Losing Short-term Confidence? Selling Out is not the Answer

Every action we take is based on our confidence that the action will produce a result, hopefully the desired result. Often we are not overwhelmed with confidence, but believe that we must do something, remembering that doing nothing is in itself an action.

In last week’s blog about my stock selection training vs. using passive ETFs, I indicated that it was rare that macro considerations impacted my investment selection decisions. Macro elements are what is happening to the world as a whole, whereas micro elements are what is happening to a single or a small group of potential investments. One of the reasons to focus on micro elements is that they have proven to be easier to identify. After any review of what various political, economic and investment gurus prognosticate, one has the feeling that there is a high error rate. Often the more clever pundits get some things right, but not enough to be truly helpful for those of us who have to make investment decisions for others.

While I think throughout the previous week what I am going to say in Monday Morning’s blog, I pay particular attention over the weekend. Often I search for confirmations or challenges of my beliefs online, frequently focusing on what is probably the largest data bank of computerized investment company data in the world as put together by my old firm, Lipper, Inc. This weekend I am coming up empty for relevant micro insights, as the range of potential outcomes on the macro side is too great and my confidence in the short run of the market is waning.  (I do not have to be right, I just need to not be really wrong.)

The Macro Factors that can go either way:

The debate as to the final constellation of the euro

My frustration is that I cannot add anything to the debate. Worse, I do not see any progress to a permanent solution to the deficit production of governments and central banks supported by the general populations who in aggregate want more in government services than they are willing to pay. Having no responsibility to solve the currency problem, I can perhaps too easily come up with a grand solution.  At the currency level, Finland, Denmark, Holland, and possibly Austria should lead Germany to a hard euro with responsible governments. France and Italy should lead the peripheral countries into a softer euro with one or more devaluations and probably some form of centrist government eventually. I hope the solution evolves quickly; then all of Europe as well as Russia and China can turn to a much more serious problem in their midst which is the growing population of Islamists that fundamentally hold different cultural norms, particularly in the rule of law.

China: can the government continue to get it right?

For at least the last decade, which is the Chinese Party’s time frame, no government has done a better job of controlling its economy in both a huge expansion and a slowing contraction. Power has devolved from the central control of a headquarters-based party to lower levels of government, including getting down to the village and city levels. Actually it is at the lowest level where the biggest monetary contribution is made to the general population’s benefit. From the study of large organizations be they political, military, corporate, religious, or sporting activities, we recognize how difficult it is for good orders from the top, (and they are not always good orders), to be carried out effectively at the lowest level. Recently China has experienced a significant problem on the political level and another at the industrial (railway) level. I am sure that there have been other malfunctions. At the speed that the society must find reasonably well-paying jobs for the population, the Party may not have sufficient control factors in place. An uncorrected mistake could spark the feared social tensions that could derail the growth plans. I will not have high confidence in this arena until I see what the new political leaders will do.

The US election may not be decisive

I do not know many potential voters that are happy with their particular favorite for President or for Senator, when one is running in their state. They vociferously favor their choice over the opposition, but are still not totally thrilled with their candidate. Perhaps this is a good thing, for many political leaders that came into office with a large wave of enthusiasm have disappointed. My real concerns are that unless things change dramatically, getting effective fiscal legislation through the Senate will be difficult. Along with the rest of the world there does not appear to be any groundswell in the US to drastically cut the costs of the things it enjoys and little delight in paying more taxes. Perhaps out of this morass some true statesmen or women will arise and lead the US onto a prudent growth path.

US exceptionalism comes with a price that it cannot deny

The exceptional results of the US are not solely, and may not be mainly, due to its population. The two ocean borders and the abundance of arable land and other natural resources should not be dismissed or discounted. At the moment the US has a large number of the leading universities of the world;  I speak with a bias as a trustee of Caltech. In many fields such as software and biotechnology (including the Human Genome Project) the US is the leading developer of technology. With the gifts that have been given to the United States, the country has a responsibility to others less fortunate. If it shirks these responsibilities as it is now doing, other nations will surpass and could even suppress it. My meetings with the brightest young Americans I know does give me confidence, but not when I see many existing political and corporate leaders.

