As has been noted on this blog and my book, MONEY WISE, which is about to go into paperback, I believe that each major investment need should have a separate set of investments. The end game for all investing is to produce capital for eventual spending. In many cases, the time frame for charitable institutions and wealthy families is infinite. Investing through mutual funds and hedge funds is not necessarily the best single way to invest, but it is far from the worst. Due to my background of studying funds for the last 50 years or so, funds are the first choice in my investment tool set.
To accomplish the goal of providing for future spending needs, one is essentially dependent on the current spending rate and the growth of capital as they pass through the filters of inflation and taxes. Like most all other investors, I am predisposed to the term “growth.” One of the ways to grow capital is to invest in growth stocks, often found in growth funds.
As someone who has probably created more fund classifications than any other individual, I recognize that turning fund classifications into investment objectives was never designed primarily to help in fund selection. The beneficiaries of classifying funds into peer groups include fund portfolio managers, independent directors of fund groups, owners of fund management organizations and the fund marketing systems. In essence, fund classification produces bragging rights. Particularly in the developed world’s competitive focus, ranking against peers becomes the title requirement for ownership of bragging rights. This is exactly where a dichotomy lies between the needs of a fund investor and the above-mentioned beneficiaries of fund classifications’ bragging rights.
To keep the reward game honest, a set of rules are needed which should be based on empirical evidence. For example, my old organization, now known as Lipper, Inc., defines a growth fund as a fund that has a price/earnings ratio greater than the S&P 500, and a three year average growth rate of sales per share that is above the same broad market indicator. Others use some variation of high price sensitivity and historic trend analysis. Note that all of these measures are backward looking because they are known and are usually not adjusted for post-period recognitions of material differences.
One of the sound arguments against using any broad market securities index is that you are paying for past successes. Remember the SEC requirement that is meant to go with any performance advertising: that past performance is no guaranty of future performance. As a matter of fact, after prolonged periods of specific progress, the mathematical pull of regression to the mean becomes overpowering. Leaders give up the performance leadership and often become laggards, while laggards become leaders. Usually at some point in a sales pitch for a fund, reliance is placed on the fund classification bragging rights mentioned above.
Extrapolation is easy, particularly if one sees no imminent signs of major reversals. Instead, I am addicted to anticipation. I think about the uncertain future. I have a preference for managers who are also searching the future to find stocks that do not represent an extrapolation of the past. This is much more difficult. In the mid- 1960’s a very good analyst caught the shift from a cyclical valuation to an expected growth valuation for a, now much smaller, company named General Motors. His market call worked for a while until it became accepted word near its cyclical peak. Think about IBM, which started life with more water in its balance sheet than assets. For many years, IBM was considered a growth company; then it became an income stock and now is a consulting services company. Imagine the problems of keeping IBM within any giving index as a predictor of future price behavior.
After a long period of declining prices, the best relative performances are held by those funds that exert a tight price discipline and/or have used cash as a significant investment. Many of the best, well known, investors have used this type of “value” oriented approach. For investment needs where the spending rate is high relative to the earnings rate, these price disciplined investments should play a major role. However for some needs (particularly in the early stages of many portfolios), the growth of the long term capital is of greater importance than the annual total return generation. Growth of capital is also a primary driver for many wealthy families, who believe the current level of capital is insufficient to meet future generational and /or philanthropical needs.
By dividing one’s resources into need-focused portfolios, one may have the best of both worlds (value + growth). Periodic rebalancing between the portfolios should be driven by the changing levels of needs. As the late Sir John Templeton would direct, changes to the individual portfolios should be made on the basis of focusing on better bargains. These bargains can be in future growth stocks or funds.
The successful selection of future growers is difficult, at best. In my case it is achieved by listening to smart managers that have different points of view based on their own research methods. As noted previously, I am willing to own funds that have different, and in some cases conflicting points of view.
Do you agree?
Sunday, August 2, 2009
Sunday, July 26, 2009
I have met the enemy
which has trained us.
The great modern philosopher of our age, Pogo, describes the nature of the failure of the human condition by intoning, “I have met the enemy, and the enemy is us.” In essence, what he is saying is that, individually and collectively, we cause our own problems. How can this be? Aren’t we the most brilliant people with the best education and the greatest media support the world has ever seen? And we seem to make the same mistakes as our ancient ancestors. I would suggest that the primary reason for our failure to develop a higher percentage of winning bets is that we have limited our learning capacity.
Our first fundamental mistake, as mentioned in last week’s blog, is a lack of full understanding of Newton’s Third Law of Motion, that every action creates an and equal and opposite reaction: You kill me, my son or brother will kill you, etc. As a “certified bright person,” I may perceive buying something as cheap, while the seller, equally bright and perhaps with more or different information considers the sale as off-loading an expensive piece of merchandise. If a government restricts a profitable trade for someone, a willing buyer and seller will find other ways to transact, even if trading costs are higher.
Our second mistake is where we look for guidance and how we receive it. Consider if you were going to have a critical medical operation, or have a major piece of architecture begun, you probably would search for the most knowledgeable expert that was available. In our selection process, experience usually plays a major role. In contrast, I would look for an expert who had some failures (e.g. a patient died, or a building did not meet with its essential critical requirements). Personally, I would have little confidence in an all-knowing arrogant personality, who would be unlikely to quickly identify when something was going wrong and thus less prepared to shift course.
