Lack of Confidence in Brexit Era Could be Costly

Introduction

I am a student of long-term investment performance for our accounts and my family. Some of the money entrusted to us is designed to make future payments many, many years into the future. Thus, I study which are successful and unsuccessful investors and their strategies over long periods of time. In that light I mentioned at a recent meeting of the New York Society of Securities Analysts celebrating the thinking of Ben Graham, the father of value investing, why I believed that the “experts” were wrong that the British would vote to remain within the European Union. They violated my rules for avoiding large losses that I derived from Ben Graham and my old professor David Dodd. The rules are:

A.  Overconfidence (Almost universal belief in an outcome)

B.  Faulty, incomplete, and poorly timed assumptions (Economic only

arguments) - Lack of non-financial milestones (Confusing money bets with bookies and number of bets + % undecided)

C.  The frequency of massive overconfidence in financial history is relatively rare; e.g., “Tulip Bulb” Sub-prime mortgages with house prices never declining. Avoiding those losses are critical to the number one rule of successful investing which is to avoid (big) losses along with the second rule, which is not to forget the first rule.

The First Two Rules Are Not Enough

One could have avoided losses from overconfidence by just moving into an all cash position and one would have saved all or the bulk of one’s capital. But if you stayed in cash you would have missed out on the compounding growth that investors have experienced over many years. Using a no-brainer approach of investing in a market index since 1926, one could have compounded at about 9% which doubles money every 8 years. (This is not a prediction of future returns.)

Our objective relative to the risks assumed is to do better than a mechanical index strategy. However, to beat the index one should analyze the performance of the index compared with actively managed investment accounts. In the periodic market declines, the index declines more than the accounts because first it does not have any cash and second most indices are heavily weighted in favor of the most liquid stocks which typically drop the most as they are the easiest to sell. The reverse is true on the way up from the bottom. The indices have no cash to reduce their rate of gains and are in the most liquid stocks that late-comers plow into.

As a student of investment performance of successful managers, I have noted that they have more confidence in what they are doing than others. Often they are lonely in adopting a particular stance or set of securities. Typically they are not positioned defensively in early stages of what proves to be a rising market. Many times this lonely confidence (compared to a market of little confidence) produces a superior compound growth rate. The superior managers don’t always do extremely well, which is why our portfolios have a number of funds that have characteristics that suggest in appropriate markets that they will do well.

Is Brexit an Opportunity?

Caveat emptor or buyer beware: we can not predict the future. My training at the race track is such to wish most of the time to avoid the betting favorites (weight of money) as well as my contrarian nature suggests that Brexit could well represent a major long-term opportunity for investors around the world.

Why?

There are potential parallels between 2016-17 and 1848 as indicated in last week’s post.    There are already eight European elections scheduled plus the re-vote in Austria. Australia finished voting this weekend with the present government weakened. The US will have a new administration and a different makeup of its Senate. There is a likely chance that within Europe there will be Brexit type votes either the in planned elections or in special referenda.

Around the world the existing order is under attack by groups on the right and the left claiming that the politicians and other “experts” have not delivered. Further they claim, governments are too big and therefore expensive and inefficient. Supranational bodies are viewed as even worse, as they are further away from the disgruntled people. In part due to social media, many minorities have expressed unhappiness with majority cultures and are expressing desires for autonomy or even independence. One wonders whether the concept of nationhood will need to change.

The world has changed. Even small companies and to some degree small investors view the world through multinational lenses. In the forthcoming negotiations between the UK and the EC, at the moment the UK has the advantage in that it should not be in any hurry. In the meantime it will be free to develop singular trade deals around the world. At the same time multinational companies and investors will seek out their own best deals. There is a long history of wartime enemies arranging a regular flow of trading between combatants. (I suspect that some in Germany are already at work on this option.) In the eventual final negotiation it would be wise for the UK to have one with the negotiating skills of “The Donald.” This is not a US political judgment, but one that recognizes commercial realities. It would not surprise me if the length of the negotiations is not similar to the twelve-year period between The Declaration of Independence and The Constitution. And that process had the benefit of the Founding Fathers led by Hamilton, Jefferson, Madison, and Monroe.

