Preventing Investment Mistakes - Weekly Blog # 533

Confirmation and Anchoring

Confirmation and anchoring, according to a recent survey, are the two most popular biases of investment advisors. I suspect these are largely the biases of their clients. While these biases tend to drive investors at all levels into the most popular strategies and investments, they imply that the crowd is normally right, or at least it is safer when wrong to go down with a crowded ship than try to swim in lonely waters.


The Favorites

Those that search for popularity did not attend my first class in analysis of securities and people. The class was held on most days, including Saturday, in an open-air setting at various New York racetracks. The most popular horses had the smallest betting odds. These were called the favorites, as if they were like the most popular high school dates. The problem with chasing favorites is that on average they only win between 30 and 40% of the time.

More importantly, when they win, after deducting the portion of the winning pool that went to the track and state taxes, they do not generate sufficient winnings to cover the 60-70% of the time when they lose. (Like many investors, the winners do not recognize that they owe income tax on their winnings.)


Useful Information

Many investors believe that they are smarter or have more useful information than those on the other side of the bet or transaction. They quickly confuse temporary winning with greater mental capabilities. Just as various political leaders, central bankers, and pundits of all types view an errant morsel of information.

A new breed of binary judges is being marketed to investors as factor funds, which ranks and chooses securities by various statistical measures, such as revenues (Fortune), Market Capitalization (Standard & Poor’s and Russell), Earnings Per share Growth, Price/Earnings Ratio, Free Cash Flow, Current Yield, and others. Sometimes single factors are brought together into multi-factor portfolios. The problem with this approach is that if it were that easy various printers of financial statements would be the richest people in the world.

One of the early lessons from the track, security analysis, and topographical maps/photos is that these are given to all who can afford them. The key to more victories is what is missing, often in plain sight but not recorded for publication or correctly understanding the value of a corporation’s inventories, fixed assets, patents, and customers.

There are other occasions when both the buyer and seller are correct or wrong, one being an expected time span in ownership ranging from one moment to almost infinity. Another is completing a portfolio structuring or restructuring. A third might be the value of a shareholders’ vote.


Avoid Arrogance

Thus, to avoid unforced mistakes avoid the arrogance of assuming the party on the other side of the trade is dumb. Make a serious attempt to guess the motivation on the other side. They may know something that might be helpful.

The professors at Caltech believe that what we commonly call thinking is reaching back into our memory banks. There is a growing gap between those that have experienced either a bond bear market, deflation, or even a 1987 style stock market. Therefore, many investors make mistakes that seniors avoid. If you don’t know something it is easy to be arrogant and not look to understand the other-side of a trade.


Cross Winds

One of the big mistakes that far too many investors are guilty of is not examining a large enough set of inputs. Rare insights are often in plain sight but ignored by most. With that thought in mind, the following are some factoids that I saw this week which could impact some short to very long-term investment decisions:


Possible short-term inputs

The top three global market weekly advances were - Nikkei 225 +3.71%, Shanghai Composite +3.06% and S&P BSF Sensex (India) +2.48%. (Asians must believe that they won’t be hurt significantly by the trade politics, or there is massive short covering.)

Somewhat linked to the above is that the next two index risers were the NASDAQ 100 and the S&P 500 Info Tech Index. This was supported by the 18 of the best 25 performing mutual funds for the week, which likely held those types of securities.

Both the S&P500 and NASDAQ Composite were at record price levels this week, but their trailing price/earnings ratios were not higher than year ago readings. (This suggests that higher prices are being driven by reported earnings, not changes in valuation levels.) However, margin debt is continuing to grow at record levels. My guess is that margin debt is supporting speculative holdings of bonds and/or stocks.


Intermediate Term

Over the last year the average Taxable Long-term Bond fund’s total reinvested return was less than the average coupon on the bonds in the portfolio. This suggests that those investors spending their distributions are eroding their capital. To a lesser degree this has been happening for the last five years. Even though nominal inflation has been historically low, on a “real” return basis, they are eating into their spending power and are certainly doing so if they are tax payers.

With the global aging of developed nation populations, the result of longevity expansion and healthcare becoming more extensive, the underfunding of pensions is growing. This does not take into consideration the self-funding that many are or should be doing.

We may have entered into a world where the money cycle is more important than the trade or product cycle. One of the indications of the impact of technology on jobs can be seen in the oil patch, particularly for those involved with fracking. The number of employees used in extraction is flat to declining and the number used in energy service is growing and is larger than those used in extracting. It would be even higher if the service companies could find a sufficient number of truck drivers.