In contrast to the somewhat painful experience searching for medical or architectural experts, when seeking financial advice we rely on 20 second sound bites, 55 minute university lectures and newspaper columns limited to 700 words or less from very thoughtful columnists such as Jason Zweig, in the weekend Wall Street Journal.
As all of us are insecure about making financial and investment decisions, we tend to find comfort in conforming to what other individuals of perceived similar intelligence do with their money. (The prudent man principle is based on this conformity, not on what was actually prudent under the circumstances.) Our decision-making may be compared to a voting machine or a set of scales. Most often the quantity of popular views weighs more heavily in our decisions than the apparent expertise of one or more experienced leaders.
To overcome this quantity over quality trap in building portfolios of funds for wealthy families or institutions, I try to select a few managers who see the market and the world differently than the rest. To me, the greater the arrogance, the greater there is the need to hedge and find different smart views. One way I try to reduce the power of the enemies is to control my own arrogance.
Our first fundamental mistake, as mentioned in last week’s blog, is a lack of full understanding of Newton’s Third Law of Motion, that every action creates an and equal and opposite reaction: You kill me, my son or brother will kill you, etc. As a “certified bright person,” I may perceive buying something as cheap, while the seller, equally bright and perhaps with more or different information considers the sale as off-loading an expensive piece of merchandise. If a government restricts a profitable trade for someone, a willing buyer and seller will find other ways to transact, even if trading costs are higher.
Our second mistake is where we look for guidance and how we receive it. Consider if you were going to have a critical medical operation, or have a major piece of architecture begun, you probably would search for the most knowledgeable expert that was available. In our selection process, experience usually plays a major role. In contrast, I would look for an expert who had some failures (e.g. a patient died, or a building did not meet with its essential critical requirements). Personally, I would have little confidence in an all-knowing arrogant personality, who would be unlikely to quickly identify when something was going wrong and thus less prepared to shift course.
In contrast to the somewhat painful experience searching for medical or architectural experts, when seeking financial advice we rely on 20 second sound bites, 55 minute university lectures and newspaper columns limited to 700 words or less from very thoughtful columnists such as Jason Zweig, in the weekend Wall Street Journal.
As all of us are insecure about making financial and investment decisions, we tend to find comfort in conforming to what other individuals of perceived similar intelligence do with their money. (The prudent man principle is based on this conformity, not on what was actually prudent under the circumstances.) Our decision-making may be compared to a voting machine or a set of scales. Most often the quantity of popular views weighs more heavily in our decisions than the apparent expertise of one or more experienced leaders.
To overcome this quantity over quality trap in building portfolios of funds for wealthy families or institutions, I try to select a few managers who see the market and the world differently than the rest. To me, the greater the arrogance, the greater there is the need to hedge and find different smart views. One way I try to reduce the power of the enemies is to control my own arrogance.
Sunday, July 19, 2009
Learn from London and Paris
But Invest Creatively Elsewhere
Ruth and I have just returned from a trip to London and Paris. In addition to accompanying my wife on New Jersey Symphony Orchestra business, one of the reasons for the trip was to gain insights from various financial professionals. I spoke with the leaders of two publicly-traded companies, several portfolio managers, the strategic adviser to a large hedge fund, a successful currency trader and a data provider with an academic orientation. While all of these gentlemen were very intelligent, they did not share similar approaches or views of the future (I should note that I have visited many accomplished professional financial women in prior visits.)
I did notice that many of my discussions relatively quickly evolved into the use of complex derivatives, which represented 30-100% of the net equity of portfolios managed by these professionals. In almost all cases, the derivatives were used in various hedging strategies. While they expressed a generally positive long-term view, they were also using short positions through derivatives to hedge against a sudden, unexpected sharp decline. In almost all cases, the gentlemen relied heavily on their academic training and their experience of survival. To most, the future would be some pale extrapolation of the past. All feared changing regulation that will increase their operating costs, restrict their flexibility, and in the end, hurt the public’s ability to make money. They seem to have good reason not to try future-oriented strategies. Their instincts are similar to many analysts found on this side of the Atlantic. I have often said that if you scratch an analyst, a historian will bleed. There is comfort in knowing how the movie, play, or opera ends.
Investing in China, India, and selected other Asian countries was the source of good performance numbers for a number of the funds based in London and Paris. While some managers conduct research from London, others use Hong Kong and occasionally Singapore. If they do have Tokyo offices, it is to track Japanese, and possibly Korean securities. China is the biggest single bet or actually twin bets. The first investment bet is on product producers for the export markets (largely dollar earners). The second wager is on the growing home market for goods and services. The potential dynamite of rising expectations in a controlled environment is recognized as a difficult situation, and can go wildly wrong at times.
Currencies are viewed as trading vehicles rather than assets of long-term value certainty.
What does this all mean to those of us who manage money for retirement plans, non-profits and families of substantial means? I am still recovering from some jet-lag, thus my current thinking is evolving. First, most European analysts are much more financial statement-oriented than I am. They do not seem to want to understand how a company or a fund actually works. As statement-oriented analysts, they are much more likely to be enthusiastic about “value” than “growth.” They seem to see things in an orderly solar system and will use their intellectual skills to protect themselves against change. I tend to look forward to finding change, and discovering those investments that benefit from change. In America, we use far less leverage than they do in Europe. The fact that many European managers tended to invest in companies that used leverage is one of the reasons that financials often represented 50% of their portfolios. Even for someone who manages a financial services hedge fund, this commitment to financials seems a bit high to me.
