Investing via Imperfections

My two most valuable investment assets are learning and recognizing imperfections. Most of the time when events don't work out the way we expect, we look for someone or something to blame. The perpetrators are not trying to disappoint or hurt us, but compared to our model of events, their model is proven to be imperfect. Because we are humans by nature, we are imperfect. Thus it would be wise to be prepared for imperfections in thinking about investing.

There is an enormous lesson that will be learned by a small minority of investors from the classic mistake of getting the recent election results wrong. They don't have the advantage that the Caltech and other scientists have over most economists. While almost all of us want certainty, political and investment pundits need to predict with absolute certainty. If they don't, they may lose the title of "expert" in the eyes of their audience. In contrast the research scientist is in the business of expanding knowledge. Thus, when "mistakes” occur in well constructed experiments the boundaries of knowledge are expanded through the recognition of the imperfections in their model. Often through recognizing the imperfection worthwhile discoveries are made.

The essence of the difference between the public expert and the research scientist is the pundit is looking for certainty and the researcher is looking for imperfections in the accepted model. Both use the power of mathematics to summarize behavior. The pontificator uses perceptions of the masses, whereas the scientist is searching for the limitations to perceived wisdom. Perhaps, the big difference is the good analyst/scientist incorporates a large quantity of doubt in his/her thinking. While every effort is made to reduce the quantity of doubt, only the fool would believe that all doubt is removed.

The biggest source of imperfections is that we do not completely understand  what we are measuring. Much more importantly, we do not fully understand what is not being measured as well as the fallacies built into our measuring devices. One of the standard series of questions on intelligence tests is which item is like the others shown. This kind of recognition is built into our way of thinking. Unfortunately for statistical analysis purposes no two people or groups are exactly like another person or group. Thus in searching for good investments we should pay more attention to the differences rather than similarities. With that in mind when we see a long chain of results such as investment or economic performance, we should remember from the racetrack and other sporting histories that streaks always get broken eventually. Thus, we need to examine the current situation and look for differences from past events (or at least express a doubt that the current event could be different than expected through extrapolation of the past).

I define my task in managing money for clients and family is to be a student of the Investment Arts. Thus, among other tasks I look to understand where the "experts" got it wrong. Recently I have found three major current and understandable mistakes that we can learn from:

• Most economic predictions

• "By the numbers" investing

• Who owns the record 

Economic Predictions

At this time of year a number of major investment organizations produce short to long-term economic predictions. There are at least two problems with these predictions. The first is that they are being made largely if not entirely by economists. (Remember no institution has more highly credentialed economists than the Federal Reserve and its regional banks. Look at their long- term record of predicting even the current economic conditions!)  Interesting that they could get some help from the institutions’ portfolio managers and some of their investment strategists who are dealing with what market prices and volumes are in effect every day. Because all who predict the markets are wrong at least some of the time, the managers and strategists may be wrong but they have a daily report card that often causes them to adjust their working assumptions.

The second drawback to most economic predictions is the source of their inputs. For the most part they use government-gathered data. This is hardly the most accurate or timely source. Two examples follow of what the government models are missing (or if you prefer imperfections to the government models). The first is income. Importantly, they use reported income from tax forms. What individual does not report the least that they are obligated to report? I am guessing if we add up all spending done through the economy it would be larger than the income reported for it would include both the "informal" segments and indirect benefits from gifts, etc. Significantly, many of those that are not solely relying on reported wages make their economic decisions based on their own perceptions of their wealth and changes to it. Our national data on wealth suggests that it is roughly divided in half with variably priced assets and so-called fixed assets (largely real estate less mortgage debt). One of my learning experiences in working with successful families is that they view their wealth differently than what is shown on tax and other documents. Because we are living in a particularly volatile time, attitudes to the size of wealth can change rapidly. These changes affect both consumption and investing that are not adequately recorded in inputs that most economists use. I suspect those who deal with major segments of our population have at times quite different concepts about where the economy is currently going compared with most economists.

In general, investors should probably pay more attention to what the people who are managing companies and their money than institutionally employed economists. The only time that it may be wise to pay particular attention to an economist is when the expressed views are not coincident with what his or her organizations are currently selling. Also it may be worthwhile to be alert to them when they express doubt as to their inputs.

