Time to Think Long-Term - Weekly Blog # 692

 

Mike Lipper’s Monday Morning Musings

Time to Think Long-Term

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

Dull Can Be Difficult

As perpetual investors, we are like military or golf warriors. When Marines are deployed into temporary defensive positions where they are trained to constantly improve their defense against always expected attacks. Professional golfers or club level champions often spend considerable time on the driving range and putting greens. Thus, I view the current stock market environment as a good time to shift focus to long-term investing, the primary focus of this blog.

The Biggest Picture

Perhaps the biggest picture of all investable assets is our earth. Following the geographical slant, I suggest we start with the US based market, where we come to our first confusion of terms. In the US you can buy pure foreign companies through American Depository Receipts (ADRs) in dollars. Multinationals, which often grow faster and have better margins than pure domestic companies are also available. Pure domestic companies rarely exist in an economic sense, especially with the American consumer addicted to imports of food, clothing, cars, television sets, cell phones, oil, and many other products and services. Thus, we have become globalists whether we like it or not, creating a dichotomy for our politicians who are mostly lawyers. The politicians see the US as mostly bound by laws and regulations they created. They fail to appreciate that one appeal of these goods and services to consumers and investors is that they are not bound by the whims of politicians in DC or state capitals.

What is the Outlook for the “Governed” USA?

Both in terms of actuality and perceptions, there are negatives in assessing the long-term outlook, briefly listed as follows:

1. Militarily, the US is in geographical retreat from Asia, Europe and the Mid-East. Coupled with a declining budget for fighting expenditures, senior officers are being selected based on their political skills.
2. Homes and schools are producing unemployable students, lacking intellectual integrity, discipline, leadership, and physical skills.
3. We elect governments that prefer top-down, centralized, restrictive control, lacking in bottom-up experience.
4. The US is currently burdened by a lack of rigorous international leadership skills.

Offsetting the negatives are some positives for the US:

1. Around the world, people want to live and earn in the US.
2. Compared to other developed countries we have a strong geographic location.
3. We generally have abundant natural resources, which are becoming increasingly expensive to produce and get to market.
4. We have the richest consumer and commercial markets in the world.
5. We have the largest and deepest financial markets in the world, likely to become more expensive and restrictive in the future.

What Other Choices are There?

There are lots of attractive long-term investing and trading opportunities in other countries. However, in terms of geographical hedging against possible problems in the US, there appears to be only one large choice. Most other developed countries are export driven, with the US being their largest single market. If there are problems in the US, these countries will not be useful hedges in a domestic portfolio. 

One clue to this correlation with the US is the leading performing industries in their local markets. According to Standard & Poor’s, the two best performing industry groups are technology and materials in the stock markets of almost all the developed countries and many developing countries, including the Islamic countries. Hard to imagine a long-term situation where these local industries do well without a parallel move in the US.

This correlation is not accidental, the tie between the UK and US is an example. Wealthy people in the UK took part of their economic winnings from domestic sources and invested them in the US. Some of the early growth of The Financial Times and Reuters was based on their publication of US stock prices in the 19th century. In the early 20th century, my grandfather’s brokerage firm had a London office service their UK account’s needs for US transactions. Later in the century, both my brother’s brokerage firm and my fund analysis firm also had London offices. The appeal of servicing the needs of UK clients continues to this day.

One of the leading positions in our private financial services fund is Raymond James Financial (RJF). It announced it is acquiring the wealth management and brokerage firm Charles Stanley, a venerable firm founded in 1792. RJF plans to keep Charles Stanley wealth management separate from its own local wealth management activity. While the two offices will largely be using different securities and funds, I suspect they will become similar over time. In part because they will be using RJF’s superior technology adapted for the UK market.

The Only Choice as a Hedge?

The traditional choice as a hedge is one that goes up when the primary investment goes down. A more modern approach used by early hedge funds and other traders was a bet on different rates of growth, often labeled “pair trades”. The problem with that strategy was pair components moving more due to external forces than to the differences between the pairs.

Thus, as a global investor, like it or not the best hedge is China. This is not a happy choice, think of all the objections to investing in China. When you boil down these objections, they largely come down to one thing. They are not the US!!!

