“This was the Worst Week of the Year” - Weekly Blog # 773

Mike Lipper’s Monday Morning Musings

“This was the Worst Week of the Year”

 

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

 

 

 

Wrong Perspective 

No investor likes to see a markdown of prices in their portfolio. However, these declines are likely less than the future reductions that lie ahead. We may be close to temporarily removing one of several overhanging dangers. The real risk to our long-term condition is the possibility of a short or shallow recession! 

 

For the pains sustained we have taken little in the way of corrective actions. We have largely maintained the same sets of problems we had prior to the recent price declines. 

 

Throughout our society we have a deep leadership vacuum in most activities, from small startups to our largest organizations of government, commercial, intellectual, health, and non-profits. Our problem is not that current leaders are fundamentally evil. Our problem is that in too many cases the present leaders rose to their top positions due to their political skills of getting along. They had to make compromises in the short-term, which had serious longer-term penalties. This is natural because we judge success by short-term achievements. 

 

What Have We Created? 

While there have always had inefficient organizations, we have too many of them today. These zombies exist throughout all cultures. If we adopt Sir Isaac Newton’s view of God as the watch maker who controls the universe wanting us to learn how to solve our own problems without His help. God must periodically intervene through abrupt changes in weather and the economy. These corrective measures are seen to be periodic recessions.  

 

Humans don’t always take advantage of the first clues and sometimes repeated strong medicine is necessary. The wake-up medicine comes in different strengths and duration. History suggests three generic types: 

1. Recessions often caused by climate.
2. Price recessions where critical supply shortages cause long periods of stagflation and cover up structural changes in the rules of the game. There is a good chance of missing major corrections for a relatively short period. We are swapping time for the beginning of an intense correction.
3. The biggest percentage losers are those involved with companies labeled zombies. We should recognize that those hurt by zombie companies are not just the proprietors, but also those who have supplied equity and debt capital. Employees working for going concerns and communities housing the zombies could also be hurt. (Perhaps the time before the larger corrective recession hits could be used to reduce the large number of zombie companies.) 

 

Who Created the Zombies? 

The creators are not maligned leaders. They are just short-sighted in encouraging the zombies to grow and experience some prosperity. Normally, societies have constraints on growth to protect consumers and other capital providers. Periodically these constraints are relaxed or fail to be modernized to accommodate new conditions. The biggest relaxed constraint permitting large numbers of zombies to limp along is low interest rates. These companies do not have sufficient credit reserves and may not have been appropriately regulated by savvy regulators. 

 

Are You a Potential Zombie? 

Warren Buffett in his worthwhile annual letter to shareholders addressed the issue of pinpointing those that have insufficient credit. He suggests that those who I am calling zombies will be revealed as being naked when the tide goes out. 

 

While it is difficult to spot the soon to be naked players, it is not impossible. Warren Buffet and Charlie Munger have a remarkable record of avoiding problems. (Their few major loses are small in number and relative size. They follow the same strategy as the Kansas City Chiefs in the latest Super Bowl, as noted in our only non-weekly bulletin, which is about winning by avoiding losing. That is one of the main reasons we personally own shares of Berkshire Hathaway in other accounts.) 

 

The key characteristic of a zombie company is often a habit of admired=persistence. There is a critical difference between a zombie and a recovered hero. A zombie company persists in taking down its ship and all aboard who depend on their delivery. Those who recover stop digging their hole deeper. As investors we need to identify the critical player or players who have too much pride to abruptly return to shore before the next wave hits. History suggests that there is always an unexpected wave. 

 

Those who have made financial, political, and behavior mistakes, should look for self-help groups or a consultant that encourages them to periodically question their persistence. We should always contemplate the possibility of being wrong at some point in time.  

 

Subscribers, please share your successful review functions of questioning your actions.      

