Understand Numbers Before Using - Weekly Blog # 851

 

Mike Lipper’s Monday Morning Musings

 

Understand Numbers Before Using

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

 

The most common mistake made by investors is too brief an introduction to the investment and economic numbers used by most who chatter about “the Market” or the “Economy”. For example, the three most quoted US stock market indices are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the NASDAQ Composite. Each of these unique indices was created for a specific purpose and was designed for a specific audience. However, they are now used for numerous purposes worldwide, including New York, Chicago, Washington, London, Tokyo, and Shanghai. The biggest mistake is assuming the indices are identical. Although the indices all have short comings, proper use of the numbers can lead to useful insights in making decisions.

“The Dow”
The most well-known of all market indices is the “Dow” (DJIA), although it was not the first indicator from the Dow Jones newsletter writers. They originally tracked the performance of trunk line railroads as the most important stocks in the 18th Century. Later, due to the industrialization of America, they created an index of a small number of large industrial company stocks. The main readers of their newsletter were retail brokers. At that time, it was believed that the higher the price of shares the higher the quality, making them more valuable. This led the DJIA to be weighted by the prices of the shares. As is often the case, there was unanticipated demand for the results achieved by the index. Consequently, they took advantage of the wire systems of both the large “wire houses” and the press in developing a national and international market for the index. (The equivalent of the Rothschild’s carry pigeons.) Most local papers, and later radio/television, quoted the close of the NYSE market by using the “Dow”.  Thus, across the US many more people than owned shares were exposed to the index.

The Washington Applications
Political people in Washington started following the index as a measure of the economy. They used it as a gauge of what local voters thought about the economy. The Fed’s Open Market Committee consisted of a rotation of the presidents of the local Federal Reserve Banks, whose districts were roughly tied to the size of the financial assets the local reserve banks supervised. The boards of directors of these local reserve banks all have financial leaders familiar with the DJIA. Thus, the index became an unofficial factor in bank regulation.  Fed PhDs, recognizing the limits of a 30-stock index in producing many economic studies, used NYSE data to supplement the DJIA. (This thinking led to the recognition that other indices would be needed.)

Standard & Poor’s 500
Historically, the index that next came into use was the S&P 500, which was primarily used by institutional investors. This index was designed to correct the acknowledged problems of the DJIA. First, it had roughly 500 stocks. Second, it used the market capitalization of the issuer’s common stock for weighting purposes. Standard & Poor’s is a premier bond rating organization which also covers equities. The company had an extensive menu of data points that it used to assign credit ratings on stocks, which it also applied to the S&P 500 Index. Thus, we can now compare the price of various indices relative to their book values. The S&P 500 Index trades at 5.09 times book value vs 4.08 times for the DJIA. This comparison highlights the S&P 500 index’s investment in companies perceived to possess more growth than those in the DJIA.

In my work in analyzing large-cap mutual funds, which have many more assets than other slices of the mutual fund pie, I use the SPX as the first comparator before more narrowly using growth, value, and core breakouts. I similarly do the same for most global funds. Unfortunately, I can’t find enough data rich breakouts in many local markets, indicating these funds are primarily looking for local shareholders.

NASDAQ Composite
This 3rd index does not have a size bias. The index is comprised of bank stocks, local companies, and companies located in various geographic locations, including Canada, Israel, China, and numerous other countries. Additionally, it is the initial home for companies recently gone public. Consequently, many of the stocks on the NASDAQ have limited liquidity due to the low number of shares offered and/or the founders retaining a significant portion of the stock. It is not unusual to see 4 or 5 times the number of shares traded on the NASDAQ compared to the “Big Board”.  

The “Market” is Changing
Volume is more sensitive to speculative opportunities than highly rated investments and it is amplified by the use of derivatives, ETFs, off-market transactions, and less capital present on the floor. Dow Jones S&P Global is now the owner and provider of both the DJIA and the S&P 500. Even though there have been changes, there are still missing elements in market tools.

The separation between stock and commodity markets does not make it easy to provide a fuller solution to evaluate a uniform portfolio of assets and their risk modifications in a 24-hour, seven-day world. Agricultural products, impacted by weather, are important to food manufacturing and distribution industries. Many, if not most business cycles, are impacted by agricultural disruptions, real or feared. One of the causes of the great Depression was farm belt problems caused by excessive debt creation and poor climate conditions. These led to the passage of the Smoot-Hawley tariff and its global ramifications.

(While agricultural products as a percent of population is much smaller today than in the 1920s, the global impact may be the same order of magnitude.)