Absolutely true, but China is the second largest economy in the world and is growing much faster than the US or the developed world. This should not make us apologists for their perceived transgressions. The recent 50% or more fall in many shares is a demonstration of the evils of a “command economy”.  There is an interesting parallel between what their central government and Washington attacked; the power and scope of large monopolies, lose credit conditions outside the formal banking system, and privileged for profit education. The main difference between the number one and number two economies was that China moved faster and was more devastating.

I am not suggesting you buy individual Chinese stocks, bonds, or loans. What I am suggesting is you follow the late and great old data customer of our firm, Bill Berger. He called some of his investments “Chicken Bergers”. These were positions that participated in a trend but had more downside protection. In my case I am suggesting the use of regional mutual funds with analysts in the Asian region who have significant minority holdings in global portfolios. This is a good time to consider such a move as I suspect we will soon be entering a more intense higher volume period where it may be more difficult to think long-term.

Current Indicators of Change

I believe the structure of the market is in the process of changing, but it’s not yet clear as to direction. This could be a cause for concern and the following are “straws in the wind” as to future changes:

1.  Change in fixed income issuance over the past 12 months:

Investment Grade bonds    +68%

Leveraged Loans          +208%

Structured Finance       +203%

 2.  This week’s 6-month prediction in the AAII weekly sample survey shows a change of 6% “Bullish” and “Bearish” move, with Bullish positive and Bearish negative. Both were at 30% last week.

3.  Number of days to cover shorts: NYSE 2.9 vs NASDAQ 2.3

4.  The JOC-ECRI Industrial Price Index had a weekly gain of 1%, substantially below its 12-month rate. 

Working Conclusion:

Changes are coming soon and the time to develop global hedges may be short.

Comments are solicited, as I am sure not every reader is in total agreement with this blog.

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

https://mikelipper.blogspot.com/2021/07/mike-lippers-monday-morning-musings_25.html

https://mikelipper.blogspot.com/2021/07/correcting-impression-and-gaining-some.html

https://mikelipper.blogspot.com/2021/07/sentiment-appears-to-be-changing-weekly.html

Did someone forward you this blog? 

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Current Investment Traps

Introduction

To use a term from tennis, a trap is an unforced error. In our arena of investments a trap is a concept/thought that leads us to significant losses of capital, or worse, opportunities to make sound productive investments.

Last week I had the opportunity to address ASCOSIM, an organization of Italian investment advisors. My talk in Milan included a brief list of ten concepts in structuring portfolios of collections of mutual funds. Email me at MikeLipper@Gmail.com, and I will send you a copy of the ten slides which might promote useful conversations with investors.

I mention this journey to highlight one of the advantages of spending sixteen hours in an airplane over the course of two days, the ability to have ample time to read, think and to write.

In the world that I inhabit of professional investors and their competent advisors, there are many opportunities for mistakes of judgment. During my flight home from Milan, I kept wondering why these smart people make dumb, unforced mistakes. In thinking about the mistakes that I and others have made, I realized that we all fell into traps. Most of these traps first started with the principles we utilized. We use tools for the impatient. Instead of celebrating data diversity, we use labels as a way to bunch information so we can quickly narrow our focus to making a selection from a pre-sorted list of alternatives. We believe that we can reasonably predict the relative outcome of the labeled alternatives. For example “growth,” “value,” stocks, bonds, developing markets and a whole bunch of other classifications. Our problem is the comfort brought by these and other navigation skills. One example is the ability to predict with a high degree of certainty our arrival time on an airplane trip covering more than five thousand miles with greater precision than our arrival time in our daily land-based commuting. In math and physics we are taught by problem-solving and experiments that there is only one correct answer, and to get it all one needs is to follow the prescribed formula. 

The focus of this post is the current traps that I see smart and perhaps very smart people falling into. They are examples of using labels that can lead to traps. They are not listed in any particular order. Pick your own trap as we all do.

Value

We all enjoy the warm feeling when we believe that we have bought a bargain. We want to pay a price at a significant discount from its true value. There are two traps here. The first is that we can mathematically determine the exact true value of something, including securities. The second is not being concerned with the seller’s motivations which could well change our evaluations and results.

One of the ideas that I hope to get over to the incredibly smart Caltech students (including Doctoral candidates as well as post-docs) that I will be addressing this week is that the person on the other side of the trade may be even smarter and may have better information.

