Opportunities Gained Through Losses for Some

Highlights
I.            The Best 401(k) and New Opportunities 
II.          Seth Klarman’s Warning and Permanent Losses  
III.       ISEEE White Paper on Emerging Companies

Introduction

This last week a number of things have occurred that will intrude on my work in the next several weeks.

Regular readers of these posts have learned that there are two related themes to my investment thinking. I am very wary of a future peak leading to a major stock price decline and I am impressed with the value of time horizon portfolios.  

One rarely appreciates the advantages or disadvantages that accrue to individuals based on the time they enter their first professional jobs. I began my first professional investment job in 1960 as a junior analyst/trainee. I was part of the second wave of young people to enter the business in a long time. Some others entered Wall Street about 1955. Each of the phalanxes moved up the ladders very quickly to replace the managers that were scarred by the tales of the Great Depression. Many of these managers (and more importantly, their clients) were extremely afraid that the post-World War II boom was about to end and therefore were reluctant to buy stocks in the early 1960s. Their clients found them to be wrong by 1968 if not earlier, and allowed us relatively unseasoned analysts and portfolio managers an opportunity to make important investment decisions. Out of these experiences I became conscious that the larger losses suffered because of the collapse of stock prices in the 1929-1932 market were not the dollar losses sustained. A much larger loss that many investors and their heirs suffered was caused by former investors or their friends and relatives neglecting to reinvest into the stock market. They lost huge opportunities to make a great deal of money.

Ever since that recognition I have been focused on not making that mistake for myself and clients. This is exactly why I believe in creating investment portfolios structured to meet needs for different times. I have little confidence in my and most others ability to make correct risk on/risk off decisions.

The #1 401(k)  - Our client 

For many Americans a large part of retirement savings is in their 401(k) salary savings plans sponsored by their employers. From my point of view as a manager and consultant to a number of these plans they should be invested for the long-term, utilizing my time horizon approach.

Each year BrightScope creates a list of the best 401(k) plans. This year they named the Second Career Savings Plan of the National Football League (and the NFL Players Association) as the number one in the country. Numerous factors were considered including total fees charged. Because of participant choice they did not measure aggregate performance. I can clearly state that investment performance was good as does the plan sponsor. This has been satisfying to all who have been involved.  I wish them well in the future. After twenty years of working with the plan,  I have elected to pursue other opportunities utilizing our expertise and efforts. They should do well due to the generous employer contribution and the structure and administration of the plan.

Seth Klarman’s warnings and permanent losses

Seth Klarman is a well known hedge fund manager that is used by some of the non-profits whose investment committees I sit. He has sent back cash to investors (rather than investing it), so his latest letter as published by John Mauldin is not a complete surprise. Let me summarize his points as follows:

• Most investors are downplaying risk and this never turns out well.

• Maybe not today or tomorrow, but someday a collapse may occur.

• The pain of investment loss is considerably more unpleasant than the pleasure from any gain.

• Correlations will be extremely high.

• Investors in bear markets are always tested and retested.

Analytically, I agree with Mr. Klarman’s cautions, but I do want to put them into perspective. For those accounts that have long-term needs beyond ten years, I would be reluctant to place less than 50% of the value of the portfolio in risk-assuming investments. I do recognize that in periodic down markets the major stock market indices can decline 50%. The decline from the peak in 2007 to the bottom in 2009 was 57%, with many good managers losing more. The recovery since the bottom has more than made up from the loss and then some additional gains, often more than 50%, above the former peak.

What to do?

Along with most professional investors, I do not posses the market timing skills of Mr. Klarman and a handful of others. Nevertheless, I am conscious of his warnings. Thus, recently I cut back on two of the largest and quite profitable stocks in my private financial services fund. Also I am reducing some of the positions in Small Cap funds in our managed fund account portfolios after they have performed very well and have no or little cash reserves. These moves will not be sufficient if I am totally surprised when the next major decline happens. I am, perhaps foolishly, expecting a more speculative rise before the peak is reached. There are two clear parameters to my thinking. The first is to get prepared for a decline and the second is not to get too long-term bearish as to flee from taking risks for long-term gains opportunities.

ISEEE white paper and emerging companies

There is a very healthy tendency of people in the global financial community to meet and discuss, often heatedly, their views as to the investment future. I belong to a couple of these and learn to appreciate from other professionals’ experiences. One of the groups I recently joined is the International Stock Exchange Executives Emeriti (ISEEE). This is a group of present and former senior stock exchange officials from around the world that meet periodically. Evidently my term of office as the Chair of one of the advisory committees to the board of the New York Stock Exchange qualifies me for membership. For a number of years the group has been concerned about the general inability of emerging companies to get adequate financing in most of the world’s markets. 

Next month at the ISEEE conference at the Museum of American Finance^* in New York (one of their conferences around the world) the topic will again be discussed. I have been asked to prepare a brief white paper on my concerns for losses while investing in emerging companies. There is no doubt that there will be some outstanding successes where capital will be multiplied numerous times. On the other hand, it is almost axiomatic that there will be loses sustained by inexperienced investors.

