LONG-TERM TRENDS MAY NOT BE A FRIEND - Weekly Blog # 568

Mike Lipper’s Monday Morning Musings

LONG-TERM TRENDS MAY NOT BE A FRIEND

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

                     
     

“Big Mo” in the political world, “The Trend is your Friend” in the commodities world, and momentum investing are beliefs in continuing that which is into the future. Certainly, various media pundits stress current trends. Salespeople of all stripes find it is easy to sell their wares by highlighting current conditions. As a contrarian investor I am delighted to see great levels of enthusiasm for the currently popular, because it leads to significant mispricing of both rewards and risks, creating opportunities for the careful investor. For those swept up in what is currently popular, it should be a well-earned learning experience.

Faulty Long-Term Predictions

This week there were two very relevant notices in the press. The first was a statement by Ajay Sing Kapoor, an analyst at Bank of America/Merrill Lynch. The statement said “There is really no permanent trend just lazy intellectuals confusing a long cycle for a perpetual-motion machine.” This is a useful insight in the climate change debate. One of the best market analysts I know grew up on a farm which he has owned for 30 years. He mentioned the feast and famine cycles experienced while living there, much like the biblical seven fat years followed by seven lean years. 

The belief in long-term trends is present in today’s investment selection, which focuses of selected factors based on selected histories. The strongest of these is the belief that changes in earnings per share will dictate the price of the shares. This was true even when I was a junior analyst at a trust bank, where investment leaders used the change in reported earnings per share to make investment decisions. Even then I was suspicious, feeling that reported earnings were the result of both controllable and uncontrollable forces. It is only later that I became more conscious of the changes in Generally Accepted Accounting Practices (GAAP). Today, earnings report releases emphasize “adjusted earnings, adjusted operating margins, adjusted profit margins and even adjusted revenues”. The SEC has mandated that these reports must also show the results according to GAAP, but they don’t  highlight the fact that almost every year AICPA makes changes to GAAP. Corporate data complements government produced data as critical inputs to thinking on the economy according to Jim O’Neill, the former Goldman Sachs partner and global economist who coined the “BRICS” term for the rapidly developing emerging markets countries. He writes, “Though economics aspires to the rigor of the natural sciences, at the end of the day it is still a social science.” Thus, the specific numbers produced by economists are kidding us with their precision, particularly when they are expressed with decimals.

An Improved Fan Dance

If the base data is questionable, its use as the foundation for future prediction is extremely questionable. Consequently, The Bank of England and some of the US regional Federal Reserve Banks are showing charts using the most current or corrected datapoints, then adding a fan like wedge showing the range of future predictions.  My natural skepticism questions if the wedge is too narrow. I can accept that a narrow fan probably includes most of the probabilities utilizing a single up and down standard deviation. However, as an investor I like most others feel much worse after a decline than a pre-tax gain. I would much prefer a wider wedge that includes the reasonable possibility of two or three standard deviations. (I believe that both long-shots win and racing accidents happen on occasion, depriving the best horse from winning.)

Jason Zweig on the Wrong Long-Term

The second important item in this week’s press is a column by my friend Jason Zweig. He cautions against investing in companies that are building for the long-term, properly concerned that the focus on long-term investing can lead to the mistaken allocation of resources. Tech companies spend substantial capital on new facilities and equipment for future markets that might not evolve. Think of the engineering and construction geniuses responsible for the construction of the Egyptian Pyramids. The pyramids were monuments to the rulers while living, as well as in their after-life. I am much more interested in the long-term development and acquisition of talent, including the building of multiple generations of leadership at all significant levels. 

Investing for the Long-Term

I have devoted most of my investments to the long-term and where appropriate for my clients I have done the same. While this on average generally means a low turnover of securities and funds, it is not a lock-step process of holding regardless of current input. It requires careful examination of current information versus long term perspectives, both of the specific investment and its place in the portfolio, as well as any changes in the needs of the beneficiaries. I accept the cyclicality of both the markets and my ability to correctly analyze the inputs. I often expect to be premature and less often to be wrong. My long-term attitudes are derived from the study of some of the best investors as far back as I have information. In general, these attitudes have been good for my accounts and family over time.

Mid-Term Platform or Lid?

Each week I look at the investment performance of mutual funds around the world as a good representation of the results of managed money. This week I paid attention to the average returns of US Diversified Equity funds for the five years ended this week. The period included the final years of the past administration and the first couple years of the present one. The importance of politics is questionable. The twenty-investment averages for the five years generated an annualized compound growth rate of +5.69%. This included some extremes on the upside: large-cap growth funds +12.13%, S&P 500 index funds +10.72% and multi-cap growth funds +10.16%. On the down side there were dedicated short bias funds -19.35% and alternative equity market neutral funds -0.74%. These results suggest that large-cap tech companies produced a disproportionate portion of the gain and that being out of equities was a loser. 