Successful young investors

Having grown up in the investment business I have experienced and benefited from the battle for investment thinking supremacy between young analysts, portfolio managers, and investors and those who are older. Wisdom is not chronologically based, but the work being done at Caltech and elsewhere indicates that memory plays an important role in judgments. The cyclicality of markets and investment themes over time reinforces the need to avoid obvious risks. It has been many years since the general stock market has risen significantly above previous peak levels, thus many of today’s enthusiastic investors have only had the experience of the decline and recovery phases of the last five and ten years; they think a bull market is a new phenomenon. They don’t see that within every surge of higher prices and volume that there are built in time bombs of future problems. Some of these rises will produce spectacular results. Enjoy them, perhaps participate, but don’t count on today’s gainers getting you out ahead of time of their collapse, it will be new to them. In other words it could be a trap.

Book value’s trap

Many purveyors of investment products use a corporation’s book value as a measure of investment value. People tend to forget the calculation of book value is a balance sheet measure of subtracting the liabilities from the assets found on the balance sheet to get the equity and translating that to a book value of a corporation. This may be like choosing a new friend solely based on their precise phone number. Remember that the assets are shown on the basis of the cost to acquire them if they are demonstrably below their current market value. The liabilities are based on the size of known obligations. People tend to forget that the book value they were taught in college or graduate school as well as the CFA exams is a teaching device not a measure of reality.

A better way

As someone who has both bought and sold intellectual property companies and have advised others to do so, I have found book value is only of use in comparing other transactions when their true value is unknown. When one is privileged, or perhaps burdened, to get into the mind of the driver of the transaction, one sees an entirely different set of algebraic calculations. The first is what would be the cost to recreate that portion of the subject company’s customer relations and sales? This is then compared with the potential buyer’s estimate as to what it would cost to build the desired value itself and how long would it take.

The trap of overlooking human factors

All businesses have inherent problems usually involved with human relations. What will be the costs and bother to deal with these?  Most importantly can the buyer supply the talent needed to solve these issues? With those questions what are the balance sheet assets really worth to a particular buyer? One of the more difficult imponderables in evaluating an acquisition or disposal is the reactions to the announcement. What will the customers think and long-term what will they do?  What will the “good” employees do, what will the various regulators and communities attitudes be, what affect will the acquisition have on the acquiring company, will the combination lead to enhanced talents or to a talent drain? These are just some of the questions that should be determined.

Moving to the liabilities; do they reflect all the reasonable contingent costs including retention bonuses, possible adverse law suits and tax consequences, costs to shut down and move facilities and people, unmet needs for research and development and other elements of essential research? As one can see there are real differences between the real value of a company and stated book value. This is not to say that book value is meaningless.  If one can make the tentative judgment that the sum total of the missing factors are similar to the same or related questions of other transactions, the relative multiple of book value of other transactions is a somewhat useful guide as to the trend of deal pricing. (When I know more I prefer to use the metric of price times sales. Stratifying companies that are worth one half of their sales, or even better one times, two times, three times, and more is a good measure of what buyers believe the future value of an acquisition is.) My bottom line is that present valuation is a good current guess of future valuations, but you should not rely on book value as a sole measure.

Predictability of VIX

S&P Dow Jones Indices publishes monthly comments on various indices. In its latest commentary the first point was as follows:

  “The VIX is down over the past month and the current reading of 12.84 suggests that the potential for significant moves lies only to the upside…..The Australian, Hong Kong, and Canadian VIX equivalents are also down, a pattern repeated elsewhere across developed markets.” 

In its simplest terms the VIX is a measure of the implied volatility of S&P 500 Index options.  Often market professionals view the level of the VIX as a measure of fear operating within the market place. Considering the absolute closing high for the VIX was 80 in late 2008, one can see that currently there is not a great deal of price pessimism in the marketplaces around the world. As a contrarian this is exactly when a negative surprise could be its most potent. The sell off thus far in January, which appears to be worldwide, may be the trap that was sprung on those that use immediate market movements to predict future trends including turning points.

The failure of stock investors to pay attention to bonds

Stocks can surprise both positively and negatively. In most cases the best thing that can happen to owners of bonds is that they receive timely payment of interest and principal. Thus bond prices are more sensitive to potential bad news than the stock market. As a stock investor, I am aware that bond prices can be a useful warning device for me. Changes in credit ratings are often a coincident indicator of bond price movements. Nevertheless, they can be leading indicators for the general stock market prices. Moody’s^* has published a schedule of quarterly down grades and upgrades. For the 4^th quarter of 2013 there were 78 high yield downgrades (68 upgrades) and 21 downgrades of investment grade issuers (12 upgrades). The extreme downgrade readings were 303 for high yield and 93 for investment grade. 

