Avoiding Shallow Statistical Judgments; e.g., Last Week

Introduction

Even long-term investors like me need to pay attention to near-term information. Often I have said the critical price risks to investors are their fellow holders. At critical times the first ones to sell get materially better prices than those that follow. Early last week quick sellers did better, but paid the price later.

Trading Speed

In last week’s blog I briefly listed what many consider the 4 most crowded trades. They are: (1) Long US Dollar, (2) Short Commodity Stocks, (3) Short Emerging Market Stocks and (4)  Long US Tech Stocks. These are sizable positions relative to current marketability in large hedge funds and other trading accounts. All of these led the parade of falling prices. While one could argue about the investment merits of these positions, what was clear by being on the most crowded list is that there was limited near-term liquidity in these trades. In order to get out of the way of the falling prices, the players had to accept lower prices quickly. For some time many of us have been pointing to the shrinkage of commercial and investment banks’ capital devoted to market making activities. What we saw early is that the total dollars of the sellers overwhelmed the dollars of the buyers. (When similar markets occurred in the old days when I had a small trading desk reporting to me my instructions were to back away and let the energy of the moment exhaust itself before we entered the market at calmer prices.)  

The intensity of the selling was apparently driven by disappointments caused by statements made by the central banks of Europe and the US. Because the world is so interconnected, in a nanosecond the sellers lined up and started to compete for exit prices and volumes. Some may wish to lay additional blame beyond reduced market making capital on the current era of accelerating speed of information flow. The Economist, like some politicians, comes down squarely on both sides of the issue. It points to in an article entitled “The Creed of Speed” that reports Apple^* customers download an App every millisecond, which demonstrates the growing interconnections and thus reaction times to news. On the other hand it points out that active mutual funds have almost doubled their patience by holding stocks for almost two years, which shows a portion of the active market is taking its time on sell decisions compared with the turnover in the S&P 500 which is under one year.

^*Held personally and/or in the private financial services fund I manage

Before turning to an important cause for the rapid decline and even more rapid recovery on Friday, I will alert you as to possible future extreme intraday and single day price changes. The most popular price index and the one with the longest history is the Dow Jones Industrial Average. I should point out that on the day in 1929 when the DJIA collapsed, it fell by 13%.  Most people focus on this market break and neglect to point out that by December of that year the index rallied to its former levels, just as we saw the rally on Friday when the DJIA made up all the ground lost earlier in the week. What is critical is that in 1929 the average non- index stock did not recover to former peak levels. This lack of full market representation by most indices raises questions as to their utility for sole decision making (more on this later). Having warned you as to the utility of using an index for decision making, I should also warn you about my statistical, not investment view, as to a potentially huge one day move in the DJIA. Because the market structure has changed since 1929 and due to worsened regulation in addition to the abolition of floor specialists and reduced capital devoted to market making, I suggest that a 10 to 15% move measuring from the low to high price on a crisis day is more than possible. While this might make the news and give the pundits a lot to talk about, it may signify far less than it appears at the time.

The Real Cause for Concern

As a card carrying Chartered Financial Analyst (CFA) and someone who learned analysis at the racetrack, I have never had enough numbers. People in the global investment community use numbers to build models  of what has happened and our best guesses of the future. In truth we create statistical abstractions. I would like to have all the money that has been bet on the “best horse or stock in the race.” Not too often do we get our numbers individually wrong, more often we get the weighting of the inputs wrong. Most of the big errors come from not understanding the human equations of the managements in depth as well as the critical group of customers. In addition there is the Mark Twain quote of what will hurt us is what we know is not true. Combine this with the ever present quantity of racing luck covering the unknowable. Thus, to me the sole or main reliance on statistical measures can produce small gains and big losses, particularly losses of opportunities.

As an example I recently heard about a fund group that we think highly of losing an institutional client because the client’s consultant didn’t like that the fund group’s stock selection did not look like the average fund of that type. This is a statistical comparison, not an investment judgment. I could see redeeming the fund if an examination of its portfolio led to the conclusion that the fund managers did not have sufficient skill to pick sound investments. In this case a recent visit with both fund managers and their analysts produced the opposite conclusion.

Trading Speed vs. Sound Investing

This week’s price volatility largely shows the results of making very rapid statistical comparisons. I believe there are a very limited number of skilled artists that can play that game well consistently. For long-term investors looking to see their capital grow in the decades ahead to meet funding requirements from current needs all the way out to those who want to meet perpetual needs, I believe that they should rely on the combination of wisdom and future judgment. Wisdom is the sum total of past experience that can be learned as well as experienced. For example, the brief discussion above about the 1929 DJIA performance is part of the wisdom data bank which should include a great amount of historical inputs and personal learning, including acknowledged mistakes. The purpose of wisdom is to understand the range of what has happened. When I look through my wisdom bank, the main lessons are not from some statistical array, but from what various people through the ages accomplished in spite of identifiable mistakes and hurdles.

