Twin Problems: Not Enough Excitement and Too Many Fears - Weekly Blog # 584

Mike Lipper’s Monday Morning Musings

Twin Problems: Not Enough Excitement and Too Many Fears

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

Stock Markets Don’t Confirm New Highs 
On the Wednesday before the July 4th US Independence Day Holiday, the US stock market indices reached new highs on low volume. On the next trading day, in a shortened session, there was no enthusiastic follow through. Is the very slight decline is a symptom of a self-correcting advance that likely curtails a significant enthusiastic response in volume? Greed is now not overcoming the sense of ennui or complacency. Those not fully participating have lots of fears, like:

• The timing and nature of a stock market reaction to the oncoming recession?
• Unattractive political leadership choices
• Global strategic issues  

These considerations and others were on my mind over the last four weeks when my wife and I visited London, Dublin, Melbourne, Uluru, and Sydney, where I talked with investment professionals and other investors.

Lessons from Uluru
Most investment types are very quick to adjust their thinking to the headlines of the day. As a brother of a US Marine Corps Reconnaissance veteran from the Korean War and my own search for appropriate long-shots, I wonder whether the right questions are being asked? In some ways the visit to Uluru helped crystalize my concerns, which made me re-think what I saw in London, Melbourne, and Sydney.

Uluru is in a desert in the Northwest Territories, in the middle of Australia. It celebrates the Aboriginal worship of the massive rock formations sacred to them. In Uluru we found a good regional airport, a bunch of modern hotels, a fleet of tour buses and crowds of tourists, both from Australia and from around the world, with a focus on tours from Japan. Hotel reservations were difficult to obtain and the entire commercial scene was an enormous bet that tourists will continue to descend on Uluru for a long-time into the future. In a somewhat similar fashion, visits to London and Sydney, as well as my experience walking around New York City, one can’t help but be impressed by the huge amount of permanent capital being invested in the continued growth of mid to high price tourism around the world.

Excess Expansions Bring Tears
I have often said that if one cuts into a securities analyst a historian will bleed. I have started to question whether this global outpouring of capital into hotels is somewhat like the gold rushes in the US, Canada, Australia, and South Africa? There were similar surges in the building of  the transcontinental railroads in the 19th century and the over 300 automobile manufacturing companies competing in US and other countries in the 20th century. Closer to the present, one could look to the “Dot-Com” and sub-prime periods for phases of euphoria.

Demand Failures
There are many ways to look at these expansions and collapses. Most attention has been directed at what proved to be unsound financial arrangements, which in some cases were fraudulent, but in all cases were the result of bad judgement. Many of the dreams of the “Dot Coms” have subsequently been delivered, but by different groups with largely overseas resources. The biggest problem for the owners of over mortgaged homes was that momentary supply exceeded demand. To me, a more important issue was the failure of demand or substitute demand. Where could the talents involved have been utilized? Where could the workers and their families have found paying jobs?

Financial Services Clues
I pay particular attention to the Financial Services businesses, where almost all the participants in this global industry are trying to present themselves as Technology companies that happen to be dealing with financial matters. I wonder if this is similar to GE and many large industrial manufacturers in the 1950s, who began divisions to be in either Atomic Energy or Computers. Currently, Financials are competing with Tech companies for both experienced and inexperienced credentialed employees. They are paying Silicon Valley wages and are trying to manage these freer spirits in a more regimented company. In the academic world, are we producing too many people to find long-term employment in Fin Tech? On Friday, the only major group to go up in price was Financials, a rare occurrence. The thinking behind this rise was that good employment numbers suggest the postponement of the expected drop in interest rates by the Fed and many Financials would gain due to level or higher interest rates.

Low Rates Produce Long-Term Troubles
Paradoxically, lower interest rates are not favorable long-term for the economy. Low rates encourage the issuance of lower quality credit loans or the renewing of loans of deteriorating borrowers. Furthermore, the lower the rates the less power the central banks have to step in and prevent major financial failures. Perhaps the most negative implication of low interest rates is that it does not address the globally growing size of the retirement capital deficit in a world when people are living longer and more expensively.

Question of the week:
Do you see excessive expansions?