Investment Implications

My short term confidence and those of others may recover very suddenly. Markets can move extremely rapidly from the present level. I would rather be a worried investor reasonably fully invested in equities than trying to time a re-entry move. Where possible I would have a significant investment in technology companies that have a practice of being leaders in disrupting the status quo. The world has progressed to such a point that all of my investments must address a global world to prosper. Sleep may be overrated as a priority in this pursuit.

Do you have confidence in your portfolio?  In which securities and why?

______________________________________________

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The Active vs. Passive (ETF) Investment Debate

The differences between watching golf and football are similar to the differences in active vs. passive investing.  Viewing a golf tournament such as the US Open, one focuses on the shots and skills of individual players. Each player addresses each shot and each hole somewhat differently. At the end of the day it is the way the individual utilizes the combination of his/her skills with specific shots that will translate into being a winner. Equally enjoyable is watching intensely fought team sports. In league competition such as American or European football, the different teams develop certain attributes (strong defense, high scoring, deceptive plays, and extraordinary athletic abilities) which make some teams winners over others that have many of the same skills and talents.

Advantages of passive ETFs

As an analytical device the differences between watching team-focused sports vs. individual-focused competitions are useful in the selection of funds and managers in a multi-asset portfolio. Recently I was in a couple of investment meetings with advocates of using, or completely using exchange traded funds (ETFs) as contrasted with selecting individual funds or managers. In the institutional world this issue is an extension of the passive vs. active manager debate.  One reason for the growth in popularity of ETFs over the choice of good managers/funds is that the latter group can and has underperformed the “market” benchmark (a statistical index of individual securities usually selected by a financial publisher such as Dow Jones, S&P, or Russell to describe a group or an absolute numerical goal). As passive vehicles do not utilize investment management, they are able to charge considerably less total expenses. All other things being equal, the lower the fees deducted from the gross returns of an account, the better the performance.

Being the best in a poor league is not good enough

The professional football teams that meet in the Super Bowl have the best records in their leagues and/or their play offs even though at any given game any team can win, occasionally not the expected winner.  One of the reasons that I did not comment on the 2012 running of the Belmont Stakes is that I felt that this year’s crop of three year-old horses were not as good as past classes. On the same basis, some Super Bowl winners are not as good as winners in the past. Nevertheless, on a relative basis they were the best at the time.

Because most of my accounts are directed to the long-term, individual annual winners are not usually helpful to me in building portfolios of funds and managers.  When taking a long-term approach, some individual years and other data points are not very revealing; e.g., extreme performance outliers are less critically important than market cycle turning points.

Over the last couple of years, correlations between various investment classes has narrowed significantly, “bunching” fund performance results on top of each other. Unfortunately this concentration makes it much more difficult for individual managers to assemble distinctively different portfolios that are capable of producing outstanding results.  For example, if you invested in the entire technology sector, you would have significantly under-performed a portfolio investing in only three stocks, Apple (NASDAQ: AAPL), IBM (NYSE: IBM) and Microsoft (NASDAQ: MSFT).  

Active management: picking more winners

Active management, particularly my style of investing, is quite different than passive approaches, particularly those of exchange traded funds (ETFs). All ETFs are built around a single specific metric. Some use market capitalization, sector groupings based on sales, earnings, dividends/yields, book values, growth rates, or other easily determined sorting mechanisms. Some use market capitalization weighted as distinct from others that use equally weighted portfolios.

As an analyst of electronics, broadcasting, aerospace, steel, brokerage firms and financial service companies, I regularly ranked the companies I covered against each other. In order to carry out this exercise I made a good attempt to adjust all of the issuers’ data to the same standard of disclosure. For example:  paid and accrued tax rates, product and customer mixes as well as revenue and income recognition policies. In addition I attempted to array shareholder orientation, tables of organization, motivations, etc. Using these screens I could rank with some difficulty the companies from best to worst. 

