenging is the receipt of money near term to meet future needs, which may not be well-defined in the current period.

 

Currently, the biggest hurdle in managing long-term money is the new economic/financial situation, which is different from the recent past. Most of the time change moves relatively slowly, which allows the participants time to adjust their actions to the pace of change. However, there are some brief periods of even more rapid change where it is difficult to catch up and adjust to the radical changes. I believe we have entered such a period and expect to have more difficulty predicting the future. For a period, we will likely be out of step with the fundamental changes likely to occur.

 

What is Changing?

The following elements of change surfaced last week.

• Weekly S&P sector performance: S&P Finance +2.80% vs -4.01% for S&P Tech.
• Goldman Sachs will soon cut 3-5% of its Vice Presidents.
• Schroders will lay off 200 employees to refocus and improve profit margins. They will also cut their Executive Committee by half, which is 44% family owned.
• There are $3 trillion ageing and unsold private equity deals. (Retail investors are taking risks in Private Equity that exceed public investing protections.)
• The US has not seen so much restructuring in the Federal Government, Corporations, Energy, and Retail since the Depression.
• The AAII weekly sample survey’s 6-month bullish prediction is now 19.3% vs 57.3%. (The lowest I have seen, which is often wrong at turning points)
• Global financial communities are developing new instruments that can be leveraged.
• With copper and coffee commodity prices going up, I am not surprised the Fed is holding off on lowering interest rates.
• There is probably more to the reluctance in naming a bank supervisor than we know.

 

We know that history does not repeat (exactly), but it does rhyme. There is an incomplete comparison one could make with the 1930s, but I hope it isn’t so.

 

 

 

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

Mike Lipper's Blog: Reality is Different than Economic/Financial Models - Weekly Blog # 878

Mike Lipper's Blog: Four Lessons Discussed - Weekly Blog # 877

Mike Lipper's Blog: Recognizing Change as it Happens - Weekly Blog # 876

 

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Current Investments for Future Results

Introduction

In our job as professional investors for others as well as personal stewards for ourselves and families we do something today that we want to have a good result in the future. This is easier said than done. To accomplish our goals we need to answer at least two basic questions: 

What are we doing?  Which future?

To help answer these questions, we should be asking ourselves on which time period are we focusing. We have created at least four time spans to put the answers into perspective. These four slices go from:

1. The immediate as defined as the next two years,

2. The following five years to replenish spent capital,

3. The succeeding ten or more years to address longer-term needs for the current decision makers, (endowment issues) and

4. Future periods to aid fulfilling the legacy of the grantor and his/her succeeding generations.

This weekend I seek to apply the items that cross my information screens to appropriate investment time spans.

The current period

To meet current and near-term needs we assume that we can convert our present investments to cash for either spending or repositioning. Too many investors look entirely to current prices and economic conditions. As someone who has grown up in the investment business, I am concerned that the changing structure of the marketplace is not being considered. What I add to my decision process (and what is missing from many strategies today) is a focus on liquidity.

The real price

Portfolio managers and analysts can learn a lot from professional traders. Traders will tell you that a stock or a bond is worth only what it can be sold for. Far too many investors use the last published price without understanding the conditions that led to the price in terms of the relative balance of supply and demand. Quite possibly because of changes of capital on trading desks or floor participants the last published price is quite stale. This is particularly true if you are a potential seller with an over-sized position. A current example of this is the recent drop of 6% in three minutes for shares of Apple^*. According to some, the sudden drop was caused by one or more major players that used algorithms to significantly reduce over-sized positions in tech stocks.

Investment committees have regularly received reports on what specific days to liquidate positions based on average historic volume. Traditionally these reports are meant to show how quickly cash can be raised. Sole reliance on these reports is dangerous. First, liquidity is very much a function of the current desire for the security. Second, increasingly more volume is transacted off the floor than on it and there is no real floor for bonds thus the published volume figures are more an artifact than accurate. I wonder when looking at liquidity whether one should follow the dictum of US Supreme Court Justice Potter Stewart in ruling as to what was pornographic or not: he said he would recognize it when he saw it. To reinforce my skeptics’ view on liquidity let me use the extreme performance of Precious Metals mutual funds as an example.