As important as wisdom is, investment judgment is more important. Wisdom is in effect our memory drive, where judgment is our investment plans for the future. Authors and historians make up good stories about people. Almost always they make the individual they are portraying to have a singleness of mind, knowing exactly what they want to accomplish and how they are going to do it precisely. I have yet to study such a person in reality. Judgment comes from making decisions while in motion not at the beginning. There is an expression in the US Marine Corps that it taught junior officers: in a combat situation you will never be judged on Plan A, but on Plans B,C, all the way to Plan Z. This is exactly why I divide my clients’ portfolios into sub groups.

As an entrepreneur with limited capital I had to “bet the farm” on a sole product and then on a very limited number of products, however that is not how I now invest  as a fiduciary. I put a portion of my resources in direct confrontation with selective elements of the market. Some resources are held back to add when the front line elements get tired through losses and need time to rejuvenate. Finally I try to develop specific talents that can leap frog over today’s leaders to find new ones. The key to evolving judgment is to know when to regroup. This is very strange for me to say, but I do not use investment performance as my principal decision tool. Primarily I look to whether my people judgments were correct. If I get my people judgments correct in time, stock prices will reflect it.

Proper Traits of Professional Investors

In searching for good portfolio managers and advisors of all types there are some basic characteristics for which I look. The first is the thirst for knowledge; in the modern world something new is happening every day. The next in this lawsuit-prone world is judicial temperament. Does the individual carry on his/her activity in the light of possible challenge? Does the individual know, particularly in the world of many ethical challenges, how to distinguish his or her role as an agent and as a principal? A good person can play both roles carefully. Notice I did not require mastery of various types of securities. Those are mechanical skills which lead to continual usage even when they are no longer the most suitable.

When developing the Lipper Mutual Fund Performance Analysis we said the service was for analysis not for fund selection. The funds were broken down into investment objectives of what they were trying to accomplish not what they contained. The latter was an outgrowth of how Marine Corps officers were instructed to give orders to their senior non-commissioned officers; which was to state the objective and what resources they had to accomplish the mission, not specifically how to get the job done. (This is a very different approach than saying you had to look like the rest.) In my latest endeavor, the TIMESPAN L PORTFOLIOS^®, we assign assets to specific timespans, but the instruments that can be used include mutual funds, commingled funds, separately managed accounts, individual stocks and bonds or some combination.

Question of the week: What are the chances of new index high in 2015? Will a new high be achieved in 2016?

Question of the month:  Do you react to investment tweets?

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A. Michael Lipper, C.F.A.,
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The Risk of Being Right and Other Lessons

Introduction

I am dedicated to the mission of learning something every single day. Often I get a small insight into some relationship of minor long-term significance, but I never know its value either in the present or possibly in the future.

Was April 17, 2015 important?

One of my many advantages is that I am part of a loosely connected group of formerly senior securities analysts, portfolio managers, chief investment officers, institutional sales people and technical market analysts. We physically meet most months and we are in electronic communications daily. Last Friday, starting with the Chinese markets, global markets fell sharply. For a number of US portfolios the decline in one day wiped out the entire gain earned on a calendar year to date basis. I asked this group of former investment professionals if this drop was important or just a momentary blip. I broke the question into five parts which may or may not be related as follows:

1.  As we already knew many Chinese like to speculate, particularly with the new margin borrowing facilities. Can this kind of trading bring global markets down?

2.  Changing market regulation does not encourage liquidity when in short supply. Does the impact of various “To Big to Fail” measures to protect banks, and firms, (but not investors) actually raise transaction costs indirectly charged to investors? In periods of stress many deal with the absence of sufficient liquidity to bid for it by lowering offer prices contributing to the decline.

3.  There is no such thing as a totally fail-safe electronic system, no matter how many back ups. Those who were not too inconvenienced by the Bloomberg system being down for a few hours remembered how to use other devices; e.g., telephones, Reuters, and actual pencils and paper. Total reliance on new technology, as those of us why fly in planes know, can produce unhappy results. In the end and under stressed conditions the market has a place for human talent. Did the temporary halt of an electronic system materially hurt investors?

4.  The single day decline was not effectively captured by the volatility measures that some use as a measure of risk. Should investors not use volatility to measure the daily risk to their portfolios, but instead the depth of buy orders?

5.  Toward the end of the US trading day Friday, the size of the decline was cut significantly. Was it just a factor that there were not any new flows of sell orders hitting the market, or were there bargain hunters? Were buyers primarily long-term investors or just refreshed speculators?

Investment lessons from World War II

In a recent book review that covered the enormous contribution General George C. Marshall made to both the war effort and the European economic recovery after the war, there was a discussion that General Marshall, who at the time was US Army Chief of Staff, was not given the command to lead the allied forces for the European invasion.  There was no question by training and respect he was the logical choice, but FDR choose General Dwight Eisenhower^*, a relatively junior officer for the job. There were lots of reasons for this choice, not the least is that Ike was more likely to be able to get along with the difficult British (then) General, later Field Marshall, Montgomery. Understanding this decision process I can appreciate Steve Jobs’ choice of Tim Cook to lead Apple^** after he was not able to continue. Jobs did not choose someone with similar skills as his in terms of creative designs but rather someone who had a very different set of capabilities, which was the development and management of the supply chain.