Moving on to the hard commodities, the timely completion of new mines and transportation systems can be disruptive to many areas, including stock markets.

For every global consumer, global producer, shareholder, and military person, the fluctuating value of major currencies is a cause of concern. This summer the US dollar dropped from $106.4 to $100.7. (This is likely to have an impact on inflation)

A Working Conclusion
Indices are a useful snapshot, but what is needed is a continuous motion picture and an understanding of what is causing the change, including built in construction biases and an identification of what is missing. If you have any thoughts, please share them.

 

 

 

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Difficult Symbols, Equity Opportunities and Bond Worries

Introduction

One of the college textbooks that I vaguely remember made a big thing of people being either inner or outer directed. In truth, I suspect that each of us are in different ratios at different times and conditions. Over the last six to eight weeks there have been many trumpet calls trying to lead us into new and/or strong beliefs in answering our needs for outer-direction. Being a skeptic by nature I am recoiling from these attempts to lead me and others.

Different Inputs for Trading and Investing

As we can not avoid being influenced by some outside influences, I try to be selective. I regularly quote  Jason Zweig, one of the better students of investment behavior. In his latest column in the weekend edition of The Wall Street Journal, he cautions about the influence of others on investment decisions. He acknowledges that many want the comfort of going along with the popular mood of the time. One of the ways I control my investment urges is to identify what it is I am trying to accomplish. If near-term success is important, other's opinions that support the current momentum can become dominant. If I am focusing on building a long-term oriented portfolio of securities and funds, I am much more likely to search for counter trends.

You can do a little bit of both if you segregate your money and your actions. In our four sub-portfolio approach, TIMESPAN L Portfolios^®, we are very conscious of both momentum and counter trend investing. The Operational Portfolio to pay bills in the next one or two years needs to be cautiously sensitive to momentum. The Replacement Portfolio is very much oriented in replacing the capital that has been used to pay current bills along with the almost certainty of some market reversals. The Endowment Portfolio is designed to generate capital for those that are currently alive. This portfolio accepts periodic down markets, but essentially is focused on investing wisely for the long-term. The Legacy Portfolio needs to recognize much of what is expected won't happen as intended. Thus the Legacy Portfolio will include investments that are part of the disruptions that regularly occur. In this way one can use your outer directed and inner directed instincts.

Symbols

Political and religious leaders going back to Biblical times used concrete symbols to convey the abstract, unseen  power. Remember the Golden Calf, the grandeur of Rome, staged events in Nazi Germany. To some extent various inaugurals and marches serve the same purpose, that of a symbolic message to convey outer-direction to the masses. As with most symbolic promises, the deliveries will be different. This is particularly true today when new interpretations will change the more current views of symbols. Bottom line: enjoy the massive pageantry, but expect severe modification.

Upsides for Stocks Possible

Though we have had a long, but mild expansion, is there room for more economic expansion in the US and elsewhere before historic limits lead to a bear market for stocks? Without predicting it, a look at the data says it is possible. According to government sources we are currently operating at about 75% of industrial capacity when other booms topped out at close to 83%. Also only 57% of working age population is actively working when recently close to 60% were working.  However, if one looks deeper, there are a number of doubts. Most importantly we are no longer a heavily weighted goods producer dependent on domestic industrial capacity to turn out these goods. Further, I suspect that we are actually using a significantly higher percentage of modern capacity. Where there is scope for substantial expansion is in vastly improving our transportation capacity of airports, roads, rails, harbors, etc. These will require long lead time efforts and probably will depend directly or indirectly on private financing.

Actually one of the retarding factors to increased production is finding qualified, honest, high energy workers with appropriate skills. Thus there is a need for a massive infrastructure investment into schooling at all levels with the hope that it will lead to useful human education. This is a huge necessity throughout the developed world. We need smart, reliable workers' earnings to pay for our expanding healthcare costs as well as the need for protection domestically and internationally. The US could be a leader on this front, but we will have to move fast.

Much of the future will need to serve two new unaccounted for masters. The first are the growing number and money of the consumers. While management and labor are often represented in some of the halls of power, the consumer is not. We need to respect and serve the consumers. The second growing power who is critically involved with effectively serving the consumer is the corporate state. While their first loyalty will be to their customer bases, they will also serve their multinational owners and lenders. The consumers will increasingly buy what they feel is good for them and not where it is produced. The consumers and the owners will focus on what is good for them and use governments to help or at least not hinder them.

At the moment the symbols for this new world are not apparent to me.

