Dead Cat Bounce > Last Chance - Weekly Blog # 952

 

 

 

Mike Lipper’s Monday Morning Musings

 

 Dead Cat Bounce > Last Chance

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

 

          

 

We appear to be in a normal trendless summer, with relatively low volume on hints of fall upsurges and declines. This poses a big risk for

investors with large gains in their portfolios who could be subjected to major moves from stampeding investors selling for fear of a big decline or speculative surge.

 

I am therefore suggesting that this is the time to build cash reserves so that you are in a position to take advantage of large future declines. The trick is to have a reserve large enough to shelter the portfolio from meaningful losses, but small enough to protect against being out of the game following the next rise. The next decline could be major and last for a long time, which might encourage those who have too much cash to stay out of the game. That is the real risk facing careful investors.

 

My suggestion is to treat your account as a long-term pension or endowment account with annual flows of about 10%. This would require a two-year buildup of short-term cash reserves under normal investing conditions. This suggests a target equity commitment of 70%, with a short-term reserve of 20% and an emergency reserve of 10%. The key to this strategy is avoiding a down market that reduces the equity commitment below 50%. One way to accomplished this is to begin an orderly reinvestment program in the declining market.

 

Reasons for Concern this Week

• The Consumer Confidence survey fell to 50.8% vs the expected 52.4%.
• Estimated GDP for the second quarter came in at +1.5%, below the estimate of +1.8%.
• Chinese tech stocks fell -8.6% in July. On Friday, Apple (personally owned) fell -7.4% on rising earnings.
• Barron's 10-year high grade bond yields slipped -0.03% while yields on 10-year mid-quality bonds rose +0.04%. (The bond market is more concerned about the future of the US Government and the currency than commercial credits.)
• There were 286 new highs and 189 new lows on the NYSE, versus 468 new highs and 692 new lows on the NASDAQ*. Suggesting there is presently more opportunity in industrial and financial stocks on the "Big Board" than tech-driven stocks on the NASDAQ. (*NASDAQ stock owned in managed accounts and personal portfolios)
• Warren Buffett is quoted as thinking the market is gambling, not investing. (In the past his general warnings have proven accurate.)

 

What Do You Think?

 

 

 

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Mike Lipper's Blog: Long-Term Money Via Telescope, Not Microscope - Weekly Blog # 951

Mike Lipper's Blog: Before Focusing on Shorter-Term Reactions - Weekly Blog # 950

Mike Lipper's Blog: Little Occurred During the Trading Week - Weekly Blog # 949

 

 

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Lessons from London: Mistakes Repeated - Weekly Blog # 707

 

Mike Lipper’s Monday Morning Musings

Lessons from London: Mistakes Repeated

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

The Learning Process 

For thousands of years human bodies and emotions have not changed. One should therefore not be surprised we repeatedly make the same mistakes. Too bad because most of the time we only learn from our mistakes, and possibly those of others. One of the great advantages of visiting London and friends/colleagues of fifty years or more is the opportunity to ponder past mistakes. It is a particularly good time now, as the financial community is being forced to play a role in governing human behavior through directing corporate and market behaviors. My recent visit to London this week has brought me to this task. 

Humans often want more than they currently enjoy and search for things beyond their current condition e.g., defense. The search starts with the extended family, community, tribe, state, nation, alliances, supranational organizations, and corporations (particularly utilities and financial communities). Why is the list so long? 

The answer rests on the reliance of top-down thinking. A review of top-down mandate disappointments demonstrates that without well thought out bottom-up practical thinking, the desired grand idea fails to be carried out successfully. A couple of examples will illustrate the point. 

In the UK, wisdom is apparently equated with investment success and that is why most CEOs are replaced in their sixties. Independent directors also have limited terms. An extreme example is the likelihood that no chief investment officer or investment CEO has lived through a bond "bear market". It is now very popular for incoming CEOs/Chairs to be female or minority. Many are qualified, but one wonders whether they are the most qualified. Much of what is done today is done to obtain a high ESG numerical rating. In the future, as in the past, clients and shareholders could suffer from the single-minded thinking of graduates from elite universities, military regiments, or clubs. 

