Long-Term Investing is at a Crossroads

Introduction

There are three problems about thinking about the future. The first is not to believe the future as starting with what we see today. The second is “when does the future end?” Finally, “what unpredicted events will occur?”  Far too many investors ignore these questions. However, the best guess answers to these questions are the essence of long-term investing. We currently have the responsibility for investing for the indefinite future for institutional and family accounts and so must deal with these questions. Like all investment advisors, we need to do this well for us to be able to add new accounts.

As our present responsibilities to clients and beneficiaries require certain levels of current income, we managed balanced accounts on their behalf. Thus we need to pay some attention as to what is happening in the fixed- income markets, which leads to the first fork in the road. 

Fixed-income disruption

Usually the exploding bubble that brings down markets is caused by an imbalance of demand over supply. If the market can not supply sufficient merchandise the demanders will increase the prices that they are willing to pay. During the ramp up the owners of supply will become hoarders in the belief that prices will continue to rise; and so it will as sellers become scarce. The bubble pops when the hoarders become insistent sellers and the buyers retreat as their only interest was higher prices. 

In some respects the way fixed-income investors think about securities is the exact reverse as stock buyers. They translate their need for income into a yield calculation. Their literature is full of commentary about rising yields not falling prices which is the direct result of the fixed nature of fixed-income.

Any long-term history of bubbles will reveal that bubbles never really totally disappeared; the surviving “animal instincts” just shift their focus often with the help of governments. The speculative excesses from the “dot-com” arena morphed into the prime mortgage bubble. The way one can spot the next bubble is to look for large instances where there is excess demand over supply. In the fixed-income world that translates into higher prices for bonds and lower yields. We are currently within a huge increase in the demand for income to meet institutional and individual needs.

I have written in the past about the studies done at Caltech and other places as to how the mind accepts risk of sharp declines based on the belief that the mind will be able to execute a rapid withdrawal safely. Growing up in the investment business we used to call this “the greater fool theory” meaning one recognized that they were foolish buyers and owners of securities, but there would be always be a bigger fool who would buy the tarnished merchandise at a still higher price. Today, the nerves of the fool are quieted most of the time in the belief that the major central banks will continue to manipulate interest rates lower and in effect put a floor under these foolish bets.

The fears are not totally put to sleep as we saw this week when a single missed payment by a partially owned upstream affiliate of the largest Portuguese Bank (Banco Espirito Santo) triggered a broadly-based European stock market sell-off. This kind of market action reminds people of the unpredictability of events.

In the past, prior to government/central bank intervention, interest rates covered both the cost of money and a cushion for the cost of credit to make the loan eventually good.  The sharp drop has people concerned that what they thought was the proper attention had been paid to the question of credit repayment. Now they are wondering. This may well be the reason that in a US stock market which is hesitantly but gently rising, the stock price of its most powerful bank JP Morgan Chase^* is slightly down -4.6%.

One of the lessons that stock players over the years should have learned is that the fixed-income market is much more sensitive to short-term changes in the chances of getting repaid than the stock market. Thus for stock investors, the bond market plays the role of the warning canary in a deep mine. (This is not a totally new concern. In 2013, the Investment Company Institute reported that both Citi and State Street temporarily suspended redemptions of some of their Exchange Traded Funds.)

As all analysts are essentially historians, I am concerned about the excess of fixed-income demand over high quality supply. In addition, there are two newer concerns. The Federal Reserve has announced that after October they will no longer be regular buyers of US Treasuries and Mortgages, which may reduce the supporting buyers.

My second concern is that because of more restrictive regulations most major banks around the world are finding that they must reduce their expenses in order to get a reasonable return on their equity. This translates into laying people off. Some of these people are in supervisory and/or credit reviewing positions this could hurt all of the services that the banks provide to both institutions and individuals,

       

Melt up before melt down

As said by Monty Python's Flying Circus “Now for something completely different;” a quantity of  US stock investors is actually enjoying good returns.  I tend to look at stock returns in terms of multiples of pension fund and non profit institutions’ funding needs. If one assumes a 7% required rate of return (which is too high), then on a year-to-date basis the owners of Apple shares^* have earned more than double that rate, with an 18.8% gain. The same could be said for Merck with an increase of 16.8%. Even the bond substitute of Utilities is up 14%. (This relates to our fixed-income concerns.)

The truth about the stocks going up in price is that current prices are not drawing in sellers. As many have commented on the current bull market, it is the most unloved bull market in history. While the near-term outlook for revenue growth for most companies is modest and they already have record profit margins and are shrinking their capital base, one wonders what is driving some of these stocks higher.

