Awareness Risks and Opportunities: The Search for Outliers

Introduction

After stock prices slumped last week, particularly Thursday and Friday, we should be aware that our judgments are far from perfect. To help us in our deliberations, I am calling up our top strategy team, RT&E. Let me introduce the team: they are more formally known as Donald Rumsfeld, Mark Twain, and Albert Einstein. Rumsfeld divided knowledge into “Known Knowns,” “Known Unknowns,” and “Unknown Unknowns.” Mark Twain cautioned us as to what we “know” that is just not true. Einstein, a three-time visiting professor at Caltech, told us “Everyone sits in the prison of his own ideas, he must burst it open.” He suggested that we must think differently to produce different results. We should always be aware of risks and opportunities including those that we create by our own narrow thinking.

Known Knowns

1.      In the modern era, where the leading academic institutions teach the unsuspecting students a top/down view of the world in order to put the academics near the top of the power structure, they teach that markets are primarily driven by monetary policies implemented by the Fed and other central banks.

2.      The best examples are China and Russia, both are command economies and therefore the governments can totally deliver what they want.

3.      Price momentum leads to further price momentum for stock prices.

(see table below).

Known Unknowns

Each of the “knowns” are macro trends, or if you prefer, gross understandings that can be transmitted to the audience in sound bites up to 40 minutes of class time.  These averaging or actuarial approaches to human behavior lead to surprises or counter developments that are derived from the study of micro trends which when netted against the gross trends cause periodic reversals. This may well have been what happened last week with the gross beliefs being carried beyond their “sell date.”

For some time it has been reported that most publicly traded stocks in the US were falling, but the popular market averages were being held up by a couple handfuls of favored shares. Many of these favored stocks prices in one day fell into a correction (10%) or a full bear market (20%).

Filtering the largest dollar volume declines on NASDAQ the following names could lead a major price trend change list:

Priceline	(-67%)
Google	(-45%)
Amazon	(-37%)
Netflix	(-19%)
Tesla	(-12%)
Baidu	(-11%)
GoPro	(-10%)
Gilead	(-10%)
Apple	(-10%)

These stocks have preformed very well in the past, but the unknown element is when would they give some back, and how quickly would it occur.

(I am not commenting on the attractiveness of these names, but the surprising rapidity of their decline in high dollar volume which up to last week was unknown.) 

Unknown Unknowns

The “knowns” are premised on “all other things being equal.” We live in a world of small and occasionally large changes daily. Strange as it may seem, each day we grow older and perhaps wiser, but not definitively different than the day before in terms of our attitudes and mental and physical health. Not only are we changing, but we are experiencing the never-ending changes caused by technology.   Because of cell phones, billions of people are now aware almost instantaneously of any important news item, interesting rumor, or critical price change. Markets move with the speed of electronics; in many respects for major “chunks” of money no market is closed.

Teenagers’ buying habits and other consumer demand swings occur rapidly, responding to perceived models can lead to major changes in distribution chains globally, with much unsold inventory.

The Known is Untrue

While I am a professional analyst and money manager at my core I am also a student. Thus each day I am aware that some of my rock-solid facts are going to be challenged. Many of these “facts” come from respected sources. The best of which are my own experiences and yet some of these are extrapolated too far to be general cases and not just specific relationships. For example, for many years I have been following the weekly Barron’s Confidence Index which measures selected Intermediate-rated bond yields compared to a selection of High Grade yields. When the yields of the High Grades go down relative to the Intermediate Grade, which means that high grade prices are raising at a faster rate than the lesser quality is a measure of risk coming off for bonds, which often is indicative of current attitudes toward stocks. Most weeks the change in relative yields is under 1%. This week the move itself was 3.7 percentage points which is the most dramatic change I can remember and signifies a major risk aversion. Whenever some ratio goes to a historic level most people believe it is a confirmation of a trend. My training from the racetrack is to either doubt the mechanics or believe it is less reliable in terms of the future because it represents an extreme. At the moment I am being cautious and doubting the validity of the ratio, but I can be wrong.

Dr. Einstein’s Prison Breakout

We all like the past because we know what happens. The future is uncertain and we need to learn when to jump off the comfort of extrapolating the past. One of the advantages of my practice is that regularly I can examine extreme performance both good and bad. I would be a poor analyst if I assumed that these extremes would continue. The odds are that there will be some reversals where a poor performing fund will do much better than average in some future period. Often this happens because the portfolio manager or the CEO of a company sees something in a different light than the rest of the pack. My job is to find these rare reversal types and get enough confidence in their approach to follow them. The nice part of our portfolios is that almost always there can be room for an unusual approach as they breakout of the conventional prisons.

Question of the week:

Which managers are doing unconventional things that we should study?

