Faulty Decision Processes at Change Points - Weekly Blog # 607

Mike Lipper’s Monday Morning Musings

Faulty Decision Processes at Change Points

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

On the surface stock owners are expecting seasonal presents----unless they have already received them. By Friday morning media headlines were mostly good and had set up a favorable 2020, unless one looks deeper. Frequently, I reference a chart in the Weekend Wall Street Journal that measures the change in the current prices of stocks, commodities, currencies and other investments. This week 65 of 72 prices rose, suggesting some form of inflation is mounting. The numbers hawk in me saw a possible problem, as we normally see positive category price changes in the 31-42 range. (The seven falling prices were: S&P 500 Real Estate, Natural Gas, Lean Hogs, Yen, S&P 500 Telecom, US Dollar, and corn). The out of normal price behavior made me think about the benchmarks that investors use to guide their decisions.

The most prevalent sales pitch in moving investors into or out of securities is a short comparison of two alternatives. If “A” is larger than “B”, “A” is a buy. This assumes the measure is relevant to the needs of the investor and most importantly, the relationship between A and B is reasonably constant and meaningful. Currently, the price of gold mining stocks is going up, yet the price of gold is flat. One could say that this is compensation for the plentiful risks in mining. Alternatively, some stock buyers expect gold to become more valuable due to the fall in the dollar. Regardless of the reason, the market for physical gold is not sharing the same enthusiasm. Perhaps the comparison is faulty, as one alternative represents a view of future attractiveness and the other a measure of current value. This dichotomy suggests that simple statistical comparisons need to be understood more fully.

As someone who’s developed a large number of open and closed-end fund indices, I question whether many benchmarks are relevant in making decisions as to the future value of investments. This week my old firm noticed that two mutual fund categories, equity income and utilities, were getting net inflows, while other equity categories were not. Some buyers, perhaps spurred on by their wealth managers or other investment advisers, were attracted to these two investment categories because of their comparatively high dividend yields and/or lower volatility. In our investment management practice we rarely use funds from either category. If some of our accounts need current income we use higher yielding funds, but not the highest. Furthermore, we prefer to use funds growing earnings and cash flows that pay higher dividends. A few growth and income funds have delivered both rising dividends and capital appreciation for years, which over time has given investors a better return than either Equity Income funds or Utility funds.

There were two recent articles in The Financial Times that I believed should have been tied together. The first, based on Morgan Stanley research, was titled “Investors Braced for Low-return Decade after years of Robust Growth”. The article compares the last ten years to the last thirty years and estimates that current investment performance is below both. Initially, I felt they’d failed to adjust for inflation and currency depreciation.

A few pages later there was a news article about the rapid movement in the location of magnetic north. It has been moving for 500 years, causing navigators on land, sea, and in space to adjust their navigational instruments. To me, the second article reflects the reality of change and should also be required before we apply benchmarks. The world of medicine adjusts for changes in height, weight, and other characteristics when it compares modern people to those in the past. Popular stock and bond market indices should also be adjusted and consider both the world we live in and what the future might hold. “Political scientists” that use pooling data to predict attitudes and voting preferences also need to adjust their slicing and dicing of the population and the way they collect data, which will be between expensive and very expensive.

A Barron’s panel of experts have concluded that the S&P 500 will rise 4.1% in 2020. The precision is breathtaking, but if you actually believe the number wouldn’t it be prudent to sell now and wait for a better re-entry point, likely to occur in most years? (This applies to tax-exempt and not tax-deferred investors).

Alternatively, a contrarian indicator is the number of puts vs. calls traded on the S&P 100. Last week the ratio was close to three times normal. While buy and hold investors in aggregate have a better record than traders, those in derivative markets and on NASDAQ are better short term. I believe we will remain in a sentiment driven trading market for a while longer, which could be emotionally trying for investors. However, those who are steadfast will likely accomplish most of their realistic long-term goals.

Please privately share what you think with me, as my crystal bowl is unusually cloudy.



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.html



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Leaders vs. Managers

Introduction

In building a portfolio of funds for clients, essentially the choices are to choose leaders, managers or a mix.

Leaders

This last weekend may show my inclination. We spent the weekend with our enlarged family group of forty-seven, some or all participated in visits to George Washington's home in Mount Vernon, the US Marine Corps oldest base at 8th and I street in Washington for the sunset parade and silent drill team demonstration, and the National Museum of the Marine Corps.

One could build an entire leadership course based on George Washington's life and pursuits. While much has already been written on these topics, for us involved with investing, two themes merit our review. The first is aggressiveness. Before and after his military battles during the American Revolution Washington was an aggressive investor in land. At the time of his death he owned some 70,000 acres all the way into the Ohio Valley. Many of the land parcels he had surveyed years before, but some were virgin territory for him. Unfortunately while he believed in both physical as well as financial planning, he died with lots of land and some debts and very little cash, thus much of his assets had to be liquidated without further development in order to meet his debts. As with most leaders he was ahead of his time focusing on the potential of future development. (He could have used a more competent cash manager.)

