Watch Out for the Four - Weekly Blog # 938

 

 

Mike Lipper’s Monday Morning Musings

 

Watch Out for the Four

 

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

 

          

 

Preface

As subscribers have been told, I am shifting my focus to investing for long-term gains, hopefully for multiple generations. This is the time to begin searching for future winners, although it’s not the time to begin serious buying. If you are like me, at times it can be difficult to only follow an investment intellectually. I need to own a small amount so that I go through all the relevant info while awaiting the time to begin a meaningful buy program.

 

Timing May Not Begin Until:

The beginning of the buy program will not start until people and the data change. In terms of people, there are four structural leaders. These are the men who wish to change the future and are governing to do that. They lead and largely dictate activities in the US, China, Russia, and North Korea. Only the last one, North Korea, is preparing to eventually pass the torch of control to a very young daughter. In each case the eventual leader will be different than the present leader and will have to exert power to stay in place. Any of these replacements could have input into future global investments. Because of the similar ages of the first three, investors will be faced with cross currents that will make choosing investment policy difficult.

 

Before these leadership transitions occur, the global economy is likely to change multiple times. I expect we will be dealing with the terrible “4s”* at least some of the time. The data series likely to experience major swings are inflation, currencies, and taxes, among others. Changes to these data series may not be dictated from on high, but in the marketplace. Additionally, secular changes in demographics and technology will have an impact on how people act and feel.

*Terrible 4s are 4% for inflation, unemployment, and dollar decline, leading to an S&P 500 price that starts with a “4”. A high 4 signals a recession and a low 4 a depression.

 

What Can We Do Now?

First, we can pay attention to what people are doing, not saying. Actions speak louder than words. While the media is full of pundits talking about market indices at new highs, 58% of the stocks on the New York Stock Exchange (NYSE) fell in the latest week. Perhaps more meaningful, 56% of the stocks fell on the NASDAQ. A survey of investment advisers and their clients found advisers twice as bullish as their customers.

 

Second, be aware of financial and economic history. We know that historic patterns don’t exactly repeat, but directionally they are pretty accurate. Economic cycles are based in part on the level of debt being created throughout the system. (Government deficits need to be considered as well as business debt, personal debt, and accidental debt.)

 

When debt repayment becomes too burdensome it won’t be promptly repaid and will cause purchasing power to drop and fixed income/equity markets to decline. Depending on the severity of the decline it will be called a recession or a depression. The frequency of recessions is normally five to ten years, suggesting one is due. A depression is much more serious and infrequent, usually every fifty to one hundred years. Depressions are often caused by mismanagement of an economy in a recession. We have not had a depression for ninety years and some believe the last one brought on WWII. The key for us is knowing that these occurrences are possible and being aware and ready to change behavior.

 

While Waiting

The present should be devoted to looking for stocks to buy for the next expansion. A study of the past suggests the leaders of the next cycle will be quite different than the present. Bearing in mind that many children born today will need retirement money 100 years from now, the odds of most large companies surviving is not good.

 

There are lots of ways to choose stocks to research. None of them are perfect and they will change over time, so investors should always be learning what will cause change. From time to time, I’ll pick one approach to explore briefly, so keep tuned to find an approach that helps you.

 

Acquisitions

No solution is perfect, and conditions change unpredictably. It is normal to change our choices after looking at the cards we are given. The easiest approach is to add a new holding and temporarily retire a present holding. Additionally, no one plays the investment game without making periodic acquisitions. Unfortunately, many investors fail to discard some part of what is not working. This habit of adding without discarding leads to an ever-increasing number of acquisitions, which in most cases leads to average and eventually below average results.

 

I have never seen an acquirer who couldn’t benefit from getting more talent, often with different characteristics than their existing talent. I have often found it better to buy a company for management and tax purposes, even if it’s for a single individual. It has worked for me, even when it was a bad choice. It is easier for me to make a bad choice than to fire an individual or a small group who I like as people, but not as workers and co-venturers. I am comfortable with the way Apple often buys tiny companies, compared to others who acquire much larger companies with all sorts of personnel problems.

 

I was speaking with the manager of a small unit in a very large company who wanted the unit to grow by hiring more people doing the same thing his present employees do. That may be efficient in terms of output, but it just adds to existing problems. I would not view this situation as growth but view it as adding new machines. If on the other hand the new people brought new talents, they could serve a different group of clients who had different needs, which is real growth.