The Fallacy of "By The Numbers" Investing in Mutual Funds

Media sound bites, sales people and regulators seem to think that fund investors have limits to their investment intelligence. They do not know the critical difference between ratings and rankings. When I started to develop the market for our Lipper Mutual Fund Performance Analysis, first for my brother's firm and then my own, the critical target markets were the mutual funds' independent directors and their counsel. They had a specific task to decide whether to renew the investment advisory contract for their funds. In rare cases they did not renew. I convinced them that an independent source of fund data protected them in case they were sued by regulators and/or shareholders. The service as it evolved delivered rankings of their fund compared with what we felt was the list of competitive funds in various time periods. Ranking is an ordinal listing of past performance. As long as I was the CEO of the publisher we resisted the use of the term "ratings." To this day I believe the term ratings is an attempt to predict the future as the various commercial credit ratings firm do. Their function, which they do quite well, but not perfectly, is to predict the chances that interest and principal will be paid as promised. Rates are predictors, ranks are ordinal listers.

One of the reasons I so resisted the rating term was I was an investor in mutual funds for myself and a limited number of advisory clients. I learned quickly that mere extrapolation of past trends led to unfortunate results in terms of future performance. At times highly ranked funds in various short-term periods repeated their high rankings in future periods. This is exactly why those who are serious about investing in mutual funds and many other securities need constant advice as to selection, weighting, and sale of investments.

Compounding the utility of "ratings" is the extreme focus on expenses. While expenses are important both as a deduction from gross performance and as an example of the stewardship attitude of the fund's management to its shareholders, it is only a component to proper decision making. Even a maximum expense ratio of 2% will rarely change a bad investment into a good one by total elimination of a low fee fund to become a good investment. Further one should understand the continuing cost of marketing support being paid by the fund and whether that benefits the fund holders. Many retail investors in funds need a lot of time which translates into distribution costs before they make a decision as to their investments. Much of this effort has to do with the time spent on the process of changing thinking from saving to investing. As most households in the US hold at least four or more funds, putting together the fund portfolio takes time and effort. To the extent that the fund buyer uses an investment advisor or a broker in that role, the cost of education is shifted from the fund to holder directly. Perhaps the most valuable service from the distribution channel, including investment advisors is hand holding during periods of personal or market stress. Often timely redemptions can be more productive than good buying in terms of investment dollars earned. From the remaining fund holders’ point of view, any new money that comes into the fund during periods of market stress helps them through the reduction of forced sales at stressed prices to meet waves of redemptions.

In their stewardship function some funds become closed to new accounts and/or new money. While this benefits the existing holders, it is limiting the aggregate profitability of the fund's management company. In some cases the chosen area of investment requires a greater level of internal research than the standard large-cap segment and this may materially cost more than standard. This element is true for both some equity and bond funds.

Prudent fund investing is if anything more difficult than individual securities. Good fund investing should not be done on the basis of rankings, ratings or "by the numbers," but by careful analysis of the data, people and market structure. Hopefully, some day the media and regulators as well as the distribution channels will show proper respect to the tasks of fund investors and their supporting functions.

Who should be credited with the record?

The focus on press reviews shaped many otherwise smart investment professional's views as to who was responsible for the publicized record.
I was developing my skeptical nature even before I was directly responsible for selling and managing the above mentioned Lipper Mutual Fund Performance Analysis. At that time I was in a small institutional research effort in a large, retail oriented brokerage firm. Because of the absence of well trained institutional sales people, I had to sell my research to various institutions including mutual funds. In two instances I tried to get the mutual fund sales efforts within the firm’s large retail branch network to change its sales efforts in terms of two well known funds. In the first case a fund with a good record was being pushed through the system. This happened to be a fund that I called on and knew both the portfolio manager and some of the few analysts. The portfolio manager was good, but actually he was a better salesman. However, he was difficult and the shop while large was destined to be sold in pieces. One of the analysts that I knew decided to leave and asked me about his next shop, at which many years later he became the chief investment officer. Hopefully I was helpful to his progress. In this case what was more important in my perceived responsibility to my firm was that I reviewed the stocks that he was responsible for in the fund's portfolio. I quickly realized that he was responsible for most of the successful positions in the fund, but few if any outside the shop even knew his name. I unsuccessfully argued with my firm that they should suspend their sales effort on this fund.  Within about a year the fund's performance turned decidedly down. Relatively soon thereafter the portfolio manager left and used the fund's record to sell large overseas investors on his new firm. Too bad they did not take the time to understand as to what created the performance.  