 

 

 

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

Mike Lipper's Blog: A Terrible Week - Weekly Blog # 772

Mike Lipper's Blog: Primer on Starts of Cyclical & Stagflation - Weekly Blog # 771

Mike Lipper's Blog: Words that Trap: Growth, Value, Recession - Weekly Blog # 770

 

 

 

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

 

Copyright © 2008 – 2023

Michael Lipper, CFA

 

All rights reserved.

 

Contact author for limited redistribution permission.

Is it Always Brains over Flexible Policy in Investing? - Weekly Blog # 612

Mike Lipper’s Monday Morning Musings

Is it Always Brains over Flexible Policy in Investing?

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

Two questions:

1. Why don’t smart people always make money with their investment responsibilities?
2. When is the time to fix a leak in the roof, when it’s sunny or when it starts to rain?

The answer to the second question is obvious, when it is sunny. Why then do so many smart people fail to adjust their investment portfolios when the market is fairly, if not fully priced? Could it be that selecting good investments is emotionally more rewarding than focusing on policies that could direct future movements within the portfolio?

None of us knows for sure what the future will bring in the periods ahead. A characteristic most of us share in the developed world is the necessity to compete. We measure our results against perceived peers, or in their absence against artificial indicators that were not necessarily designed to replicate our real-world tasks.

For most investors, their responsibility is to convert the assets they manage into a series of known and unknown payments for various future periods e.g. paying bills. In order to accomplish this, they must make some difficult guesses as to the size of the bills due. Whether they like it or not they should be thinking in terms of investment survival. However, they also need to grow capital in the account to pay more bills than would be possible with current assets. This introduces a difficult and unknown risk/reward equation.

Far too many investors focus on competing with peers or indices and not on the risk/reward equation. Some professional investors also add career risk into the calculation. If they fail to please the owners of the capital, they risk losing the client and account or jobs. Unfortunately, most owners of capital and many investment executives don’t know how to evaluate their managers, except statistically or by comparison. I know of one very successful sector analyst that kept his fund from investing in it. His timing was excellent and when that sector collapsed, he was rewarded with a partnership. He eventually became the managing partner of a successful fund management firm. Charlie Munger and Warren Buffett have often said that individual investors can make better investment decisions than many institutional managers because they are not facing career risks.

Now we come to that leaky roof. The best time to fix the roof is when it is not raining or snowing. On Friday the three main US stock market indices reached a new high, as they have many times over the last three years. Stocks go up in price because more buyers than sellers believe the future will be better. They may currently be correct, but at some point in the future they won’t be. There is an old saying from the floor of the Stock Exchange that bulls and bears make money, but pigs get slaughtered. (Maybe they will be shipped to China where there is a pork shortage.)

Will the US market continue to go up? I hope so. However, in thinking about leaks in the roof I’m seeing some dark clouds that might carry rain. While the world will need more goods and services in the future, they might be in short supply at current prices. Because of geo-political fears in the US and much of Europe, the capital expenditures necessary to build additional capacity has been slim. Another capacity constraint is the working age population, which is already declining due to the falling birth rate. (It is possible that Southeast Asia and Africa will be the source of additional physical and human capacity, which is why we’ve invested some capital there.)

Should we be paying so much attention to geo-political events? I recently saw a study that looked at 21 such events, from Pearl Harbor through the killing of the Iranian general. Only 4 sent the S&P 500 Index down 10% (which is normally called a correction). Pearl Harbor was the worst both in terms of the 19.8% decline and the 307 calendar-day recovery. The average historic decline of 5% is interesting because it falls within the 3%-7% collection of 2020 institutional expectations for the S&P 500 Index. With the indices at a record high, the general’s death did not appear to affect the market. For long-term investing, JP Morgan believes you should be guided by long-term trends and not events.

What clouds are we seeing other than long-term capacity constraints? Conditions are becoming more speculative, with the NASDAQ continuing to lead the other markets. The growth of alternative styles and different trading instruments is also a concern. Furthermore, we are seeing many “conservative” institutions shift from 60% in equities and 40% in fixed income to 70/30 allocations. In the first two weeks of the year we have seen growth and tech-oriented funds gain over 4%, which translates to approximately doubling over a year if continued.

