Selecting by Market Cap Can be a Trap

Introduction

Selection and diversification policies should be based on meaningful investment filters. To win and maintain accounts most institutional investors need to surmount brief discussions with consultants, “gatekeepers,” investment committees and similar part-time investors.  To make those that hold the keys to the managers’ revenues satisfied and retained, is to make comparisons easily understood. Only a weak client relationship will focus primarily on performance. This way of thinking was driven home to me last week.

Market Capitalization Traps

During the week I met with two investment committees, entrepreneurs and their advisers, and two publicly traded fund management companies in New Jersey, Monaco, and Toronto. In each case present and future investment performance was at the heart of the discussion. The comparisons used most often pivoted around easily definable groups, such as market capitalization. For instance Small Caps, S&P500 (which is essentially Large Caps,) or MSCI World Ex-US (again Large Caps).

Questions from the Audience

In Monaco I was asked how much should a portfolio hold in Small Caps. At that very moment my dilemma became clear. In the audience there were CEOs and their advisors/investment bankers from about twenty hopeful companies. Clearly it would have been foolish to perpetuate the dream that all similar market cap stocks or funds  could become holdings in a prudent portfolio. In answer to a question I did suggest for that particular audience that in my construction of the Endowment Portfolio within the TIMESPAN L PORTFOLIOS^® depending on other factors a reasonable range for Small Caps could be between 15% and 40%.  Depending on facts and circumstances, a different range of small-cap investing could be considered.

Good and Bad Small Cap Stocks

One of the advantages of the give and take of question sessions is it makes you search for a quick suitable answer. Hopefully in my case it leads to a more thoughtful review of the topic. After much thinking and considering marketing factors, I know what I should have said. Small Caps are not a separate and distinct asset class. There are good Small Cap stocks and bad ones, and buying a stock just because it is a Small Cap is unlikely to give an investor a competitive investment.

Investor Selection Screens

More meaningful selection screens should be a function of the present and future enterprise risk and reward. The results should then be married to a separate analysis of the stock. To me the single most important risk element is that of the co-venturers, those presently and likely to be in the stock. What is the risk of one or more other sizable co-venturers moving in advance?

Another element would be the present price discount as to the future. There are countless other filters including some proprietary measures that can be used as screens. What I look for regardless of size are companies that are in businesses that I have some competence in; e.g., money managers vs. biotech where I believe that my view of the future is not already in the price.

Research Cuts at Major Banks

Having indicating my preferred way of analyzing securities, I believe that we may be entering an era when there will be bigger discovery value in Small Caps than what we have seen in the last decade. This week The Financial Times had an article reporting that research staffs at major banks have shrunk perceptively. This was not due to a view of the declining value of the research effort, but rather a reaction on the need to pay for increased compliance costs combined with restrictions lowering profitability on the use of the mandated regulatory capital. The cutback in the banks’ analytical forces will probably result in less analytical work to add new names at the edges of their portfolios, however the cut-back may also create opportunistic buying occasions.

Most banks need to have as good analytical coverage as possible on their clients’ holdings. As mutual funds are completely discretionary they can more easily add new names with appropriate research coverage.

Travel Cuts Too

Within 24 hours I flew in the business class section on an 80 minute flight going back and forth from Munich to Nice. On each flight there were people dressed in investment clothing of bankers and family office types carrying financial publications on the way to and from Monaco. In each case the business class section was less than half full. This may be normal German tight expense control particularly on such a short flight, but I had the impression that this was something of a new experience for them.

 Investor Opportunities

In Monaco I was the keynoter for an investment conference where there was only one representative of a major bank. The decline of major bank research and conference/sales participation may be an opportunity.   I think small cap buyers will have fewer competitors in finding good investments as these companies are the major contributors to domestic job growth.

This Week’s Concerns

There are a number of topics that I will be working on during the shortened Thanksgiving Week, as follows:

1. Trying to understand the dichotomy between favorable indicators for the stock market and cautionary signs for the bond market; e.g., a sharply falling Barron’s Confidence Index (an inverse indicator for the stock market) VS.  best quality bond yields dropping 14 basis points. This compares to only a 5 bps decline for intermediate credits, a widening of High yield spreads, a dearth of ratings upgrades and low reported core revenue growth.

