Showing posts with label Security Analysis. Show all posts
Showing posts with label Security Analysis. Show all posts

Sunday, August 10, 2025

DIFFERENT IMPLICATIONS: DATA VS. TEXT - Weekly Blog # 901

 

 

 

Mike Lipper’s Monday Morning Musings

 

DIFFERENT IMPLICATIONS:

DATA VS. TEXT

 

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

 

 

School Solutions

As taught academically, the critical pivots in teaching both economics and security analysis are the numerical changes of a data series. However, as a long-term investor I am much more interested in the mood changes hinted at in textual renditions. While data precisely represents the past, text allows the reader/student to think about one or more different futures. This is why I believe philosophy or similar courses should include both economics and security analysis in their teachings.

 

Below is a brief listing of several data points describing last week (Implications italicized and discussed in parenthesis).

  • Year-to-date Stock Transaction Volume: NYSE 7.11% vs NASDAQ 37.30%

(Five times greater in the younger, more speculative market, even if some of the NASDAQ is inventory swapping among dealers. Speculation normally leads to extreme up and down prices)

  • Inflation Signals: The ECRI Index tracks industrial prices weekly and it normally moves gradually. Last week it rose +1.70%.

(I believe this was in response to the tariff news at the end of the week. Some market participants believe there will be industrial price increases soon).

  • Participants in the AAII sample survey are increasingly worried about a down market in stocks, but others are not.

(Comparing the bullish and bearish projections of last week with those 3 weeks earlier. Bearish projections rose to 43.7% from 34.8% 3 weeks earlier. Bullish bets only rose to 34.9% from 33.6% for the same period, suggesting bears see reasons to be worried while bulls do not. Only one will be right over the next six months.)

  • Equity mutual fund peer group averages +10%. Only one US Diversified Fund (USDE) peer group average has generated returns exceeding 10% year-to-date, multi-cap growth funds. Forty other peer groups have generated returns exceeding +10%, although they were less diversified.

(USDE Funds hold more assets than the other peer groups, which suggests being a holder of US equities was not a winning hand for most.)

  • Investors need to be careful that the earnings reported are not accounting constructions. The London Stock Exchange Group (LSEG) and I.B.E.S. estimate that the S&P 500 Index will report a +8.3% gain for the 3rd quarter. However, they further estimate that corporate net income will rise only +6.3% for the quarter. Thus, 24% of reported earnings will be attributable to buybacks and other accounting techniques.

(Investors need to understand what they are paying 20x-earnings or more for. Hopefully, operating earnings can be repeated while earnings created through accounting cannot.)

 

Conclusions:

There are lots of reasons to be cautious. Some reserves should be considered a hedge for future down markets. However, this hedge should be viewed as a temporary buying reserve until prices more appropriately reflect the long-term value of accepting normal risk.

To aid future generations of investors as well those today, security analysis and economics need to be taught with a fuller understanding that it rests on the strength of ever-changing language.   

 

 

 

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

Mike Lipper's Blog: Rising Risk Focus - Weekly Blog # 900

Mike Lipper's Blog: Melt Up Not Convincing - Weekly Blog # 899

Mike Lipper's Blog: It May Be Early - Weekly Blog # 898



 

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Sunday, March 23, 2025

Odds Favor A Recession Followed Up by the Market - Weekly Blog # 881

 

 

Mike Lipper’s Monday Morning Musings

 

Odds Favor A Recession Followed Up by the Market

 

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

 

                             

 

The Art of Security Analysis

Security analysis uses science but is not science. Using past statistical history of up vs. down markets, one can calculate the odds of a down market. The odds suggest something along the lines of one down-market for four up-markets. This math does not tell us anything about the amplitude of the next up and down phases. Where the art comes into play is searching past cycles to measure the varied amplitudes and more importantly the probable causes. Market moves in the minds of market participants are often tied to economic, financial, political, climate, and other elements. There is a human need to explain phenomena, so it is natural that in most cases investors and others attach some non-market element as the cause for the moment. In truth, while it is comforting to label the movement as being caused by some external force, no two market moves that are exactly alike. We cannot absolutely prove the cause with any certainty.