There are at least three Investment Trusts (Closed-End Funds) that are over 100 years old, and they can teach us two useful lessons. Each was a narrow sector fund investing in American Railroads, Texas Oilfields, Mortgages, and Rubber Plantations in Malaysia. Today we have many open end and closed end specialty funds. Some perform very well during a particular period of time but underperform more diversified portfolios over longer-term periods. The second lesson to be learned from these old sector funds is that when one invests in a narrow-based fund it may evolve into something quite different. The managers often recognize the need to invest in another type of business when the original one is no longer attractive. 

I am always looking for different ways to analyze investments and other activities. One successful multi-generation family uses an additional measure to gauge success, believing losing money is much worse than not optimizing the upside. In their relatively small number of losses, they measure the multiple that gross gains represent of gross losses. This approach appeals to me for endowment and multi-generational types of accounts. 

This week there is a dichotomy between a highly valued US stock market and the slightly negative performance of the generally lackluster major stock indices. A contrarian or good analyst might look at the US data for the week and notice the often inverse 6-month prediction reflecting the American Association of Individual Investors (AAII) sample forecast. The bullish forecast jumped to 48% from 42% the prior week. Additionally, 6.9% of the NASDAQ stocks traded hit new lows, while only 3.2% of the NYSE shares hit new lows.

In walking around the non-financial districts and shopping centers there were very few working ATMs to get cash. When commenting about this to veteran investors they commented that their children don’t use cash. Local bank branch sites are increasingly being used for restaurants or stores. (Similar trends are seen in the US.)

While traveling there is a risk of not reading financial news thoroughly. One article had the headline “Berkshire earnings tumble by two-thirds”. Only in reading the small print did one discover the comparison was versus the prior quarter, which had a very large investment gain. More importantly, third quarter operating earnings rose quarter to quarter.

Two observations that could have major long-term implications became known this week: 

1. Morningstar believes that a safe withdrawal rate of 3.3% from a 50/50 balanced retirement account would preserve capital through retirement. (I have my doubts considering government inflationary policies and demographic trends producing fewer productive laborers.)
2. Apparently, the Central Committee meeting of the Chinese Communist Party (CCP) did nothing to slow Chairman Xi’s goal of being in power to at least age 83.

Question of the Week: Any changes in your thinking?

Did you miss my blog last week? Click here to read.

https://mikelipper.blogspot.com/2021/11/do-you-believe-congratulations-are-in.html

https://mikelipper.blogspot.com/2021/10/mike-lippers-monday-morning-musings.html

https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html

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Long-Term Investors, Mistakes Ahead - Weekly Blog # 624

Mike Lipper’s Monday Morning Musings

Long-Term Investors, Mistakes Ahead

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

We wish and hope that all of our readers and
their loved ones are in good health and none
suffer from Covid-19 and its aftermaths.

Investing is, or should be, a series of learning experiences. In the long-term, we apparently learn more from our mistakes than from our “successes”. One puzzling occurrence that I have noted are some individual and institutional investors making repeated mistakes that impact their long-term investment results. At critical points in time, instead of utilizing their usual contemplative decision making, they allow emotions to drive decisions. I believe we are approaching a juncture where a sizeable number of otherwise smart investors make investment decisions that significantly hurt their future long-term returns, if not reversed.

The Focal Point of Large, Sudden Recoveries
We hit a “stealth” bottom on March 18th, with a “test” on March 23rd, in the US and many other markets. (A test occurs below or higher than the first bottom, but critically does not lead to more selling and substantially lower prices.) Since these low points, some mutual funds have jumped by 40% or more. In just the last trading week, the 25-best performing mutual funds gained between +35% and 21.36%. Traditional investors could choose to ignore these results due to the performance leaders likely making successful extreme bets. Relative to the impact on the wealth of the total investor population, the performance of the 25 largest long-term funds is relevant. It’s also worth noting from a national economic standpoint that the performance of the middle of the road “Core” equity funds is especially important, as this is where the largest portion of individual and institutional money is invested. I believe it is significant that the best performing large mutual fund for the week was American Fund’s Washington Mutual Investors. It rose +10.03%, while the worst all large-cap equity funds, a global equity income fund, gained +4.98%. To put this perspective, annualizing the gain of +4.98% would surpass 250%, an impossibility. This demonstrates how unusual the week was.

