Investing Successfully – Weekly blog # 525

Introduction

Investors often unconsciously think about their assets and investing. Our own actions, as well as those of others, create opportunities to add or subtract from our assets through opportunities or threats. Our sum total of assets in life is a culmination of our experiences, including thought patterns. For most of us, far too little of our time is spent on consciously thinking about how we invest our resources, emotions, energy, and financial assets. The purpose of this blog is to develop our investment thinking.

The first step is to take an inventory of how we spend our careers, emotions, energy and capital to further our goals, as undefined as they are. The second step is to begin the process of deploying our limited financial assets, beginning at its easiest least threatening level. (For almost all of us, our assets are more limited than what we want to accomplish with them.) The third step is to spend some time and energy on what I will label Capital Motivation.

Capital Motivation

Capital motivation, in an imperfect world with imperfect people, is to optimize not maximize how we focus our emotions, energy, and intelligence in deploying our financial and other assets. We need to begin a task that will never end, listing the threats and opportunities that are before us right now. How should we optimize our capital against each of the major opportunities and threats facing us? This sounds like an almost impossible task, but begins first with conversations both with ourselves and others to draw from our experience banks. Even the most financially knowledgeable institutions and individuals do not have all the answers. They are addressing their perceived needs as best they can and in many cases recognize the unanswered threats and opportunities that stretch out before them. In reality we are all sinners in this task.

What is Your Capital?

Those of us that invest in individual securities and funds recognize that fundamentally we invest in people. When analyzing any specific investment the single most important factor is the individual personality driving the investment in terms of the timing of inflows and outflows, as well as goals. Using a concept as old as The Bible, each of us are relatively short-term renters of the assets we currently command. Over time they become the temporary assets of others, known and unknown as well as those of the global society. This is why I believe any investment plan, self generated or produced by an adviser, needs to start with the individual decision maker and perhaps terminate with the welfare of the corporate and/or individual beneficiaries.

Our single biggest asset is our reputation for integrity, not only to others but also to ourselves. Eventually we need to deliver on our promises to ourselves as well as to others. In effect, when we promise we are creating a contract and we will be known for our ability to complete our contracts and in many ways the art of investing is dependent on our ability to live up to our contract. It is in this light we manage the mix of our financial and other assets on the continuum between capital appreciation and capital preservation.

Capital Appreciation 

Through accidents of life and our own hard work we have a pile of assets which most often come with some encumbrances. Part of the strings attached to our assets, plus a desire to grow them to meet future needs, is the continuous need to manage the appreciation of our assets. There is risk of loss in everything we do and the opportunity to appreciate assets itself comes with risk. On the surface, most of the time risks appear to be equal or exceed identified rewards. It is our skills, integrity, and energies, properly committed, that change the ratio of risk to reward. Outside of internally produced risks, there are two others.

As long as society promises to take care of those who don’t take care of themselves there will be taxes and they will be likely to be progressively higher on higher income. Perhaps the biggest reduction to the value of your investments is the inability of governments to compensate you completely for what they spend, as through their control of the creation and supply of money, they induce inflation. Inflation not only increases expenses, it lowers the value of our intellectual and financial assets. Over a family’s lifespan, inflation could be the biggest hurdle to meeting perceived goals.  These two societal payments also influence capital preservation. To overcome drags on our wealth we look to different capital appreciation approaches. While there may be some income element in our choices, the main benefit we are looking for is higher terminal prices than our initial costs.

There are many ways to attempt to achieve gains. In searching for good investments there is a false assumption that looking initially or only at past performance is the best means of accomplishing this goal. This presumes that the future will be very much like the past, which rarely happens. I utilize a holistic approach in examining not only the entire asset base, but also the potential risks to the individual capital owner.

For example, look at a university that is heavily dependent on government grants and contributions from science based workers. Working with the investment committee, they could decide that tech spending is cyclical and their capital should be invested contra-cyclically away from technology. With the very same set of conditions the investment committee, because of their own experiences, could decide that they are well versed in the issues and in the long run can tolerate this kind of volatility.