 

There are some companies who try to grow by buying distant operations, adding resources outside their prime geographical area. I do not view this as growth of talent either, but as getting more copies of existing machines. They would be adding to present capacity but not getting new talents that could open new markets. For me they are not growth engines but merely machine acquirers, which will not be valuable talents as the business changes. Investors can see which type of stock I would acquire, even at somewhat of a premium price.

 

Question: What do you think about my approach?  

                                        

 

 

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Mike Lipper's Blog: Investors’ Interlude - Weekly Blog # 937

Mike Lipper's Blog: Not Yet Ready for a long-term Solution - Weekly Blog # 936

Mike Lipper's Blog: We Have a Management Problem - Weekly Blog # 935

 

 

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Equity Markets Speak Differently - Weekly Blog # 777

 

Mike Lipper’s Monday Morning Musings

Equity Markets Speak Differently

What are the Bulls & Bears Saying?

 

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

  

 

 

Prospects

All markets are in conflict between the different outlooks of buyers and sellers. They both tend to agree that stock markets will be a lot higher in the future, disagreeing only as to when, by how much, and the cause of a large advance.

 

One way to look at the conflict is to relabel the combatants as believers and historians. The believers have confidence in the factors they believe in, that have sufficient power to soon generate a substantial rise. In the current contest they lean toward a continuation of Democratic leadership.

 

The other camp agrees in the reasons to believe. They however base their view on a reading of economic and market history. Believing that the long list of current problems will be sufficiently attended to and will become better at some point.

 

The Numbers Trap

Humans have long figured out that there are seasons that change with some regularity and in a somewhat predictable rotational order. The ancients tried to time the change in seasons by inventing reasons for the changes, although most of the proclaimed reasons for the changes did not hold up. People eventually gave up trying to identify the causes and instead focused on the timing of the rotation.

 

Attempting to time the rotation relied largely on the periodicity of the changes. They tried to attach predictability to such events, like which members of long forgotten football leagues won the Super Bowl, or the term of US President. As someone who has studied both rotations, I have found that most of the time the results did have better than normal predictive value, but not perfect.

 

I spent many years consulting with the National Football League and the NFL Players Association on the selection of managers for their defined contribution retirement program. I paid attention to who won the Super Bowl each year, hoping the winner’s superior management skills would indicate which team had the best investment skills. I found that there was no consistent connection. Looking at this year’s results it seems the losing team had better results play by play, but the winner had a handful of winning or perhaps lucky plays in the last part of the game. Nevertheless, when asked which was a better team on game day, I felt the losing team was better.

 

Some market analysts have confidence in the “Presidential Cycle”, which is based on the four-year term of the US President. It assumes reelection to a second term is likely to continue the programs of the existing president. I believe this is not necessarily the case. Often in a second term the President is a lame duck, with less willingness or ability to help the party’s congressional election candidates. Some say the second term is an attempt to burnish the reputation of the office holder, a stark contrast to the motivation of the first term. With the recent split in party control of the House, executive orders have replaced difficult party line legislative actions. In this case there is a role for the judiciary, the third part of government, to impact the result. I think that is true this year.

 

If during any five-year period there is a meaningful change in corporate leadership, it can impact not only what legislation passes, but which legislation is carried out. Any change of leadership can impact what happens in the second and third years of a Presidential term. 

 

I suggest investors focus on the market, economy, and shifting political conditions to assist in guessing future stock market direction, not unrelated inputs.

 

Liquidity Drives Size Selection

Each week I examine the performance of equity funds, in part by the average size of the companies in their portfolios. In a week like last week, large-cap funds declined less than mid-caps and small-caps. Historically, the order of price movement is the complete opposite of their ability to generate earnings per share in the companies they own. 

 

I suspect there are two reasons for this. First, larger market-cap stocks have more liquidity than smaller-cap stocks, in part due to the NYSE change in attitude. In the market crash of 1987 market indices declined 25% in one day. At least one specialist firm continued to make orderly markets. That is, they kept the bid and asked spreads in their normal range by committing their own capital and debt on the buy side to offer liquidity to the market. By the end of the day “they went to the wall”. In other words, they were effectively bankrupt and had to close. (The next day there was a rally that returned profitability to the specialist book.)

 

Neither the exchange, nor the community, bailed them out. From that point on the center of trading liquidity deserted the floor. The remaining liquidity was to be found at the trading desks upstairs, which did not have the obligation to maintain orderly and tight markets. As investors we have all suffered from this withdrawal of floor liquidity.

 

The second force that hurt smaller company markets was more difficult to track and is even larger and more difficult to track today. The normal, faster moving earnings progress of smaller companies attracts M&A activity from larger companies and competitors, who hope to capture earnings and/or products/services growth absent in their companies. Note how few IPOs and acquisitions we have seen recently. (Part of this may be due to private equity funds delaying new investments until their valuations have recovered, based on higher comparative prices for their own expected sales.)