   
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/06/reduce-investment-mistakes-with-deeper.html

https://mikelipper.blogspot.com/2019/06/our-investment-mistake-is-in-labeling.html

https://mikelipper.blogspot.com/2019/06/mike-lippers-monday-morning-musings.html



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Some Retire while Others Sense Opportunity - Weekly Blog # 563

Mike Lipper’s Monday Morning Musings

Some Retire while Others Sense Opportunity

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

                                                               

                                                               

Two-way markets are generally the safest, because most investors become aware of both the future upside and downside. For those of us who were privileged to attend the New Jersey Symphony Orchestra’s Lunar New Year Concert Celebration, not only did they hear great music but they were also introduced to the year of the Pig. According to the Chinese horoscope, the year of the pig favors wealth, good fortune, and dedication to hard work. I am earnestly in favor of those sentiments for all our friends and subscribers. We can all use good fortune and a little bit of wealth and I will continue to be dedicated to hard work for our clients and family. For many investors the road to wealth is participating successfully in the primary direction of the markets. I am hard at work trying to fathom the primary direction of the markets, particularly the global stock markets. Currently there are signals that point in both directions.

Downside Signals

The near-term economic trend-rate of growth is slowing. Evidence of this emanates out of China and its pivot away from exports toward a more service-oriented economy. Signs of this are also evident in Europe, Asia, Africa, Latin America, and North America. The political picture reflects this slowdown. Markets have responded with frequent changes in direction. Underneath this increase in volatility there is a sense that we have entered into a new market.

This week’s Barron’s highlights two investment managers who announced their retirements after an incredibly successful career. Both very recently produced way below career average rates of return as the structure of the market changed. Few stock and bond investors have not heard of Bill Gross, formerly of PIMCO and more recently Janus Henderson, who for a while was acclaimed “The Bond King”. Part of Bill’s skill was his insightful short-term trading of mortgages and his ability to identify cyclical changes. His techniques are now are copied by many smart competitors. The other retiree is Steve Mandel, the portfolio manager of the hedge fund Lone Pine Capital. His long-term record of gaining 14.4% since 1998 vs. 6.6% for the S&P 500 makes him one of the best hedge fund managers. He was a successful retail analyst at Goldman Sachs and moved to Tiger Management, the home of many very successful hedge fund managers. The retail market is going through a series of rapid structural changes. One of the warnings for poker players is, if you can’t identify the “chump” or likely loser, it’s likely to be you. Thus, it’s time to retire from the game as quickly as possible. These two well-known names are not alone, a bunch of “value” focused managers who have not performed well are also in the process of considering retirement. 

Worth noting in the latest week’s ranking of the top 25 performing mutual funds, 8 were growth funds and 6 were science & tech funds. Most of these were small or mid-cap funds with a likelihood of common holdings. These appear to me to be more the result of trading decisions than the decisions of long-term investors.

Upside Signals

For some time the large and growing global retirement capital deficit has been both a concern and potentially an expanded source of new funding for investment markets. Although both political parties are aware of the problem in the US, I don’t believe discussions in the House Ways & Means Committee will produce large results.

A significant number of US corporations are raising their quarterly dividend, desiring to keep their dividend payout ratios reasonably stable. Many of their existing shareholders bought into these companies years ago and now have a cost basis that is way below the current price. While not a popular measure, the new dividend relative to the initial purchase price is producing a current yield at mouth-watering levels. If the step-up basis at time of death remains in place, the yield at cost will in most cases tend to prevent their sale. As the market structure rotates into a new phase of favoring good but not cheap companies, many of these will be like the companies that attracted Charlie Munger and Warren Buffett as discussed below.

We may have entered a “Munger” Market Phase

Charlie Munger is the long-time partner of Warren Buffett. Before they joined up, Warren concentrated on buying securities that were cheaper than others. In effect, buying the discounted vehicle in an intellectual capital arbitrage. Charlie taught Warren to buy good companies at a fair price. This switch can be seen in Berkshire Hathaway’s record of successes in buying both whole companies and stock positions, which in part is the reason we own the shares both personally and in our private financial services fund.

The recognition of a “good” company is in the eyes of the beholder. There is a coterie of portfolio managers who believe that they own and buy high quality companies in various markets and sizes. Each have found their own high-quality companies. A recognized common characteristic of quality companies is their owners reluctance to sell. Often, the only time they become available in the market is when a principal owners’ estate is selling them or when an owner is desperate for cash. Unfortunately, during periods of economic turmoil more of these jewels come into the market. We may have entered such a period.

When I look at a quality company candidate the last thing I look at is price, either in absolute or relative terms. The single most important element I look for when evaluating a company are its people. It is worthwhile remembering that the concept of an organized company comes from military organizations and groups of professionals e.g. weavers and goldsmiths. Companies were organized based on skill levels, discipline, and respect. Respect for other members of the company, critical clients, and others. Integrity within the company resulted in the reputation generated.

