Future Father’s Day Fears

Introduction

In the US, commercial interests have created a day to celebrate Fathers. For me, Father’s Day has been a day of getting together with parts of my nuclear family. Some are from great distances including Singapore. Close friends that feel a family-like cohesion with my wife Ruth and I phone in or send cards. At the moment, all appear to be well and progressing with their lives. While I am enjoying all this goodwill among our extended family, my first fear is that it can’t last.

Uncertain future

The future is and always has been uncertain, it seems particularly uncertain now. While as a human and an investor, I can handle that; what I find unnerving is that far too few people are planning to handle future problems which include opportunities. Today, there are two elements to my concern - terminal values and flight capital.

Terminal values

The purpose of not spending all of our current income and capital is to provide for future spending. As both a Father, Grandfather and surprising at least to me, Great-Grandfather, as well as a trustee for a number of organizations that are chartered for perpetuity, I should be thinking about the ending piles of dollars and other currencies to meet future needs. While it is true that this is not a unique concern of mine, notice that most all of the focus of the investment world is the present relative price of assets and liabilities. Regularly we are told that an asset is attractive because the current price on a relative basis is cheaper than other assets. There is a presumption that the particular price will rise and fill the gap compared with other assets. In my US Marine Corps days I would label that as a tactical movement. Tactics are important in the battle for investment survival, but rarely accomplish the strategic mission of winning the war and creating a lasting peace.

The first major fear

This week’s piece from John Mauldin is about the large and growing underfunding of state and large city pensions. Various governments, both in the US and elsewhere (Greece and most other countries), appear not willing to close this retirement funding gap. There are two issues with this incipient failure to keep the promises made to both government employees and their supporting tax payers. First is that future contracts to deliver pensions appears to be based on what is now clearly false assumptions as to rates of investment returns and the willingness of politicians to get taxpayers to close the funding gap. This present dilemma has three probable impacts on me and our investments that could be beyond our current plans:

a.  Our tax burden will go up.

b. The services we expect from government will decline.

c.  New money that must be invested will likely push markets higher.

I started this discussion about the lack of focus on the terminal value of investments, which I find to be disappointing. However, the discussion above about the pension gap is a clear example of an attempt to project terminal values. Many, but not all private organizations also have granted their employees pensions, and appear to be able to meet their obligations to the older employees and retirees. (Some have reduced their exposures by Pension Risk Transfer contracting with Prudential and other insurance companies.) The larger approach is to put as many of the employees into defined contribution plans; e.g., 401k or similar plans. In these plans normally both the employer and the employee contribute to the plans and have a number of choices of investments products available to select. The employee is at risk to choose the vehicles that will produce the best return based on personal and investment factors. Some will choose well and others won’t. In most plans the choices are institutional grade mutual funds. We can testify that in one case, The Second Career Savings Plan of the National Football League and the NFL Players Association that it has worked out. For the last two calendar years BrightScope has found this plan to be the Number One of large 401k plans. While the criteria for that ranking does not directly include investment performance, without reasonably good investment results for the players the plan would not have grown as it did with Lipper Advisory Services as its investment advisor.

Nevertheless, the individual players and their families are at risk as to the uncertain value of their terminal accounts. I have the very same problem when I invest for my family’s future. I can not honestly say what will be the ending value of their investment accounts. What I can do in my selection of mutual funds and individual securities is in my own mind to focus my selection based on what I believe are likely future values, at least on a relative basis. I believe that more of us professional investors should be focusing on expected terminal values.

Second major fear

This week is the twentieth straight week with net redemptions in equity funds. When looking at the underlying details, the redemptions are largely in domestically-oriented funds which are importantly offset by purchases of International funds. I find a similar pattern in most countries with the main exception of China. When people switch out of their local currency into other currencies it is traditionally a sign of expected trouble in a country. Are they doing this now through their International fund purchases? They may be seeing higher terminal values beyond their borders. As this is a global pattern, one might say the money class of investors is hedging its bets.