Stocks’  Biggest Worry is Bonds

If you are a regular consumer of the financial media, you would believe that stocks are bigger and more important than fixed income securities. Any careful reading of financial history will disabuse of this thought. Most financial crashes occur because a fixed income relationship is or has failed. For example most of the blame for the collapse that centered around 2008 was due to improper mortgages and their derivatives. The strain coming out of the collapse put banks and leveraged brokerage firms under extreme pressure. Congress, various Administrations and most mutual fund shops escaped blame, despite having some culpability. This was just latest chapter of runs on banks in many countries due to imprudent bank loans.

Because of this history, as primarily an investor in equity funds and individual stocks I keep an eye on any indicators of potential trouble in the fixed income world. Often the litmus paper test of some problems is that yields rise as inducements to accept some troubled paper. As previously written about in past posts coming out of the US election, there was a desire by some institutional investors to "re-risk" their portfolios. In the last week we saw two examples of this. The yields needed to move a number of European Sovereigns rose. Second, each week I look at what Barron's calls yields on best bonds, which I assume means of highest quality. In the last weeks their yields rose to 3.50% from 3.41% the week before. (Remember bond prices go down when yields go up.) The nine basis point gain compares with only three basis point increase yield for intermediate quality paper. I have not included yields on high yield bonds who are bought by those who can tolerate risk in some cases similar to stock risk.

Summary

We  are becoming more cautious, but not yet bearish. We will need to pick our spots and time the purchase of stock funds with any excess cash.

Question of the week: What would cause you to change your current investment policy?      

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Actions Coming from China, Berkshire Hathaway, and Caltech

Introduction

I am always looking for help in investing clients’ and my family’s money each week. I review my exposures to breaking news and views. l have reviewed the actions of the latest week and there was a lot to learn.

China

One of my basic beliefs for the next fifty or so years is that what happens in China will have material impacts on global markets as well as individual lives in many locations. Whether these impacts will be positive or negative will probably be a function on how well we are prepared to understand the implications of the actions taken in the Middle Kingdom.

Market reports noted growing illiquidity in both the internal stock and commodity markets. The volume in the steel contracts is twice the combined volume of the two largest Chinese stock markets. This demonstrates that speculative interests can find outlets in local as well as global markets. I do not know how much of the steel action is short covering or anticipation of growing infrastructure spending which could well impact global commodity demand and therefore the craving for industrial stocks.

To get a handle as to how important the Chinese markets are to the global picture, one needs to understand that almost half of the derivatives traded in the world are traded in China. Because of the huge amount of leverage that can be involved in derivatives they can be a source of disruption that will affect both the banks and the stock markets in general. Thus my fellow domestic stock and equity fund holders need to keep an eye on the commodity and derivative markets in China. This is particularly true as government policy is favoring restructuring the Chinese economy and society into companies with fewer employees producing products and services in which demands exceeds supply. This is not an easy task even in a command economy.

Berkshire Hathaway's Annual Shareholders Meeting

Some may have come away from the 51^st annual meeting with the belief that very little new information was released. However, there were a number of forward-looking comments that could be useful in thinking about future investing. Some of the nuggets are as follows:

1. Too much capital going into a sector or asset class can reduce its attractiveness. A UK manager, Marathon Asset Management, has developed a successful record using the swings in capital market flows.

2. Increasingly consumers are being attracted to "pull" over "push" marketing, particularly through the Internet. Consumers are actively pulled into the net as distinct from reacting defensively when pushed. This favors manufacturers/distributors over the retailers.

3. Eventually the real value of hydrocarbon production will be to supply chemical feedstocks. Remember Dustin Hoffman’s discovery of plastics in the film “The Graduate.”

4. There are areas that are unattractive for investment that include packaged goods, general leasing, and reinsurance.

5. Cash has imbedded an option cost inherent when it is not employed.

6. As a private company rather than a public company there are distinct operating advantages (such as freedom from quarterly earnings pressure) that Berkshire can offer to an entrepreneurial, publicly traded company.

Caltech Fund Raising

Those of us that have deep interest in both commercial and non-profit activities are well familiar with fund raising. Most of the time money is being raised to expand physical capacity. More people are to be hired to serve a greater market size.

As usual, the California Institute of Technology is unusual in its fund raising. Using its own words, “Transformative investigations underway at Caltech will come to life as institute scholars recount the powerful questions they are posing and the surprising answers that emerge.”

This weekend it is entering the public phase of a $ 2 Billion campaign after raising $1 Billion in its private phase. What is unusual is the new capital is not being raised to add students to its small base of undergraduates, graduates, and post doctoral students. The money, in effect, is being raised to expand its intellectual capacity to evolve groundbreaking research. New planets and black holes are to be found, new linkages from advanced developments of biology, chemistry, physics. What particularly interests me is developing an understanding how different elements in the brain lead to various micro and macro decisions; e.g., getting married.