Ok it is Unsustainable, Now What? = Mistakes
There are three mistakes people make when investment performance appears too good.

• An immediate attempt to lock-in an unsustainable gain, a smart decision if one is never to invest again. The first problem in selling at the presumed top is that it puts a high premium on making two correct investment decisions consecutively. The skill to recognize tops and bottoms are quite different. Recognizing the present situation while fathoming the future, or more correctly futures, is quite different. Remember, many investors believe the sole reason for the market decline in the February-March period was the Coronavirus, not our concern of a tactical and strategic slowdown in earnings power generation. (The odds on identifying future trends different from those extrapolated from the present is probably 50% to 65%, allowing for the occasional surprise.) 
• The nature of critical turning points is the second problem. Almost by definition a turning point is when the bulk of trading actively changes radically, an emotional change. To be in a position to timely anticipate the change you must believe you can accurately feel what the crowd is thinking and when it is changing. From a profit and loss standpoint, there is no difference between being premature and wrong.
• The third hurdle is the assumption that the investor completely knows of any changes in demand placed on the advisor of the capital in the investment account. As an investment advisor I have never been comfortable with such assertions by others, or myself. We live in an uncertain world.

Another group of investors that has a substantial proportion of their wealth uninvested is driven by “FOMO” (Fear Of Missing Out). They want to quickly make up for lost time and get invested in stocks that are moving up. Their answer is to jump on whatever is moving most. This is called momentum. The problem with this choice is that after the original investors’ needs are met, as the only thing driving these stocks higher are other momentum players who may quickly move on to other investments.

To avoid these problems, if you find yourself with excess capital after filling all your essential reserve requirements, I suggest you divide the excess capital into perhaps ten segments, then invest a segment on each down day, which often fall on Fridays. For those more long-term oriented who have obligations to others, I suggest with bias that they consider a portfolio of mutual funds, allowing professionals to make tactical decisions.

A Contrarian’s Dilemma
Almost all investment courses take the easy way out by statistically analyzing financial statements and past economic conditions. The reality is the value of a stock is comprised of two very different aspects. While the first is taught, the second relies on the attitudes of those with buying power. This in turn is impacted by the buyers urgency to buy and the present owner’s urgency to sell. Price is where the two forces meet, with the next price a function of the size of the commitment of both sides at current prices. If the competing buyers have more money, the sellers will benefit from a higher price. If the seller demonstrates a larger desire to offload his/her merchandise, the intelligent buyer will get a temporary bargain. This equilibrium price is not only recorded in the regulatory records, but is also remembered by the participants and those who analyze their actions, e.g. market or technical analysts who don’t have the benefit of the specific motivations behind the trade. When there are a significant number of price changes in one direction, a trend is identified. No trend goes on forever and eventually reverses. A successful contrarian attempts to capitalize on trends that reverse direction. Historically, the trend best expected to reverse is the one trumpeted by many “experts”, or other pundits. Most of them currently anticipate further single digit gains following those generated since mid to late March. With the preponderance of investors sharing that view, I as a contrarian (long-shot better) am wondering whether we are setting up for a period of double-digit future gains?

This is where market analysis might foretell the future, without knowing the motivation of future buyers and sellers. Because of my background in analyzing mutual funds and similar vehicles, I often turn to their performance data for clues. For the last five years through Thursday’s close the three largest categories by current assets have produced very sub-par compounded returns: US Diversified Equity +3.83%, Domestic Long-Term Fixed Income +2.09 %, and World Equity +0.24%. None of these averages meet actuarial requirements or satisfy planned endowment expenditures. This suggests that many pension and probably other retirement funds, including endowments, are underfunded, potentially requiring larger future contributions and lower reported earnings, or in the case of endowments less ambitious plans. They could also be bailed out by a significant period of gains over 20%. (It used to be that gains over 20% were excluded in actuarial calculations.)

As someone who must meet payroll and other business and family expenses, I cannot completely live in the world of market analysis or contrarianism. Thus dear reader, please send me a message of what will motivate buyers of securities enough to raise returns to high single digit levels, with an occasional low double-digit gain year and only minor declines. I need help!!