Perhaps coming out of all this will be a political shift favoring consumption over labor. China is attempting to do this with difficulty. The pro-labor attitude of the existing power structure has not worked. By raising the cost of labor (including benefits), it priced much of labor out of the market to be replaced primarily by automation, if not outsourced production beyond China’s borders. By focusing on consumption the drive will be in terms of price, quality, and safety which can produce a healthier and more satisfied society.

There is Still One Thing Missing.

The two largest economies in the world have been built by risk-takers. In both the US and China, the countries are populated by people who took the risk to move to their present location. Historically in the US, it is important to remember that with the exception of the Native Americans, we all came from someplace else for the past four hundred years. Because we arrived with very little in the way of financial assets, we were, and many of us are still today, risk-takers. This makes us unique among nations at the moment, which will have to be corrected if the Europeans want to catch up to the US.

Pardon a parochial view, but I often view the world through mutual fund glasses. One measure of the risk-taking attitude of investors is the portion of their assets invested in equity funds. On paper, Europe as a whole is the same size as the US economy. As of the end of the first quarter of 2016, the world has invested $16.4 Trillion in equity mutual funds. US registered funds accounted for 60.9%. All of Europe had only 27% in equity funds, including Luxembourg and Ireland which are favored by tax aware global investors outside of the US. Excluding the tax shelter investors, the four European nations with the largest share of the global equity funds were the UK with 4.3%, France 1.9%, Netherlands 1.7% and Germany also 1.7%. The potential of  less expensive and bureaucratic government focus on consumption is great. However, it won’t be achieved if most of the risk-taking comes from US and Chinese sources.

	Assets in Equity funds: as of 3/31/2016
All Equity Mutual funds	100%
US-registered funds	60.9 %
All of Europe? (including Lux & Ireland)	27.0 %
UK	4.3 %
France	1.9 %
Netherlands	1.7 %
Germany	1.7 %

Source:  ICI

How should one invest in the Brexit Opportunity?

This will undoubtedly be a long and laborious task. In a time-segmented portfolio as in our TIMESPAN L Portfolios^®, I would begin with small commitments to International funds which have 40% in Europe and buy more during periodic setbacks. The small fund participation rate in Europe may be an opportunity for financial services investing. I will be happy to discuss privately how we do it in our private financial services fund.    

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Keep Looking For Growth

Introduction

I am not always a contrarian, but an opposite view from the crowd often gives an investor a safer perspective. Thus the lackluster performance of the US stock market in the first half of January is a prod to look elsewhere for investment inspiration. This is particularly true in terms of equity fund portfolios whose gains were concentrated in the four main credit card company stocks. Further, re-examining the main US fund investment objective averages for the Fourth Quarter of 2013, one finds that there was a major difference between the results of Large-cap Growth and their Mid and Small cap fund brethren. The Large-cap Growth was clearly the leader of all the main groups and the Mid- and Small-cap Growth were the laggards. The leader benefited from a handful of social media/info tech leaders. One of the lessons that I try to teach other students of the market is to pay more attention to the laggards when searching for future leaders than the current leaders.

‘Time Horizon Portfolio’ focus

If you utilize my time horizon approach when looking at your investments, current momentum is very important for the one year or trading portfolio. The switch in momentum is very important to the cyclical or intermediate length portfolio. This second time horizon portfolio is often what insecure investment committees focus on in making their judgments. There is a little bit of the English expression “penny wise and pound foolish” in their actions. The big money is earned and kept in the longer-term portfolios and this is the hunting arena that I like.

