Diversification - Weekly Blog # 929

 

         

 

Mike Lipper’s Monday Morning Musings

 

Diversification

 

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

 

                                                                        

 

Preface

On a recent trip to London, Ruth and I attended a private fund and friend raising concert for the Academy of St. Martin’s in the Fields (ASMF), where Ruth is the first American trustee. The wonderful music was performed by Joshua Bell, the artistic director, and five other top-notch string musicians from the ASMF. Between the six talented musicians they played three different types of string instruments, alternating between lead and ensemble roles. The result was a successful combination of each of their talents.

 

Even when listening to a magnificent concert performance, I cannot forget my investment responsibilities. As individual musicians alternated from leading to supporting roles, it reminded me of what individual securities should do in a diversified long-term investment portfolio.

 

Application to Portfolio Management

In 1940 the SEC completed their depression-oriented reform rules. Among the last of these was the Investment Company Act of 1940, which unlike the other six regulations was not formed at their SEC headquarters. It was produced at the Mayflower Hotel in Washington by lawyers for the fund industry from Boston, New York (where the industry’s trade association was headquartered), Philadelphia, and Washington. Considering their recent experience of the market falling during the Depression, the mood of the meeting was to try reduce the chance of big future declines. The best model for that were state laws governing trust accounts, using generations of work by Boston and Philadelphia lawyers. (Even as late as the early 1960s a few Boston law firms had professional securities analysts on staff to assist in managing trust accounts.) Note, the main concern of the creators of fund regulation was the avoidance of losses. No word was spoken of making money on investments.

 

They thought the best way to reduce the chance of major losses was to limit an account’s exposure to any single investment. This led to limiting the percentage amount that funds could invest in any one stock, which usually meant no more than 5% of the voting stock at cost (not market). To this very day, most equity funds are labeled as diversified if they adhere to this principal.

 

The Problem with Voting Stock Limits

The biggest penalty paid by investors is not losses, but the absence of profits. Mutual Funds with long histories often make ten, twenty, or even more times as much on some of their holdings, which more than covers a small number of losses. Furthermore, great fortunes have been made, particularly over successive generations, in single stock portfolios or portfolios having a small number of investments.

 

For Professional Investors

The concept of risk management is critical but doing it by name or percentage of voting shares does not reduce risk, it may increase if all investments are exposed to a single concept. In the late nineteenth century professional investors considered concentration to be the best and safest way to invest. My college degree is from Columbia University, which had an endowment fully invested in railroad bonds and stocks, every single one file for bankruptcy. Today there is a risk that some participants in the “AI” surge could produce similar results by investing in too much in a good thing.

 

For publicly traded securities I suggest the biggest risks is with the stock owner and not the issuer, as they will be sellers of the stock before you do. Other risks include countries, technology, politics, and management. These can be identified as short-term and long-term factors. A possible short-term indicator is slightly more participants being bearish than bullish in the latest American Association of Individual Investors (AAII) survey of expectations for the next six months. Interestingly, the long-term indicator was Friday’s announcement by the Supreme Court, which ruled against the President’s authority to set tariffs using the International Emergency Economic Powers Act (IEEPA), which had very little to any impact on the market.

 

Bottom line, watch the musicians play and how well they work together, both with other musicians and staff, but also watch the reaction of the audience.

 

Understanding Going Global

In a recent conversation with a London-based fund manager, who in the past was almost completely invested in the US but now has a growing position in European stocks. While he has the biggest portion of his portfolio in US securities, he is very risk aware and expresses this by augmenting his portfolio with European stocks. Normally, he expects his US positions to outperform his European positions, but not in a declining market. In terms of P/E, Free Cash Flow, Dividend Yield, and other value measures, European stocks are less risky than US holdings.

 

 Another careful investor was Charlie Munger, who listed six principles to be avoided: High Financial Leverage, High Operating Leverage, Negative Cashflow, Poor Governance, High Risk of Obsolescence, No Competitive Advantage vs. a Strong Competitor.