 

While professional analysts look at many causes, they are not really called on to make a judgement as to what is the next element that causes the movement. Thus, professional analysts often rely on the irregular rotation of up and down-market phases in commentary. Based on this principle, I am turning bullish because I believe for whatever reason we have entered a down-market of some unknown amplitude, which will be followed by an up-market, again of unknown amplitude. History suggests, at least in the US, the odds favoring a larger gain than the prior loss. To provide comfort, analysts attempt to find reasons to support this belief, which I will do without the absolute confidence I have found the motivating force of the eventual bull market. (Subscribers are encouraged to suggest other drivers.)

 

Too Much Weight on One Side

In one edition of a supposedly learned publication, there were three articles published with the headlines listed below. What are the chances the Financial Times is wrong?

  • “How Low Can the Dollar Go”
  • “Trump lunches full-scale assault on American elite”
  • “An all-out assault on the rule of law”

Is there any connection between the authors and editors? This concerted view reminds me of the British Crown after they outlawed slavery commercially while British merchants supported the US Confederacy. Did their support have anything to do with the import of US cotton to fill their clothing factories?

 

The Future

It seems commercial motivations override political principles, which is true today. While politicians throughout the world are concerned about factory employment, they do not favor the economically larger consumer marketplaces. I find it interesting that the two largest consumer markets are China and the US, which don’t have politically powerful unions representing them!

 

On this side of the pond, Barrons Weekly published the stock market performance of 28 national indices showing 14 European countries leading as well beating the US local markets.

 

In the US it was the first week our indices were up a bit. However, it was not true for the bulk of our stocks. Friday’s gain, particularly on the NYSE, probably had more to do with the expiration of options.

 

By definition, a stock owner is future oriented and usually expects others to pay higher price/earnings ratios for their stocks in the future. The depth of the bear market will depend on whether P/Es’s hold and if their prices decline in line with earnings or rise in a cyclical recession or collapse in a structural one. I don’t know which type we will suffer, although many of the current administration’s moves appear to be more structurally focused.

 

The World keeps on producing products and services that have the potential to change economic patterns. Three recent products come to mind:

               *New lower cost airliners

               *BYD’s fast charging batteries

               *Florida’s leading the way to lowering property taxes

What do you think?    

 

 

 

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

Mike Lipper's Blog: “Hide & Seek” - Weekly Blog # 880

Mike Lipper's Blog: Separating: Present, Renewals, & Fulfilment - Weekly Blog # 879

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



 

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Sunday, October 11, 2020

Are We in Boiling Water? And Understanding Value - Weekly Blog # 650

 



Mike Lipper’s Monday Morning Musings


Are We in Boiling Water?  And Understanding Value


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




Where are we (in the market)? Many of us have traveled with impatient children that too frequently ask “are we there yet?” What they should be asking is, where are we and what difference does it make? Plenty. This is where a frog and a pot of water is useful. Placing the frog in a pot of cold water will be greeted by the frog jumping out. Place the frog in mildly heated water that is a comfortable temperature and the frog stays put. If you raise the temperature slowly the frog is not conscious of the slowly rising temperature until it reaches a boiling level, which kills the unfortunate frog.


In terms of the current US stock market expansion measured by the popular indices, is the temperature rising? There is some evidence from the last four weeks that we should be getting ready to jump out of the market indices led market. Over the past four weeks ended October 8th, the average S&P 500 Index fund gained +3.31%. This compares to gains of +4.35% for the average Large-Cap Growth Fund and +5.60% for the average US Diversified Equity Fund, comprised of 7,336 funds. Earlier in 2020 index funds were clearly in the lead, for three reasons:

  1. They were fully invested and thus had no retarding cash
  2. They had no brokerage and other operating expenses
  3. They had a large commitment to information technology stocks


What is causing the change waking up us frogs? Both brokers and the media need investors to transact to meet their commercial needs. Considering that in the current year we had a record decline and recovery in terms of annual rates of change. As this is unusual, it generates nervousness. In September the shrillness of the political campaigns upset some investors, causing them to question whether their current investments will serve them well in the next couple of years. 


