LONG-TERM TRENDS MAY NOT BE A FRIEND - Weekly Blog # 568

Mike Lipper’s Monday Morning Musings

LONG-TERM TRENDS MAY NOT BE A FRIEND

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

                     
     

“Big Mo” in the political world, “The Trend is your Friend” in the commodities world, and momentum investing are beliefs in continuing that which is into the future. Certainly, various media pundits stress current trends. Salespeople of all stripes find it is easy to sell their wares by highlighting current conditions. As a contrarian investor I am delighted to see great levels of enthusiasm for the currently popular, because it leads to significant mispricing of both rewards and risks, creating opportunities for the careful investor. For those swept up in what is currently popular, it should be a well-earned learning experience.

Faulty Long-Term Predictions

This week there were two very relevant notices in the press. The first was a statement by Ajay Sing Kapoor, an analyst at Bank of America/Merrill Lynch. The statement said “There is really no permanent trend just lazy intellectuals confusing a long cycle for a perpetual-motion machine.” This is a useful insight in the climate change debate. One of the best market analysts I know grew up on a farm which he has owned for 30 years. He mentioned the feast and famine cycles experienced while living there, much like the biblical seven fat years followed by seven lean years. 

The belief in long-term trends is present in today’s investment selection, which focuses of selected factors based on selected histories. The strongest of these is the belief that changes in earnings per share will dictate the price of the shares. This was true even when I was a junior analyst at a trust bank, where investment leaders used the change in reported earnings per share to make investment decisions. Even then I was suspicious, feeling that reported earnings were the result of both controllable and uncontrollable forces. It is only later that I became more conscious of the changes in Generally Accepted Accounting Practices (GAAP). Today, earnings report releases emphasize “adjusted earnings, adjusted operating margins, adjusted profit margins and even adjusted revenues”. The SEC has mandated that these reports must also show the results according to GAAP, but they don’t  highlight the fact that almost every year AICPA makes changes to GAAP. Corporate data complements government produced data as critical inputs to thinking on the economy according to Jim O’Neill, the former Goldman Sachs partner and global economist who coined the “BRICS” term for the rapidly developing emerging markets countries. He writes, “Though economics aspires to the rigor of the natural sciences, at the end of the day it is still a social science.” Thus, the specific numbers produced by economists are kidding us with their precision, particularly when they are expressed with decimals.

An Improved Fan Dance

If the base data is questionable, its use as the foundation for future prediction is extremely questionable. Consequently, The Bank of England and some of the US regional Federal Reserve Banks are showing charts using the most current or corrected datapoints, then adding a fan like wedge showing the range of future predictions.  My natural skepticism questions if the wedge is too narrow. I can accept that a narrow fan probably includes most of the probabilities utilizing a single up and down standard deviation. However, as an investor I like most others feel much worse after a decline than a pre-tax gain. I would much prefer a wider wedge that includes the reasonable possibility of two or three standard deviations. (I believe that both long-shots win and racing accidents happen on occasion, depriving the best horse from winning.)

Jason Zweig on the Wrong Long-Term

The second important item in this week’s press is a column by my friend Jason Zweig. He cautions against investing in companies that are building for the long-term, properly concerned that the focus on long-term investing can lead to the mistaken allocation of resources. Tech companies spend substantial capital on new facilities and equipment for future markets that might not evolve. Think of the engineering and construction geniuses responsible for the construction of the Egyptian Pyramids. The pyramids were monuments to the rulers while living, as well as in their after-life. I am much more interested in the long-term development and acquisition of talent, including the building of multiple generations of leadership at all significant levels. 

Investing for the Long-Term

I have devoted most of my investments to the long-term and where appropriate for my clients I have done the same. While this on average generally means a low turnover of securities and funds, it is not a lock-step process of holding regardless of current input. It requires careful examination of current information versus long term perspectives, both of the specific investment and its place in the portfolio, as well as any changes in the needs of the beneficiaries. I accept the cyclicality of both the markets and my ability to correctly analyze the inputs. I often expect to be premature and less often to be wrong. My long-term attitudes are derived from the study of some of the best investors as far back as I have information. In general, these attitudes have been good for my accounts and family over time.

Mid-Term Platform or Lid?

Each week I look at the investment performance of mutual funds around the world as a good representation of the results of managed money. This week I paid attention to the average returns of US Diversified Equity funds for the five years ended this week. The period included the final years of the past administration and the first couple years of the present one. The importance of politics is questionable. The twenty-investment averages for the five years generated an annualized compound growth rate of +5.69%. This included some extremes on the upside: large-cap growth funds +12.13%, S&P 500 index funds +10.72% and multi-cap growth funds +10.16%. On the down side there were dedicated short bias funds -19.35% and alternative equity market neutral funds -0.74%. These results suggest that large-cap tech companies produced a disproportionate portion of the gain and that being out of equities was a loser. 