The bottom line: While we can expect many new techniques will originate in London and Paris, it will be the United States’ distribution power that will generate the largest share of the profits. To use Peter Lynch’s term, we should be focusing on the creative skill sites of the world for our next “ten bagger.”
I did notice that many of my discussions relatively quickly evolved into the use of complex derivatives, which represented 30-100% of the net equity of portfolios managed by these professionals. In almost all cases, the derivatives were used in various hedging strategies. While they expressed a generally positive long-term view, they were also using short positions through derivatives to hedge against a sudden, unexpected sharp decline. In almost all cases, the gentlemen relied heavily on their academic training and their experience of survival. To most, the future would be some pale extrapolation of the past. All feared changing regulation that will increase their operating costs, restrict their flexibility, and in the end, hurt the public’s ability to make money. They seem to have good reason not to try future-oriented strategies. Their instincts are similar to many analysts found on this side of the Atlantic. I have often said that if you scratch an analyst, a historian will bleed. There is comfort in knowing how the movie, play, or opera ends.
Investing in China, India, and selected other Asian countries was the source of good performance numbers for a number of the funds based in London and Paris. While some managers conduct research from London, others use Hong Kong and occasionally Singapore. If they do have Tokyo offices, it is to track Japanese, and possibly Korean securities. China is the biggest single bet or actually twin bets. The first investment bet is on product producers for the export markets (largely dollar earners). The second wager is on the growing home market for goods and services. The potential dynamite of rising expectations in a controlled environment is recognized as a difficult situation, and can go wildly wrong at times.
Currencies are viewed as trading vehicles rather than assets of long-term value certainty.
What does this all mean to those of us who manage money for retirement plans, non-profits and families of substantial means? I am still recovering from some jet-lag, thus my current thinking is evolving. First, most European analysts are much more financial statement-oriented than I am. They do not seem to want to understand how a company or a fund actually works. As statement-oriented analysts, they are much more likely to be enthusiastic about “value” than “growth.” They seem to see things in an orderly solar system and will use their intellectual skills to protect themselves against change. I tend to look forward to finding change, and discovering those investments that benefit from change. In America, we use far less leverage than they do in Europe. The fact that many European managers tended to invest in companies that used leverage is one of the reasons that financials often represented 50% of their portfolios. Even for someone who manages a financial services hedge fund, this commitment to financials seems a bit high to me.
The bottom line: While we can expect many new techniques will originate in London and Paris, it will be the United States’ distribution power that will generate the largest share of the profits. To use Peter Lynch’s term, we should be focusing on the creative skill sites of the world for our next “ten bagger.”
Friday, July 10, 2009
Modified Behavior =
Intervention vs. Newton
Recently, The Wall Street Journal surveyed 51 economists as to the need for a second stimulus. In the same survey they asked these learned people about the Obama administration’s plan to overhaul financial regulation. Of the survey respondents, 44% thought that the proposal was acceptable under the current political conditions and 15% believed that proposals will make the financial system safer. Either at least the 15% of those surveyed, and possibly most of the 44%, have absolutely perfect children or they have not taken a course in Physics.
As they say, it takes two to tango. Almost none of the evils were pre-meditated. The problems that have befallen people would not have been possible without both sides agreeing on something. Purchases of homes, cars, securities, and the inherent acceptance of debt (or as we prefer to label it, leverage) would not have been possible without a signature. In almost all instances, the signature was accompanied by a difficult-to-comprehend legal document. In many cases, the obtuse legalese was in documents that were never opened, even to examine their length. What motivated these buyers, some of whom were companies and, in many cases large, publicly-traded corporations, was the desire to own something they could not afford. These loans were packaged in a number of different wrappings and sold to both individual and institutional buyers. Despite the weighty legal documents, the attraction to buyers was a perceived, essentially, riskless, above-average yield (or performance). Many of those who lost their assets in various frauds and Ponzi schemes suffered from the same desire for unrealistic returns.
The very human desire to prevent such tragedies in the future is understandable and even commendable. However, it starts with a fallacy that “they” did it to the unsuspecting public. In the current political environment, “they” is usually a financial intermediary. There is little or no recognition of the culpability of the tango partner, or the sweet music played by the government. I believe that until there is some self-recognition of the initial source of the problem, there will be few solutions achieved.
One of the frightening elements of the Journal’s survey and reporting is that government intervention would make the economy and/or the market “safer.” First of all, it is not the function of government to make all human relations safe. At best a very clever government, continuously monitoring all communications between people, could possibly make disclosure fairer, but that would go up against the legal protections that one or both parties want.
In general there is a lack of appreciation on the part of governments, particularly this one, as to the nature of intervention. Initially, the authors of intervention attempt (almost in a biblical sense) to divide the good from the bad with one quick stoke of His staff. There are lots of problems with this glorious picture. First, the intervener has to gather up all the good people on one side. (Are they always, in every respect going to be the good people?) All the bad guys (no matter how bad), will need to be forced to the other side of this bipolar world. Second, since the beginning of wars and conflicts, some of the participants on each side have traded with the enemy. In turn these trading relationships have blossomed into friendships and even marriages of some type. Third, almost no single intervention, by itself can stand the test of time. Even that most precious of all interventions in the English language, The Declaration of Independence, could not stand alone by itself for long. After much wrangling, the U.S. Constitution, the operating document for our enterprise, was created. Despite that effort, amendments soon became necessary, the first ten resulting in the Bill of Rights. Further, our founding Fathers recognized that the language of the Constitution may not be perfectly understood, and the various states (the political powers of the day), could interpret the document differently. Thus, to bring these concepts into line with their original intent, they created the Supreme Court. The purpose of this very brief history lesson is to show that no single intervention can be, in and of itself, a solution. In biblical terms it could be said the first intervention begat the second intervention which begat the third, etc.