Turning to specific concerns, the final publication of the majority report from a House Committee advocated for a new type of anti-trust legislation that would splinter large info-tech corporations. Evidence of these concerns can be found in the short positions of the tech heavy NASDAQ market, which rose 3%. This compares to the short positions on the NYSE, which rose only 0.5 %. Volatility has risen over the last three weeks compared to levels a year ago. The performance of the NASDAQ Composite has led the Dow Jones Industrial Average (DJIA) and the S&P 500 for some time, but it is no longer the clear leader.


Getting Ready to Jump to “Value” Stocks

Advocates of change are reducing exposure to tech in favor of adding to “value”. As with many labels, it covers a wide range of different types of actions and securities and could well be jumping from the “frying pan into the fire”. In terms of the professional academic literature, the earliest text I know about was titled “Security Analysis” by Benjamin Graham and David Dodd, who were professors at Columbia University during the Depression. The book was so successful in academic circles that it went through five editions. I was extremely lucky, as I took David Dodd’s Security Analysis course toward the end of his distinguished career. 


In reading his text in class, it became clear that he was describing value as liquidating value. This was a very good way to make respectable investment returns starting in the depression. Remember, this approach was that of an academic, not a business person, so there was reliance on published financial statements. As students, our first task was to recast the balance sheet by revaluing the assets and liabilities. The critical key to the analysis was to value the preferred shares and debt at their current market value, not their stated value on the balance sheet. Furthermore, assets were revalued to what they could bring in a quick sale. This meant that only finished product inventory had any real value and that was subjected to a discount. Plant and equipment were assigned little to no value. The next step was to augment the balance sheet with undisclosed assets and liabilities, including items such as leases, rights-of-way, and the net value of pensions. This type of analysis led to the conclusion that some bankrupt companies could be worth more than the lackluster common stock price. This type of analysis allowed Graham and Dodd to buy and liquidate companies in their fund.


Max Heine, founder of Mutual Shares, and Ruth Axe, founder with her husband of the Axe Houghton funds, did similar operations of railroads. Axe Houghton at one point controlled the Missouri Pacific Railroad by being the dominant holder of a cumulative preferred issue, which had not been paid dividends for many years and had to be paid off before the railroad could be sold with its attractive right-of-way real estate assets. (In a similar way, as a small investor I participated in a defaulted cumulative preferred, which over time was gaining voter control of the board of Pittsburgh Steel.) The key point of this deeper understanding of “Value” is that one does not rely on published balance sheets, but uses them as a beginning to find other assets and liabilities to recast a more realistic picture.


“History Does Not Repeat Itself, But It Does Rhyme”

In some respects the search for attractive value investments may be similar to the period of Graham & Dodd’s depression analysis, at least in questioning book value as shown on published balance sheets. There have been many accounting rules changes, but a few things remain the same. In most cases land is carried at cost and buildings and equipment are carried at depreciated value. While at this point in our recovery I don’t know what the future will bring from the pandemic, my working assumption is that WFH (work from home) will reduce the number of people in office buildings and will likely impact the value of the buildings. There may also be less value in being in major cities. (I do recognize that some of these properties may be successfully repurposed, usually by private real estate people.) We have already seen a remarkable shift in the use of equipment to produce masks and similar products. Nevertheless, I question whether that will be the case in the new era.


This Week Brought an Example of a New Right of Way Deal.

The Missouri Pacific example of using the right of way real estate value to generate a higher than current market price still works today, but in a different form. This week, Morgan Stanley announced they will acquire Eaton Vance with a combination of stock and cash, at a 40% premium to the price it was selling prior to the surprise announcement. In some respects it was similar to depression type value creation. Eaton Vance is one of the oldest mutual fund management companies, starting life as the principal underwriter for the first publicly traded mutual fund, Massachusetts Investment Trust. It later started its own funds and through a Boston merger entered the investment counsel business. Over the years it raised money through sales to various brokerage firms and investment advisers. In recent years, it was successful in developing imaginative fixed income funds and low-cost index portfolio products. 


