Current Investments for Future Results

Introduction

In our job as professional investors for others as well as personal stewards for ourselves and families we do something today that we want to have a good result in the future. This is easier said than done. To accomplish our goals we need to answer at least two basic questions: 

What are we doing?  Which future?

To help answer these questions, we should be asking ourselves on which time period are we focusing. We have created at least four time spans to put the answers into perspective. These four slices go from:

1. The immediate as defined as the next two years,

2. The following five years to replenish spent capital,

3. The succeeding ten or more years to address longer-term needs for the current decision makers, (endowment issues) and

4. Future periods to aid fulfilling the legacy of the grantor and his/her succeeding generations.

This weekend I seek to apply the items that cross my information screens to appropriate investment time spans.

The current period

To meet current and near-term needs we assume that we can convert our present investments to cash for either spending or repositioning. Too many investors look entirely to current prices and economic conditions. As someone who has grown up in the investment business, I am concerned that the changing structure of the marketplace is not being considered. What I add to my decision process (and what is missing from many strategies today) is a focus on liquidity.

The real price

Portfolio managers and analysts can learn a lot from professional traders. Traders will tell you that a stock or a bond is worth only what it can be sold for. Far too many investors use the last published price without understanding the conditions that led to the price in terms of the relative balance of supply and demand. Quite possibly because of changes of capital on trading desks or floor participants the last published price is quite stale. This is particularly true if you are a potential seller with an over-sized position. A current example of this is the recent drop of 6% in three minutes for shares of Apple^*. According to some, the sudden drop was caused by one or more major players that used algorithms to significantly reduce over-sized positions in tech stocks.

Investment committees have regularly received reports on what specific days to liquidate positions based on average historic volume. Traditionally these reports are meant to show how quickly cash can be raised. Sole reliance on these reports is dangerous. First, liquidity is very much a function of the current desire for the security. Second, increasingly more volume is transacted off the floor than on it and there is no real floor for bonds thus the published volume figures are more an artifact than accurate. I wonder when looking at liquidity whether one should follow the dictum of US Supreme Court Justice Potter Stewart in ruling as to what was pornographic or not: he said he would recognize it when he saw it. To reinforce my skeptics’ view on liquidity let me use the extreme performance of Precious Metals mutual funds as an example.

In the week ended on December 4^th the average Precious Metals fund was off -4.66%, the worst of the 30 equity funds groups tracked. However in just four weeks including the December 4^th period, the average Precious Metal fund was up +10.47% which was the best of the equity fund averages. I would suggest that the fundamentals did not change that much in those four weeks, but the market did.

Another example that attitude changes greater than fundamental changes is the price and volume in the week for the stock of T Rowe Price^*. On December 1^st it closed at $82.61 on reported volume of 753,104 shares. On December 5^th the closing price was $84.49, down slightly from its day high of $84.88 on 1,105,152 shares.

One of the Republican SEC commissioners has expressed concern about the liquidity in the bond market when interest rates start to gyrate. I believe her concerns are well placed.

The focus on liquidity is of particular importance when investing for current returns in the first or operational time span portfolio. If due to spending requirements, securities will need to be cashed-in at the same time as liquidity shrinks, the quicker the near-term portfolio will be exhausted and need to be restored by the replenishment portfolio.

Replenishment portfolio

A well thought-out piece by Marcus Brookes of Schroders Investment Management begins with the following sentence. “We end 2014 with almost every asset class offering investors scant potential return for their risk.” In looking how to build a successful replenishment portfolio I suspect that at some point over the next five years the need to earn a real return adjusted for credit risk will become apparent through a market decline. Having issued this warning, it does not relieve investors of the need to build and manage a replenishment portfolio. While many investors talk long-term they walk short-term by managing their investment against a one to five year time horizon. Under those constraints there is little room for long-term bonds or stocks that are dependent upon substantial new products or massive turn arounds.

While it increasingly looks like we may get a bout of enthusiasm, one would be wise to upgrade the quality in the replenishment portfolios even though during a speculative phase they will probably under-perform, but they will sink less when the eventual significant decline occurs. Moody’s^* is recognizing that “corporate credit has become more risk averse, while the common equity market has become more tolerant.” Surviving investors normally bet with the fixed-income markets, while the traders with the stock market. Both can be correct using their preferred time periods of five and ten years for the investor and quarter, half, and full year for the trader. 

*Owned by me personally and/or by the financial services fund I manage

Legacy investing

Very long-term portfolios are often a mix of companies that benefit from sustainable demand based on demographic and geographic changes as well as disruptive companies. This somewhat hedged mix assumes that there will be evolutionary changes as well as revolutionary changes ahead. The first group of investments should provide sustainable income and capital growth until their mistakes or the disruptions created by the second group of companies hurts them. The failure rate of the second group will be high as they will lack the management skills needed to leverage their disruptive power. The first group will have fewer failures but they will be more painful with less chance for full recovery.

The 85 most disruptive ideas since 1929 were recently published by Bloomberg Business Week in celebrating its 85^th birthday.  One could probably devote an entire business school education trying to understand the power of the 85 disruptive ideas and how few of their inventors or developers produced lasting fortunes. The first three are good examples of the tenet that early inventors and early investors don’t get the major benefit of their disruptive talents. The three are the Jet Engine, the Microchip, and the Green Revolution.

We do not invest in Venture Capital funds to participate in the invention of products and services. Sometimes Private Equity is the way to go as developers build out to an eventual exit strategy. We prefer to use mutual funds which invest in the users of the disruptive forces unleashed in a way that can be leveraged to the benefit of both customers and shareholders.

Conclusion

Pick your time period for judging investment success and that should direct the composition of your portfolio. If you need help, email me.