That was half the job. Next I turned to stock price. Except in some periods of stress, usually the better companies were more expensive in terms of normal valuation techniques, which rarely led to the identification of bargains. To find bargains I needed to find ignored critical observations, particularly those that were likely overlooking some vital facts. The next task was to analyze the stock price. This entailed examining who owned the most sizeable amounts of shares (insiders and large institutions) and whether they had a history of being good investors. Other factors to be considered included the identity of the floor specialists, when we had them, or other market makers, and the history of transaction volume. While I was conscious of global macro trends, rarely did they fundamentally affect the attractiveness within a sector of stocks in vital companies.  I cannot remember a single time when I recommended buying the entire list or sector. This rather long winded recitation of my analytical approaches is why I have problems buying a pre-fabricated list found in ETFs or other index funds. However, I have used index funds in some portfolios when I was unable to conduct enough research, or when there was a lack of pertinent information to confidently pick winners.

Are you an active, passive or hybrid investor?

Let me know which and why.

___________________________

Did you miss Mike Lipper’s Blog last week?  Click here to read. 

I invite you to be part of this blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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Winning Life with Your Retirement Capital

The greatest American horse race for three-year olds was run this past weekend, the Belmont Stakes.  As many of you may already know, I count my “misspent” youth learning to handicap (analyze) races; Belmont Park in suburban New York was one of my centers of learning. Shortly after the famed Secretariat won the race by 31 lengths and the Triple Crown in 1973, I started my firm, Lipper Analytical Services to apply some of the analytical lessons to the study of mutual funds. I was addicted to analyzing criteria to find winners.

A winning life

Some 39 years later, I realize that the process of developing a person’s retirement capital in part defines for an individual and his/her beneficiaries, whether or not one had a winning life. The accumulated retirement income in the senior portion of life will determine whether one is independent, a burden to family, a ward of the state or some combination of the three. Thus, I believe the production of retirement capital from which retirement income will flow is of critical importance to all individuals and to the society in which we live.

The defined benefit dilemma

Pension plans benefits are  obligations of the pension sponsor or employer. Obligations are treated as liabilities that are part of what the various credit rating agencies evaluate in making their credit ratings judgments. Lenders often use credit ratings to confirm their risk judgments. The level of risk is an important component in assigning an interest rate on current and future loans to the employer. Often the smaller the pension liability the lower the interest rate. Currently, employers with debt on their balance sheets may want to reduce the risks in their pension plans by favoring high quality fixed income with relatively short maturities as likely to decline the least of other investments in a down market. This judgment is based on the past and could very well be in complete opposition to a plan’s investment advisor who may believe this is the exact time to increase the plan's exposure to the risk of market forces. The dilemma for the employer is whether to rely on past history to reduce risk or to look at what appears to be an historic opportunity to buy stocks at what in the future would be recognized as great prices. My instinct is to go with the opportunity. This is not just because of my US Marine Corps training that the best defense is to attack, but also because I am familiar with another mathematically accurate analysis, utilizing "least  squares” procedures. 

"Least squares” analysis

Least squares analysis is a procedure that various analysts use to determine the best fit of a line that will be equidistant from a field of many different observation points. My concern today is that we are in a period of an unprecedented volume of inputs. I am aware that single or multiple extreme observations could for example, radically change the slope of the least squares line and produce a radically different expected growth rate. When we experience the unexpected, we are likely to experience even more unexpected results. For instance, older employees can, perhaps, take comfort from a conservative pension plan as the chances of getting the "promised" benefit is relatively good. Younger employees however might feel the opposite. Their pension provider may not have bought cheap growth assets when they were available. Thus in later years the employer may have to contribute more than normal amounts of money to offset their lower earlier returns. The question for these now aging employees becomes whether the employer can meet its pension obligations without starving the company’s future growth.