Question of the week:

What are your longer term fears?

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The Good and the Bad about “Black Friday”

Several members of this blog’s audience asked me about revisiting the topic of last year’s blog on the weekend after Thanksgiving Day. (Note that I am referring to “members” rather than “readers,” as there are now enough regular visitors to this site to cause me to believe that we now have something of a viral community.) Similar to last year, my intention was to visit both the nearby glitzy high-end mall and the local downtown on Friday following our favorite holiday. There were two interventions however, which prevented me from completing my mission on Friday.

The first intervention began late Wednesday, when I was happily notified that there was going to be an earlier-than-anticipated, sizeable contribution to the money we manage for a long-term client. One’s initial reaction to cash flow into an account, after expressing gratitude, is to apply the new money in the exact proportion in the existing allocations. However, my rule is that any addition or subtraction to an account is an opportunity to reexamine the entire structure of the account to optimize the potential net reward. (The term net reward includes risk reduction as well as looking to the upside.) In this particular case, a number of the mutual funds which this account holds are “hard closed” to new money. A few other funds are in limbo or have portfolio managers whose actions are a bit disturbing, thus I am not comfortable adding new money. In one case the inflow was large enough that it could fund a number of new positions without causing too great diversification. Much time was devoted on Friday to examine whether the new fund candidates had sufficiently different portfolios from one another that we weren’t double counting our exposure. Further, we reviewed all the funds’ total expense ratios to watch that we were not inadvertently raising the costs to the client’s beneficiaries. (This work will continue next week.)

The second intervention, which may be much more important to investors around the globe, was the announcement on Thanksgiving Day that Dubai World was asking the holders of its $ 60 billion debt to extend maturities by six months. In view of the near-term memory of the credit crisis that became a liquidity crisis coming out of sub prime mortgage defaults, the markets reacted violently. Dubai World’s real estate subsidiary, Nakheel, has a bond issue that is due for repayment on December 14th. Prior to the announcement, I am told that the bond was trading at 109 and on Friday was quoted in the 40's. In response, European and Asian banks led their markets down. In the US, significant, initial lenders to Dubai were weak. (The reason I stress initial lenders is that we have learned from the residential mortgage decline, that often the initial lenders sell out all or almost all of their positions.) Both Goldman Sachs and NASDAQ OMX fell in sympathy with their Dubai customers’ problems. As with the residential mortgage problems around the world, there were signs of trouble prior to the headlines. I know one respected investment manager, who upon returning from Dubai, stated that Dubai was out of cash to complete its various projects or to start new ones. As this brewing crisis had too great a potential to be really disruptive to our existing investments (let alone any new investments), I was glued to my computer and television screens on Friday. Thus, I did not go out except briefly for a late lunch after the NYSE early close for the day. (I expect some calming news will come out before the Tokyo market opens Sunday evening.)

Having delivered my excuses for working on Black Friday, I will now briefly describe my positive and negative reflections to my abbreviated visits to both the mall and our suburban downtown, along with a number of insightful conversations. Perhaps, the single biggest clue to how the shopping season was going is that both the mall and downtown had ample parking spaces available. In fact, I found better parking than on a normal Saturday. Walking around, we did not encounter crowds. In a number of stores the slimmed down sales staff outnumbered the purported customers. Some stores did have customers, but were not overflowing. My wife Ruth, who had a Black Belt in shopping when we married 23 years ago, noted that there were no customers at numerous cash register positions and one store had only four shoppers waiting to pay for their selected merchandise. Casual conversations with various sales clerks revealed no interest in contacting supervisors to get a more favorable price on a high-priced item. A major department store was advertising a short fur jacket rather than their normal full length fur, in their way lowering price points.