 

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Signals of Change in Historic Patterns - Weekly Blog # 912

 

 

 

Mike Lipper’s Monday Morning Musings

 

Signals of Change in Historic Patterns

 

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

 

 

 

Past Trends May Not Predict Future

There are times when using an old playbook is dangerous because the game has changed.

 

Inputs of Change

1. China overtook the US as Germany’s largest trading partner (fear of US tariffs?).
2. Meta cuts 600 jobs in their AI division.
3. Market rally is being led by low quality.
4. Consumer sentiment fell to 53.6 from 55.1 the prior month
5. Home ownership 40% more costly than renting. Will it change?

 

Other structural questions:

1. Is political power out of balance? IBES estimates 3rd quarter eps to be 10.4% and net income 8.8%, which to use?
2. Will later marriages and down-sizing earlier reduce demand for homes?
3. Will China follow the US in reducing competition through merger or bankruptcy? (autos/paints/investment and commercial banks/private capital).

 

Will we change schooling into education of life and business skills to help solve our problems.

 

Disclosure:

My personal portfolio of domestic and international securities assumes some of the answers to these questions. I could be wrong.

 

 

 

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Mike Lipper's Blog: Where Are US Stock Prices Going? - Weekly Blog # 911

Mike Lipper's Blog: A Good Time to Sell? - Weekly Blog # 910

Mike Lipper's Blog: Risks: Recession/Cyclical, Depression/Structural - Weekly Blog # 909

 

 

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Recognizing a Professional: Ratings vs Ranking - Weekly Blog # 811

 

Mike Lipper’s Monday Morning Musings

 

Recognizing a Professional: Ratings vs Ranking

 

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

 

 

While we can’t know exactly whether someone is schooled in a subject or just pretending, we can presume a lot from their choice of words. In the world of investment statics there are several tribes of analysts that attempt to predict whether a fixed income instrument will go into bankruptcy. They summarize their learned judgements with letter grades, called ratings. These ratings do not give an opinion as to whether they are good investments, just whether they anticipate them entering bankruptcy. The history of the professional credit raters is pretty good, as bankruptcies are relatively few in number. While they give an opinion as to whether the instrument will enter bankruptcy, they do not indicate how much of the issued principle will be lost.

 

One unfortunate trait of inexperienced people is the use of a term from one subject in another. While the term may have some similarities, it is not identical and may not even have the same utility as the original. This is why I used performance ranks and not ratings when developing the practice of mutual fund analysis, using the performance array of mutual funds we tracked each week. This is where my analytical training kicked in.

 

I pity those who passed through the analytical profession and did not learn as I did at the racetrack. My experience instilled in me a strong aversion to losing money. Analysis at the track is similar to the popular method of selecting investments based on past performance. This approach relies on the belief in the repeatability of events and has led to the development of quantitative systems, both in the investment market and at the track. “Quantitative” investing has periodically been very popular in the investment market, buttressed by “ratings” which are meant to be predictive.

 

 I gained an advantage from my many discussions in the grandstands following each race, where some player complained about the failure of “the system” he/she was following. Because I did not like losing money, I paid attention to the complaints of the failed “systems”. What I discovered was these systems actually worked better than half the time for a period of time, but rarely more than 60-70% of the time.

 

Later in life I heard similar complaints from more senior analysts as the corporations they followed failed to deliver the expected performance. The standard complaint was that someone was lying. It took me a while to connect the similarity of their complaints with those I heard over the weekend at the track.

 

This realization led me to think about the process of predicting the future. Since no systematic thinking produced winners all the time, there must be mistakes in the math. As securities analysis is taught as an adjunct to math, or the certainty of law, the losses had to be a function of mechanical mathematic failure. It eventually occurred to me that it was not the process that failed, but the universe of variables being different than those utilized.