A rough rule of thumb for younger potential employees rating their future employer

I am going to suggest one analytical tool that might be used as a point of departure, though many may disagree with this approach. One of the ratios that is available on most defined benefit pension plans is the funded ratio of plan assets compared with the actuarial calculations as to what is owed over time. Many plan sponsors want to keep this ratio at or slightly below 80%. Above that level they lose some flexibility in meeting payments. A ratio below 70%, could cause credit ratings to drop. In a very simplified calculation, pension funds can show the amount of money invested in equities or other large risk featured investments. Particularly at this point of time when the stock market has been generally flat for more than ten years, sponsors who have an equity ratio approximately the same as their funding ratio are positively future oriented. They believe that they will experience growth. A risk ratio below their funding ratio suggests, perhaps for good reason, they are being cautious. Perhaps the real value of this rule of thumb is that in a second level discussion, it would show a serious interest in the long-term financial health of the prospective employer.

What choices should be included in defined contribution plans?

The various options offered in 401k, 403b, and 457 plans is something of a balancing act between paternalistic fiduciary views and the desire to let the individual saver choose from all available options permitted by various regulations. Most of the options offered come in a mutual fund format with two notable exceptions, directed brokerage accounts and various types of annuities.

The US Department of Labor has indicated the minimum of options to be offered to include a high quality, short-term fixed income fund that is often translated to be a money market mutual fund or a stable value fund. The minimum number of funds is four with at least one equity fund. At the other extreme, for awhile a number of plans offered over 200 funds from a number of providers. Studies have shown that too many choices confuse participants. Further, the history of plans is that most of the money is in relatively few funds. (I suggest that any fund that does not garner 5% of the money should be a candidate for being dropped.) Each of my plan clients is different due to the beliefs of the sponsor and the perceived needs and general investment sophistication of the workforce. In a generic sense my approach is to start with the oldest type of fund, a balanced fund, with stocks as the majority asset class and fixed income for the remainder. This fund should be used as the default alternative. Some may suggest to use target date funds for this need. My problem with these vehicles is not with their portfolios, but based on studies too many of target date fund investors don't fully understand them. If there is an effective individual advisory function at work, target date funds could be added to a moderately large list. I would like to have at least two fixed income funds, both high quality and preferably US Treasury-oriented, one short-term and one intermediate.  In addition I would add a TIPS fund. In terms of equity funds I would include a Large cap and a Small cap fund with at least one of them focused on growth. A stocking-picking fund without constraints would be a nice addition. Notice I did not label the choices as domestic or international or manager-selected global funds. These are becoming less distinctive as choices today.

Investors should have their own individual investment accounts

There are two reasons for this belief. First and foremost, the individual account can select when to accept tax consequence transactions and, at least for now, gains will be taxed at the tax advantaged capital gains rate rather than the ordinary rate that will be due when the withdrawal period begins from these savings plans. Second some of the product line extensions that I do not feel are appropriate for these fiduciary savings plans, could well be useful in an individual's own account.

Using leading equity funds

Many individuals avoid funds with large unrealized capital gains for their taxable investment accounts. In my new Reuters column,  I recently asked whether there is a penalty box for funds that have had great long-term investment performance.  The answer may have some relevance for investors and beneficiaries of retirement income.

        

  

What are your reactions?

How are you planning to overcome your retirement capital concerns?

_______________________________________________

Did you miss Mike Lipper’s blog last week?  Click here to read.

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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No Guarantees in Fiat Currencies or Retirement

One of our younger relatives told my wife and me years ago that he couldn’t settle down because he had “too many questions in his head.”  Unknowingly he repeated what market sages for years have stated, that the market needs “certainty.”  Thus both the young and the wise are grappling with an unknown and perhaps more correctly, an unknowable future.

To answer our basic concerns, the strongest human marketing powers in business, government, science, and religion have repeatedly provided generally accepted guarantees that answer our concerns. During the current period of global neurotic economic stress, one wonders whether the title of Andy Grove’s book, “Only the Paranoid Survive”  is relevant. I am suggesting that as with all well-marketed messages, guarantees provide necessary comfort, but they may not be complete in each individual case. Given the uncertainties facing the modern world, the backing behind each guaranty needs to be understood.

Briefly this blog will touch on some of the accepted guarantees involved with retirement income and the value of money. As usual at the end of this blog I will suggest investment implications to these views. (Many of the views expressed will be provocative and will hopefully generate feedback.) 

