Cookbook Investing Doesn't Work

This is my 400^th weekly published blog post. Many thanks to my readers in the US and around the world, in particular to those who have commented or written to me over the years.

Amidst the global market uncertainty last week, my blog post “Probable Causes of Underperformance” was named one of the five Most Read Fund Manager Comments in London’s Citywire Global.  Click here  to read.

Introduction

Thus far 2016 looks and feels different than 2015. Our last two posts which were well received in the global investment community highlighted some of the changes. My friend, the Wall Street Journal’s Jason Zweig and Caltech have been researching how our brains are wired to handle the processing of information that ultimately gets translated into fear and greed. Both the financial journalist and the university acknowledge that people have difficulty dealing with uncertainty. This is particularly true when different elements trigger both the fear and opportunity tracks. We may be at such a junction now.

Misreading the Visible

Some of the items that are being misread are as follows:

1.  Size of government debt which does not include quasi-debt; e.g., actual and implied credit in mortgage markets, social security types of retirement plans and critical-to-national-interest large commercial activities, (in China they are known as State Owned Enterprises SOEs).

2.  Fund flows out of US and Japan, out of domestic stocks and corporate bonds and loans as well as Exchange Traded Funds (ETF).

3.  Declining Returns on Invested Capital (ROIC) of money center banks and major brokerage firms.

Investment Implications

1.  Aggregate government debt will rise as governments attempt to solve societal problems directly rather than through personal and corporate channels which will mean that governments will be sponsors of inflation to make fixed repayments easier.

 2.  Foreign investors have been correct about the direction of their flows into and out of Japan. This is the first time in 25 years when they have been wrong when they produced net outflows and the  Japanese market rose in double digits. I suspect the foreigners were expecting greater declines in the value of the yen. In the second half of 2015 foreign investment in US stocks and corporate bonds declined. Also the US mutual fund investor was a net redeemer of domestic portfolio funds while buying foreign portfolio funds. The net redemptions of Fixed Income funds raises the question,  “have bonds lost their place as a balancing instrument in mixed asset portfolios?”

3.  In many ways the biggest implication of 2015 and early 2016 activities of large money center banks and investment banks is the withdrawal of capital and people from the marketplace. In a world where there is probably 100,000 tradable securities, Merrill Lynch claims to follow only 3500 companies. We are already seeing a talent shift out of the large leaders to smaller financial groups including Registered Investment Advisors (RIAs). To the extent that the retail public is buying ETFs, I suspect that the economics work better for a former broker or bank advisor to use ETFs as an RIA. The market seems to recognize the problems that these large organizations are in. Goldman Sachs^* is selling at $164 per share which is very close to its tangible book value of $162. Thus the market is paying nothing for the firm’s talent and position in clients’ minds. Morgan Stanley^* is selling below tangible book. If these two firms are accurately priced then I have to wonder whether the general stock market is worth owning. If the "house" is not going to be adding to its long-term value, is it reasonable to assume that the bulk of investors will and if they don't, how much longer can the game go on?

*Held either personally or in the private financial services fund I manage                          

What are they Missing?

The desire for hard data is what drives both quantitative and fundamentally-oriented investors  and limits them to the known in building their algorithms or rules. A cookbook solution is usually created to publicize an investment method. There are two problems with this approach. The first is that I am told that the great chefs don't exactly follow a cookbook recipe as they always modify and improve what they do. The second is in the real world uncertainties are often present and could be large.

When I was a securities analyst studying new potential investments, I made a list of the things I wanted to know about an investment. Quickly the list reached on the order of 100 items. After diligent work I could get up to perhaps 50-60% of the items covered before the fear of a price moving away from the most desirous entry price occurred. Thus I had to make a decision and accept a large amount of uncertainty or go find another opportunity.  Based on the luck of time and investing in America, I had a favorable secular trend working for me so a good number of my recommendations performed well. Thus to this day I am willing to accept a level of uncertainty that would not be acceptable to “quants” and other rule book investors.

One of the major fallacies that many investors accept is that they only deal with what they think they know without regard for what they don't know; or in a Mark Twain world, what they know is wrong. Over the last year Money Market funds serving both individuals and institutions gained $16 Billion, the most of any asset class which demonstrates that their shareholders could not find suitable investments. Further, even with significant mutual fund outflows, the vast majority of fund holders continue to hold their assets in funds. To me the big uncertainty is what is on the mind of the fund holders. Why are they not being swept up in the excitement of the market place? I would suggest that there are two reasons for their current attitude. The first is a belief that for the foreseeable future funds in general are meeting their longer term needs. The second is the future is not clear enough to them to make changes.