 

At the track, the things that could change were the jockey, the trainer, the exercise rider, what the horses were fed, what drugs were administered, or the competition. Each of these possible changes, and others, could and often did impact results. This is why I believe we should pay more attention to changes of people and their attitudes in the investment world. More so than believing in their statistical record.

 

This week was a good example of changes that largely invalidated the past record of the entire global financial sector. As an analyst, investor, and portfolio manager, I have always had an interest in financial services securities. Stock Exchanges have been at or near the center of the financial sector and thus were always of interest. There have been five Lipper brokerage firms that have been members of the New York Stock Exchange. (Never has a son or younger brother succeeded the founder, and consequently none extended to a second generation.)

 

In most commercially viable countries, there are stock exchanges. Considering all I know about these exchanges; none are making most of their money exchanging securities. At best, most make single digit returns on this revenue. This week I attended a capital markets conference of the 300-year-old London Stock Exchange. While it is interesting looking at their history or past performance, it is of no value predicting their future.

 

Unlike racehorses and most people, some companies can be rejuvenated into something quite different than their past history. In the case of the London Stock Exchange, it has grown into the London Stock Exchange Group (LSEG), primarily through a merger with a Thomson Reuters spin-off. (In 1998 Reuters purchased our fund data business. We and our accounts still own Thomson stock, which has a major position in LSEG.)

 

The spinoff included a number of unintegrated number-crunching entities, labeled Refinitive. It was a comfortable fit because the London Exchange had previously acquired a number of similar unintegrated and under-marketed numbers-companies. To this mix they added “expert” management from various financial and tech companies, including a cooperative agreement with Microsoft based on their plans and/or dreams.

 

The CEO believed he had identified all the problems that could delay them. The current management group is investing heavily in new products and services, including the marketing of them. It would not be difficult to improve on the record of its two major founders. LSEG deserves to be ranked highly in its present efforts. I will leave it to others to predict its future.

 

This Week’s Signs of Stagflation

Despite the media and others chanting Good News, there is increasing evidence that smart professionals see an approaching decline in market prices. Whether we are just in stagflation or entering a significant contraction will be determined later. However, it is worth noting the S&P 500 Equal Weighted Index is essentially flat year-to-date.

 

The following announcements have to do with future revenues. The companies making these statements are addressing the second of two measures of their health, their investment performance and the prospect of generating new business, largely from new customers.

• Manulife is laying off 250 employees in its Wealth and Asset Management functions. (Manulife is a Canadian Life Insurance company with significant Hong Kong sales.)
• Wells Fargo is laying off 50 Investment Bankers.
• Burberry issued a sales target warning.
• A 2^nd Hedge Fund is cutting 150 of its 1000 person staff.
• Jim Chanos is closing his short selling hedge fund. (He said the market is changing away from his style.)
• Amazon is cutting several hundred from its Alexa staff.
• Another observation noted in the weekly list of prices in the Weekend WSJ. Only 8% are down, including the US dollar -1.65%.
• Fitch is negative on the investment management sector in 2024.

 

Note From London

At private investment discussions in London during the week, locals were most concerned about the US Presidential election, with differing levels of pessimism. I had two comments.

1. It is incredible considering the size of the US population that the present apparent candidates are such a poor couple. The locals agreed.
2. Much more important to me is that we won’t know the Chairs of key committees until later next year. This is more important on the Republican side, as the Democrats are bound by seniority. According to the intelligent people I talk with, a split Congress is likely, suggesting not much meaningful Legislation will pass, except for emergencies during the first two years of the new term.

 

Share your views with me and let me know what you are watching in terms of markets and votes.

 

 

 

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Mike Lipper's Blog: How to Find the Answer - Weekly Blog # 810

Mike Lipper's Blog: Preparing - Weekly Blog # 809

Mike Lipper's Blog: Indicators as Future Guides - Weekly Blog # 808

 

 

 

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Can’t Find Totally Risk-less Conditions - Weekly Blog #775

 

Mike Lipper’s Monday Morning Musings

Can’t Find Totally Risk-less Conditions

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

 

  

 

 

A Real-World Problem for Investors

Investors turn to advisors to get assurances that they are not taking risks with their money and their future. We can discuss the numerous risks of losing some or all of their money and should do so. But the news of Silicon Valley Bank (SVB) being forced to close and then taken over by the FDIC shows that these types of discussions were not had.