Discipline

I have often written about the second important aspect of Washington’s leadership, discipline, which I have learned from my active duty service in the US Marine Corps. On this trip the skills and bravery of the individual Marine was an important focus. The National Museum of the Marine Corps in their displays depicted the bravery and fighting skills of individual Marines. In addition to listening to the very talented Marine Band and the Drum & Bugle Corps, one of the highlights was watching the silent drill team's parade. This  platoon of perfectly selected young Marines go through their routines with no audio commands issued. Their memory of endless rehearsals and the discipline to follow ingrown procedures produced a striking tableau. In addition to the Marine Corps Commandant, the honored guests included  a sizable number of members of Congress who one point wore the US Marine uniform. Perhaps it was no accident that the current Commandant, General Joseph Dunford has been nominated to be the Chairman of the Joint Chiefs of Staff  pending the approval of the US Senate. In that role he will become the chief military advisor to the US President.

At the end of the evening the Commissioned Officers marched away and were replaced by the leading Non-Commissioned Officers to march off the troops returning to the barracks. These NCOs are the real managers of the infantry. They get the job done accomplishing the officers’ orders.


Do you want Leaders or Managers Managing Your Portfolio?

I sit on a number of investment committees as well as managing discretionary accounts of portfolios of funds. One of the characteristics of investment committees is that there is a strong desire for them to reach unanimous decisions. Often there are official or unofficial benchmarks that become performance targets. All too many investment committees react politically by agreeing to the least aggressive strategy, with emphasis on beating a benchmark regardless of the nature of the account or composition and management of the benchmark. By adopting this strategy they are really making the decision in favor of managers who will be graded on how close they come over time to the benchmark. As all too often the benchmark is of individual securities that are assembled without management and trading expenses they are also without the auditing standards normally used by professional organizations. In addition, not much attention is paid to component weights and methodology and the timing of additions and deletions. The drags caused by expenses and the desirability for some operating cash makes it quite difficult for most managers over time to beat securities benchmarks.

If you wish to have superior results from specific portfolios which do not have the low expense ability and/or the need for operational cash, one should take the risks of going with leaders. Leaders are managers doing some things differently than the normal (not currently the best) performers. Because of their relative isolation, leaders can often be strong personalities with some missionary zeal. A complicating factor in choosing  a potential future leader is that often they are not the smooth presenting managers that garner so much of the institutional money. Further, most of the time they have little or uneven performance records. The key to their selection rests on their well thought-out, but different investment approaches.

What Do We Do?

We build a mix of managers and leaders. The managers are selected on the basis of their expense control and their ability to reasonably hug the benchmark. These are then combined with managers that we believe will have a good chance to be future performance leaders.

Question of the week:  Can we discuss our approach with you as applied to your investments?

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A. Michael Lipper, C.F.A.,
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Will Fund Classification Hurt Your Fund Selection?

Introduction

I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases relative performance is very important. My concern is that most benchmarks be they securities or fund indices are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional  “gate keepers” or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the US. According to McGraw-Hill Financial’s survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies’ foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources.  As a matter of fact I found four which had foreign sales of over 75%. Since for many years sales outside of the US have been (in local currency terms) growing faster than in the US, I am willing to bet that a number of funds that are characterized domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher quality small cap funds had a relatively good third quarter performance (see many of the Royce^* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important on this Sunday when the Financial Times reported that the Brookings Institution announced that the global economy is coming back, being led by the richer countries. For the moment the classification of small cap appears to be working. Nevertheless, from a selector’s view point it is a flawed classification.

^* Owned by some of our accounts

Better Classifications

Originally funds were slotted into classifications solely on what the funds’ marketing people claimed they were. Over time this yielded to the language in the prospectus created by the firms’ lawyers. Increasingly their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards as to earnings growth, price to book value, yield, market capitalizations and other measures. The data sources for these were the unadjusted financial statement statistics.

As both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed.  I have already pointed out that higher quality Small Cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors.  Other such measures might have to do with the difference between turnover in dollars vs. turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float and there are others.  Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

Bottom line: Pure performance ranking numbers in one period are not an important selection device today.

What screening devices do you use?  Please let me know.

Readers’ Service

In last week’s post I mentioned that Colin Camerer, a Caltech professor that we supported with help for his post-doc students, had just won a MacArthur fellowship, often called a Genius Award.  He sent me his collaborative article in the Neuron magazine, entitled, “In the Mind of the Market: Theory of Mind Biases Value Computation During Financial Bubbles.”  The work shows that during a bubble, the “smart guys/gals” get caught up playing what we used to call “the bigger fool theory.”  Please let me know if you would like me to email the article to you.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.