Five years is a little longer than the average US stock market cycle and roughly equates to the presidential cycle. Being a contrarian I would not expect the two extremes to repeat over the next five years. The extreme contrarian would examine the funds that produced negative results feeling they could be the leaders at some point. In that vein I would be scanning for any indication that things are changing for the better for commodities funds, particularly those involved with different aspects of energy and agriculture. I don’t currently see a catalyst, but I can afford to be late as I suspect that most of the selling in these sectors is over.

Short-Term = Confusion

As is often the case the future direction from current conditions is not clear to me. Banks do not appear to need deposits to make loans as the interest rate offered on average is 0.59%, down from 0.61% the week before and its recent cycle high of 0.63%. Lack of new loan demand is not encouraging. The latest survey sample of the American Association of Individual Investors (AAII), a very volatile measure, shows the three alternative predictions for the next six months are all between 31% and 36.5 %. On a more positive note, the roster of price moves in the Weekend WSJ showed 64 out of 72 being positive. Of the 25 best performing funds for the week, 14 were growth funds and 3 were health-oriented funds.

The one certainty after a period of level market performance is that there will be a breakout on the upside or a breakdown, possibly both, based on  higher volume and enthusiasm.

Another Favored Myth Destroyed

For many years during a US recession Americans talked about moving to Australia with their US acquired skills. Very few did, but it was in the back of their minds as an economic escape. In the nuclear age several Americans thought that the safest place to live with their families was the South Island of New Zealand. The tragic events of this week have shown that there is no practical place to escape. We are going to be forced to deal with present and future problems where we are. The destruction of myths often leads to the recognition of the benefits of where we are and focuses our attention on making our lives and investments better.          

  

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

https://mikelipper.blogspot.com/2019/03/the-top-before-big-top-weekly-blog-567.html

https://mikelipper.blogspot.com/2019/03/2-speed-vs-2-directions-old-better-than.html

https://mikelipper.blogspot.com/2019/02/lessons-from-warren-buffett-and-italian.html

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Proving Investment Selection Processes

Clients, critics, and financial media consumers want to understand how other professional investment managers and I select the securities that are found in their portfolios. For me, the starting points are the financial and emotional needs of the account. I believe that one size does not fit every individual account. Using those elements as a base plus an understanding of critical time horizons colored by views as to the current market opportunities, I decide on one or more selection processes for the funds that will be resident in the account.

The purpose of this post is to examine two opposite selection processes, (1) Picking winners and (2) Avoiding losers; as well as to discuss the provability of these or any selection processes before-hand.

Picking only winners

A number of selectors of mutual fund portfolios and some newsletter writers look to near-term performance. In at least one popular case the published pundits select funds with the best available one year performance regardless of investment objective. Under their ministrations the subscriber or account holder will continue to own the fund for a year. At the end of the year the underperforming funds will be replaced with the current year's best performers. This is a momentum approach adapted from the individual stock world to the portfolios of tax-paying mutual fund holders. Early in a long cycle the momentum approach can produce good returns. Often it has the benefit of producing spectacular results near the top of a highly speculative market. The descent from the peak however can be very painful in the first year of a decline.
                                                           
Avoiding big losers

While desirous of gains, many of the clients that have chosen me to manage their investment fund oriented accounts are relatively risk adverse. With that as a filter I turn to the databank now known as Lipper for Investment Management. (I no longer have any direct connection with my old firm, the producers of the data.) I particularly search for down quarters. Because the majority of the money I manage is in large institutional accounts or on behalf of very wealthy families, I restrict my search to funds with current assets of over $100 million.  My accounts are expense-oriented, thus I seek to have total expense ratios below 1.26%.

In this example I focused on three particularly bad quarters since December of 1999 and I was interested only in those funds that declined measurably less than the average in their peer universe. Because of the needs of a particular account I looked at only small capitalization funds. My original sort started with some 400 funds. The resulting roster of funds that passed through my filters was a grand total of five. Three of these were closed to new accounts. I may have to be less stringent in my screens in order to surface a suitable number of funds to examine with current upside potential. Time will tell whether I can come up with winners, but history is on my side. What I am confident in is that when the  periodic down markets occur these kinds of selections will perform better than the momentum driven suggestions from the first approach.

Can you prove it?

