Confession: Numbers Don’t Tell All - Weekly Blog # 768

 

Mike Lipper’s Monday Morning Musings

Confession: Numbers Don’t Tell All

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

 

 

 

As a numbers-oriented person I must confess that numbers don’t reveal all critical information about a situation. For instance, future risks. The bearish financial press is focused on future profit margins shrinking on declining sales in the coming recession.

 

The real likely risk ahead of us is what an economic recession will mean to us personally. As Warren Buffet said, it will be revealed which swimmers are naked when the tide goes out. So too will we find out which companies are overextended when the economic pie shrinks.

 

The problem facing the management of companies, governments, non-profits, and individuals is the reduction of expenses. Rarely are expenses reduced proportionately to the actual decline in revenues, or the expected “top line”.  Expenses are cut either by judgement or happenstance. The cuts can impact the three “S” s on which future relationships are based. Products/services and future sales are based on their perceived Success in use, whereas Service is based on the ease of the relationship and the Safety of the user.

 

To an important degree the way customers feel about the product or service is dependent on the quality and quantity of known or unknown people they deal with at the firm and/or its distribution system.

 

The transaction price of most companies and practices are sold is leveraged over the resale value of its hard assets by its perceived reputation value. This is an attempt by the marketplace or ballot box to determine the sum total of the three “S” s. Thus, the impact on the absolute and relative value of its reputation is critical when it becomes necessary to cut people.

 

During the past holiday shopping season, it was easy to rank the service and inventory levels of various merchants through store visits. It was a little more difficult gauging the service levels provided by these service companies, particularly financial and health services. Much more difficult, but perhaps more important, is gauging the safety for the customer performed by service companies. Banks have announced employee cutbacks, hospitals are having difficulty finding qualified nurses and medical techs, certain military branches are understaffed in critical units, and law firms are reducing staff. These levels of safety should impact a company’s ultimate worth.

 

We don’t know what additional risks we are taking as consumers by relying on formerly reliable service providers whose staff support is shrinking. While I don’t know the risks, I do know that I am my accountant and back-office people are already spending more time reviewing the statements sent to us. I suspect the cost to me is much greater when a professional firm has an error or omission than when the wrong size of a garment is received at a store.

 

The following statistics suggest to me that I need to pay increasing attention to the details of safety than in the past:

 

Possible Warning Signs

1. The decreasing value of the US dollar relative to other currencies. This will likely raise the cost or reduce the quantity of what I buy.
2. There is a dichotomy between the level of transactions in the NYSE and the NASDAQ. Compared to a year ago, NYSE volume is down -14%, while NASDAQ volume is up +2%. Last week NYSE prices rose while NASDAQ prices fell. With many older company stocks generally flat for a year or more, the outlook for making money in these stocks looks limited. Some “growth stocks” are finding their sales more cyclical than in the past and the demographics are not promising.
3. China’s business capital returns are declining. Growth in global trade has been heavily dependent on Chinese export earnings. If they become smaller as the rest of the world slows, it is likely that export earnings will decline and result in lower imports.

 

Self-Appointed Mission

Bernard Baruch, a friend of my grandfather, labeled himself a speculator at a congressional hearing. He then explained to members of the House that the term speculator comes from the Latin term “to see far”. I use a speculative focus on the future for me and my clients. Part of looking at the future is identifying different possibilities. I take my marching orders to spot both “bull” and “bear” cases.  

 

My blogs often warn of problems, as Mr. Baruch did. However, I think the time for a new “bull” market is coming. Hopefully, we will make enough adjustments to our society/economy so that we won’t need to go through stagflation to adjust.

 

I lack the ability to see the future. Hopefully, a few subscribers to these blogs will have some thoughts they are willing to share about the next major “bull” market. (Please don’t focus on inflation and interest rates which are old news, they are attributes, not causes.) Help!!

 

 

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Does the Decline Influence the Recovery? - Weekly Blog # 723

 Mike Lipper’s Monday Morning Musings

Does the Decline Influence the Recovery?