I have two warnings for those who plea for an intervention: First, they will get more than they intended. The second warning is that it will not work as completely intended, no matter who designs it. Why? Get out your Physics book. Sir Isaac Newton’s third Law of Motion states that each action is met with an equal and opposite reaction. With diligence equal to that of the government, clever people will succeed at finding ways around any regulation.
There is even a more important reason why pure intervention won’t work. How many of you, as parents, successfully intervened with your children by just taking away some privilege, which they thought was their absolute right. Did it work? In most cases this pure punishment did not work. What usually worked was to forge some form of behavior modification, so that the child first understood the consequences of an action, and second (and much more importantly), modified their behavior. The solution to preventing future problems is behavior modification, not reliance on intervention.
One of the challenges in working with families of wealth is the desire of the senior member to posthumously intervene in their children’s, grandchildren’s or favorite charity’s lives. There are all sorts of provisos written into wills and trusts that are an attempt to allow the dead to control from the grave. A number of these stipulations withhold funds unless certain things are done, e.g. going to the Alma Mater, getting married, having children, completing a certain task, teaching a particular view, playing only a certain kind of music, etc. There was even one family that we worked with that tied the physical weight loss of the contingent beneficiary with the provision to receive an inheritance. Some of the more difficult situations occur when there is a family business involved, with some members of varying skills working within the business while others are non-working members. In each case, the senior member is desperately trying to make up for failures of the past. My job as the adviser to the senior member is try to get him or her to recognize, like the government, that benefits of intervention may not last, and we need to focus on current behavior modification.
The bottom line is that people eventually win over the dictates of past interventions.
As they say, it takes two to tango. Almost none of the evils were pre-meditated. The problems that have befallen people would not have been possible without both sides agreeing on something. Purchases of homes, cars, securities, and the inherent acceptance of debt (or as we prefer to label it, leverage) would not have been possible without a signature. In almost all instances, the signature was accompanied by a difficult-to-comprehend legal document. In many cases, the obtuse legalese was in documents that were never opened, even to examine their length. What motivated these buyers, some of whom were companies and, in many cases large, publicly-traded corporations, was the desire to own something they could not afford. These loans were packaged in a number of different wrappings and sold to both individual and institutional buyers. Despite the weighty legal documents, the attraction to buyers was a perceived, essentially, riskless, above-average yield (or performance). Many of those who lost their assets in various frauds and Ponzi schemes suffered from the same desire for unrealistic returns.
The very human desire to prevent such tragedies in the future is understandable and even commendable. However, it starts with a fallacy that “they” did it to the unsuspecting public. In the current political environment, “they” is usually a financial intermediary. There is little or no recognition of the culpability of the tango partner, or the sweet music played by the government. I believe that until there is some self-recognition of the initial source of the problem, there will be few solutions achieved.
One of the frightening elements of the Journal’s survey and reporting is that government intervention would make the economy and/or the market “safer.” First of all, it is not the function of government to make all human relations safe. At best a very clever government, continuously monitoring all communications between people, could possibly make disclosure fairer, but that would go up against the legal protections that one or both parties want.
In general there is a lack of appreciation on the part of governments, particularly this one, as to the nature of intervention. Initially, the authors of intervention attempt (almost in a biblical sense) to divide the good from the bad with one quick stoke of His staff. There are lots of problems with this glorious picture. First, the intervener has to gather up all the good people on one side. (Are they always, in every respect going to be the good people?) All the bad guys (no matter how bad), will need to be forced to the other side of this bipolar world. Second, since the beginning of wars and conflicts, some of the participants on each side have traded with the enemy. In turn these trading relationships have blossomed into friendships and even marriages of some type. Third, almost no single intervention, by itself can stand the test of time. Even that most precious of all interventions in the English language, The Declaration of Independence, could not stand alone by itself for long. After much wrangling, the U.S. Constitution, the operating document for our enterprise, was created. Despite that effort, amendments soon became necessary, the first ten resulting in the Bill of Rights. Further, our founding Fathers recognized that the language of the Constitution may not be perfectly understood, and the various states (the political powers of the day), could interpret the document differently. Thus, to bring these concepts into line with their original intent, they created the Supreme Court. The purpose of this very brief history lesson is to show that no single intervention can be, in and of itself, a solution. In biblical terms it could be said the first intervention begat the second intervention which begat the third, etc.
I have two warnings for those who plea for an intervention: First, they will get more than they intended. The second warning is that it will not work as completely intended, no matter who designs it. Why? Get out your Physics book. Sir Isaac Newton’s third Law of Motion states that each action is met with an equal and opposite reaction. With diligence equal to that of the government, clever people will succeed at finding ways around any regulation.
There is even a more important reason why pure intervention won’t work. How many of you, as parents, successfully intervened with your children by just taking away some privilege, which they thought was their absolute right. Did it work? In most cases this pure punishment did not work. What usually worked was to forge some form of behavior modification, so that the child first understood the consequences of an action, and second (and much more importantly), modified their behavior. The solution to preventing future problems is behavior modification, not reliance on intervention.