Focusing on prices was revealing. Several stores had significantly lower-than-normal priced merchandise in their display windows. Not lower prices on their normal products, but lower value, lower priced goods. Perhaps, the most revealing input we got was how the mall’s management reacted. Prior to the season there were a number of empty store-fronts. Most of these are now filled with “pop-up” stores that can quickly open with easily moveable fixtures, signage, and support equipment. These “pop-ups” are usually for seasonal items or marketing tests. Often these stores do not occupy the full store bay of the prior tenant, adding short space stores to the category of short-sale real estate transactions. The mall management is vigorously protecting its base. According to local real estate gossip, the mall gave significant rent concessions to a brand name merchant to prevent them from moving out of the mall and into the town, (reversing the normal pattern). I suspect there must have been a major concession, as the downtown now has 19 vacant stores. (We saw a similar pattern when we visited Birmingham, Michigan recently; another wealthy suburban community that has had a vigorous downtown retail district.)

An additional cause of concern to me is that it now appears appropriate to call this the “Shopping Season.” In our politically correct world there is little mention of Christmas or Chanukah. Religion and religious events seem not to be discussed in polite society. This approach has supposedly been taken so as not to offend anyone. As a Marine, I find this a defensive, or worse, a passive stance. We should stand for care and concern for others, which can even include our families and friends, but most importantly to those who are less fortunate. The muzzling of religious and spiritual thoughts is an attack on another pillar of our society. Institutions are important to our way of life, and incidentally important to how and in what we invest. Without strong, viable institutions in which we believe, we will be lost in a morass of meaningless politeness.

The job of a good analyst is to see things that others don’t. In the aforementioned “glitzy” mall, there are a number of higher-end jewelry stores. In these times one would expect to find at least one of these stores to be in the bankruptcy process. I found it encouraging that, in an auction of one store’s assets, the winning bid was by a respected professional liquidator. To my mind, the existing competitors were more logical buyers, as they already have sales outlets to sell the acquired merchandise, and wouldn’t have to employ the failed store’s people. That a professional would put up cash to buy merchandise from a failed firm in order to sell it out of existing locations, is a very positive sign. I hope they make a lot of money on this bet. Their past history would indicate that the odds are good.

One of the reasons that the US has been traditionally successful is that we adapt to calamities well. We rise to the occasion. Taking a leaf out of the liquidator’s book, adding the “pop-up’ stores, lowering price points but maintaining price discipline, are all signs of adapting to the current economic problems. Unlike a number of other recessions which impacted lower wage people primarily, the current one is a trickle-down recession with the problems hitting the wealthy either before, or at the same time, as the general population. Thus the adaptability at the high end is a good sign that unless materially higher taxes don’t prevent it, the high end will lead us out of the recession.

Therefore I expect we are coming out of our recession if we haven’t already done so. While we may take a little bit of time in making new equity fund commitments with new money, we think we will look back from the future and see that today’s prices will look as opportunities.

Please share your thoughts and reactions.

Old Money vs. New Money Mistakes

One of the truths about investing is that to invest is to make mistakes. I am not suggesting that investing is an avoidable mistake. We have no choice but to invest our time, talents, and capital. The reason we have no choice is that these resources already exist in some form and if we do not change them, we are reinvesting them in their present forms. Innately, humans and animals instinctively know that our resources will deteriorate and perhaps disappear over time. Thus, we choose to do something with our resources. For most of us, we have no choice but to invest or attempt to improve our condition.

How we choose to invest is primarily a function of our experience. Our experience is not just what we individually have lived through, but also what we have consciously learned through the experiences of others with whom we choose to identify. Whether we like it or not, one of the inputs to our experience is our own DNA. This DNA is composed of elements of human race characteristics and more directly, family background. This is not to say that since there have been four separate (and not connected) Lipper brokerage firms, that for all time members of my family are condemned to be members of the New York Stock Exchange. What it does suggest is that we have a disposition to be attracted to transactions and services for others who transact. These tendencies can be applied to the various worlds of art and computer services among others. Luckily for the world, people are wired differently so we can find essential diversity in what we do. For the most part, our experience, no matter how formed, does not trap us into certain behavior, despite our propensities. Thus, as we enter each new theater of experience, we either treat what we are about to do as something new, or part of a continuum from the past.