These distribution relationships were not on their balance sheet, but was what Morgan Stanley found attractive. (Morgan Stanley itself is the largest brokerage firm using Eaton’s funds.) Morgan Stanley found that 95% of Eaton Vance’s sales were to US and Canadian clients. They were under distributed internationally, which is where Morgan Stanley has considerable strength. There is another element that makes this merger attractive to the acquiree. The CEO of Morgan Stanley publicly announced that he was wrong to have sold Van Kampen, another fund management company with a strong distribution organization. Morgan Stanley also sharply curtailed its capital absorbing fixed income trading a few years ago.  They will be using a limited amount of its accumulated capital for this deal. All companies make mistakes, but few admit to them. I believe a former “sinner” is more likely to be a good partner in the future.


There are a couple of additional personal pluses to this deal. In the development of my own firm, when we generated sufficient capital beyond our operating needs we began investing in our clients. The main purpose was to avail ourselves of a shareholders’ view of our clients. In 1981 I purchased some shares in Eaton Vance for the firm. Luckily, when Reuters acquired our assets in 1998 they did not want our small portfolio, as they did not see the intelligence value of the holdings. Thus, today we are the pleased owners of a few shares that cost under 9 cents a share due to splits. (To demonstrate that it is better to be lucky than smart, over the years we have sold some of these shares for other portfolio operations.) As a member of a number of investment committees, I believe long term ownership of reasonably diversified portfolios of common stocks to be very capital productive over a long period of time.


Concluding Thoughts

We may or may not be at a pivot point in the stock market. If not, it is only a matter of time before performance leadership changes. At that point, some of the leadership will be labeled value. However, I believe future success in terms of stock prices will not be based on published book value. Attractiveness will be the result of finding unrecognized assets and ways to reduce liabilities. So, Professor Dodd will once again be correct.  




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

https://mikelipper.blogspot.com/2020/10/what-is-nasdaq-saying-to-whom-weekly.html


https://mikelipper.blogspot.com/2020/09/there-is-incredible-shortage-weekly.html


https://mikelipper.blogspot.com/2020/09/headlines-excite-dictate-or-respond-not.html




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Copyright © 2008 - 2020


A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.


Sunday, May 31, 2020

Investors Can Learn from History, If Diligent - Weekly Blog # 631


Mike Lipper’s Monday Morning Musings

Investors Can Learn from History, If Diligent

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



Most memories are summaries of what people think happened and these memories over an extended period become enshrined as facts that are used for future investment decision making. Current investors are under the impression that “history” favors “value” and “Goodbye Globalization”, without being fully conscious of the history that created these impressions. Upon further study, one would realize that the underlying history is more nuanced and complex.

Value vs. Growth
We like to use short labels to cover complex situations. For example, we use the same label for both a company and its stock price, which often go in different directions. A company’s growth is essentially dependent on increasing sales and possibly its earnings, whereas stock prices are the result of buyers and sellers, often evaluating the stock in relation to other investments. Daily stock prices make them easy to rank from best to worst performance for each time period, which probably has little predictive power for long-term investing. Nevertheless, some investors search through the poorer performers looking for turnarounds, fitting with a part of the American psyche that likes to cheer for the underdog. Many investors who have missed being heavily invested in different forms of growth are now cheering the long-awaited trend of “value” beating “growth”, at least for a period.

I believe the first textbook publishing of Security Analysis by Ben Graham and David Dodd was written during the Depression in the 1930s. (The first was an adjunct professor and the second a full professor at Columbia University, which twenty years later suffered having me in his class.) Their approach, both in class and to some extent in their practice at a successful closed-end fund, was to find a security selling at a substantial discount to their analysis of value. What worked for them and others like Ruth Axe and Max Heine, was looking at distressed bonds and preferred shares using this approach.