Another unsound extrapolation is that over $40 billion went into bond-like funds during the first 16 days.  This extrapolates to annual rate of $1 trillion. We are already seeing intermediate interest rates moving up. Intellectually, I suggested that it would make sense to short the 30-year US Treasury. (The trend of universities issuing 100-year bonds is spreading overseas. Caltech has now done it 3 times and I believe Cambridge is considering it too. With the average US government debt maturity under 10 years and the UK’s under 14 years, we would like to see a lengthening of maturities.) With gains in many cases over 10%, 2019 was an outstanding year for bond holders. I suspect it will not be wise to own bonds for quite awhile.

Sir Isaac Newton is an example of someone considered to be among the smartest of people. He was a young Cambridge Professor who first conceived the three laws of motion and in so doing formed the basic principals of modern of Physics. He was so respected that he was knighted, very unusual for a scientist. He became the master of the Mint, a high honor. At that time in England the government had not yet set aside money to pay its debts, so they created a lottery. The lottery involved the newly formed South Sea Company, which had dubious prospects, but the potential odds were attractive. Sir Isaac recognized the fallacy of the issue and sold his shares. However, he got seduced by the skyrocketing prices and went back in. He is thought to have lost his investment, which may have been 22,000 pounds in 1722. After the Bubble popped, he was quoted as saying “I can calculate the movement of the stars, but not the madness of men.” Clearly a very bright person who made a big investment mistake.

Subscribers, please help me and yourselves from getting sucked into the concluding whirlpool when the current enthusiasm subsides.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/01/architectural-sway-points-and-current.html

https://mikelipper.blogspot.com/2020/01/how-much-will-markets-decline-10-25-or.html

https://mikelipper.blogspot.com/2019/12/repeat-past-history-probable-or-just.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.

Lessons from Warren Buffett and an Italian Monk to 2nd Generations of Wealth - Weekly Blog # 565

Mike Lipper’s Monday Morning Musings

Lessons from Warren Buffett and an Italian Monk to 2nd Generations of Wealth

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

                                                               

One of the consistent career risks for long-term successful investment managers is dealing with the inheritors of sizeable accounts portfolios at the instant of perceived under-expected performance. Throughout their lives the inheritors have heard about the investment successes of their seniors’ advisors and investment vehicles. They take for granted it will mechanically continue for them. They do not understand that all investments, like all of life, involves risks. There are no absolute guarantees under any condition. Investments are packages of risks and rewards over numerous cyclical time periods and need to be understood.

Lessons from Warren:
We regularly write about Warren Buffett and the incomparable Charlie Munger concerning their investment vehicle, Berkshire Hathaway. We do this not because it has been a successful investment for myself personally and the holders of our financial services portfolio, but because of the valuable lessons that can be gleaned from these two remarkable investors in both words and actions.

Let me put their record into perspective. According to the latest issue of the Financial Analysts Journal, if Berkshire Hathaway had been a mutual fund over the last 40 years it would have beaten 100% of the competition. Even for the last ten years, a more difficult period in view of their size, they would have finished 11th, beating 99.7% of their perceived peers. That is the good news, now the bad news. On Saturday they issued their results for the fourth quarter of 2018, reporting a net loss on investments of $25 billion.

This is not the first time they have reported a loss. The original source of their name could not be turned around and was liquidated. Additionally, there were losses in a Baltimore department store and losses in airline common stocks, among others. Why do we own the stock today when on Monday it is quite likely there will be many commentators bewailing the loss of investment skills of Buffett and Munger. Those critics do not appreciate the evolution of the company and what has been built for future investors.