 Another long-term trend to consider is that selling mutual funds today is far less profitable than other products like IPOs, hedge funds, private equity funds and securities. ETFs can be much more profitable when they are leveraged and frequently traded.

There is lot written about ETFs, but very little about the source of their volume on the market. What looks like general acceptance of the investment value of a particular ETF may be just the opposite. The only ones who can transact with the ETF sponsor is one or more Authorized Participants (APs).  These are market making dealers on the floor of the exchange. Many of their customers are hedge funds or other trading entities who have shorted the ETF as part of a hedged trade in which they are long. Thus they are betting that the value of the ETF will decline more than what they are long.

Bottom Line

With many stocks down over 5% and in some cases more then 10%, we could be half way to a bear market. I believe the real risk for long-term investors is not being in a position to participate in the next major upswing, whenever it appears.

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Comment or email me a question at: mikelipper@gmail.com.

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Copyright © 2008 - 2016

A. Michael Lipper, CFA,
All Rights Reserved.
Contact author for limited redistribution permission.

Probable Causes of Underperformance

Introduction

Most investment managers produced returns of mild single digit to mid- teens losses. Some of these managers were research-intensive managers with long histories of good results. They did not take dumb pills or drink depressing Kool-Aid on a summer eve. While they were confronted with a world where the vast majority of securities and commodities fell, they should have done better, including having some of their money in the minority of stocks that rose. What happened? I believe conditions fundamentally changed.

Lessons from the Racetrack

The first time I had to confront making bad decisions was at the racetrack when I didn’t cash winning tickets. In many ways that is when I started to learn valuable thought patterns that I applied later to investing for others and myself. In roughly the half hour between the losing race and the next one I hurriedly reviewed all of my calculations and visual inputs. I divided these into categories. In the first category were the questions did I miss changes or underestimate the importance of track or equipment changes? For example I usually noted that my horses had changes of equipment or jockeys and trainers, but I also asked, “were they being equipped with blinkers to keep them running straight and not being bothered by other horses?” Too often I did not look at these changes on all competitors which meant that I missed a poorly performing animal prior to the race that became easier to ride and guide to the finish line that was not characteristic of its past performance. (Too often investors don’t fully appreciate the changes in management of competing companies or portfolio managers.) The biggest category was the expected winning time of the race. Often if the race is slow almost any horse can win, similarly in a low performing market any investment that has a slight advantage does win. My mistake was to look at the recent track record for the race and guess which horse could run at that speed or better. In the market all too often investors look to an investment that can be spectacularly better than average. Too often one needs to look to the risks undertaken when finding such a vehicle or horse. Most of the time, a spectacular win will start with a chorus of disbelief, which could be correct. By far the biggest hurdle to handicapping or investing is to recognize that the basic conditions have changed which could be rules changes, unexpected weather, personal issues of the professionals, etc.

From an investment viewpoint, I believe 2015 experienced such cumulative changes that make many of our old approaches less useful.

What Changed?

The following are a list of important differences in 2015:

1.  The reduction of position capital at trading desks of major institutions and investment banks which are under the restraints of the Volcker Rule. Liquidity was available, but at a price and at a time of the liquidity provider’s choosing. This has led to a significant level of intraday volatility. This plays into the hands of the high frequency traders and other algorithm users picking off large scale movements. Bottom line: trading has become meaningfully more difficult and perhaps expensive in terms of full execution costs. What used to be only an equity market problem now is very much a factor in trading in US government paper and starting to be an issue for investment grade trading.

2.  The central banks’ manipulation of internal interest rates has morphed into manipulation of foreign exchange rates which are impacted by both flows into and out of the market that are not price sensitive, the values of global securities and a range of commodities.

3.  Big data comes to the Biggest Markets in a Big Way. US based managers feel comfortable having their US offices managing non-US securities. Similarly global portfolios of US securities are being effectively managed in distant offices of foreign investors. The availability of all that is known about a security instantly means that there is less opportunity to strip or dump into a market. The passage of “FD” (Full disclosure as mandated by the SEC) means the investment/trading value of published information has declined. As more institutions utilize secondary and tertiary research their value becomes discounted.

4.  “TINA” (There Is No Alternative) is not the only alternative. The investing public has globally built up their stake in money market funds and other repositories of low returns with the ability, not used yet, to rapidly reinvest. Some are using long or short positions in index ETFs or index funds. (I prefer the latter.)

