Beware of ‘Risk On’ Enthusiasm

Introduction

Confidentially I will let you in on a big secret as long as you don’t tell anyone. The secret is that I can not predict the future and have serious doubts that others can sequentially. I view my responsibility as an investment manager is to review the possibilities of future events and attempt to refine them into logical probabilities and to determine whether these opportunities are priced rationally. I try to follow the precepts of strategic military intelligence, if that is not an oxymoronic belief. A strategic as well as a tactical commander should be supplied with an array of potential future events. The commander then makes the judgment as to which are probable and makes his/her plans accordingly.

Enthusiasm Risk

As regular readers of these blog posts may recall, I have taken the position that most stock markets top out with a demonstration of excessive enthusiasm. As we have not seen an example of this for some time, I have not been worried about a strategic decline. Historically these happen once in a generation and cause the general stock market levels to fall by 50% from their peak. For my long-term oriented accounts I have witnessed several tactical declines every decade in the order of 25%.

Too many of us think about only stock markets. This often is a mistake. Historically, elements of the bond market have performed the ‘canary in the mine’ function of warning about oncoming stock declines. Possibly a chirp could be heard this week. Having observed estimated weekly net flows by mutual funds and ETFs, I can see substantial inflows into both High Grade Corporate and High Yield (Junk) bond funds. In light of both the popular view of an eventual rise in interest rates when we exhaust the lower for longer phase plus current corporate operating data, bond investors could be subscribing to more risk which will be discussed more fully shortly.

This week on the equity side of the ledger there were also signs of growing enthusiasm. Forty out of forty-four global markets tracked weekly by The Economist showed gains. Further, the transacted volume of JP Morgan Chase^* shot up from 17.7 million shares on average in the first two days of the week to 27 million shares on average in the last three days of the week.  One important element of caution for novice investors in bank shares is there is a second way to read the apparent discount between a bank’s stock price and its tangible book value. The market may be suggesting that the historic tangible book value is overstated. A proper analysis of a bank’s assets and liabilities, including contingent liabilities, could mean that current prices of many banks are appropriately priced and are not the bargain that the discount implies.

^* Shares owned personally.

There may be another class of enthusiasm that should be identified. For about a year the US auto industry has been reporting close to historic sales levels of 20 million units. Even at last month’s rate of about 17 million, some of these gains are due to the fact that the average car on the road is 11 years old and the average light truck is 13 years old. However, some industry and financial professionals point out that the decline in gas prices has helped to fund purchases and many do not expect lower prices. At the same time the length of both leases and sales contracts have lengthened beyond past levels. Part of the growth for these has been characterized as sub-prime loans. The smarter banks have been cutting back on these loans. If one switches to sales dollars as distinct from unit sales the increases in SUV and light trucks has been meaningful and possibly replacements for lower priced and lower profit margin sedans.  (One of our two cars is an SUV purchased more than five years ago.) The car buying public has shown a bullish belief in our future.

Capacity Utilization and Productivity Warnings

At the same time that the level of industrial production is published each month another statistic is released and may have more impact on future profitability than production numbers. Capacity utilization measures how much of a plant’s capacity is utilized in that month’s production. The latest reading is 74.8%. This is 5% below the monthly average since 1972. This is significant for many plants an 80% utilization generates optimum operating margins. (Higher utilization rates will produce larger aggregate profits, but the last bits of capacity often are outmoded and produce lower margins.)

Profits are the direct result of the level of production and the productivity of labor. The risk to bond holders and particularly high yield holders is that revenues are currently growing at best very slowly if at all and wages are starting to rise. Moody’s believes that the default rate on non-energy High Yield bonds will rise this year as some of these companies’ profits will be squeezed between flat sales and rising wages.

Why are wages rising for new employees?  In order to survive, companies have been replacing manual labor with machine labor and in many cases not using outmoded plant capacity, which is written off when the plants are closed rather than on a contemporaneous basis. Regardless of the accounting niceties, the new machines require more skilled labor. These as a class are in short supply and hence result in high hiring costs.

Part of the reason for the shortage of highly skilled labor is the failure of our educational system, starting with the home and going all the way to the formal educational system including our PhD programs at elite universities. We are producing students who not only don’t possess adequate knowledge, more importantly many job seekers don’t have the right attitudes. They are not prepared for the workplace culture of integrity and cooperation. We are not producing people who are skilled at reading others in a group or individual basis, so they lack sales ability. (In any group of two or more, sales ability is needed to get optimum results.)

What to do?

Since I have let you in my secret, here is what I recommend for your portfolio under the current circumstances:

First, I recommend for consideration the development of timespan buckets or portfolios similar to the TIMESPAN L Portfolios^®.

Second, one should make small and somewhat frequent portfolio changes, perhaps in one timespan bucket at a time.

Third, have sufficient diversification so one has appropriate hedges, in case some of the expected future trends don’t work out as expected.

Fourth, we live in a global world, whether we like it or not. As we can not escape from many global trends, keep that in mind in your selections of managers and securities.

Fifth, continue your learning process as we are trapped in a dynamically changing world and we need to wisely adapt.      

Question of the Week: Are you watching bonds to help with your stocks?

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Copyright © 2008 - 2016

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

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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Comment or email me a question to MikeLipper@Gmail.com.

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Copyright © 2008 - 2016

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