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

Positioning

As a contrarian I am comfortable sharing my view of the market with the majority. Sharing this view is not done to stand out among a crowd of students of the market, but to attempt to position myself and the accounts for which I hold myself accountable. Over time, the rate of return earned by the majority is less than some of the minority, who happened to be right for some reason. With that thought in mind, I will try to focus on the recovery from the predicted downslope we are in, looking across the unknown valley to the beginning of the recovery.

Where are We?

As is often the case, there are conflicting trends. In terms of stock prices, we are in a decline. Until it is finished, we won’t know if the decline is just a trading event, a correction, or a bear market. The media makes a distinction, defining a decline of 10% as a correction and a fall of more than 20% as a bear market. Using the most popular market indices the picture is muddled, with the NASDAQ Composite well into the correction phase, dropping -15.9% from its January high and even more from its all-time high in November 2021. The S&P 500 has flirted with the -10% level. (Based on the present length of the market expansion and the nature of changing stock leadership, I believe that we are heading for a bear market.)

The broader economy is also showing disturbing signs. The JOC-ECRI Industrial Price Index rose 2.8% last week and is up 31.3% for the year. January’s backlog data was up +19.6%, with the number of new orders up only +6.8% and non-durables up only +5.6%. In February, before the Ukrainian invasion, purchasing orders were down -3.8%.

“Buy the Dip” Advocates May Get a Bad Bounce 

This week in Seeking Alpha there were four different recommendations to buy shares of T. Rowe Price (a stock owned in both personal and managed accounts). I have had the pleasure and honor of meeting with all the firm’s Chairmen, going back to Mr. Price himself. I hope my heirs continue to hold these shares, although much like Berkshire Hathaway, I have concerns about a potential change in the shareholder base. The difference is price action may be signaling a long-term change in the valuation of the stock. The low price this week was $137.76, a long way from the 2021 high of $220. What is a bit more worrisome is the $137.76 low on Friday, on 2 million shares of volume. The high for the week on Monday was $145.11, on 1.6 million shares of volume.

I reviewed four recommendations of T. Rowe Price which touted the remarkable financial record of the firm and concluded the stock was a buy. I hope they are right; however, like most current recommendations to buy Berkshire, they dwell on history. When a stock drops by 1/3 and the “market” hasn’t fallen much, it raises questions as to the repeatability of the record. Clearly, if the record is repeated the stock is a great long-term buy, but if not repeated, it will disappoint shareholders staying on board. I have not read any reports questioning the long-term vitality of T. Rowe Price; however, I could dream up some worries that could cause disappointment if they turn out to be correct. 

The following is a brief list of issues that could go wrong in the future, which the firm has not dealt with in the past:

1. Private Equity and Private Debt have been important contributors to the gains in many of the firm’s funds and accounts. Almost every investment manager is fielding similar products. With so many firms raising money in the markets for “privates”, the purchase price demanded by entrepreneurs will undoubtedly rise, while about half of the privates offered to the public through IPOs declined in the “after-market”. One clue this phase may be coming to an end is the SEC demanding more disclosure from this sector. (Nothing like the Police showing up after a crime is committed.)
2. There is a trend of financial intermediaries merging into larger organizations. At some point the larger intermediaries will demand a bigger slice of the profits of the account.
3. Governments are concerned about a large portion of the voting population still without any, or sufficiently large, retirement packages.
4. With more pressure from clients or their agents, fees may come down, regardless of inflationary increases cutting profit margins.
5. An activist government may force advisory firms to go into less profitable businesses.
6. Some large settlements may be awarded by activist courts.

I believe the current management is aware of these and other risks, but bad things can happen to all of us.

Question?

What are the non-present risks that could hurt your investments?  