At this very moment, most stock and bond prices are flat to down this year, with principal gains in a handful of global tech stocks and their satellites. In these circumstances, a family with a combination of aging seniors and grandchildren entering college years could choose to optimize cash generation rather than aggressive capital appreciation, as they might have done in the past. Again, this is a particularly difficult time to make this judgement. Interest rates on high quality paper, while rising a bit recently, is absolutely lowering the value of fixed income because of the threat of rising global inflation. In addition, reinvestment risk on maturing investments is cyclically raised. The implementers of these decisions could benefit from discussions with their investment advisors, tax preparers, legal advisors, and family.       

Capital Preservation

Capital preservation is not the opposite of capital appreciation, but more like the other side of the coin. We all start with a bundle of talents, energy, and some money. We, over the lifetime of an individual, family, and institution, convert capital appreciation to beneficiary spending and interim investing. What is interesting is that during the investing period we are judged by investment performance, including the generation of cash. However, at the end of the period, and all periods end, we are judged by the aggregate size of the capital. All too often this is translated only as a sum of money. What should be included in this final assessment is what the expended capital has done in known and unknown people’s lives. (Read Andrew Carnegie’s views not necessarily his actions.)

What should we do now?

Any morning is a good time to change our future by making changes to our investment portfolio. I ask myself this question every weekend when I analyze the average investment performance of mutual funds as produced by my old firm, now part of Thomson Reuters. My conclusion is that at most one should consider tinkering with the mix of funds in specific portfolios, but not implement wholesale dramatic changes. The inputs to my thinking can be summarized as follows:

Year to date Average Investment Objective Performance
• No matter what size, growth funds are up 2X value funds
• World stock and bond funds are flat to down
• High Quality Bond Funds are down more than their coupon
• From David Rosenberg, at Gluskin Sheff since 2009, 13 million people are new to finance careers
• The last bond bull market began 35 years ago

“You can see a lot by observing”  

A wonderful quote from Yogi Berra and something we attempt to think about when making only minor modifications to our various investment portfolios. My wife and I just returned from, in many ways our graduate school, The Mall at Short Hills on a drab and occasionally rainy Sunday of the Memorial Day weekend. This is a very upscale market place which had a good size crowd, but they carried relatively few shopping bags and were there with one or more other people. It seemed to me that in terms of their wardrobe and other shopping needs, they were tinkering at the periphery of their sartorial assets. If something at Amazon was priced right or had particular appeal they would buy and perhaps more than just one. (As usual, the Apple* store had the most people and a longer than usual line for specific appointments.) Many of these people are either direct investors or participants in salary savings plans, 401(K), 403 (b) and 457 plans.  Their shopping ode suggests to me that in terms of their financial assets, while they make tinker at the edges of their portfolio, they are not currently driven to make radical changes.
*Personally held in investment portfolios

The tinkering that I am suggesting to various portfolios is as follows:
• In longer term equity portfolios look to good managers out of phase.
• Longer term international funds and quite possibly selected emerging markets should be reviewed.
• Sacrifice fixed income yield for shortened durations.
• Plan for a busy fall and a difficult 2019-2020.

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A. Michael Lipper, CFA
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Career Risk Can Hurt Long Term Performance - Especially Now

One of the traditional ways to address the potential conflicts between agents and owners of capital is to measure the performance of the agent or in the case of investments, the investment advisor.  As both a registered investment advisor and the chair or member of various non-profit institutions’ investment committees, I am very conscious of the potential for the termination of a relationship due to this focus on the measurement of performance. My experience is that current poor performance is often only the excuse for a termination, as opposed to deeper, more serious concerns over the relationship with the managers. I hope that other managers join me in assuring our accounts that from time to time we will under-perform. Obviously this warning is meant to defer the career risk of losing the account relationship.