The Promise

The heart or essence of any guaranty is the promise that under specifically-stated events or occurrences a predetermined reaction will automatically be triggered. In effect, the promise is a contract, often ill-defined or in some cases not even written down. As time passes, what is remembered is what someone believes to be the promise, without any review of the contract. In typical wedding vows, the only exit is by death. There is no mention of actions and attitudes that lead to today’s large number of divorces. In Europe and elsewhere, the fear of either the marriage contract or divorce has led to a large portion of the population living together for extended periods of time rather than marrying.

Retirement Income

Rational people for ages have been saving money, in part to meet a future period where they will no longer be sufficiently economically active to provide for their own needs. For centuries hoarders have converted much of their stash of wealth into savings. In turn some or all of their savings have been entrusted to various financial instruments and institutions. Since the 19^th century and that great “humanitarian” Otto van Bismarck, people have increasingly relied on taxing authorities to supply retirement income.  (Bismarck created the first social security system which would pay retirement income starting at age 65. He picked that age because he believed that very few would reach that age.) In a more modern era, recognizing that most employees would not have enough discipline to save for themselves, companies would defer some current compensation to be paid out later in retirement. Unfortunately, these two sources, the government and various employers, represent the bulk of the expected retirement income for those that had a career of working. For the most part these people are not worried now and don’t expect to be worried in the future because they believe that they have been guaranteed these payments.

These guarantees are increasingly being issued by some  entities  that are having their own financial difficulties. Most federal and some state and municipal governments around the world are operating at a deficit. We, the citizens, consciously or involuntarily are consuming more from the government than is being taxed. Almost all now recognize that this deficit production cannot continue forever. The two standard solutions are to cut expenses or raise taxes. Somewhere in between these two difficult choices there is a stop-gap measure of changing the payment schedule assumed by the government.  Delaying debt repayment to foreign borrowers can lead to materially higher borrowing costs in the future. One can see the possibility that the government could materially change the net effective payment of social security payments. After all, it is difficult or almost impossible to sue the US government without its permission. Most beneficiaries may not realize it, but social security payments are already effectively means tested. The amount of the payment which becomes reportable as taxable income is based on the level of other income received. Remember that half of the benefit received came from your employer or you as self-employed. Changing the date of full retirement is another way of changing the shape of the government debt. For some time I have warned all of my young employees that they should view that FICA (social security) taxes withheld from their pay and matched by their employer are tax payments and they will be unlikely to receive any real retirement income from their tax payments.

What is probably a larger problem for some is the so-called Pension Guaranty Corp, a government body that is meant to guaranty some pension payments for corporate pension plans of bankrupt US corporations. With the government proclivity to bailout pre-packaged bankruptcies of companies with large union member work forces, the guarantor will run out of money and will have to raise fees on those declining number of defined benefit plans or get an infusion from the US Treasury through an act of Congress. Both are uncertain.

Other ways to save are through various financial instruments directly or thru financial institutions. These are only as good as their continuing credit conditions.

Bottom line:  the various sources of retirement income are not perfectly secure under all conditions. The prudent saver needs to be aware that the expressed guarantees have some limits.  

The Value of Money

In the US, much of life’s activities are ultimately measured by colored pieces of paper approximately 6 by 2 ½ inches called the dollar. The pretty paper which circulates around the world in various denominations has little face value, but has substantial spending and trading value based on the belief that there is some almost universally accepted value because of a series of ill-defined guarantees.  Thanks to President Nixon,  the US dollar no longer has direct backing of gold or even now a fixed basket of currencies. As long as others will exchange goods and services for these painted pieces of paper, the dollar and other fiat currencies have value. Around the world the dollar trades against other currencies 24/7. In theory the Federal Reserve currency  has the vastly expanded Fed balance sheet as backing. These are supported by various issues of  US Treasuries that are the debt of the US government. What makes this curious to a financial analyst is that we have never seen a published balance sheet for the US government. We can speculate as to the enormous value of the government’s real and intellectual property. Most of us don’t know the size of the debt against these assets, particularly the future contingent debt. Value-oriented investors regularly arbitrage the difference between a quoted price and its intrinsic value. I cannot perform this equation as I lack any sort of precise knowledge as to the value of the dollar other than what is trading for now versus other currencies, including gold. Thus, I do not recognize fiat currencies such as the dollar have a guaranteed conversion price.

