TOO MANY HISTORIC LESSONS - Weekly Blog # 786

 

Mike Lipper’s Monday Morning Musings

TOO MANY HISTORIC LESSONS

 

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

 

 

 

Are we looking in the wrong direction?

The most important task for any analyst is guessing the future direction his/her enterprise should take. The standard approach is to review history. The problem with that approach is most history is written by the surviving winners and told to us by scribes who feel the need to make history interesting, clear-cut, and supportive of the commerce of the payor of the scribe. I have played that role. My problem is that for myself and my accounts the picture is not clear, particularly now.

 

Current Picture

Today’s blog is being written on the Saturday of the weekend before the grand compromise of the US Debt Limit/Tax Expenditure Legislation. We should never have been put in this position! Our elected leaders have had full knowledge of the twin conflicts of debts and expenditures for many months. Hopefully a tactical compromise will be announced within days.

 

There is however a more depressing structural problem facing us. These two problems have been with us ever since our leaders first determined what amount to spend for the perceived benefit of the governed and where to get the money. I am sure there are written Middle and Far Eastern texts, but the first I know of came from the ancient Roman Republic.

 

Rome conquered the known civilized world through the strength of its Roman Legions and superior engineering. The money to accomplish this came from taxing citizens, effectively the free residents of the city of Rome. Citizens elected the Senate who then passed these taxes. These senators had political skills, which they used to get the votes for their leadership. They induced citizens to vote for them by providing “Bread and Circuses”, or in other words food from conquered lands and mass entertainment.  As long as the Senate provided these in sufficient quantity, they remained in power. Upon failing to do so they were replaced by emperors who felt the political need to continue some of the “bribes”.

 

To keep the food supply growing the Empire continued its military conquests, enabling them to award the legionaries the captured farmland which benefitted from the Roman roads and aqueducts. However, the fidelity of the farmers declined over time, as did the quality of their military skills. Consequently, the Empire was overrun by the barbarians.

 

The political lesson for today is that bribery works as long as it continues to increase.

 

There is another lesson, this time from The American Revolution. One of the rallying cries of the colonials was “no taxation without representation”. They got around that issue by placing tariffs (taxes) on imports, and later through the power of inflation reduced the future value of the dollar.

 

In an aging world all governments need to address the increasing requirements of the elderly. China is under pressure to raise the retirement age from 50 for women and 60 for men. We have seen the difficulty France is having in attempting to raise its retirement age by just by two years.

 

Two Different Views

In general, the evolving political views of many Americans parallels their investment views. One group wants the government to be funded by taxes on the “rich” to pay for their growing needs. The second group wants to be able to provide for their families and their needs with their own funds, sharing equitably with those less fortunate.  In most cases the first group believes it will benefit as the economy continues to grow. The second group believes it will be increasingly difficult to create sufficient economic growth to meet everyone’s needs.

 

The second group sees the following signals as anti-growth:

1. Labor productivity is growing less than inflation.
2. Well established investment bankers and law firms are selling out, partially due to the views of the dominant partners.
3. The following financial firms, after studying the issue, are meaningfully reducing the number of staff in tech and operations: Wellington, Capital Group, and JP Morgan.
4. Some Private Equity firms are selling positions at a discount.
5. Consumers have shifted their buying habits from Best Buy to Costco.
6. Shortage of landlords.

 

Search for Conclusions

Please let us know your opinion on whether this is a time to buy risk assets to be sold in one to five years.

 

We close this Memorial Day blog with a quote from Theodore Roosevelt “We must dare to be great; and we must realize that greatness is the fruit of trial and sacrifice and high courage.”

 

 

 

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

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Michael Lipper, CFA

 

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Beware of Cheap, Seek Fair Slowly - Weekly Blog # 743

 

Mike Lipper’s Monday Morning Musings

 

Beware of Cheap, Seek Fair Slowly

 

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

    

Current Conditions

This coming week we will get the Federal Reserve’s view of the appropriate level of interest rates. Much of the focus will be on the interest rate number. Far less attention paid to the cause of the action. Without understanding the causes, it is difficult to comprehend whether the resultant rates and other measures are going to have the desired result.

 

Not discussed is what I am labeling the “Politicians’ Put”. Where politicians avoid responsibility for causing harm to people’s income, jobs, and capital by making the Fed and Administrative State Commissioners responsible. There is precious little evidence that the Fed and various commissioners have any skills at predicting the future or recommending wise actions.

 

Part of the fallacy in relying on these individuals is that they tend to depend on numbers questionably put together. Too little attention is paid to the weekly local Reserve Bank presidents’ lunches with businesspeople and consumers. Some Presidents are better at asking follow-up questions than others.

 

I have seen the coming of the recession since last autumn. My source of information was walking various malls, talking with competent people unable to find jobs, and employers failing to find applicants possessing the right attitudes. In many cases, the supply shortages were due to a lack of front-line labor and supervisors.