Long Shot
As is often the case, the solution could come from beyond the present universe where we have the vast bulk of our assets. Perhaps there will be a reversal in the value of the safe-haven dollar, without medical and demographic plagues interfering with them. Emerging markets, with particular emphasis on Asia and later Africa, are currently an unpopular area. Both could make sense for our younger grandchildren, or more likely great grandchildren, but it won’t meet retirement needs or the needs for better educational diversity and other worthwhile goals.

Question: How are you addressing your investments today in order to meet longer-term needs? 



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/04/time-to-get-out-of-foxhole-weekly-blog.html

https://mikelipper.blogspot.com/2020/03/where-we-are-depends-on-where-we-have.html

https://mikelipper.blogspot.com/2020/03/stealth-bottom-and-other-considerations.html



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Three Major Sources of Investment Losses

Introduction

Essentially I am a student of investment performance. For the most part I use the global universe of mutual funds as my laboratory. In addition, I serve on a number of investment committees that employ external managers as well as own individual securities. Recently, I suggested that in addition to looking at the rank of our endowment performance that we isolate five to ten winners and a similar number of losers. I was much more interested in the second group. There were many similar characteristics of the winners however there were fewer in the laggards.

As an investment manager for serious investors my first job is to avoid losing large amounts of money for my clients. With this particular task in mind I have identified three main causes of many large portfolio losses.

Major Source # 1: Gross Domestic Product (GDP)

The academic definition of GDP is the sum of the goods and services produced within a national economy. From that top down level other economic projections are made by economists that in turn produce investment strategies of portfolio managers and strategists. There are numerous problems within this approach. First, much of the data collection going into the aggregate GDP number is flawed. The source is usually government data which can be easily manipulated for political purposes to such a significant degree that the former Premier of China indicated that he did not trust GDP as it was “man made.” He used other data produced by the private sector to help him guide the Chinese economy.

There are substantial portions of the US economy that go largely unreported. Not only is the “informal” or underground economy uncounted, the value produced by the volunteer sector is also unknown as is the work carried on within the home for no direct monetary compensation. Paul Samuelson, the great MIT economist and the author of one of my college economy text books pointed out that if a man married his maid and she continued to clean his home as his wife, the GDP would shrink because the maid’s income would no longer be counted.

In the modern world the production of GDP is done for political leaders to guide their economic policies. Because the politicians have most of their political power within their borders, they are essentially focused on domestic job creation. This is not the way consumers look at their purchases which are focused on quality, price, style, and availability from any acceptable source. Managers must manage both domestically produced products and imports and their relative prices. Investors need to follow their investments in companies that have both domestic and foreign activities as well as follow world trade flows and currency fluctuations.

Thus in the real world GDP is not of much use to us as consumers, managers, and investors. Therefore, be very careful of any manager that starts his/her investment strategy based on changes of the level of the GDP. That is not the real world and only useful in dealing with the politicians and the uninformed media.

Major Source # 2: Reported Earnings Per Share

As soon as earnings per share numbers are published, investors are bombarded with slews of “Non-GAAP” statistics often adjusting most of the operating numbers on the income statements. Managements want investors to focus on these adjusted numbers not the reported numbers and the differences can be meaningful, from a loss to a profit excusing some non-recurring occurrence. Managements are often getting paid through stock price changes, but the statistical services are using the reported numbers. So whether the stock and the market is cheap or expensive relative to earnings is a function of which set-off earnings are being used.

As a professional analyst, I prefer to focus on operating earnings excluding in many cases net interest income, but adding actual and additionally needed capital expenses. In essence I am looking to determine the net cash generation of the business after expenditures and debt service. Thus different investors can come up with different valuations from the same financial report. For the professional investor the published financial statement is the beginning of the analytical discussion not the end. Therefore, a manager that relies exclusively on reported earnings could be misleading both investors and him/herself as to the significance of the report.

