People Decide, Numbers Report Investment Success

Introduction

The actions of people drive investment results. Numbers are an abstraction of the various realities that people produce. Quantification is useful in reporting history, not motivation. As a long-term student of investing and the investment business, I have seen repeated failures of extrapolating a given set of numbers that produce very different results. At best past numbers are useful as to what has happened in the past of repeated results.

Why Repeated Numbers Won’t be Predictive

People are not machines. Most of us live, think, and emote in the current time period. While our memories do produce faulty or incomplete renditions of the past that we often use as judgments, we don’t always. We don’t follow the old paths, all the time because of change elements perceived or real.

Change Agents

I believe that the presence of change agents occasionally lead to change in behavior. Some but not all change agents are physical, emotional, political, and may be a result of new personalities entering the decision process; e.g., the titular or actual investment committee. Thus I believe it is useful to apply more weight to the study of people than numbers. (This is quite an admission for a green eye-shaded CFA^® charter-holder.)

Investment Personalities

I suggest that it is worthwhile to practice the art form, not the science, of people watching with open eyes and empathy. The three useful areas of the study of investors are:

• The specific investor
• The collection of investors
• Speculators called “the market” and financial intermediaries

Each is quite different, intermittently changing, making false starts and reversals and are sometimes unwilling or unable to state clearly their intentions and motivations. Our good friends the technical market analysts and other quant type analysts and managers believe that their recorded actions are sufficient for predictive purposes. They will be right some of the time but often miss a major change in the mood.

The Decision-Making Investment Committee

As a practical matter for some individuals and institutions there is a singular decider who makes final decisions without benefit of external counsel. In addition they are legally empowered to make investment decisions,  consult with others and/or are heavily influenced by external sources. Having chaired, sat on, or served various investment committees, I have learned some investment committees, in truth,  make all the decisions. Others are essentially ratifiers of outsourced chief investment officers (OCIOs) or are driven by the chair or other dominant personality. What I have experienced even with a number of people on the formal or informal committee is: change one person, and the direction of the committee may change. The new person may be the change agent for a reluctant prior group, a dynamic leader, one with a different set of investment or management experiences. The informal committee may include a personal lawyer, tax accountant, neighbor, spouse, significant other or a friend of your golf buddy.

“Time to Judgment”

There are two interrelated statistical periods which could be the current quarter, year, length of term expected on the committee, lives of beneficiaries or eternity. (We have suggested that the portfolios be sub-divided in terms of payment streams into timespan portfolios from short operational needs all the way out to legacy considerations.)

Measures of Success

After the targeted investment period(s) are identified, a key question is what measures of success to use. The first duty of a fiduciary (and we are all fiduciaries for ourselves and others)  is to deliver returns sufficient to meet expected spending levels. Thus one of the measures is in real, after-inflation returns. If the beneficiary is tax paying, the payment to the beneficiary should be after taxes.

That is the easy part. Much more difficult are the appropriate measures of investment success and prudence.

Indices made up of individual securities were never designed to be prudent portfolios, but rather a measure of perceived central tendencies. To me these are inappropriate measures.

Usefulness of Mutual Fund Performance Databanks

I suggest the comparisons should be with other investors which are operating under the same constraints as the account. 

My experience is that the most transparent Databank on performance is mutual funds. These can be segmented by investment objective, size, expenses, turnover, tax efficiency, consistency of performance and other factors. 

  

In most periods the bulk of investment performances will be centered in the middle of the performance array. Thus I suggest to divide performance into quintiles. The beauty is that one can treat those funds in the middle quintile (40-60). Then an interesting analysis would allow one to examine the frequency of quintile performance by quarters over long periods of time or when the portfolio manager or policy changes. This type of analysis will demonstrate the investors patience. (Over an extended period of time a number of different investment philosophies will produce similar results, but quite different interim results.)

In assessing the investor or investment committee, their actions over time will have a great deal to do with their ultimate success. The best time for them to make changes within their portfolios of securities or managers is when performance is so good that it is likely to be unsustainable. The other criteria for their future success is whether or not they are developing a long-term plan on how their assets will be managed beyond the Principal’s lifetime.

Measuring “The Markets’” Personality

A look at history will show that a high percentage of the time markets move within reasonably well defined price and valuation boundaries. Unfortunately, these periods produce pedestrian returns. It is the extreme periods which might be 10-20% of the time that will capture the big gains and losses. These periods are often tied to perceived external changes. Europe enjoyed a long period of economic expansion due to the use of Latin American gold that was brought back which made their currencies stronger and created inflation. Wars can be both good and bad for stock, bond, and commodity prices at different times. Discoveries of natural resources and technology can create important changes and reversals. The very same factors that cause dramatic change in one market will not in others due to the mood of the market. There are times almost every item will be positively at other times the same items will be viewed negatively.

