Introduction
Are you an investment trend follower or a selector? The answer to the question will determine the
result and the comfort level of your volatility.
Many institutional and
individual high net worth investors inherently believe in the comfort of being
gathered into the current central tendency of the market. They fundamentally
believe in the phrase “the trend is your friend.” Others with some exposure to
the sports and/or political world are very aware that there is an end to every
trend which can be surprising and dramatic. Other investors practice a
diversion from the central tendency by being selective.
The
“H” and “T” Choices
While each of us think
we can easily make rational choices between trend following and selectivity, to
go against the trend you may have to identify whether you are more “H” or “T.” Briefly “H” stands for Herodotus and the “T” for Thucydides. Both
were historians of ancient Greece. The
first has been called “The Father of History” and by some “The Father of Lies.”
He was among the first to write down the combination of what he saw and what we
would call oral history without much authentication. He put these stories into
a continuum in order to show a developing trend.
Thucydides has been called the father of scientific
history. Unlike his predecessor he did not often express an opinion and
required hard evidence in the experiences beyond his own. In effect, he was a
collector of incidents including the motivation and expertise of the main
players. I must admit to a leaning in his direction as he was a general in
addition to be being a historian. His history is required reading in the US
Naval War College.
Why
are so Many People Wired to be Trend Followers?
Which way we have been
taught may very well have to do with a political decision made by the Communist
Party in the US and probably elsewhere in the 1920s. The party saw that it needed
to convince people as to the inevitability that communism would triumph
eventually. They were clever in getting educators at various universities, high
schools and even grammar schools to accept these so-called trends as the way
the world will go, thus building the belief in the inevitable march through the
left to socialism and then communism after a number of generations. Many, if
not most of us have been schooled in trend identification and following. Once
this becomes our main thought process toward political history it is difficult
not to apply it to our investing.
Trends
Don’t Last
A careful study of the history
of almost any topic will show that the human genius often comes up with
intelligent breaks of emplaced trends, be it fashion, art, music, politics,
sports or investing. While there are some risks in being too early in deviating
from the existing trends, the loss of capital opportunity of getting on sound
future trends is much more expensive than being too early.
The
Job of a Professional Analyst
The most important job
of professional analysts is to act as Thucydides would to examine what is
actually happening and apply the lessons prudently. This is what I attempt to
do every day for the benefit of my accounts. I do this with the comfort of
knowing that most investors will be trend following. This will help in keeping
my losses relatively small when I am too premature and have the pleasure of
selling into the crowd when the new trend becomes acceptable.
This
Week’s Historical Implications for Possible Trend Disrupters
Last week the Chief
Investment Officer of Matthews Asia with his forty strong investment group had
a breakfast meeting at a midtown Manhattan hotel. He is betting on rising wages
within Asia led by China and India to create massive consumer spending. (Interesting
that the government of China recognizes that its hold on power is dependent
upon job creation funding a rising standard of living.) He expects that China’s
former role as the driver of demand for many industrial commodities will be
filled by India with announced major infrastructure projects. To accomplish
these goals India will need (as in China) to pay attention to the level and
grasp of corruption. Asian stocks while not relatively cheap in terms of
price/earnings ratios, appear to be relatively cheap on a price/sales ratio. I
would be focusing on the spread between return on invested capital and return
on equity to focus on the risks of over-leverage. As these countries move from
low wages to higher, I find operating earnings per person is a trend of
particular interest to me.
Much of my focus on
deeper financial ratios comes from almost a year solely devoted to getting my
arms around General Electric in the mid 1960s. Interesting from my seat at the breakfast last
week I could see across Lexington Avenue to the entrance of what used to be the
General Electric headquarters building. One of the reasons I question lots of
trends is that while the numbers proceed,
the way they have been generated has changed to such a degree that past
comparisons are less meaningful. My analysis of GE was that the company was
essentially a manufacturer which had various financial and insurance activities
to support the manufacture and sale of its products. That started to change as the CEOs changed. GE
moved its headquarters to lower-taxed Connecticut and started to grow GE
Capital into an independent, financially aggressive series of unrelated
activities. The move to southern Connecticut cut the taxes for the most senior
executives living in that state, and detached itself from the New York financial community.
Initially this helped GE overcome an aging plant and employment base, but it
also fundamentally changed the corporation into a materially slower operating
growth company on the industrial side and increasingly dependent on, in my
opinion, lower quality earnings from GE Capital. Thus while GE is probably the
only stock in the Dow Jones Industrial Average stock for the last 100 years, its long-term
trend is not particularly useful in predicting its future stock price.