 

Working Conclusions

For those who are still believers, you need to learn how to take advantage of stressed markets. Those that are historically oriented need to be ready to pounce quickly in periodic bear market rallies.

 

Thoughts are appreciated.

 

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Mike Lipper's Blog: We Allow Our Investment Professionals to be Lazy - Weekly Blog # 776

 

Mike Lipper's Blog: Can’t Find Totally Risk-less Conditions - Weekly Blog #775

 

Mike Lipper's Blog: Data Performance/Easy.Interpretation/Not - Weekly Blog # 774

 

 

 

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Adjust Investment Tools for Next Phase - Weekly Blog # 667

 

Mike Lipper’s Monday Morning Musings

Adjust Investment Tools for Next Phase

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

As Rules Change, or are Better Interpreted

For many years to the extent possible, I managed the Defined Contribution Plans for the NFL and the NFL Players Association. At the time of each Super Bowl, when asked which team I was rooting for, I replied “for those in the black and white uniforms”. I hoped the officials would see all the relevant plays and correctly interpret the changing rules of the game. As it turns out, that was good training for watching the constantly unfolding investment games between buyers and sellers, various regulators, shifting weather conditions, injuries, mistakes, and pure luck. None of the results were pre-ordained and would be argued about for many years into the future. I approach each market and market phase with the same weariness in preparing for the next market phase. Part of the preparation is examining the terms used to describe the game, and when appropriate improve definitions. This exercise may be particularly important this year, as it appears we are close to a crossroad.

Enthusiasm vs Crumbling Underlying Structure

Many global stock markets are rising in February, despite the historical odds that after a decline in January there is only a 22% chance that the remaining eleven months will produce a profit. The general media, revealing their political views, interpret the various executive orders and other political pronouncements as accomplishing their goals, and see an economic expansion beyond the release from the lockdowns. It could happen, but the odds of complete success are unlikely. 

The current small-cap +5.03% and emerging market +3.07% leadership in January is like other late stages of the past. Fixed income funds often lead equity funds in terms of direction. For the year through Thursday night, the average S&P 500 Index fund was up +3.16% vs -2.95% for the average General US Treasury mutual fund. Another worrisome note is the size of margin debt, which perhaps due to short squeeze actions has reached record levels.

A good investor should look beyond stock prices to see a different economic view, which I attempt to do. Large futures speculators are increasing their shorts in copper, Eurodollars, S&P 500 minis, emerging markets, and US Treasury bonds. In recent blogs I mentioned the Industrial Price Index rising compared to a year ago and this week it accelerated to a gain of +33.18%. The bond market recognizes these tensions and the yield curve has continued to steepen. Even the Congressional Budget Office sees that inflation will likely be over 2% by 2023. (My guess is that it will be a lot sooner, raising the cost of financing the politically generated deficit.)

Understanding the Tools of Security/Fund Selection

Headline writers and many marketeers prefer short words to describe complex tools, e.g., “growth” and “value”. These create good pictures or charts, with ever rising growth and ever declining value. Would it be so. As with the changing weather at a football game, conditions change, as do the useful definitions of terms. 

Speculators essentially bet on what others will pay for their shares, bonds, or loans in the future and a successful speculator primarily knows his/her markets. An investor is a partial owner of a company that at some point could be purchased by a knowledgeable buyer. It has been the motivation of buyers and sellers in marketplaces around the world since recorded time. Perhaps in response to the “great depression”, securities analysis became a separate academic subject, distinct from older economics courses. 

Benjamin Graham was a successful analyst/portfolio manager/investor. He was also a good writer as an adjunct professor at Columbia University and worked with Professor David Dodd in writing the first textbook on Security Analysis. Graham and Dodd were primarily interested in avoiding unnecessary investment losses in their writings and emphasized the use of financial statements, particularly balance sheets. In early editions of their six-edition book, they emphasized anticipated liquidating value, an issue appropriate during a depression.

While Ben Graham is often erroneously called the “Father of Security Analysis” and the first value investor, this is not where he and his partners in a closed-end fund made most of their money. The fund became a dominant shareholder in an insurance company which had no real equity left on its balance sheet. What it did have in this period of substantial unemployment was a customer base of relatively low wage employed government workers. They saved and ended up controlling Government Employees Insurance Company (GEICO), which Warren Buffett analyzed and eventually bought outright.