At this moment the US stock and bond markets are highly priced but showing relatively little momentum except in certain narrowly defined sectors. There are two elements that other times would cause some concerns, but may not presently.

The first is what economists call a “Minsky Moment” after an economist that many felt should have been awarded a Nobel Prize. His concern was for the unbridled growth of speculative borrowing/lending. This is the type of activity where the borrower expects to roll over the debt and not generate the capital to pay it back. Some are focusing on China’s industrial and real estate debt. I am concerned of the attitude of various governments and non-profit institutions here in the US who intend to cover their fund raising needs through new debt that they expect to be rolled over.

The second element is an examination of the daily price chart of the NASDAQ Index in the Wall Street Journal. (This is a technology-driven index. Technology prices have now risen to the peak level seen in March of 2000.) If the prices do not fall appreciatively, it could lead to what the technical analysts at Merrill Lynch describe as a failed pattern. These two elements may be “straws in the wind” and blow away, but watching people’s changing moods will have some impact on near-term prices.

Financial Intermediaries’ Personality

We used to live in a world of single purpose intermediaries. They were either transaction-oriented, making their money largely through the bid and asked spreads and/or commissions or advisors which earned largely through percent of asset fees. Theses are now being effectively combined into multi-purpose entities. Within the financial community many former service providers are now competitors. Through this homogenization process the prices for services has come down but it is not clear that the quality and integrity of service has improved. Banks have morphed from being financial services department stores to perhaps the full financial services mall. If money is involved, so will be the banks. On a real estate basis we are seeing many of the old temple-like head offices becoming restaurants or event spaces which has happened in New York and Philadelphia. (We had a graduation lunch for a magna cum laude grandson in a space that used to be the main banking hall for the First Pennsylvania Bank, the fist bank in the US until it merged.

While some of the intermediaries have large amount of capital it will be used primarily for them to make money for themselves rather than for their clients. They are hiring PhDs from Caltech and other leading research schools to convert their processes from seasoned employee functions to automation. There is not the same service attitude from machines and call centers that were previously bestowed on us by the familiar faces of yore.

The great damage sustained in major declines was suffered by investors who feel abandoned and dumped their good investments. With fewer people who have the investors best interest in mind to consult, there is a probability that a number of investors will believe that they are condemned to live through their own Minsky moment.

Question of the week: How well do you think your financial service providers really understand your needs and will be there when you need them in a general market meltdown?    

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

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Usual Models Force Investment Errors

Introduction

In last week’s post I focused on too many investors that are not identifying the correct correlation models. Building on that foundation, this week I will focus on most investors, including professionals making investment decisions on today’s headlines rather than future potential prices.

Correlation Traps

Scientists who study how the brain works and those of us who have developed performance and fee tables recognize the need for comparisons. We are taught that higher ranked items are better than lower. Because rankings are so important, we prefer that the leagues be mathematically constructed, even though our choices of art, music, and significant others are not mathematically based. I will leave it to others to decide which mindset produces better results. Clue: My wife Ruth and I regularly go to concerts performed by the New Jersey Symphony Orchestra.

In the investment arena we measure nanosecond by nanosecond how well a stock or a fund performs versus market indices. (At my old firm, now known as Lipper, Inc., I convinced funds’ independent directors to compare with similar funds.) Because professional investors recognize that there are differences between companies, the popular approach is to measure companies that generally produce the same type of products or services.

This particular matrix approach did not help explain the performance of most security prices in the first three weeks of 2016. On the downward slide at least 80% or more fell, and on the not too inspiring recovery of this last week, a majority of stock prices rose from a Wednesday bottom. (See my friend Jason Zweig’s weekend Wall Street Journal article entitled “Market Capitulation is Nowhere in Sight (So Far).”

As a life-long student of investing and a professional investment manager, I am not satisfied with the comparisons normally produced as a jumping off point for analysis of investment decisions. This bears on fiduciaries and individual investors as well.

Starting from the premise that a stock and a company share the same name, but often not some of the same characteristics, I suggest for stocks (as distinct from whole company buyers) the perceived characteristics of the stock has more to do with its current and near-term performance than those of the operating company. I am suggesting that there are distinguishing characteristics that stock buyers and owners attach to a stock. All of these are far less mathematically defined than price indices, but like identifying the sought after traits of a life-long companion, lead to actionable conclusions. Because there is no easy math to guide us into putting a stock in a particular bucket, investors will reach different decisions at different times as to what is the single most important element.

