Are We Complacent or Petrified?

Introduction

On my recent one day visit to San Francisco when I spent 12 hours on planes for a two hour meeting, I chatted briefly with what seemed to be an intelligent stewardess. She wanted to know whether any of the papers I was discarding would make her rich if she read them. I suggested that she should enter the pilots’ cabin and learn to become a flight captain. She demurred as her friends who were pilots were mostly bored when flying these airliners. (Of course, boredom can turn to panic when something goes wrong.) Her comment echoed in me when I read that Dave Tepper, the New Jersey-based, very successful hedge fund manager was quoted as saying the market had an air of complacency. Examining my own and others' current thinking, I believe our low level of activity could be that we have become petrified.

Why are we petrified?

Sir Isaac Newton introduced the concept that God was the watchmaker in the sky that kept all the physical forces in balance so it would appear that many countervailing forces were in balance. During this period of extremely low stock market volume we instinctively should be taking advantage of apparently reasonably priced securities. Except that our somewhat undefined fears or constraints are playing off against one another, so we are doing nothing.

What is the import of these messages for bonds?

Both German and more remarkably French 10 Year bonds are yielding below similar US Treasury bonds. The lower yields are caused by investors pushing prices up and therefore yields down as German and French bonds appear safer than those of the US.  At the same time the spreads on the five year TIPS have widened which is somewhat counterintuitive. If the dollar appreciates due to higher rates, in theory, both inflation and recession risks should decline according to Moody’s^*. The desired loosening of underwriting standards for mortgages as dictated by the government brings fears that we are once again starting another residential housing bubble.

In terms of stocks: more confusion

One way to look at the stock market is to use a military approach. The large caps or if you will, the generals, are leading the grinding march upwards while the smaller caps are in retreat. In April, of the 10 S&P 500 stock sectors earning estimate revisions, telecom (+15.8%) was the only double digit gainer and discretionary (-10.2%) and financials (-11.0%) were the double digit losers. Five sectors were up and five were down which showed that within a relatively flat market there was a lot of selectivity. This selectivity was even more pronounced when one looks at movement within market capitalizations. In terms of price movements by sectors, eight of the large caps were up; led by energy (+5.11%) and utilities (+4.2%). In contrast for the S&P Small Cap 600, eight of the sectors declined, however the same two were the leading sectors but with much smaller gains of +1.84% and +1.08% respectively.

Thus hiding out in large caps has worked as it has in the past in a nervous, late stage bull market.

Better valuation methods

I am pleased that S&P is providing both reported estimated earnings price ratio and their estimate of changes in operating earnings. First, I have never been comfortable with the academically derived CAPE (Cyclically Adjusted Price to Earnings ratio) approach to valuation; i.e., accepting reported earnings as a basis for valuation. (Having run a company albeit a small private firm I am very conscious of the difference between operating earnings that one can spend and financial statements' bottom lines.) Second, the current market only looks reasonably cheap if one buys into the forward estimates. For example, the P/E for the S&P500 using 2013 earnings was 17.74x and 26.01x for the S&P600 (small cap) both declined using what looks to me a very generous estimate for 2014 price/earnings ratios of 15.1x and 17.99x respectively. The reason for my skepticism is based on S&P’s estimated gains in operating earnings, +17.51% for the 500 and +44.56% for the 600. In the latter case this is almost 3 times the operating estimate gain for 2013 of +15.96%.

The problem with too generous estimates

To my mind the overly generous estimate of operating earnings gains for small caps in 2014 is to some extent petrifying me in my investment management responsibilities. As regular readers of these posts know, I believe in utilizing time spans to segment portfolios. The longest time span is for a family fortune or an endowment for future users of an institution. Recognizing that a portion of the future belongs to those that successfully disrupt the markets of today, most often this kind of guts or perhaps desperation is found in smaller companies. Thus, smaller companies, particularly those found in small funds are a regular diet for most of our accounts. While I am looking for quintuples or “ten baggers” in this kind of merchandise, I can materially cut our returns by paying too high an initial price. Perhaps the very recent 10% correction in NASDAQ prices helps a little but not enough. I need a substantial discount in many of these biotech and new technology stocks which to use Warren Buffett’s term are beyond my circle of competence and thus I use appropriate mutual funds and related vehicles.

