Winning Investment Strategies Shrinking - Weekly Blog # 608

Mike Lipper’s Monday Morning Musings

Winning Investment Strategies Shrinking

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

Premise: Winners are not Good Teachers
In the Northern Hemisphere this is the season where sports fans look forward to identifying the best team to crown as champion of their league. They celebrate the stars that did exceptionally well, but because we don’t like to pick on those that are down, we avoid focusing on the players that performed badly. This highlights the difference between a good sports or investment analyst and one likely to perform poorly in the future. As a contrarian I believe I learn far more from the mistakes of previously competent players than the exceptional winners.

Matter of fact, most winners owe their success to the mistakes made by others, something that is certainly true in military history. Many competitors try to model themselves after recently crowned champions,  but more often than not those who study a broader list of mistakes made by individuals, and their managements will be on the way to becoming future champions. (General George Washington was one who learned from early battle losses.)

Applying Lessons to Professional Investment Battles
Since every investor starts with some cash and perhaps some borrowing capability, all investments and investors are in competition. Most choose to stay in the middle of the pack rather than venturing out to the extremes. Nevertheless, it is not what a single investor or a single investment does, it is what others do that determines the absolute and relative profitability of the decision.

Why is this? It has to do with what is called the weight of money. (A lesson I learned from the real investment professionals at Fidelity.) Prices don’t move on the basis of brain power or information, but on the size of the flows into and out of investments. (This is the fundamental basis behind technical or market analysis.)

Flows follow Performance
Brains don’t move prices, conviction as measured by the size or the weight of money behind the flows do. No one is required to sign an affidavit as to why we do anything, it’s what we do and with what size or force. In viewing different asset classes we can see that the lack of  money going into commodities and some elements of real estate has led to flows into some equities and somewhat indiscriminately to fixed income.

Excessive Flows are Often Late
As with most investment rules and policies they can be taken to an extreme, which might be viewed as an antidote to the weight of money argument. One critical element of flows is who the sellers are at various prices, or for fixed income securities, yields. In many cases the sellers are more disciplined than the buyers. Owners of fixed income products are initially interested in current yield, but those like pension plans are also focused on the reinvestment of their interest payment receipts. When rates are too low they may decide to exit the fixed income asset class with their profits and explore total return vehicles, largely equity-oriented investments.

In the third quarter, worldwide equity funds had net redemptions of $3 billion, bond funds net inflows of $271 billion, and money-market funds net inflows of $311 billion. The smarter sellers may be speaking, especially if you consider that interest rates are among the lowest in 500 years, before the inflation caused by the discovery of South American gold. Even though rates are low, the yield curve is becoming a bit steeper. Currently, the thirty-year US Treasury yield is 2.35%, which may be the “market’s” guess of the long-term inflation rate. Some escapees from high-quality fixed income and some nervous equity investors are congregating in high yield paper/funds. Moody’s (*) has expressed their concern after rising prices in this category, fearing an increase in problems for future issuers.

(*) A position in our Private Financial Services Fund)

All is not Great in the Domestic Equity Arena

1. The US dollar’s rate of exchange is softening, making foreign investments more attractive. 
2. Too much attention is being paid to the S&P 500, which year-to-date is producing a return north of 30%, including reinvested dividends. What is not being noticed is the significant number of stocks producing lower returns, particularly the value-oriented and industrial company stocks found in many portfolios. The latter dealing with lackluster sales and weakening prices. 
3. Low interest rates are allowing companies that should close to limp along and depress prices. 
4. The very volatile American Association of Individual Investors sample survey, a contrarian indicator, showed 44% of investors being bullish vs. 20.5% bearish. (Most readings are in a 20-40% range.)
5. The oldest Central Bank in the world has given up using negative interest rates. Sweden, a very respected central bank, is now no longer one of the few negative interest rate users. I suspect some central banks and investment people with a knowledge of history see higher rates in their future, perhaps much higher.

A useful set of indicators
The New York Stock Exchange (NYSE) currently trades 3,099 issues and the NASDAQ 3,466. Historically the NYSE had more stringent listing standards, so on balance it has older and higher perceived quality. Both had 47 issues that were unchanged last week. The NYSE had 2.6% of its stocks hit new lows, whereas the NASDAQ had 20% hit new lows. The NASDAQ Composite has gained +38% this year and the DJIA +25%. On average the NASDAQ attracts more active traders than the senior exchange and thus may better reflect sentiment.