Years later I personally had the honor of taking the Security Analysis course under Dave Dodd, but I disagreed with him and believed that growth was an important factor in choosing investments. He  quickly shut me up by indicating how much money they had made on their investments. Years later, as a small entrepreneur, this led me to include growth and more importantly the evaluation of key people in making successful investments. (In evaluating three cases, one had to be closed, another was key to a bigger product, and the third was very successful). As a side matter, I was particularly pleased to receive the Benjamin Graham Award from the analyst’s society in New York for a private matter requiring some investigative skills a few years ago.

Today, when I review financial statements, particularly the footnotes, I have little confidence they will reveal the “true value” of the company. We live in a litigious world and accounting practices are designed to protect the accountant, the underwriter, or the company itself against lawsuits, rather than to ascertain value. However, there are some very good analysts that are pretty good at finding the range of values for a company. These analysts don’t publish their work, as they are employed by investment bankers, private equity funds, or serial acquirers. While they don’t publish, the price of their bids and deals are known, and this sets the market price for similar deals. If I can’t get enough data, I use the multiple paid for earnings before interest, taxes, depreciation, and amortization on successful bids. 

To understand value investing, one needs to understand where the current market is and what is best indicated by the price of deals. These in turn are influenced by the level of interest rates used to discount future growth and the cost of acquisition.

How to Measure Growth

Many believe that any number larger than the previous number is growth. For valuation purposes however, what is useable are growth comparisons. They should deduct inflation, exclude acquisitions, currency changes, and the impact of changes in regulation or competition. To me, each period may be different, so a long period growth rate can be misleading. 

I like to see the consistency of growth rates. There are times when highly variable growth rates leading to above average long-term trends are valuable and times where a more consistent return is more valuable, particularly for accounts that have finite payments requirements. (For mutual funds, we measure both total return and consistent returns.)

What about both Growth and Value?

In truth many companies go through periods of growth and value. IBM, before it changed its name and was under Tom Watson’s management, had so much debt that it was viewed as an underwater stock. Years later, it became the prime example of a growth stock and later still its growth slowed to the point where at times it was viewed as a value stock. Because of various recent changes I don’t know how to characterize it. What I do know, is that past financial history is not of much use to an outside investor. 

Since many companies go through numerous growth and value changes, I favor looking at many periods. However, it is more important to look at changes within the company, including the people hired at the senior and entry level, changes in product/service/prices, and the reaction to competition/regulation.

Conclusions

1. Look at how things are, don’t overpay for history.

2. Expect surprises!

3. Take partial positions initially.

4. Admit mistakes quickly and serially.

Your Thoughts?

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https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html

https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html

https://mikelipper.blogspot.com/2021/01/contra-messages-weekly-blog-664.html

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Are Too Many Long-Term Investors Too Short-Term?

Many of us who claim to be long-term investors (LTI) worship at the feet of Warren Buffett and actually own shares in Berkshire Hathaway as I do both personally and in the private financial services fund that I manage. While “the Sage of Omaha” claims his favored investment period is forever, as noted in a recent column  by Chuck Jaffe, a study of his actual publicly-traded portfolio transactions suggests a holding period of four to five years. I suspect his two relatively new portfolio managers (who like Mr. Buffet have a background in managing hedge funds) have a shorter period of satisfaction with their holdings.

Corporate CEOs have little true confidence in the steadfastness of their institutional shareholders, with the possible exception of index fund holders if the companies are cursed or blessed by being found within one or more indexes or ETFs. Assuming no large earnings or other shortfalls, most particularly large corporations have the same CEOs for five years. In terms of transformational investments, ten years is a reasonable planning period to examine the success of many companies. For those businesses that make large capital expenditures in fixed plants or ground-breaking R&D, particularly in pharmaceuticals, twenty years or even longer is a reasonable measurement period.

Those of us who are investing for the education and future of our grandchildren will take our money to the ultimate fulfillment. For those of us like me that serve on boards and investment committees of large tax-exempt groups that are responsible for universities and hospitals, the time horizons are even longer. Think about granting tenure to a forty year old professor who could be teaching for forty or more years voluntarily and an administration without an easy ability to either improve the quality of the teaching or cutting the expenditures. As far as hospitals are concerned, the outer skins of the buildings are likely to hold up for fifty to one hundred years, that is if they weren't built to federal government specifications and by low-bid contractors. However, with the marches of science and regulations many if not all of the physical plants will have to be reworked rather frequently due to perceived obsolescence.