The difference in time horizons between value and growth investing

When applied by disciplined knowledgeable professionals both value investing and growth investing have worked,  however each uses time very differently. Ben Graham and David Dodd taught students at Columbia University and succeeding generations of analysts and investors the utility of value investing. In an oversimplified way they were urging analysts to carefully study financial statements to understand the nature of investments currently on offer. Their studies led to the identification of the gap between the current intrinsic value and the current price. In effect, they (value investors) arbitrage the difference with the belief that the current price will relatively soon reflect the intrinsic value they determined. Their most famous student was Warren Buffett who took value investing one step further by focusing on what the future value and price would be. At approximately the same time a Baltimore-based investment counselor was developing this into his theory of growth stock investing and he was T. Rowe Price.

I have memorable experiences as an student, investor or more to the above. David Dodd was my professor; T. Rowe Price^* (the a firm) was a client and subscriber; for many years I have invested with Berkshire Hathaway^* and attended its annual meetings. Most recently I was awarded the Ben Graham Award by the New York Society of Security Analysts.

Disclosure:  ^*Stocks either owned by me personally and/or by the financial services fund I manage.

Growth investing

What value investors are looking to do is to get a bigger piece of the available pie, whereas the growth investor is betting on a growing pie and quite probably one that has a different taste. The growth investor needs to know the current financial statements; the value they bring to the exercise is a well-reasoned view of the future and some luck. (More on that later) As we live in a global space where there are product developers/inventors and markets everywhere, one of the areas for some of our longer-term sophisticated accounts is in funds that invest in Asian science and technology. A recent article by J. Michael Oh, the portfolio manager of the Matthew Asia Science and Technology fund,  makes the point that the rising standard of living in many Asian countries will allow new markets to “leapfrog” over the stages that developed countries had to go through. One example is in many places of the world the population has jumped directly to mobile phone use without first having landlines. My background years ago was as an electronics security analyst, thus my inclination is to think of some electronics developments as enhancements to our present gadgets. Michael Oh would suggest that I might be missing the biggest advances. He is very bullish on the improvements in medical products and their vast Asian market potential.

Is Google nuts?

This is the question that the Financial Times asked in an article after it was announced that it had paid a big price in terms of current valuations for Nest, which is headed by Tony Fadell, a critical developer of the iPod for Apple. The firm produces devices that through iPhones or other hand-held devices can remotely control temperature and other elements in a distant home. His pitch is that he wants to re-imagine and reinvent the unloved products we all have. I have no idea whether his work will ever produce earnings per share for Google, but it is not a dumb company and clearly Google has views about the future. However, they need (to quote a line from “My Fair Lady”) a little bit of luck.

Getting lucky

“Getting Lucky” is the title of Oaktree Capital Chairman Howard Marks’ latest thoughtful letter. In his memo he decries those successful people that do not recognize the elements of luck that contributed to their success. He shares with us the elements of luck that contributed to his and Oaktree’s enormous success in the credit and bond funds. He focuses on the accident of meeting people born in approximately the same year that happen to work in the same large company or become close just because they were in college together. He gives a number of good examples in terms of his life, and those of Bill Gates and Joe Flom.  Howard suggests that successful investors succeed more often than not when their expectations work out or as he says, “performance is what happens when events collide with an existing portfolio.”  Luck has a great deal to do with timing, as Marks quotes an old adage, “being too far ahead of your time is indistinguishable from being wrong.” (I will be happy to send my marked up copy of his letter to any of my subscribers.)

Will either Michael Oh’s fund or Google will produce good future results in a timely fashion? I do not know. What I do know is that they are both looking for a bigger pie that will be different than the present one. I also believe that this kind of thinking is an appropriate part of sound long-term portfolios.

What do you think?

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Value Trap by the Book

Introduction

One of my functions for clients is developing the menus of 401k and 403b rosters of funds. Quite properly the sponsors of these programs wish to offer a relatively low-risk equity alternative along with presumably higher performing funds. Many institutional as well as individual investors also seek lowered perceived risk investments. Each of these potential investors gets attracted to funds that have ‘value’ in their name. As has been said often, “One should not judge a book by its cover.” The perception of value may be quite different from the reality.

