PROBABLE VIEW OF NEXT DECLINE - Weekly Blog # 576

Mike Lipper’s Monday Morning Musings

PROBABLE VIEW OF NEXT DECLINE

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

Preface
My focus in building portfolios of mutual funds is to meet the needs of multiple generations. Nevertheless, I pay attention to very short-term inputs as well, like last week.

Tariffs Rising, Stock Markets Decline
Global stock markets fell last week after rising for four months and it may suggest the structure of the next major decline. Last week 57 of the 72 price indicators for stocks, ETFs, commodities, and currencies were lower.

Using the performance of mutual funds may show some important lessons about the decline.

1. S&P 500 index funds    -1.56%
2. Large-Cap funds        -1.40% 
3. Mid-Cap funds          -1.34%
4. Small-Cap funds        -0.81%

The performance array suggests that the sellers were seeking to reduce risk were often the same trading-oriented investors who drove up large-caps, particularly tech-oriented stocks. Index funds are required to be fully invested with no cash, whereas the large-cap funds had some cash to meet immediate redemptions, helping to cushion their declines. Investors who prize liquidity were less interested in mid-cap and smaller-cap investments.

We noted a similar pattern with SEC registered global and international funds, where large-caps declined more than mid and smaller-cap funds. The classification scheme for funds registered beyond the SEC is not identical to that used in the US, so it is more difficult to make identical conclusions, but looking at individual funds I think the tendencies tend to be similar. It is worth noting that fixed income appreciated during the week when equity funds declined

The Origin of Value Investing Leads to Confusion
Just as economists wish they had the certainty of the laws of physics, academic courses teaching value investing were an offshoot of accounting courses. Their first illustration was of stocks selling below their “net-net” value, current assets excluding inventories greater than all liabilities. This measure also excluded fixed assets. An investor did not need to know the value of inventory, fixed assets, or non-financial assets like customer lists and intellectual property.

In the days when analysts were labeled statisticians, a net-net situation did appear occasionally, and financial liquidators often swooped in and attempted to conduct a fast liquidation. These are quite rare today. Nevertheless, most value investors believe they are buying shares at a major discount from the net worth of the company. There are a few problems with this approach.

1. It is exceedingly difficult to liquidate a company quickly for tax and other regulatory reasons. Thus, the number of financial buyers has been reduced.
2. To replace financial buyers value investors instead sought out strategic buyers. The strategic buyer was often better able than the current management to see that they could make money out of the target’s assets. Even if this view is not naive, it is not easy to execute quickly. While one can attempt to tie up critical people, they may not work as hard after they become richer or older, particularly for a different generation of management. Customer loyalty will be tested by the competition and may have to be re-marketed to be assured. 
3. In a period of low interest rates and less stringent loan covenants, marginal competitors can enter on a price basis. 
4. Enticing discounts are derived from a reasonably fixed value and most fixed values are directly or indirectly tied to the value of a currency. Currencies fluctuate in value for lots of reasons, including relative inflation and interest rates.

I still believe in value investing, but it needs to be less of an accounting statistical approach and more in the hands of a proven merger & acquisition group, with excess talent and capital, or cheap financing.

A Place for Value Investing in Diversified Portfolios
Simplifying construction of an equity portfolio into growth and value components is a useful approach. Depending on the various time spans of expected outflows, the portfolio manager should be allocating to some investments that appear to have a reasonable chance of providing an acceptable total return over extended time periods.

The level of predictability will often define a growth company and they will be subjected to many successes and a few failures. Cyclicality will also generate different levels of expectations and enthusiasm. Far too many investors view growth stocks on a short-term basis, making them volatile. While volatility in and of itself has little to do with long-term performance, it can make for some anxious reporting periods.

To dampen reported performance swings value-oriented investments can help, particularly in periods of rising interest rates. Since most investors are less attracted to value-investing, they tend to have less market sensitive volatility and generally have fewer negative surprises leading to price drops. For example, within the same portfolio one can hold stocks that will benefit from the change to electric vehicles, big data, and scientific breakthroughs, along with some financials that are selling below their normal 25% discount to acquisition value.

Hope for All of US
Neuroscientists at Caltech and other places have determined that people, at least short-term, can be trained to learn new things. Evidently, the trick is to attach new thoughts to an existing thread in our minds. As I spend a good bit of my waking life studying markets and people, I hope that I can continue to learn. Hopefully other investors will also learn and that will create better markets.


WHAT DO YOU THINK?   

   

Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/05/2nd-of-mays-good-lessons-weekly-blog-575.html

https://mikelipper.blogspot.com/2019/04/value-investing-will-be-superior-but-it.html

https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html



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A. Michael Lipper, CFA

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How I Invest Using Conglomerate Analysis Tools

I suspect we all go back to thought patterns that brought success to us earlier in life. As a junior analyst I was assigned to follow steel, farm equipment, electronics, auto parts, aerospace and broadcasting companies. As I matured as an analyst I realized that many other analysts preferred to follow companies that were within one industry and that complicated companies (particularly those that were essentially works in progress) were shunned by a large number of good analysts. Providing “sell-side” (brokerage research for institutional investors) was and is a highly competitive endeavor.