Major Source # 3: Investment Predictions

Charlie Munger and Warren Buffett place very little reliance on economic or corporate predictions. This is contrary to most of the financial community which rotates, sometimes violently, on changes in predictions. Many studies of investors' behavior and particularly of their losses show that high levels of confidence as to the future can lead to poor results. If one emotionally needs to make predictions, make them often, but go back to the base case each time to see the nature of the differences and the strength of the prediction. The odds are that we will be wrong much more often in our predictions than in our analysis of the present. Our view of the past will be occasionally wrong as well.     

Applying this Week’s Thoughts

Each week Barron’s publishes a confidence index that compares the yields of the best (high quality) bonds and intermediate (lower investment grade) bonds. Over time if the relation between the yields widens, high quality stocks will rise. For the last several weeks that is exactly what is happening with the yields on the higher qualities being flat and the yields on the intermediates rising. Over the latest 12 months the high quality yields have dropped from 3.64% to 3.23% where as the intermediates’ yields have risen from 4.68% to 4.92%. The way I interpret the data, the intermediate yield gain is showing a measurable increase in an estimate of the default risk which to me is more significant than a somewhat larger decline in the best bonds’ yield. I am a little more confident in the analysis of what the present market is saying than I am in the future prediction.

Question of the week: How do you measure your confidence ?

 _________________

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“Data Dependent” Portfolios

Introduction

Future interest rate moves of the US Federal Reserve are described by its members as “data dependent.” This is meant to suggest that when a statistic reaches a certain level, a future action is ordained and carried out. The immediate present (or actually slightly old) figures determine the future according to these economists and other politicians of the top-down persuasion. Considering how bad the record is of the Fed’s predictions, it is a “puzzlement” why these predictions are given so much credence that some mythical king of Siam might wonder.

What is even a bigger puzzlement is why so many investment performance reports start explaining their performance based on the latest data dependent pronouncements. Strange that so many so-called professional investors dwell on the current price (yield or P/E) level and not what as an investor I am really interested in. What I care about is the terminal price of my investments.

The terminal price of my investments is difficult to guess, but that is exactly what I will use to meet future spending needs, whether I am acting as an individual or a fiduciary for a public or private endowment. To determine my terminal price I will need to project the range of the most likely future price trends for the investments. Estimating my place on these price curves will be determined by the range of my likely factors including spending/saving habits including health-related, some actuarial assumptions and probable reactions to cyclical markets. Not a single one of these unknowns is easy to determine. Nevertheless, each one of us unwittingly does this at every buy, sell, or hold decision we make or we allow to be made for us.

A Helpful Took Kit from the Racetrack

When we are besieged by too many questions it is useful to break them down into logical groups. At many US racetracks there are up to ten individual races a day. This translates into about 100 horses trying to win. Luckily for the handicapper, or if you will the analyst, the horses are only trying to win their specific races. These races are divided by length of the race from short to long distances, age of horse, racing experience of the horse, prior level of winnings, and whether the owner is willing to sell the horse at a specified price. One could take conditions of the race as a determinate as to which of the myriad factors on each horse that is to be considered for a bet. Out of this you could come up with a single or a very limited number of probable winners for the race. That is half the job at best. Moving away from the past you should look to see whether the horse looks healthy and is being ridden by a jockey (portfolio manager) that is experienced with this horse and others who run the same way.

While there are numerous other factors, the final decision on what to bet and how much to bet is a function of the odds or the weighted opinion of others compared to your own views. If you are in total agreement with others even if you win, the payment odds after the track's take and taxes are deducted won’t be very large. On the other hand, if your analysis leads you away from the crowd’s choice as most great portfolio managers do, your payoff will be larger but you will suffer the indignation of hearing about the brilliance of the popular choice. Racing and investing are not like picking a winning political candidate. In politics it is guessing what the majority will do rather than picking the most qualified.

Applying Data Dependent Factors to Racetrack Tools to Win

One of the reasons we developed the Lipper Timespan Portfolio concept is that different data points have vastly different impacts on portfolio orientation. For example, demographics are unlikely to have much impact on the investment performance for the next five years. Bear in mind that in the last five years today’s equity funds (now numbering 14, 834)  rose +11.79%.  Taxable fixed income funds (now numbering 4831) gained, including income, +3.66% in the same period. However, when I look to invest money for a minimum of ten years I am struck with the fact in 2014,  Germany & Japan’s average age was 46 years, Italy & Austria  44, Canada was 41.7, Russia 38.9, Australia 38.3, US 37.6 and China 36.7 years old.    