Value definitions

There is no universally accepted definition of value. Most investors believe that within the rubric of ‘value’ there is some attention being paid to the risk of permanent loss of capital. The marketing and distribution forces within the money management industry often attempt to demonstrate that advisors focus on value by quoting the price/book value statistic. According to this logic, the lower price/book ratio is better. A ratio below 1 is meant to be a sign of a real bargain. I believe this may well be a trap.

What is book value?

This is not the place or the time to produce a treatise on double entry accounting principles. The term ‘book value’ has a specific accounting definition. An investor searching for value needs to understand that there are a number of links between the income statement and the balance sheet. One of the key concepts is that the income statement is required show all of the costs that should be charged against the current period’s revenues. This is fairly simple to do for the cost of labor and supplies consumed during the period. There is a problem however on how to allocate some of the capital that has been invested in longer-lived assets like buildings, acquired customer lists and patents. Accounting rules dictate how much should be charged to the current period. The remaining portions of these costs are capitalized and are found in various entries on the balance sheets. They are included in the so-called book value. (In its simplest terms, book value is calculated by deducting from the assets all liabilities divided by the number of shares currently outstanding to arrive at a book value per share number.) Currently, auditing requirements demand an annual review as to whether these assets are at least worth what they are stated on the balance sheets. If they are worth less, they are to be written down on the balance sheet and an impairment charge is to be made to the income statement. Under conventional accounting procedures there is no provision to writing assets up.

Sound security analysis and effective loan officer research techniques should include reviewing these assets on internal spreadsheets. These augmented financials could lead to a justifiably higher price for the stock, the company, and/or an increase in collateral value for loans. These upward adjustments to book value cannot be published by the company issuing the financial statements.

“The Market” knows

While appropriate adjustments to stated book value are not published, market prices often reflect these changes. Years ago a successful, wise trader told me that a stock is only worth what it is selling for at the moment, not some theoretical accounting value. On Friday two of America’s strongest banks reported their first quarter results. Some in the media called attention to the fact that Wells Fargo* was selling at 1.29 times its book value and JP Morgan* was selling at 0.91 times its book value. Remembering what my old trader said, the market was suggesting that it was deducting an impairment charge for the “fortress balance sheet bank” (JP Morgan), and not for the bank with the largest home mortgage business (Wells Fargo). Considering that a portion of the former’s good earnings came from reversals in its bad loan reserves, the market could be right.

* Please note in terms of disclosure that I personally owned shares along with many other financial service stocks in my personal portfolio. Neither stock is included currently in the private financial services fund that I manage. The comments in this blog should not be interpreted as a recommendation to buy or sell these securities.

The corporate finance view on ‘value’

Both Warren Buffett and I studied at the feet of Graham and Dodd at Columbia. He studied under Benjamin Graham and I was with Professor David Dodd. Both instructed us to reconstitute financial statements in order to determine at least liquidating value. Part of the exercise was to eliminate most, if not all inventory value; also to re-price the outstanding debt at its current market value among other adjustments. The genius of Mr. Buffett was to recognize the economic value of the “moat” around the company that protected the firm’s market share. In many of Berkshire Hathaway’s** acquisitions, I believe the size of the “moat” relative to the price was an important element in the final decision. In some cases, key personnel were very much part of Berkshire’s valuation of the “moat.” (I know in the purchase and sale of financial data products and companies, the customer relations experience was a critical factor that I used in valuing the various opportunities before me.) These and similar approaches are used by corporate finance groups to determine acquisition value.

** As noted in earlier blogs, I personally own shares in Berkshire Hathaway, as does the private financial services fund that I manage. The mention of this stock should not be construed as a recommendation to purchase.

My concept of ‘value’

I try to divide potential investments into two large buckets. The first is one that future events will cause the stock to raise. Often this may have to with new products, processes, sales strategies and competitors’ problems. In the other bucket are stocks that are selling substantially below their current liquidating value, or at a price that a reasonably smart strategic buyer would pay for the company.