The first thing the good professor taught us was to reconstruct the balance sheet by discounting finished inventory by 50%, work in progress by 100%, and raw materials by 75%. In the same fashion we reduced the value of physical assets to our estimate of quick resale prices. We wrote off all intangible assets and what was left of the underlying equity (more on this later). Comparing our new estimate against the depressed price of the senior securities became our initial estimate of value. During the 1930s and into the war years, this led to some very successful investments in railroad bonds and preferred shares. In effect, what we were taught was the rapid liquidating value.

Today, Merger & Acquisition activity has become the main determiner of value. Instead of determining the liquidating value, the acquirer is interested in what accountants call the going concern value. However, the acquirer often writes off some of the assets, adds the cost of expected layoffs, and determines an estimated increase in earnings based on “better” management and new opportunities from existing assets. I suspect that in the acquirers view of the future there is no estimate for a down period or the reactions from competitors.

M&A driven prices create an accounting problem, because after accepting the remaining costs of fixed assets transferred to the new balance sheet, an amount must still go to the consolidated balance sheet. Some of this gap can be labeled as the value of intangibles, such as customer lists and patents. However, even with these additions there is typically still a gap labeled “goodwill”. (I was the beneficiary of this math when I sold the operating assets of my data business, a service business who’s price was substantially above the value of the physical assets sold.) This is where the fictional portrayal of balance sheets and  book value come into the picture.

For publicly traded companies, “goodwill” and other assets cannot be written up but can be written down if there is clear evidence of loss of value (a non-cash charge which lowers reported earnings). The CFA Institute notes that private companies can write off goodwill over ten years and there is a movement to allow publicly traded companies the same privilege. In an article they pointed out that there are 25 corporations that have between $28-$146 billion of goodwill on their balance sheets, including Berkshire Hathaway, CVS Health, and JP Morgan Chase. In my case it would be difficult to write off the goodwill from the transaction, as they continue to use the name and basic calculations for the statistics. As the acquirer continues to have many of the same clients after a sale 22 years ago.

I believe too many investors lump “value” stocks with cyclical stocks, which is why they have been greeted by poor performance for over ten years. Most of the world’s economies have grown during this period due to increasing services revenue growth. Over the same period there have been relatively few goods and materials shortages. Prices of goods, particularly manufactured or natural resources, have not kept up with inflation.

In our fund selection process we like to find true value stocks that show substantial discounts from their intrinsic value. These tend not be economically sensitive and are found infrequently. Most of what others call value, are cyclical stocks selling at the low point in their cycle. Typically, their stock prices rise when shortages appear, often when large competitors drop out or the demand level shifts in their favor.

There is a difference in when to sell a true “value” stock versus a cyclical stock. One completes a trade when the discount disappears in the value stock price. Cyclical stocks should be sold when the investor believes the demand for a company’s product or service is peaking. My own way of timing this is to watch commodity prices and commodity fund performance. We could be entering a more favorable period for cyclicals as 66 of the 72 weekly prices tracked by the WSJ were up, but most commodity funds did not rise, except for those invested in energy.

“Goodbye Globalization”
Goodbye Globalization is the headline in a recent edition of The Economist. This magazine is in the running to replace Time and Fortune magazines as excellent negative indicators. They do not know their history, countries and companies that build fortresses by gathering all needed resources within their walls have proven to be builders of self-inflicted prisons, with high costs and lowered productivity. History suggests that even during wars, opponents trade with each other through third parties. In WWII, the relatively easily conquered Sweden and Switzerland were left unoccupied to serve that purpose. Even when the US was clamping down on an increase in Japanese car imports, they still came in through factories in Mexico and Canada.

But the real historical lesson happened in the 15th Century, within those one hundred years created the “new normal” that guided economic and political trends until the late 18th century. During the 1400s the new young Emperor of China decided to recall its very powerful ships from the Mediterranean, India, Africa, and possibly America, before destroying them. At the time, China was the most advanced country in terms of science, gun power, and business structures. China has still not recovered from that decision and this is one of the reasons for China’s leadership moves today.