Question of the week: When was the last time you looked at your fixed income investments with the same scrutiny as you do your stock investments?



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/12/faulty-decision-processes-at-change.html

https://mikelipper.blogspot.com/2019/12/investors-are-worrying-about-wrong.html

https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html



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Learning from the Demise of G7 through the Battle of Cowpens - Weekly Blog # 528

I learn and apply these lessons to our investment tasks, communicating them through these blog posts. Global policy judgments are not a focus of these blogs. One can learn from watching conflict resolutions in military, political, and sports worlds that are useful in thinking about future investment decisions.


The G-7 meeting

The G-7 meeting in Canada was a wonderful display of tactics that may predict future strategic movements. President Trump was widely criticized before the meeting as a protectionist, particularly by European allies and Canada. In a brilliant flanking move, he surprised them at the meeting by suggesting a relationship with no tariffs or other barriers to trade. What it revealed was that each of the other countries involved had higher tariffs and more trade constraints than the US. The reason for the discomfort (or more correctly, horror) was that these were put into place to benefit specific politically powerful interests, which would presumably be hurt in a no-tariff world and would cause most of the governments at the meeting to fall. (The US is very conscious of the tariff wall which was the primary cause of the early conflict between the Northern and Southern states and thus really led to the Civil War.

The future may well depend on how close a parallel this is to the Battle of Cowpens during the Revolutionary War and its aftermath.


The Battle of Cowpens

The Battle of Cowpens, fought in 1781, was an engagement between American Colonial forces under Brigadier General Daniel Morgan and British forces under Sir Banastre Tarleton. Tarleton’s force of 1000 British in the King’s Army went up against the 2000 men under Morgan. Only 200 of the 1000 British troops escaped the battle. The Colonial forces conducted a double envelopment of Tarleton's forces.
From the American side, almost equally as important, they lost two major cannons that could have helped the Colonial forces at Yorktown.

Tarleton was a young and impetuous commander who marched tired troops into battle and fell into a well designed trap of counterattacking by the Americans. The Americans were instructed to fire two rounds and then retreat into the hills, sucking the tired troops into fire from three emplaced positions with their open flank. That is where the American cavalry showed up, having circled the British lines.

The battle was a turning point and coupled with the British defeat at King’s Mountain, compelled Cornwallis to pursue the main southern front of the American Army into North Carolina, leading to Cornwallis’s surrender at Yorktown. Quite possibly, if Cowpens had turned out differently, there might have been a British fleet off Yorktown rather than the French fleet and the US would have remained within the British Empire a little longer. Except, unknown to the participants, a peace treaty had already been signed in London, with considerable help from some members of Parliament.

Clearly the tactics at Cowpens may have had a role in the strategic reorientation of Britain and the United States. Could this also happen to the make-up of the G-7? Was the difficult meeting in Canada a part, perhaps a necessary part, of the pivot to Asia?


Investment Lessons

The following are possible parallels from the G-7/Cowpens actions:
• Read more fully about the past and look for less popular, simplistic explanations.
• Be careful about following young, impetuous leaders.
• Early gains can be a trap.
• Rest is an important ingredient for victory.
• Don’t leave your flanks unguarded.


Follow-Up Bits

Everyday we are greeted with bits of information, rarely however do we get the complete picture. Often, the bits are in conflict with each other and formerly perceived “truths.” The following are listed in order of their published date.

• Money Market deposit account interest rates jumped to 0.52% vs. 0.47% before the Fed raised rates by 25 basis points.

• The American Association of Individual Investors (AAII) weekly survey turned roughly 5 percentage points more bullish, dropping 5 percentage points from the bearish category. [At this level, rising short-term interest rates are apparently viewed as bullish.]

• Mutual fund investors around the world are primarily investing for long-tem needs, largely retirement. At the end of 2017, US investors owned 44.8% of the $49.3 trillion invested in Funds, with only 31% in equity funds. Of American households, 45% own Funds, with 61% owned in tax deferred accounts. Thus, conventional mutual funds are unlikely to be the leaders in the next speculative surge in the market.
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Managing for the Next Decline - Weekly Blog # 484

Note:

In order to ease indexing, I have added the blog sequence number to my weekly posts.

Introduction

All life is cyclical going from good periods to poorer periods. No one has repeatedly been able to predict the tops and bottoms on a regular basis. Unlike actuaries, those who learn the basis of analysis at the racetrack assume that they will be wrong some of the time. There are two keys to investor survival, the first is to be selective in which races to bet on. The second is to change the levels of the bet based on both the intensity of the conviction and to a lesser degree the need to preserve some wealth. At least this is how I look at the markets and manage the money for which I am responsible.