Count our blessings

The fashion of the times is moving away from the old numerical fads such as Modern Portfolio Theory (MPT) which was modern in the world of physics over one hundred years ago, had nothing to do with the construction of winning portfolios, and was a very much an unproven theory. During this current particular phase in the stock market as correlations within and among stock groups breakdown, we will need a new set of blankets to cover the different speeds the various proverbial horses are running. I would suggest two general approaches; the first has to do with operating results and second the nature of the ownership of the shares.

Correction: Last week I inadvertently gave a Caltech Degree to Charlie Munger which was not the case. He did get an education on meteorology from Caltech which probably helped him to become a very successful lawyer and investor as well as a partner in Berkshire Hathaway’s^* operating and investment success.

^*Owned personally and/or by my private financial services fund

Question: What are you looking at to characterize this market?

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Opportunities Gained Through Losses for Some

Highlights
I.            The Best 401(k) and New Opportunities 
II.          Seth Klarman’s Warning and Permanent Losses  
III.       ISEEE White Paper on Emerging Companies

Introduction

This last week a number of things have occurred that will intrude on my work in the next several weeks.

Regular readers of these posts have learned that there are two related themes to my investment thinking. I am very wary of a future peak leading to a major stock price decline and I am impressed with the value of time horizon portfolios.  

One rarely appreciates the advantages or disadvantages that accrue to individuals based on the time they enter their first professional jobs. I began my first professional investment job in 1960 as a junior analyst/trainee. I was part of the second wave of young people to enter the business in a long time. Some others entered Wall Street about 1955. Each of the phalanxes moved up the ladders very quickly to replace the managers that were scarred by the tales of the Great Depression. Many of these managers (and more importantly, their clients) were extremely afraid that the post-World War II boom was about to end and therefore were reluctant to buy stocks in the early 1960s. Their clients found them to be wrong by 1968 if not earlier, and allowed us relatively unseasoned analysts and portfolio managers an opportunity to make important investment decisions. Out of these experiences I became conscious that the larger losses suffered because of the collapse of stock prices in the 1929-1932 market were not the dollar losses sustained. A much larger loss that many investors and their heirs suffered was caused by former investors or their friends and relatives neglecting to reinvest into the stock market. They lost huge opportunities to make a great deal of money.

Ever since that recognition I have been focused on not making that mistake for myself and clients. This is exactly why I believe in creating investment portfolios structured to meet needs for different times. I have little confidence in my and most others ability to make correct risk on/risk off decisions.

The #1 401(k)  - Our client 

For many Americans a large part of retirement savings is in their 401(k) salary savings plans sponsored by their employers. From my point of view as a manager and consultant to a number of these plans they should be invested for the long-term, utilizing my time horizon approach.

Each year BrightScope creates a list of the best 401(k) plans. This year they named the Second Career Savings Plan of the National Football League (and the NFL Players Association) as the number one in the country. Numerous factors were considered including total fees charged. Because of participant choice they did not measure aggregate performance. I can clearly state that investment performance was good as does the plan sponsor. This has been satisfying to all who have been involved.  I wish them well in the future. After twenty years of working with the plan,  I have elected to pursue other opportunities utilizing our expertise and efforts. They should do well due to the generous employer contribution and the structure and administration of the plan.

Seth Klarman’s warnings and permanent losses

Seth Klarman is a well known hedge fund manager that is used by some of the non-profits whose investment committees I sit. He has sent back cash to investors (rather than investing it), so his latest letter as published by John Mauldin is not a complete surprise. Let me summarize his points as follows:

• Most investors are downplaying risk and this never turns out well.

• Maybe not today or tomorrow, but someday a collapse may occur.

