Mike Lipper’s Monday Morning Musings
Securities Analysis as Taught Leads to Volatility
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
The long-term history of making money in the market is not following the majority with their money. In simple terms, choosing not to conform with what others are doing. Winning in the market means converting some of the wealth of others, often the majority, to our own. This maneuver requires using different approaches and tools than others use.
Sector Bets Fail to Produce Top Results
The academic course on Securities Analysis is taught as a companion course to accounting, or worse, macro-economics. Both work on past history and have precious little to do with future movements of companies, stocks, or economies. More useful studies would instead focus on profits and securities.
All too often securities selection processes screen for companies which appear to be in the same industry, as measured by misleading government data. As a junior analyst I was assigned the steel industry. I quickly discovered that although the number of steel companies was small, it was a mixed bag of companies. You could divide the group by the location of their headquarters and proximity to critical resources, usually coal, or to a growing customer base. In this case an investor did far better with Inland Steel, based in steel-short Chicago, rather than in Pittsburg and West Virginia coal country.
Another worthwhile distinction was the cost and quality of labor. In the early days of the externalization of producing payrolls, commercial banks were prominent. However, overtime they lost market share and eventually lost the entire market to independent payroll service providers who provided better services. They provided more help filing payroll tax returns and offered lower prices, due to their labor not being paid bank-type overhead. Today the payroll market is dominated by service companies with extensive and modern computer systems, which are good at servicing. (Our accounts own ADP.)
A final example is computers. Many of the large industrial companies manufactured the early computers, the biggest and best being IBM, a stock my grandparents owned. The key to their success was not only adequate technology, but superior leasing prices and great sales engineers. IBM’s top salesman regularly presented to Wall Street and was a missionary sales person. However, the industry changed from massive main frames taking up large airconditioned rooms, to desktop personal computers whose parts could be produced in low-cost regions of the world and could be assembled elsewhere.
Dell started out by taking customer orders for computers which could be customize and air shipped to customers. Today, many believe Apple (owned in our accounts) is the leading company. This is the result of the late Steve Jobs’ focus on style and ease of use. His most important achievement however was handpicking his successor, Tim Cook, an expert known for supply management and development. What relatively few investors appreciate is its global network of Apple Stores and a growing mail order business generating repeat business, essentially building its own annuity business. (Remember, US automakers had market level price/earnings ratios when customers replaced cars every three years with newer models.)
Less popular ways of analyzing securities included:
- Paying more attention to insufficient supply than excess demand.
- Focusing on differences in manufacturing approaches and costs.
- Understanding the personalities of key operational people vs known leaders and their educational biases.
We Don’t Create Winners, Losers Do
No matter how prescient and bright we are, to have great results we need others to create attractive entry prices and unreasonably excessive exit prices. Utilizing these as working assumptions, I am getting nervous about the flow of institutional and individual money in private equity/debt (private capital). For many years there were more good private companies offering participation in their attractive futures than potential investors. They attracted investors with relatively low entry prices.
Recently we have seen a reversal, with a huge flows of institutional and individual money seeking to exit the public markets and enter the private markets. By definition, entry prices either directly rose or the firms had to carry senior debt prior to generating private capital returns. There is so much reversal of traditional roles that one of the oldest buyout firms, with a great long-term record, is converting some of their US and European investments to a publicly traded fund. For some of its investments Sequoia is trading up in liquidity.
One of the disturbing concerns in the privates market is the number of new advisers that have entered the market. They have increased the number of funds and are spreading the investment talent more thinly. In response, T. Rowe Price, an experienced investor in privates, is buying an existing manager to get the necessary talent in an increasingly competitive market. (Owned in Financial Services Fund accounts)
A number of well-known university and institutional portfolios have announced performance in excess of 40% for the fiscal year ended June 30. Some are probably reporting private investments with at least a quarter’s lag. (My guess is performance for the year ended March was better than the year ended June 30.) Most investors did not do as well and consequently some are likely to pile into an overheated private market with scarce investment talent. The history of investment returns is that it is extremely rare to find a manager who can consistently return over 20%, which is roughly three times the growth of industrial profits. The organizations that reported 40%+ profits undoubtedly benefitted from lower entry prices and better terms than is currently on offer.
I am a long-term member of the investment committee of Caltech, an internally managed investment account with a talented staff. They have put a cap on their exposure to buyouts and venture capital. I applaud this decision because of the history of hedge fund performance. It shows that even very good hedge funds suffer when a minority of hedge funds experience serious liquidity problems. This was in part because of debt, but some of their holdings were also owned by trading interests desperate to liquidate some of their excessively leveraged holdings created by falling prices. This is a classic example of others causing some investors to have poor results.
Moody’s is also concerned about the rapid growth of inexperienced managers offering private capital vehicles. The credit-rater was criticized for the exponential growth of CMOs. (Moody’s recovered, and just this week was selling at a record stock price. Moody’s is owned in our managed and personal accounts.)
Historical Odds of Equity Bear Market
There is wisdom in the saying that history does not repeat (exactly), but rhymes. The ebb and flow of markets are driven by emotional excesses, with investors reacting to various stimuluses. I previously mentioned a successful pension fund manager liquidating his equity portfolio after it gained 20% in a calendar year, reinvesting the proceeds at the beginning of the next year. He produced a record absent of large losses, with reasonably good gains on the upside.
We may be approaching a “rhyming event”. I feel more confident taking a contradictory view when it is supported by large scale numbers. The US Diversified Equity Funds (USDE) have combined total net assets of $12.4 Trillion, representing 2/3rds of the aggregate assets in equity funds. According to my old firm’s weekly report, the year-to-date average gain was +21.01%, vs a 3-year average gain of +19.21%, and a 5-year average of +16.76%. More concerning is only 4 of the 18 separate investment objectives within the USDE bucket produced over 20% 5-year annualized growth rates. Of the 14 Sector Equity funds, only 2 grew +20%, and only the World Sector Fund average gained 20%+. At the individual fund level, only 3 of the 25 largest funds produced 20% growth rates. During the same 5-year period, the average taxable fixed income fund gained 3.34%, and the average high yield bond fund grew 5.47%.
Recently, a number of endowments reported gains of over 40% for their June Fiscal years, driven by successful private equity/venture capital investments. Some of these private investments were reported on a logged basis. Remember, in many cases they had spectacular performance through March, and have been relatively flat since then.
The cyclical nature of human emotions suggests that when earnings growth does not support lofty valuations, we are likely to have a “rhyming event”.
What do you think?
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/10/are-we-listening-as-history-is.html
https://mikelipper.blogspot.com/2021/10/guessing-what-too-quiet-stock-markets.html
https://mikelipper.blogspot.com/2021/10/what-is-problem-weekly-blog-702.html
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A. Michael Lipper, CFA
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