 

This weekend I spent considerable time thinking about “risklessness” and concluded that it does not absolutely exist, nor can there be such an asset in an absolute sense. There are known and unknown opportunities to lose all or some value of an asset.

 

The reason is that we do not live in a one-dimensional world where all is known, or unknown conditions exist. We and our assets exist in multiple dimensions. Few if any of the investors who sold securities in an IPO and deposited the cash proceeds in SVB were waiting for an opportunity to buy appropriate assets. I suspect most investors felt their cash was being held at one or more underwriters for a short period, not at a corporate depository.

 

If they considered it at all, they were pleased that their assets in the company were unencumbered by loans. My guess is that they never considered they were at risk of a “run on the bank” by unrelated depositors. But such a run happened, putting the bank in an insolvent condition, which led to bankruptcy.

 

Ecology

While it may come as a surprise, some investors were concerned about changing climate conditions many years ago. They felt it was not being appropriately considered by institutional investors in making investment decisions. The “buzz” word at the time was ecology. Which meant that if something changed, more things could change.

 

Today’s investors should dust off the old studies on ecology. A current example might be a military battle in the Ukraine causing the price of flour to rise in Egypt, which in turn factors in the price of Mideast oil rising, which in turn impacts gasoline prices in middle America and consequently the prices of local homes in the Midwest.

 

The World View

Today, every consumer and investor is a globalist, whether he or she likes it or not. This impacts transaction prices for everything he or she does, including wages and taxes. Funds that invest in Europe are increasing in price as they attract flows from America, where prices of US dominated funds are going down, leading to a decline in purchasing power for the US dollar.

 

US Investors vs Washington Politicians

The current administration in Washington has proposed raising taxes while continuing to curtail domestic production of goods and services. This will add to inflation as the world continues to fund a major war. Similar to society turning its back on climate and ecology years ago, which resulted in today’s conditions. Our government is pro inflation through restraint of trade and raising prices.

 

Last Week: Another Warning ex SVB

While most of the financial headlines on Thursday and Friday were focused on the implications of SVB, there was worse long run news for American investors, consumers, and citizens. The Standard & Poor’s 500 declined -1.58% for the week ended Thursday, similar to its performance for many prior weeks. However, the depressing news was that China Regional Funds, the largest contributor to world growth, had declined -6.31%. While China exports more than its imports, the major exporter to China is the US. If the US is going to get out of its near recessionary condition, it will need to export a lot of US products and services.

 

What Are We Looking For?

Last week there was significant weakening of market conditions. While paying close attention to present conditions, we are nevertheless searching for the stocks and managers that will participate and, in some cases, lead the next significant “bull” market. We are in the early stages of our search and it’s still conceivable we may go through a longer period of stagnation. We are searching for the kind of corporate leadership and product/services that demonstrate superiority. Some may be overseas, but many will come from the US. Please help us.    

 

 

 

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

 

Mike Lipper's Blog: “This was the Worst Week of the Year” - Weekly Blog # 773

 

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

 

 

 

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Should Changes in Markets Change Your Investment Structure? - Weekly Blog # 618

Mike Lipper’s Monday Morning Musings

Should Changes in Markets Change Your Investment Structure?

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

Warning
Traditionally, investors use comparisons as a tool for making critical judgments and grow comfortable with current events that are within the envelope of past experiences. Momentum driven investors prefer data in the mid-range of past experiences, whereas contrarians look for a reversal of “normal” trends. Both sets of investors may find the current marketplace unsettling. Some may be considering changes to either the structure of their investment thinking and/or their specific selections. Possibly turning off the autopilot based on past security price action, or viewing corporate results through the lens of political or economic pronouncements.