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

The current preponderance of downgrades in an economy that is meant to be recovering is a cause for one to be cautious about committing new money to the stock market.

Please share with me the traps that you have avoided and which ones are you wary about now.      

_____________________     

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

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

Manipulated Markets Thwart Wise Allocators

One of the insightful columns to read in each Weekend Edition of the Financial Times is written by Henny Sender. Her column is always well written and at times explores extreme positions which should be read to broaden one’s views. This past weekend’s column is entitled “This rapacious appetite for junk could yet result in indigestion.” The article describes the significant sales of below investment-grade bonds. Ms. Sender cites an example of a successful bond underwriting of an American utility whose common stock is viewed by many as worthless. Her view is that with high quality bonds yielding low rates (in most cases significantly below actuarial assumptions for pensions and less than the spending rates of trusts and tax-exempt institutions) investors are forced into extreme investments. At the opposite extreme, there are investors concerned about the value of their currencies; we have at least 15 countries with two-year bonds yielding below zero in terms of “real” rates (adjusted for inflation).

What has caused this behavior by so-called sophisticated institutional investors? This was not taught to them at their schools of supposed high learning. This bizarre condition occurred because at the urging of the politicians, central bankers have attempted to manage the supply of credit to support their faltering economies by making cheap credit available. In other words they have manipulated interest rates lower than they would have been under the present economic conditions. In non-manipulated markets the exact price of an investment is determined by the meeting of buying and selling forces. Normally, the market determines a rate of interest that is a reasonable gauge of the perceived risk of loss of an investment. In an administered market there is little in the way of risk discovery. Thus, all too often allocators will choose high interest rate paper for their portfolios to meet unrealistic demands for current income.

One of the misapplications of Newton’s First Law of Motion, (a body in motion tends to stay in motion) is that current market conditions will remain the same in the future. As is often the case, the best economic text, the Bible, has the early recognition of the seven feast years followed by seven lean years. Further as history shows, wweventually all manipulations become exhausted and then there is a return to freer markets. Currently those that pursue the high yield, or if you prefer junk markets, are not worried. The interest rate spread between their merchandise and US Treasuries of similar maturities is historically tight, showing the market’s acceptance of high-yield paper. I suggest that any appropriate analysis of the US government’s finances would suggest that the interest rate for US paper is too low as reflected in its credit rating downgrade. A more realistic interest rate on US paper should force higher rates on “junk” which will cause lower prices for these bonds.

The above views may appear contrary to the flow of money into high-yield bond funds and the issuance of new high-yield paper. This weekend some were suggesting that one way to take advantage of the current market is the purchase of high-yield municipal bond funds. The author of one article conceded that there could be an increase in defaults, but the current superior yields could absorb the defaults. (I do not believe that is the way the math will work out on the net asset values of these funds.) At this point I am unaware of any tax-exempt entity increasing its ratios of solvency. I am sure that there are some, but not many.

The job of an asset allocator

In my opinion and practice the sum total of a specific client’s assets should be arrayed to meet all the expected needs of the account, present and future. This belief and practice is very different than maximizing the disposition of current assets to meet current needs. Many allocators believe that in their infinite wisdom they will be able to shift allocations as the markets turn. There are a few that have the history of successful shifts to catch the big trends. In a review of mutual fund records I cannot find any significant number that has pulled off this feat three or four times in a row with large pools of capital. Thus, as portfolio allocator for most of our accounts, we rarely are all in or all out. (Or, if you prefer the current lexicon, risk on/risk off.)

The insatiable drive for income

Those allocators who get sucked into providing large amounts of current income are producing better current results than those of us who are using a more balanced approach. However the balanced approach appears to be working.  In a forthcoming review of a major account system for one of our clients, all forty-seven of the funds used are showing a positive result for the first seven months of the year. (A much longer period of perhaps ten or more years would be needed to demonstrate skill. But after some rough months in the second quarter, it is nice to momentarily see progress.) Remember that past performance is no guarantee of future results.

How much are you allocating to high-yield and at what yield will you exit these investments?

_____________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com. 

Please address your comments to: Email Mike Lipper's Blog.