I have been recently asked “What do you believe about investing, but know that you could never prove?" Before addressing whether I can prove that my approach of avoiding large losers rather than the approach that is momentum driven, I want to share some of my thoughts as to "proof" of investment decisions.

From my exposure being a Caltech Trustee and my vague memory of my physics classes at both Columbia University and the Staunton Military Academy, the discipline of the "scientific method" makes me question whether anything can be proven about investments before the final trade is tabulated. The basis of the scientific method is that anyone following the same procedures will get the same result. In physics there is no attention to the emotions of the experimenter or the fact that all conditions surrounding the experiment are known. As we don't know why anyone buys or sells a security, we don't know the critical motivation to the trade.

Is the seller making an investment judgment as to the value of a security absolutely or relative to some other security?  Are they putting their portfolio in the desired order or are they meeting a funding need? The buyer may find this particular security attractive in and of itself or may want to increase the portfolio's exposure to the market or sector. The buyer may need to be in a more fully invested position by a report date. Both the buyer and seller may be reacting to competitive pressures from within their organization or beyond. Given the same general economic, political, and announced corporate results but a change in any of the other factors listed above, a different set of results are possible. As Mark Twain said, “History does not repeat itself but it does rhyme.” A good example of this is when Ruth and I go to many of the wonderful concerts of the New Jersey Symphony Orchestra; the program informs us as to what is going to be played, but not how it may sound to us. Guest conductors and soloists as well as different musicians on stage let alone different concert venues and weather can produce startling different levels of appreciation.

Instead of utilizing my academic exposures in getting comfortable with expectations of future results, I fall back on my two real sources of thinking:  the racetrack and the US Marine Corps.

What I try to do is guess what the odds are on a result. I use past experience adjusting for current conditions as well as the persistency of trend. (The longer the trend the less likely it will be continued.)  Like many who are always focused on survival, I accept that my bias for quality will reduce some of my upside potential. Nevertheless I echo “The Long View” column by John Authers in Saturday’s Financial Times, “Numbers add strength to Buffett's law of selection not only for Warren Buffett's focus on quality, but his price discipline.” That discipline can be summed up by "It is better to buy an excellent company at a decent price than a fair company at an excellent price."  I believe the same concepts can be used in selecting fund mangers.

You can have it both ways

One of the nice elements of a portfolio of funds is, when appropriate, one can assemble a portfolio following a number of different approaches. This multi-approach portfolio could make sense for a portfolio that has different time horizons.

Which approach do you use?

Traveling and learning

September will find Ruth and me in London and Budapest. I would be happy to meet with any members of this blog community to share views, particularly from those who will help me learn.

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Picking Winners

The job of a professional investor is simply to pick winners, or is it? Professional investors focus on avoiding  losses (nominal or “real” )
and not appearing to act imprudently.

As regular readers of these posts already know, my two great learning schools were the race track and the US Marine Corps. The first taught me how to analyze and the second how to act. Allow me to share some of what I learned from going to "the track" in my quest to pick investment winners for clients and my family.

What is winning?

My betting objective for each day at the track and each season of visits was to finish with more money than when I started. As a wager of limited means I had to overcome my costs incurred including transportation, food, admission and the portion of winning tickets that went to the track and state/local taxes. For me these amounts could easily add up to a hurdle rate of 25%. Thus when it came to investing in the stock market or through mutual funds the costs seemed like a bargain particularly at long-term capital gains rates. With my objective of producing the first dollar of net profit after paying all incurred expenses dragging on my returns, certain basic strategies evolved:

          1.      Avoid losing by selecting only a limited number of races. (No multi bets or the equivalent of indexing).

          2.      Arbitrage the difference in potential payoffs between the winning payoff on a highly favorite horse versus half of the net pool for second place, if one of the first two horses is highly favorite.  At times such a bet may lead to a better return with some less risk than on betting on a favorite to win.

          3.      Look at current race conditions compared with the past record of the racers. Most often the odds on the horses that recently did well were less than those of horses whose immediate past results were poor. (For investors this is the difference between momentum investing or extrapolating vs. searching for new opportunities amidst almost always changing conditions.)

Applying winning strategies

Most fund selectors follow a disciplined approach to avoid losers;  they seek to avoid having any performers in the bottom performance quintile. If their remaining choices are averaged, they should have a performance record that is better than the average of the overall universe which is the equivalent of earning the first (small) dollar of profit.

The investment manager of a portfolio of funds, like me, constructs a mix of funds that in many, if not most markets should produce a satisfactory result. The way to do this is to diversify into a group of funds which will by direction and magnitude offset periodic losers with winners. The selection process should be guided by the assessing the chances of success over the chances of permanent loss of capital.

