Improve Your Returns: Watch Short-Term and Learn Long-Term

Introduction

With the passing last week of Andy Grove it seems appropriate for me to consider the breadth of thinking in his book Only the Paranoid Survive. While some can be comfortable following Warren Buffett’s words (not his actions) to buy and hold forever, along with most professional investors, my insecurity does not permit me to buy and forget. We worry all the time and particularly when trends turn and accelerate in our favor. This is one of the reasons why I came up with the four increments in the Timespan L Portfolios^® . These require me to focus on both the short-term to make tactical decisions and to learn what are critical lessons for successful long-term investing.

The Short-Term Operational Portfolio Worries

The timespan model for this portfolio was designed for an endowment that has to feed an operating activity over a two year duration, (in practice we will modify the timespans to meet client needs). While we think of this as a short-term portfolio, a number of individuals and institutions perceive their preferred measurement period for the entire portfolio is one year, thus for some, this is a long-term portfolio.

As longer term readers of these blogs have learned, I find a need for excessive enthusiasm to be in place before I start to prepare for a major decline, possibly of 50%.  I am beginning to see some growing enthusiasm. After all of a five week improved US stock market, and rising Chinese stocks and oil prices, I see shopping at the nearby high end mall getting crowded. Parking spaces are hard to come by, shoppers (mostly women) are carrying three or so shopping bags. Stores were reasonably crowded and both the Apple and the Verizon Communications stores have customers waiting.

As an analyst I search for negative indicators as much as positive ones. As long as there is sufficient uncommitted money to equities I know that there is spare buying power that can push prices higher. This is particularly true if the money is being guided by so-called professional, conservative money managers. In a recent asset allocation study of forty large wealth managers' recommendations, I looked at the five most aggressive wealth managers who were recommending that their clients put 60-70% in equities compared to the average of 51% for the forty. Only one manager would put 10% in Emerging Market equities and another sole manager would put 16% in High Yield debt. In both cases the average for the group was about 4%. This was the same level of group aggressiveness in terms of private equity where the five most aggressive had between 10-14%. The commitment to hedge funds on average was 9% where the leaders had 18-25% in these vehicles. Thus the wealth managers in general haven’t been swept up yet by enthusiasm.

Some of the money in hedge funds and other trading vehicles is finding its way into ETFs either on the long side or short side. For the week ending March 23^rd there was a net inflow into equity ETFs of $2.8 Billion which included $1.1 Billion into Balanced ETFs. (It is important to remember that the institutional community has learned that Index ETFs are a cheaper entry vehicle than futures for their hedging and other trading purposes. I will be discussing the impacts of ETFs on the structure of the market places in early April at a meeting of the International Stock Exchange Executives Emeriti.)

I would not pay a great deal of attention to the net redemptions from conventional mutual funds in terms of future direction of the market. In the latest recorded week $1.5 Billion were redeemed, all of it from Domestic funds, almost all that from Large Cap funds. It is my contention that the bulk of these redemptions are in effect “completions” of long-term investment plans prior to funding other needs. This is an old phenomenon which in the past was offset by new purchases of funds that are not happening because it is more profitable for the distribution systems, including registered investment advisors to deal in other products including hedge funds, private equity funds, and to some extent ETFs.

There are some signs of significant enthusiasm which need to be tracked. In the last week $3 Billion went into Emerging Market equities. Some could be short covering. In a recent survey the second most crowded trade was being short Emerging Market stocks which are less liquid than our domestic stocks.

Other examples of rising enthusiasm are the quarterly hockey stick-like estimates of earnings for the S&P 500: 1^St Quarter ‑6.9%, 2^nd quarter ‑1.9%, 3^rd quarter +5.0%, and 4^th quarter +10.6%%. Certainly part of the gains is earnings from the Energy sector going from a ‑98.9% decline to a gain of +10.6. While these estimates suggest a trailing price/earnings ratio of 17.2x and a forward one of 17.0x, the real action is more towards the large and midsize companies found in the Russell 2000 with a trailing p/e of 24.9x and a forward p/e of 22.5x.

Bottom Line For Short Term Portfolios

With the above list of inputs, I still believe that the short-term portfolios should set up a price grid to begin to reduce their risks as the market moves higher. For longer term portfolios they should continue to invest for the long-term and occasionally buy into some opportunities that the market will serve up, but not attempt to market time.