The same approach should be used in selecting partners in private relationships. As the sole owner of a private company who made a few acquisitions, including some that really worked and others that didn’t, I know what I am looking for in new partners who can share the enhanced value from our working together. Being smart is important, but smart is not necessarily brilliant. Smart people have a good idea of what they know and have the intellectual integrity to know what they don’t. It is the second trait that makes them good partners and different from those that are brilliant. Too often, those that are brilliant claim it is based on solving problems completely by themselves. In looking at people I find that this kind of brilliance is a sometime thing. In periods between bouts of creativity, brilliant people are often frustrated, frustrating, and difficult. Smart people, when they are wrong recognize it and seek help in new directions.

Another key characteristic to look for is high physical and intellectual energy. Often the most creative time for developing useful ideas is not during regular work time and rarely during committee meetings. The real test of a manager or management is how they work their way through problems. One will only know how good someone is when you know how they handle surprises and mistakes. Years after dealing with a crisis, some public companies  are still benefitting from their recoveries, e.g. American Express (salad oil), IBM (360), JP Morgan (whale), and Johnson & Johnson (Tylenol).

Most of the time owners of good assets are loath to part with them. We may have entered a period when more of these high-quality assets can be bought at “fair prices”, but not necessarily on the cheap. We should watch Berkshire Hathaway and other high-quality acquirers who take advantage of these opportunities. History suggests that these periods don’t last long.

A particularly difficult task in selecting companies or people is separating current popularity from long-term value creation, i.e. Hula-hoops vs. home equipment for exercising. A related concern is gauging the probability of solving future concerns.

The list of desired attributes is both long and difficult to determine and capture. Thus the strong likelihood that when they are found their price will not be cheap. If we have entered the “Munger” market, the odds may have improved.

    

       

Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html

https://mikelipper.blogspot.com/2019/01/excessive-security-risks-weekly-blog-561.html

https://mikelipper.blogspot.com/2019/01/completion-analysis-fuller-picture.html

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Insights from Mutual Funds in 2016 and Their Influences in 2017

Mutual Funds are Important to all Investors

First, funds are an important part of many publicly traded markets around the world. On a global basis they hold more than $44 Trillion dollars today.

Second, funds provide more relevant disclosure than probably any other financial sector.

Third, much of the less well disclosed institutional investments are managed by people who received their early training in the mutual fund business. Large financial institutions often manage mutual funds in addition to their other accounts.

Fourth,  in most countries mutual fund boards include independent directors and in most cases those independent directors represent the majority of the directors. In the US the annual investment contracts must be approved by the independent directors. These directors  have civil liability for their actions (or the lack of action).

Fifth, most mutual funds are managed by privately owned management companies or are part of large multi-product organizations such as banks and insurance companies. However, in a number of global markets there are publicly traded mutual fund management companies. Their disclosures reveal important trends as to the profitability of money management and related information. From time to time we have found these companies to be worthwhile investments.

Sixth, with the world's growing retirement capital deficit, it is important to recognize that mutual funds are a major gatherer of retirement capital. Of the $16 Trillion invested in US mutual funds, $7.5 Trillion were in identified retirement accounts about equally divided between employer-sponsored Defined Contribution Plans and Individual Retirement Accounts (IRAs). Upon exiting from employer plans, investors often place money into IRAs. 

The total US retirement market is $25 Trillion with the Defined Benefit Pension market flat and expected to decline as employers choose to shed the accompanying fixed and growing liability.  There is ample scope for Defined Contribution plans to grow and could lead to an increase in the size of the mutual fund share of the market. The average individual mutual fund is currently held between four and five years, more than twice the holding period for Exchange Traded Funds. Due to the lengthening of people's retirement period it is reasonable to expect that IRAs will remain open for at least twice to possibly four times the non-retirement money in mutual funds.  

Insights from 2016

1.   In the US market there was more money entering the fund business than leaving. From first glance, most of the net gain went into Money Market funds. However this gain occurred during a time when the number of funds declined. Due to changes in regulation most of the decline occurred in the Prime Retail Money Market funds arena. Considering the emotional turmoil caused by the US election and rising interest rates, it is not surprising that money flowed into Money Market funds. While a portion of the money in these funds will never enter the long-term mutual funds arena, some will.

