(1.) Future Investment Success Depends on Productivity, (2.) A Possible Re-play of Sub Prime Crisis

Introduction

Often a publicized trend enters into private conversations. During the summer two day meeting of the Board of Trustees of the California Institute of Technology, there is a dinner with selected undergraduate, graduate, and post docs with some of their professors. At the dinner last week, we were sitting at a table with other trustees, some of the students and a very prominent young professor. She turned to the trustees present and asked. “What should Caltech focus on in the future?”

The initial reply was from a trustee who has earned all three of his degrees from Caltech. His answer was that Caltech should continue to seek to hire the very best professors which would attract the very best students. I applaud this continuing goal set, and I suggested that for the future there should be an additional goal. This goal should be to increase the productivity of the professors, students, and staff, and therefore society.

As a board member and contributor to a number of other non-profits, I am seeing this need in lots of places throughout our global society. I suspect that future structural improvements in productivity will be led by a combination of commercial interests and a few non-profit leaders.

Economic and Business Trends

One of the best commentators on these trends is my Securities Analyst Society friend, Byron Wien. In his latest publication for Blackstone he laments that one of the biggest risks is “the inadequate investors’ attention to productivity.” He points out that productivity has been declining since it peaked globally in the 1996-2005 period, except in China and India (increasing areas of investment interest in the funds in our clients’ portfolios). He further points out that the number of new companies has declined by 50% and the number is about equal to the numbers of companies that disappear. (Many of those that disappear are doing it voluntarily through the richness of M&A activity, lack of family interest to continue to work hard as the founders, and tax considerations.) He  suggests that since the development of the internet and smart phones there have not been significant productivity inducers. He laments the decline in high school students mathematical capabilities.

On this topic, I applaud the generous gift by Ronald and Maxine Linde that re-purposed the Caltech mathematics  building into the Ronald and Maxine Linde Laboratory of Mathematics and Physics.

To focus on the significance of the productivity problem, I wonder whether more attention should be given to a statistic I used as an analyst which was the ratio of revenue and costs per employee. In both the profit and non-profit arenas the additional costs of compliance and welfare oriented employees may be causing these ratios to narrow and thus the number of employees, I did not say workers, is a useful statistic.

Actually part of the productivity problem has more to do with personalities than pure analytical ratios. While profit margins are expanding due to higher returns from capital expenditures than employees, it is understandable these margins are hiding the very pedestrian growth in top line revenues adjusted for price increase. Too often sales are fulfilling only existing demand, not in problem-solving or creating new demand. In many companies and non-profit agencies clients are only to be tolerated, not cherished as the real assets of the activity.

Help is on the way. Currently the best performing fund in our clients’ portfolio has changed its name and focus to Innovators Fund Investment.

Perhaps the most bullish area that is benefitting from global attention is consumer spending and activity. In many of our homes and lives we still do things the way we did years ago. But today we can utilize the internet to search and buy items we did not have. We are already benefitting from the delivery of medical services through electronic communication. The race is on to remotely automate elements within our home for higher functionality than what we had in the past. The question is how we are going to use the time efficiency in our personal rising productivity, which is not in the published productivity numbers?

There are some reasons to be positive long-term.

Are Sub-Prime Type Risks Lurking?

One of the key responsibilities of prudent analysts and portfolio managers is to worry, particularly when others don’t. Many of the worries about the future do not come to pass, but some do. A full ten years has elapsed since the public recognition of the problems created by the excessive use of sub-prime residential mortgages. Are there similar type risks today? One should remember the old quote about history not fully repeating, but rhyming with the past. To me the keys to these concerns are not in the instruments but in the behaviors that are similar from one era to others. In an over-simplification, a list of some behaviors shown below could be useful in identifying future problems:

1.  Reliance on the predictability of long-term trends

2.  Investment vehicles that can be leveraged

3.  Inexperienced investors and advisors

4.  New entrants, some from well-known organizations facing slow downs

5.  Media cheerleaders

6.  Few skeptics

7.  Things not what they seem

8.  The deep linkage with the larger financial community

9.  Lack of specific regulatory oversight

10. Global activity

Some may feel the current wave of enthusiasm for Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) apparently has some of the similar characteristics experienced in the sub-prime era. The results don’t have to turn out the same way, but prudent investors should consider the parallels and make their own judgments.

The underlying statistical trend that made mortgages attractive was that housing prices always went up, though the careful student of long-term history could point out some long periods when this was not the case. The possible equivalent today is that active managers on average can’t beat the popular market averages, but it is happening in 2017.