How to apply in fund/manager selection?

Avoid those managers that emphasize the value of published price/book ratios. Work with managers that know enough and have enough good contacts within an industry to come up with an independent valuation. Due to the time to research available companies, the preferred managers typically have relatively low portfolio turnover rates. However, these managers must have a history of reacting to their own misjudgments and exiting from what looked like great values.

All long-term successful investors use trial and error techniques. Thus the success of any particular investment is far from guaranteed. The truly great investors recognize their errors and quickly move on, so some portfolio turnover is a good thing to see. The essence of value-focused investing is to reduce the chances of large avoidable losses.

How do you find and invest in good values?
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Growth & Value: Buyers and Sellers Disagree

In my periodic conversations with formerly successful fund managers, I am struck with a comparison to that wonderfully broad comic television program from the 1970s,“Fawlty Towers.” The essence of the program was a depiction of the “Peter Principle” at work in a small seaside hotel. The somewhat disdainful employees who filled the roles of hotel manager, desk manager, and chef all graduated, perhaps too quickly, from entry level jobs. In their roles they assumed the attitudes of what they perceived to be the deportment of professional hotel personnel, with some very humorous (but sad) results.

The formerly successful portfolio managers that I speak with mouth the same platitudes that they attribute to Warren Buffett and others, as well as their own statements of years ago. While these antics are amusing on the screen, they are tragic for the investors in the formerly successful funds.

Repetition doesn’t make it true today

Almost all of these managers vehemently proclaim that they are growth or value or somewhere in-between investors. These are wonderful banners that masses of investors march under, but have little practical meaning today. While all investors want to grow their capital, particularly after inflation and taxes, the original concept of growth investing as articulated by Thomas Rowe Price, Jr., and others in the 1930s was to invest in companies which produced earnings that grew faster than the economy (market). As no one wants to invest in securities that have questionable worth, value investing is buying something at a discount to a readily identifiable value. Contemporaries with Mr. Price, Ben Graham and Dave Dodd (my old Security Analysis professor) focused on securities with large discounts from current values. At its base level, they were speaking of liquidating value, which is why their initial focus was on buying bonds priced way below their value in liquidation. Warren Buffett, a student of Ben Graham, evolved these two approaches to look for investments that were selling well below their future or intrinsic value.

The apparent message from “The Market”

These formerly successful managers are trumpeting how “cheap” current prices are. The principal suppliers of this ammunition come from the sell-side brokers, academics trapped in the past, and talking heads desperate to find encouragement in an effort to hold on to their shrinking audiences. Why don’t the dumb investors and professional buy-side institutional investors accept the “cheap” argument and commit to current prices? As usual the answer is reflected in the numbers. Buyers are not accepting that stocks have as low price/earnings ratios and price/book values as the sales-side trumpets.

Why not?

There are two main reasons for this buyers’ strike. The first is faulty math. One of the very first things that Professor Dodd taught was not to accept published financial statements as a sole basis for making judgments. We spent hours on reconstructing these statements before applying any valuation issues. First, we focused on removing from the balance sheet any asset that was not readily saleable at the stated value. These would include inventories, real estate, goodwill, and intellectual property. In addition, we learned that liabilities are often understated, particularly in what could go wrong. Warren Buffett would add to the balance sheet the brand name value and the deepness of “the moat” that protects the proprietary value. (While these are not easy to calculate, some attempt is needed. Often this is called acquisition analysis which sub-divides into two categories; one for financial buyers and one for operating buyers.) The whole area of real estate utilization requires careful analysis. One needs to look at not only the current value reflected on the books, but also to ask, “are there any sweetheart arrangements with controlling interests that are giving the company a break on costs; or the other way around, with the company in effect paying a selective dividend by overpaying for the use of some property owned by insiders?” In addition, for many organizations with a large number of branches or offices, some of their leases are a competitive advantage in terms of key locations; some were signed during higher rent periods. In many companies this is too important an area not to be carefully examined.

