Diversification - Weekly Blog # 929

 

         

 

Mike Lipper’s Monday Morning Musings

 

Diversification

 

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

 

                                                                        

 

Preface

On a recent trip to London, Ruth and I attended a private fund and friend raising concert for the Academy of St. Martin’s in the Fields (ASMF), where Ruth is the first American trustee. The wonderful music was performed by Joshua Bell, the artistic director, and five other top-notch string musicians from the ASMF. Between the six talented musicians they played three different types of string instruments, alternating between lead and ensemble roles. The result was a successful combination of each of their talents.

 

Even when listening to a magnificent concert performance, I cannot forget my investment responsibilities. As individual musicians alternated from leading to supporting roles, it reminded me of what individual securities should do in a diversified long-term investment portfolio.

 

Application to Portfolio Management

In 1940 the SEC completed their depression-oriented reform rules. Among the last of these was the Investment Company Act of 1940, which unlike the other six regulations was not formed at their SEC headquarters. It was produced at the Mayflower Hotel in Washington by lawyers for the fund industry from Boston, New York (where the industry’s trade association was headquartered), Philadelphia, and Washington. Considering their recent experience of the market falling during the Depression, the mood of the meeting was to try reduce the chance of big future declines. The best model for that were state laws governing trust accounts, using generations of work by Boston and Philadelphia lawyers. (Even as late as the early 1960s a few Boston law firms had professional securities analysts on staff to assist in managing trust accounts.) Note, the main concern of the creators of fund regulation was the avoidance of losses. No word was spoken of making money on investments.

 

They thought the best way to reduce the chance of major losses was to limit an account’s exposure to any single investment. This led to limiting the percentage amount that funds could invest in any one stock, which usually meant no more than 5% of the voting stock at cost (not market). To this very day, most equity funds are labeled as diversified if they adhere to this principal.

 

The Problem with Voting Stock Limits

The biggest penalty paid by investors is not losses, but the absence of profits. Mutual Funds with long histories often make ten, twenty, or even more times as much on some of their holdings, which more than covers a small number of losses. Furthermore, great fortunes have been made, particularly over successive generations, in single stock portfolios or portfolios having a small number of investments.

 

For Professional Investors

The concept of risk management is critical but doing it by name or percentage of voting shares does not reduce risk, it may increase if all investments are exposed to a single concept. In the late nineteenth century professional investors considered concentration to be the best and safest way to invest. My college degree is from Columbia University, which had an endowment fully invested in railroad bonds and stocks, every single one file for bankruptcy. Today there is a risk that some participants in the “AI” surge could produce similar results by investing in too much in a good thing.

 

For publicly traded securities I suggest the biggest risks is with the stock owner and not the issuer, as they will be sellers of the stock before you do. Other risks include countries, technology, politics, and management. These can be identified as short-term and long-term factors. A possible short-term indicator is slightly more participants being bearish than bullish in the latest American Association of Individual Investors (AAII) survey of expectations for the next six months. Interestingly, the long-term indicator was Friday’s announcement by the Supreme Court, which ruled against the President’s authority to set tariffs using the International Emergency Economic Powers Act (IEEPA), which had very little to any impact on the market.

 

Bottom line, watch the musicians play and how well they work together, both with other musicians and staff, but also watch the reaction of the audience.

 

Understanding Going Global

In a recent conversation with a London-based fund manager, who in the past was almost completely invested in the US but now has a growing position in European stocks. While he has the biggest portion of his portfolio in US securities, he is very risk aware and expresses this by augmenting his portfolio with European stocks. Normally, he expects his US positions to outperform his European positions, but not in a declining market. In terms of P/E, Free Cash Flow, Dividend Yield, and other value measures, European stocks are less risky than US holdings.

 

 Another careful investor was Charlie Munger, who listed six principles to be avoided: High Financial Leverage, High Operating Leverage, Negative Cashflow, Poor Governance, High Risk of Obsolescence, No Competitive Advantage vs. a Strong Competitor.