It is cheaper to use ETFs and ETNs to leverage market bets than the purchase of futures contracts. Thus traders of all types including hedge funds are rapidly moving in and out of these products either to express a short-term market view or as part of a hedging operation on the long or short side.

Utilizing information that was called to my attention by Lilia and Leo Clemente, illustrates the rapidity of these flows in a particular week’s net flows as a percent of the aggregate assets in a specific fund.

Exchange Traded Funds are a fast changing market as they evolve into increasingly a trading market.  One measure of the manic weekly inflows is to measure the net weekly flow for a specific fund, as a percent of the asset under management in the fund. 

ETF	Net Flows	AUM % Change
Goldman Sachs Treasury Access 0-1 Year	$295.	83.07 %
iShares MSCI Japan Small Cap	$21.	13.35 %
Kramer Shares CSI China Internet	$52.	8.80 %
SPDR Bloomberg Barclays High Yield Bond	$999.	8.68 %
iShares Short Treasury Bond	$408.	7.89 %

These weekly net flows are in USD millions and we don't know the size of the gross numbers, but clearly the aggregate size of the trading would represent a larger share of the assets under management.

I suspect most of these transactions were by trading activities, including fee paid discretionary investment advisors.

The size and volatility suggests to me that there are speculative forces at work. 

I am seeing many traditional active mutual fund and brokerage shops entering the ETF and ETN markets. In terms of details and the personalities in the market place, they are quite different than the market participants that were successful in the past. Since many of the ETF and ETN manufacturers advertise heavily, there are few media skeptics.

Many of the users of these products have not taken the time and the continuing effort to understand the construction of these portfolios and the mechanisms for change. Also some of these products have built-in, larger than normal fees.

Most of the transactions in these products are conducted through “authorized participants” (AP) these are largely dealers who utilize their undeclared capital for all of their trading activities. Goldman Sachs* has recently withdrawn from being an AP. Goldman is an intelligent prudent risk seeker. For them to withdraw could be indicative of either too high risk or too low profitability. Due to the linkage, largely through counterparts leverage, a problem in these markets can generate rumors of bigger financial community problems.

^*Owned personally or by the private financial services fund I manage

These products do not have a specific regulator but are overseen by numerous securities and financial regulators some of whom are thinly staffed.

In many countries that have a viable, active, securities markets there are either locally manufactured or globally traded ETFs and ETNs with different degrees of intelligent regulation.

Just be careful .   

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Time Horizon Decisions Require Different Skills

Introduction

The essential question facing investors this Monday morning is whether this just a rally in a trading/bear market or possibly the beginnings of a new bull market.  Only time will tell, but having the right skill sets and time frame focus will improve your odds. This is similar to the race track when a knowledge of various jockeys' preferred race tactics, the training and pedigree of the horse, the conditions of the race and those of the competitors’ may improve, but do not guaranty the gambler’s chance of success.

The Conditions of Today’s Race

We have had six years of generally rising US stock markets followed by six weeks of falling prices through mid February and four weeks of rising prices. Different patterns are affecting different major markets. Europeans seem to translate the latest multiple moves by the ECB as a reaction to a fear of a business slowdown. China is being pumped up by various governmental moves. Many emerging markets have suffered by negative currency comparisons and a sharp drop off of their exports to China and a cut back in the funding of various projects by the Chinese. Japan’s negative interest rate policy has hurt the value of the yen, but has not released constrained consumer and corporate spending. Clearly the almost 50% recovery in the posted price for crude oil is being treated as a symbol of recovering global demand in contrast to some beliefs that we are heading into a recession, forgetting that there is only a tangential connection between economic cycles and market cycles.

Misreading the Evidence

Many investors and traders are being pitched so-called value stocks. Others are being reassured that disruptive corporate and consumer spending will only be felt in a limited number of industrial sectors. Finally others are relying on flows into Exchange Traded Funds (ETFs) representing long-term bullish investment demand.  All three of these beliefs should be challenged and some or all will be found to be wanting.

Value is not a Trap, but some Value Stocks are a Trap

True value is defined when a knowledgeable unconstrained buyer meets a knowledgeable troubled seller and can agree on terms and price. One should be wary of pitches by a sales force that is part of an investment banking chain that focuses on book value or tangible book value.  I have been a buyer, a seller, and an adviser to buyers and sellers of transactions that produced values to all or almost all involved. In my blog discussion of Warren Buffett’s annual letter I agreed with him in terms of the validity of book value as a measure of investment value.