Brokers
are Sharing the Disappointment
The pre-Tax Return on
Equity in 2014 was 9.2% compared with 25.1 % in 2000 and 40.3% in 2009 for the
aggregated NYSE reporting firms according to SIFMA, the industry trade
association. Revenues are less than half their peak levels of 2007 and have
been essentially flat at $165 Billion between 2008 and 2014. The number of
registered representatives for FINRA has not varied much since 2009 and is now 637,000. The average annual turnover
rate of shares traded on the NYSE is the lowest it has been in the last 15
years.
What has gone up and
shows the change in the structure of the market is total margin credit
(borrowing); in 2014 it reached $456 Billion compared to $187 Billion in 2008.
The growth in margin credits is a mirror of the growth in hedge funds and other
trading vehicles. Another growth element through 2014 and probably reversed (at
least temporarily) is the portion of the Global Equity Market Capitalization that
is now 23% which is double its 1995 level of 11%. When Emerging Markets return
to favor there is a good chance that the 42% invested in the US will drop. (Any
investor that has more than 50% invested in the US is betting against the
rising standard of living outside of the US.) This is a major change in the
structure for the long-term demand for US stocks. For those who have a portfolio structure
similar to our TIMESPAN L PORTFOLIOS®, I would recommend to have
significantly greater international holdings in their Endowment and Legacy
Portfolios than their Operating and Replenishment Portfolios. Charles Schwab’s
next 12 months earnings growth is 2% higher for the Eurozone at 15%, and 5%
higher for Emerging Markets.
Bulls
Could be Disappointed
Readers of my blog know
that I don’t like being in crowded trades, viewing that often one’s co-venturers
in a security are potentially a greater source of price risk than the issuer
itself. Further, I have often identified that I manage a private Financial Services
fund. In this week’s Barron’s nine
investment strategists were asked to pick their favored sectors. Eight had
financials in their selections. The saving grace for me is that I
believe our stock selection is quite different than the bulk of others, without
significant holdings in commercial banks, credit card networks or life
insurance companies. Nevertheless, I get concerned when new money is coming
into my neighborhood.
All
is Not Clear Sailing Ahead
The Third Avenue
Focused Credit Fund has had too many redemptions so has suspended the ability
to redeem from the fund. This is particularly instructive on a number of
levels. For some time the yield spread between high yield paper and US
Treasuries has widened considerably. At the same time the credit rating
agencies have raised their year ahead estimate of the percentage of high yield
paper that is likely to default. The combination of low sales growth, falling
energy prices, rising interest rates and maturing debt schedules are some of the
market’s apprehensions.
What is fascinating to
me is that the management company was founded by Marty Whitman, a 91 year
old very successful distressed
securities player who made a lot of money for me. As part of my research on
closed end funds that we were tracking I bought some shares in a West Coast
fund that was being managed by a trust bank, but was selling at a big discount.
Mr. Whitman bought control of the fund and converted its portfolio into a
distressed securities portfolio with particular focus on firms that had large
tax loss carry forwards. He then merged
operating companies into those with large losses and thus freed them of a
tax burden. This was a wonderful investment particularly as it was not an open
end fund that had to meet redemptions. To me this is the appropriate place for
investing in similar merchandise, not like the Third Avenue open-end fund.
Fund pioneer and value
investor Max Heine with his associate Mike Price at Mutual Shares did the same
thing on a smaller scale in their open end funds which always carried large
cash reserves plus a portfolio of very liquid stocks. There is nothing wrong
with selectively owning distressed securities if you know what you are doing
and do not need liquidity in a market with shrinking risk-oriented liquidity. (If
anyone is interested I will share what I did with cumulative shares in arrears
as a another distressed securities play.)
The final possible
storm warning is the interest rates that many banks are offering for deposits.
Just this week the average dropped to 0.26 basis points from 0.28 the week
before and 0.44% earlier in the year. There is a demand for loans, but banks
may be so constrained by bank capital requirements they would prefer to keep their
money with the Fed or in the highest quality corporate bonds whose yields according
to Barron’s are averaging, 3.74%
which is more popular this week than last.
Question
of the Week: What portion of your portfolio do you
consider significantly different than mainstream thinking?
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A. Michael Lipper, C.F.A.,
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