2. In a reaction to some negative to flat performance results around the world, except in Japan, many marketing driven managers are becoming advocates of alternative investing. While there are a few quite successful practitioners, most are not producing significantly positive results and those that are garnering returns are doing so below the funding needs of their fiduciary accounts.

Disaggregating the performance of these groups may be a useful exercise. In the week ending Thursday the average US Diversified Equity Fund gained 1.32% with none of the alternative fund averages doing as well. This may be explained either by their total expense ratios being higher than the average funds or the fact that some of their extreme tactics are not working; e.g., 161 Dedicated Short Biased funds fell -3.22%. Some alternative funds may use leverage to magnify their results, 194 Equity Leveraged Funds gained 3.52%. For the year to date the short funds declined -7.47% and the leveraged funds dropped -6.75% as compared with a minuscule loss of -0.12% for the US Diversified  group and most alternative funds producing less than plus or minus 1%.

Question of the Week: What are your thoughts on the two topics above?

Thankful Harvests

As we move into the traditional harvest season, Ruth and I celebrate our blessings with family and friends on our Thanksgiving. This year we will be particularly aware of those less fortunate and particularly those who have lost dear ones through the violence of the last week.

Copyright © 2008 - 2015

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

Flat Earth Wrong Again

Introduction

Because most people in the Fifteenth Century were focused on the difficulties of their lives, it was easy for them to believe that they and their neighbors were the center of the world. Their view of the world was limited by the height of the tallest mountain and the depth of the deepest valley. Thus it was easy to believe in boundaries that they could see. From this vantage point it was simple to believe that the earth was flat and was the center of the universe. To some degree investors and political leaders have the same view today. We have been trapped in a flat general stock market that experiences significant daily to weekly volatility before reversing to attempt to breakthrough either on the up or downside.

Low Volume Trading

These movements use up a lot of energy in expressing hopes and despairs. Having grown tired of this dance to nowhere, many investors have shut down their transacting activity. At most the low trading volume absorbs the net additions to investors’ cash flow or provides a trading arena for those who believe that they possess superior trading skills. Thus, we have created an investment audience who believe that not much will dramatically change until they perceive a major and probably unknown stimulus. They have returned to the flat earth view.

Open Your Eyes

One of the jobs for the long-term strategic investor in companies, securities, and people is to examine daily inputs of change to discern what could change and what are the odds on that change would occur.   One of the lessons that I learned through handicapping thoroughbred horses for a specific race was to deal with absolute uncertainty by assigning relative odds on each potential bet and comparing my personal-generated odds compared with other players/investors to find where I saw a better than normal opportunity that others did not see. Therefore I learned to look for early indicators of transformative disruption that others did not take into consideration. Like some of those in the Fifteenth Century, I looked far wider than others. I looked beyond the statistical measures such as reported earnings, present yields and last transaction prices. The following items are what I am now seeing.

The Downside

The first thing any investor should do is to look at the odds on losing money. In every transaction there is a buyer and a seller. Each side has his or her own motivation for the trade, but both are forcing themselves to do this trade at this time and at this agreed on price. Both could be correct for themselves because they have different time frames for their judgments and/or different plans for their money.

Lots of Great Sales, Few Great Buys

Having both bought and sold securities and financial service companies I sense the buyer of companies is more long-term oriented particularly if the buyer believes he or she can dramatically improve the profitability of the seller’s merchandise. The seller is more currently oriented, feeling that the price offered more than adequately pays for the present risk and rewards available. As someone who has been following the financial services business for more than fifty years it is my impression that there have been relatively few great buys and a lot of good sales. Today there is an increase in the number of insurance-related and data services providers that are selling out, often for cash and some stock. Broadly speaking, financial services is only about one-quarter of the available stocks, however the business of financial services is critical to the workings of all economies. Therefore, to me the odds of a security price downturn in the near to intermediate term is going up. This is reinforced in the fact that the number of business start-ups is way below what would have been expected after a six year economic expansion.  Should you care?