What has Changed?
If we have entered a period of fundamental change, it has not been going on long enough to catalog all that is changing. The following is a partial list of observations different than past experiences:

1. US stock market indices have dropped more than 10% from record levels in six trading days. (Historically, a drop of 10% is labeled a correction, suggesting record price levels were not appropriately valuing current conditions.) In the latest week, our list of client owned funds or those of possible interest showed only 9% in the best performing quintile, compared to 35% for the trailing twelve months. (Obviously, the funds’ managers were not positioned for the correction.) Within the S&P 500, they would have needed substantial holdings in Communication Services, Real Estate, or Healthcare, down -6.34%, -6.34% and -6.66% respectively. For the week, the best performing equity category within the index was Growth, which fell -7.15%. The ten best performing funds on the list fell under 1% and the ten worst declined -12.11% to -13.31%
2. One of the base beliefs of many investors and particularly large investors, is that large market capitalization reduces risk. That was not the case this week, with the Dow Jones Industrial Average falling -12.36% vs. -10.54% for the NASDAQ Composite.
3. During the week ended Wednesday, ETFs had net equity redemptions of domestic investments of $14.5 billion, compared to $4.3 billion of domestic equity redemptions for the larger conventional mutual fund universe. I believe most of the trading in ETFs is done by investment advised retail accounts and institutional trading accounts, whereas most mutual fund redemptions come from retirement oriented accounts seeking to reduce perceived risks by cutting back on their equity exposure.
4. Each of the four largest private equity fund groups has over $1 trillion in assets under management. In total they are believed to hold over $2 trillion in “dry powder”. Private equity and private capital (Fixed Income) used to be funded exclusively by institutional investors. Increasingly they are receiving money flows from retail investors, directly or indirectly. (This has led to a situation where the prices paid by private vehicles are higher than those paid by the public, which could drive deal prices higher and possibly result in more leverage.)
5. In fixed income there are risks from a slowing global economy due to a normal economic cycle. There are also temporary payment problems caused by Covid-19 and credit terms are growing loser in response to increased competition from higher flows. Simultaneously, some investment advised money is fleeing equity markets and rushing into fixed income markets, where interest rates are declining.
6. A change is likely in future weekly blogs regarding the alerts of news items with a contrary perspective. In the past, I have highlighted the negatives along with some positives. Going forward, I will redouble my effort to find positives.

New Alerts
China has experienced three long-term positives that have not gotten a lot of attention:

1. The Chinese government has ordered its mines and refineries to open for business.
2. Apple stated that all its manufacturing plants are now open.
3. While the Apple store may not be open, I suspect customers are ordering merchandise and services on their Apple and other devices from their homes. Recent checks with companies reveal that much of their “intellectual” and service works are being conducted from employee’s homes. (I have not been able to determine when this will be recorded in their financial records)

The spread between the 30-year US Treasury bond yield and the 3-month yield has gone negative. In the past this was a reasonable predictor of a recession. I suspect some small and mid-sized companies will fall behind in paying their bills, due directly or indirectly to the Coronavirus (Covid-19). In many cases, I believe their creditors will try to avoid starting the bankruptcy procedure, but some will be forthcoming. (The US Treasury should have sold all the 30-year paper they could, as demand exceeded supply. The average maturity on US government paper is about half the UK’s maturity.

What to do Now?

1. Recognize that the structure of the economy and markets are changing. Compartmentalize a single portfolio into sub portfolios based on payment responsibilities, separating risk appetites.
2. Most patient investors don’t need liquidity to get out of declining positions in the majority of their portfolio. From a risk standpoint, market capitalization is only critical in rare circumstances and can be expensive. More critical in the long run are the time and effort to follow what one owns, as well as any new opportunities. I personally address this issue by using both investment companies and individual stocks. For example, I believe a good investor should be exposed to healthcare, although I don’t own a single stock in that category. What I do own is some specialized healthcare funds and more generalized funds that have good healthcare analysts and/or portfolio managers.