One of the challenges in working with families of wealth is the desire of the senior member to posthumously intervene in their children’s, grandchildren’s or favorite charity’s lives. There are all sorts of provisos written into wills and trusts that are an attempt to allow the dead to control from the grave. A number of these stipulations withhold funds unless certain things are done, e.g. going to the Alma Mater, getting married, having children, completing a certain task, teaching a particular view, playing only a certain kind of music, etc. There was even one family that we worked with that tied the physical weight loss of the contingent beneficiary with the provision to receive an inheritance. Some of the more difficult situations occur when there is a family business involved, with some members of varying skills working within the business while others are non-working members. In each case, the senior member is desperately trying to make up for failures of the past. My job as the adviser to the senior member is try to get him or her to recognize, like the government, that benefits of intervention may not last, and we need to focus on current behavior modification.
The bottom line is that people eventually win over the dictates of past interventions.
Sunday, July 5, 2009
Can We be Independent?
We have just celebrated Independence Day to commemorate that brave band of Americans who have declared their independence from, at that time, the most powerful nation in the world. On late night cable on July 4th the film “1776” was broadcast. The plot centers on the days of wrangling that went on among the delegates to the Continental Congress. Until the final day, there were not enough votes to pass the bill. What is quite clear is that this remarkable group of men chose to lead rather than merely represent the popular will of the people. As investors do we have the wisdom, courage and fortitude to declare our own independence? Just like those earlier patriots we are facing a tyrant. At that time the tyrant was not just the King of England, but the tyranny of experience. The American Revolution had no historic precedent; no people’s revolt had ever created a new nation.
As investors we have suffered mightily from a sharp decline in market prices. More importantly, the world has gone through an economic devastation. The tyranny that we are now facing is the normal reliance on experience. We are looking at the events of the past as just another cyclical series with the thought that we will rise once again to the former heights. I, for one, doubt it. What was quite clear from the American Revolution, was there would be deaths and other casualties to our lives and to the ways that our society and economy worked.
Before we put too much weight on our ability to order the future, we need to remember, as with all wars, the losing side contributed more mistakes than the winning side. Luck was with us in the sense that the storms off Newport, Rhode Island kept the superior British Fleet bottled up, rather than doing battle with the French Fleet. Thus, Cornwallis could not evacuate his losing army from Yorktown and had to surrender to the forces commanded by the indispensable General George Washington. This was the last major battle of The Revolution, but it took two more years before a peace treaty was signed. What Americans in general (and investors in particular) did not appreciate was that the “peace party” in Parliament at the time was gaining the upper hand, and wanted the war ended, for they had better things to do with their resources.
How should we learn from the American Revolution today as investors? First, do not hold up a mirror to the past cycles. Though we can still learn from sound principles from the past in terms of risk management, they will be broader than in the past. Second, look for changes in structure in both the world economy and in the market place. We have seen the rise of sovereign wealth funds and the expansion of central banks, which could be the tyranny of new attempts at central controls. We have already seen the disappearance of floors of securities exchanges in favor of electronic exchanges, which will operate from the ether, domiciled in the least regulated locations. We are finally close to getting some of the derivatives, (e.g. credit default swaps) clearing through a series of central clearing houses. Finally, within a relatively few years, we will see new leaders arise who will be much better equipped to manage themselves, their own activities and perhaps even governments. Just as the leaders of the American Revolution succeeded through the much more difficult task of writing a Constitution and creating a new form of government, we may see new groupings of people, not based on location but rather their own particular interests.
In looking to a brave new and frightening new world, we may have to get rid of old ways of thinking. For instance, the so-called “prudent man rule” has been the foundation for courts and learned investment opinion since it was handed down by a Massachusetts state court in 1830. The case questioned whether Harvard College was managing its endowment properly. Judge Putnam ruled against Harvard, by defining prudence as what other intelligent people did with their own money. (Seems as if Harvard has a slow learning process.) Despite this definition of prudence, we could be entering a period that new and thoroughly thought-out investment policies should be followed. For example, is the legal form of an investment as important as the predictability and terminal value of a security? Thus, we may find that compartmentalizing a portfolio into stocks, bonds, funds, and various forms of illiquid investments is not as important as the variance of future year-by-year returns, expected or tolerated. Another consideration that may come increasingly important is the evolving body of corporate and civil law, e.g. stipulating the priority position of senior secured bond holders or the imposition of “gates” on hedge fund redemptions, etc. Will changes in estate taxes alter the motivations and valuations of various investments in public and private securities? The list of examples is far from complete. The purpose of these radical, perhaps not revolutionary, ideas is to indicate some of the range of changes that should guide us to seek a new way of thinking.
In the end, tyranny of all forms is self-defeating, as it can never for all times be complete. Eventually the unknowns become known, which some people identify early enough to survive, and in some cases prosper.
Be alert, and share with us what we should be seeing.
As investors we have suffered mightily from a sharp decline in market prices. More importantly, the world has gone through an economic devastation. The tyranny that we are now facing is the normal reliance on experience. We are looking at the events of the past as just another cyclical series with the thought that we will rise once again to the former heights. I, for one, doubt it. What was quite clear from the American Revolution, was there would be deaths and other casualties to our lives and to the ways that our society and economy worked.