Any survey of known history identifies periods of rising and falling prices as human emotions react to changes in perceived conditions. From a portfolio management perspective, to me the odds favor a meaningful decline between now and probably the time of the next US Presidential election. The decline will be measured in terms of prices of securities and/or general economic data; e.g., Gross Domestic Product (GDP). There have been times when individual markets or economies have fallen and occasionally both at roughly the same time.

The problem is that few investors have had a good record of timing these declines. My life-long study of mutual fund performance suggests that winners in a particular phase who raise a lot of cash on the downslope are not very successful at recommitting the cash on the way up and often over long periods of time underperform those that accept the pains of declines, but in general remain largely fully invested in equities and especially in well managed equity funds. This is less true in bonds and commodities.

To attempt to answer the questions as to selectivity, weighting, timing, and turnover, I have developed the concept of Timespan investing. Thus, today I look at the future through the filters of at least four different Timespan Portfolios.

Short-Term Operational Portfolios

At the moment these are the most price sensitive portfolios because these have near-term payment responsibilities. For some non-profit institutions and active families the next several years can be particularly stressful. Not only that the odds favor some price disruptions in most securities and commodities markets, but there are the new imponderables of net federal and state tax payments. At the very same time as we may be experiencing a cyclical decline, calling for more contributions to those who are suffering, but a high likelihood that those of wealth will be paying more taxes as forgone taxable deductions will have greater impact than a decline in federal tax rates. In addition, in many states and local communities taxes will go up to fill some of the smaller grants from the federal government.

Often these short-term portfolios are made up of income-producing securities. As corporations see new opportunities to profitably invest in capital expenditures (even as they may reduce buy-backs) the rate of dividend increases may slow. Depending on the depth of the decline, markets may fear that there will be reductions in some dividends.

To balance the stock risks in these portfolios often a significant part of the money is invested in a variety of credit instruments. Historically the prices of these instruments did not move much. There is however a good chance that some of these will become much more volatile. Over the last couple of years many institutional investors with a primary background in stocks have offered to their clients new Credit funds. (In some cases to improve their yields these portfolios are leveraged with borrowed money.) One might be concerned with the impacts of a rumor on the credit worthiness of any of these instruments creating volatile prices which will surprise some holders.

To those that are funding some non-profits and/or family spending, they may be caught in a squeeze as inflation rises. I tend not to give too much credence to government produced inflation figures. For those who have borrowed on the doubling of LIBOR levels in the last year as it moves closer to the mythical 2%, it could be driving costs up for some people. Interestingly there is a real dichotomy on savings rates offered by institutions who are paying LIBOR or higher rates, while the average money market deposit rate has dropped to 0.29%.

Limits on Upside Removed

Now that the price gaps have been filled in by the recent declines, the limitation on further price appreciation has been probably eliminated. This elimination does not guaranty gains, it is just more likely to occur than recently.

Bottom line: shorter-term portfolios will require more than custodial attention.

Intermediate or Replenishment Portfolios

These are the portfolios that are meant to replenish the operating portfolio’s payments. The duration of these portfolios should be tied to the internal policies of the account. One guide may be the period that the chair of the company or investment committee is likely to be in place. From a stock market vantage point it would be wise to consider that the period should include an expected market cycle.

As I have worked with funds advising on incentive compensation, I have favored four to seven years to set the target period of a portfolio manager’s performance pay. I am particularly concerned about the use of three-year periods, because they can be one directional and not show important elements of a full cycle. Over the last fifty years in the US 37% of the time there has been a down quarter which means 63% of the time the stock market has risen and therefore there is no institution-wide experience in down markets. This may be of real significance today as there has been only 15% of the quarters in decline since the first quarter of 2007. We could well see a major rise in down quarters to bring the current 15% closer to the historical rate of 63%.

Portfolios often own both growth and cyclical stocks. Almost all companies are affected by the cyclicality of the economy and various segments. If one could count on the bouncing ball type of behavior of a cyclical market to come back to prior levels, a buy and hold strategy would work fine. This is particularly true if the dividend is maintained through the cycle. However, in some cases former performance is not repeated. For example investments in telephone companies largely dependent on physical long lines in the age of the internet are unlikely to reach their old levels of profitability. For years there has been the substitution of aluminum and plastics for steel in cars and trucks which suggests that despite what happens on the tariff front it is unlikely that many steel companies will return to their old levels of profitability and employment.