  

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

https://mikelipper.blogspot.com/2022/02/successful-investing-expects-unexpected.html

https://mikelipper.blogspot.com/2022/02/we-are-progressing-weekly-blog-721.html

https://mikelipper.blogspot.com/2022/02/building-long-term-investment.html

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Uncertainty is Inevitable - Weekly Blog # 697

 

Mike Lipper’s Monday Morning Musings

Uncertainty is Inevitable

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

Numbers and People Are the First Traps

When a baby takes its first uncertain steps it eventually falls, despite hovering caregiver parents and others. From that instant on, the baby wishes to avoid falling. As we learn to balance our movement, we believe we have solved the problem of safely walking. Thus begins our first mistake in judgement which we apply to all activities, including investing in life and securities. While we fall or stumble less frequently throughout our lives, we accept it with annoyance, but carry on nevertheless.

Our next mistakes are our imperfect memory and learning from people. We expect those we love and/or respect to be correct in their pronouncements all the time. Only from experience do we appreciate that they can and will make mistakes. Later in our development we learn the discipline of the power of numbers, usually through achievement or time. However, we also learn that conditions change, and success or failure also changes with conditions. Thus, we should question the inevitability of future events occurring exactly as people and the numbers foretell, as uncertainty changes as we mature into risk. Whether we like it or not, we become risk assumers or hopefully risk managers.  My philosophy of life and investing is based on addressing risks whenever possible. This blog is devoted to some of the current risks I perceive, which are generally not focused on by many professional and individual investors.

1.   Sellers’ Risk

Most people view the buyer as the one at risk in any transaction. While this is true in terms of money transferred at closing, including expenses to make desired changes and upkeep, what most don’t fully recognize is the seller in one transaction becoming the buyer in the next transaction. Home prices recently reached record levels in the US, the UK, and many other developed markets. As these homeowners become sellers and eventually new buyers, they will bear the initial cost of a new home, including its desired changes and upkeep.  

Many buyers are at risk due to the vagaries of current inflation, including through delays. Most communities have not updated their infrastructure, apparent after the latest weather-related expenses, which will increase costs. I suspect local schools and universities will need to change the education being taught so their students can find meaningful employment and lives. (This will increase taxes and won’t be cheap)

2.   Co-Venture Investment Risks

In almost any investment one of the bigger risks is attempting to sell. One or more sellers can “ruin” the market by removing though sale a higher buyer. This can happen in terms of a neighbor’s home, a similar property, or a fellow shareholder. The probable or contemplated seller’s actions are difficult to guess, but it should be attempted.

Let me share an example that happened this past week. A non-US stock I own announced a 29% decline in net income for the first half of 2021 and the price barely moved. Yes, revenues rose 54% and they announced a few new items to replace outmoded products. While I was surprised by the net income decline, I was not particularly surprised by the stock price action of BYD. [These comments should not be construed as a recommendation, in part because I don’t follow its industry or its competitors.] My relative lack of concern comes from knowing two of the largest stock investors and having visited the headquarters and plant in Shenzhen. In looking to the nature and reputation of major shareholders, I relied on one of the oldest investment techniques, identifying sponsorship. 

A story that has been told from the 19th century involves a leading member of the London Stock Exchange asking another member what he could do in repayment for a favor. Replying to Lord Rothschild, he said “just put your arm around me and walk across the floor of the exchange”. With that in mind I regularly look at the owners of stocks of interest. Some funds have high portfolio turnover rates and tend to look for explosive earnings. Others, like the two owners, are long-term investors who would probably be buyers if the stock dropped temporarily. Currently, with 20 million new retail accounts since 2020, I don’t expect many to have learned to be buyers of shares that are declining in price.

3.   Market Price Leadership Rotation 

The current leading macro group investment is commodity funds, benefitting from the play on current shortages. Combine this with what I previously mentioned, some institutional investors cutting back on equity exposure after 20% gains in the S&P 500 within a calendar year. (The difficulty with this approach today is the lack of low-risk alternatives to move some stock money into.)