5.  A growing recognition that much of government produced data needs to be questioned. In one of his first acts the new President of Argentina was to order his government to create accurate data. Another example is the former Premier of China acknowledging that its GDP was “man-made” which meant he did not trust it. 

One can take the position that one of the reasons that the Federal Reserve has had such off the mark forecasts is bad data. At a public meeting at the New Jersey Performing Arts Center (at which I am a trustee and chair of the investment committee) I asked Bill Dudley the President of the NY Federal Reserve Bank and a permanent voting member of the FOMC what additional data would he like. Bill who is a veteran numbers crunching economist at Goldman Sachs responded that he would like to know much more about the creation of the rapidly expanding student debt. He is right as student debt is the largest amount of consumer debt, greater than residential mortgages. To the extent that this debt is to be repaid colleges are going to have to produce easily employable workers who will have to postpone buying their first home and other consumer spending. An important driver of the size of student loans are the costs of food and lodging, which are often superior to their first apartment post-college, if they graduate).

6.  Many of the major economies are increasingly being driven by the service sector and not manufacturing whereas most governments and central banks have tools to spur a declining manufacturing sector. In the US it is important to focus on how US auto sales are recovering to previous heights established years ago with a smaller population. What should be noted is that in 2015 US branded cars are filling less than half of the demand. This is important because to an increasing extent a car or light truck is an electronic platform on rubber wheels. This signals that the auto (and for that matter almost all markets) have changed and our governments have not kept up. Some are conscious of this as the Bank of England has noted that there was more acquisition of service companies in 2015 than manufacturers.

7.  Target Date Funds are being questioned due to their exposure to bonds in a somewhat rising interest rate environment. This could be quite harmful to those who are about to retire when much higher interest rates and lower bond prices start to occur.

Don’t Bet on Favorites Most of the Time

I learned at the track that normal favorites win only about a third of the time, but because their betting odds have been beaten down by players pouring in the winning dollars when they do win, do not pay for the 2/3rds of the time they don’t win. That is why my bet for 2016 is for a big year up or down. My best guess is UP, for the Wall Street Journal may have taken over from Time Magazine and the former version of Businessweek with its cover pictures of success people. Saturday’s Wall Street Journal had a front page article headlined “Drab Outlook for Markets.” If the article is correct my clients don’t stand to lose a lot, but if I am correct 2016 will be anything but drab with a reasonably good chance of a better than average result. Perhaps some of the poor performing managers could produce great results in their recovery.

What Should I be addressing Next Week?

The next post of this blog will be my 400th. Are there topics I should address or would you like me to reprint any of the old posts?

As you start the New Year we wish you and your family and associates a Healthy and Happy New Year.       

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Did you miss my blog last week?  Click here  to read.

Comment or email me a question to MikeLipper@Gmail.com.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

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

What does 2015 say about ’16?

Introduction

Does what happened in the markets in 2015 set a trend for 2016? In prior posts I have discussed trends and the general comfort in trend following as well as the advantages in terms of bigger profits or smaller losses while picking up early divergences from a trend. On the last weekend of the year it is difficult to separate the evidence between nothing new and as ordered in “Alice in the Looking Glass,” the lobsters continue their dance. Or can we identify future turning points? Let’s look at the current situation for clues.

Continue the Dance

What will continue in 2016? We will enter the eighth year of the second period of the key US decision maker being a woman. My concern is not that these were both women, but that critical decisions were made by people unelected and/or unconfirmed by the US Senate.  The first was the second Mrs. Woodrow Wilson and now Valerie Jarrett. In the first case, some of our British friends suggest the decisions made through the Woodrow Wilson White House set in motion both the lengthening of WWI and the critical impetus to WWII. Some may be seeing a similar pattern being caused by the current occupant’s last year in office.

The Federal Reserve is one of the worst forecasters in the US. No recession is in its forecasts at least until 2019. Moody’s won't go that far, it believes that the “wide high yield spread doesn’t mean a recession is nigh.” Further, “jobless rate and yield curve have yet to predict” a recession. Stephen Roach’s latest piece in Project Syndicate suggests the reason for this is “the Fed, like other major central banks, has now become a creature of the financial markets rather than a steward of the real economy.”