Longer Term Lessons

As much as I question the perceived wisdom from academic sources, like many analysts I am always a student of our environment. As a practical matter it is more difficult to learn from successes than mistakes. Almost every aspect of a success could be the critical element, if you will, the secret sauce that made the success. Most mistakes come from slavishly following the perceived wisdom of reported successes without looking deeper as to why they worked when they did. Probably the toughest part to learn of the art of investing is timing. There is nothing fundamentally wrong with balanced accounts, all equity accounts, private equity funds, and hedge funds. The keys are when to use each of these, in what mix, and what level of patience should be applied. Generally one should use these tool sets when others are not. Most of the time it is a mistake to follow the crowd.

This week I read about an endowment that fired its poorer performing managers after the first seven months of its fiscal year which occurred through the horrible January performance. The group couldn’t take that it was down ‑8.5% and the S&P 500 was off ‑6.6%. The endowment fired their hedge funds and moved into private equity funds. We don’t know what the future will bring but I have serious reservations on the basis of the little bit that we do know. The endowment:

• Probably picked its managers largely on the basis of past performance
• Accepted a popular asset allocation
• Did not understand the cyclical nature of performance
• Did not have sufficient patience
• Elected to do a dramatic change all at once 
  
• Chose to go into the currently most popular asset class with the proceeds of transactions.

I will attempt to follow the organization's future progress because I am always looking for decision makers who have a high percentage of mistakes. These rare negative indicators hopefully will help me and my accounts from making similar mistakes.

Secret Sauces

Far too many investors follow successful other investors and try to mimic what “the experts” do. They don’t focus on the tools the experts applied to their art.  Classic examples are Warren Buffett and Charlie Munger at Berkshire Hathaway, who we will visit this spring. In many ways the tools, not the judgments that they bring to investing is in their annual report. The report contains 67 pages of notes and supplements to their financial statements. I do not claim to fully understand all the nuances that could be found in these pages. To fully grasp the tools that they have used, one would need individual courses in accounting, corporate finance, tax accounting/management, insurance accounting, treaties, various state/federal/foreign legal codes, and various forms of investing. Unless you have a firm understanding of these arts, don’t attempt to play their game. I benefit from both their skills and tools as a long-term share holder.

Other users of secret sauces were the late Sir John Templeton ably assisted by the late Tom Hansberger, both of who were my long-term data and consulting clients. In many respects Sir John was the leading expert on tax code differentials which he applied brilliantly to his personal and company benefit. Tom acted as symphony conductor skillfully managing different personalities as portfolio managers and analysts with global offices and people always on the move. Both understood the sales process and more importantly the sales people as well as how to motivate and control them.

Both of these pairs of artists were much more than stock pickers. Each brought much more to the process of building wealth for themselves and their companies.

Question of the Week: What are the secret sauces that you have seen?
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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Comment or email me a question to MikeLipper@Gmail.com.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

 

I Suspect and I Accuse

Introduction

Today’s post is a double header with the first part focusing on thoughts as to the current markets and the second on longer-term issues that should be considered for investment policy considerations.

I suspect a “Melt-Up”

In last week’s post I discussed three possible directions for the current market, “melt-up, muddle along, and decline.” At this juncture, for at least awhile, the apparent path of least resistance is to go up in price.

Positives

There is a belief that surviving a problem that doesn’t kill you makes you stronger.  Most global stock markets did not fall on the two threats to geo-political peace last week; the downing of the Malaysian airliner over Eastern Ukraine and the beginnings of the Gaza strip ground attack. If the markets did not fall, then some believe the path of least resistance is for stock prices to rise. (Remember it took one month from the assassination of the Austrian Archduke and when World War I was declared on the European continent.)

Often when low to intermediate credits rise in price (decline in yields) relative to high quality paper, it is favorable to stock prices. Each week Barron’s publishes a confidence index based on this relationship. Normally it is quite stable. For the week that just ended the current reading was 69.9% vs. over 74% one year earlier. English translation is “risk-on.”

Because so many analysts and portfolio managers are relatively new to the business they tend to look at past history in terms of calendar movement of the Standard & Poor’s 500 index. They do not recognize that in an average year since 1980, according to JP Morgan Chase there is a 14.4% decline from peak to bottom. I am particularly sensitive to 1987 when for the year the S&P 500 index was up slightly but there was a  -34% peak to trough decline thru the year, and much worse in the average stock. In our analysis of mutual funds for our clients we pay particular attention to the declines of- 49% and -19% in 2008 and 2011 respectively. But who cares, the market always come back.