In contrast, the individual security analyst is most oriented toward the future, looking for the odds of meaningful changes that are not appropriately recognized in current prices.

The current picture

Market price correlations are widening; the price performance between the best performer and the worst are no longer parallel. This phenomenon could make the use of ETFs less useful. A number of actively managed portfolios are demonstrating that their selectivity is what produced better than average performance in the first quarter. In many cases the weighting of individual issues combined with good selectivity produced meaningful performance increments.

Dividend paying stocks have been leaders for over a year. But the focus is narrowing away from just yield production. JP Morgan is recommending common stocks of companies with high free cashflow production as companies that could increase their dividends among other uses of their cash generation. A number of mutual funds have either publicly espoused or just followed a strategy of selecting stocks of companies with rising dividends. The focus on dividends is part of what appears to be an almost insatiable drive for income to replace the former sources of reasonable interest on government bonds or bank savings accounts. This drive has caused an enormous flow of money into corporate bond funds. But this is beginning to show early signs of change. In 2010 the average trading turnover (the amount of trading vs. the amount of outstanding bonds) of investment grade bonds was 95% and now has dropped to 75%. This may indicate that the objective of trading to add to yield is declining a bit.

Searching

We have done a good job for our accounts, but at this point in the cycle I am worried that on a relative basis my accounts could use more future growth-oriented funds as well as highly selective fixed-income funds. If you have any suggestions in terms of techniques, or perhaps a securities analyst-trained person who should join us, please let me know.

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Brains are Wired to Produce Long-Term Losses

“Don't blame me for the way my mind is wired, nor how I made wrong choices over my investment life.” This statement is a cop-out,  equivalent to the old Flip Wilson line "the devil made me do it."

One of the reasons to read Jason Zweig's column in the Wall Street Journal every Saturday is that he is one of the few columnists who regularly reads, understands, and reports on academic papers found in the learned journals.

Brain wiring produces long-term losses

In Jason's column this week, he reports on a study published by the Journal of Neuroscience. The authors of the paper were professors/researchers from Caltech, NYU, and the University of Iowa. (Disclosure: I am a trustee of Caltech and have supported some of its work in examining how brain functions drive investment decisions. Furthermore, I seek to keep current with NYU and the University of Iowa, as a grandniece is entering NYU and Ruth and I know a number of successful graduates from UI.)  These studies indicate that most people rely on short-term memory to shape their actions. Therefore immediate past successes count more than longer-term experiences. (My technical analyst friends have known this for years under the rubric of momentum investing.)  This pattern conforms to Newton's First Law of Motion whereby a body in motion stays in motion, or as commodity players often believe, "the trend is your friend." The portion of the brain that is wired to produce these results is called  the "frontopolar cortex." People with a damaged frontopolar cortex do not rely on short-term memory, but are more influenced by a combination of long-term trends.

Performance significance

While there are not many short-term traders that have been able to put together a career history of above-average investment results, there are more successful long-term investors. The secret to their results stems from the ability to buy sound companies when they are unpopular. I have known a few of the managers that exhibit these attributes, including Warren Buffett, Charlie Munger, John Neff, and Sir John Templeton. 

In terms of today's global markets, I would suggest that a heavy commitment to growth-focused mutual funds or equities would be a good place to start.

The same rules apply in the political world

The current crop of political leaders are also reacting to short-term focused issues in preference to addressing the longer-term problems. Their global focus is on the momentum in the latest polls, or what American political leaders call the "Big Mo." These are politicians not statesman. Perhaps even worse is the tendency of central bankers to follow the politicians rather than to focus on the structural threats to their nations.

Forthcoming blogs

Ruth and I are in California for the Caltech board meeting after listening to good music at the Aspen Music Festival. I suspect next week's blog or the ones thereafter will focus on investing in technology and the importance of what is happening in China. If you have any views on these topics, please share.

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Identify Your Strategic Risk Points

• The ease of Momentum Investing
  
• Patience rewarded
  
• The lessons from sports
  
• Managing the strategic risk in the portfolio

The ease of Momentum Investing

The great investment counselor Will Rogers told us to invest in stocks that went up and not the ones that went down. In essence he captured the kernel of momentum investing. Find a series of numbers that go up with each reading, higher than the prior one. When the string is broken get out. Simple enough to say, but more difficult to put into practice - nevertheless many try. Below are some of the time series that investors have used:

• Daily, weekly, monthly, last 50 or 200 trading days’ stock prices: the longer the period the more volatile the average change.
  