Before we put too much weight on our ability to order the future, we need to remember, as with all wars, the losing side contributed more mistakes than the winning side. Luck was with us in the sense that the storms off Newport, Rhode Island kept the superior British Fleet bottled up, rather than doing battle with the French Fleet. Thus, Cornwallis could not evacuate his losing army from Yorktown and had to surrender to the forces commanded by the indispensable General George Washington. This was the last major battle of The Revolution, but it took two more years before a peace treaty was signed. What Americans in general (and investors in particular) did not appreciate was that the “peace party” in Parliament at the time was gaining the upper hand, and wanted the war ended, for they had better things to do with their resources.
How should we learn from the American Revolution today as investors? First, do not hold up a mirror to the past cycles. Though we can still learn from sound principles from the past in terms of risk management, they will be broader than in the past. Second, look for changes in structure in both the world economy and in the market place. We have seen the rise of sovereign wealth funds and the expansion of central banks, which could be the tyranny of new attempts at central controls. We have already seen the disappearance of floors of securities exchanges in favor of electronic exchanges, which will operate from the ether, domiciled in the least regulated locations. We are finally close to getting some of the derivatives, (e.g. credit default swaps) clearing through a series of central clearing houses. Finally, within a relatively few years, we will see new leaders arise who will be much better equipped to manage themselves, their own activities and perhaps even governments. Just as the leaders of the American Revolution succeeded through the much more difficult task of writing a Constitution and creating a new form of government, we may see new groupings of people, not based on location but rather their own particular interests.
In looking to a brave new and frightening new world, we may have to get rid of old ways of thinking. For instance, the so-called “prudent man rule” has been the foundation for courts and learned investment opinion since it was handed down by a Massachusetts state court in 1830. The case questioned whether Harvard College was managing its endowment properly. Judge Putnam ruled against Harvard, by defining prudence as what other intelligent people did with their own money. (Seems as if Harvard has a slow learning process.) Despite this definition of prudence, we could be entering a period that new and thoroughly thought-out investment policies should be followed. For example, is the legal form of an investment as important as the predictability and terminal value of a security? Thus, we may find that compartmentalizing a portfolio into stocks, bonds, funds, and various forms of illiquid investments is not as important as the variance of future year-by-year returns, expected or tolerated. Another consideration that may come increasingly important is the evolving body of corporate and civil law, e.g. stipulating the priority position of senior secured bond holders or the imposition of “gates” on hedge fund redemptions, etc. Will changes in estate taxes alter the motivations and valuations of various investments in public and private securities? The list of examples is far from complete. The purpose of these radical, perhaps not revolutionary, ideas is to indicate some of the range of changes that should guide us to seek a new way of thinking.
In the end, tyranny of all forms is self-defeating, as it can never for all times be complete. Eventually the unknowns become known, which some people identify early enough to survive, and in some cases prosper.
Be alert, and share with us what we should be seeing.
Monday, June 29, 2009
The Temptation to Go Short
There appears to be general agreement that a bottom in the stock market indexes was achieved on or about March 9, 2009. April was a strong month, and in some cases showed the kind of progress one sees in what we used to think was a “normal" year. May, and the first few weeks in June, showed additional progress, but at a slower rate. The penultimate week in June showed some weakness. Now we have just two days to see whether we will have a trading rally for the late institutions trying to get rid of too much cash, and trading desks attempting to square their positions.
The popular press (if that term is meaningful anymore), is developing an expectation gap. Very few new jobs have been created by the government’s stimulus. Auto sales have not picked up since the intervention. Interest rates are low, which in many respects shows the lack of solid loan demand. Though somewhat counter-intuitive, many would consider moderately rising rates a plus.
Could we see another test of the recent lows? The answer is yes. But that is not the right question. The correct question is, “What are the odds that we have seen the bottom for most stocks in 2009?” My guess is that there is a better than a 75% chance that we have seen the bottom for most stocks. There is a new symbol for this bottom, “VL.” This suggests that we have already seen something of a “V” bottom coming off the March lows, to be followed by dull, relatively flat movements of most prices. (Within the horizontal portion of the “L” there is plenty of opportunity for trading successes.) Some believe this flat, range bound, market could last for a long time. One might say “VL” stands for very long.
In the face of these observations, why do I believe, in general, shorting it is now unwise for most investors? Often, the study of mutual funds provides answers to larger investment questions. The mutual fund industry is competitive always within its own market, but has grown by entering other providers’ markets; money market, tax exempts, and bank loans are just three examples. Many in the fund business feared the “retailization” of hedge funds (the decline of hedge fund minimum investment requirements) might cause mutual funds to lose customers. The counter attack by the fund industry was led by the so-called 130/30 funds. These funds invest 100% of their assets on the long side and with the use of leverage (often margin) allocate 30% on the short side. Other funds, also willing to bet on declines at least of the markets, if not civilizations, are available.
My old firm, once Lipper Analytical Services, now known as Lipper, Inc., created an investment classification called “Dedicated Short Bias Funds” as a peer group for the 130/30 and other funds betting, at least in part, on a decline. Setting up this peer group worked well. In 2008, and again in the first quarter of 2009, Dedicated Short Biased funds were the best performers (and often the only profitable funds on average) in the diversified US equity fund super-group. As I have often stated, fund performance is cyclical, driven by the highest mathematical power, within a large universe, of reversion to the mean. (Both the leaders and the laggards move in the direction of the middle of the array, often way beyond the point of becoming the new leader or laggard).