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The Importance of Turnover in Picking Managers

Most of my posts end with a question to our readers. I ask questions not only to promote a dialog, but more importantly to learn from some pretty smart people who regularly read these posts. Last week one of the long-term members of this community sent me a series of thoughtful questions. One of which was, “When you conduct your analysis of funds and manager(s), how important is portfolio turnover in your calculation?” In effect, he is asking, do turnover rates matter?

When an investment analyst is asked this type of question you should not be surprised that the answer is “yes and no with an explanation.”

 A compliance invention misused

The earliest use of the term turnover rate was by the US Securities and Exchange Commission (SEC) in required prospectus disclosure. (As I hope to be visiting our British friends shortly, I need to distinguish between the US use of the term and UK’s use of turnover as a synonym for sales.) The SEC’s prospectus requirement was not designed as a selection tool to pick funds. The purpose of the calculation was to spot excessive churning of a portfolio to generate, what used to be valuable brokerage commissions. This purpose will become clearer when one knows the methodology of the calculation which is take the smallest of aggregate purchase dollars or sales divided by the monthly average of total net assets. Now you have learned more than you ever wanted to know about turnover rates.

Turnover is a good place to start asking questions

Portfolio turnover is an important place to start, but perhaps more important is personnel turnover which I will discuss further below. In terms of portfolio turnover data, when I talk with portfolio managers the following questions are asked:

1.      On balance are they selling losers or winners?

2.      What is the average length of time before transacting?

3.      Is the average length of time different for the winners and losers?

4.      Do they do any post-transaction analysis to see in the succeeding six or twelve months whether the decision was a good one?

5.      In general, what did the transactions do to the portfolio?

6.      How does the current turnover rate compare with those in the past and does this have any particular significance?

There are other questions that are then asked about the research behind particular positions in the portfolio. However, if the Portfolio Manager (PM) does not have answers to most of the turnover questions above, I find it difficult to have the requisite confidence in the fund for it to be owned by my clients.

There is an important caveat about turnover rates that needs to be recognized. That is they seem to be rising; meaning that the weighted average in the portfolio is being held for a shorter period of time. One of the reasons for this is the consultants'/selectors' “Three Year Fallacy.”  Under normal conditions three years is only a portion of an investment cycle. Four years fits closer to the historical trends and normally contains a US Presidential cycle. Actually the command economies have favored a five year period for their planning. I personally prefer a ten year period which would give ample time for a recovery from a management mistake. Enough of the numerology, the real reason for the intermediaries to focus on three years is that it is the shortest period that they can earn a new fee for a search to replace a poorly performing manager. (Often there is a substantial relative performance recovery after a three year period. This could be caused by redemptions that are forcing the PM to sell and often he/she sells some positions that didn’t do as well as expected in the recovery.)

There is a second and more structurally dangerous factor causing turnover rates to rise. I have been on non-profit investment committees who are doing a good job meeting the twenty or more years need for funding. They invest for the long-term and review their performance intensively once a year and less so quarterly. Because of the long-term nature of their tasks they will put up with a number of underperforming periods before they switch investments. That period of disappointment might last five years or 20 quarters. Today we have the ability to get publicly traded portfolio performance monthly, weekly, daily and perhaps even hourly. If it took 20 observations for the long-term manager to finally terminate a fund, the same number of unhappy reports could occur in a month of twenty trading days or a year and eight months if monthly numbers are the trigger.

Hopefully owners of accounts in funds and/or individual securities will be mature enough not to be solely driven by performance numbers and will pay attention as to what is happening within the portfolio and within the investment organization.

The important turnover report: Personnel

In our meetings with various fund groups we are sensing many more portfolio managers being switched than what we have seen in the past.  The same trend is also being noted by Citywire outside of the US, where at the current rate by year-end over 1000 portfolio managers will be replaced. Several US organizations which have been remarkably stable for years are now experiencing portfolio manager turnover. Some of this may be due to financial or psychic compensation or in a number of instances, performance problems. In some cases these changes are not disclosed. What is definitely not disclosed is the turnover in analysts. Only at a recent face to face meeting with a PM did we learn about a reduction in the number of analysts in the office. (Interesting enough the PM believes that it could help improve the quality of investment research and decisions.) 

The turnover of senior officers in a firm is important to me. Recent turnover of CFOs has caught my attention as these are not just bookkeepers but play critical roles in developing and carrying out corporate strategies. Rarely do we see announcements of critical changes on the trading desks at institutions. For many funds that have a high portfolio turnover and/or invest in small or micro-caps, the traders can add great value. This also true in the fixed income and credit markets. 

Is turnover important?

Yes, the context of the turnover in the portfolio and in the organization is important, but the number itself can be misleading.

How do you view turnover?

Please let me know privately or publicly.

I am looking forward to seeing some of you in London in September.

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