 

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Mike Lipper's Blog: To Win Long-Term, Learn From Great Presidents - Weekly Blog # 928

Mike Lipper's Blog: Strategically, Time to Think Differently - Weekly Blog # 927

Mike Lipper's Blog: Do Current Prices Lead Future Markets? - Weekly Blog # 926

 

 

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Concentrate or Diversify, 2 Questions with 3 Answers - Weekly Blog # 594

Mike Lipper’s Monday Morning Musings

Concentrate or Diversify, 2 Questions with 3 Answers

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

I have been asked to respond to two intellectual investment questions that parallel real word actions. The first question comes from a long-term subscriber of these blogs. The second comes from my preparatory work for a potential investment management client.

1. European Portfolio Manager response to Sub-Zero Interest Rates?
2. Appropriate Structure for a Long-Term Charitable Account?

In my mind both questions revolve around the same risk management question. Is it better to concentrate one’s assets and energy or spread the risk by diversifying? Too often investment people view their problems as special and quite separate from the real-world problems of others. We do this at the risk of not seeing the universality of problems.

Perpetuation of the family/species is at the core of human and animal creation. Due to potential violence, insufficient food, and medical risks, some produce multiple offspring with the hope that some will survive. Others choose to produce a limited number of descendants and protect them carefully. This is the very same quandary that investors face, particularly those with responsibly for others.

One approach to a decision process with two alternatives is to create a barbell type solution by combining the two extremes of diversification and concentration. To be prudent we should not use this barbell decision model. The third element to consider is the presence of other factors, which often determines the appropriate decision.

Reactions to Negative Interest Rates
On the surface, paying a financial institution for the privilege of letting them hold your money, which they then lend out without sharing the proceeds with you, appears to violate Newton’s laws of physics. It suggests a collapsing universe rather than an expanding one, raising the question of why an investor would contribute to such a scam?

Jim Grant, one of the best columnists on fixed income, called for the end of the 38-year bond bull market in this week’s Barron’s. In his column he quoted from a 1981 article by Parker Hall, a deceased but old friend who heralded the beginnings of the bond bull market. Today’s question is somewhat more complex than just betting on a cyclical turnaround in bond prices. It has been made more complicated by the policy dictates of various governments for political purposes. Although interest rates are expressed in their local currency, e.g. euros, they are compared to rates in other currencies and are exposed to different inflation rates. Governments, officially or unofficially, direct their central banks to induce low interest rates to create and preserve jobs, often through problematic loans which create additional market distortions.

Most large fixed income portfolios are managed through or for the political establishment, making it difficult for many managers in Europe to meaningfully exit from negative interest rate paper. However, I am seeing some increased diversification into both high-quality corporate bonds and very long-term government bonds, including century bonds. The latter is interesting in that they’re betting they can, over the long-term of possibly 100 years, reinvest the low yielding coupons at higher expected interest rates. (It is worth noting that the biggest return in long-term bond investing is through the reinvestment of payments at current rates).

If European fixed income managers can get out of the euro they generally will, often by buying US paper. Most cannot and are therefore effectively corralled into the euro and forced to extend their maturities. However, there is a limit as to how much they can lengthen their maturity structure, as many portfolios are designed to pay pension benefits. In most European countries the retirement ages are lower than in the US, thereby limiting maturity elongations.

Portfolio Structure for a Charitable Investment Account
The payout needs for any account requires current cash to make payments. There are two main ways to achieve this. The traditional way is to let the gross income earned on the entire account make the required payments, but due to market price fluctuations the available cash will fluctuate. To the extent that current income is insufficient, proceeds from sales can supplement the cash generated from dividend and interest payments.