Wall Street focused pundits are at best predicting a flat to middle single digit gain for stock prices. Numerous pension plans and granting foundations are using portfolio gain rates between 5% and 8% in their planning for the next year. This relative caution could be the cause of business capital expenditures to decline a bit, but at the same time consumer expectations are higher than current readings. As of the last weekend of the year, the Dow Jones Industrial Average without benefit of dividends is down -1.5% and the S&P500 +0.1%. That is not the full story, the Dow Jones Transportation Index is down -16.6% and the NASDAQ 100 is up +9.1%. This dichotomy explains the results of most equity mutual funds with those focusing on growth particularly in global health/biotech providers showing average gains of +9.45%, which is the single best performing investment objective tracked by my old firm Lipper Inc, now a ThomsonReuters company. Whereas portfolios largely focused on manufacturing and transportation showed losses, they were not alone, a value focused portfolio produced flat to slight declines. Many hedge funds both equity and debt-oriented also showed negative results.

Using the handicapping tools I learned at the race track trying to find suitable bets on imperfect horses, I tend to pay less attention to annual moves of 10% positive or negative. Big gains and losses of significance come in packages with at least 20% moves, even if they are a bit abnormal in coming. Thus in my portfolio selection efforts for 2016 for investing in the year as well making choices for Timespan Portfolios with 15+years duration, I am noting but not dwelling on 2015 results.

Negative Inputs

1. Electronic trading, including high frequency trading (HFT) is dominating the trading in US treasuries and now investment grade bonds to such an extent that the short side in US Treasuries is now viewed as a crowded trade. (Crowded trades are ones when the bulk of one side of the market is dominated often by fast traders; e.g., Hedge Funds and Proprietary Trading desks. The risk involved is that these players may follow momentum at any price, thus creating extreme market movements unrelated to price and value.)

2. Globally the US dollar has become too attractive vs. other currencies. Thus, at the end of 2012 the Canadian dollar was trading at parity with the US dollar and now the Loonie, the Canadian dollar is worth about $0.72 cents.

Compared to most other countries the apparent political risks to capital in the US is less. Almost all markets reverse and some will find eventual bargains in other currencies selling some of their US dollars to buy attractive goods and services as well as securities. On a long-term basis I am looking to add to my Canadian holdings of management company stocks. On a very long-term basis I find the Australian superannuation (pension) business attractive and I am hoping to find some euro denominated attractive investments.

3. Moody’s regularly publishes the market interest rates being charged on operating leases. These are very sensitive to credit ratings of the issuer. What caught my eye is that the interest rate range for those in the investment quality group from the highest to the lowest is 2.05%. On the other hand the interest spread between the highest quality “junk” and the most risky credit available in the market was 5.41% with CAA credits having to pay 10.07% which is higher than the average High Yield bond.

One of my concerns about our manipulated low interest rates is that far too many loans are priced to cover the cost of capital and operating expenses and too little for the cost of credit. My worry, despite the Fed’s lack of immediate worry about a recession, is that the size of the credit losses will be larger than historically expected. In the case of the US as distinct from China, the growth of other financial lending (shadow banking) has grown to about 33% of total loans compared with about 4% in China. Therefore the US banks won’t bear all of the costs of distressed credits.

Positive Inputs

1. The lack of any well known pundit screaming about a major upside

move is probably the single most bullish indicator. One should always remember as in golf the purpose of the market is to create humility,

thus the chance to be embarrassed the most is missing the upside.

Various sentiment polls of global portfolio managers are also expecting limited gains in 2016. If they are wrong they will have to play catch-up ball and not only commit reserves quickly but switch out of some under-performing holdings.

2. Retail fund investors both in the US and Europe have been adding to their fixed income fund investments. The combination of rising interest rates and increased credit concerns suggests to me that flows out of bond funds will eventually find a home in equity funds.

3. We like to be ahead of the market and thus now are looking at 2017, the first year of the new US Administration. History shows the first year of a new Administration of either party is often the worst of the four years. Whoever is sitting in the Presidential chair  would be wise to bring on a recession as quickly as possible so it could be blamed on the former occupant. Also with four years to work with, the new President should be able to get the economy expanding and be seen to be creating jobs.

4. I am finding lots of companies in the financial arena that I would like to permanently own at current prices. Combining this with the knowledge that there is a large quantity of talent that is ready to move for the right opportunity suggests to me that there are lots of profitable opportunities ahead.

Bottom Line

Because I have a contrarian streak, I expect a different sort of year in 2016 and if I am wrong, I won’t be hurt much.

Question of the Week: What do you expect in 2016?

________   

Did you miss my blog last week?  Click here  to read.

Comment or email me a question to MikeLipper@Gmail.com.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2015

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