One of the repeated fallacies that I hear from formerly successful managers and pitching analysts, is that if one deducts the cash on the balance sheet, the stock is selling at a very low ratio to its historic price/earnings ratio. This is doubly naïve. First, in many cases 80% of the cash is overseas and there could be lots of taxes to be paid on repatriation. In addition, a good bit of the cash hoard is a requirement of various lenders, buyers, and suppliers. The second naïveté is that when the cash is brought back to the home country, there would be a measurable benefit to the common shareholder. Unfortunately this is not always the case. The current fad with managements is to use the cash to buy back their own stock, disagreeing about the value of their stock with the market. The big advantages of the buyback are to help the management. First, it reduces the float of somewhat disgruntled shareholders, making a raid on the company more difficult. Second, by reducing the balance sheet equity, the management’s ‘incentive’ contracts, (based on return on equity) become easier to achieve. The third “tout” point is that the money could be used for acquisitions. Because so many acquisitions fail, both entrepreneurs and investor should ask, “will the deal ultimately build or destroy value?"

After unfortunately determining that they can not use all their excess cash, the more responsible managements increase their cash dividends, which often are tax effective and useful for the endowment-type shareholders who have grant responsibilities. (We manage the investments of several grant-making foundations where dividends are important.)

Turning to the income statement, a lot more work is needed before one should accept the bottom line net income number. Starting with the revenue components, it is important to understand how and when revenues are recognized. (There is a lot more leeway than many investors realize and there are differences in how competitors report.) Often the next quarter after the annual statement is full of changes from the last annual report, particularly on revenue recognition and the use and value of inventories. The whole topic of “other income” requires study as to the changing nature of its components, particularly if a portion of this revenue comes from lending money to clients either directly or through leases. The value of other income revenue may be different than the value that careful analysts put on sales. On the expense side, the largest single element is often compensation. Is compensation reflected correctly, i.e., what does it really cost to get these people to work for the shareholders? Balance sheet footnotes and proxy statements often give a different or at least an expanded picture on compensation. In my experience as CEO, the cost to continue or terminate employment is often very much higher than the last year’s compensation line on the income statement. Other expenses also need to be reviewed as to their reasonableness from an owners’ point of view.

After all of this work one can get a good approximation of current realistic book value and current earnings power. This is another place where the bulls get it wrong.

The future is not the past retold

Your past travels are not a sound predictor of all of your future travels. The same can be said as to the value of a stock, a portfolio of stocks, and the gauge of a manager’s skills. I manage a separate account investing in financial services stocks for my family and a few selected other clients; in doing so I look at the world through the eyes of the interaction between the financial services segments and the “real world.” The financial service sectors are the roads where capital changes hands and through very careful use of operating and financial leverage, that capital should grow. One of the problems facing investors in general is that the financial sector is shrinking. Due to the combination of operating losses from the use of unwise leverage and increased rearward-looking regulations, the earnings power of the sector has been reduced. This translates to fewer salespeople raising capital for new needs or capital transfers. Until the financial sector leaders figure out new ways to grow, one would expect that the general level of market valuation may well suffer. Further, bank leaders must deal with the realization that the many former ways they earned significant returns are no longer possible. Outside of the financials, other sectors have also changed dramatically, e.g., book publishing and selling.

What does this all mean?

One should not expect to find good investments by applying unexamined financial ratios to historical data.

What I am looking for in managers?

The first thing that I am looking for in a manager is a discipline of detailed, current security analysis, not a record of parroting the past. Normally too much turnover of stock positions leads to poor long-term performance, particularly on an after-tax basis. Today however, I would favor managers that increased turnover to repopulate their portfolios. I would like to see new names, with new stories based on new field work. Like other investors, I want to see new, sound merchandise.

Note: I would also like to replace “growth” and “value” with more accurate terms.
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Add to the Dialogue:

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