2nd of May’s Good Lessons - Weekly Blog # 575

Mike Lipper’s Monday Morning Musings

2nd of May’s Good Lessons

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

The inestimable Charlie Munger has labeled Warren Buffett a learning machine, someone who is always learning from his own and other’s mistakes. This is a good model to follow. The first couple days of May provided some good classrooms, the Berkshire Hathaway annual meeting and The Kentucky Derby, both on Saturday, May 4th.

The Annual Meeting/ Investment School

While many attended the meeting to gather bits of information to help guide their views as to Berkshire’s earnings and/or near-term stock price, I view it as an opportunity to learn about the art of investing. For me this is a linear progression from my Introduction to Securities Analysis course under Professor David Dodd at Columbia University. Dave Dodd was both a teaching and investment partner with Ben Graham, Warren Buffett’s first mentor. The following are the nuggets gathered from the meeting which can be applied to investing in general:

1. Paying too much makes it very tough to make money on an investment. (They did for Kraft.)
2. Intrinsic value is a range not a specific point. This range could be 10% plus or minus. (This is the fulcrum point for their buybacks.)
3. Individual Investors are their preferred owners rather than bureaucratic institutions.
4. They have a desire that their heirs hold onto their shares long after Charlie and Warren are gone. That is why they are developing the next tier of management, which will be different and better.
5. A large opportunity reserve has two values, it cushions periodic declines and creates bargain opportunities.
6. The allocation of resources allows them to shift capital to where it is most productive long-term.

The Kentucky Derby 

I have written about “racing luck” or surprises in the past. At this year’s running of “The Derby” we witnessed a classic example of “racing luck”. With far too many horses on a rain-soaked track there was at least one bumping incident, which the three racing stewards felt impacted the order of the finish. After reviewing many films of the race and a call to the two leading jockeys, they disqualified the winner and gave the victory to the horse that came in second. The level of surprise can be gleaned from the betting odds. The first horse to finish was the second favorite at $9 to $2. The declared winner was a $63 to $1 long-shot. This is the first time in the history of this race that they have disqualified the winner for an on-track violation.

The investment lesson from this experience is to avoid putting too much faith in the “inevitable conclusions”. Surprises do happen, even those that are the first in more than one hundred years.

The Mixed Current Picture

Change Signs?

1. While the NASDAQ composite has gained the most since its January low, +26% compared to +17% for the Dow Jones Industrial Average and +20% for the S&P 500, this past week the 420 new highs on the NYSE exceeded the 305 new highs on the NASDAQ. Have traders shifted their focus to more industrial and  seasoned companies from growth and tech?
2. Of the 72 price indicators tracked by the WSJ covering securities, commodities and currencies, only 30 are rising, Recently, the number of gainers were in the majority.
3. Both High quality bonds and intermediate quality bonds gained in price, showing some shift in demand away from stocks. 

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

https://mikelipper.blogspot.com/2019/04/value-investing-will-be-superior-but-it.html

https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html 

https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html

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Relations and Correlations

At this time of year people of many faiths hold family gatherings. At the same time, those who are not physically near their biological families often group together for a meal. In the current era, some of us define our families through various types of electronic media. All of these relationships bring people together that have some common directions that keep these individuals glued together, at least for awhile. In a similar fashion, at times security prices moves in the same direction, and often in similar magnitude. The year 2008 saw almost all stocks, bonds, commodities, and even currencies and interest rates drop. There were very, very, few price series that rose. A number of observers commented that the only thing that went up was the correlations of prices to one another. This being the case, there were very few price trends that were reliably going up. Thus, with the exception of successful short selling, most natural hedges did not work at all or did not work well enough to totally offset declining prices.

Even before last Thursday’s price spike (April 9), we started to see various commentators issuing views as to what investors should do when, not if, the next upward phase begins. These pundits are savvy enough not to issue a declarative statement that they had seen the bottom point, (even though I believe many common stocks have seen their bottom prices). Few, if any commentators see an immediate sustained rise in prices, and almost none are firmly predicting new record prices. Also, they are not predicting when the upsurge will begin. Nevertheless, they believe that there will be a meaningful rise.

The interesting, and much more difficult job is to define a winning strategy to take advantage of the force of the animal spirits which will drive the market higher. Some investors rely on the historical patterns of certain types of stocks, bonds and commodities leading the way, e.g. large cap growth stocks, high yield bonds, commodities in short supply, etc. A second group focuses on the expected human reactions to the drubbing that portfolios have sustained in a very rapid manner. They also hold the knowledge that the last ten years have yielded little or no positive results, particularly on an after-inflation basis, and where needed, on an after-tax basis. The third and much smaller group, to which I am a member, believes that the future will be shaped more by the future structure of the players and events, rather than by dogma.

The U.S. Congress and other political organizations are currently in the “blame and punishment” mode, trying to ensure that the problems that have been created will never happen again. This is an impossible task for several reasons. The first is that they have forgotten that it takes “two to tango” (or to do other dangerous and competitive contact sports). None of the imprudent paper would have been sold if it were not for the greed and ignorance of buyers of all sizes and sophistication levels. The second barrier to ensuring a solution is that we are in the process of creating new and different investment organizations, with talent freed from the government-mandated bureaucracies of today’s large financial institutions. The third barrier is that the globalization of the world’s commerce is keeping some of the world’s brightest students from studying and eventually settling in the United States.

I am convinced that new types of investment organizations have been and will be formed. I hope that new and refined financial contracts and instruments will be created. As both natural resources and technology will find more immediate payoffs overseas, the financial community and many of us as customers will follow with our dollars. Increasingly it will become clear that national governments are important part of the problem. But even a larger part of the problem is a lack of awareness; we must teach people of all levels of economic knowledge that they are primarily responsible for what happens to them.

How does this translate into a portfolio selection process? First one should deal with a multiplicity of forward looking managers who combine “beyond- the-horizon” awareness with an intimate knowledge of the details of the tactical exploitation of events. Second, in order to be able to avoid the liquidity problems of rapid purchases, an “opportunity reserve” is a good idea. The opportunity reserve should be made up of two elements, short term cash or money market funds, as well as the most liquid index funds. The mix should be dictated by a general market view. Note that this reserve is quite low cost. Opportunistic investments should be few in number. Even for the ultra high net worth individual/family or a large institution, no more than ten probes into the future should be undertaken.

I have a personal bias toward specialist managers whose skills are more focused on future developments. I also suggest that portfolio components should not be well correlated to each other in terms of performance. If and when they become too correlated, it may be time to rebuild the opportunity reserve with particular emphasis on the cash side.

This Easter Sunday finds me pro families however they are related, but I am anti correlations in the long run.