The big investment lesson that I draw from the Caltech campaign unlike most capital raising, is its intent is to get better not bigger which is a tall order because on many scales it is already the best at what it does. For those of us in the investment business it is a call to get better at what we do rather than getting more money to manage.

Question of the week: What are your reactions to these lessons?

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Rising Earnings Do Not Make a Growth Stock

Introduction

Caltech is the origin of many new companies as well as Nobel Prizes. Each year Caltech treats its trustees at its Annual Meeting to a number of research presentations by some of its leading professors. To the extent that we can comprehend what is being said, my wife and I find these talks one of the highlights of our visits. Along with other leading research universities, Caltech is an internal tech transfer group that both licenses some of its growing intellectual properties and also occasionally invests in the pre-IPO activities. Next month I will be addressing a couple dozen CEOs who are in the process of raising public capital.

The Next to Last Ownership

Both the entrepreneurial professors and the later stage CEOs are heavily focused on the next capital raise as they should be. To the extent that they are successful and don’t lose their independence, they should start to think about developing attractive characteristics for the next to last ownership of their shares. Often when successful, the next to last owner will be established growth stock holders, most of the time found in Growth fund type vehicles. (The last owner will be the eventual buyer from the originator’s estate.)

Sustainable growth of capital is the prime objective for many of these buyers. In our context I am talking about positions in the Endowment Portfolio within the TIMESPAN L PORTFOLIOS^®. Assuming no reason to sell, these positions should have a duration between six and sixteen years before some are transitioned over to the Legacy Portfolio for the benefit of future generations.

Finding Sustainable Growth

Numbers, process, and management are the clues to follow in the search to find sustainable growth. Numbers that are ratios, trends, and deviations are the easiest to appropriately identify. Good professional security analysts should have the appropriate intellectual rigor required. This process requires some depth of understanding of what the company, customers and competitors actually do and think. Someone with experience and broad business knowledge can help.

The Difficulty When Analyzing Management

Assessing management is the most difficult of the analytical tasks and requires the greatest amount of humility. From an early age successful survivors are artful in hiding both emotions and thought patterns. If it is difficult to scope-out one talented person's relations with other people (some of whom are just as bright) it is more difficult by an order of magnitude to do the same for an entire management team.

Focus on the Numbers

I will first focus on the easiest of the three clues, the numbers. As other sports followers have learned, one of the things that one becomes skilled at from “handicapping” or analyzing at the racetrack is to be suspicious of a continuation of long streaks. We know that very good performers have off days. Understanding the reasons for falling off a sustained trend line would help, but that is not always discernible. Nevertheless, I am comfortable throwing a rare mishap out in my guess as to the future. Unless something major has changed, I tend to accept an 80% compliance with a trend to be useful as an element to future predictions. Also, one of the lessons people should have learned from the Madoff scandal is that perfection is suspicious.

In viewing my comments about financial statement analysis, please bear in mind that I don’t expect every stock in a sustainable growth stock portfolio to completely mirror these filters, but the weighted average of the holdings should. I am not going to comment on every line item in the Income Statement and Balance Sheet. However, each item may color a prudent investor’s decision process much more than the press release of XX % gain in earnings per share. This is particularly the case if the GAAP accounting earnings are considerably different than the more popular non-GAAP numbers.

Operating Revenues

In the business as well as the personal worlds, without a consummated sale there is little belief. After I understand how revenue is recorded I like to see periodic growth that is faster than that experienced in the sector. A fad sales is often like a report of speed dating. While not normally reported, repeat sales demonstrate that in the eyes of the customer that the sale addresses a  customer’s problem. Repeated revenues from the same customer is showing dependency which is the goal of the drive for sustainable relations. In addition, growth in market share shows competitive strength except for the price leader which may be buying the business by educating the customer to place price over value. Often it is extremely valuable to be recognized as the low cost producer. Though it is a extremely valuable defensive weapon, it is analogous to eating one’s young. On the other hand, being acknowledged as the low cost producer can exert some price discipline on a competitor. Good analysts will markdown sales growth if returns and warranty costs are rising. (Inventory management will be discussed when balance sheet accounts are reviewed.)