The Terrible Link

Both the value of future retirement income and the value of the dollar are linked to the rate of future inflation, which itself has no guaranty. The value of the current dollar, euro, pound, yen, and Renminbi is exclusively based on what they can buy today in the way of goods and services. If one isn’t going to spend currency today, one must be concerned as to its future value. Often its future value will be dependent on the path of relative prices. This is particularly true for the retired when an expenditure is likely to draw down retirement income or capital. As these are unknown or probably unknowable, I seriously question the certainty of both currencies and retirement capital that people are using.

 Investment Strategies in a World of Questionable Guarantees

First is my guaranty. My guaranty is that I won’t guaranty any specific future scenario or strategy that will produce only winners.

Second, in a period of increasing uncertainty, excessive concentration is dangerous. 

Third, as I believe significant inflation is eventually probable, I believe up to a quarter of one’s portfolio should be in an inflation defensive mode to include TIPS and selected foreign treasuries of up to five year maturities issued by  small population/commodity rich governments with small to no deficits.

Fourth, all equities should have a global orientation. These companies should have some of these characteristics: exporters, foreign operations, net royalty recipients and managements that think beyond their local borders.

Fifth, technology developers and users should play dominant roles.

Sixth, put at least 25% of your or your clients’ portfolio into stocks of companies that are more flexible than their large competitors. This puts one into smaller capitalization securities.

Seventh, as only a few mutual funds are constructed exactly along these lines, a portfolio of funds that appropriately counterbalance their portfolios will be needed and selected carefully.

Feedback Sought

Please share with me your thoughts on the guarantees discussed and or how one should construct a portfolio for such uncertain times.

______________________________________

Did you miss Mike Lipper's Blog last week?  Click here to read. 

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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Additional Views on US Energy Independence

Should the US pursue a policy of  energy independence?

Today I am continuing a discussion began in last week’s blog about the economics of  international energy policies.  I offered opinions about these topics prompting a response from my long-time friend and adviser, Dr. Philip M. Neches,  the founder of Teradata, who has spent a great deal of time studying the Energy sector.  Phil Neches received his BS, MS, and PhD from the California Institute of Technology;  he is a successful entrepreneur, writes a thoughtful blog and sits with me as a trustee of  Caltech. 

Last week a portion of my blog explored an Adam Smith-inspired hypothesis that would have the US buy up and deplete as much of the world’s oil as possible, using its own production and reserves for long-term international competitive advantage.  Berkshire-Hathaway’s Charlie Munger, among others, have also discussed this approach.

Oil pricing as a factor

Phil Neches began his response by indicating that he thinks my analysis of oil did not take price sufficiently into account.  He writes, “Yes, the US depends less on imported oil than major economic competitors, but that matters only in the extreme.  In the more ordinary course of business, it will take several more decades of consumption for oil to actually become scarce,  and, as you point out, that can be stretched out by more efficient use.”

He continues, “The short term issue with pricing is not as much about the ultimate depletion of world oil reserves but by the imbalance between demand, which can shift quickly with economic circumstances, and supply, which can only change slowly through expensive development of fields, refining capacity, and transport. Bad actors can make quick changes in supply, and this causes the risk perceived, correctly I think, by the general public and politicians of all stripes.”

US Strategic Petroleum Reserve

Last week I buffered my position with the fact that the US Strategic Petroleum Reserve provided some solace for future emergencies.  Phil offered an offsetting  point I had not mentioned, that today’s military depends upon the civilian economy much more than in the past.  As Phil states, “If the civilian economy is crippled, the military may still be able to operate, but will be far less effective.”