We are advocates of another approach which divides expected payment responsibilities into specific timespan portfolio sub-accounts. The most current timespan portfolio should generate the funding necessary to make required payments. This portfolio could be structured in a way where cash or short-term investments satisfy the payment obligations before being replaced with the next timespan tranche. The advantage of this approach is that it makes certain that current bills are paid, regardless of market volatility. It also allows the rest of the portfolio to be invested for longer term horizons.

Charities, even private ones, are fiduciary accounts that are distinct from personal accounts. No one must know how well or poorly one’s personal account performs. Most fiduciary accounts make reports as to the success of their investment program from time to time and the frequency of this reporting can influence how a portfolio is managed. Financial markets are by their nature volatile. Over very long periods a fully invested portfolio of reasonably selected securities or funds should produce a higher return than a portfolio that has frequent changes.

To some degree, in dealing with fiduciaries it is more difficult to manage their expectations than manage the performance of the funds and/or securities. Using a rough rule of thumb, the potential peak to bottom declines are as follows:

     A 10% decline - Three times in a ten-year period
     A 25% decline - Some time over a ten-year period
     A 50% decline - Once in a generation of approximately 25 years

Many investors do not achieve the general returns available in the market because of timing their moves in and out of the market.

Diversification reduces specific risks of individual securities. However, it also reduces the opportunity for doing much better or worse than the market average. Over an extended time period, wise concentration in a small number of choices produces the highest returns, but the results can be volatile.

Pulling these thoughts together the following structure may be appropriate for a charitable account, assuming a ten-year horizon:

     10% in Money Market funds and short-term US Treasuries
     40% in growth funds of various sizes, most in mid/small-cap funds
     30% in international funds, with 2/3rds in Asia
     20% in value funds

The selection of individual funds will be guided by risk tolerance, size of the account, operating procedures, and special factors. The higher the risk tolerance the greater the commitment to a concentrated portfolio of funds.

If you need help in constructing or reviewing your portfolio, please contact me.



Did you miss my past few blogs? Click one of the links below to read.
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https://mikelipper.blogspot.com/2019/09/excess-capital-less-equity.html

https://mikelipper.blogspot.com/2019/08/an-awkward-moment-with-frustration-not.html



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Be Aware of History

Introduction

My basic belief is that you can scratch an analyst and a historian will bleed. The good professors and scientists at Caltech tell me that our memories are a critical decision-making part of our brain. Thus each of us are to some extent historians. On this weekend before the historic Brexit referendum I thought it would be useful to selectively search history for clues as to future wise investment moves.

Lowest Interest Rates in 5000 Years

In Mesopotamia about the first recorded interest rate was 20%. That was the same rate charged in Babylon in 1772 BC as well in Italian cities about 1150 AD. The highest recorded rate was in 539 BC of 40+% at the time of King Cyrus taking Babylon. What may have been a spur to colonization of the US, English interest rates were 9.92% in the 1700s. To show the volatility in the US, our rates were about 1.85% during WWII. By the 1980s rates rose to 15.84% compared to the 0.25-.50% the Fed is using currently. The sources for this and other similar data are the Bank of England, Global Financial Data and a book by Homer and Sylla entitled “A History of Interest Rates.” Dick Sylla an NYU professor for many years has been the chair of the Museum of American Finance whose board I served on. The purpose of showing the historic swings in rates is to alert investors that a future surge in rates may not peak in the mid single digit range.

One of the very best chart readers I know suggested to me that the continuously offered 30 year US Treasury Bond has possibly reached a thirty-five year peak in a move that began in 1981. I am conscious that Treasury officials, the SEC, and various hedge fund operators are concerned about the illiquidity in portions of the Treasury market. This may well be the reason that the Treasury is not materially expanding the duration of the US Government Debt structure. As investor for clients and my family in equity funds I find that any potential disruption in the most senior market can be unnerving. The modern theory of equity investing is based on the floor created by the risk free interest rate on US Treasuries. Perhaps it could be suggesting that we should be looking for a sub-basement below the floor!