On the other hand Nigeria and Uganda averaged 15 years and three several other African countries averaged 16 years. India was in the middle with an average age of 27.

To avoid a political collapse which can lead to military problems, we will need to aid in the retirement of the senior populations of the so-called developed world which suggests that taxes on the productive sections will go up. For the teenagers in Africa we will need first to feed them, then educate them to find useful jobs with a future. 

Currently almost all general portfolios are invested largely in the Northern Hemisphere and in developed countries. We don’t have ten years to make the shift if we want to be ahead of the data dependent crowd betting on low return solutions. At some point we will need to understand demographics as we answer the cover of this week’s Barron’s, “Commodities: Time to Buy?” In building our longer term portfolios, we need to recognize that increasingly people will be living in or very close to cities, not in the country. This should refine our investments even further.

For most investments you can see a lot by just looking.  Earlier this week, in walking relatively few blocks into the local business district I saw a uniformed workman with a meter rapidly going from home to home. When I caught up with him, he announced without breaking stride that he was a meter reader and the day was so pleasant that he wanted to finish his task. Years ago, as an electronics analyst I followed companies that were developing remote meter reading that could be done from some base station. I was pleased and somewhat dismayed that my brief walking companion still had a job. I don’t know that if he had been replaced by technology he would go to the mall or the downtown where stores were looking to add sales people.

Last year I told someone that I could assemble a world class investment organization knowing a large number of investment professionals that were out of employment or were unhappy where they were. Enough of these individuals have now found their conditions have changed that I feel I could not back that statement up today. From my friends currently running financial groups I hear they are finding it difficult to find the right type of people to hire.  Because of our educational systems' failures we are likely to have increased structural unemployment such as the meter readers or the children recently graduated with liberal arts degrees. Nevertheless our economy is showing signs of strength. The five year and under portfolio is likely to enjoy both improved results and a measurable downturn which hopefully will come later.

Question of the week: Which will come first, DJIA 32,000 or 10,000?

__________    

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Reputational Risks Await Big Money

Investment management literature usually covers portfolio manager career risks gently. This is the risk of a managed portfolio in a current time frame under-performing an index, or for the more advanced managements, underperforming peers either by accepted asset classes or better yet, by well-chosen funds. As a natural defense against career risk, too many active managers dwell on short-term variations to the index and often hide out with a somewhat closet index portfolio. From a career standpoint this strategy works when correlations between securities are close.

Reputational risks are not a composite of career risks

Many large institutional accounts have an investment committee or a board to which portfolio managers report. My British friends who I expect to visit in October call these groups a collection of the “worthies.” Generally these worthy gentlemen and gentle ladies are retired from the investment, financial, and marketing fields. Somewhat naturally these people think of long-term as a period up to their retirement from these boards/committees. This is the first risk to the underlying institution:  that the relative light hand of this governance is shorter and often very much shorter than the institution’s planned life. For endowments and other immortal bodies, their investment life is way beyond that of the current portfolio manager and their team.

The risk of comfort

Many of the members of these investment committees are no longer in the business of finding new and different major investments. Much of their focus is on the macro concerns facing the world. Numerous members have had instant favorable reaction to the latest announced moves by the ECB to permit central banks to buy bonds with maturities of three years or less. If they dig into the matter they will see that this is a way for the governments to recapitalize the banks so they can write off the government and commercial loans to the countries and companies on the periphery of “Euroland.” Similarly the committees believe they know which way the German Constitutional Court will decide, the size and shape of the soft landing in China, and the results of key elections around the world, as well as knowing the impacts of these events on short and longer-term stock prices. The broader the subject, the greater comfort they have in setting policy. I find this point of view to be frightening.

Many of the brightest minds in the hedge fund world manage “Macro Funds.” A study of these hedge funds (which have little in the way of constraints) shows how few of them have a consistent long-term record of success. In various investment committees, too much time is spent on macro judgments, which in my opinion have little chance of being meaningfully correct.