Natural gas

I am mostly in agreement with Phil when he writes that “The most obvious strategy for the US is to encourage substitution of natural gas for oil and coal.”   He continues,  “the biggest win is in electricity generation, for a number of reasons: 

 

First, it would permit early retirement of the dirtiest coal burning plants.   From a Pareto analysis standpoint, this is the best thing we could do to reduce not only carbon emissions, but other pollutants.

Second, gas-fired plants can be sited closer to loads, stretching out the investment in the distribution network.  This is important because there is more capital tied up in distribution networks than in generating capacity.

Third, to the extent that people adopt electric vehicles (either plug-in hybrids or all-electrics), then demand from the transport sector can shift away from oil.”

My thanks to Phil Neches for his additions to this conversation

Investment implications

Careful long-term focused investments should be considered to take advantage of the transportation of oil, gas and coal. The use of energy will go up, adjusting for the cyclically of the global economy. As long as the sources of energy are distant to its users, energy in some form will have to be transported. In the intermediate time period that would include ocean-borne oil, gas and coal. In addition, land-based pipelines and railroads will still have good payloads. I suspect that these thoughts are behind the disproportionate current and future capital expenditures in these areas by Berkshire Hathaway* and other large capital investors. Currently many of these stocks are down from recent peaks because the level of shipments and prices are down. I cannot accurately predict when they will go up, but I believe they will as the world recovers and we move toward rational energy independence.

Disclosure: I personally own a position in Berkshire Hathaway, as does the private financial services fund that I manage.

Historical context

In the United States we celebrate Memorial Day on Monday, May 28^th.  Officially the holiday was started to recognize the death of so many Union (Northern) forces in the Civil War, which some still call the War Between the States. Over time the holiday was combined with a similar day of remembrance for the fallen Confederate soldiers.  For the US, the Civil War was responsible for more total deaths than any war before or since.  In addition to the many domestic causes of the American Civil War, economic forces, particularly international trade, played an incendiary role. As European harmony deteriorates, this holiday weekend I am reminded of the curse of one citizen/nation fighting another on the basis of economic interests and tariffs.

_______________________________________

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

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1776 Can Make Us Independent Again

Historical Introduction

Most Americans believe the single most significant act of 1776 was the signing of the Declaration of Independence. I suggest that when facing today’s economic problems we consider a still more important event that occurred  in 1776, the publication of Adam Smith’s The Wealth of Nations.  (Not to be confused with the very insightful contemporary author and television personality who uses Adam Smith as a pseudonym.)

The two events are very much related. Our Declaration of Independence was driven by the colonists’ abhorrence to the Navigation Acts and other laws of Great Britain that raised the costs of imports into America and restricted the transportation of our exports. Remember the famous Boston Tea Party was caused by the tax on imported tea.

These laws were an outgrowth of the mercantilist philosophy of European governments to promote their own exports and restrict imports into their lands. This governing philosophy reigned between about 1500 and 1800, and was based on the need to get trading partners to ship gold to those countries where they had an unfavorable balance of trade. The importance of gold was not primarily economic, but rather to pay for their constant wars. In the minds of the European leaders, particularly the British and French, this was a matter of survival.

What Adam Smith advocated was that nations should specialize in their production of items to be exported and import those items where they did not have a cost advantage. Over the succeeding generations his ideas were finally accepted.

Today and for some time American Presidents have announced policies that would make the US independent of foreign oil. In response to questions and comments from a number of regular blog readers, I will attempt, in a small way, to play an Adam Smith role.

My biases

I have never seen a totally unbiased report. Most of the authors are not fully conscious of their own biases, particularly those that were inculcated into them at their universities. As we are all captives of our experience, biases cannot be completely avoided. The best we should do is to identify either the biases or the sources of our biases. Mine starts with a college course in Middle-Eastern history, geology and geo-politics. I learned that in Saudi Arabia, the direct lifting cost of a barrel of oil was approximately four dollars and did not change much over the years. From time to time I have invested directly into domestic gas producers to make money or energy-focused mutual funds as an inflation defensive move. When I was lucky enough to become a trustee of Caltech I was exposed to numerous professors who were focusing advanced scientific approaches to find energy and use it more efficiently. These inputs allow me to think about a problem from different viewpoints, and therefore biases. 