  
• Sales: currently this is in vogue, coming off a cyclical recovery that has not yet entered into full bloom.
  
  
• Announced earnings per share: favored by both the press and the data base providers, like the certainty of a number without any adjustment for its composition.
  
  
• Operating earnings: an initial attempt by the accountants to remove non-recurring earnings. These are not the same items that an analyst might adjust for an early or late Easter, price changes, new product launches, etc.
  
  
• Pre-tax margins (sometimes known as returns on sales): a measure of how much of the sales dollar comes down to the bottom line before paying income taxes without any adjustment for changes in selling prices, costs, or quality of product and services.
  
  
• Net income rank within a sector presumes that each corporation is attempting to maximize the results during the period.
  
  
• Return on capital (or return on capital employed, which deducts from capital any identified excess capital): a measure that does not differentiate between the sources of capital, e.g. short and long-term borrowing, temporary capital or float, preferred shares and common equity.
  
  
• Return on invested capital: usually calculated to include long-term debt and equity.
  
  
• Return on equity: usually calculated to include all forms of equity compared with net income.
  
  
• Return on tangible capital which removes goodwill (goodwill is particularly useful in comparing acquirers of intellectual property producers).
  
  
• Return on gross assets or ROGA was a measure I learned analyzing defense companies, comparing corporations that had a mix of government owned and privately owned facilities.

The above is not an exhaustive list. The way the momentum game is played is that one holds or buys the security as long as the current reading is higher than the last one. As soon as the number is less than its predecessor, one sells. Many of the followers of these techniques describe themselves as growth stock (fund) investors. Over the years General Motors, IBM and airlines have been labeled as growth stocks. Not only are there risks to this kind of investing (the potential of a lower reading), but there is a bias in the numbers that changes.

Patience rewarded

In the eyes of too many quasi-sophisticated investors and much of the financial press, the opposite of growth-oriented investing is value focused investing, which at its essential is a view that the current price does not represent the current value. (There is a half way house of "growth at a reasonable price" or GARP which requires both the expectation of growth-momentum and a less enthusiastic price.) Often the key to value investing is the belief that the current price only reflects the immediate past. The value investor has patience and expects that better results, using many of the same measures of the growth investor, will occur soon. In an engineering sense they have built some “fault tolerant” elements into their analysis. We all recognize that too much patience can lead to low returns or losses, even when ultimately successful. To avoid exercising too much patience, the value investor identifies where the prospect security is, relative to its past cyclical behavior. Other approaches average the results over distinct periods of perhaps five or even ten years, with the thought that over time the results will return at least to average.

The lessons from sports

As many of our blog community members know, I view handicapping at the race track as one of my two most formative educational institutions. Further, from a professional investor standpoint, I follow the ups and downs of the National Football League teams and players. Both of these experiences teach that while it is exhilarating to cheer or bet on the continuation of a winning record, the odds are that all strings will break sometime. The “normal” is that one’s choices include some victories and some losses. This is by design. At the race track, officials attempt to see all the horses finish exactly the same by setting the conditions for the race, including the level of weights carried. The genius of a number of professional sports leagues is that on any given day any team can win beating a team with a better record. One of the many lessons from watching these results is to occasionally throw out or disregard a specific contest, particularly the last one, on the basis of weather, location, and/or health of a key participant. A second lesson is to adjust one’s thinking due to an expected change in tactics. Perhaps, the most important lesson is to believe in luck. If for no other reason, the randomness of luck suggests that additional bets (or if you will, diversification) are often appropriate.

Managing the specific risks in your investment portfolio

A portfolio that is exclusively built on the belief in momentum, or current price discounts from value, is likely to move largely at the same time. That is why we often hear that “this market” is good for growth or value investors. I suggest that a portfolio that is entirely focused on one or the other is likely to experience the biggest career risk to an institutional investor. If the “market” is going up for some time and your portfolio is not participating, you are likely to be terminated as a manager. Additionally, you will likely experience the further pain that many of your positions suffer from similar investors being forced to dump their holdings as assets are redeployed. In many cases the biggest risk to an institutional portfolio is the co-venture risk, when too many others have the same or similar positions in a market that changes emphasis dramatically. The best way to defend against these risks is to have some balance of growth and value opportunities, as well as not to own institutional favorites. Currently, many of the portfolios that I see are much more value oriented, and where they do have growth investments, they are one way or another related globally to the Internet. Be careful: luck normally falls on a smaller population than a larger one.

What do you think? Please let me know.
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