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

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Copyright © 2008 - 2014

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

Horses for Courses and Thoughts for Two of Four Time-Span Portfolios

Introduction

I believe whatever my analytical skills are, they got started at the New York racetracks. Thus for years the first Saturday in June was very important to me, even more important than the Chartered Financial Analyst (CFA) exam usually given on that same day.

The Belmont Stakes day is the single most important US thoroughbred race day in determining the future breeding fees for young stallions and in rare cases, mares. At a mile and half which is the longest race for three year-old horses, the winner is usually accorded the title of Best Three Year-old or even Horse of the Year in America. This year the question for the sports-oriented public was whether we would finally have a new Triple Crown winner after 36 years. The answer was no.

Linking these thoughts to what I currently do for a living which is picking the best fund accounts for my clients and other responsibilities, I have learned that it is wise to diversify my bets. I have never found a portfolio that could be the best in each and every time period and change of market conditions. With good horses and good managers there appears to be a finite season for successes; this is what prompted me to use “Horses for Courses” as the title for this post.

One of the questions facing investors every day is whether we are entering a new season or a new track and whether we can extrapolate from past performance records. The majority of the money bet on the Belmont Stakes was attempting to leverage the previous racing success of California Chrome and willing to accept low financial returns if this remarkable horse won. In this case it was not a wining bet and perhaps not even a smart one. Our job is to make smart bets that occasionally win enough to meet various investment needs.

Time Span Fund Portfolios-a recap

1. An Operating Portfolio is for immediate needs.
2. A Replenishment Portfolio is designed to produce the required funding after operational funding has been spent.
3. A Legacy Portfolio is designed to meet needs for those currently alive and/or beyond current management.
4. The Endowment Portfolio is for beyond our own lifetime and for future generations.

Replenishment Portfolio concerns

As regular subscribers to these posts have learned I am concerned about a parabolic rise in market prices followed by a major decline. While there are some early signs of a peak, we have not yet experienced the heady experience of excited enthusiasm which characterizes the run-up to an extended peak. However, each week I see some signs that make me nervous. The latest is work done by Morgan Stanley^*. In this piece the strategist does not see great parallels with past cycles. He postulates that we have entered a "no cycle" phase. His argument is based on comparisons with general economic data. To me he does not focus on the real causes for cycles which are human behavior that goes to extreme excesses from time to time. I see no evidence that we have changed people's behavior.

*Owned by me personally and/or by the private fund I manage

I am reminded that just before the 1929 crash (the real one) a learned economist and market guru said that we had reached a new plateau and in effect there would be no declines. If the recent Morgan Stanley view gets general acceptance I would be worried.

Lessons from history

One of the ways to study history is to identify the underlying causes from wars and other various tragedies. In the case of the First World War it was the assassination of the Archduke Franz Ferdinand and his wife. If my memory is correct one of the immediate causes of the 1987 market break was the inability of a United Airlines labor/management group to be able to use the airline’s gates at O'Hare Airport as collateral to support a buyout. I wonder if the extra large short positions in US Treasuries, copper, West Texas Intermediate (WTI) crude oil and Canadian dollars are issues of collateral for major traders including some hedge funds? Therefore the rumor or the reality of major bank having a new source of loan problems could prove to be quite disruptive.

The Replenishment Portfolio

For the management of the replenishment portfolio which normally has a five year time horizon perhaps the well known view about a glass that is partially filled could be useful. If the liquid is champagne, in addition to its level there will be bubbles, mostly small. The argument will be whether the glass is half full or half empty and as usual the focus will be immediate. I suggest that over time the level will decline due to evaporation. Over the next five years the odds increase that my concerns about a major market break could occur.  Thus these interim portfolios should be sensitive to any signs of market disruptions.

The Endowment Portfolio

In previous posts I have suggested that an important part of this portfolio class be invested in disruptive companies. A long-term subscriber asked whether this was just a collection of opportunistic investments. Not in my mind; the key to opportunistic investing is entering at a particularly attractive price at a good time. In contrast the investments that I believe should be in these portfolios will be companies that will profitably benefit from important if not major changes to the global economy. These will not be evolutionary or innovative changes. They will introduce radically different ways of thinking similar to the impacts of cell phones, sulphur drugs and steam engines.

 
In The Wall Street Journal, Jason Zweig discusses James Anderson, a successful portfolio manager for Vanguard and Baillie Gifford. As indicated in the article he is attempting to put together a portfolio, possibly for the next one hundred years, of technologically elite companies and similar leaders which have been recognized and currently sell at high valuations.  Anderson believes great innovative companies will continue to be great and innovative. While some of these well known stocks might be represented in my preferred fund portfolio, there will be other names of smaller, perhaps tiny companies.

Why I disagree

There are three reasons for my departure from the views reported above. The first reason is based on a discussion in Nantucket with Dr. Phil Neches who has three degrees from Caltech and is a fellow Trustee with me. Phil's commercial experience has been in disruptive companies as a founder, chief technical/scientific officer and venture capitalist. In Phil’s opinion, with rare exception disruptive companies can maintain their ability to be disruptive for only two generations. This view makes sense to me as an investor. Thus there will be a need to prune the portfolio of what our British friends call "the worthies."

The second reason is that disruption from start-up to commercial viability usually takes time. During this gestation period the market usually does not put high valuations on these companies, which gives the knowledgeable investor a chance for a relative bargain.

The third reason is that all company investments run the risk that successive managements do what turns out to be dumb things. Thus, even long-term, future-oriented portfolios should not follow a complete buy and hold strategy. I like to see understandable selling.

Which time spans concern you most?

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Copyright © 2008 - 2014

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