More to Learn by Seeing More - Weekly Blog # 640

Mike Lipper’s Monday Morning Musings

More to Learn by Seeing More

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

Yogi Berra it was reported to have said that you can see a lot by observing. The distinguishing characteristic of most investors, be they institutions or individuals, is that they thrive on information. However, most investors devour what is served up to them and don’t take the time to observe how the information is served up to them. This week’s blog will focus on two critical streams of information driving the portfolio allocation of many investors. My purpose in displaying how I look at these factors is to illuminate how to look deeper than what is served up, not to suggest that you adapt the way I think.

Asset Allocation

When reviewing investments, most investors start with a listing provided by an advisor, broker, or custodian. The way the information is arrayed often directs our thinking and therefor our actions. We don’t realize that the array reflects how the producer of the portfolio organizes their information flow, often to reduce their liability. When was the last time you were asked how you’d like your investments shown to you? When was the last time your agent asked what other critical information would be useful to you to in making decisions?

During this lazy summer, with the aid of the computer and forced companion in isolation, creating an information matrix giving a different viewpoint. The different view will probably show you how to think about investments and give you a more complete picture, like when your investments will be depleted after meeting various significant expenses.

The following discussion is my first pass at creating an investment framework. It will probably evolve from more thinking and hopefully from the reactions of some of our thoughtful subscribers. I am not recommending this structure for anyone, I’m challenging you to develop your own thinking from a similar exercise.

Once a second investment is added to your first, a portfolio is created. The ability to meet future payments will likely result from the performance of the portfolio, not just a single position. That is true even if the money comes from a position, as it is chosen from the list of available choices. Most investors are collectors of investment opportunities of different natures. Thus, I find it useful to group investments in different categories based on some common theme rather than looking at a portfolio in alphabetical order.

For this first exercise, I created five categories or buckets. In this case the buckets are based on their desired usage and not necessarily their investment characteristics. The five are Capital Preservation, Capital Appreciation, Long-term Hedges, Future Merger & Acquisition candidates, and Expenditures. These terms have specific attributes for me and reveal a great deal regarding my thinking, as described below:

• Capital Preservation requires a belief that these assets will grow reasonably in value over time relative to inflation, purchasing power (currency risk), sustainability through economic cycles, and after-tax benefits. Assuming none of the positions fail to meet the continuing criteria they will be part of my estate. Because the criteria changes over time, the portfolio is also likely to change. For example, a major change in tax regulations could cause some of the holdings to move out of the Capital Preservation bucket. (Notice, I did not specify stocks, fixed income, or public/private investments. Each of these could qualify in the right hands.)
• The Capital Appreciation bucket includes holdings, which over an investment cycle, are expected to do better than the appropriate index. The bucket includes both positions doing well and some fallen angels, where there is hope for recovery. Some fallen angels with large losses should be held until they can be used to offset large realized gains. Because of the inclusion of both fallen angels and some leveraged holdings, I do not expect them to be considered “trust quality”.
• Long-term Hedges are those positions likely to rise when specific Capital Preservation issues are falling. They can be competitive with the Capital Preservation items, e.g. Morgan Stanley vs Goldman Sachs, or an economic trend contrary to a Capital Preservation holding, like Jet fuel oil vs airlines.
• Future Merger & Acquisition holdings would be good companies with attractive products and market share, possibly with an aging senior management with estate problems and weak middle management. Amazon or Tesla could be examples.
• Expenditures would include available cash in various currencies and instruments. The currencies result from fund and individual security distributions, where their initial purpose was to be a small reserve for future purchases of investments in those currencies.

In the table below is the current percentage commitment to each bucket and the current number of holdings.

                                  

Allocation            % of Total  

Capital Preservation       40   

Capital Appreciation       34   

L-T Hedges                 10  

Future M & A               13  

Expenditures                3   

                        Approx. #

Allocation             of Holdings

Capital Preservation        29

Capital Appreciation        54

L-T Hedges                   2

Future M & A                22

Expenditures                 7

Clearly, there is little relation between the level of commitment and the number of holdings in each bucket. To emphasize that point, adding the single most heavily owned position in each bucket would represent 42% of the total portfolio, demonstrating the power of compounding winners. The large number of holdings represent a behavior pattern of investing in a number of companies when entering a new industry or sector. It also reflects the retention of a number of fallen angels, either due to a belief in an eventual recovery, or the desire to reduce the tax impact of selling large winners.

What would you do with this portfolio instead of one heavily invested in financial services, that is globally diversified with an Asia heavy focus and a substantial Canadian commitment? I am not suggesting the unconventional display above is superior, it is just different and might add to your decision making capabilities.

There are any number of other buckets you can use to group your investments. The following is just a sample for both individuals and institutions, it is far from exhaustive.

                              

Sample Allocation Categories

For Individuals             

Pre and Post Retirement     

Acquisition of Major Real Estate      

Major Family Event                          

Large Educational Bills                       

Death and Inheritance Issues            

 

For Institutions

Credit Rating Protection

New Buildings or Laboratories

Funds for strategic acquisitions

Balance sheet to repel a raid

Sufficient Flexibility to Pivot

Operating Leverage

So far, in the second quarter of this year most companies reported materially larger declines in operating earnings than in revenues, excluding some tech companies. Under normal conditions this would indicate the company has lost control of its costs and should be sold. However, as with everything on our march to a series of “New Normals”, our experience and training may prove to be wrong. 

Many companies claim their staff is their most critical asset. (I disagree and believe their customers are their biggest asset, followed by their people.) Most successful companies are labeled as skilled or non-skilled, regardless of their existing employees bringing them to their recent former highs. Instead of slashing employment along with sales, some are consciously increasing their losses by maintaining employment or payroll for as many of their people as possible. In many cases this is likely to prove to be wise from the employee, management, and shareholder point of view. Thus, when analyzing second and possibly third quarter’s earnings, try to grasp how much of the operating earnings decline is due to the fall in sales and covering current expenses. How much of the cost is for carrying employees that are not currently producing? That is exactly what I did when I was running a larger firm during periodic market declines. It proved to be a wise move for our clients, employees, and not bad for me either.

Please let me know if I am making sense to you or if you need help in building your own Personal Allocation View.

  

   

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

https://mikelipper.blogspot.com/2020/07/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2020/07/that-was-week-that-was-change-weekly.html

https://mikelipper.blogspot.com/2020/07/currently-selling-more-important-than.html

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A. Michael Lipper, CFA

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The Most Important Trade: Switching - Weekly Blog # 494

Introduction

Almost all investment advice is framed primarily as buy recommendations and to a lesser extent sell recommendations. For the sake of brevity and complexity these recommendations are at best incomplete and in many cases misleading. Even when we start with cash and expect our estates to be settled in cash, we are dealing with at least with a two-step process.

Cash

Nothing can be simpler than cash or it may seem so on the surface, but it is actually a series of decisions that can be a major influence on the ultimate performance of any other investment. The single most important characteristic of cash is that it has the burden of opportunity cost. The decisions to accept or reject the opportunity to make or lose nominal amounts of money is borne by one’s cash pile. In an inflationary environment any uninvested cash will see its purchasing power decline. If the central bank’s desire for 2% inflation is achieved on average for ten years, most of the current purchasing power of cash is wiped out. While there is a low probability that our custodians will disappear with our money, a few have done so in the past, thus there is risk entrusting our cash pile to any single custodian (and some may say in any one currency or location).

Asset Allocation Switches

Most asset allocation, after costs of the transaction including taxes, produces dollars that are moved from one asset to another. Even a move into or out of cash could be viewed as a time or possibly price allocation when one side is immediately executed and the other side is delayed until perceived conditions change. The opportunity cost of the delay should be assessed. Perhaps a long-term reasonable approach to this assessment is a figure between the inflation rate and a generalized accrual pension target of seven to eight percent. Bear in mind that the current fifty two week gain for the average general equity fund is 20% which is highly unlikely to continue. However, it does show that the size of opportunity cost is variable as well as cyclical.

Motivated Switches

Most switches are motivated by either a strong desire to buy or sell an investment and almost all the emotional attention is spent on that motivation. I want to own “X” or I must get out of “Y.” Far less attention is spent on the other side of the transaction, the funding vehicle or the receiver of the proceeds. When one thinks of the longer term impact of the transaction there is some chance that the less-desired part of the equation will be more important than the initiating desire. Remember any decision could be wrong both in terms order of magnitude and direction of any swap. This is not a clarion call to be passive and let market, economic, and political events dictate results. Just consider both sides of any transaction in making one’s decisions. One approach is a quote from my old data and consulting client Sir John Templeton when he said his transactions were motivated by choosing “better bargains.” This suggests a reasoned analysis of both what one owns and what one may want to own.

Portfolio Driven Switches

In truth most individuals and some institutions actually own a collection of investments that were chosen only for the attractions of the individual investments. One of the reasons that I use mutual funds for clients is that they get judged on how well the entire fund performs not any individual investments. The long-term compensation of the portfolio management team and the owners of the management company is based on how well they perform compared to their peers.

For the managers of portfolios, the weighted mix of investments is critical to the ultimate results. Today I see too many portfolios of institutions and individuals owning some or all of the ten most popular stocks. Unfortunately while they own the names of currently winning stocks, they own less of these names than they occupy in the popular market indices. Thus when the indices rise they are underweighted in the winners and so lose out to the market, which can be costly in terms of marketing to outer-directed investors. They get some relative benefit when the market goes down, but probably lose absolutely.

I am attracted to portfolios that pay attention to their total opportunity and risks. Many of these use cash or equivalents to partially de-risk portfolios. At times it may be difficult to assign all of the cash to de-risking as many funds that have an easily stampeded audience carry redemption reserves. (Unfortunately in rising markets reserves of all types hurt near-term performance.)

Another important factor to me is how much investment sensitivity to long-term currency risks is in my clients’ base currency (which is currently in US dollars). As there is practically no US investment that is not directly or indirectly at risk or benefit from the movement of the US dollar, this is an important consideration for me and my clients. There are numerous ways to address this opportunity and risk. One can own foreign currencies, own foreign securities that are primarily owned by local investors and multinationals that are themselves operating globally and measuring currency and other risks. The funds to avoid are those that are not paying attention to both the risks and opportunities.

Are We Approaching a Tipping Point?

Almost all professional investors and many sophisticated individual investors are thinking or obsessing about the next major decline that could begin in a day, by year-end, after the 2018 Congressional elections or the 2020 Presidential election. I will let others focus on the timing of a major decline. I have suggested that unless we see a great deal more enthusiasm for equities, the next decline looks to be in the “normal” variety of around 25%. A review of fund history and those of many individuals, shows there are very few investors that can sidestep a normal decline and recommit at lower prices and deliver an investment performance better than the majority that held through the round trip.

However, with this week’s focus on the 22.6% decline on October 19th 1987, it reminds me that thirty years has passed and beyond the normal decline there is a once in a generation (which is normally about twenty five years) a 50% market decline. Some may feel the 2007-2009 decline represents the needed 50% decline. Perhaps they are right, but I see enough similarities in both declines to put me on my watch.

My Watchlist

1.  Both declines started with fixed income markets weakening due to excess speculation. I am wondering whether we are seeing that in both the US Treasury market and the number of new credit funds being established.

2.   The infamous South Sea Bubble was created by almost universal belief in the forthcoming riches from Latin America. Today the fast growing asset classes are Emerging Equity and Emerging Debt Funds. Bear in mind some concerns about the existing Chinese debt structure and probable expansion as it attempts to build its “One Belt One Road Initiative.”

3.   Not the cause, but a primary accelerator of the 1987 collapse was the regulatory mismatch between Chicago and New York stock futures markets. Is there a potentially similar accelerator in ETFs and ETNs?

4.   There are twenty mutual fund investment objectives tracking the diversified, general equity market. On a year-to-date basis, five are performing better than the S&P500 funds, but in the last four weeks eight are performing better, with three of the Small Cap investment objective joining the leaders. Until very recently, the NASDAQ composite has been out-performing the larger cap markets. One can’t help to question whether this is a late stage speculative surge.

Bottom Line

Think through your allocation switches as to what you are buying and selling and also pay attention to parallels with history.  

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A. Michael Lipper, CFA

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Asset Allocation - Three Psychological Inputs

Introduction 

The psychological need of the investor is a major contributor to the dominant asset allocation chosen. This is a preliminary, hopefully useful insight in a world of over-simplification. Further it can be a useful aid in structuring timespan portfolios. For the moment think of an asset allocation spreadsheet with three psychological columns and four timespan rows.

The investment account needs to fill in the matrix below:

TIMESPAN	Income	Value	Growth
Now Operations Portfolio
Intermediate Term Replenishment Portfolio
Long-Term Endowment Portfolio
Longest Term Legacy Portfolio

                        TIMESPAN L Portfolios^®

Income

The oldest investment need is to meet critical expenses. For each investor these may go from the immediate need to put food on the table to obtaining the most expensive item of fashion which can be real estate, life style, breakthrough medical care or the latest gadget. The income need includes the cash generation from capital and capital itself. Enough income is in the end not a statistic but a feeling of well being.

The need for income may be immediate and/or a stream of cash for different timespans. For example, it may be high immediate expenses or future streams of payments requiring well covered cash generations. To the extent of long-term payments in a world of paper or electronic money, the impact of inflation should be considered as to the value of cash levels.

Most income driven investors tend to live very much in the present. They view loss of income as much more serious than a missed opportunity to enhance income and capital generation. They believe that they are conservative, but often they are taking into account only what is present and not the value of current and future income.

At prevailing interest rates on presumed high quality fixed income paper, investors are being pressed to meet perceived payment needs. This is particularly true for US foundations with a tax requirement payout of 5% over time. Currently, in most cases income investors are ignoring the present but low level of inflation. This is reducing the real value of both the spending and capital base.

Our preferred solution is to invest in established companies that have a long history of growing well protected dividends in good times and bad. Currently there are a number of these in the financial services field which we can discuss offline. In these cases I believe the income is secure and generally grows faster than normal inflation. The risk is in the fluctuation of the price of the shares. In many existing cases they are reasonably priced in terms of their intermediate- term outlook.

Value

Value investors really don't like making meaningful mistakes. Perhaps earlier in the investment experience they were exposed to big mistakes made by others or themselves. Their reaction to prevent future mistakes is to accept a well defined price discipline. They will often quote the two big investment rules:  Rule 1: Don't lose money and Rule 2: Don't forget Rule 1. This is the historic coda from my old professor David Dodd of Graham & Dodd fame. This strong survival instinct at times prevents them from buying into big opportunities with substantial risk of loss. They are just the opposite of successful venture capital investors that have more losers than winners but the winners are large enough (and then some) to make up for their losses. Because we live in an uncertain world, most often they own lots of securities to diversify their risks. 

Most of the time they are attempting to arbitrage the difference between current price and some standard of value. It is in the selection of this standard of value where the value investor tribe breaks into sub smaller units  or families. Many of these families use the various corporate accounting statements to determine their values; e.g., book value, net tangible value, revenues per share/per customer or net liquidation value. It has been my experience that often many stocks sell at a 30% discount to their theoretical value. However, normally this discount is not fully captured quickly without some internal or external activist event.   

In effect the value investor lives in the current price range and wishes for the market to relatively quickly recognize the present value. These kinds of investments, when they work well, are found in the Replenishment Portfolio which invests through the present cycle. Because of their risk aversion value investors have better than market performance record, but often underperform when the market is looking for dramatic changes in the future.

Growth

The growth investor fundamentally believes in dramatic change that most do not fully comprehend. The change could be based on technology, radical price movements because of fundamental and largely permanent supply and demand shifts, as well as substantial and lasting impacts of demographic evolution. The successful growth investor not only believes that he or she can spot future changes but also which company can be the most successful exploiter of these changes. Relative to the value investor they are more tolerant of near-term price risk because they see larger and longer-term price rewards. Except for large funds investing in smaller companies they tend to have more concentrated portfolios. However, they are much more sensitive to changes on the horizon  which makes them less patient than value investors. Thus often they have more concentrated higher turnover rate portfolios.

Putting Income, Value and Growth to Work

In each cell of our intellectual investment matrix of the three asset allocation types and the four timespan investment periods, the investor should determine the appropriate mix. Thus one might have 60% in income, 30% in value and 10% in growth for the Operational Portfolio; 60% in value and 40% in growth for the Replenishment Portfolio and the reverse in the Endowment Portfolio. The Legacy Portfolio could have 70% in growth and 30% in value. Please note that I do not divide the world into domestic and international. I believe just about every company and most individuals are increasingly impacted by activities beyond their national borders. As indicated in earlier blogs "We are all Global." The location of incorporation or main securities market is a third level sort for administrators and sales people to worry about.

         

Rebalancing

The very next trading day changes the actual allocation from the planned and prior day. Far too many investment organizations rebalance mathematically back to an original allocation. I believe rebalancing is an account-specific responsibility. I am very conscious that most large successful investors/entrepreneurs have made most of their money in a few or even one security. I am also aware that a family's concentrated wealth can be wiped out in a major failure. Thus, I  suggest that rebalancing is a critical decision for the capital owner to make. One can see the degree of concentration will change as investment control shifts from the founder to succeeding generations of family workers and non-workers. Further, to me rebalancing is essentially a market call of quasi permanent market change or a return to some concept of "normal."  The decision may be heavily influenced on payout considerations from how "income" and capital are defined.

What Not to Invest in the Legacy Portfolio

The whole concept of the Legacy Portfolio is that since the current generation of investment managers are responsible there are likely to be future periods of disruptive change compared to the present construct of our investment thinking. Often we may want to focus on investments that would benefit from expected changes. It is equally important to focus on what should not be there.

Two possibly negative trends that should be considered for reduction or elimination in a Legacy Portfolio are:

1.  JPMorgan Chase

I have great respect for JPMorgan Chase and its CEO Jamie Dimon. Personally I have owned the stock for many years and it is our main deposit bank. Nevertheless, it should not be considered in a Legacy Portfolio of companies to benefit from disruptions. I commend Dimon’s brilliant 46 page letter to shareholders that describes their success and outlook. It is the bank’s very success under Jamie that makes me question whether at some future point the stock of JPMorgan Chase may not be an investment leader. If one links the performance of JPMorgan Chase from the date of its merger with Bank One  its stock was up 211% compared with a gain for the S&P500 of 154.8% and the S&P Financials 32.3%. For the last ten years the annual compounded growth was +8.6%, vs. +6.9% for the S&P and -0.4% for the financials. JP Morgan Chase has been a great stock. In the same period the large foreign banks have retreated. My fundamental concern is that it is less likely that the bank's relative performance advantage will continue. I expect that at some point the global financial businesses will be restructured to reduce the odds of continued  success for the current bank.

2.  Urban Real Estate

The second area to possibly exclude in the Legacy Portfolio is urban real estate. Cities are absorbing rural populations all over the world for sound economic and demographic reasons. At some point there will be intolerable overcrowding and with the advent of the internet and driverless vehicles, some of the people and capital will migrate to exurbia.

Whether these two thoughts work out, the key message is to look for those investments that will be advantaged and disadvantaged in the future.

Your Thoughts? 

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.