Completion Analysis: Fuller Picture - Weekly Blog # 560

Mike Lipper’s Monday Morning Musings

Completion Analysis: Fuller Picture 

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

                                                 

One of the first things I learned as an analyst selling sell-side research conclusions to a skeptical institutional audience were the negatives to my view point, or at least the contrary facts. Often when I thought I had a sound point of view I would arrange a week of visiting mutual funds and other institutions in Boston. In many respects this was an intensive course in the analysis of both more facts to consider, including the points of view of more knowledgeable analysts from the vantage points of their portfolios. By the end of the week I had a much fuller understanding of my own views. Further, I made up my mind that I should not consider a sales pitch until I was familiar with the opposite point of view. Thus, for me and those who eventually worked with me I insisted on learning and using a more complete picture, or as complete an analysis as possible.

With that as an introduction, this blog will discuss the other side of two very popular items in the popular and professional press, Saint Jack Bogle and the celebration of high return on equity and operating profit margin.

“Saint Jack”

Jack’s high intelligence and high intensity appealed to the CEO of Wellington Management, then located in Philadelphia. At that time Wellington was a load fund group relying on good wholesalers to convince retail brokers to sell the Wellington Fund and its new and much smaller, all equity and value focused, Windsor Fund (managed by the great John Neff). Walter Morgan decided it was politically smarter to name Jack president, rather than one of the competing sales people. At that time fund buyers were more interested in investment performance than the relative safety of the Wellington balanced fund, which was losing market share in the fund business. Jack trusted numbers more than people. He was taken in by the advocates of Modern Portfolio Theory (MPT), which in truth was not modern, not a portfolio theory. Nevertheless, Jack had urged the SEC to require alpha and beta numbers to be required in fund prospectuses. Luckily, even with the endorsement of the CFA Institute, the SEC, some recognized that these numbers were history and might be used to make poor decisions. Jack was determined to get Wellington moving again.

Accelerating growth was the rage at the time and Jack engineered a deal with a Boston manager of growth funds. The deal gave the acquired control of the merged company in a ten-year voting trust. I was visiting Jack either on the day the announcement was published or very soon thereafter. He was pleased with the deal. I cautioned that he might have lost his company. Thus, I was not surprised when he was removed. (By the way, this follows a long tradition of an antipathy between Boston and Philadelphia, since the American Revolution.)

Jack was always resourceful, from his scholarship days at Blair Academy through Princeton. He recognized that while he had lost control of the investment advisor, the independent directors of the mutual funds remained his friends. He convinced them they should internalize the operation, like many closed end funds in the US and Investment Trusts in the UK. The idea of investing in a passive market vehicle was not new. Since at least the 1940s, the Founders Mutual Depositors Fund had been a UIT invested in the 40 largest companies in the Fortune 500. I believe there were several UK Investment Trusts that had similar strategies.

What particularly appealed to Jack was that by going no-load he was materially reducing the power and presence of the sales people. He had the view that they were just a bothersome expense. There was never a study done as to the value of the sales people. (Having known many of them over the years, I suspect some were good and provided both good advice and service to investors.) Jack was a very good student of the mutual fund industry and what he saw as a benefit for Vanguard was the difference in Total Expense Ratio (TER) between an index fund and an actively managed fund. While a lower fee was a plus, what probably aided performance more was that index funds were fully invested in the market and did not have a built-in redemption reserve. Most active funds have up to 5% in cash to meet redemptions and opportunities. By getting these reserves committed, all of the investment was working for them in rising markets. When markets went down, which happens a minority of the time, active managers holding cash can outperform. This advantage also persists in the early phase of recoveries. For example, the average S&P 500 index fund was up +5.22% in the first 17 days of 2019, compared to the average US Diversified Equity fund which gained +6.22%. There were other advantages for index funds, the first is that when dealing in size active funds may have knowledge of something of upcoming importance. To protect themselves the dealers who were providing liquidity to these funds, wanted a wider spread in their favor. Index funds convinced the marketplace that their trades were without information value and that there was no need for a wider spread. There were also administrative expense savings possible.

While this numbers-oriented pitch would have appealed to Jack, there were some sales aids that were also of great help. The first is that New York State in the 1940s permitted the Teachers Investment Annuity Association (TIAA) to sell the College Retirement Equity Fund (CREF) to college professors. For many years the bulk of CREF was indexed. Many Professors had proven to themselves that they were poor investors and therefore didn’t trust the market. When Vanguard’s group of institutional sales people discovered this, they had found a fertile field of investors at both educational institutions and foundations. The benefits of indexing were taught at lots of schools, without giving a fuller understanding of investing or indexing. Many of today’s media pundits were educated in these incomplete classes.