Five years is a little longer than the average US stock market cycle and roughly equates to the presidential cycle. Being a contrarian I would not expect the two extremes to repeat over the next five years. The extreme contrarian would examine the funds that produced negative results feeling they could be the leaders at some point. In that vein I would be scanning for any indication that things are changing for the better for commodities funds, particularly those involved with different aspects of energy and agriculture. I don’t currently see a catalyst, but I can afford to be late as I suspect that most of the selling in these sectors is over.

Short-Term = Confusion

As is often the case the future direction from current conditions is not clear to me. Banks do not appear to need deposits to make loans as the interest rate offered on average is 0.59%, down from 0.61% the week before and its recent cycle high of 0.63%. Lack of new loan demand is not encouraging. The latest survey sample of the American Association of Individual Investors (AAII), a very volatile measure, shows the three alternative predictions for the next six months are all between 31% and 36.5 %. On a more positive note, the roster of price moves in the Weekend WSJ showed 64 out of 72 being positive. Of the 25 best performing funds for the week, 14 were growth funds and 3 were health-oriented funds.

The one certainty after a period of level market performance is that there will be a breakout on the upside or a breakdown, possibly both, based on  higher volume and enthusiasm.

Another Favored Myth Destroyed

For many years during a US recession Americans talked about moving to Australia with their US acquired skills. Very few did, but it was in the back of their minds as an economic escape. In the nuclear age several Americans thought that the safest place to live with their families was the South Island of New Zealand. The tragic events of this week have shown that there is no practical place to escape. We are going to be forced to deal with present and future problems where we are. The destruction of myths often leads to the recognition of the benefits of where we are and focuses our attention on making our lives and investments better.          

  

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/03/the-top-before-big-top-weekly-blog-567.html

https://mikelipper.blogspot.com/2019/03/2-speed-vs-2-directions-old-better-than.html

https://mikelipper.blogspot.com/2019/02/lessons-from-warren-buffett-and-italian.html

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Accurate and Misleading Measures Will Hurt Investors - Weekly Blog # 486

Introduction

A cynic is described as knowing the price of everything and the value of nothing. In a society supposedly led by the intelligent there is a great tendency for the top-down thinkers to be a source of guidelines that a cynic would produce. Experts pandering the supposed short attention span of the populace produce mathematically accurate measures for comparisons to aid or direct decision making. These “experts” are found in government, media, universities, and private practices.

Three examples of this approach and their results illustrate this cynical attitude are as follows:

• Car buying by gas mileage delivered
• College selection by test scores and future income
• Investment choices vs. securities indices

Car Buying

The US government in its desire to foster climate management requires auto manufacturers to place on the price stickers the estimated average gas mileage of each car being considered with the intention to lead the buyer to purchase the most fuel efficient vehicle. Early after these requirements were promulgated some of the manufacturers advertised their high number of miles per gallon. While initially there were some market share shifts in that direction, but recently the relatively low gas mileage SUV and light truck models market shares have risen dramatically.

Why didn’t the guidance work? There are two main reasons. The first is that in buying a new car the buyer is interested in other values. Many buyers either consciously or not want their purchases to say something about them either to themselves or others. This is the basis of most successful advertising. The second reason is that the number set of just city and highway driving consumption is inadequate on two levels. First, in the early years of car ownership the cost of fuel is among the smallest amount spent on the car, where normal repairs and servicing (plus in certain locations garage and insurance) are higher than gas. Second, none  of us are average in many things that we do or consume. If the data showed the range of consumption, it may become very clear that our own driving habits have a great deal to do with the results.

College Selection

For many people the single or the next most important purchase is their school education. As with any purchase it is useful to examine the transaction from both sides of the trade. From the student and/or the student’s family viewpoint early on in the decision process there is a series of statistical arrays to sort through. These include test scores, acceptance ratios, and average income expectations. Again these pinpoint numbers do not show the ranges of outcomes or even in most cases the difference between averages and medians.

I have had the privilege of sitting on two Boards of Trustees of universities that I didn’t attend. I have watched in each case the admissions staff create a model of the desired incoming class. The importance of test scores is only in the absence of other indicators. For some universities class ranking is more important combined with an overall grade point average and trend. The incoming class should augment the other students in terms of academic, sports, and social skills to produce the best universe for the school over the next few years. From their point of view, the yield of the accepted applicants to those who attend is an important measure. The odds are that an application without a visit particularly from a distant home raises the probability of attendance question. I suspect, but have no confirmation, an eye should be placed on the odds of future financial or public success of the student. In these lights, awards and work progress either for pay or organized charities is important.