• The pain of investment loss is considerably more unpleasant than the pleasure from any gain.

• Correlations will be extremely high.

• Investors in bear markets are always tested and retested.

Analytically, I agree with Mr. Klarman’s cautions, but I do want to put them into perspective. For those accounts that have long-term needs beyond ten years, I would be reluctant to place less than 50% of the value of the portfolio in risk-assuming investments. I do recognize that in periodic down markets the major stock market indices can decline 50%. The decline from the peak in 2007 to the bottom in 2009 was 57%, with many good managers losing more. The recovery since the bottom has more than made up from the loss and then some additional gains, often more than 50%, above the former peak.

What to do?

Along with most professional investors, I do not posses the market timing skills of Mr. Klarman and a handful of others. Nevertheless, I am conscious of his warnings. Thus, recently I cut back on two of the largest and quite profitable stocks in my private financial services fund. Also I am reducing some of the positions in Small Cap funds in our managed fund account portfolios after they have performed very well and have no or little cash reserves. These moves will not be sufficient if I am totally surprised when the next major decline happens. I am, perhaps foolishly, expecting a more speculative rise before the peak is reached. There are two clear parameters to my thinking. The first is to get prepared for a decline and the second is not to get too long-term bearish as to flee from taking risks for long-term gains opportunities.

ISEEE white paper and emerging companies

There is a very healthy tendency of people in the global financial community to meet and discuss, often heatedly, their views as to the investment future. I belong to a couple of these and learn to appreciate from other professionals’ experiences. One of the groups I recently joined is the International Stock Exchange Executives Emeriti (ISEEE). This is a group of present and former senior stock exchange officials from around the world that meet periodically. Evidently my term of office as the Chair of one of the advisory committees to the board of the New York Stock Exchange qualifies me for membership. For a number of years the group has been concerned about the general inability of emerging companies to get adequate financing in most of the world’s markets. 

Next month at the ISEEE conference at the Museum of American Finance^* in New York (one of their conferences around the world) the topic will again be discussed. I have been asked to prepare a brief white paper on my concerns for losses while investing in emerging companies. There is no doubt that there will be some outstanding successes where capital will be multiplied numerous times. On the other hand, it is almost axiomatic that there will be loses sustained by inexperienced investors.

I don’t know that large losses can be prevented, but there are two concepts I am going to try and develop. The first is that various restrictions  caused by the regulators and case law should be modified to present more information about future plans and greater discussions as to the specific market opportunities and threats the company is likely to be exposed. The UK polices are more helpful than those in the US. A second proposal that also surfaced (to the best of my knowledge in some UK reports) is that each emerging company offering needs to require at least one or more institutional investors, with perhaps a required carve out of 10% of the offering. I have some other ideas that I might include.

I find it a bit ironic that for this conference I will be sitting in the old banking halls at 48 Wall Street, the former home of the Bank of New York, my first professional job after leaving the US Marine Corps.

I solicit the readers of this post to share their thoughts as to how we can protect investors from losses but still encourage them to be lifelong investors.

^* I am a trustee of the Museum of American Finance

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Copyright © 2008 - 2014

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

 

Our Arrogance Hurts Our Investments

Today’s blog may be uncomfortable or argumentative for some.

This is the season of arrogance. With one US political convention over, the next one about to start, and a major hoped-for policy speech from the chair of the US Federal Reserve, each event characterized by speakers proclaiming that they are correct on all issues. At no point during these polemics did any of the speakers ever admit that they have been wrong in the past and that their espoused policies could produce any negative impacts along with their expected good results. Beyond the US, various other politicians are singing the same song and will do so until this election cycle ends in 2013. Think about it, with the exception of our spouses and significant others, do we know of anyone including ourselves who has not made mistakes and is likely to make at least some mistakes in the future? To deny the possibility of human error on our own part is the height of arrogance to me.