As someone who is long financial services securities both personally and in my private financial services fund, I do not start my investment process with the financial data. I start with an understanding of the relationships with clients, employees, regulators, and media. I attempt to calculate the cost and the time involved to reproduce the target under investigation. I then look at what would be a reasonable estimate of the costs involved of exiting various elements of real estate and other leases. Severance costs need to be determined as well as crystallizing all of the expected contingent liabilities. A good example of this I heard about recently is a financial operator taking over an upscale supermarket chain and before the deal even closed, selling a meaningful number of stores in a geographical region to a national company who was not really into the same local markets. This buyer was valuing the locations, management and shoppers and not the financials of the stores, assuming that the purchase of these supermarkets would be close to the dollar for dollar shown on its internal statements.

When I sold my data-based operations, I was transferring respected customer relationships with numerous major financial institutions. My people, most of whom had worked for our clients, were a particularly prized asset in my opinion. At the time we were able to expense practically all of our software development thus these assets were not represented on our balance sheet in a transfer of operating assets. I bought a number of modest US and non-US acquisitions, in each case acquiring management was the real goal. I couldn’t have hired them without buying their operations. While the investing public, be they institutions or individuals, may buy on book value-related trades, the professionals don’t.

Most Opportunities are “Disruptable”

A major investment banking organization recently published a well written thirty page report entitled “The Age of Disruption” which did a good job of describing the ongoing process of many companies and sectors that have been or are being disrupted. What caught my eye was that the report listed five sectors that have been the least disrupted with the presumption that they will continue to be protected from disruption. Two of those sectors were business services and real estate. I believe well within a generation if not well before that many of these sectors’ ways of doing business will be distorted if not totally eliminated. One of the major concerns for the taxing authorities in New York State and to a lesser degree in New Jersey and Illinois is that many organizations within the financial trading communities are reporting record revenues with decreasing profit margins. The number of employees is dropping due to technological replacement and greater concentration. I suspect that these trends are happening throughout the business service sector.

In terms of Real Estate the banks and others in the mortgage business have drastically reduced their head count through better controls and technology. Good creative real estate people who can quickly deliver transactions and provide other services should be in high demand well into the future. However, those that troll for listings can be easily replaced through technology. There will be increasing pressure on all costs involved with real estate including title insurance and closing costs. 

Surge in ETF Flows

I believe individuals and the media misinterpret the flows into and out of ETFs and also mutual funds. Most of the volume is essentially a beta play for or against an index. It is my belief that the bulk of the flow comes from traders; e.g., hedge funds and other fast market participants. Occasionally one sees brokerage firms and registered investment advisors committing discretionary or near discretionary money into ETFs. In almost all cases these transactions are part of complex trades (often carry trades) with the use of ETFs on the short side vs. individual securities on the long side. We see very few ETF holdings that are meant to be a permanent holding. Thus their flow data is for trading consumption not investment attributes.

Most mutual fund redemptions are, in effect, completions of self-administered investment programs to meet life’s needs. What gets reported is the net flows out of funds and into ETFs which are not related. As already indicated the ETF flows are principally from the trading community. The net redemptions of mutual funds (until last two weeks) is essentially a function that intermediaries have suitability and churning constraints with mutual funds they don’t have with ETFs. There are numerous undisclosed ways that the investment firms are better off dealing with ETFs than mutual funds. I hope to find out more in a panel that I will chair at the International Stock Exchange Executives Emeriti summit conference in April.

Investment Timespans and Skills

As the regular readers of these blog posts may recall, I have suggested that investments should be allocated to different time horizons by using the matrix of the Timespan L Portfolios^® to cover various time horizons between the immediate cash needs all the way out beyond our current lifetimes.

In building these custom portfolios there are different investment skills required to buy, hold, and sell securities. A good buyer is a prudent believer, often of changing conditions both within a particular security and its market environment. A good holder is someone who diligently follows trends and is quick to determine whether any variation is acceptable under the conditions. A good seller is essentially a skeptic that views the present and the future looking for any sign of contrary elements which should alert a sale process.

Applying Investment Skills to Timespans

1.  The first task is to identify whether the security, mutual fund, or investment manager is already on board or just one under consideration. (If you already own it you may have to do something, if you don’t you have the luxury of not doing anything.) In the case of the short-term operational portfolio one is very concerned as to whether on a total return basis the principal will be substantially intact during the short-term duration of this portfolio. Liquidity becomes very important in this analysis. One probably should not add to this portfolio unless it makes this portfolio more liquid and stable.