4.   A Potential Large Risk for the Next 3 Years

In addition to the current legislation before Congress, which is not likely to be paid for during their expenditures, there are at least two other issues Congress will need to deal with sooner or later. The current administration is discussing cutting the income tax rate on lower earnings. (I suggest it be called “lower real income for lower wages”.) A portion of the low wages paid to those who pay little if any income taxes is not likely to increase spending. To offset the cost of lower taxes on low wage earners, one should expect materially higher taxes for higher earners (This is the real motive of certain people in The White House and of far-left leaning members of Congress.) 

To offset this increase, higher rate taxpayers are likely to see prices rise for goods and particularly services. If it continues long enough, the cost of transportation and other items for low-end wage people will also rise. As profit margins decline, more business will flee the country and/or reduce risky investments. The increase in the price of oil already demonstrates the skill of the current administration. Words from the White House suggest the economic impact of the new proposal will be measured against “the success of our withdrawal from Afghanistan”. 

5.   A Longer-Term Problem that Must be Addressed

The Old-Age and Survivors Insurance, the largest component of Social Security, will run out of money in 2033. Undoubtedly this will be met with tax increases and probably a lower value dollar, which will hurt investors who are not properly hedged.

Share with us what you are doing now

Either for attribution or privately, just to help me in my thinking.

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

https://mikelipper.blogspot.com/2021/08/possible-major-change-missed-by-media.html

https://mikelipper.blogspot.com/2021/08/another-but-discouraging-look-at-market.html

https://mikelipper.blogspot.com/2021/08/mike-lippers-monday-morning-musings-are.html

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Are Too Many Long-Term Investors Too Short-Term?

Many of us who claim to be long-term investors (LTI) worship at the feet of Warren Buffett and actually own shares in Berkshire Hathaway as I do both personally and in the private financial services fund that I manage. While “the Sage of Omaha” claims his favored investment period is forever, as noted in a recent column  by Chuck Jaffe, a study of his actual publicly-traded portfolio transactions suggests a holding period of four to five years. I suspect his two relatively new portfolio managers (who like Mr. Buffet have a background in managing hedge funds) have a shorter period of satisfaction with their holdings.

Corporate CEOs have little true confidence in the steadfastness of their institutional shareholders, with the possible exception of index fund holders if the companies are cursed or blessed by being found within one or more indexes or ETFs. Assuming no large earnings or other shortfalls, most particularly large corporations have the same CEOs for five years. In terms of transformational investments, ten years is a reasonable planning period to examine the success of many companies. For those businesses that make large capital expenditures in fixed plants or ground-breaking R&D, particularly in pharmaceuticals, twenty years or even longer is a reasonable measurement period.

Those of us who are investing for the education and future of our grandchildren will take our money to the ultimate fulfillment. For those of us like me that serve on boards and investment committees of large tax-exempt groups that are responsible for universities and hospitals, the time horizons are even longer. Think about granting tenure to a forty year old professor who could be teaching for forty or more years voluntarily and an administration without an easy ability to either improve the quality of the teaching or cutting the expenditures. As far as hospitals are concerned, the outer skins of the buildings are likely to hold up for fifty to one hundred years, that is if they weren't built to federal government specifications and by low-bid contractors. However, with the marches of science and regulations many if not all of the physical plants will have to be reworked rather frequently due to perceived obsolescence.

Faulty starting points of too many LTIs

Too often we become captives of both history and the headlines of the day. Any study of past investment mistakes shows that over-confidence in our wisdom and our ability to foretell the future leads to disastrous results. I have learned through meetings with existing and potential investment managers and investment consultants that many confuse the difference between a book report and a book review. The report form abbreviates the history of their investments both statistically and thematically. A review has to do with the ability of the managers to successfully negotiate the future, or more importantly futures. I am in the continuous process of meeting with existing managers that we use and candidates for future use. To the extent that the portfolio managers and their chief investment officers (CIOs) think deeply about the future or futures, I will be probing them with some of the questions shown below and other items they or I think are important.  In addition, I ask the readers of this post to react to these queries publicly or privately.