Longer-Term Considerations

In about twenty years, just 8 US states will comprise 49.5% of the expected population. Adding another 8 states raises the total to about 70%. These states are mostly on the east coast, California, Texas, and Colorado, although they are still unlikely to control the US Senate.

Nigeria will replace India as the home of the most poor people. While this is good for India, it suggests that Africa will likely be the home of most conflicts for many years. While I have been suggesting that the bottom performing commodity funds should be looked at for long-term investing, it may require too much patience as commodity players and farmers remind me that commodity cycles typically take 30 years.

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1776 Can Make Us Independent Again

Historical Introduction

Most Americans believe the single most significant act of 1776 was the signing of the Declaration of Independence. I suggest that when facing today’s economic problems we consider a still more important event that occurred  in 1776, the publication of Adam Smith’s The Wealth of Nations.  (Not to be confused with the very insightful contemporary author and television personality who uses Adam Smith as a pseudonym.)

The two events are very much related. Our Declaration of Independence was driven by the colonists’ abhorrence to the Navigation Acts and other laws of Great Britain that raised the costs of imports into America and restricted the transportation of our exports. Remember the famous Boston Tea Party was caused by the tax on imported tea.

These laws were an outgrowth of the mercantilist philosophy of European governments to promote their own exports and restrict imports into their lands. This governing philosophy reigned between about 1500 and 1800, and was based on the need to get trading partners to ship gold to those countries where they had an unfavorable balance of trade. The importance of gold was not primarily economic, but rather to pay for their constant wars. In the minds of the European leaders, particularly the British and French, this was a matter of survival.

What Adam Smith advocated was that nations should specialize in their production of items to be exported and import those items where they did not have a cost advantage. Over the succeeding generations his ideas were finally accepted.

Today and for some time American Presidents have announced policies that would make the US independent of foreign oil. In response to questions and comments from a number of regular blog readers, I will attempt, in a small way, to play an Adam Smith role.

My biases

I have never seen a totally unbiased report. Most of the authors are not fully conscious of their own biases, particularly those that were inculcated into them at their universities. As we are all captives of our experience, biases cannot be completely avoided. The best we should do is to identify either the biases or the sources of our biases. Mine starts with a college course in Middle-Eastern history, geology and geo-politics. I learned that in Saudi Arabia, the direct lifting cost of a barrel of oil was approximately four dollars and did not change much over the years. From time to time I have invested directly into domestic gas producers to make money or energy-focused mutual funds as an inflation defensive move. When I was lucky enough to become a trustee of Caltech I was exposed to numerous professors who were focusing advanced scientific approaches to find energy and use it more efficiently. These inputs allow me to think about a problem from different viewpoints, and therefore biases. 

Parsing the search for energy solutions

The three main fuel sources of energy are oil, gas, and coal. (For the purposes of this search I am ignoring nuclear, solar, wind, hydro, and geothermal with the belief they will play an expanding role, but won’t provide sufficient power in the short to intermediate future.) I believe that each of the age-old big three should be addressed individually.

Oil

This is where I put my hat on as a modern Adam Smith. The popular view of Americans from the White House to Main Street is that it is dangerous for us to rely on the importation of oil from those nations that  “don’t like us.”  The fear is that in time of military conflict those that supply us with oil will cut off flow, or at least hold it up for ransom. There are many counter arguments to this fear. First, our military has developed lots of means to defeat an enemy without the need for the quantities of petroleum products required in World War II and subsequent engagements. Second, we have built a strategic oil reserve which is intended for military emergencies. (Not to be used as a politically-inspired price mechanism.) Third, if needed, government agencies believe that there is more oil underlying US government-owned land than has been discovered in the rest of the world.

There is another set of economic arguments which update Smith, the canny Scotsman. If oil is a scarce resource and cannot be easily replaced, we should deplete other countries’ reserves and political power by buying all that they will sell to us. Further, a rise in the international price of oil, while somewhat painful to the US in the short-term, dramatically changes our competitive position in the world. The US is less dependent on foreign oil than Western Europe, Japan and China. If petroleum manufacturing costs for the rest of the globe goes up and we have competitive products at a lower price, the US share of market will go up which can aid our job growth. Based on what we have already seen, the threat of higher priced oil will trigger greater conservation efforts and the development of more efficient uses of energy.