I doubt that there will be a meaningful reversal of the performance and rank of the average Dedicated Short Biased fund for the first half and second quarter of 2009. In both periods, these funds are the only classification within the U.S. Diversified Fund super group which shows negative results. Their current fund declines of over -20%, is larger than any other fund in the super group on the upside. (A number are getting close to a 20% gain for the first half.) Further, I believe it is too early to see a counter-reversal for the short sellers.
Thus my considered judgment for investors, not traders, is: this is not the time to go short.
The popular press (if that term is meaningful anymore), is developing an expectation gap. Very few new jobs have been created by the government’s stimulus. Auto sales have not picked up since the intervention. Interest rates are low, which in many respects shows the lack of solid loan demand. Though somewhat counter-intuitive, many would consider moderately rising rates a plus.
Could we see another test of the recent lows? The answer is yes. But that is not the right question. The correct question is, “What are the odds that we have seen the bottom for most stocks in 2009?” My guess is that there is a better than a 75% chance that we have seen the bottom for most stocks. There is a new symbol for this bottom, “VL.” This suggests that we have already seen something of a “V” bottom coming off the March lows, to be followed by dull, relatively flat movements of most prices. (Within the horizontal portion of the “L” there is plenty of opportunity for trading successes.) Some believe this flat, range bound, market could last for a long time. One might say “VL” stands for very long.
In the face of these observations, why do I believe, in general, shorting it is now unwise for most investors? Often, the study of mutual funds provides answers to larger investment questions. The mutual fund industry is competitive always within its own market, but has grown by entering other providers’ markets; money market, tax exempts, and bank loans are just three examples. Many in the fund business feared the “retailization” of hedge funds (the decline of hedge fund minimum investment requirements) might cause mutual funds to lose customers. The counter attack by the fund industry was led by the so-called 130/30 funds. These funds invest 100% of their assets on the long side and with the use of leverage (often margin) allocate 30% on the short side. Other funds, also willing to bet on declines at least of the markets, if not civilizations, are available.
My old firm, once Lipper Analytical Services, now known as Lipper, Inc., created an investment classification called “Dedicated Short Bias Funds” as a peer group for the 130/30 and other funds betting, at least in part, on a decline. Setting up this peer group worked well. In 2008, and again in the first quarter of 2009, Dedicated Short Biased funds were the best performers (and often the only profitable funds on average) in the diversified US equity fund super-group. As I have often stated, fund performance is cyclical, driven by the highest mathematical power, within a large universe, of reversion to the mean. (Both the leaders and the laggards move in the direction of the middle of the array, often way beyond the point of becoming the new leader or laggard).
I doubt that there will be a meaningful reversal of the performance and rank of the average Dedicated Short Biased fund for the first half and second quarter of 2009. In both periods, these funds are the only classification within the U.S. Diversified Fund super group which shows negative results. Their current fund declines of over -20%, is larger than any other fund in the super group on the upside. (A number are getting close to a 20% gain for the first half.) Further, I believe it is too early to see a counter-reversal for the short sellers.
Thus my considered judgment for investors, not traders, is: this is not the time to go short.
Sunday, June 21, 2009
The Aging of the Uncertainty Principle
As a child growing up in one of the small towns, if you will, neighborhoods, pushed together on the island of Manhattan, I collected railroad timetables. Initially it was the maps that attracted me, depicting routes of the railroads often displaying them quite differently than their competitors. Later I became intrigued with the precision of the times of arrival at the various destinations of different trains. I was told that, at some point, I was able to recite to so-called adults, the fact that currently a train was leaving New York and would arrive at a particular destination at a precise time. Perhaps it was the certainty of these predictions that appealed to me during World War II. (I was blissfully unaware of the reality of train delays.) Later in life I remember spending an entire day at both the Detroit and Geneva airports, waiting for the weather to clear so the scheduled flights could take to the sky. I guess it was then that I learned the wisdom in the saying, “If you have time to spare, go by air.” Only reluctantly have I learned that the precision of timetables masks the uncertainty of arrivals and departures.
One of the most common of all beliefs of politicians, marketers, and analysts of all types, is that demographics dictate the future. There is a calming feeling of certainty being able to make mathematically precise predictions of the number of people of various types who will be alive, consuming so much protein, with a specific percentage employed, etc. Actuaries are paid to predict exactly when our poorly designed social security system will reach the single point of no return. That point is the exact date when the inflow from employment taxes will be surpassed by the outflow of benefits. In theory, the importance of this date is to determine how the government will deliver on promised retirement provisions.
Either inflow has to be raised by one means or another or outflows must be modified. Within the Beltway of Washington, tinkering with social security is considered touching the third rail. (Interesting that this is an illusion going back to the electrification of railroads as well as to present day subways.) The date of this presumed point of no return occurs in 2016. This date was partly determined on the projected proportion of people aged 55 who would continue to work. The last estimate was that only 40% would continue to work. Currently the number is about 55% and expected to go higher due to the decline in retirement savings assets caused by the market and economic declines. This is where my sense in traveling by train or by air is alerted; I believe it is wise to presume some margin of safety regarding expected arrival times. My own estimate is that 75% of Americans will continue to work, and most importantly, pay payroll taxes beyond age 55. In some ways this is an extremely bullish view, for it rests on the assumption that members of the 55 and older set are able to find jobs.