Improved Correlation Elements

Over time I am sure that we will find other ways to group stocks and corporate bonds. The first four that I use are:

• Demand

• Supply

• Time

• Talent

One example of the criticality of Demand was the sharp reversal on Wednesday which seemed to be driven by overturning the depressing view that the decline in the prices for oil and selected other natural resources was a fall in demand. Apparently investors understood that supply was in excess of demand temporarily which many feared was showing signs of a recession. The prices of crude oil and a few minerals jumping higher was a sign of increased demand from the global economy. (That supposed surge in demand could be right, but based upon my over half century of market experience there could be another explanation. Any time after a material decline is experienced in prices and then there is a sudden price spike it may well be caused by the covering of exposed short sellers.)

Too often we think of supply in terms of the items mentioned above, but I am more concerned with the delivery bottlenecks that are developing and are lengthening distribution times of various products and services produced in the US.

Regularly the number one or two major worries of small businesses are their inability to find qualified labor at reasonable wages. As consumers, people are experiencing delays which is annoying and could be a cause for imports remaining strong even with the escalating dollar. In answer to these concerns, there were discussions as to the impact of robots and artificial intelligence at Davos last week. The shares of companies that are seen to be addressing this supply of qualified labor will be in demand.

Time has two very different buckets. The first has to do with the aging process that can’t be accelerated; nine women can’t have a baby in a month  nor can anyone produce 12 year old Bourbon in a year. Similarly, waiting for the next CEO can require patience. The second bucket is the time proclivities of various shareholder and bond holder groups.

At one point an important group of institutional shareholders were the general accounts of Life Insurance companies who held these securities against the expected maturities of their insurance policies. Often growing defined benefit pension plans had somewhat similar needs. Today hedge funds with currently shaky performance need quarterly successes. Sound defined contribution plans (401k) invested through prudent mutual funds are somewhere in between in terms of time sensitivities or at least the ones we have managed. The nature of the shareholder base for any stock is likely to influence its price behavior.

Talent

In many respects the recognized talent in a company is the most difficult and often the single biggest differentiator for many stocks. Currently there are three major US investment banks. Because of regulatory changes and the persistent low interest rates all three are cutting employment. The leader (while perhaps slightly increasing its annual cull rate) is still hiring a significant number of bright accomplished young people. The second, managed by a former consultant, views people as one of the ingredients to making profit goals and is cutting deeply. The third with a slightly different business mix has raised senior executives’ compensation because they executed well. From time to time I have owned all three, though I now only own the first in our private Financial Services fund.  

One of the reasons for this belief in talent is what I have learned about the discovery of the Ninth Planet, one of the only three identified in modern times. The work was done at Caltech and started with a couple of graduate students who found compelling elements in the sky. Their professor of Planetary Astronomy went down the hall to discuss what the students found with an assistant professor of Planetary Science. Thus they combined observation and theoretical science to confirm the existence of the Ninth Planet. It is just this sort of cooperation of in-house experts in a maturing organization that I look forward to in a smart, talent heavy organization.

Interesting enough all three investment banks are now selling below their published book value which does not carry talent as a balance sheet item. Certainly in the case of the first and quite possibly the other two, if I could buy just their talent and none of their other assets and liabilities, I think I would.

Entry Point Microscope vs. Terminal Telescope

For my sins I sit on a number of Investment Committees and chair some. At this point my fellow members are focused on reading the current “tea leaves” about the near-term conditions including the likelihood of further market declines. Considering their brains and experience they are probably right in the short-term. My frustration is that this microscopic focus is preventing them from acting to position some of the money we are responsible for by investing in the future.

There is no question that a microscope will provide much more accurate measurement than even a thirty meter telescope. However, part of every fiduciary’s responsibility is to provide benefits to the last beneficiary. Since these institutions are designed to be eternal and some of the families that we serve expect eternity, we should be looking to the future. We can not be as precise about 10-50 year futures as we can be about tomorrow’s opening price, however that does not relieve us of our responsibilities to future beneficiaries. I am reasonably confident that this is the right time to invest for the future.

As a contrarian, I like that most investment professionals are focusing on current market and economic conditions. Historically, one can age a “bull market” by how far out investors are discounting the future. The focus on this quarter’s earnings or the next rate hike or the number of producing drilling rigs is reassuring to me. I have lived through periods when investors were using five to twenty year projections for their investment decisions.

A study of great investors depicts that many have been lonely in their exposed positions before achieving success. While I recognize that there are numerous flashing caution lights, such as the sudden drop in the confidence index published by Barron’s each week of the spread between high quality and intermediate quality bond yields, I am comfortable with some money for some clients investing for the long-term. You probably should as well.  

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Comment or email me a question at: mikelipper@gmail.com.

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Copyright © 2008 - 2016

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