For the sake of the future, "Are profit margins too high?"

This is not a mirrored concern of my good friend Byron Wien and others that are worried that margins will surprise many by coming down in the second half of the year. My concern is different and perhaps deeper. As an entrepreneur I know that profit margins are not just a result, but to some extent are the outcomes of a very important series of operating asset allocations. Final operating margins are the consequence of a series of simultaneous equations between personnel management, development spending, foreign exchange management, balance sheet concerns and the mix of interest received and paid. Often margins are the beneficiaries of past acquisitions bringing the acquired margins up to the level of the new corporate parent. The simple statistic of profit margin does not reveal enough about its present and future composition for wise investors to properly evaluate the investment's long-term attractiveness.

Why can margins be too high?

I am not a socialist, but I raise the question, “As a society, outside of government, are we paying too little to employees?”

Because of the prior demands of individuals and organized labor, plus government intervention, we have encouraged the substitution of technology and to a lesser extent foreign workers, for domestic workers. My concerns are two. The first concern is the actual and implied replacement of domestic workers. One example is that we are not getting enough useful new ideas from our senior and professional staffs. There are untold numbers of instances where a relatively low paid worker on the factory floor or in the mail room recognized something of value to the process that was missed by the executives.

The second concern comes from Henry Ford, certainly no radical labor leader. Ford raised wages to an unheard of $5 per day. The history books record that his decision to raise his workers' pay was so they could afford to buy the increasingly mass produced Model T automobile. The growth of high corporate revenues needs strong consumer demand.

Currently one of the concerns of investors is that while earnings progress is surprisingly good, domestically produced revenues are flat with the gains attributed to record profit margins. The news from the job front is at best misleading. While the number of new hires is marginally good, the quality of the jobs being filled is at lower levels of pay and satisfaction. Two of the indicators to watch are short-term sales in stores that cater to the middle class and the purchase of new homes.

Will the current wave of M&A lead to tears?

As pointed out by London's respected Marathon Asset Management, one of the reasons for the good margins has been bringing an acquired company's margins up to the new parent's levels. However this is a one time occurrence accomplished by tighter financial management and bigger discounts from bulkier corporate buying.

However, there are longer-term negative impacts of these deals. Often the senior management of the acquired company is locked into the acquirer as an indentured servant for a specified period of years. After their Liberation Day most of the original people are gone including, perhaps those at above-scale wages. At this very point it will become clear whether the combined company has the breadth of management needed to make this work out well in the long-term. One of the historic problems for companies like General Electric is the belief that a good manager can manage anything well. In a more complex world it doesn’t happen all the time. Rarely do we see the practice that I followed with some tiny acquisitions: while I liked the products the acquired firm produced, what I really wanted was the new management to join us and play a bigger role in the overall growth of the firm. This is not happening today.

The big risk for the acquirers is that not only do the former senior managers leave the "Mother Ship" but they bring along with them or attract the bright young and entrepreneurial people that will develop the new leading edge competition.  As a partial answer to these concerns  I believe, along with others, that we will see more spin-outs or strategic sales. To accomplish this well and to keep the loyalty of the former parent company's workers will require skills only a few firms have.

Are you prepared for the next bubble?

In our economy we normally don't fix the inflating force that created the bubble, we just remove the flow of the assets that created the bubble. But the assets go somewhere. Most of the time investors still search for above-normal yields and because of their confidence in their own selection skills or those of their managers, dealers or brokers, they remain speculative. We are at the point of looking at mutual fund flows worldwide to suggest that the High Yield Bond fund bubble is deflating. Where is this money going to go? Wherever it goes eventually, it will likely prove to be disruptive.

What to do?

Try to look to the next visible time horizon and beyond to what may be large mistakes that in some future time periods can be corrected. Do not have too much confidence in the correctness of your present, firmly held investment beliefs. As they say, many roads to Rome (investment success).  One should be on multiple routes, the more the better.

Please share your thoughts.   

_______________________

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
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