 

The following data is mixed in terms of future implications:

·      An inverted yield curve with the ten-year rate at 2.78% vs the two-year rate of 2.99%

·      The JOC-ECRI Industrial Price Index falling -9.5% vs last year

·      The Labor Force Participation Rate falling -5% vs 2000

 

Start Buying?

The sign a bottom price has been reached is often a surge in transaction volume, signifying massive capitulation. “While everyone is talking bearish, no one selling is being heard”. Stock transaction volume is mild, although bond transaction volume may signify capitulation.

 

In the weekend Wall Street Journal (WSJ) there is a headline titled “Business Activity Declined Sharply”. In addition, showing the US and Global purchasing managers index dropping to 47.5 from the prior week’s 52.3, clearly showing a contraction.

 

After a significant decline there is a burning question in the heart of every investor about when one should begin buying stocks? The question pivots not on timing, but price.

 

I have had the extreme pleasure and honor of knowing great investors over 60 years. The first is Charlie Munger, who taught Warren Buffett that it is better to buy a great company at a fair price than a good company at a cheap price. His belief is that a great company gets better over time, whereas a cheap price only goes up for a period.

 

Before John Neff created a great record with Windsor and Gemini funds. He worked at a midwestern bank where they evaluated corporate loan applicants based on their average earnings power over five years. He applied this process to stock selection at Wellington Management for Vanguard funds, which helped his winning funds during bear markets.

 

One must be very careful applying the lessons of these two investor giants today. Some pundits are currently recommending so-called fallen angels. These are good or possibly great companies currently trading at depressed or “cheap” valuations. Current prices compared to last year’s earnings, or the last period of rising earnings is not particularly relevant. Particularly if we are in a recession that extends beyond a year. It is quite possible with future depressed earnings and today’s prices some stocks may be selling at record high valuations.

 

Depressed Earnings

There are two main causes for depressed earnings.

• A fall in demand for their products or services. As demand is a function of people’s attitudes, demand tends to fluctuate fast and cyclically.

• Companies investing substantial resources in future products and services will materially leverage current sales and earnings if successful.

I am following a few financial services companies in the second group. Their earnings are being penalized substantially more than their peers who have only cyclically depressed results in this downturn. My job as an analyst/investor is to attempt to select a company becoming a greater company, by accepting a bigger stock price decline than peers. This approach could lead to a different roster of candidates than held presently.

 

To some degree the relative size of a price decline is related to the nature of their shareholder base. That is why I tend to favor institutional quality companies, where a substantial portion of shares are owned by those relying on their own experienced internal analysts.

 

Question:  Have you changed your way of selecting securities due to the changing structure of the market.

 

 

 

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

https://mikelipper.blogspot.com/2022/07/time-to-be-contrary-weekly-blog-741.html

 

https://mikelipper.blogspot.com/2022/07/mike-lippers-monday-morning-musings.html

 

https://mikelipper.blogspot.com/2022/06/switching-prime-focus-weekly-blog-739.html

 

 

Did someone forward you this blog? 

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Copyright © 2008 - 2022

 

A. Michael Lipper, CFA

All rights reserved.

 

Contact author for limited redistribution permission.

Completion Analysis: Fuller Picture - Weekly Blog # 560

Mike Lipper’s Monday Morning Musings

Completion Analysis: Fuller Picture 

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

                                                 

One of the first things I learned as an analyst selling sell-side research conclusions to a skeptical institutional audience were the negatives to my view point, or at least the contrary facts. Often when I thought I had a sound point of view I would arrange a week of visiting mutual funds and other institutions in Boston. In many respects this was an intensive course in the analysis of both more facts to consider, including the points of view of more knowledgeable analysts from the vantage points of their portfolios. By the end of the week I had a much fuller understanding of my own views. Further, I made up my mind that I should not consider a sales pitch until I was familiar with the opposite point of view. Thus, for me and those who eventually worked with me I insisted on learning and using a more complete picture, or as complete an analysis as possible.

With that as an introduction, this blog will discuss the other side of two very popular items in the popular and professional press, Saint Jack Bogle and the celebration of high return on equity and operating profit margin.

“Saint Jack”

Jack’s high intelligence and high intensity appealed to the CEO of Wellington Management, then located in Philadelphia. At that time Wellington was a load fund group relying on good wholesalers to convince retail brokers to sell the Wellington Fund and its new and much smaller, all equity and value focused, Windsor Fund (managed by the great John Neff). Walter Morgan decided it was politically smarter to name Jack president, rather than one of the competing sales people. At that time fund buyers were more interested in investment performance than the relative safety of the Wellington balanced fund, which was losing market share in the fund business. Jack trusted numbers more than people. He was taken in by the advocates of Modern Portfolio Theory (MPT), which in truth was not modern, not a portfolio theory. Nevertheless, Jack had urged the SEC to require alpha and beta numbers to be required in fund prospectuses. Luckily, even with the endorsement of the CFA Institute, the SEC, some recognized that these numbers were history and might be used to make poor decisions. Jack was determined to get Wellington moving again.