In summary, I have great respect for Saint Jack, the mutual fund business’s Don Quixote. He brought a number of important issues forward, but his motivation was not as pure as is being memorialized. We do use index funds within our managed accounts when we can not find better actively managed funds at a reasonable cost.

High Number Celebrations

We are probably at the crest of the current economic expansion. As has happened in the past, markets can decline while the general economy remains in expansion. However, one of the functions of a prudent investor and manager is to be on the watch for signs of trouble ahead. During this season of reading annual reports and conference call pep-talks, one should be looking into the celebration of big numbers. As an analyst I pay little attention to reported earnings, as they have been adjusted by favorable accounting moves or management’s focus on what is working now and avoiding what is not, which is more difficult to spot. While I look at many ratios, the three that are the most important to me are return on equity (ROE), operating profit-margin, and net cash generation after debt service.

This season I am seeing record results reported for ROE. In one case, a net interest earner reported average ROE at an annualized 20%. This is being created by shifting client assets into more favorable earnings for the organization and there isn’t a great deal more to go. The 20% number reminded me that before the Bogle impact and other structural changes, members of the NYSE could attract general and limited partners based on a 25% return on partner’s balances. These firms were not particularly special in terms of skills so I declined to join them, which saved me from several failing firms. 

One of the lessons coming from a recent experience with Apple (*) is the danger of showing high profit margins based on high prices. In effect, Apple is holding out an umbrella over competitors in order to use price competition to successfully take market share at lower levels of profitability. Apparently, investors are expecting revenues to grow slower than they were in 2018, but sufficiently enough to be acceptable. I wonder whether a 1% slower revenue growth will lead to a 1% decline in either profit-margin or ROE. Instead of 1%, a 3% or 5% revenue decline will have a more serious impact on the ratios, as operating leverage works both ways.

After four favorable weeks of US stock market performance we could be slowing down in the recovery, even if the three major stock indices appear to have gotten over their 65-day moving average. I continue to wonder, even with bouts of enthusiasm in between, whether 2019’s average performance results will be in single digits, similar to their first full week’s performance. By the way, the AAII sample survey has all three choices in the 30% rage: bullish, neutral, and bearish.

Thoughts?     

*Held in personal accounts

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/01/twtw-recognizing-capitulationrisk.html

https://mikelipper.blogspot.com/2019/01/tis-season-to-be-mislead-weekly-blog-558.html

https://mikelipper.blogspot.com/2018/12/2018-lessons-should-be-learned-weekly.html

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Investing via Imperfections

My two most valuable investment assets are learning and recognizing imperfections. Most of the time when events don't work out the way we expect, we look for someone or something to blame. The perpetrators are not trying to disappoint or hurt us, but compared to our model of events, their model is proven to be imperfect. Because we are humans by nature, we are imperfect. Thus it would be wise to be prepared for imperfections in thinking about investing.

There is an enormous lesson that will be learned by a small minority of investors from the classic mistake of getting the recent election results wrong. They don't have the advantage that the Caltech and other scientists have over most economists. While almost all of us want certainty, political and investment pundits need to predict with absolute certainty. If they don't, they may lose the title of "expert" in the eyes of their audience. In contrast the research scientist is in the business of expanding knowledge. Thus, when "mistakes” occur in well constructed experiments the boundaries of knowledge are expanded through the recognition of the imperfections in their model. Often through recognizing the imperfection worthwhile discoveries are made.

The essence of the difference between the public expert and the research scientist is the pundit is looking for certainty and the researcher is looking for imperfections in the accepted model. Both use the power of mathematics to summarize behavior. The pontificator uses perceptions of the masses, whereas the scientist is searching for the limitations to perceived wisdom. Perhaps, the big difference is the good analyst/scientist incorporates a large quantity of doubt in his/her thinking. While every effort is made to reduce the quantity of doubt, only the fool would believe that all doubt is removed.

The biggest source of imperfections is that we do not completely understand  what we are measuring. Much more importantly, we do not fully understand what is not being measured as well as the fallacies built into our measuring devices. One of the standard series of questions on intelligence tests is which item is like the others shown. This kind of recognition is built into our way of thinking. Unfortunately for statistical analysis purposes no two people or groups are exactly like another person or group. Thus in searching for good investments we should pay more attention to the differences rather than similarities. With that in mind when we see a long chain of results such as investment or economic performance, we should remember from the racetrack and other sporting histories that streaks always get broken eventually. Thus, we need to examine the current situation and look for differences from past events (or at least express a doubt that the current event could be different than expected through extrapolation of the past).