In a second case a well known portfolio manager left Fidelity to start his own mutual fund organization. He did not take any of Fidelity's good analysts with him. He picked up two journeymen analysts to join him. On the basis of a very favorable cover story in a business magazine (whose writer eventually joined him) he contracted with a firm to conduct underwriting of an open-end fund. My firm was in the syndicate. I tried to explain that the manager was leaving a well put together team like the very much respected New York Yankees. I was so successful in my argument the firm became the second largest underwriter of the new fund. After a very successful underwriting and follow-on sales, performance was less than good and eventually the management company had to be merged out. The initial fund exists today after many name changes and mergers at probably less than 10% of its peak assets.

This concern for understanding the record also holds true for individual companies. In our private financial service hedge fund we rarely short stocks, but years ago we did short one of the largest industrial companies in the world. On the surface it had a much celebrated record. However, when one pulled apart its financials, most of the firm's earnings progress was coming from a relatively small revenue producing segment. The gains that were being generated came from leveraging its fast growing loan portfolio. When I called on a number of large but marginal companies who were growing through leveraged borrowing programs, I found in most cases the lender at high interest rates was the same large industrial company and no other source was readily available to make these, in my judgment, risky loans. 

However, there is a positive side to this story. It is now relatively close to the price we shorted the stock more than ten years ago. This is a wonderful example of one of Wall Street's favorite investments ploys. “The Street" loves recovery plays. Recognizing that there is not a widely consistent winner, when the eventual disappointment sets in and pushes the price below its liquidating value, an opportunity is created if one believes that some of the attributes that created the good record remain. With the exception of investing for a pension fund experiencing large benefit payments, I am not particularly attracted to a consistent performer. I much prefer a fund where there are logical signs of improvement in process and results. We have few potential candidates in the recovery category that are attempting to improve their investment process which could be good investments for our clients in the future.

Bottom Line

Regression to the mean eventually overrides a "hot hand." All inputs need to analyzed not just accepted.

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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
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University of Investing Through a TIMESPAN Lens

“Today, if there is a run out of US Treasuries because of the Volcker Rule and Dodd-Frank,

 there is not enough liquidity at current prices.”

Introduction

I feel that each day is the first day of attending a very learned university. In my case it is a University of Investing. I search each item that crosses my screens, my desk, or interactions with others for possible meaning for my clients or my family's investments. Every day there is so much to learn that without some attempt to organize the inputs one can get overwhelmed. Thus I am suggesting that the inputs be organized into class structures as if one progressed from basics to advance courses. After the confusions from the recent elections, including (as I compose this blog) the Italian referendum allow me to demonstrate how I place inputs into a somewhat organized structure.

Freshman Level

It is at this level one learns basic principles that one applies throughout life. One could do far worse than to have as your initial investment professor Jason Zweig, the erudite columnist for The Wall Street Journal. There is wisdom in his opening sentence to this week's column on the attractiveness of small-caps. He wrote, "When markets go way up, your enthusiasm should go down." This wise cautionary statement should be applied to all asset classes and individual investments. Applying this to various popular leaders also may be wise. Remember in both the sports arena and the political world the crowd’s purpose is to build up a person or an idea to an untenable height to then have the pleasure of watching them fall. Coming out this class one should believe in moderation. One needs to be prepared for some failures along the way, which does not signify that in the long-run our hero or heroic idea will not work out.

No freshman year should be complete without some field work. It is important to identify what other people think. More importantly it is critical to learn whether opinion leaders should be believed. Thus, the next course might be devoted to the various Pew surveys, in this case reported on by Kopin Tan of Barron's. When asked in terms of trust, the respondents indicated their level of trust was 33% in the military, 24% in medical scientists, 5% in media, 4% in business leaders and 3% in politicians. As a US Marine now in civilian clothes and a senior trustee at Caltech, I believe in the ranking order if not the numerical results. I wonder where the average academic would place? The investment lesson drawn from this survey is to focus on what people actually do and what they can do by themselves.

Sophomore Year

This is often the period of students knowing it all because they believe that they have decoded the world and know what is actually happening. They have learned that this has been a difficult performance year, particularly beyond the popular mechanical averages. What they may not appreciate is that there were many ways to produce above average returns. There were eight separate mutual fund investment indices that produced double digit returns as of Friday. The lead was Small Cap Value +22.82% which was followed by a number of other small, mid caps, and multi-caps both value and core. More interesting to me that in addition to these, both Large-Cap value and Equity Income made the double digit list. This suggests to me that while being in the favored asset class helps, individual security selection was also important. A somewhat similar conclusion can be derived from examining the ten best performing fixed income fund categories. In the year to date period when the average general US Treasury fund had a 0.61% return, there were ten taxable fixed income objectives that gained between 4.26% and 11.34%. The top five were:

Fixed Income Objective	Year-to-Date Performance
1.  High Yield funds	+11.34%
2.  Emerging Market Debt Hard currency	+  8.78%
3.  Loan Participation	+  7.96%
4.  Multi Sector	+  6.17%
5.  Emerging Market Debt Local Currency	+  6.08%

To show the trading mindset one can look at this week's flows into specific Exchange Traded Funds (ETFs). The second largest inflows were to First Trust Industrial/Producers Durable + $740 million and the largest redeemer First Trust Consumers Staples -$707 million. This suggests that main players in  ETFs are trading not investment organizations and as they grow and narrow their focus they can be a disruptive influence on some stocks some of the time.

Combining the first two sophomore class lessons, one of the best technical market analysts is close to calling the end of the thirty five year bull market in US Treasuries. As essentially an equity investor, I am worried of a repeat of what happened to emerging markets debt and equity when Russia defaulted on their own Treasuries. While this was a specific isolated problem, trading desks that owned them found that they were substantially below minimum capital requirements and sold whatever they could to get back into capital compliance. Today if there is a run out of US Treasuries because of the Volcker Rule and Dodd-Frank, there is not enough liquidity at current prices. Thus various banks, brokerage firms, and leveraged hedge funds will sell what they can to meet capital needs which means they could be massive sellers of equities. This condition may never come to be, but a rumor of it could cause almost the same level of damage. For the moment in one part of the fixed income market there is some lessening of risk. Moody's^* has reduced its estimates of high yield default risk.

^*Owned personally or by the financial services fund I manage.

Upper Classmen and Women

Once the students get closer to graduation from their protected environment they should be focusing on jobs both in general and specific for them. The pre-lawyers and pre-politicians in the class will be quickly disappointed to find in various constitutions that there is no requirements to create jobs or preserve them from economic realities. For some time students and their academic advisors believed that this was the function of the reigning government and if not this one, the next one. In a global world the reality is that government using its tax power on present and future generations does not have direct ammunition to create all the desired jobs. As my fellow Caltech Trustee and neighbor pointed out to me in a well reasoned reaction to last week's blog, (copies available for the asking), that the US has been shedding manufacturing jobs since the 1950s and Western Europe, Latin America, and Japan are following. It is his guess that China has or will soon enter this phase.

There is a growing need for employees in the service sectors. The problem that I see is that these openings are not being currently filled. The cover story is that the applicants don't have the requisite skills. My experience as an employer is that too many of the applicants don't have the right attitudes of providing honest service to customers, fellow employees, supervisors, and owners. Far too many don't know how to budget their time, money, and efforts. They don't show respect to others that is the foundation of a successful service operation. Today we all are competing with international competitors and we need to respect them as well. I suspect that today's students will need to adjust their working life plans. In southern Europe the current official working life is 33 years, in Northern Europe it is 38 years. I have been working for sixty years and expect we should prepare today's students to plan to work in service industries for forty-five to fifty years.

Senior and Graduate Studies

Often one of the parlor games after a sports or political team loses is a post mortem as to where to assign blame. I remember a lot of books and words generated as to how we "lost" China. The plain truth is we never really understood China and never did own it.  As investors we need to come to grips on why China is gaining more power. It actually starts for us in an elementary school practice no longer being followed. In school every month we had to contribute savings from our allowance to a local savings bank account. We were being taught savings. This is not done today. As a matter of fact, one of the critical differences between us and Asians is their aggregate savings is about on-third of their GDP. In the US and Europe it is closer to one-fifth. Play out the benefits of faster capital growth and a materially-oriented younger population.

This is one of the reasons that I believe that the results both for good and less so will pivot on the events in China and the rest of Asia. From an investment standpoint we need to hedge our own success with some attention to them.

On a longer term basis after we get over the focus on job creation and preservation, when are we going to see organizations that will gain political prominence because they represent consumers and possibly another group representing savers?

After Graduation

Through these four phases of investing education you can see the logic behind our approach to TIMESHARE L Portfolios^®. 

Sunday Night’s Headline

 “Euro falls sharply against the dollar after Italian Prime Minister Matteo Renzi suffers a heavy defeat in Sunday's referendum.” There is a need to study more in terms of implications for near-term investing in Europe.  This could well be similar to the immediate Brexit decline and snap-back.

__________

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Copyright © 2008 - 2016

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