Gross Margins

The direct cost to growth product companies to produce sales is often about half of the revenues received over a market cycle, producing a gross margin in the 40-60% range. Service companies, where their principal expenses are people costs, can have lower gross margins as they have materially lower plant and equipment depreciation. Many financial services companies use substantial amounts of borrowed capital (unless it is customers’ float), and have interest costs that bring margins below those of product producers. Analysts become concerned when gross margins contract because it may signal some loss of competitive standing with peers or from substitute products from outside the industry.

Operating Margins

After the cost to produce a current product or service there are other costs which include selling and general corporate administration (SG&A). In addition to research and development for new products are periodic charges that need to be absorbed as well as depreciation and other charges. Often interest expenses are included. I prefer to see a net interest item that subtracts from interest earned the interest paid/accrued. If net interest is a significant item, analysts may question whether the company has an adequate capital structure and how it will get one. Overall operating margins can be approximately 20 percentage points below gross margins.

Income Tax Rates

Analysts want to know what income taxes have been paid or accrued. Most importantly the source of the differences and the implications for the future. Wise tax management is applauded if it does not constrain the company’s future actions.

Impact of Foreign Sales and Earnings Translation

A long-term investor normally does not want to value currency translation gains and losses highly. However, hedging does tell investors what management’s is attitude toward short-term results. There are several ways to hedge. The more popular short-term approach is by entering the foreign exchange market through derivatives and/or local currencies. A longer-term approach is to balance sales and earnings from various foreign countries with the home or functional currency. One also needs to understand in which currencies the bulk of the foreign operation’s expenses are incurred. Further it is important to understand in which currency profits are measured including where and at what level taxes are paid and when.

Reporting on Industrial Conditions

Good analysts will have other sources of information as to the growth in various markets as well as significant price trends. The reporting company should be a source of these critical elements in an unbiased way. The absence of these may show a lack of serious interest in their shareholders’ welfare.

Brief Balance Sheet Concerns

Inventories - Often a firm will provide three levels of inventory: finished products, work in process, and raw materials. If inventory levels are rising faster than sales, particularly in the finished products and to a somewhat lesser extent in work in progress, it can be a tip off that the company may have to lower its selling prices or improve its terms to bring inventory levels back below the sales rate. If the build up is in the raw materials line item, the company may be speculating as to future rising prices or trying to create a shortage as a competitive device. In any case, changes in inventory levels need to be understood.

Fixed Assets -  Physical fixed assets of plant and equipment are recorded at historical cost, unless written down minus accumulated depreciation. Depending on the industry, the ratio of the remaining un-depreciated assets as a percent of the original cost of the assets compared with peers can be a useful clue as to which competitor has the newest facilities and possibly who has the lowest cost of production relative to its sales level.

Intellectual Property -  Intellectual property can be of great value to a company’s barriers to entry or moat. The size of the moat and how well it is defended can be critical in the ability of the company to resist attacks by competitors. To my mind this is of secondary importance compared with the clients’ dependency on the company’s products and services and the clients’ attitude toward that dependence.

Liabilities - Accrued but unpaid taxes, while they create valuable float, as in all liabilities need to be understood and appropriately recorded. One also needs to ensure the full extent of the retirement liability is recorded. (In terms of educational institutions rarely is there an estimate of the long-term cost of tenure.) One of the jobs of a thorough analyst is to determine the off balance sheet contingency reserves. If a company states it doesn’t have one, that can be a problem.

The Second Clue = Process

For a company to have a sustainable growth pattern it needs a well understood and hopefully written down process for most of its critical functions. A thorough research report should be able to summarize the process as well as reports to regulators and shareholders. A series of well defined processes can aid a company if critical management disappears or perhaps serve as an aid in regulatory inspections. Far too many institutional shareholders do not fully understand the critical processes. This means that when there is a market disruption investors will be flying blind until they can get a reasonably full and responsive communication with the company. Often this will lead to the sale of the position in part due to unfounded but believable rumors.

  

The Toughest Clue = Management

While past history is never fully complete and not exactly like the current condition, it is somewhat helpful but hardly guaranteed. In Jason Zweig’s new book “The Devil’s Financial Dictionary” he quotes Warren Buffett, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Nevertheless, we often have to make a decision as to whether the existing management can carry the company to the rosy future in which we would like to believe. The attributes that we look for are as follows:

1. Unquestioned integrity, not only in a legal sense, but also in an intellectual sense. We need to recognize that some people lie to themselves and overstate their views of the future.

2. Innovations both of product and process are critical to long term success.

3. How do the key executives as well as those at the lower level treat each other is a good clue as to how they will treat absentee owners of both debt and equity.

4. Good controls of people, finances and processes will provide the everyday discipline which is critical to the success of the enterprise.

I look forward to discussing these thoughts with you.

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