Faulty starting points of too many LTIs

Too often we become captives of both history and the headlines of the day. Any study of past investment mistakes shows that over-confidence in our wisdom and our ability to foretell the future leads to disastrous results. I have learned through meetings with existing and potential investment managers and investment consultants that many confuse the difference between a book report and a book review. The report form abbreviates the history of their investments both statistically and thematically. A review has to do with the ability of the managers to successfully negotiate the future, or more importantly futures. I am in the continuous process of meeting with existing managers that we use and candidates for future use. To the extent that the portfolio managers and their chief investment officers (CIOs) think deeply about the future or futures, I will be probing them with some of the questions shown below and other items they or I think are important.  In addition, I ask the readers of this post to react to these queries publicly or privately.


For the sake of the future, "Are profit margins too high?"

This is not a mirrored concern of my good friend Byron Wien and others that are worried that margins will surprise many by coming down in the second half of the year. My concern is different and perhaps deeper. As an entrepreneur I know that profit margins are not just a result, but to some extent are the outcomes of a very important series of operating asset allocations. Final operating margins are the consequence of a series of simultaneous equations between personnel management, development spending, foreign exchange management, balance sheet concerns and the mix of interest received and paid. Often margins are the beneficiaries of past acquisitions bringing the acquired margins up to the level of the new corporate parent. The simple statistic of profit margin does not reveal enough about its present and future composition for wise investors to properly evaluate the investment's long-term attractiveness.

Why can margins be too high?

I am not a socialist, but I raise the question, “As a society, outside of government, are we paying too little to employees?”

Because of the prior demands of individuals and organized labor, plus government intervention, we have encouraged the substitution of technology and to a lesser extent foreign workers, for domestic workers. My concerns are two. The first concern is the actual and implied replacement of domestic workers. One example is that we are not getting enough useful new ideas from our senior and professional staffs. There are untold numbers of instances where a relatively low paid worker on the factory floor or in the mail room recognized something of value to the process that was missed by the executives.

The second concern comes from Henry Ford, certainly no radical labor leader. Ford raised wages to an unheard of $5 per day. The history books record that his decision to raise his workers' pay was so they could afford to buy the increasingly mass produced Model T automobile. The growth of high corporate revenues needs strong consumer demand.

Currently one of the concerns of investors is that while earnings progress is surprisingly good, domestically produced revenues are flat with the gains attributed to record profit margins. The news from the job front is at best misleading. While the number of new hires is marginally good, the quality of the jobs being filled is at lower levels of pay and satisfaction. Two of the indicators to watch are short-term sales in stores that cater to the middle class and the purchase of new homes.

Will the current wave of M&A lead to tears?

As pointed out by London's respected Marathon Asset Management, one of the reasons for the good margins has been bringing an acquired company's margins up to the new parent's levels. However this is a one time occurrence accomplished by tighter financial management and bigger discounts from bulkier corporate buying.

However, there are longer-term negative impacts of these deals. Often the senior management of the acquired company is locked into the acquirer as an indentured servant for a specified period of years. After their Liberation Day most of the original people are gone including, perhaps those at above-scale wages. At this very point it will become clear whether the combined company has the breadth of management needed to make this work out well in the long-term. One of the historic problems for companies like General Electric is the belief that a good manager can manage anything well. In a more complex world it doesn’t happen all the time. Rarely do we see the practice that I followed with some tiny acquisitions: while I liked the products the acquired firm produced, what I really wanted was the new management to join us and play a bigger role in the overall growth of the firm. This is not happening today.

The big risk for the acquirers is that not only do the former senior managers leave the "Mother Ship" but they bring along with them or attract the bright young and entrepreneurial people that will develop the new leading edge competition.  As a partial answer to these concerns  I believe, along with others, that we will see more spin-outs or strategic sales. To accomplish this well and to keep the loyalty of the former parent company's workers will require skills only a few firms have.

Are you prepared for the next bubble?

In our economy we normally don't fix the inflating force that created the bubble, we just remove the flow of the assets that created the bubble. But the assets go somewhere. Most of the time investors still search for above-normal yields and because of their confidence in their own selection skills or those of their managers, dealers or brokers, they remain speculative. We are at the point of looking at mutual fund flows worldwide to suggest that the High Yield Bond fund bubble is deflating. Where is this money going to go? Wherever it goes eventually, it will likely prove to be disruptive.

What to do?

Try to look to the next visible time horizon and beyond to what may be large mistakes that in some future time periods can be corrected. Do not have too much confidence in the correctness of your present, firmly held investment beliefs. As they say, many roads to Rome (investment success).  One should be on multiple routes, the more the better.

Please share your thoughts.   

_______________________

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