^* After the War and before he was President of the US, he became President of Columbia University where I graduated and received my commission in the USMC.

^** I have holding in Apple.

Another lesson occurred to me last week. In reading the program for a concert by the Boston Symphony at Carnegie Hall that featured two pieces by Shostakovich, I learned how his music was evaluated by Stalin’s thought police/music critics when Stalin was alive and after his death. 

While not as draconian as Stalin’s control of the media and so called “intelligencia,” the current US Administration and much of the mainstream media have a single opinion on numerous issues including climate, inequality, economics, and foreign relations issues. Under varying political conditions it is reasonable to assume that popular opinion will change on some of these topics. The lesson for us as investors is that whenever there is a preponderance of opinion in one direction, it is likely to change in the future.  

No truer words

In his pensive column in this week's The Wall Street Journal, Jason Zweig quotes the late Peter Bernstein who I knew for many years. Peter said, “The riskiest moment is when you are right.” Not only does the correctness of the view breed arrogance, but it flies in the face of reality. No one is always right, excepting perhaps some favorite relatives. As with calling heads or tails on a flipped coin, after a correct call the odds on the next call being correct is 50/50 and certainly by subsequent calls there is substantial chances of being wrong. This awareness should prevent investors and manager selectors from being outcome-oriented. Picking winners eventually leads to losers. A better procedure is to pick managers that follow certain processes and procedures.

Two questions for the week:

1. What do you think Friday meant to your investments?

2. How do you pick winning managers?

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Copyright © 2008 - 2015

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

Patience Can Be Expensive To Your Portfolio

In a recent blog post, I made the statement that patience can be expensive. This thought became clearer to me after reading a number of third quarter reports that were, in effect, apologies for performing so badly. In essence, the apologists were intoning the message that fund managers buy securities well below their estimated intrinsic value. These so-called “bargain purchases” did not hold up very well in the dramatic decline in the third quarter. They were praying that their investors be patient and it will turn out alright in the end.

Premature purchases

Over the last couple of months, members of this blog community have received my views that we should be investing in Asian equities. Since these calls for action were prior to the very recent bottoms, by necessity I practiced some patience before the recent upturn. This last volatile week I was early once again, purchasing some shares in UK money managers and brokers. Luckily for me, I had only to wait until the end of the week to see positive, albeit slight, gains. I did not have to exercise patience for long. The point here is that it may be okay to be a little premature.

Long suffering patience

In contrast to my brief pain for being premature, one needs to look at the funds that are pleading for investors to be patient. In some cases they have underperformed their own identified targets 1,3,5, and 10 years. The insistence that their performance numbers will come out ahead is based on the fact that over the time since inception, these multi-billion dollar portfolios have very attractive results.

When should impatience take over?

In discussing this briefly with my sage wife Ruth, she warns that impatience can be worse than too much patience. This is all too true; for example if we had dumped our clients’ Asian fund holdings in September, or my personal UK asset management stocks early in the week. What could have compounded either error would have been not investing at all or investing in the wrong vehicles.

If you take the attitude that each day you repurchase your holdings, you should examine the research case for buying your positions today. As we live in a very dynamic world, I am getting increasingly impatient with the same rationale for buying into similar names today as what I heard 1, 3, 5, and 10 years ago. The absence of new fundamental, analytical support other than “price has made something cheaper,” is not reassuring. Some of the relatively poorer performance players have recognized these concerns; they have detailed a portion of their staff to produce the "Bear case" for their holdings. In a number of cases, the more traditional managers are attempting to learn from long-short hedge funds. Another approach is to rotate the analytical coverage of the names in the portfolios. I have yet to see much relative improvement in funds applying these techniques. (I could be too impatient.) Those analysts and portfolio managers trying the new approaches may be too junior in their organizations to have their opinions lead to prompt action.

Trading Markets vs. trading “The Market”

Most long-term investors desire to have quasi permanent holdings of securities or at least similar investment objectives. These people may very well feel that for the past ten years we have been in an essentially flat market as measured by the securities indices, therefore they have been right not to make changes, as “the market” has not spoken with clarity and force. They are going to wait patiently until it does.

At the race track, one of my two learning institutions, horses who come from behind do occasionally win, if they can get to the lead by the known finish line. With our race for acceptable returns, we don’t know where the finish line is. Yes, we do know what various “gate keepers” and fiduciaries want to see in their periodic reports. However, we don’t know when that all important breakout or breakdown reporting will be. That is the time when patience will run out and results without excuses will determine whether the institutional relationship will continue.

Multi fund managers and accounts

For those of us who have the fiduciary responsibility for these accounts, we need to deliver acceptable performance. In the best cases, we need some demonstrable winners and only a relatively few managers that try our patience. Bearing in mind Ruth’s warnings on the natural impatience of those in the market, we should periodically prune those formerly good-to-great funds that beg for our patience. We can hold a few of these if they can supply current reasons to believe that their holdings will work, but each year we should eliminate or rotate out those that do not.

What do you think?
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