By mid-century the Ottoman Turks captured Orthodox Constantinople, turning it into the Moslem dominated Istanbul, enabling them to challenge Eastern Europe. An event that has effects even up to today.

Finally, by the end of the century there was the discovery of the misnamed America. This led to the extraction of Latin American gold which turned the European economy positive and the investment opportunity that the US proved to be.

The lessons to be learned from the 15th century was:
  1. Adam Smith in his book titled "The Wealth of Nations" showed the benefit of countries/companies specializing to get economic advantage through world trade.
  2. Fortresses become prisons, eventually.
  3. Often, new critical stimulus come from outside the recognized ecosystem.
It would be difficult not to be a global consumer and investor today, it would deprive us of a better life.

Good News
In April we saw some individual mutual funds and mutual fund management companies having positive net inflows. The winners had particular selection skills rather than being focused on sector section. Much of the inflows came from institutional or retirement investors. In brief discussions we heard that the trends seen in April continued in May. Nevertheless, on an overall basis equity products had net outflows, but larger amounts went into fixed income investments. Being a contrarian suggests to me that once the risks of higher interest rates and inflation rates become more pronounced, we are likely to see substantial equity inflows that can absorb the actuarially driven outflows.

Any thoughts? Please Communicate.



Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2020/05/mike-lippers-monday-morning-musings_24.html

https://mikelipper.blogspot.com/2020/05/time-to-review-investments-weekly-blog.html

https://mikelipper.blogspot.com/2020/05/top-down-sells-bottom-up-pays-weekly.html



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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.

Monday, May 31, 2010

On Memorial Day,
and the Future Leaders of the
Investment Community

On this Memorial Day weekend my first thoughts turn to the ordinary people who have been our extraordinary heroes and heroines, who gave their lives and bodies so that we can be free of imposed dictatorships. One of the characteristics of wars and most conflicts is that they are battles between offense and defense. Rarely can one succeed without relying on both sets of skills.

CAPITAL WARS

As I write this blog, I am exercising my freedom to think about the war for the survival of our investment capital. Military wars have alternating offensive and defensive phases which often pivot on the success or failure of both new technology and more importantly, new applications of human behavior. Think about the language in the press, quoting many participants throughout 2008 and during this month of May, 2010. Frequently one reads about someone saying that they were “killed” or “mauled” by the fall in the market, and more recently by sharp spikes. The terms of war appear to be appropriate in describing this battle for the survival of our investment capital.

LEADERSHIP

Wars are won and lost by exceptional leaders and by using resources more intelligently than the opposition. Often the battle leaders have something in their background that one can point to as common among them. There have been a couple of graduating classes at West Point "where the stars fell." The leaders (generals) from these classes led us through our bloodiest wars. I had the distinct honor and good luck myself to be the member of an extraordinary class in the US Marine Corps’s Basic Officers Class. Out of a class of six hundred peacetime Marines, we had six members who became general officers, including a future Commandant and another four star general. (I believe that this was the first time the Corps had two four star generals at the same time.) In addition to the military success story, my class also included a number of very successful civilians in many walks of life. With this as a background, the members of this blog community will not be surprised to learn that I have been an analyst of leadership for most of my adult life.

BOND MANAGERS

As the background of leaders change, so does the way battles are fought. Until recently, the investment leaders were either solid, surviving investors or were salespeople who could deliver good investments. Since the 1930s the Bible for professional investors has been Graham & Dodd’s Security Analysis. I had the distinct honor to study under Professor David Dodd, and more importantly, Warren Buffet studied with Ben Graham. The original text and the six later editions discussed the various ways to make sound investment decisions. To the best of my recollection there was nothing about how to place or execute securities transactions. For the next couple of generations, equity analysts trained to become portfolio managers, who gave buy and sell orders on the various stock exchanges to “clerks” to execute. Over time these so-called “clerks” became professionals in their own right and some were admitted to ownership of their firms. As is often the case, the bond market was ahead of the stock market. Bond portfolio managers sat on the fixed income trading desks. Bonds trade largely in the over-the-counter market of occasional limited liquidity and discontinuance prices. Bond portfolio managers added or subtracted value due to their trading skills. As a student of fund performance I have seen that the relative performance results of a bond manager has more to do with making correct trading decisions than correctly anticipating interest rate moves.