Bond Downgrades, Reality or Rumor

Without signs of great enthusiasm for stocks, any cyclicality is likely to be limited to a decline in the twenty percent range which is a difficult arena to successfully raise cash and redeploy fast enough to beat many buy and hold quality stocks. This is not true on the bond side as there has been too much money coming into the bond markets at current prices and yields. At some point rising interest rates will drive bond prices down. It is quite possible some of those who purchased their positions with leverage will be forced to sell out into an illiquid market. A credit rating drop from investment grade BAA down two levels to B increases the expected default rates for maturities of five years from 1.67% to 22.06%, In other words the rumor or the fact of downgrade could raise the possibility of losing over one-fifth of the par value of the bond.

Long-Term Aspects of the Endowment Portfolio

Our Endowment portfolio is meant to fund the expected needs of those currently alive and thus expected to live through numerous cycles. Quite properly long-term investors should be concerned about a major market decline. In the past approximately once a generation there have been a period, usually quite short, of a 50% decline. All investors at all times should be on the lookout for the bubbles that lead to theses declines. Bubbles are created by human nature when greed relegates fear to a forgotten corner of the mind. Those of us who dwell in the world of numbers will often be very premature, that is wrong, in spotting bubbles through the use of market or economic statistics. The more useful guide is to listen to the level of enthusiasm both the professionals and the public express. Some of the attributes of past bubbles are as follows:

- A new discovery that is expected to bring wealth to many.

- Apparent liquid markets, often one-sided in reality.

- Easy and cheap credit.

At the moment in terms of stocks I don’t yet see signs of a bubble which means that long-term endowment accounts should stay reasonably well invested in stocks now.

Legacy Portfolio Items

Periodically equity market prices are focused predominately on near term results which are often troubled. At the very same time these enterprises are developing not just the products and services that will be in great demand in the future, but more importantly a cadre of managers that can bring a lot of the potential to fruition. To an important degree it is like looking at young racehorses who are expected not only to have winning records but to be successful breeders. Not easy to find, but worthwhile. Currently perhaps the best returns in these searches may be found in frontier and emerging market investing. All of these opportunities will experience some turmoil during their development. One needs very skilled analysts and portfolio managers to find these opportunities and enough patience to hold them.

Questions:

What are you going to do in the next decline?

Have you been able to identify desirable Legacy investments?

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Lack of Confidence in Brexit Era Could be Costly

Introduction

I am a student of long-term investment performance for our accounts and my family. Some of the money entrusted to us is designed to make future payments many, many years into the future. Thus, I study which are successful and unsuccessful investors and their strategies over long periods of time. In that light I mentioned at a recent meeting of the New York Society of Securities Analysts celebrating the thinking of Ben Graham, the father of value investing, why I believed that the “experts” were wrong that the British would vote to remain within the European Union. They violated my rules for avoiding large losses that I derived from Ben Graham and my old professor David Dodd. The rules are:

A.  Overconfidence (Almost universal belief in an outcome)

B.  Faulty, incomplete, and poorly timed assumptions (Economic only

arguments) - Lack of non-financial milestones (Confusing money bets with bookies and number of bets + % undecided)

C.  The frequency of massive overconfidence in financial history is relatively rare; e.g., “Tulip Bulb” Sub-prime mortgages with house prices never declining. Avoiding those losses are critical to the number one rule of successful investing which is to avoid (big) losses along with the second rule, which is not to forget the first rule.

The First Two Rules Are Not Enough

One could have avoided losses from overconfidence by just moving into an all cash position and one would have saved all or the bulk of one’s capital. But if you stayed in cash you would have missed out on the compounding growth that investors have experienced over many years. Using a no-brainer approach of investing in a market index since 1926, one could have compounded at about 9% which doubles money every 8 years. (This is not a prediction of future returns.)

Our objective relative to the risks assumed is to do better than a mechanical index strategy. However, to beat the index one should analyze the performance of the index compared with actively managed investment accounts. In the periodic market declines, the index declines more than the accounts because first it does not have any cash and second most indices are heavily weighted in favor of the most liquid stocks which typically drop the most as they are the easiest to sell. The reverse is true on the way up from the bottom. The indices have no cash to reduce their rate of gains and are in the most liquid stocks that late-comers plow into.