Part of the lexicon in dealing with investments is to communicate the relative performance to other trustees, members of the family and even ourselves. This routine usually includes statements such as, “We beat the other universities, foundations, market indexes, (and my favorite) fund indexes.” This sequence continues, moving on to other topics. The brief bullet comments usually found do not address whether the account is going to fund the critical long-term needs of the account owner or beneficiaries. In one of its wisest edicts, the US Securities and Exchange Commission requires any performance statement to carry the caution that past performance is no indication of future performance. On the basis of my fifty-plus years of experience, I can state that absolute and relative performance is cyclical. 

Two personal examples of overreacting to career risk

First, when discussing the long-term outlook with an adviser to a significant museum endowment ten years ago, I cautioned him not to go to the extreme of owning only non-US stocks and high grade US fixed income. While I could see the relative attractiveness of selective foreign stocks, to me going out of US stocks was so extreme that there was significant career risk to the trustees and managers that took this approach. However in a ten year review, the relative performance of high-grade US fixed-income out-performed the popular stock market averages. As a result the endowment became larger and used its money when other museum endowments were cutting back. 

A second example illustrating my concern for other people’s career risk is when I met with a beneficiary of what I presumed a large family trust. I thought that the individual was not schooled in investments. He wanted some backing to urge the trustee and its professional investment manager to materially increase exposure to bonds. His view at the time was that bonds were a safer investment, regardless of how it would impact his income from the trust. I explained the long history of stocks out-performing bonds, particularly on an after-inflation basis. I suggested that if the trustee followed his desire, he was taking on career risk. This “uninformed” beneficiary has thus far proved to be wiser than the standard professional view.

Performance is cyclical, and occasionally extreme views need to be investigated, including both historical factors and future developments.

What should investment committees do?

Bragging rights are important and probably cannot be neglected in the face of strong development (fund-raising) efforts by the institution. I have two suggestions. The first is to focus as soon as possible on a twenty quarter rolling results analysis wherein not only the raw performance numbers are compared but also the number of better than average quarters achieved by each of the key components. Further, I would tie the spending rate to the same twenty quarter roll. The second suggestion I offer is to carve off at least one side of the portfolio that can take extreme choices, which would be measured over very long periods. This may well be an excellent time to explore extreme positions.

Why now?

I am not a market timer or a short-term trader, but rather a humble student of investing that has read and seen a lot. The biggest career risk we all face is that conditions change. In the early phases of most periods of change we tend to believe that past trends are continuing and that the current move is just another cyclical wiggle on a chart. We are not prepared for fundamental secular change. Our very unpreparedness is what raises the odds that we will be first surprised and then doubtful of a meaningful change.

The evidence for an advance

The US stock market and some other major markets have been essentially flat for twelve years. The market analysts refer to this chart pattern as either accumulation or distribution. We will know which when the market moves to a new high or breaks down past old lows. The theoretical math suggests that a move to a new high will eventually be extended at least by the same percentage move from the old low to the new high. From here this would translate to more than a 25% move from the old high when achieved. While there is little enthusiasm currently in the US stock market, it is set for an explosive advance.

The impetus

The impetus for this take-off in stocks is much more difficult to guess. Perhaps the sequence will be somewhat like the run-up to the First World War where the various countries were jockeying for global political advantage. No one expected that the assassination of the Austrian archduke would very quickly lead to armed conflict both in Europe and Africa.

What could give the spark to an explosion in equities would be news events such as the last night’s scheduled Mars landing (managed by Caltech’s Jet Propulsion Laboratory), the unveiling of the new iPhone and iPad or political developments in Europe and/or America.

Why do we need a strong equity market?

Jeremy Grantham and others have written about the coming food and water shortages that can destabilize large portions of the world population. To solve these issues we will need large infrastructure investments which are typically better done by the private sector. The one long-term need I am particularly watching is the need to productively put to work the huge number of people who will be freed from higher education classrooms and their dependent unions, as we shift from ineffective education to practical and reality-based learning.  In only a few years these students are going to make an enormous difference to our world and the investment processes have to be in place.

The question of the week

How are you going to spot the next secular change? Please share your approaches.

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