2.  In terms of the replenishment portfolio which is designed to provide capital to the exhausted operational portfolio, this portfolio has a limited duration in the four to seven year range and presumes at least one if not more down years. The critical skill for this portfolio is the diligent holder who is very alert to any variation to the outlook for any part of this portfolio. An appropriate risk balance is necessary to insure that the replenishment portfolio can and does perform its job well.

3.  The third portfolio type is the endowment which has a timespan from the end of the second portfolio to the end of the power base of those who are in command at the time and would be often in the ten to fifteen year range. All three of the investment skills  (buy, hold and sell) should work on the third portfolio.

4.  For  the fourth portfolio both the buyer and seller skill sets are important. One wants only those investments in this portfolio that look in the long-run to perform materially better than the market and when they don’t they should be replaced.

How Do I Come Out?

Recognizing that t the only thing I can promise my accounts is that I will be wrong time from to time and hopefully that I will correct quickly enough so that the client is not fundamentally hurt. With that as a caveat:

•For my conservative clients, I would be reducing risk in the operational portfolio as markets became more enthusiastic.

•For the replenishment portfolio, I would use periodic dips to raise  my market risk exposure a little bit.

•The Endowment portfolio should not be particularly market trend oriented, but should focus its attention on viable quality leaders.

•The Legacy portfolio should look for the survivability of disruptive companies.

Question of the Week: How are you addressing the market as a temporary rally, the beginning of a market upsurge, or a distraction?

Please let me know

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Copyright © 2008 - 2016

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All Rights Reserved.
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Friday’s Market: An Investment Trap?

The Dow Jones Industrial Average rose 277 points on Friday, June 29, for a single day gain of 2.2%. The Standard & Poors 500 rose even more to 2.49%. Our own financial services private fund jumped 3.15% on a gross basis. That gain represented approximately three quarters of the estimated gain for June which in turn is about one-half of the six month’s gain. Clearly, I don’t want to give back Friday’s gains, but I am concerned that Friday’s market action could be setting a major trap for all of us.

A trap works if it looks to be relatively attractive compared to other actions. In this case there was the confluence of three incentives:  (1) favorable news as to the Euro crisis, (2) the Supreme Court ruling on Obamacare, and (3) the market mechanics. As we examine the three items, we need to recognize whether they are poison fruit.

The Euro trap

The agreement made early Friday morning to permit the central market to make funds directly available to the Spanish and possibly the Italian Banks requires the creation of a single banking supervisor for the 17 member countries that use the Euro. The supervisor is meant to be in place by the end of the calendar year and thought to be imbedded within the European Central Bank (ECB) with funding to start in 2013. If this were to happen on schedule, it might be considered the eighth Wonder of the World. First to get these particular seventeen countries to agree quickly will be very difficult. Already both Ireland and Greece are looking for similar bank support that does not raise the nominal debt of the country.  Until the money flows from the center to the banks, there is a good chance that depositors will shift their assets to stronger banks and/or currencies. These actions may cause substantial changes in market shares of specific banks. I wonder how the scheme to have a single bank supervisor is going to attract the other members of the European Community that do not use the Euro currency? In particular I question what would cause the UK to give up its banks’ sovereignty?  Without the UK, and the Scandinavian countries inside the tent, I do not see how the other banks will agree. One of the provisos that the German legislature required in their rapid agreement was a transaction tax. If this tax is put into place for all of Europe, Europeans will have ceded a good bit of the institutional market to the Americans and Asians, a very improbable event. Bottom line, I am not swallowing that the agreement on the Euro is really going to help any time soon.

The supreme trap

Along with practically everyone else I was surprised how the US Supreme Court ruled on the Affordable Care Act. Having read parts of the decision and much of the commentary produced by legal scholars and political pundits, my conclusion from a practical viewpoint is the decision just opened up many more questions than it attempted to answer. For approximately thirty years I have been inordinately concerned as to the rise of healthcare costs within the US. Initially my concern for the rising costs led me to complain to my firm’s trade association, the Securities Industry Association (SIA) as to the annual increase in health insurance premiums that the medium and small sized brokerage firms like my own were paying. In answer to my gripes, as is often the case, they invited the complainer to sit on the board of the captive insurance company. While on that board I did find some inefficiencies and failure to optimize the float for the benefit of the members. No matter what the other members of the board and I did we could not prevent annual premium increases of double digit percentages.