I have always been attracted to investments that have unrecognized opportunity and less competition. Thus I started to follow a limited number of multi-industry companies that combined manufacturing activities with a capability of making reasonably priced acquisitions. These companies normally had at least some important activities in defense work (electronics), broadcasting and original equipment auto parts manufacturing. Thus, I became one of the first analysts to specialize in what became to be called conglomerates. In order to handle the complexities of each of these quite different stocks I developed a number of what were for me, useful analytical approaches. In some respect a number of these approaches were looking at conglomerates as unrecognized and unregulated closed-end funds, typically selling at significant discounts.

Several of these approaches of dealing with complexity and under-appreciated investments are useful to me and to my clients as we invest in funds as well as individual financial services stocks.

Professor David Dodd taught me well

Most analysts start and in some cases end with the financial statements issued by a corporation. I had the advantage of taking the Securities Analysis course under Professor David Dodd of Graham and Dodd, the authors of the first main text on and titled Securities Analysis. One of the many lessons he taught me was not to accept the financial statements as published. He wanted us to soundly reconstruct the statements for their investment use as distinct from their creditor usage. In many cases this meant taking a skeptical eye as to the worth of various levels of inventories as well as not accepting cost as the measure of value. He wanted us to add to the liabilities side of the balance sheet any contingent or possible liabilities. Among other lessons he drilled into us that fixed assets were worth what they could be sold for, not cost less depreciation.

Advantages of being an entrepreneur

The second advantage that I have is that I have not only earned a reasonable living as an analyst, but I have been an entrepreneur operator of an analytical business dealing with many of the world’s major financial institutions. My third advantage is that I have bought and sold intellectual property companies.

These advantages became useful in understanding the differences between the factors that I used in gauging the success of my business and the financial statements prepared for us by our gifted accountant. The most important factors for me were our ability to help our institutional clients make money or avoid problems. I believe this capability was of great importance when it became time to sell the operating assets of the company. In addition, on a daily basis I kept an eye on our cash balances. This was the key to not only paying bills, but also the pace that we could invest in further development which was important to our future utility to our valued customers. In essence I feel that many and much larger companies are driven by the same motivations.

In application

Many market pundits and investment reports talk about the reasonableness of the current stock market levels and quote a historical average of market indexes or price/earnings ratios.  I believe that neither individual investors nor institutional investors are setting the current price level. With the large amount of money in private equity funds that is not invested, the buying power of potential raiders, and an excessive amount of cash overseas on corporate balance sheets, stock prices are being set by the absence of a wave of acquisitions. The main metric used by these professionals is not the price/earnings ratio but EBITDA (earnings before interest, taxes, depreciation and amortization). While not quite up to the standard that Professor Dodd would have wanted, it is a series of important steps in the direction of assessing the values of the underlying business. I prefer (when I can get the data) to use operating earnings over one or more cycles to approximate the financial value of a business. These calculations are only one side of the equation for a strategic acquisition to take place. A knowledgeable buyer who wants to be in the business most likely would focus on what it would cost to build an operation that would have the same or enhanced value to the customer base.

Using these tools to view your investments

Just as I examined my potential value to our institutional clients versus the perceived competition, one should conduct a similar analytic exercise in looking at a stock. The short to intermediate price level of a stock is a function of who owns and who does not own the stock. Dramatic price moves occur when there are insistent waves of buying and selling. For an owner of a security he/she is much more at risk to the actions of co-investors than the direct actions of the company or the central bank. The vehemence and direction of the wave will be based not on how the investor interprets the news or rumor, but how others react to it. Corporations with a relatively limited number of large, usually institutional investors can pivot more quickly than companies with stockholders that are widely dispersed. A small group of significant shareholders can make their views known quickly to management and/or a potential raider. A relatively under-owned stock that represents an opportunity is a believable “story” that happens to be true and if it can be substantiated, could be a good opportunity.

One of the reasons that my reports on a limited number of conglomerates proved to be useful, at least for awhile, was that my analyses made these companies more understandable to both thoughtful investors and to the financial news media.

The change in attitudes of both the investor and media communities made these stocks more acceptable. Speaking with bias as an owner/portfolio manager of financial services stocks, the same thing is gradually happening again. Particularly as some investors are looking for sound companies whose stocks are below their former peak levels with improving balance sheets.

Now what to do?

The lack of capital devoted to keeping stock prices stable is very small in part because there are at least 13 markets available to institutions who are interested in equities trading in the US. Thus, we could see sudden sharp multi 100 point moves of the Dow Jones Industrial Average. One possible impetus on the upside might be the perceived need of hedge funds to cover their increasingly short positions. As a long-term oriented investor I am always looking for investment opportunities. Most of these opportunities come about more due to changes in perception than hard facts. The other investment opportunity cluster occurs when prices plummet. The fear in a sharply declining market is that one does not know where the bottom is. Going back to my formal education as an investor sitting in Professor Dodd's classroom, at some level (probably not a great deal lower than today’s valuation) the ratio of EBITDA or better yet, operating earnings, will entice many value investors to build positions. The risk to these investors is that before this happens we could enter into a wildly speculative market the likes of which we have not seen in many years.

Please share with me what are you doing now and how are you positioned for the current market. 

Postscript

Sunday night reports of opening in Asia markets have the Japanese markets up 3%. Also Chinese exports reporting a surprising low 1% gain instead of the expected 7%. (I wonder whether this report is being influenced by reactions to the stories of false or inflated export invoices.)
 

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