Investment Markets are Fragmenting - Weekly Blog # 839

 

         

Mike Lipper’s Monday Morning Musings

 

Investment Markets are Fragmenting

Flows Going to Potentially Higher Risk

 

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

   

       

   

Why the Fragmentation?

The answer is simple, salespeople make money by getting investors to make investment choices. At the institutional level commissions have totally disappeared, and the same largely applies at the retail level too. However, “vigorish” is alive and well, just with different names for spreads, underwriting fees, and management fees. Passive clients may decide at some future point that management fees are not worth it.

 

A valuable client is one that is actively investing and directly or indirectly aiding in getting new active clients.  The value of a client occurs either through the flow of new money or the reallocation of the portfolio. The marketing agent is consequently a bit of a worrier when communicating with clients. Furthermore, there is a desire to introduce new investment ideas, particularly new types of securities or new investment markets. The marketer will often present him or herself, or their firm, as more knowledgeable than the client. Thus, the marketer can dominate the client more than they expect.

 

Performing Better with More Risk

What follows is a brief discussion of current possible ploys that might be suggested. In truth these ideas might be sound if executed when not so popular. If peers already hold positions in the new play, their length of time to the eventual peak and subsequent major decline is shorter.

 

There are a very limited number of investors who have trading skills, and that does not include me. Most successful investors hold a relatively small number of holdings for many years. These are the types of investors who own Berkshire Hathaway with the goal of transferring assets to heirs after they are gone. (I am one.)

 

Until perhaps this week, James Mackintosh a Wall Street Journal columnist, noted that “Four giant tech stocks added more market value than all other stocks in the S&P 500 for the last month.” I suspect many investors were enticed to buy those four stocks. Unfortunately for them, the only class of stocks to rise for the week ended Thursday were small caps. regardless of growth, core, or value orientation.

 

Many individual and institutional investors have portfolios consisting of stocks listed on the NYSE, usually with dividends. These investors might be enticed to invest in NASDAQ listed stocks due to the greater number of tech stocks. There is a belief that most short-term NASDAQ traders are better than those playing on the big board. In the latest week only 23% of NYSE volume fell, compared to 42% on NASDAQ.

 

The fastest growing asset class today is Private Investments, either individually or through funds. As is often the case, the biggest risk is not the issuer, but other holders. The sponsors of private debt and equity do not have an obligation to buy back securities, except at the terminal date. The secondary market is very limited, and prices favor professional dealers.

 

Jaime Dimon, CEO and Chair of JP Morgan Chase is worried about inevitable investment mistakes in the privates. Although he does not see a structural problem, I think there potentially is one for two reasons.

1. These securities are being sold to individual investors. When the public loses money, they often complain to the media and members of congress who are always pro regulation.
2. There are very few pension funds still operating. Many have promised fixed returns to government employees, which includes teachers. For years these plans have used interest rates much lower than current rates, many of which have been bought from insurance companies. I believe some insurance companies will go bankrupt if interest rates stay at current levels or go higher, with the retirement burden falling on taxpayers. Politicians are probably better at getting the feds to change regulations. A guaranteed payment funded by a variable (market) sensitive vehicle is dangerous.

 

What are Your Thoughts?

 

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Are You Getting Value from Numbers? - Weekly Blog # 758

 

Mike Lipper’s Monday Morning Musings

Are You Getting Value from Numbers?

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

            

 

  

Investors tend to be number hogs. They trust that the numbers they see represent reality, which sometimes they do. Most of the time investment solutions start and end with some form of equation.

 

We would be better off if we started and ended our analyses with qualitative descriptions. These could capture our depth of thinking on the topic and clue us into our weighting philosophy.

 

 If we can’t immediately use a numerical relationship, we tend to discard it. It would be more useful if we filed it under future problems. The rest of this blog is built on three numerical relations that have been ignored. I believe they have kernels of useful thoughts.

 

Value of Market Index Leadership

Among the market indices, I pay particular attention to three. The Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ composite. I believe the particular index leading or lagging the other two is descriptive of the type of leadership driving the general market.

 

Regular subscribers to these blogs probably noticed I was getting increasingly bearish starting November 2021. This was because the NASDAQ Composite hit a new high in November, which was not followed by the other two indices. Furthermore, the NASDAQ was driven by tech companies, which seemed like a stretch. Projected gains as a percentage were greater than the prior percentage gains. The bulls on these stocks were probably overextended.

 

Currently, the index flashing caution is the S&P 500, which on down days flirts with its historic lows or scores a minor low. It remains very close to its low for the year. At the very same time the DJIA has risen most and is least analyzed by professionals. I call this weak leadership.

 

As of Friday’s close, the S&P 500 was up 5.41% and the NASDAQ up 0.56% from their respective 2022 bottoms.

 

How Much Do You Know about Your Stocks?