The consulting community and institutional “gate keepers” pay attention to ranked performance particularly of short periods. We have maintained for some time there is little in the way of persistency of good performance from quarter to quarter and even for one year and particularly for three years. S&P recently did a study of top first quarter performers for the first quarter of 2012. They compared these winners to the top 25% winners for the similar quarter two years later. They found that only 3.78% of the funds repeated in the top quartile. What were even worse were the large capitalization funds where only 1.9% repeated. Remember large cap stocks have more analysts following them than smaller companies. What this suggests is that the market may well be shifting to favor short-term momentum winners which would be leaders in a sharply rising market.

Ignoring what you don’t like

If you can ignore facts and views that are cautious, one can become more bullish quite quickly. Some of the subjects that investors seem to be ignoring are: 

1.      Private Equity Funds are selling their holdings at high valuations.

2.      Lust for yield is forcing investors into less conventional-higher risk paper.

3.      People seem to forget that most Merger & Acquisition deals work out poorly for continuing investors. That it took so long for Steve Forbes to find an acquirer for the majority of his company shows that the private equity buyers are more cautious now than the public investors.

4.      Interest rates are rising each week, for example: 15 and 30 year mortgage rates, new car loan rates and the banks’ cost of deposits (MMDA). At the same time numerous banks are reporting, as forecast, lower quarterly earnings and are looking to new markets to replace their crunched earnings power, e.g. PNC. This is occurring in a period when people are saving less and the spreads between high and low credit quality is narrowing.

5.      Many US investors are turning to Europe to find good investments. This surge in demand has led to a 102% increase in Western Europe High Yield issuance in the first half of the year. (Anytime there is an increase in low credit quality issuance I wonder when we will see a meaningful uptick in defaults.)

I Accuse

This is the famous title of an open letter to the President of France by Emile Zola about the “Dreyfus Affair” which eventually led to Captain Dreyfus being exonerated and a public recognition of societal biases in France. In a far less dramatic context I accuse my fellow members of the global financial community of complacency. While we all see any number of troubling events, most do not change or plan to change our investment positions. In effect many have elected to play “the greater fool theory” card in an undisciplined way.  A few of the things that should cause at least some of us to begin to shift away from risk of loss of capital are as follows in no particular order:

The sale of the Russell indexes to the London Stock Exchange opens more questions as to the future value of index production.

Internally both the US and Canadian central banks are looking for methods of improving their research in private recognition that they have not been very good.

We are seeing considerable “flight capital” movements. In the US the net sales of international funds is increasing as domestic oriented funds are in slow growth or net redemptions. In Europe we are seeing that the bulk of the long-term fund sales are not in funds from cross-border managers and are often going into investments outside of their domestic market.

Some very visible investors have made the following statements:

Carl Icahn:“This is the time to be cautious.”  

David Kotok: of the esteemed Cumberland Advisors indicates that tapering is now going to be tightening.

Kathleen Gaffney: Well-known bond fund manager now of Eaton Vance^* noted that traditional bonds have interest rate, credit and liquidity risks which is shoving us into unconventional paper.

*Stock owned by me personally and/or the private financial services fund I manage

An example of a real concern of mine is the discussions of an informal group of retirees, semi-retired and active portfolio managers, analysts both fundamental and technical, and an experienced institutional salesman. In periodic meetings, from my viewpoint, too much of this group’s discussion is on the issues of the day (often political) and not enough about individual securities and portfolios.

This group may well be a microcosm of the investment community trying to get the last high price for what they own while wringing their hands as to problems facing the investment world.  Within my own responsibilities I have only recently started to sell long held positions, but still are very much an investor in equity funds and some individual stocks, mostly in the global financial services arena.

What we should be doing if the melt up gathers momentum is to place sell orders at various different levels so that we maintain our survival capital for the next major bull market, which I expect beyond the next five years.

To my readers at Citywire Global

Thanks to my City, UK and European readers for once again making my blog one of your top choices.  Last week’s post was listed as Number One of the five most read stories on Citywire Global. I appreciate your readership.

Question of the Week: Do you have any specific plans to liquidate some of your “at risk” assets? 

__________________

Did you miss my blog last week?  Click here to read.

Comment or email me a question to MikeLipper@Gmail.com .

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.