I have a partial answer from my experience as a leader of a global analyst trip many years ago. I got a call late one night when we were in Australia from a brilliant international portfolio manager. He was asking how the trip was going. I started by reviewing for him our various visits. In his demanding way, he cut me off and asked whether my fellow analysts were believing or not. I asked him what his concern as to what we thought was. His reply was stocks went up on the basis of the weight of money behind each stock.

In a similar fashion I believe that the stocks that are going up are due to the weight of money. Some institutions and many individual investors are not fully committed to this stock market. (Fund net flows are larger for international funds than domestic oriented funds.) I suspect that if the S&P 500 on a price basis goes much higher than the current year-to-date gain of 6.4% (Vanguard’s 500 Index fund on a total return basis is up 7.6%), there will be a competitive rush to get fully invested. 

^*Owned be me privately and/or by the private financial services fund I manage

As readers know, I have been concerned about a major top in the stock market caused by stock price acceleration. Typically for a market to get into a bubble condition, the last phase is a parabolic rise where people start talking in terms of short-term doubles and more. It was just such a phenomenon that suckered in Sir Isaac Newton, who knew better, and much later, John Maynard Keynes into participating in the collapse of their bull markets.

I hope this doesn’t happen. But both from my study of history and my research lab at the New York race tracks I can not rule it out. I will be intently watching the action of the crowds, to see whether successful business people are giving up their well paid jobs to day trade from their home computers.

Muddle through

There is nothing axiomatic to the two extreme cases discussed above. The Wall Street Journal which started publishing on July 8^th, 125 years ago created what is known today as the Dow Jones Industrial Average. Over this period it has compounded at a little more than 7%. For those who want to catch the extremes, on the same day in the heart of the depression the index bottomed at 41, compared to today’s level of about 17,000. I must deny I had anything to do with the occurrences on July 8^th,  even though I was born years later on that date.

What to Do?

I don’t have the luxury of avoiding decisions to wait on clearing developments. I can neither wait until another major bottom appears nor can I be a seller at the top in a meaningful way. Thus, while I can adjust portfolios when warranted I must have a starting position everyday.

For long-term accounts that are looking well beyond ten years I express my faith in the power of well selected equities in well managed funds and would be committed to these holdings as long as I could meet funding needs through income supplemented by total return.

For accounts that for internal political requirements that can not see beyond five years I would reduce risk assets to no more than 66% and no less than 50%. For those unfortunate accounts that will be judged on the basis of annual returns, I would own no fixed-income with maturities beyond one year. I would accept that I might underperform a recovery in small cap and technology, including health care, by focusing on large caps, with adequate balance sheets that had a reasonable amount of secular growth in revenues and mutual funds that owned these kinds of securities.

My question of the Week

As these views are somewhat extreme what are your views? 

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Are Too Many Long-Term Investors Too Short-Term?

Many of us who claim to be long-term investors (LTI) worship at the feet of Warren Buffett and actually own shares in Berkshire Hathaway as I do both personally and in the private financial services fund that I manage. While “the Sage of Omaha” claims his favored investment period is forever, as noted in a recent column  by Chuck Jaffe, a study of his actual publicly-traded portfolio transactions suggests a holding period of four to five years. I suspect his two relatively new portfolio managers (who like Mr. Buffet have a background in managing hedge funds) have a shorter period of satisfaction with their holdings.

Corporate CEOs have little true confidence in the steadfastness of their institutional shareholders, with the possible exception of index fund holders if the companies are cursed or blessed by being found within one or more indexes or ETFs. Assuming no large earnings or other shortfalls, most particularly large corporations have the same CEOs for five years. In terms of transformational investments, ten years is a reasonable planning period to examine the success of many companies. For those businesses that make large capital expenditures in fixed plants or ground-breaking R&D, particularly in pharmaceuticals, twenty years or even longer is a reasonable measurement period.

Those of us who are investing for the education and future of our grandchildren will take our money to the ultimate fulfillment. For those of us like me that serve on boards and investment committees of large tax-exempt groups that are responsible for universities and hospitals, the time horizons are even longer. Think about granting tenure to a forty year old professor who could be teaching for forty or more years voluntarily and an administration without an easy ability to either improve the quality of the teaching or cutting the expenditures. As far as hospitals are concerned, the outer skins of the buildings are likely to hold up for fifty to one hundred years, that is if they weren't built to federal government specifications and by low-bid contractors. However, with the marches of science and regulations many if not all of the physical plants will have to be reworked rather frequently due to perceived obsolescence.