Many investors, including some professionals, treat some of their stocks and CEOs as icons to be followed regardless of results. Two of these are Warren Buffett and Charlie Munger. I would suggest that stock or political investors who do not regularly read Berkshire’s quarterly SEC form 10-Q are not being prudent.

 

In the latest 47-page edition they go through both the tax and legal reason they conduct business the way they do. The 10-Q was published this Saturday and most of the press focused on the reported loss resulting from price declines in their equity portfolio, as well as storm and accident losses in their insurance complex.

 

This information resulted from required SEC disclosures. What many articles either ignored or only later covered was the increase in operating earnings of the wholly owned, or at least 20% owned companies. Buffett and Munger believe that operating income is the real measure of their company’s progress. (They fought the SEC about the requirement to include the price movement of their portfolio in earnings per share, rather than just showing it as an adjustment to book value.)

 

They run the company as a giant trust account for the heirs of the present shareholders. As both an owner and portfolio manager for family and other accounts, I agree with them. Matter of fact, that is the way I look at most of my long-term holdings. To me, the after-tax free cash flow earnings of a company is the most consistent measure of an operating company.

 

When I use mutual funds and other portfolio holding companies, I recognize that outside people value the company by its actions in the market. To me, the impact of market action is a cyclical phenomenon, having more to do what other owners are doing with their assets. It is not the reason I hire managers to grow the assets for the beneficiaries of my efforts.

 

I therefore need to track both the after-tax operating cash flow and market input to judge the skills of my operating managers. I also need to evaluate how well I react to what the market does to my owned assets.

 

Believing a reasonably well selected portfolio of assets will rise through inflationary and other periods, I can be patient.

 

Selective Review of Prices Is Appropriate

Nothing about prices and the actions of people is guaranteed to be repeated exactly as it was in the past. Nevertheless, from time to time it makes sense to review what has happened in order to think about future portfolio actions.

 

The following are views of market analysts of a major financial-services company worth considering:

1.   US Treasuries may see a major bottom in March-May ‘23
2.   Some expected inputs that may also bottom:

A.   Lower Consumption

B.    Higher Savings

C.    Selling of stocks by retail

D.   Major Credit Events

3.   China to re-open

4.   Similarities with the 1973-first quarter - 1974 pivot

5.   Small Caps, which are not a target of government, will lead the market. A trend that could last five years

The next two years will be difficult, because enforcing discipline will be tough. Nevertheless, it is time to rethink investment strategy.

 

What are your thoughts and plans?

 

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A. Michael Lipper, CFA

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Selecting by Market Cap Can be a Trap

Introduction

Selection and diversification policies should be based on meaningful investment filters. To win and maintain accounts most institutional investors need to surmount brief discussions with consultants, “gatekeepers,” investment committees and similar part-time investors.  To make those that hold the keys to the managers’ revenues satisfied and retained, is to make comparisons easily understood. Only a weak client relationship will focus primarily on performance. This way of thinking was driven home to me last week.

Market Capitalization Traps

During the week I met with two investment committees, entrepreneurs and their advisers, and two publicly traded fund management companies in New Jersey, Monaco, and Toronto. In each case present and future investment performance was at the heart of the discussion. The comparisons used most often pivoted around easily definable groups, such as market capitalization. For instance Small Caps, S&P500 (which is essentially Large Caps,) or MSCI World Ex-US (again Large Caps).

Questions from the Audience

In Monaco I was asked how much should a portfolio hold in Small Caps. At that very moment my dilemma became clear. In the audience there were CEOs and their advisors/investment bankers from about twenty hopeful companies. Clearly it would have been foolish to perpetuate the dream that all similar market cap stocks or funds  could become holdings in a prudent portfolio. In answer to a question I did suggest for that particular audience that in my construction of the Endowment Portfolio within the TIMESPAN L PORTFOLIOS^® depending on other factors a reasonable range for Small Caps could be between 15% and 40%.  Depending on facts and circumstances, a different range of small-cap investing could be considered.

Good and Bad Small Cap Stocks

One of the advantages of the give and take of question sessions is it makes you search for a quick suitable answer. Hopefully in my case it leads to a more thoughtful review of the topic. After much thinking and considering marketing factors, I know what I should have said. Small Caps are not a separate and distinct asset class. There are good Small Cap stocks and bad ones, and buying a stock just because it is a Small Cap is unlikely to give an investor a competitive investment.

Investor Selection Screens

More meaningful selection screens should be a function of the present and future enterprise risk and reward. The results should then be married to a separate analysis of the stock. To me the single most important risk element is that of the co-venturers, those presently and likely to be in the stock. What is the risk of one or more other sizable co-venturers moving in advance?

Another element would be the present price discount as to the future. There are countless other filters including some proprietary measures that can be used as screens. What I look for regardless of size are companies that are in businesses that I have some competence in; e.g., money managers vs. biotech where I believe that my view of the future is not already in the price.