Notice that most headlines or declarative statements at social gatherings are begun with a specific prediction as to a future event, be it sporting, political, or market-related. As we are all just large children, we love the certainty of a prediction delivered with the force of a strong personality. Most investment portfolios, particularly those managed by financial institutions, can be summed up as predictions of a specific future. These predictions provide us assurance that we are acting prudently, and that planned expenditures (or outflow) demands can be met. In many ways this is just as childish as having total faith in timetables. To put it bluntly, we don’t have the certainty of a financial statement when it comes to the future, and what it will hold for any of us. What makes the certainty of this belief somewhat incredulous is that this goes against our “bible.” Most securities analysts trained in the black art of the market have read, or at least have been taught from Securities Analysis, originally written by Graham and Dodd. I remember quite vividly taking Professor David Dodd’s course, and listening to his intoning on the need for a margin of safety. Dodd’s margin of safety was defined as an additional discount from current price, after all other discounts were taken for various financial calculations, i.e. inventories, pensions, etc. This margin of safety (in Warren Buffet’s terms, “the moat”), around the future value of a security, is needed to cover for the unknown. While many investment professionals claim they adhere to these principles in terms of individual security selections, their portfolios do not.
Most of today’s portfolios are based solely on the most probable future that is expected. Often this perceived future starts with precise measurements of economic growth, inflation, value of the currencies etc. From these projections (timetables), various expenditure patterns become acceptable or not. I suggest that this approach is not wise and belies the history of human experience. Long-term portfolios, which are not under intensive daily management, should be able to deliver under most conditions (even some extreme ones). This may mean holding, within a portfolio, securities that are cyclically oriented, growth oriented or trading in different currencies.
A more realistic approach is not to plan to spend future income to meet needs, but rather to wait until income is achieved and appropriate reserves are taken for future valuation changes. The approach of earning before spending is often the base of conflicts between the generators of wealth and their families and key charitable interests. A compromise should be possible in the diversified portfolios of both ultra high net worth families and those of more modest size. The compromise should be to “agree to disagree,” that each perceived need requires its own specific portfolio, with its own operating procedures. Some might even follow timetables, while others will keep refreshing their “moats.”
One of the most common of all beliefs of politicians, marketers, and analysts of all types, is that demographics dictate the future. There is a calming feeling of certainty being able to make mathematically precise predictions of the number of people of various types who will be alive, consuming so much protein, with a specific percentage employed, etc. Actuaries are paid to predict exactly when our poorly designed social security system will reach the single point of no return. That point is the exact date when the inflow from employment taxes will be surpassed by the outflow of benefits. In theory, the importance of this date is to determine how the government will deliver on promised retirement provisions.
Either inflow has to be raised by one means or another or outflows must be modified. Within the Beltway of Washington, tinkering with social security is considered touching the third rail. (Interesting that this is an illusion going back to the electrification of railroads as well as to present day subways.) The date of this presumed point of no return occurs in 2016. This date was partly determined on the projected proportion of people aged 55 who would continue to work. The last estimate was that only 40% would continue to work. Currently the number is about 55% and expected to go higher due to the decline in retirement savings assets caused by the market and economic declines. This is where my sense in traveling by train or by air is alerted; I believe it is wise to presume some margin of safety regarding expected arrival times. My own estimate is that 75% of Americans will continue to work, and most importantly, pay payroll taxes beyond age 55. In some ways this is an extremely bullish view, for it rests on the assumption that members of the 55 and older set are able to find jobs.
Notice that most headlines or declarative statements at social gatherings are begun with a specific prediction as to a future event, be it sporting, political, or market-related. As we are all just large children, we love the certainty of a prediction delivered with the force of a strong personality. Most investment portfolios, particularly those managed by financial institutions, can be summed up as predictions of a specific future. These predictions provide us assurance that we are acting prudently, and that planned expenditures (or outflow) demands can be met. In many ways this is just as childish as having total faith in timetables. To put it bluntly, we don’t have the certainty of a financial statement when it comes to the future, and what it will hold for any of us. What makes the certainty of this belief somewhat incredulous is that this goes against our “bible.” Most securities analysts trained in the black art of the market have read, or at least have been taught from Securities Analysis, originally written by Graham and Dodd. I remember quite vividly taking Professor David Dodd’s course, and listening to his intoning on the need for a margin of safety. Dodd’s margin of safety was defined as an additional discount from current price, after all other discounts were taken for various financial calculations, i.e. inventories, pensions, etc. This margin of safety (in Warren Buffet’s terms, “the moat”), around the future value of a security, is needed to cover for the unknown. While many investment professionals claim they adhere to these principles in terms of individual security selections, their portfolios do not.
Most of today’s portfolios are based solely on the most probable future that is expected. Often this perceived future starts with precise measurements of economic growth, inflation, value of the currencies etc. From these projections (timetables), various expenditure patterns become acceptable or not. I suggest that this approach is not wise and belies the history of human experience. Long-term portfolios, which are not under intensive daily management, should be able to deliver under most conditions (even some extreme ones). This may mean holding, within a portfolio, securities that are cyclically oriented, growth oriented or trading in different currencies.
A more realistic approach is not to plan to spend future income to meet needs, but rather to wait until income is achieved and appropriate reserves are taken for future valuation changes. The approach of earning before spending is often the base of conflicts between the generators of wealth and their families and key charitable interests. A compromise should be possible in the diversified portfolios of both ultra high net worth families and those of more modest size. The compromise should be to “agree to disagree,” that each perceived need requires its own specific portfolio, with its own operating procedures. Some might even follow timetables, while others will keep refreshing their “moats.”
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