In the week ended on December 4^th the average Precious Metals fund was off -4.66%, the worst of the 30 equity funds groups tracked. However in just four weeks including the December 4^th period, the average Precious Metal fund was up +10.47% which was the best of the equity fund averages. I would suggest that the fundamentals did not change that much in those four weeks, but the market did.

Another example that attitude changes greater than fundamental changes is the price and volume in the week for the stock of T Rowe Price^*. On December 1^st it closed at $82.61 on reported volume of 753,104 shares. On December 5^th the closing price was $84.49, down slightly from its day high of $84.88 on 1,105,152 shares.

One of the Republican SEC commissioners has expressed concern about the liquidity in the bond market when interest rates start to gyrate. I believe her concerns are well placed.

The focus on liquidity is of particular importance when investing for current returns in the first or operational time span portfolio. If due to spending requirements, securities will need to be cashed-in at the same time as liquidity shrinks, the quicker the near-term portfolio will be exhausted and need to be restored by the replenishment portfolio.

Replenishment portfolio

A well thought-out piece by Marcus Brookes of Schroders Investment Management begins with the following sentence. “We end 2014 with almost every asset class offering investors scant potential return for their risk.” In looking how to build a successful replenishment portfolio I suspect that at some point over the next five years the need to earn a real return adjusted for credit risk will become apparent through a market decline. Having issued this warning, it does not relieve investors of the need to build and manage a replenishment portfolio. While many investors talk long-term they walk short-term by managing their investment against a one to five year time horizon. Under those constraints there is little room for long-term bonds or stocks that are dependent upon substantial new products or massive turn arounds.

While it increasingly looks like we may get a bout of enthusiasm, one would be wise to upgrade the quality in the replenishment portfolios even though during a speculative phase they will probably under-perform, but they will sink less when the eventual significant decline occurs. Moody’s^* is recognizing that “corporate credit has become more risk averse, while the common equity market has become more tolerant.” Surviving investors normally bet with the fixed-income markets, while the traders with the stock market. Both can be correct using their preferred time periods of five and ten years for the investor and quarter, half, and full year for the trader. 

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

Legacy investing

Very long-term portfolios are often a mix of companies that benefit from sustainable demand based on demographic and geographic changes as well as disruptive companies. This somewhat hedged mix assumes that there will be evolutionary changes as well as revolutionary changes ahead. The first group of investments should provide sustainable income and capital growth until their mistakes or the disruptions created by the second group of companies hurts them. The failure rate of the second group will be high as they will lack the management skills needed to leverage their disruptive power. The first group will have fewer failures but they will be more painful with less chance for full recovery.

The 85 most disruptive ideas since 1929 were recently published by Bloomberg Business Week in celebrating its 85^th birthday.  One could probably devote an entire business school education trying to understand the power of the 85 disruptive ideas and how few of their inventors or developers produced lasting fortunes. The first three are good examples of the tenet that early inventors and early investors don’t get the major benefit of their disruptive talents. The three are the Jet Engine, the Microchip, and the Green Revolution.

We do not invest in Venture Capital funds to participate in the invention of products and services. Sometimes Private Equity is the way to go as developers build out to an eventual exit strategy. We prefer to use mutual funds which invest in the users of the disruptive forces unleashed in a way that can be leveraged to the benefit of both customers and shareholders.

Conclusion

Pick your time period for judging investment success and that should direct the composition of your portfolio. If you need help, email me.

__________    

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How to Survive Banner Headlines

Introduction

Investors and the public in general tend to believe in big headlines and invest in the direction of the headlines. Often this is a mistake. On the front page of The Wall Street Journal last week there was a five column banner headline trumpeting “Broad Gains Power Historic Rally.” A sub headline stated that for the first time since 1993 that six closely watched indexes rose in the first half of the year. (The indexes were two from Dow Jones - DJIA and Commodities; two from MSCI - World Stocks and Emerging Markets Stocks;  as well as indexes for Gold and Bonds.)

The financially sound investor would quickly point out that the flow into tradable elements was caused by people getting out of cash money. Institutions and individuals were recognizing that excessive borrowing to meet or prolong deficits and the central banks manipulating interest rates has caused a twenty year recognition that in today’s world cash is trash.