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.html

https://mikelipper.blogspot.com/2020/02/investment-losses-can-be-prots-weekly.html

https://mikelipper.blogspot.com/2020/02/the-art-of-portfolio-construction.html



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Unpopular, Unconventional, Painful and Disruptive

Unpopular, Unconventional, Painful and Disruptive is not the name of the new hot law firm. The title is a summation of some of my "out of the box" thinking flying home from a too-brief visit to an offsite board meeting of the California Institute of Technology and a visit to PIMCO, the world's largest bond manager.

"The New Normal"

One of the reasons bond managers think in terms of secular trends is that at times they invest, rather than trade, bonds with long maturities. While those who buy stocks should be thinking in terms of long to infinite time periods, many of them focus on much shorter periods; e.g., quarters, twelve months, five or ten years - certainly not thirty years. That is why understanding bond managers is important to equity investors.

In meetings held by senior PIMCO investment people with a group of Caltech trustees, PIMCO focused on an expected period of prolonged very low interest rates. They also shared their opinion that the various stimulus moves by leading central banks and governments will not lead to effective de-leveraging. I got the distinct impression that these moves would prolong the valley of low employment and a decline in the developed world's standard of living, while many of the emerging countries enjoy rising standards of living. A further examination for the sluggish response to the various government actions reveals that in the US, 71% of GDP comes from consumer spending with 47% of that total spent on services and only 24% on goods. As services are time perishable, the old pump-priming techniques of the 1930s don't work as well.

Re-thinking

If the present generalized approach is only going to prolong the problems, why not stop banging our heads against the stone wall and let the natural correction forces operate? In other words, let rapid de-leveraging happen through a normal bankruptcy cycle. During bankruptcies, various contracts can be abrogated. I would carry the process further by removing various constraints and restrictions in government policies that are no longer valid. What should come out of a bankruptcy is a new beginning with an enthusiastic attitude. Unfortunately, only 42% of the American public believes that hard work leads to success as indicated in a recent Wall Street Journal article. This attitude must change.

 

The whole idea of re-thinking past dictates of government is accelerating. I recently attended a conference organized by the Museum of American Finance at the New York Stock Exchange. The focus of the conference was how to restore individual investors' confidence in the equity market. For some time I have maintained that the regulatory pressure to lower transaction costs is a significant contributor to the problem. When commissions and spreads were large, retail salespeople sold stocks and provided other investment services to the public. As their remuneration rapidly diminished, salespeople gravitated to higher commission products such as hedge funds and structured securities. The chair of the NYSE recognized that the switch from quoting prices in fractions to decimals, including sub-pennies, has reduced the attractiveness of selling stocks as a business. I find it interesting that there are news accounts that the SEC is considering a test of a return to the use of fractions. If the SEC can see itself reversing some of its past policies, there may be hope that other government bodies can re-examine their past actions to become more pro growth.

One of the most rigid congregations in the world is the scientific community. Scientists regularly make pronouncements of various laws and theories. This weekend my wife Ruth and I listened to leaders that supervised the work at JPL (Jet Propulsion Laboratory, an affiliate of Caltech) of the Mars landing of  "Curiosity." Each manager described some of the various scientific beliefs and budget constraints to carry out the mission. This remarkable success is viewed around the world not just as a success of Caltech/JPL or of the US, but of mankind as part of its conquest of knowledge beyond our earth. I hope this achievement and the continuing reports back from Curiosity will lead to a greater understanding of what we are capable of doing with our collected talents. We can achieve growth by re-thinking our various constraints.

Investment implications

The markets ahead can be painful either on a prolonged basis with current government policies or more painful but of shorter duration if we allow normal "animal instincts" to operate. In terms of investment policies, in most cases I would not want to own government bonds. I believe the risk premium will rise and stocks will do better than bonds in general. In terms of stock selections, I favor disruptive companies that can take advantage of significant structural changes in our various market places.

What disruptive securities do you own?

______________________________

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