In my opinion, one of the tragedies of the American college scene is the level of student debt being assumed. Too many students and their families believe just graduating from college is the ticket to a successful career. They don’t try to determine the percent of the starting class that graduates on time, the range of income earned immediately after graduation and over the working lifetime, and an all-in estimate of the costs to attend a college including a reasonable estimate of spending. A non-statistical measure that can be probed through interviews is whether the prospective college student is ready for this level of commitment and responsibility. As with many things in life, the selection of schools should not be solely or perhaps even importantly, a “by the numbers” exercise.

Investment Choices

Making investment choices can be intellectually and emotionally difficult. No wonder many people including professional investors seek quick, simple decision tools. Often they are serviced by media or salespeople that have been trained under the mantra of “keep it simple, stupid.” While the summation of a planned course of action can, and often should be, transmitted simply, most simple thinking is simply wrong. Any one sided decision that does not consider both the rewards and the risks of each decision is unwise.

The most grievous mistake is to make a comparison of two unequal subjects.  Securities indices were developed as a sales method to describe the movement of a market as if it was a single force, not a collection of many. Pooled investment vehicles, including mutual funds, are more than a collection of individual securities. Mutual funds are a legal entity that are required to follow specific federal and state regulations. Funds have expenses involved with gathering and redeeming assets, expenses of managing assets, including transaction costs. In may cases, through some marketing activity the ability is provided to discuss immediate concerns of an investor that is troubled due to personal or market concerns. Historically, a wise steadying hand has prevented many investors from selling out at the bottom. None of these functions and constraints are on the publisher of indices. (I was one a number of years ago.)

Recently, I have noticed a number of brokerage houses and other wealth management organizations are attempting to hire qualified analysts in their fund selection efforts. I wish them well as that is part of the process of what we do. It is not easy once you no longer rely solely on “The Big Mo” or momentum as spoken by a former US President. One of the great dangers of following momentum is that it can’t go on forever in recognition that once everyone is dancing to the same tune, there will be no new followers. Momentum often ends abruptly with sharp reversals.

Fund selectors should be focusing first on comparisons with other mutual funds that are actually doing what the fund under scrutiny does, also other funds that could do those things but don’t. As someone who learned basic analysis at the racetrack, in every decision there are odds that one can be wrong. Each manager, active or passive could be wrong. The critical skill set is mixing funds with different potential risks into a portfolio that on average can sustain it itself under varying circumstances.

Conclusion

In each of the three decisions discussed the single most critical variable is the individual involved. How you drive will determine your gas mileage and satisfaction with your car. The student will for the most part determine his/her success at college and beyond. The owner of the securities or funds will be the biggest single determinator of the investment. In addition the people that manage the funds will drive their investment vehicle within the range of available choices and they are more important than their records.    

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Brains are Wired to Produce Long-Term Losses

“Don't blame me for the way my mind is wired, nor how I made wrong choices over my investment life.” This statement is a cop-out,  equivalent to the old Flip Wilson line "the devil made me do it."

One of the reasons to read Jason Zweig's column in the Wall Street Journal every Saturday is that he is one of the few columnists who regularly reads, understands, and reports on academic papers found in the learned journals.

Brain wiring produces long-term losses

In Jason's column this week, he reports on a study published by the Journal of Neuroscience. The authors of the paper were professors/researchers from Caltech, NYU, and the University of Iowa. (Disclosure: I am a trustee of Caltech and have supported some of its work in examining how brain functions drive investment decisions. Furthermore, I seek to keep current with NYU and the University of Iowa, as a grandniece is entering NYU and Ruth and I know a number of successful graduates from UI.)  These studies indicate that most people rely on short-term memory to shape their actions. Therefore immediate past successes count more than longer-term experiences. (My technical analyst friends have known this for years under the rubric of momentum investing.)  This pattern conforms to Newton's First Law of Motion whereby a body in motion stays in motion, or as commodity players often believe, "the trend is your friend." The portion of the brain that is wired to produce these results is called  the "frontopolar cortex." People with a damaged frontopolar cortex do not rely on short-term memory, but are more influenced by a combination of long-term trends.

Performance significance

While there are not many short-term traders that have been able to put together a career history of above-average investment results, there are more successful long-term investors. The secret to their results stems from the ability to buy sound companies when they are unpopular. I have known a few of the managers that exhibit these attributes, including Warren Buffett, Charlie Munger, John Neff, and Sir John Templeton. 

In terms of today's global markets, I would suggest that a heavy commitment to growth-focused mutual funds or equities would be a good place to start.

The same rules apply in the political world

The current crop of political leaders are also reacting to short-term focused issues in preference to addressing the longer-term problems. Their global focus is on the momentum in the latest polls, or what American political leaders call the "Big Mo." These are politicians not statesman. Perhaps even worse is the tendency of central bankers to follow the politicians rather than to focus on the structural threats to their nations.

Forthcoming blogs

Ruth and I are in California for the Caltech board meeting after listening to good music at the Aspen Music Festival. I suspect next week's blog or the ones thereafter will focus on investing in technology and the importance of what is happening in China. If you have any views on these topics, please share.

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