This focus on the time of judgment combined with operating conditions that are funded by investments is why I have trademarked the name Lipper Time Span Portfolios. The concept rests on four portfolios of stocks, funds, and managers. The first or Operational Portfolio is designed to fund current operating needs for a period of a couple of years. As a downturn may not recover within this period, concerns about a downturn are very important. The normal hiding places today like short-term high quality paper unfortunately do not pay enough to cover at least my perceived level of inflation, particularly after all taxes. Thus, some level of equities should be included, but with a manager or investor that will quickly liquidate once a downturn has begun. We will focus on the other three portfolios as part of the upside discussion that follows.

The Coming Upside

History suggests that for America, there will always be an upside. The only question is when will it occur and will it happen as a breakthrough of the upper limit of the current flat market or will we experience a once in a  generation breakdown first. I remain optimistic and reasonably fully invested in equities and equity funds. I have four reasons for my optimism.

The first is based on all the exciting research technology on and off the campus at Caltech as well as what I hear about Carnegie Mellon. The marriage of technology with the biotech world will lead to faster and better treatments for many of the world’s debilitating illnesses and untimely deaths.

The second reason which is very short-term is based on data from the American Association of Individual Investors, which surveys its members frequently. The latest AAII survey displayed in Barron’s shows only 21.1% Bullish and 40.7% Bearish. These kinds of readings often occur at reversal turning points.

My third reason is based on recent developments in the commodity markets. The performance of many commodity managers for the period ending in June and extending into July has been extremely poor. Many investors are fleeing these funds with a number of the funds closing. Commodities are priced based on their scarcity value. With many commodity producers withdrawing their capital from the production of various commodities, and large numbers of skilled and semi-skilled labor being laid off, eventually supply will sink below demand - especially when global demand picks up. At the racetrack occasionally a long shot surprises and comes in first. In some races it makes sense to look for long shots when the crowd has driven the odds down below their reasonable probability on their favorites.  A few, well chosen long shots become logical small bets. Commodities will likely be such a bet in the future. More importantly, the future rise in their prices will signal a rise in general global demand which should be good for the rest of the portfolio of stocks, bonds, and real estate. I can not guess the timing, but it is probably closer than those who are fleeing commodities today believe.

The fourth reason for my optimism is because informally I have managed portions of my portfolio in the mode of the Lipper Time Span Portfolios. As in the example above, I have some money to meet current spending needs for a couple of years. Eventually this portion will be spent. The next portfolio concept is the Replenishment Portfolio to create the new Operational Portfolio. This portfolio is structured so that it can remain reasonably fully invested through the next major downturn seeking to avoid the risk of being too late.

The next portion of the my Timespan Portfolio money is the Endowment Portfolio, which should see my younger wife through her expected long life spending needs. The securities and managers used are similar to what are in the Endowments Portfolio that I see or manage. The final portfolio or the Legacy Portfolio is designed to meet the needs of the family and charities.

Conclusion

The earth is not flat, nor for that matter round as more popularly portrayed, but spheroid with bulges around the equator and a bit flat at the poles. The flat earth believers were wrong, but the common belief today is not quite accurate which gives to some an information advantage. It is often a point of view based on more thorough information that leads to good long-term investing.

Question of the Week: How have you segmented your long-term investments?   

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Copyright © 2008 - 2015

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

 

Losing Short-term Confidence? Selling Out is not the Answer

Every action we take is based on our confidence that the action will produce a result, hopefully the desired result. Often we are not overwhelmed with confidence, but believe that we must do something, remembering that doing nothing is in itself an action.

In last week’s blog about my stock selection training vs. using passive ETFs, I indicated that it was rare that macro considerations impacted my investment selection decisions. Macro elements are what is happening to the world as a whole, whereas micro elements are what is happening to a single or a small group of potential investments. One of the reasons to focus on micro elements is that they have proven to be easier to identify. After any review of what various political, economic and investment gurus prognosticate, one has the feeling that there is a high error rate. Often the more clever pundits get some things right, but not enough to be truly helpful for those of us who have to make investment decisions for others.

