Introduction
The words correlation, diversification and value are often used to describe purported solutions to avoid losing money. Yet rarely are these tools or concepts in and of themselves fully understood. Currently, many investors with substantial amounts of their investment portfolio invested in stocks and fixed income securities appear to be more worried than usual. This week’s blog post will examine some of my thoughts on these three words. I will be happy to discuss them with you to apply to your own specific portfolio needs.
Correlations
Correlation and its opposite, dispersion, are terms that come from the scientific realm that describe how members of a collection relate to one another. In concept, if there is a group of individual people or securities, they must have some common characteristics. Our psychological need for reaffirmation tends to view correlation as supporting us in our decisions.
In the last week ending Thursday night, the net asset values or prices of mutual funds fell. Eighty nine out of ninety six equity type mutual fund investment objective categories declined. Twenty five out of twenty seven taxable fixed income fund investment objectives also fell, according to my old firm Lipper Analytical Services, now a part of Thomson Reuters. (Money market funds and tax-exempt funds were excluded.)
On the surface it appears that geo-political and interest rate concerns caused the small number of transactors to slightly sell more than they bought. I suggest that a greater motivation was that after a prolonged period of unrealized gains in their stock and bond portfolios they were worrying about committing the biggest sin of investing - roundtripping.
My racetrack betting experience saw it differently. I saw investor confusion as to the smart bet. At the track this usually leads to many horses with relatively low payoffs if they happen to win. Thus, to me current prices/and price momentum are not particularly useful tools in making investment decisions. I will rely on my continuing analysis as to the long-term imbalance between buyers and sellers and other fundamental investment principles.
Diversification
In discussing investments with a highly respected analyst of fifty plus years of experience, he suggested that in his portfolio it was important to build it in such a way as to be able to sleep well. As I have given up sleeping well years ago in favor of occasional short naps, I didn’t know how to do what he wanted. I countered that sleeping well should not be confused with being asleep for long periods of no intellectual involvement. The sleeper is frozen into position until they wake up. As a US Marine I avoid being frozen into place.
My investment policy rests on the thesis that not only do I not have the skill to predict the future with complete accuracy, but the future will be made up of periods of rotating leadership. I execute this strategy for my accounts and personally through the extensive use of mutual funds. I look to the individual funds’ managements to make smart, occasionally successful tactical moves within their sets of capabilities and mandates. I reserve to myself and my associates the proper mix to meet specific needs and the timing of changes.
Changes should be based on specifics within a fund, such as to tactics and policies, including key personnel, but not performance. Performance is the consequence of prior changes, explicit or implicit. As all human activity tends to be cyclical, periods of poor performance are likely to be followed by good performance.
The key to this portfolio strategy is diversification. I get nervous when all of my investments are doing well at the same time. Thus I am afraid of too much correlation as I won’t have some investments going up, or at worst going down slowly, when others are falling. For the last several years low and declining interest rates have reduced the temporal value of cash or near cash. The search for yield has reduced the level of cash in many formerly sound portfolios.
We should collectively consider rebuilding our cash commitment as ballast to our investment voyage. As a practical matter, unless cash is above 25% of a portfolio it won’t likely keep the market value of a portfolio positive; what a smaller amount of cash will do is two-fold. First it will allow for the payment of current needs without having to liquidate good investments in a declining market, as would be provided by the Operational sub-portfolio in a Lipper TIMESPAN Portfolio®. But probably more important than taking care of current needs is a focus on buying bargains. The great fortunes are made by buying bargains near a bottom. As a practical matter better risk diversification can be achieved in less crowded markets, which often means investing in smaller caps and smaller countries.
Value
Investors should not want to buy fairly valued securities. While not completely accurate, Benjamin Graham is viewed as the father of value investing, with Warren Buffett as his leading disciple. As a proud winner of The Benjamin Graham Award for Service to the New York Society of Securities Analysts, which Graham helped found, I am conscious that his fame rests on his writing of the seminal book for analysts labeled Securities Analysis with Professor David Dodd.
When I took his course, Professor Dodd instructed us to recast published financial statements to determine the real value of the company, which was its liquidating value or as some call it “net-net” value. Graham and Dodd published their initial work in the real depression of the 1930s. They were primarily focused on defaulted bonds, which were many. They viewed them as future equities. Their approach, as implemented in their leveraged closed-end fund, was to use a substantial discount from the net-net value as their entry point into the reconstruction of the defaulted entity’s new equity, with the old equity either completely or largely written off. There were a handful of others playing this game, but Graham & Dodd were the only ones writing about this approach.
What brought this to mind was the Barron’s cover story this week, entitled “Are Value Stocks about to Grow Again?” The article focuses on book value compared to current price as the measure of value, and mentions Ben Graham and Warren Buffett. The concept may be right but the tool can be very misleading. What most of the time drives up the price of so-called value stocks is an above market bid.
In general there are two types of acquirers, financial and strategic buyers. I have been involved with both. The financial buyer is essentially a liquidator, the faster the better. Often the financial buyer is using borrowed money to execute the raid, so they do not have time to get maximum value out of real estate or unfinished inventory. The quicker they can shed people the better. The strategic buyer sees a bigger value in the acquisition than the present management is producing. The acquirer values the customers, the intellectual property, and often the people.
Since most companies are not about to be acquired, they sell at a discount to their acquisition value. Roughly speaking, I start with a belief that many stocks are selling at a 25% discount to a potential acquisition price, which won’t be realized in the foreseeable future because a financial buyer’s net-net calculation is close to an extended book value calculation. Strategic buyers don’t see what they can do quickly with the targeted acquisition to make the return on the new investment.
Liz Ann Sonders from Charles Schwab suggests that value stocks will rise. I agree selectively. A number of companies are capacity limited, with long lead times to bring on new capacity. As customers for their products and services find bottlenecks causing delays, corporations may either buy new capacity by buying a company or will tolerate higher prices. These are capacity plays not book value plays.
A New Constraint
The Department of Labor is questioning the value of recognizing the “ESG” attraction in selecting securities for employee 401(k) plans. A number of foundations and endowments are devoting a portion of their investment pools for similar purposes. They may be challenged by the DoL’s view as to the investment merit of ESG, no matter how laudatory the objectives. It would be difficult to include ESG elements in the calculation of value for many investors.
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A. Michael Lipper, CFA
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