Research Cuts at Major Banks

Having indicating my preferred way of analyzing securities, I believe that we may be entering an era when there will be bigger discovery value in Small Caps than what we have seen in the last decade. This week The Financial Times had an article reporting that research staffs at major banks have shrunk perceptively. This was not due to a view of the declining value of the research effort, but rather a reaction on the need to pay for increased compliance costs combined with restrictions lowering profitability on the use of the mandated regulatory capital. The cutback in the banks’ analytical forces will probably result in less analytical work to add new names at the edges of their portfolios, however the cut-back may also create opportunistic buying occasions.

Most banks need to have as good analytical coverage as possible on their clients’ holdings. As mutual funds are completely discretionary they can more easily add new names with appropriate research coverage.

Travel Cuts Too

Within 24 hours I flew in the business class section on an 80 minute flight going back and forth from Munich to Nice. On each flight there were people dressed in investment clothing of bankers and family office types carrying financial publications on the way to and from Monaco. In each case the business class section was less than half full. This may be normal German tight expense control particularly on such a short flight, but I had the impression that this was something of a new experience for them.

 Investor Opportunities

In Monaco I was the keynoter for an investment conference where there was only one representative of a major bank. The decline of major bank research and conference/sales participation may be an opportunity.   I think small cap buyers will have fewer competitors in finding good investments as these companies are the major contributors to domestic job growth.

This Week’s Concerns

There are a number of topics that I will be working on during the shortened Thanksgiving Week, as follows:

1. Trying to understand the dichotomy between favorable indicators for the stock market and cautionary signs for the bond market; e.g., a sharply falling Barron’s Confidence Index (an inverse indicator for the stock market) VS.  best quality bond yields dropping 14 basis points. This compares to only a 5 bps decline for intermediate credits, a widening of High yield spreads, a dearth of ratings upgrades and low reported core revenue growth.

2. In a reaction to some negative to flat performance results around the world, except in Japan, many marketing driven managers are becoming advocates of alternative investing. While there are a few quite successful practitioners, most are not producing significantly positive results and those that are garnering returns are doing so below the funding needs of their fiduciary accounts.

Disaggregating the performance of these groups may be a useful exercise. In the week ending Thursday the average US Diversified Equity Fund gained 1.32% with none of the alternative fund averages doing as well. This may be explained either by their total expense ratios being higher than the average funds or the fact that some of their extreme tactics are not working; e.g., 161 Dedicated Short Biased funds fell -3.22%. Some alternative funds may use leverage to magnify their results, 194 Equity Leveraged Funds gained 3.52%. For the year to date the short funds declined -7.47% and the leveraged funds dropped -6.75% as compared with a minuscule loss of -0.12% for the US Diversified  group and most alternative funds producing less than plus or minus 1%.

Question of the Week: What are your thoughts on the two topics above?

Thankful Harvests

As we move into the traditional harvest season, Ruth and I celebrate our blessings with family and friends on our Thanksgiving. This year we will be particularly aware of those less fortunate and particularly those who have lost dear ones through the violence of the last week.

Copyright © 2008 - 2015

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

Will Fund Classification Hurt Your Fund Selection?

Introduction

I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases relative performance is very important. My concern is that most benchmarks be they securities or fund indices are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional  “gate keepers” or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the US. According to McGraw-Hill Financial’s survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies’ foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources.  As a matter of fact I found four which had foreign sales of over 75%. Since for many years sales outside of the US have been (in local currency terms) growing faster than in the US, I am willing to bet that a number of funds that are characterized domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher quality small cap funds had a relatively good third quarter performance (see many of the Royce^* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important on this Sunday when the Financial Times reported that the Brookings Institution announced that the global economy is coming back, being led by the richer countries. For the moment the classification of small cap appears to be working. Nevertheless, from a selector’s view point it is a flawed classification.

^* Owned by some of our accounts

Better Classifications

Originally funds were slotted into classifications solely on what the funds’ marketing people claimed they were. Over time this yielded to the language in the prospectus created by the firms’ lawyers. Increasingly their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards as to earnings growth, price to book value, yield, market capitalizations and other measures. The data sources for these were the unadjusted financial statement statistics.

As both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed.  I have already pointed out that higher quality Small Cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors.  Other such measures might have to do with the difference between turnover in dollars vs. turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float and there are others.  Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

Bottom line: Pure performance ranking numbers in one period are not an important selection device today.

What screening devices do you use?  Please let me know.

Readers’ Service

In last week’s post I mentioned that Colin Camerer, a Caltech professor that we supported with help for his post-doc students, had just won a MacArthur fellowship, often called a Genius Award.  He sent me his collaborative article in the Neuron magazine, entitled, “In the Mind of the Market: Theory of Mind Biases Value Computation During Financial Bubbles.”  The work shows that during a bubble, the “smart guys/gals” get caught up playing what we used to call “the bigger fool theory.”  Please let me know if you would like me to email the article to you.

___________________

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