While I think throughout the previous week what I am going to say in Monday Morning’s blog, I pay particular attention over the weekend. Often I search for confirmations or challenges of my beliefs online, frequently focusing on what is probably the largest data bank of computerized investment company data in the world as put together by my old firm, Lipper, Inc. This weekend I am coming up empty for relevant micro insights, as the range of potential outcomes on the macro side is too great and my confidence in the short run of the market is waning.  (I do not have to be right, I just need to not be really wrong.)

The Macro Factors that can go either way:

The debate as to the final constellation of the euro

My frustration is that I cannot add anything to the debate. Worse, I do not see any progress to a permanent solution to the deficit production of governments and central banks supported by the general populations who in aggregate want more in government services than they are willing to pay. Having no responsibility to solve the currency problem, I can perhaps too easily come up with a grand solution.  At the currency level, Finland, Denmark, Holland, and possibly Austria should lead Germany to a hard euro with responsible governments. France and Italy should lead the peripheral countries into a softer euro with one or more devaluations and probably some form of centrist government eventually. I hope the solution evolves quickly; then all of Europe as well as Russia and China can turn to a much more serious problem in their midst which is the growing population of Islamists that fundamentally hold different cultural norms, particularly in the rule of law.

China: can the government continue to get it right?

For at least the last decade, which is the Chinese Party’s time frame, no government has done a better job of controlling its economy in both a huge expansion and a slowing contraction. Power has devolved from the central control of a headquarters-based party to lower levels of government, including getting down to the village and city levels. Actually it is at the lowest level where the biggest monetary contribution is made to the general population’s benefit. From the study of large organizations be they political, military, corporate, religious, or sporting activities, we recognize how difficult it is for good orders from the top, (and they are not always good orders), to be carried out effectively at the lowest level. Recently China has experienced a significant problem on the political level and another at the industrial (railway) level. I am sure that there have been other malfunctions. At the speed that the society must find reasonably well-paying jobs for the population, the Party may not have sufficient control factors in place. An uncorrected mistake could spark the feared social tensions that could derail the growth plans. I will not have high confidence in this arena until I see what the new political leaders will do.

The US election may not be decisive

I do not know many potential voters that are happy with their particular favorite for President or for Senator, when one is running in their state. They vociferously favor their choice over the opposition, but are still not totally thrilled with their candidate. Perhaps this is a good thing, for many political leaders that came into office with a large wave of enthusiasm have disappointed. My real concerns are that unless things change dramatically, getting effective fiscal legislation through the Senate will be difficult. Along with the rest of the world there does not appear to be any groundswell in the US to drastically cut the costs of the things it enjoys and little delight in paying more taxes. Perhaps out of this morass some true statesmen or women will arise and lead the US onto a prudent growth path.

US exceptionalism comes with a price that it cannot deny

The exceptional results of the US are not solely, and may not be mainly, due to its population. The two ocean borders and the abundance of arable land and other natural resources should not be dismissed or discounted. At the moment the US has a large number of the leading universities of the world;  I speak with a bias as a trustee of Caltech. In many fields such as software and biotechnology (including the Human Genome Project) the US is the leading developer of technology. With the gifts that have been given to the United States, the country has a responsibility to others less fortunate. If it shirks these responsibilities as it is now doing, other nations will surpass and could even suppress it. My meetings with the brightest young Americans I know does give me confidence, but not when I see many existing political and corporate leaders.

Investment Implications

My short term confidence and those of others may recover very suddenly. Markets can move extremely rapidly from the present level. I would rather be a worried investor reasonably fully invested in equities than trying to time a re-entry move. Where possible I would have a significant investment in technology companies that have a practice of being leaders in disrupting the status quo. The world has progressed to such a point that all of my investments must address a global world to prosper. Sleep may be overrated as a priority in this pursuit.

Do you have confidence in your portfolio?  In which securities and why?

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