Those of us who have any knowledge of how people (particularly investors and voters) react will recognize that when there is a large imbalance of opinion that the majority will win for a relatively short while to be followed by major disappointments. Such may well be the case this time.

How do I know? Years ago I learned from a very sound investor who happened to be one of my accounting professors that I should read financial statements from the back forward. I should spend as much time reading the footnotes and auditor’s certificate as I would in reading the CEO’s comments even though the CEO’s comments were designed to be more easily understood. I suggest that all who wish to be informed and to have the ability to change one’s views to read the small articles at the end of the pages in most newspapers. If you do you might come up with what I am seeing.

Bits of information important to me

1.      In the last week the average interest rate paid on bank deposit accounts (MMDA) went from 0.37% to 0.43%. In most weeks there is no change or only minor moves of .01%. This 16% move could be for some technical reason or could be that banks, mostly retail banks, are starting to make loans and need more deposits.

2.      The five month increase in CCC (low credit quality) loans is up 17.2%.  At the same time there was a decrease in high quality loans being sold.

3.      Moody’s ^* is concerned that the combination of below trend profit growth and above trend borrowing will lead to an increase in defaults.

4.      Two very respected investors from quite different vantage points, Stephen Roach and Wilbur Ross, are worried about too much easy money. Steve is one of the leading experts on investing in China and Wilbur Ross has had a very successful career investing in distressed securities both in the US and elsewhere.

5.      Bank for International Settlements (BIS) which is the international bank that provides credit to banks globally is warning about “euphoric markets.”

Applying concerns to portfolios

As a professional investment advisor I need to be concerned each day as to how the accounts that I am responsible for are positioned. In almost all cases these accounts must be in the market to meet their long-term needs. Today, with interest rates in the range of perceived long-term inflation, (if not lower, as shown by the WSJ banner headline), the bulk of the accounts are balanced accounts with a preponderance in equities.

Regular readers of these posts have learned that I am worried about a major, once in a generation, drop in equity prices. Up to now I have been focusing on stock prices to generate sell signals. Increasingly I believe I should focus much more attention on fixed-income markets. The triggers to the last major declines were caused by the failure of Lehman Brothers ability to finance itself and the widespread fears of residential mortgage defaults. These were fixed-income problems that severely impacted stock prices.

I want to learn from other investors and investment managers. This is why I prefer in most instances to invest through funds managed by bright people. This week someone sent to me a copy of Schroders^* latest investment letter. In the letter Schroders divides its outlook for the future of its accounts into scenarios. The most probable is an extrapolation of present trends. However, the letter mentions seven other scenarios which could be important. I have listed them in order of their probability according to Schroders:

• Capacity Limits
• G7 boom
• China Hard Landing (Steve Roach believes the increasing codependence on China could hurt the US if we don’t come to a better relationship.)
• Secular Stagnation
• Eurozone Deflation
• Trade War
• Russian Rumble

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

While each of these could be the problem that sets off the market decline, to me the key is the proportion that Schroders gives to the most probable outcome, the essential “muddle through” scenario which is at 65%.

Why I am limiting equity exposure

Coincidentally because of my concerns after five good market years and below average economic years, I think it would be wise to limit equity exposure in a conservative balanced account to 65%. While I expect we could have one more major, almost skyrocket selected stock price move, I would be moving lower in terms of equities, if I could find some reasonably safe fixed-income alternatives producing above inflation rates of return.

The equity exposure mentioned is for those accounts that will have funding responsibilities in the next five years. Longer-term accounts could selectively be higher, except I am beginning to worry about long-term endowment type accounts. In the past I felt that this account should be invested all in equities as the best way to get the benefits of disruptive technology and favorable demographics. I am beginning to worry that pricing competition could be too fierce. 

In terms of demographics, I believe that the US will accept more legal and if not illegal immigration. My concern is as to the quality of our young labor force today. I find it disturbing that in the US Army’s reported view, only 29% of the population could be accepted. (I don’t know what the experience is for the US Marines, but we only wanted “the few”). Without the right people our long-term returns will not match our needs.

Please share with me your views.   

__________________

Comment or email me a question to MikeLipper@Gmail.com .

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

Copyright © 2008 - 2014

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