I define my task in managing money for clients and family is to be a student of the Investment Arts. Thus, among other tasks I look to understand where the "experts" got it wrong. Recently I have found three major current and understandable mistakes that we can learn from:

• Most economic predictions

• "By the numbers" investing

• Who owns the record 

Economic Predictions

At this time of year a number of major investment organizations produce short to long-term economic predictions. There are at least two problems with these predictions. The first is that they are being made largely if not entirely by economists. (Remember no institution has more highly credentialed economists than the Federal Reserve and its regional banks. Look at their long- term record of predicting even the current economic conditions!)  Interesting that they could get some help from the institutions’ portfolio managers and some of their investment strategists who are dealing with what market prices and volumes are in effect every day. Because all who predict the markets are wrong at least some of the time, the managers and strategists may be wrong but they have a daily report card that often causes them to adjust their working assumptions.

The second drawback to most economic predictions is the source of their inputs. For the most part they use government-gathered data. This is hardly the most accurate or timely source. Two examples follow of what the government models are missing (or if you prefer imperfections to the government models). The first is income. Importantly, they use reported income from tax forms. What individual does not report the least that they are obligated to report? I am guessing if we add up all spending done through the economy it would be larger than the income reported for it would include both the "informal" segments and indirect benefits from gifts, etc. Significantly, many of those that are not solely relying on reported wages make their economic decisions based on their own perceptions of their wealth and changes to it. Our national data on wealth suggests that it is roughly divided in half with variably priced assets and so-called fixed assets (largely real estate less mortgage debt). One of my learning experiences in working with successful families is that they view their wealth differently than what is shown on tax and other documents. Because we are living in a particularly volatile time, attitudes to the size of wealth can change rapidly. These changes affect both consumption and investing that are not adequately recorded in inputs that most economists use. I suspect those who deal with major segments of our population have at times quite different concepts about where the economy is currently going compared with most economists.

In general, investors should probably pay more attention to what the people who are managing companies and their money than institutionally employed economists. The only time that it may be wise to pay particular attention to an economist is when the expressed views are not coincident with what his or her organizations are currently selling. Also it may be worthwhile to be alert to them when they express doubt as to their inputs.

The Fallacy of "By The Numbers" Investing in Mutual Funds

Media sound bites, sales people and regulators seem to think that fund investors have limits to their investment intelligence. They do not know the critical difference between ratings and rankings. When I started to develop the market for our Lipper Mutual Fund Performance Analysis, first for my brother's firm and then my own, the critical target markets were the mutual funds' independent directors and their counsel. They had a specific task to decide whether to renew the investment advisory contract for their funds. In rare cases they did not renew. I convinced them that an independent source of fund data protected them in case they were sued by regulators and/or shareholders. The service as it evolved delivered rankings of their fund compared with what we felt was the list of competitive funds in various time periods. Ranking is an ordinal listing of past performance. As long as I was the CEO of the publisher we resisted the use of the term "ratings." To this day I believe the term ratings is an attempt to predict the future as the various commercial credit ratings firm do. Their function, which they do quite well, but not perfectly, is to predict the chances that interest and principal will be paid as promised. Rates are predictors, ranks are ordinal listers.

One of the reasons I so resisted the rating term was I was an investor in mutual funds for myself and a limited number of advisory clients. I learned quickly that mere extrapolation of past trends led to unfortunate results in terms of future performance. At times highly ranked funds in various short-term periods repeated their high rankings in future periods. This is exactly why those who are serious about investing in mutual funds and many other securities need constant advice as to selection, weighting, and sale of investments.

Compounding the utility of "ratings" is the extreme focus on expenses. While expenses are important both as a deduction from gross performance and as an example of the stewardship attitude of the fund's management to its shareholders, it is only a component to proper decision making. Even a maximum expense ratio of 2% will rarely change a bad investment into a good one by total elimination of a low fee fund to become a good investment. Further one should understand the continuing cost of marketing support being paid by the fund and whether that benefits the fund holders. Many retail investors in funds need a lot of time which translates into distribution costs before they make a decision as to their investments. Much of this effort has to do with the time spent on the process of changing thinking from saving to investing. As most households in the US hold at least four or more funds, putting together the fund portfolio takes time and effort. To the extent that the fund buyer uses an investment advisor or a broker in that role, the cost of education is shifted from the fund to holder directly. Perhaps the most valuable service from the distribution channel, including investment advisors is hand holding during periods of personal or market stress. Often timely redemptions can be more productive than good buying in terms of investment dollars earned. From the remaining fund holders’ point of view, any new money that comes into the fund during periods of market stress helps them through the reduction of forced sales at stressed prices to meet waves of redemptions.