Faulty starting points of too many LTIs

Too often we become captives of both history and the headlines of the day. Any study of past investment mistakes shows that over-confidence in our wisdom and our ability to foretell the future leads to disastrous results. I have learned through meetings with existing and potential investment managers and investment consultants that many confuse the difference between a book report and a book review. The report form abbreviates the history of their investments both statistically and thematically. A review has to do with the ability of the managers to successfully negotiate the future, or more importantly futures. I am in the continuous process of meeting with existing managers that we use and candidates for future use. To the extent that the portfolio managers and their chief investment officers (CIOs) think deeply about the future or futures, I will be probing them with some of the questions shown below and other items they or I think are important.  In addition, I ask the readers of this post to react to these queries publicly or privately.


For the sake of the future, "Are profit margins too high?"

This is not a mirrored concern of my good friend Byron Wien and others that are worried that margins will surprise many by coming down in the second half of the year. My concern is different and perhaps deeper. As an entrepreneur I know that profit margins are not just a result, but to some extent are the outcomes of a very important series of operating asset allocations. Final operating margins are the consequence of a series of simultaneous equations between personnel management, development spending, foreign exchange management, balance sheet concerns and the mix of interest received and paid. Often margins are the beneficiaries of past acquisitions bringing the acquired margins up to the level of the new corporate parent. The simple statistic of profit margin does not reveal enough about its present and future composition for wise investors to properly evaluate the investment's long-term attractiveness.

Why can margins be too high?

I am not a socialist, but I raise the question, “As a society, outside of government, are we paying too little to employees?”

Because of the prior demands of individuals and organized labor, plus government intervention, we have encouraged the substitution of technology and to a lesser extent foreign workers, for domestic workers. My concerns are two. The first concern is the actual and implied replacement of domestic workers. One example is that we are not getting enough useful new ideas from our senior and professional staffs. There are untold numbers of instances where a relatively low paid worker on the factory floor or in the mail room recognized something of value to the process that was missed by the executives.

The second concern comes from Henry Ford, certainly no radical labor leader. Ford raised wages to an unheard of $5 per day. The history books record that his decision to raise his workers' pay was so they could afford to buy the increasingly mass produced Model T automobile. The growth of high corporate revenues needs strong consumer demand.

Currently one of the concerns of investors is that while earnings progress is surprisingly good, domestically produced revenues are flat with the gains attributed to record profit margins. The news from the job front is at best misleading. While the number of new hires is marginally good, the quality of the jobs being filled is at lower levels of pay and satisfaction. Two of the indicators to watch are short-term sales in stores that cater to the middle class and the purchase of new homes.

Will the current wave of M&A lead to tears?

As pointed out by London's respected Marathon Asset Management, one of the reasons for the good margins has been bringing an acquired company's margins up to the new parent's levels. However this is a one time occurrence accomplished by tighter financial management and bigger discounts from bulkier corporate buying.

However, there are longer-term negative impacts of these deals. Often the senior management of the acquired company is locked into the acquirer as an indentured servant for a specified period of years. After their Liberation Day most of the original people are gone including, perhaps those at above-scale wages. At this very point it will become clear whether the combined company has the breadth of management needed to make this work out well in the long-term. One of the historic problems for companies like General Electric is the belief that a good manager can manage anything well. In a more complex world it doesn’t happen all the time. Rarely do we see the practice that I followed with some tiny acquisitions: while I liked the products the acquired firm produced, what I really wanted was the new management to join us and play a bigger role in the overall growth of the firm. This is not happening today.

The big risk for the acquirers is that not only do the former senior managers leave the "Mother Ship" but they bring along with them or attract the bright young and entrepreneurial people that will develop the new leading edge competition.  As a partial answer to these concerns  I believe, along with others, that we will see more spin-outs or strategic sales. To accomplish this well and to keep the loyalty of the former parent company's workers will require skills only a few firms have.

Are you prepared for the next bubble?

In our economy we normally don't fix the inflating force that created the bubble, we just remove the flow of the assets that created the bubble. But the assets go somewhere. Most of the time investors still search for above-normal yields and because of their confidence in their own selection skills or those of their managers, dealers or brokers, they remain speculative. We are at the point of looking at mutual fund flows worldwide to suggest that the High Yield Bond fund bubble is deflating. Where is this money going to go? Wherever it goes eventually, it will likely prove to be disruptive.

What to do?

Try to look to the next visible time horizon and beyond to what may be large mistakes that in some future time periods can be corrected. Do not have too much confidence in the correctness of your present, firmly held investment beliefs. As they say, many roads to Rome (investment success).  One should be on multiple routes, the more the better.

Please share your thoughts.   

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