As a student of investment performance of successful managers, I have noted that they have more confidence in what they are doing than others. Often they are lonely in adopting a particular stance or set of securities. Typically they are not positioned defensively in early stages of what proves to be a rising market. Many times this lonely confidence (compared to a market of little confidence) produces a superior compound growth rate. The superior managers don’t always do extremely well, which is why our portfolios have a number of funds that have characteristics that suggest in appropriate markets that they will do well.

Is Brexit an Opportunity?

Caveat emptor or buyer beware: we can not predict the future. My training at the race track is such to wish most of the time to avoid the betting favorites (weight of money) as well as my contrarian nature suggests that Brexit could well represent a major long-term opportunity for investors around the world.

Why?

There are potential parallels between 2016-17 and 1848 as indicated in last week’s post.    There are already eight European elections scheduled plus the re-vote in Austria. Australia finished voting this weekend with the present government weakened. The US will have a new administration and a different makeup of its Senate. There is a likely chance that within Europe there will be Brexit type votes either the in planned elections or in special referenda.

Around the world the existing order is under attack by groups on the right and the left claiming that the politicians and other “experts” have not delivered. Further they claim, governments are too big and therefore expensive and inefficient. Supranational bodies are viewed as even worse, as they are further away from the disgruntled people. In part due to social media, many minorities have expressed unhappiness with majority cultures and are expressing desires for autonomy or even independence. One wonders whether the concept of nationhood will need to change.

The world has changed. Even small companies and to some degree small investors view the world through multinational lenses. In the forthcoming negotiations between the UK and the EC, at the moment the UK has the advantage in that it should not be in any hurry. In the meantime it will be free to develop singular trade deals around the world. At the same time multinational companies and investors will seek out their own best deals. There is a long history of wartime enemies arranging a regular flow of trading between combatants. (I suspect that some in Germany are already at work on this option.) In the eventual final negotiation it would be wise for the UK to have one with the negotiating skills of “The Donald.” This is not a US political judgment, but one that recognizes commercial realities. It would not surprise me if the length of the negotiations is not similar to the twelve-year period between The Declaration of Independence and The Constitution. And that process had the benefit of the Founding Fathers led by Hamilton, Jefferson, Madison, and Monroe.

Perhaps coming out of all this will be a political shift favoring consumption over labor. China is attempting to do this with difficulty. The pro-labor attitude of the existing power structure has not worked. By raising the cost of labor (including benefits), it priced much of labor out of the market to be replaced primarily by automation, if not outsourced production beyond China’s borders. By focusing on consumption the drive will be in terms of price, quality, and safety which can produce a healthier and more satisfied society.

There is Still One Thing Missing.

The two largest economies in the world have been built by risk-takers. In both the US and China, the countries are populated by people who took the risk to move to their present location. Historically in the US, it is important to remember that with the exception of the Native Americans, we all came from someplace else for the past four hundred years. Because we arrived with very little in the way of financial assets, we were, and many of us are still today, risk-takers. This makes us unique among nations at the moment, which will have to be corrected if the Europeans want to catch up to the US.

Pardon a parochial view, but I often view the world through mutual fund glasses. One measure of the risk-taking attitude of investors is the portion of their assets invested in equity funds. On paper, Europe as a whole is the same size as the US economy. As of the end of the first quarter of 2016, the world has invested $16.4 Trillion in equity mutual funds. US registered funds accounted for 60.9%. All of Europe had only 27% in equity funds, including Luxembourg and Ireland which are favored by tax aware global investors outside of the US. Excluding the tax shelter investors, the four European nations with the largest share of the global equity funds were the UK with 4.3%, France 1.9%, Netherlands 1.7% and Germany also 1.7%. The potential of  less expensive and bureaucratic government focus on consumption is great. However, it won’t be achieved if most of the risk-taking comes from US and Chinese sources.

	Assets in Equity funds: as of 3/31/2016
All Equity Mutual funds	100%
US-registered funds	60.9 %
All of Europe? (including Lux & Ireland)	27.0 %
UK	4.3 %
France	1.9 %
Netherlands	1.7 %
Germany	1.7 %

Source:  ICI

How should one invest in the Brexit Opportunity?

This will undoubtedly be a long and laborious task. In a time-segmented portfolio as in our TIMESPAN L Portfolios^®, I would begin with small commitments to International funds which have 40% in Europe and buy more during periodic setbacks. The small fund participation rate in Europe may be an opportunity for financial services investing. I will be happy to discuss privately how we do it in our private financial services fund.    

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All Rights Reserved.
Contact author for limited redistribution permission.