In their stewardship function some funds become closed to new accounts and/or new money. While this benefits the existing holders, it is limiting the aggregate profitability of the fund's management company. In some cases the chosen area of investment requires a greater level of internal research than the standard large-cap segment and this may materially cost more than standard. This element is true for both some equity and bond funds.

Prudent fund investing is if anything more difficult than individual securities. Good fund investing should not be done on the basis of rankings, ratings or "by the numbers," but by careful analysis of the data, people and market structure. Hopefully, some day the media and regulators as well as the distribution channels will show proper respect to the tasks of fund investors and their supporting functions.

Who should be credited with the record?

The focus on press reviews shaped many otherwise smart investment professional's views as to who was responsible for the publicized record.
I was developing my skeptical nature even before I was directly responsible for selling and managing the above mentioned Lipper Mutual Fund Performance Analysis. At that time I was in a small institutional research effort in a large, retail oriented brokerage firm. Because of the absence of well trained institutional sales people, I had to sell my research to various institutions including mutual funds. In two instances I tried to get the mutual fund sales efforts within the firm’s large retail branch network to change its sales efforts in terms of two well known funds. In the first case a fund with a good record was being pushed through the system. This happened to be a fund that I called on and knew both the portfolio manager and some of the few analysts. The portfolio manager was good, but actually he was a better salesman. However, he was difficult and the shop while large was destined to be sold in pieces. One of the analysts that I knew decided to leave and asked me about his next shop, at which many years later he became the chief investment officer. Hopefully I was helpful to his progress. In this case what was more important in my perceived responsibility to my firm was that I reviewed the stocks that he was responsible for in the fund's portfolio. I quickly realized that he was responsible for most of the successful positions in the fund, but few if any outside the shop even knew his name. I unsuccessfully argued with my firm that they should suspend their sales effort on this fund.  Within about a year the fund's performance turned decidedly down. Relatively soon thereafter the portfolio manager left and used the fund's record to sell large overseas investors on his new firm. Too bad they did not take the time to understand as to what created the performance.  

In a second case a well known portfolio manager left Fidelity to start his own mutual fund organization. He did not take any of Fidelity's good analysts with him. He picked up two journeymen analysts to join him. On the basis of a very favorable cover story in a business magazine (whose writer eventually joined him) he contracted with a firm to conduct underwriting of an open-end fund. My firm was in the syndicate. I tried to explain that the manager was leaving a well put together team like the very much respected New York Yankees. I was so successful in my argument the firm became the second largest underwriter of the new fund. After a very successful underwriting and follow-on sales, performance was less than good and eventually the management company had to be merged out. The initial fund exists today after many name changes and mergers at probably less than 10% of its peak assets.

This concern for understanding the record also holds true for individual companies. In our private financial service hedge fund we rarely short stocks, but years ago we did short one of the largest industrial companies in the world. On the surface it had a much celebrated record. However, when one pulled apart its financials, most of the firm's earnings progress was coming from a relatively small revenue producing segment. The gains that were being generated came from leveraging its fast growing loan portfolio. When I called on a number of large but marginal companies who were growing through leveraged borrowing programs, I found in most cases the lender at high interest rates was the same large industrial company and no other source was readily available to make these, in my judgment, risky loans. 

However, there is a positive side to this story. It is now relatively close to the price we shorted the stock more than ten years ago. This is a wonderful example of one of Wall Street's favorite investments ploys. “The Street" loves recovery plays. Recognizing that there is not a widely consistent winner, when the eventual disappointment sets in and pushes the price below its liquidating value, an opportunity is created if one believes that some of the attributes that created the good record remain. With the exception of investing for a pension fund experiencing large benefit payments, I am not particularly attracted to a consistent performer. I much prefer a fund where there are logical signs of improvement in process and results. We have few potential candidates in the recovery category that are attempting to improve their investment process which could be good investments for our clients in the future.

Bottom Line

Regression to the mean eventually overrides a "hot hand." All inputs need to analyzed not just accepted.

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Copyright © 2008 - 2016

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