Gas

There are reasons to believe that the US and certainly Canada can be net exporters of natural gas. Other countries are also developing their gas properties. From a strategic viewpoint, I might be reluctant to become too reliant on imported gas except from Canada. Over time I would expect the bulk of our heating requirements will be filled by natural gas. We are likely to see both the military and large trucking fleets switching to hybrid or fully dependent upon “nat. gas.” The environmentalists will need to prove that fracking is dangerous to the neighborhoods of gas extraction and then our technologists will probably find solutions.

Coal

Some politicians have proclaimed that there is no such thing as clean coal. Considering the US has a reported 250 year supply of coal, I hope they are wrong.

If the price of energy goes up, I believe that there will be enough room in the final price of coal for both steel-making and heating to cover the costs of technological fixes that are underway.

Conclusions

Just as 1776 brought forth thoughts and actions that changed the world, I think we are at the point of achieving meaningful economic energy independence in the near-term future as we modernize our thinking.

As is my wont turning to investments, I would suggest investments in stocks of companies that are devoting some of their efforts to new ways to make our search and use of energy more efficient. These areas could be mining and extracting efforts, transportation efficiencies, and battery producers among many other beneficiaries of the application of new and improved technologies. These could include some, but not all, of the major oil, gas and coal companies.

Are you ready to be independent in the new world?  Let me know.

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Exploring for $1/Gallon Gasoline

This is the season that the great religions of the world celebrate the past and look forward to a rewarding future. Analysts should also study the past and look to the future by thinking the “unthinkable thoughts.” Today’s blog seeks to do exactly that. I am exploring the possibility of $1 per gallon gasoline. Like most prospectors and researchers, our work is a series of explorations, not of successful predictions. Whether we will ever see $1 gas is dependent on many of the variables to be discussed. As with successful prognosticators to the public, I should not predict both a direction and timing; but I suggest that if you choose to save these thoughts, it should be for your children or probably your grandchildren.

An incomplete list of the variables:

Taxes

No government that I am aware of will let a major stream of energy move from its source to its consumption without layering on taxes. (The main differences between our close to $4 price and Europe’s about $9 price for the same amount of auto fuel are the taxes imposed. There are some governments that subsidize the retail price, but find other ways to collect tax revenues.) Thus, the final price that we pay is dependent on tax distribution policies of host countries.

Technology

Due to my biases as a US Marine Corps communication officer, a securities analyst of tech companies, and most of all as a trustee in close contact with Caltech, I admit to being in awe of technology. Fundamentally, most forms of physical energy are found in nature and converted to power through various mechanical steps. Just as wars have spurred on the development of much of what is considered to be modern medicine and organizational management practices, I suspect that our exploration of space will lead to material changes in finding sources of energy, the extraction of energy as well as the processing, distribution and safe use of energy. Already, major oil deposits have been found through the use of manned and unmanned satellites. In order to accomplish our mission of exploring the planets, various remote techniques have been developed that deal with dangerous gasses and techniques for probing and “mining” from land surfaces. Some of the technological developments from space such as efficient payload management and global positioning systems (GPS) found use here on earth.

Technology is at work uncovering more efficient and safer ways of developing our natural resources; bringing into economic production energy sources that today look to be too expensive and too dangerous. Clearly we will utilize more fuel efficient vehicles on land, sea, and air in the future. Homes, offices, and manufacturing/processing plants will manage their usage of energy better. There are many other ways in which technology will both help give us more bang for our energy buck, and will also make us even more dependent on the increasingly efficient use of energy. Thus technology will affect both sides of the supply/demand equation.

Oil, natural gas, coal and nuclear

Ever since I first started looking at the economics and politics of energy in the 1950s, I have heard about reaching “peak oil production,” as we are not finding oil as fast as we are using it. I recall that some believed that we would have found all the oil the Earth had to give us by the 1960s. In each decade since, the peaking date has been reestablished, and in each decade more “juice” has been found. For both commercial and regulatory reasons, the size of these discoveries has been downplayed. Further, I suspect secondary drilling through the use of advanced technology will be more productive than is currently believed. In this season of heightened religious belief, I believe that there is more productive oil out there than most others believe, and a good bit of it in or near the US.