2.   Due to automatic reinvestment of income and capital gains, distribution funds have another source of inflows other than net sales. For the first eleven months of 2016, reinvested dividends of about $42 Billion came in from this source to Long-Term funds which meant for the eleven months the flow into Long-Term funds was positive.  

3.   Appropriately in November there were net redemptions in bond funds for the first time. The redemption rate slowed for equity funds, particularly for World Equity funds.

4.   In the shortened time horizon that many advisors and brokers are using with their accounts, they are relying on the correlation among mutual funds and ETFs.  But these are not currently working. In the performance reports issued by my old firm, Lipper, Inc, now owned by Thomson Reuters, there are twelve investment objective averages of compound performance for the last five years (through December 29^th) between +11.83% and +13.80% . Nine of the thirteen were clustered at the 13% level. A nice tight group. These are funds grouped first by the size of market capitalizations within their portfolios. These include Large, Multi-Cap, Middle-Cap and Small-Cap. They are further sub divided by investment objectives into large, core and growth.

In 2016 the close correlations exploded. The Large-Cap Growth funds averaged a gain of +2.49% and the Large-Cap Value funds gained +14.93%. Hardly a tight correlation. Thus the fund selection criteria became critically important. Market capitalization did not help meaningfully in terms of the Large Cap. Actually if one ranked performance within this subset of 12 investment objectives, Large Caps where most of the money is, came in fourth behind in rising order, Multi Caps, Middle Caps and the winner was Small Caps.

Within the market cap segments, the choice of investment objective was even more meaningful. In each case the Value funds did better than the Core funds which beat out the Growth funds. Thus in the 12 fund categories analyzed, the best was the Small Cap Value funds which averaged +27.25%, compared with the previously mentioned +2.49% Large Cap Growth.

The real lesson in owning the best performing funds in 2016 was selection not correlation.

Looking Forward to 2017

1.   Though we are in a period of annual forecasts, in many respects it should be called the period of extrapolation. Most people including analysts and other pundits  draw on what they call the use of the brains, but their real pattern is elongating some past trends into the future without limit. This is natural and is discussed in a book entitled Seeking Wisdom from Darwin to Munger which was sent to me by Charlie Munger. The book ties in with the work that I have seen from Caltech; that the brain is essentially a memory device of personal experiences. Really bright people are not limited by their own experiences, they seek to learn from others' experiences current and past. That is why I say that if you slice a vein in a good analyst, an historian will bleed. Many of the published forecasts that I have seen as of today either extend the 2016 trends or one from November 9th. In my mind neither group has learned the lessons of 2016 which could be summarized as follows:

• Search for what is not in the data.
• Events can change perceptions.
• Many people are not forthcoming as to their plans.
• There is a need to learn from others with different backgrounds.
• Doubt much you have been taught.

2.   As one who is often described as a contrarian, I need to warn that after accruing the benefits of being a contrarian in 2016, there will be some times when the apparent majority will be right. (For a while and to a limited extent.)

3.   Unless you are primarily trading, looking at new highs is not often productive of big winners. My investment strategist son suggests one should look at the new low list which could be a better hunting ground for research. He is also more focused on industries rather than large segments of the market. For me, I focus on individual management of businesses that Charlie Munger and Warren Buffett would find of interest.

4.   Many Frontier market securities and some Emerging Market stocks have been beaten up pretty hard. In selected cases their prices have much less risk within them than before.

5.   The only two fixed income categories showing double digit gains for 2016 were High Yield funds +13.25% and Emerging Market Hard Currency Debt funds +10.75%. Be careful in 2017, these are taking on equity type risks without enough equity type gains.

6.   One possible way to gauge the level of excess enthusiasm is the cost to hedge against continued growth. It has been pointed out that the cost of hedging the enthusiasm for Small Caps is that the cost to hedge the Russell 2000 is very low. Options to protect against a decline in the iShares Russell 2000 ETF  haven't been this cheap since August 2015. While there could well be technical reasons for this, one should be on guard anytime it is too cheap to hedge.

7.    One of the lessons from the election campaign is that many in the middle class and the working rich feel that the economic future is limited. In the past many of these people would have been mutual fund buyers. It is their absence from the marketplace, not disappointment with results, which has impacted fund sales. To the extent that their post-election elation is real if they come back into the market, the bears on mutual fund management companies will once again be proven wrong.  

__________

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http://mikelipper.blogspot.com/2016/12/will-etfs-factor-investing-lose.html

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A. Michael Lipper, C.F.A.,
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