The historical trap

Investors in general and most investment committees present their views in the context of historical performance. A given number is larger or smaller than another number and that defines good or bad. As someone who for many years sold relative performance to fund groups and their directors around the world, I have often stated that performance analysis did not supply answers, but was a good place to start a dialog of questions. Many committees treat poor performance as the reason to fire a manager, without any understanding as to what caused the variation. Every good manager with a long-term record has had an uncomfortable number of periods with sub-par performance. I attempt to understand the nature of investment mistakes. Often such errors are result of making poor personality judgments on managements. Other times it is a premature or faulty choice on new product/services, sometimes it is getting out of step with a major macro change, and at times it is sloppy financial analysis. Good managers learn from their mistakes and don’t often repeat them. If one studies the cyclicality of performance, one of the best times to buy into a manager is after a period of poor results. Thus firing a manager with “poor performance” as the only explanation is probably an early sign of institutional reputational risk. 

The biggest risk is extrapolation

Most committees have become captured by immediate past history. They are like many general staffs for the military. The generals and admirals plan to fight the last war better this time. History suggests that the early success of an aggressor is based on not just tactical surprise but some believed technological or political advantage. (America does not seem to learn from this history in that once again we are shrinking our global and to some degree our technological capabilities which will likely invite a new attack for which we are not prepared. So believes this proud member of the US Marine Corps.)  In the investment world the equivalent to the generals refighting the past war is to believe that all of the conditions that are now present in the marketplace will be the same during the life of the institution. There is no awareness of a Christopher Columbus effect or the invention of the semiconductor, let alone the impact of the fall of the Berlin Wall.

Today most committees are looking to protect their image as “worthies” in preserving their assets. To me this is the biggest single reputational risk to the long-term health and respect for any institution dependent upon its investments. Currently we are in an extended period of a flat equity market and a rising fixed-income market. I don’t know when things will change; 2012, 2013, 2016, 2020 or some other initiation of a major equity market and a crumbling of fixed-income prices. I firmly believe that this will happen soon enough that an institution that is not prepared for this change will miss out on substantial amounts of easy money.

These beliefs have led me to exit a more conventional thinking investment committee after many years of service.

How to get ready?

First, reduce exposure to fixed-income, particularly high quality and do not expect high yield paper to do particularly well as spreads versus treasuries narrow as the market (with or without additional quantitative easing) will recognize the risks in the low yielding treasuries. Next recognize that each day technology marches on in almost every field of human endeavor, from new building techniques, retail shopping in person and on the Internet, the encashment needs around the world, the delivery of improved medical products and services and a need to eventually rebuild our global defense establishments. Equities should be viewed on a global basis. Dodge & Cox International fund noted that on the surface it had 40.7% invested in Europe (using the custodian’s balance sheet standards). However, management points out that 70% of its “European” investment is in companies that have 60% or more of their sales outside of Europe. Analytically this suggests that when we look at this portfolio some 17% of its sales are outside of Europe, so its exposure to the problems of a narrowly defined Europe is not what it seems. Further, one of the fund’s small positions, 1.3%, is invested in a bank that has half its market value covered by its minority investments in fast growing banks in Poland and Turkey. Whether they are counted as US or European, I believe many of our holdings in other funds have similar sound investment exposures. These views are ahead of market indexes and the ETF crowd. For the first six months this fund gained 3.3% after expenses vs. the MSCI EAFE gain of 3.0%. There are other funds being led by active managers who are also aware of these developments. As the game changes I want to be with some funds that slightly anticipate the changes rather than wait for the committee of the “worthies” to catch on to the change.

Holding cash

Should a nimble account raise cash? My studies suggest a major cash commitment, (e.g., 25% of the total value) will retard a sudden decline, but won’t produce a positive result. For many, the biggest problem with cash is that it is too comfortable and therefore difficult for many to get the courage to reinvest until the market is higher.

Our own investment committee

Even as individual investors we have an informal investment committee of people whose judgment we trust. You know who they are even if they have not been formally identified. In many ways your working investment committee is like that of an institution. You have the same problem of getting them up to speed with your own investment needs and that of your family and heirs.

Please share with me how you are refreshing your own personal and institutional investment committees.

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