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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Current Investments for Future Results

Introduction

In our job as professional investors for others as well as personal stewards for ourselves and families we do something today that we want to have a good result in the future. This is easier said than done. To accomplish our goals we need to answer at least two basic questions: 

What are we doing?  Which future?

To help answer these questions, we should be asking ourselves on which time period are we focusing. We have created at least four time spans to put the answers into perspective. These four slices go from:

1. The immediate as defined as the next two years,

2. The following five years to replenish spent capital,

3. The succeeding ten or more years to address longer-term needs for the current decision makers, (endowment issues) and

4. Future periods to aid fulfilling the legacy of the grantor and his/her succeeding generations.

This weekend I seek to apply the items that cross my information screens to appropriate investment time spans.

The current period

To meet current and near-term needs we assume that we can convert our present investments to cash for either spending or repositioning. Too many investors look entirely to current prices and economic conditions. As someone who has grown up in the investment business, I am concerned that the changing structure of the marketplace is not being considered. What I add to my decision process (and what is missing from many strategies today) is a focus on liquidity.

The real price

Portfolio managers and analysts can learn a lot from professional traders. Traders will tell you that a stock or a bond is worth only what it can be sold for. Far too many investors use the last published price without understanding the conditions that led to the price in terms of the relative balance of supply and demand. Quite possibly because of changes of capital on trading desks or floor participants the last published price is quite stale. This is particularly true if you are a potential seller with an over-sized position. A current example of this is the recent drop of 6% in three minutes for shares of Apple^*. According to some, the sudden drop was caused by one or more major players that used algorithms to significantly reduce over-sized positions in tech stocks.

Investment committees have regularly received reports on what specific days to liquidate positions based on average historic volume. Traditionally these reports are meant to show how quickly cash can be raised. Sole reliance on these reports is dangerous. First, liquidity is very much a function of the current desire for the security. Second, increasingly more volume is transacted off the floor than on it and there is no real floor for bonds thus the published volume figures are more an artifact than accurate. I wonder when looking at liquidity whether one should follow the dictum of US Supreme Court Justice Potter Stewart in ruling as to what was pornographic or not: he said he would recognize it when he saw it. To reinforce my skeptics’ view on liquidity let me use the extreme performance of Precious Metals mutual funds as an example.

In the week ended on December 4^th the average Precious Metals fund was off -4.66%, the worst of the 30 equity funds groups tracked. However in just four weeks including the December 4^th period, the average Precious Metal fund was up +10.47% which was the best of the equity fund averages. I would suggest that the fundamentals did not change that much in those four weeks, but the market did.

Another example that attitude changes greater than fundamental changes is the price and volume in the week for the stock of T Rowe Price^*. On December 1^st it closed at $82.61 on reported volume of 753,104 shares. On December 5^th the closing price was $84.49, down slightly from its day high of $84.88 on 1,105,152 shares.

One of the Republican SEC commissioners has expressed concern about the liquidity in the bond market when interest rates start to gyrate. I believe her concerns are well placed.

The focus on liquidity is of particular importance when investing for current returns in the first or operational time span portfolio. If due to spending requirements, securities will need to be cashed-in at the same time as liquidity shrinks, the quicker the near-term portfolio will be exhausted and need to be restored by the replenishment portfolio.

Replenishment portfolio

A well thought-out piece by Marcus Brookes of Schroders Investment Management begins with the following sentence. “We end 2014 with almost every asset class offering investors scant potential return for their risk.” In looking how to build a successful replenishment portfolio I suspect that at some point over the next five years the need to earn a real return adjusted for credit risk will become apparent through a market decline. Having issued this warning, it does not relieve investors of the need to build and manage a replenishment portfolio. While many investors talk long-term they walk short-term by managing their investment against a one to five year time horizon. Under those constraints there is little room for long-term bonds or stocks that are dependent upon substantial new products or massive turn arounds.

While it increasingly looks like we may get a bout of enthusiasm, one would be wise to upgrade the quality in the replenishment portfolios even though during a speculative phase they will probably under-perform, but they will sink less when the eventual significant decline occurs. Moody’s^* is recognizing that “corporate credit has become more risk averse, while the common equity market has become more tolerant.” Surviving investors normally bet with the fixed-income markets, while the traders with the stock market. Both can be correct using their preferred time periods of five and ten years for the investor and quarter, half, and full year for the trader. 

*Owned by me personally and/or by the financial services fund I manage

Legacy investing

Very long-term portfolios are often a mix of companies that benefit from sustainable demand based on demographic and geographic changes as well as disruptive companies. This somewhat hedged mix assumes that there will be evolutionary changes as well as revolutionary changes ahead. The first group of investments should provide sustainable income and capital growth until their mistakes or the disruptions created by the second group of companies hurts them. The failure rate of the second group will be high as they will lack the management skills needed to leverage their disruptive power. The first group will have fewer failures but they will be more painful with less chance for full recovery.

The 85 most disruptive ideas since 1929 were recently published by Bloomberg Business Week in celebrating its 85^th birthday.  One could probably devote an entire business school education trying to understand the power of the 85 disruptive ideas and how few of their inventors or developers produced lasting fortunes. The first three are good examples of the tenet that early inventors and early investors don’t get the major benefit of their disruptive talents. The three are the Jet Engine, the Microchip, and the Green Revolution.

We do not invest in Venture Capital funds to participate in the invention of products and services. Sometimes Private Equity is the way to go as developers build out to an eventual exit strategy. We prefer to use mutual funds which invest in the users of the disruptive forces unleashed in a way that can be leveraged to the benefit of both customers and shareholders.

Conclusion

Pick your time period for judging investment success and that should direct the composition of your portfolio. If you need help, email me.

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