Historic Perspective on Brexit

I do not know which way the vote will go, but the way I look at the polls as of now the “leaves” appear to be winning. Regardless on the outcome unless there is at a least ten point spread, it is my belief there will be other elections in the UK and Europe both for leaving and joining. From a historic point of view one can see that Common Market is just another attempt at European unity which goes back to the time of Julius Caesar. All of these have failed in the end for two intertwined reasons, (1) lack of confidence in the leadership particularly and (2) the provision of defense of the life of the homeland. During the Spanish Civil War there was great fear of the “fifth column” of enemies in civilian clothes creating great damage. Today throughout the world this fear is again present in the inability to properly screen immigrants or perhaps their children.

In the developed world these fears (along with concerns about the future economic outlook) are leading to a decline in the rate of marriage as well as fertility. Demographic trends take a long time to develop and change slowly. In time these trends play a political role and the referendum and the coming US elections could be influenced beyond the political leadership’s expectations.

Risk Management

On a recent trip to Europe one of my good analytical friends who is now a US citizen but was born elsewhere was anxious to return to the US, a land of risk-takers. By implication he was decrying that most of the Europeans that he was talking with were not attuned to taking risks. I believe that the US has benefited from the fact that many of our ancestors had to take big risks to get here. But we are not as much gamblers as other people are. What we risk is our hard labor against long-term goals.

One liberal arts university whose board I sat on recognized the need to offer business related courses to keep its attendance up to the level that they could afford the professors and staff. The would-be business professors came to the board and were outlining what they wanted to teach. In one case they wished to teach risk avoidance. I demurred. To me they should teach risk assumption and therefore risk management. Our whole private and public equity culture is based on wisely seeking risk assumption at the right price and conditions. To an important degree this drive is missing in many countries, but not others -  particularly in Asia.

Getting Bullish

The essence of risk management is to take on risk when others shed it as much as possible or are reluctant to commit to a future. While both Brexit and the high quality bond market may prove to be hurdles, they are not absolute impregnable walls. When too many are in their foxholes or trenches, this could be the time to advance. Clearly if bad things happen there could be cheaper entry points if one is not too petrified to move. Thus, I would urge long-term oriented investors to begin or increase their equity investing. If they are having trouble finding the appropriate funds to use, I will be glad to help for awhile.

Question of the week: Will the outcome of Brexit change your equity allocation by more than 20%? 

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More Opportunities from Disruption + Confusion

Introduction

One of the relatively consistent habits of people in the global financial community is an insatiable focus on the current price trends and almost no focus on factors that may reshape their workplace. I see this right now, but I should admit by nature I am a contrarian and that I often focus on what I see coming over the horizon.

Financial Services Employment

Knowing people within the financial community I am conscious of an increasing number of senior employed executives looking for new opportunities and those recently “at liberty.”

Over the years this has happened a few other times and in most cases my friends have found new and profitable activities. During these periods I have said that based on the available people, on paper, I could form one of the best financial groups in the business. (The reason for the “on paper” caveat is knowing the personalities, I am not sure all of these experienced people could work well together.)

I perceive we have entered another and perhaps much larger such period. Recently I have had conversations with presidents of large and small investment funds groups, senior traders, strategists of various types, etc. Part of this personnel reduction is due to present and projected profitability squeezes. Part may be due to low (relative to the past) prices for financial organizations. As an investor in financial services stocks I am used to seeing this kind of cyclical behavior. Too many people within the financial community believe that their own value is similar to whatever is the current growth stock leader.

The problem of risk management is tied to the growing illiquidity in the markets which is addressed by Jamie Dimon on pages 19 and 20 in the JP Morgan Chase annual report^*. With his personal worry about abrupt rise in interest rates, it is likely that markets will become more illiquid and some traders and investors will be shouldering more risk.

^*A personal holding. I will be happy to send those copyrighted pages to subscribers who contact me. 