Natural gas was a waste product in the days of early oil production; it was just burned away at the wellhead. Through the use of technology and higher prices for oil, the governments and the people of the world have begun to appreciate the economic advantages of natural gas. We are addressing the concerns about fracking in terms of environmental dangers. Actually, at the moment we have too much natural gas, and this week we hit the lowest recorded price for this commodity in ten years. To me, it is only a matter of time and some technology until we have a significant expansion in the use of “NG” (No longer standing for Not Good, but for Natural Gas.) Thus, I see that the available supply of energy will rise and at some point impact the price of oil.

Coal

We are all aware of how dirty coal is. We are conscious of the dangers of manned mining and the effects of coal burning on our once pristine environment. Because of these issues and to some extent unwise government regulation, coal in all its forms has lost share of market. However, as a firm believer both in technology and the eventual power of economics, I do not think we have experienced the last of the beneficial use of coal on a global basis. In South Africa, I have seen the conversion of coal to oil to meet a politically-driven need, which demonstrates the creativity of some of the coal business leaders.

Nuclear

If you don’t want coal burning in your backyard do you want to have an atomic reactor quietly producing energy? The tragedies both in Japan and Russia were caused by faulty locations and poorly constructed facilities. Little publicity is seen on the safe use of atomic power in Europe, US, and elsewhere. After a period of twenty years, the US government has authorized the first new non-military use of a reactor. (The US Navy and others have been successful users of atomic power for a couple of generations.) Will procedures be developed to reduce the odds of fatal accidents? Yes.

Thus, I believe that with technology’s help, we have sufficient potential supply of energy.

The demand side

The Saudi Arabian government and others are vitally aware that the price of energy is, in the end, driven by demand. One of the best ways to measure the level of economic development in a country is to track its use of energy. (Some of the political leaders in China are more sensitive to the level of electricity use than they are to the softer calculation of GDP.) While the price for oil will have an impact as to the costs of a society to produce a particular standard of living, Saudi Arabia’s fear is that too high a price will drive substitution efforts even faster. On a long-term basis they should be worried. (As mentioned above, there are energy alternatives and technology is making them safer and cheaper.)

Habit changes

Slowly we are becoming more efficient consumers of energy. However, this is being offset by our growing demand to use more energy by our various appliances, including computer and entertainment devices. Some governments recognize that gradualism won’t work to bring energy demand into better balance. As an Easterner I hate to admit it, but the government of California has a useful idea. A recent Wall Street Journal article, entitled “California Declares War on Suburbia” suggests that a more efficient use of resources would be to gently move people into the cities, which is what is happening in China. Not only could this improve our use of energy, but could significantly improve the overall level of education and safety available within the cities. If it were to happen, then the number of energy consuming cars is likely to drop.

Two other considerations

Our current world is, as always, a balance of power. The current fulcrum of power is in the amount of energy that is produced both for internal and external use. If we had a world with a more balanced use of energy, various forces would likely cause changes of political leadership, and perhaps even the composition and identity of various countries. Many political leaders are not blind to these possibilities.

The second consideration is the monetary value of energy. At the wholesale level, energy today (particularly oil) is priced in dollars. This is a historic accident of past wars, economic development and relative stability of the value of the US dollar. At the moment, I believe the US society is committed to inflation, therefore at some point the rest of the world will wish to price things in dual, if not multiple currencies to protect from politically-inspired deficit spending by the US government. Thus, perhaps I should amend my search for $1/gallon gasoline to a level commensurate with about a $1700 per ounce price of gold.

Investment afterthoughts

Consider the following on how to put these thoughts into practice:

1. You should not bet that the price of oil will always be a good inflation protection.
   
   
2. Inflation is a product of global excessive spending relative to saving, and is likely to continue
   
   
3. View some of the large international oil companies as akin to investment banks. If they choose investment wisely within their circle of competence, they can have good results. (Interestingly, both international oil stocks and those of investment banks are low price/earnings ratio groups. The difference is that the oil companies have higher dividends and yields.)
   
   
4. Find technology producers that have a pattern of producing labor and energy saving devices, particularly those that can be applied to finding, extracting, transporting, processing, and using energy.
   
   
5. Watch for useful lessons from space activities in terms of uses of energy on earth.
   
   
6. Bet on increased urbanization, some of which will be cajoled by the government, which will lead to better primary and secondary education and safer streets.
   
   
7. While $1/ gallon gasoline is not an “odds on favorite,” it could happen and that may not be a good thing
   

Does any of this make sense to either discuss with your children/grandchildren or to pass it on to them at some future point?


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