Experienced investors, or if you will, old money, invest differently than those with new money. Each of us is human, and therefore makes mistakes; but often the mistakes of old money are different than the mistakes of new money.

Most of the old money that I know did not materially change the disposition of their financial assets after the experience of the last couple of years, even though their money piles are smaller. Their “normal” asset distribution might have been 5% in cash, 35% in bonds, 20% in domestic growth stocks or funds, 20% value stocks or funds and 20% international stocks. At the end of last year they may have had over 60% in cash and fixed income, 15% in value-oriented stocks or funds, 15% in international and 10% invested with a growth objective. An experienced investor believing that almost all relative performance is cyclical, might not change any commitments. For what the market takes away it will return over time. Further, from their experience, they believe after a major decline they should not change most managers or stocks of currently profitable companies. Old money has an affinity to long term records as they have had their money over the long term. They also generally prefer investing with organizations rather than in the success of any particular CEO or money manager. Thus, they chalk up the declines they have experienced as just a “normal’ cyclical decline which will be corrected by a “normal” recovery followed by some secular growth. In many ways this is almost a Newtonian view of a grand watchmaker overseeing our universe.

Owners of new money are full of themselves. They earnestly believe that their investment results are largely, if not totally, dependent upon themselves. They look at the current market always as an opportunity to show how bright they are relative to the mistakes of others. This personality-driven approach often identifies with specific hero CEOs or hot money managers. A somewhat over-simplification of their choices is that they believe in participating, if not leading momentum. Everyone recognizes that at any given time there are numerous unknowns that are likely to dramatically impact security prices and trends. If momentum won’t supply the answer, the new money is more likely to divine the right answers. They have more tools, or if you prefer gadgets, than the old money players and this give them an almost insurmountable advantage.

In these stylized cases, both the old money and the new money are making fundamental investment mistakes that others have committed in the past. Old money is betting on repetition, as in history repeats itself. If that was entirely true there would be no progress, as everything would circle back to our beginning point. In truth, history does show an uneven upward bias to the human condition and valuations. What many do not realize is that the upward bias is caused at least in part by the abandonment of failed, or too weak to survive, elements; as well as the pull of some new potential riches. Further progress is made by recognizing mistakes/opportunities. In the “old money” asset allocation example shown above, some wise investors might reallocate their money back to their “normal” portfolio. (There may be a seldom-declared advantage to this tactic: By increasing one’s commitment to a currently depressed area, if successful, the quicker one will get to the upper limit of the allocation causing a cut-back. One of the reasons for the dramatic declines in numerous portfolios last year was their over-investment in what was “hot” was not automatically corrected.)

New money often does not recognize that what is working so well now is very similar to similar beneficiaries of momentum in past market cycles. One of the many lessons coming out of the Great Depression of the 1930s was the peril of the extreme use of leverage or margin in the 1920’s by various utility holding companies, the great Goldman Sachs Trading Company and individual investors. Applying those lessons from the ancient past might have reduced the 2008 losses in various leveraged vehicles.

Both the stereotypical old money investor and the new money investor do not take into their considerations that they may be wrong. Their “system” like those of many disappointed race track bettors, does not contemplate that judgment mistakes are as normal as other accidents. Both set of investors can reduce their odds on big individual mistakes of judgments by using professionally sound funds. (Caveat Emptor: I manage portfolios of funds for institutions and a very limited number of individuals.) One might combine both the old money and new money approaches (using the asset allocation example above), by reweighting the equity portion of the account in favor of growth stocks or funds as momentum appears to be picking up in that direction. Another example of combining the lessons from these two habit patterns is taking the view that in terms of high-quality fixed income, it appears unlikely that interest rates will drop materially and therefore the capital appreciation potential from this particular segment is limited, and thus the commitment to high quality fixed income should be below “normal.”

Which kind of an investor are you old or new?