We should not assume too much guilt for our individual heights of arrogance; politicians of all types are much more professional in their arrogance. As distinct from the rare statesman or stateswoman, the self-interests of a politician require observing the audience closely. When there is a movement or a high profile issue, they quickly get to the head of the parade and become the loudest advocates as to where the crowd wants to go. People want to ignore deficits, the critical threat to our capital and possibly our well-being and safety.

The imminent threat

The growing deficits with spending in excess of government revenues leads almost inexhaustibly into transferring wealth from private domestic owners to the government and foreign lenders. The transfer of wealth is unlikely to create new wealth through productive investment, but instead goes into immediate consumption. This is precisely where the second stage of our arrogance comes into play. We are all consumers of government provided services, including protection from foreign and domestic enemies, transportation subsidies, healthcare, and useful regulation. Much of what we consume is involuntary such as military and police power. But as individuals we feel entitled to these services. (We thought we paid for them which often not the case entirely.) This is what we think we are “due.” However, many feel that the money the government spends on others because of their unsafe life styles and similar protections and benefits are wasteful and create the shortfall in government revenues. We arrogantly defend our own expenditures and deprecate money spent on others (perhaps less deserving).

Where does our arrogance come from?

From the moment of our birth to the very present, we live in a competitive world. We compete for the attention of our loving parents. In sports we compete for position and rank. In business we compete in this “dog eat dog world.” This week Newsweek published a list of the 25 most stressful colleges. (I am not endorsing the magazine’s methodology or the conclusions that the graduates from these top 25 highly selective colleges will perform the best in life.) What I found of personal interest is that in the case of nine of the colleges, our family or close friends attended or are senior officers. This result gives me an insight as to why so many that are close to me are so intense. They have been trained through the process of generating stress to be strong in their opinions. I suspect that this kind of training in civilian colleges mirrors the stressful training in the military which also produces intense and we hope aggressive military leaders.

Solutions

When arrogance meets arrogance nothing gets decided as long as there are two or more left standing. What is desperately needed is to attack the low-level of efficiency in large areas of spending. This is difficult and requires important levels of good will on all sides. If we can put a vehicle on Mars we should be able to solve our traffic problems on Earth. Think of the economic benefit to society if commuting and shopping times were greatly reduced! I suspect the use of iPads at an early age could well free teachers’ time to instruct and to bring learning into the home so that parents can participate alongside their children. We also need to have sufficiently stable tax and administrative rules that permit businesses to confidently plan expansion. There are many other ways that we can use our talents to make and spend money more efficiently.

Arrogance and my portfolio

The most dangerous portfolio is one managed out of arrogance. There are far too many individual and institutional investors who have predicted the investment future and will only act when the present conditions meet their perceived future. They could eventually be right, but I doubt it. Over the years I have been blessed with many private conversations with some of the best equity managers in the world. What has struck me about these conversations is that most of the time these “fishermen” wanted to discuss the ones that got away. Often there was a discussion on what mistakes they made and how they have modified their investment behavior. If the great can learn, then I think we can all learn if we are not too arrogant.

Where to find the less arrogant

One of the worst things that Fortune magazine and other media did was to be the first to rank companies on aggregate sales.  Sales rank alone is not a particularly good measure for investment or even job opportunity. Nevertheless, large companies often quote with pride their sales rank and mindful of the list, possibly consider acquisitions more favorably. Bigger is not always better. (A study of the Newsweek 25 stressful colleges also demonstrates this principle.) Bigger does mean more people and higher compensation for senior executives. Often the leadership of large companies become isolated. As demonstrated by politicians around the world, the more isolated the leader becomes, the easier it is to become arrogant. Large companies also attract more media attention which gives their leadership more opportunities to pontificate and lock themselves into arrogant positions. Further, with so many ETF type products in the marketplace the chance for breakaway performance for a mammoth company is somewhat less. For these and other reasons we would want most portfolios of funds to have a few reasonably concentrated Small Cap funds managed by experienced portfolio managers who are not arrogant. For the more venturesome, investing in small companies internationally may be rewarding but stressful.

What do you think?

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