Accelerating growth was the rage at the time and Jack engineered a deal with a Boston manager of growth funds. The deal gave the acquired control of the merged company in a ten-year voting trust. I was visiting Jack either on the day the announcement was published or very soon thereafter. He was pleased with the deal. I cautioned that he might have lost his company. Thus, I was not surprised when he was removed. (By the way, this follows a long tradition of an antipathy between Boston and Philadelphia, since the American Revolution.)

Jack was always resourceful, from his scholarship days at Blair Academy through Princeton. He recognized that while he had lost control of the investment advisor, the independent directors of the mutual funds remained his friends. He convinced them they should internalize the operation, like many closed end funds in the US and Investment Trusts in the UK. The idea of investing in a passive market vehicle was not new. Since at least the 1940s, the Founders Mutual Depositors Fund had been a UIT invested in the 40 largest companies in the Fortune 500. I believe there were several UK Investment Trusts that had similar strategies.

What particularly appealed to Jack was that by going no-load he was materially reducing the power and presence of the sales people. He had the view that they were just a bothersome expense. There was never a study done as to the value of the sales people. (Having known many of them over the years, I suspect some were good and provided both good advice and service to investors.) Jack was a very good student of the mutual fund industry and what he saw as a benefit for Vanguard was the difference in Total Expense Ratio (TER) between an index fund and an actively managed fund. While a lower fee was a plus, what probably aided performance more was that index funds were fully invested in the market and did not have a built-in redemption reserve. Most active funds have up to 5% in cash to meet redemptions and opportunities. By getting these reserves committed, all of the investment was working for them in rising markets. When markets went down, which happens a minority of the time, active managers holding cash can outperform. This advantage also persists in the early phase of recoveries. For example, the average S&P 500 index fund was up +5.22% in the first 17 days of 2019, compared to the average US Diversified Equity fund which gained +6.22%. There were other advantages for index funds, the first is that when dealing in size active funds may have knowledge of something of upcoming importance. To protect themselves the dealers who were providing liquidity to these funds, wanted a wider spread in their favor. Index funds convinced the marketplace that their trades were without information value and that there was no need for a wider spread. There were also administrative expense savings possible.

While this numbers-oriented pitch would have appealed to Jack, there were some sales aids that were also of great help. The first is that New York State in the 1940s permitted the Teachers Investment Annuity Association (TIAA) to sell the College Retirement Equity Fund (CREF) to college professors. For many years the bulk of CREF was indexed. Many Professors had proven to themselves that they were poor investors and therefore didn’t trust the market. When Vanguard’s group of institutional sales people discovered this, they had found a fertile field of investors at both educational institutions and foundations. The benefits of indexing were taught at lots of schools, without giving a fuller understanding of investing or indexing. Many of today’s media pundits were educated in these incomplete classes.

In summary, I have great respect for Saint Jack, the mutual fund business’s Don Quixote. He brought a number of important issues forward, but his motivation was not as pure as is being memorialized. We do use index funds within our managed accounts when we can not find better actively managed funds at a reasonable cost.

High Number Celebrations

We are probably at the crest of the current economic expansion. As has happened in the past, markets can decline while the general economy remains in expansion. However, one of the functions of a prudent investor and manager is to be on the watch for signs of trouble ahead. During this season of reading annual reports and conference call pep-talks, one should be looking into the celebration of big numbers. As an analyst I pay little attention to reported earnings, as they have been adjusted by favorable accounting moves or management’s focus on what is working now and avoiding what is not, which is more difficult to spot. While I look at many ratios, the three that are the most important to me are return on equity (ROE), operating profit-margin, and net cash generation after debt service.

This season I am seeing record results reported for ROE. In one case, a net interest earner reported average ROE at an annualized 20%. This is being created by shifting client assets into more favorable earnings for the organization and there isn’t a great deal more to go. The 20% number reminded me that before the Bogle impact and other structural changes, members of the NYSE could attract general and limited partners based on a 25% return on partner’s balances. These firms were not particularly special in terms of skills so I declined to join them, which saved me from several failing firms. 

One of the lessons coming from a recent experience with Apple (*) is the danger of showing high profit margins based on high prices. In effect, Apple is holding out an umbrella over competitors in order to use price competition to successfully take market share at lower levels of profitability. Apparently, investors are expecting revenues to grow slower than they were in 2018, but sufficiently enough to be acceptable. I wonder whether a 1% slower revenue growth will lead to a 1% decline in either profit-margin or ROE. Instead of 1%, a 3% or 5% revenue decline will have a more serious impact on the ratios, as operating leverage works both ways.

After four favorable weeks of US stock market performance we could be slowing down in the recovery, even if the three major stock indices appear to have gotten over their 65-day moving average. I continue to wonder, even with bouts of enthusiasm in between, whether 2019’s average performance results will be in single digits, similar to their first full week’s performance. By the way, the AAII sample survey has all three choices in the 30% rage: bullish, neutral, and bearish.

Thoughts?     

*Held in personal accounts

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

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

Did someone forward you this blog?

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.