RISE OF TRADING

In response to the growing professionalization of trading beginning in the 1990s, I started to see the hiring of traders as portfolio managers initially by and for hedge funds. These traders were often well trained at various hedge funds and proprietary desks of brokerage firms. In a vast over-simplification, the traders knew what was moving and they believed that a stock was only worth what it was selling for, not a discount from some future value. As these traders became more successful (and for political reasons the community was destroying the quasi-monopolistic power of its center), the skills of traders became more important. Various new market centers were created, both as exchanges and private markets. One of the keys to their success was the speed in which they could trade. The speed of trading depends on the speed of information transfer so trading technology has become critical.

TRADING OVER INVESTING

As the equity world woke up to this change (similar to surface ships recognizing the risk from torpedoes and aircraft), the intellectual leadership began to change. Instead of hiring liberal arts majors who could “think” and develop models of future values for companies, they hired PhDs with math and physics backgrounds. These “rocket scientists” from Caltech, MIT and Carnegie Mellon among other schools, became the bonus babies for “The Street.” (Bias is showing in that I am a trustee of Caltech, MIT bought mutual fund data from me years ago, and I have a freshman nephew at Carnegie Mellon.) The tasks of the rocket scientists were to determine the likely trajectory of the missile, (in this case, the next price) and intercept it for a brief moment. They were being wired to make very rapid, small, frequent gains or cutting their losses very quickly. As this kind of thinking became the dominant market leadership mode, I saw major changes in relative fund performance leadership. Due to the intraday induced volatility, trading added more than investing in many instances.

TWO EXAMPLES

Some great past performance leaders did not master the new art. I saw a similar thing happen in the market break in the late 1960s, where two performance leaders had similar spectacular performance on the way up and very different on the way down. While they owned similar and perhaps identical positions, the one that lost less sold his most liquid positions first. The lesser performing fund attempted to sell his most illiquid positions first. What is important in this leadership example is that in the subsequent recovery, the loser kept a significant cash reserve for the first time and the winner went back to his old, almost fully invested portfolio. In effect, the loser and his shareholders lost their nerve. In time the loser who still had some good performance retired and was replaced

NEW STARS...BUT OLD WAYS

I believe we have gone through at least one, if not multiple, inflection points and I expect the next new class which will have stars fall on its shoulders has graduated from law schools and is now getting into position to seek fortune. At this present time, we have about half the scenario for the next leadership battle. We already have, (and are getting more) data as to the instability in the marketplace. What is missing is the regulatory response. New national and international rules will be put into place that will attempt to fight the last battle. The rules will have all the benefit of the Pentagon’s past favorite practice: to fight the last war brilliantly on paper. They do not focus enough on how the future will build on the past.

MR. JOHNSON

The new rules will attempt to constrain various perceived ills. The constraints will add a level of complexity that will retard many. There will be some that will actually read the various regulations, and some more will understand the reporting technology put in place. By seeing things more bureaucratic minds will miss (the signs of a good lawyer), they will find new ways to make money. This will be not the first time that legal training led to investment success. One example, and there are many others, is “Mr. Johnson.” A Boston-based lawyer in the 1940s, Mr. Johnson had the opportunity to buy the ownership of one of his clients, which he renamed Fidelity Management & Research. Everyone including his son Ned referred to him as “Mr. Johnson.” For approximately thirty years it was his skill in seeing investment and marketing opportunities that others missed, that became the foundation of what Fidelity is today. He encouraged young associates to research stocks with same vigor as an attorney in preparation for an important case. He saw through regulations and practices that others didn’t.

What should we do now? We should be looking for new leadership to be our investment heroes, some will come from an understanding of the law.
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