I don’t know that large losses can be prevented, but there are two concepts I am going to try and develop. The first is that various restrictions  caused by the regulators and case law should be modified to present more information about future plans and greater discussions as to the specific market opportunities and threats the company is likely to be exposed. The UK polices are more helpful than those in the US. A second proposal that also surfaced (to the best of my knowledge in some UK reports) is that each emerging company offering needs to require at least one or more institutional investors, with perhaps a required carve out of 10% of the offering. I have some other ideas that I might include.

I find it a bit ironic that for this conference I will be sitting in the old banking halls at 48 Wall Street, the former home of the Bank of New York, my first professional job after leaving the US Marine Corps.

I solicit the readers of this post to share their thoughts as to how we can protect investors from losses but still encourage them to be lifelong investors.

^* I am a trustee of the Museum of American Finance

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A. Michael Lipper, C.F.A.,
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Lifetime Investment Views

In last week's post I mentioned the views of Warren Buffett and Charlie Munger at the annual celebration of  Berkshire Hathaway in Omaha: that one should keep on learning over his/her lifetime,  I would suggest everyday. For me investing is an experienced derived art form, thus I believe that investing should be an everyday practice.  Every single day, whether one does or does not make a transaction and/or hold excess cash is an investment decision day. Everyday brings both new information and experiences of oneself or others that should be digested.

With these thoughts, I am trying to figure out what to say to my eldest grand daughter. She is graduating cum laude from William & Mary, the first chartered university in the US. She has had many investment-oriented advantages in her life including going to school outside of her home country and the fact that her father is the investment strategist for a growing asset allocation fund. Nevertheless I feel compelled to lay out some basic views that will help her to become a successful investor throughout her long and productive life.

To recognize that everyone is a gambler

The decision to get out of bed in the morning is based on a belief that the day will produce more good impacts than bad ones. While we have no enforceable guarantees, our experience is what has happened in the past. So we gamble that this is our fate for today. When we cross a street we gamble that everyone will follow both the laws of the land and physics, otherwise we are at risk of loss of life, injury, and property damage. There are many of examples of us taking gambles everyday. I believe that we cannot avoid gambling.

Every gambler believes that there is at least one more opportunity to win. Because we each take the gamble of getting out of bed and crossing the street, we are all optimistic. Some of us more than others. Chuck Jaffe had an interesting column focusing on the recent high of the Dow Jones Industrial Average. 

In the article he quoted an old friend and client of ours the late and sometimes great growth mutual fund manager, Bill Berger. Bill believed or at least said that in the 2040 period the famous benchmark could reach 116,200. The view was based on a mathematical rule that could produce two occurrences of a triple in thirty-two years. Few today would be that optimistic, but the rules of chance do not absolutely rule it out. It would help to start from a depressed level, which will happen sometime in the future. When that happens it would be wise to remember the words of Seth Klarman, a hedge fund manager with a brilliant long-term record. He has said, "Investing, when it looks the easiest, is at its hardest." The payoff from risk-adverse long-term orientation is just that - long-term measured over one or more cycles of looking stupid.

For my grand daughter and many endowments, they need to understand that they will live through many cycles of alternately looking brilliant and then appearing to be stupid. This could be labeled the curse of future orientation which pivots on the externally determined timing of events as well as a normal load of disappointments.

Hurdles

At any given time there will be problems that need to be understood and put into perspective. For example, let me deal with a couple that got my attention this week. 

Margin debt

According to the Wall Street Journal, the dollar level of margin debt is almost equal to its all time high hit in July, 2007, just before the market peaked out in the fall of '07. I noted the level but I am not unduly concerned because the size of the market has grown and some of the borrowing is for non-security investments not tied to stock market prices. Worth watching, but not worrying, yet.

High yield spreads - the canary in the mine?

John Lonski, chief economist of Moody's Capital Market Research is expressing concerns that the revenues of the companies that have issued high yield bonds is sub-par historically when the spread between the yields on these bonds compared to the yields on similar maturities of US Treasuries is historically small. The yield spread normally is a collective view as to the credit quality of the bonds. This dichotomy with concerns of low relative revenue growth could signify a potential problem. Smart stock investors have learned that the movement of bonds can foreshadow stock price moves. Again, in this case I have noted these elements, but I am not unduly concerned. The high yield bond fund of today is yield driven and not as sophisticated as those in the past. I will be concerned when the yields on US treasuries double from current levels.

For my grand daughter the lessons are first, there are always things intelligent people are worried about. Second, most worries need to be put into historical perspective. Third, be most worried when too many people have no worries. Fourth, like the great investors at Berkshire Hathaway^*, as well as good managers like Seth Klamer, use worrying times as buying opportunities and do not be afraid of looking stupid.

^*A position in our fund and personal holdings

Please share with me what investment thoughts are you suggesting to your young investors for the long-term.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission