Investors Should Use Microscopes – Weekly Blog # 513

Introduction

Learning experiences occur everyday for investors with an active, searching mindset. We can see their importance more clearly if we utilize a number of tools. At this point in the market’s evolution from a combination of volatility and no forward progress for many stocks, we should be searching for some guides for both our investment emotions and our considered actions. I am suggesting there may be some valuable insights being offered by looking through a microscope as to very recent investment performance for equities and fixed income.

 Current Views through a Microscope – Equities

One of the basic beliefs supporting market analysis is that from time to time the ownership of stocks rotates from “strong” sound, long- term holders to short-term oriented momentum trading “weak” players. Strong and weak are applied loyally to their current holdings. In theory the market’s purpose for periodic meaningful declines is to shake out the weak holders selling at indiscriminate prices; e.g., offering bargain prices to strong buyers who foresee longer term value at these depressed prices. Historically, after a low price is followed by a rally, the question comes up whether the low price is actually the bottom of the move. Often a second or even a third down move “test” is required to convince some strong investors to be buyers. These tests can be at or somewhat near the prior low price. For me it is not only the price move that is critical in declaring a bottom. What I look for is a dramatic change in attitude on the part of the sellers who are exhausted from the emotions of the decline and proclaim they are leaving the game, often calling it “fixed.” At the moment I am not hearing this lament from the sellers. Thus, I believe the February bottom to be a weak bottom. Most of the time weak bottoms are not when the base for subsequent, substantially new highs are generated.

With the above thoughts in mind I wonder whether the stock market, not individual stocks has seen its high in January, which would fit the pattern of post performance from a prior good year.

For Those Committed to Equities for the Long-Term

Many of us have responsibilities to be largely invested in stocks or stock funds because the history of successful large macro bets is poor for many that have tried. Getting three successive correct decisions (Buy-Sell-Buy) in a row has proved to be difficult for most who try. Thus for the rest of us professionals we try to produce the best returns that we can within our prescribed market.

One of the reasons that all institutional investors should pay attention to the results of mutual funds is in aggregate they are the best contemporaneous record of institutional money. (Bear in mind many of the mutual fund management shops manage a great deal of money in non-mutual fund accounts, but use many of the same securities and strategies.) By using a microscope on the very small number of average mutual fund performance through March 1st, one can see some useful patterns. The average US oriented diversified fund declined only -0.31% where the average sector fund fell -3.13 % and the average world equity fund gained +0.11%. What these numbers suggest to me is that during periods of volatility liquidity is important. Further, that an important part of short-term global investing are the inputs from currencies.

There are some other lessons from this study. The best diversified US oriented fund category was the Large-cap Growth funds, which gained +4.02%. (Part of the gain is probably due to investments in a small number of globally oriented tech companies; the average Global Science & Tech fund rose +6.36%) What is significant about the leading performance of the Large Cap Growth funds is that in most weeks it has the largest redemptions. Contrary to the popular view that redemptions are a sign of disappointment in returns, (as these are often the oldest funds many investors own) the redemptions are the completion of particular phases in an investor’s life cycle; e.g., retirement.

Fixed Income through the Microscope

Utilizing the mutual fund data through March 1st, the average domestic fixed income fund was down -0.91%. Not particularly helpful to balanced accounts that were looking to fixed income gains for stability to offset equity losses. Institutional investors and some retail investors did find better investments than the general bond market in Loan Participation funds (Bank Loans) +0.97% and Emerging Market Debt funds in local currencies +2.65%. To emphasize, the importance of currency in Emerging Market Debt fund investing, bonds traded in dollars were down -0.63%.

In reading the annual reports of fixed income funds that our clients own, I found the following statement, “Credit sector is less compelling.” This particular fund has a long history of providing slightly above average income with less downside than most of its peers. Currently, they are sitting with shorter duration bonds or higher quality.

I have written in the past of my unease with the growth of credit funds, both in the US and globally. The leading bank distributing syndicated loans is Bank of America, not one of the leaders that I know of in credit research. The search for yield has been a trap in the past.
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Picking Winners at the Track and Market

Introduction

The skills required to pick winning horses and selecting successful funds are very similar. As I have indicated numerous times, despite my degree from Columbia University, my two real institutions of useful learning were the US Marine Corps and the racetrack.

The Belmont Stakes

For those handicappers, or if you prefer, racing analysts, the Belmont takes on great importance. This race is the longest race for American three year old thoroughbred horses. Most US races on the flat surface are give or take a mile, with the Kentucky Derby a mile and a quarter. The Belmont is a mile and a half with a very long home stretch. Few of each year’s crop of young three year olds have the stamina to compete.

Even though in theory the Belmont is the truest race for these young horses, the results are not often as expected. The same is true in picking funds, but I have an advantage. At the track all the attention is on picking the winner, while often one can make the same money (and take less risk) by being correct on the second place finisher. For our accounts the winning selection is beating the average of the competitors.

Ten factors plus one “kicker”

This year’s Belmont provides me with an opportunity to identify the Ten Factors plus One “Kicker” that can be used in selecting the most probable winner. Each factor is followed by a description of how I also apply these items to my fund selection responsibilities.

Breeding (DNA) Does the portfolio manager come from a background of striving and demonstrates discipline?

Training What are the current demonstrations of personal analytical and portfolio skills?

Raced or trained at Belmont How long has the portfolio and analytical teams worked together?

Weather (this year’s starting time was late, did the angle of the sun matter?)What are the fund's characteristics in up and down markets, not just performance but concrete actions taken?
 

Soil (composition and slope) Within the organization is there a big advantage to good early performance? What is the tolerance of the entire organization for a “come from behind” performance?

Jockey Is this particular portfolio manager critical to the fund’s success and if so what are his/her strengths and weaknesses?

Trainer As all of us are the product of our learning, who were the critical teachers and what did they teach?

Post position (in the starting gate) Most of the time we are not dealing with a brand new fund. What are the carry-forward implications about sources of cash flows and tax considerations?

Likely early fractions of the lead horse What are the critical time periods for the investors as distinct from gate-keepers and marketing people?

Skill of the ride What is the history of making organizational changes of portfolio managers, key analysts, trading people + trading systems, and marketing people?

Kicker:  The kicker is “racing luck”- unexpected things that no one is ready for. For instance: How does the ecosystem around the portfolio handle both good and bad luck?

Good luck on your choices in the race and picking winning funds

The bond side

Any careful reader of these posts will quickly spot that my mind focuses primarily on equities and equity funds. For a long period of time I have been attempting to get balanced accounts to shed long-term fixed income securities and funds. In 2014 this was a mistake as long-term bonds in general performed better than stocks and stock funds.

2015 is different

My old shop now known as Lipper, Inc., has been estimating for almost all of this year that mutual fund investors have been adding to their long-term Corporate Bond funds both of high quality and high yield types. At the same time they have been redeeming their Domestic Equity funds. What is curious is that the total return of all Domestic Bond funds for the year to date through June 4^th is +1.62%. While total return measurements are normally the single best measurement of relative investment performance, in this case it may be misleading to the bulk of individual investors that own or recently purchased bond funds. I suspect the +1.62% is largely the interest paid and often spent. The price value of the bonds and bond funds is probably close to or completely negative. In addition if one takes into consideration taxes and over 1% inflation that the Federal Reserve uses in its calculations, bonds have been a loser.

One of the things that I have learned from handicapping is to ask after a race what was it that I mis-analyzed or didn’t even see? Thus, before condemning the public investor for being dumb, one should look at what would make them seem quite bright. Perhaps, the public is more worried about a renewed recession caused at least in part by future US Fed policy.

Lesson from the winner

American Pharoah won and led the Belmont from beginning to end. He did all he had to get home first with a large lead. The handicapper in me noted that the fractions at the quarter mile and six furlongs were acceptable, but not a record (neither was the final time itself, but it was good). The analyst in me noted that the place or second horse, Frosted,  paid the same as the winner did for winning and was a better money bet than the winner due to less risk taken.

In terms of picking funds the lesson may be enjoy the leader, but there is a safer bet with less risk of an unpleasant surprise (always remember luck). 

Question of the week:

Are you ready for a renewed recession?

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Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015

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