The first vehicle was the very successful Buffet Partnership, a hedge fund. At the time, when too many publicly traded stocks were trading above their private market value, they began to buy control and at times  a 100% ownership interest in the operating companies. This was in addition to their stock and bond portfolio and led to the acquisition of various insurance companies. For Berkshire, the attraction of these casualty insurers was their sizeable “float”, the difference between the premiums received and the claims paid. Today this is the largest source of leverage for the firm. (A few companies do this, but not as successfully as Berkshire.) Further, the use of the float is not taxed until the claims are paid, which may take many years and creates another form of leverage.

Frequently, during periods of financial distress, good companies with too much debt have been forced to seek additional capital to protect their reputation and credit rating. In the past these companies were willing to pay above market interest rates, pay preferred dividends, and issue options to Berkshire in order to benefit not only from their cash but also from their perceived endorsement. I call this reputational leverage. Finally, it is important to recognize that due to the large tax credits earned by its railroad and energy ownership, Berkshire can shield the operating earnings of any tax paying private companies it acquires. Berkshire also benefits when their publicly traded investments buy back stock and raise cash dividends. For example, over time they have purchased 12.6% of American Express, but currently own 17.9% of the company due to stock repurchases.

In the classic sense Berkshire is not a large user of stock margin loans. From a credit perspective it is not overly exposed to changes in the level of interest rates. In this light its 3rd largest public stock holding is an almost $19 Billion position in Coca-Cola, which is unlikely to move much if interest rates take a sudden jump.

What are they creating? Recognize that much of the stock is owned by people senior in age that have not benefited from cash dividends all these years. I believe to an important degree the 88 and 95-year-old owners are building something for their heirs. When they are no longer leading the company, they will have completed the transition from a capital appreciation vehicle to more of a capital preservation vehicle producing a regular stream of dividends and buybacks. This is not to say, despite Mr. Buffett’s expressed political views, that he is any less than optimistic as to the growth of the US and much of the rest of the world. (This contrasts with a report that the wealthy Chinese have become increasingly pessimistic, with some moving their wealth overseas and some thinking about physically moving as well.)

A Missing Nobel Prize
Getting back to helping the second generation of wealth, there was something missing from their schooling which could have led to their real education. What I am suggesting is that in their study of either history or philosophy there was no mention of an Italian Monk. Luca Pacioli, a Franciscan friar, published the first book describing double entry accounting 1494. Earlier examples occurred in Korea and Egypt centuries before. What they recognized was that every entry created an equal and opposite entry on a proper set of financials. Thus, the original size of an asset would need to be offset by debt or changes in equity. In modern language, it is like saying that there is no such thing as a free lunch. This recognition deserves a Nobel Prize, for it would make us think through all relationships and flows of money. I believe it was Sir Isaac Newton or some other ancient scientist who stated that every action has an equal and opposite reaction. An understanding of this dual nature of human and physical reality could help all those who believe in one-way streets.

What is Happening Now?
Using my familiar lens of looking at the markets through mutual fund performance averages. For the year-to-date through last Thursday night Small-Cap funds were the leader, with an average gain of +13.08%. The best of the best were the Small-Cap Growth funds +17.62%. Part of the gain was due to global science & tech funds, but an equally important part were the gains resulting from the recovery after the fourth quarter decline. I believe the decline was the result of a liquidity squeeze on traders and dealers, rather than the consequence of fundamental concerns. In the weekly WSJ list of 72 price changes for indices of stocks, bonds, ETFs, currencies, and commodities, only 9 fell, an unusually low number.

With many funds and stocks displaying double digit gains, the idea of a mid-single digit gain for the year could be wrong. Being wrong does not bother me much unless it is very wrong. Let me suggest a warning level for the much expected overly enthusiastic top. If the rest of 2019 produces a return, that when averaged with 2017 and 2018 is substantially above the corporate return on equity, watch out.


  
Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/could-biggest-risk-be-confirmation-bias.html

https://mikelipper.blogspot.com/2019/02/some-retire-while-others-sense.html

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.