After that experience I felt that the hospitals were inefficient and therefore costing the patients and their insurance companies too much and once again the curse of being a complainer struck and I was invited on the investment committee of the local community-owned hospital. Once again costs continued to escalate. This in turn led to a series of mergers with other community-owned hospitals and now I find myself on the Financial Oversight Committee of a complex of three hospitals. Still the costs keep growing. Finally, my wife and I have informally become the healthcare reinsurer to cover expenses that are not picked up by others for a large and growing family.  Thus the rise in healthcare costs really does matter to me. The way I read the decision and the various expected “fixes,” follow-on legislation and regulation, all will add to our costs. Further, I see very little that will improve the quality of healthcare or increase the number of doctors and highly trained nurses and technicians. As you may suspect, I am gagging on the benefits of the Supreme Court delivered fruit.

Fruits of the marketplace

At the end of the trading day, the New York Stock Exchange produces a list of large trade imbalances that wish to have an execution at or near the close. On Friday there was a materially larger than normal list of stocks with an imbalance. I am guessing that the imbalance was many more shares were wanting to be purchased than sold. I am guessing that at least the final twenty point surge in the DJIA was caused by the desperate need for these trades to be executed. Based on my experience as a former member of the NYSE, I believe that some of these trades (as well as some of the above average volume) were initiated by market professionals to add to their first half published holdings, reduced cash positions, and covering exposed short positions. (In the weeks prior to the quarter-end the number of average volume trading days needed to cover shorts rose.) I view each of these trading factors as transitory and cannot be expected to play a similar role in the days and weeks ahead. 

Throw out the implications of June 29^th

As regular readers of this blog know, one of two of my most important learning institutions was learning to handicap (analyze) at the race track. One of the lessons in examining past performance was questioning which results were normal and therefore had a higher likelihood of repeating and which were abnormal. In terms of the latter, I learned to disregard atypical events as I had less confidence of a repetition. Using this hard earned logic I am suggesting to throw out the implications of last Friday. 

Having suggested ignoring Friday results, Sunday night and early Monday morning I will be looking at Bloomberg Television. The Sunday night focus will be on Asian markets. Europe is both an important source of trade and bank capital for the Asians. If their markets continue the New York rise, I could be wrong as to the significance of Friday. This trend could be reaffirmed by opening trades in the major stock markets in Europe.

If there are dramatic changes suggested by these trading sessions, I will send out a follow up bulletin. For those of you that depend upon social media, please let me know how I can reach you with a brief message.

As of the 28^th of June

The following thoughts stated briefly were going to be the basis of this week’s blog before the 29^th surge.

1.  Marathon Asset Management, a London based global asset manager, has a well-written monthly letter focused on the current battle between the optimists and the pessimists. As a long-term investor with a long portfolio, Marathon is clearly in the optimist category.  However the letter introduced the concept that  “a pessimist is an optimist with better information.”  The logic implies lots of reasons to be optimistic, but grants the pessimists the recognition that those good times are further ahead. I would suggest the recently announced trend of a slower rise in consumer spending than consumer income plays into the timing question. In the US, spending patterns may be suggesting that consumers are self-imposing their own austerity program which is bad for consumption, but good for savings long-term.  The result is better for the markets that long-term investors care about. The current downgrading of corporate sales and earnings guidance is reinforcing this trend.

2.  Moody’s* in its Weekly Market Outlook  produced an interesting analysis on the predictive power of the yield spreads between high yield bonds and equivalent maturity US Treasuries. Currently the spread is 100 basis points  higher than normal. This is a bit strange in view of the expected default rate which is below normal at about 3.5. The current spread suggests a default rate of 10%. This is an important bit of analysis for two reasons. First traditionally the bond market is ahead of the stock market at sensing economic and financial problems. Second, there can be another explanation along the lines of the old adage, “if the bridge won’t go up, lower the water.” Maybe the enlarged spread is indicating that in this interest-repressed world, treasury yields are not representative of the appropriate yield to give holders a real return after inflation. I am slightly more concerned about the second interpretation than the first.

* Moody’s common stock is owned in our private financial services fund.

For any of our blog readers who would like to discuss the two longer term items of my focus on the implications of June 29^th, please contact me.

For those in the US, I wish you a happy and healthy July 4^th Independence Day. To our other readers I will be checking your markets on the 4^th and hope that they are kind to all of us.

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