Using the often used phrase “This time is different,” I think we may be entering a new phase. For many years we have been going through a concentration phase largely through mergers or acquisitions. This trend could well see a reversal in the next couple of years and the individual investor could be the loser.

Government Interference in Compensation

On both sides of the Atlantic as well in selected Asian countries governments are interfering in the compensation practices of large financial organizations. Officially the politicians drive is to reduce the risk taking that leads to government bailouts. (A far better way to do this is to prohibit such rescues by the politicians in governments and particularly in their central bank dependents in sponsoring bailouts.) The latest action by the US government is to require those in senior jobs or those in a position to assume risk to have the bulk of their income to come from deferred equity ownership that will vest in 4 to 7 years and be available for recapture for cause.

New Enhanced Trading Groups

I suspect the real motivation on the part of these bureaucrats is to address their concerns for wealth inequality both on the personal and corporate levels. The initial rules are built on a scale with the greater the assets owned the more draconian the implications. The focus is on principal trading. If these regulations are fully implemented it is where the job and profit opportunities will be created. Instead of the bulk of trading being conducted on exchanges and by the members of the concentrated players, it will shift to smaller asset owners who control large amounts of clients’ money; e.g., Hedge Funds or similar non-deposit taking groups. These groups will have no obligations to the marketplace and/or to provide service to individuals. In effect we will have reinforced the kind of private markets that currently run most of the commodity and real estate markets. The new enhanced trading groups will need research for both decision-making and institutional marketing. Some of these groups will gather money through accounts, others may use private vehicles that that have similar characteristics to mutual funds.

Historically any attempts to legislate risk has only shifted to other locations including beyond borders. Thus the aggregate total of risks assumed is unlikely to change. People’s business cards and the location of some of their computer servers accessing the Cloud will change. By the way, the biggest source of risk for most citizens is the induced risk that is inherent in current government practices; for instance deficits, unfunded liabilities, and unaccounted for contingent risks.

The Enthusiasm Watch

As repeatedly set forth, I am on the watch for growing enthusiasm for stock prices as a warning device of a major top. Here are three cautionary signs:

• Only three of forty-four markets tracked by The Economist declined in the week ending April 20^th.

• Both in the US and Europe mutual fund investors are putting money into Fixed Income funds and out of Money Market funds showing a lack of Jamie Dimon’s concern about rising rates.

• Barron’s Big Money Poll of global money managers has 35% bullish and only 16% bearish with 49% neutral. However 59% are bullish on commodities. (They must have high confidence in their individual selection skills for their outlook for corporate profits this year is under 5% and under 10% in 2017. This suggests reliance on concentrated, less diversified portfolios.)

Standard Approach to Look for New Winners

One of the lessons I learned from an old market pro was to search the new low list for future winners. This is why I insisted on showing the lagging funds much to the annoyance of fund managements when I was publishing Mutual Fund Performance. I still believe it is a good exercise in the search of future winners. This view was reinforced with the arrival of Dimensional Fund Advisors' Matrix Book.

Near the very end of this interesting compendium were two pages that looked at twenty years of relative performance of developed and emerging markets which I found to be instructive. Below is a table for the last six years of the best and worst performing countries in these two universes:

Year	Developed		Emerging
	Best	Worst	Best	Worst
2015	Denmark	Canada	Hungary	Colombia
2014	USA	Austria	Egypt	Russia
2013	USA	Singapore	Taiwan	Peru
2012	Belgium	Spain	Turkey	Morocco
2011	New Zealand	Austria	Indonesia	Egypt
2010	Sweden	Spain	Thailand	Hungary

My data analysis points out how rare there is a repeat with only USA having a next year winning repeat and Austria and Spain repeating on the downside later.

Much more important in the emerging market lead, both Hungary and Egypt went from the worst to the best in a few years time.

Using the Hungary/Egyptian model I would be looking for opportunity in both Canada and Singapore.

Question of the week: How do you search for future winners?     

________   

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All Rights Reserved.
Contact author for limited redistribution permission.