Parsing the search for energy solutions

The three main fuel sources of energy are oil, gas, and coal. (For the purposes of this search I am ignoring nuclear, solar, wind, hydro, and geothermal with the belief they will play an expanding role, but won’t provide sufficient power in the short to intermediate future.) I believe that each of the age-old big three should be addressed individually.

Oil

This is where I put my hat on as a modern Adam Smith. The popular view of Americans from the White House to Main Street is that it is dangerous for us to rely on the importation of oil from those nations that  “don’t like us.”  The fear is that in time of military conflict those that supply us with oil will cut off flow, or at least hold it up for ransom. There are many counter arguments to this fear. First, our military has developed lots of means to defeat an enemy without the need for the quantities of petroleum products required in World War II and subsequent engagements. Second, we have built a strategic oil reserve which is intended for military emergencies. (Not to be used as a politically-inspired price mechanism.) Third, if needed, government agencies believe that there is more oil underlying US government-owned land than has been discovered in the rest of the world.

There is another set of economic arguments which update Smith, the canny Scotsman. If oil is a scarce resource and cannot be easily replaced, we should deplete other countries’ reserves and political power by buying all that they will sell to us. Further, a rise in the international price of oil, while somewhat painful to the US in the short-term, dramatically changes our competitive position in the world. The US is less dependent on foreign oil than Western Europe, Japan and China. If petroleum manufacturing costs for the rest of the globe goes up and we have competitive products at a lower price, the US share of market will go up which can aid our job growth. Based on what we have already seen, the threat of higher priced oil will trigger greater conservation efforts and the development of more efficient uses of energy.

Gas

There are reasons to believe that the US and certainly Canada can be net exporters of natural gas. Other countries are also developing their gas properties. From a strategic viewpoint, I might be reluctant to become too reliant on imported gas except from Canada. Over time I would expect the bulk of our heating requirements will be filled by natural gas. We are likely to see both the military and large trucking fleets switching to hybrid or fully dependent upon “nat. gas.” The environmentalists will need to prove that fracking is dangerous to the neighborhoods of gas extraction and then our technologists will probably find solutions.

Coal

Some politicians have proclaimed that there is no such thing as clean coal. Considering the US has a reported 250 year supply of coal, I hope they are wrong.

If the price of energy goes up, I believe that there will be enough room in the final price of coal for both steel-making and heating to cover the costs of technological fixes that are underway.

Conclusions

Just as 1776 brought forth thoughts and actions that changed the world, I think we are at the point of achieving meaningful economic energy independence in the near-term future as we modernize our thinking.

As is my wont turning to investments, I would suggest investments in stocks of companies that are devoting some of their efforts to new ways to make our search and use of energy more efficient. These areas could be mining and extracting efforts, transportation efficiencies, and battery producers among many other beneficiaries of the application of new and improved technologies. These could include some, but not all, of the major oil, gas and coal companies.

Are you ready to be independent in the new world?  Let me know.

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Unknown Impacts from JP Morgan

Since Thursday night, no single financial topic has gotten more print and airtime than the announcement of the unexpected net loss of an estimated $800 million, out of a $2 billion gross loss sustained in the Chief Investment Office (CIO) at JP Morgan Chase (JPM) London. With market participants and the media searching for more information and in some cases insight, one can perhaps benefit from former US Defense Secretary Donald Rumsfeld’s method of dealing with the press. He divided the questions he was asked between known knowns, known unknowns, and unknown unknowns. According to Rumsfeld:

• There are known knowns; these are things we know we know.
  
• We also know there are known unknowns; i.e., we know there are some things we do not know.
• There are also unknown unknowns; these are things we do not know we do not know.

I will array my thinking using this pattern.

One should understand the biases of the sources one is using. Regular readers of this blog already know that I have investments in many financial services companies. These investments were largely obtained through stock-based mergers in my personal account as well as a selection, I think of the better ones, in a private financial services fund that I manage. While I have been a long-term investor in the JPM stock in my personal account, I do not own the company in my managed fund. This is the same distinction that Warren Buffett revealed at the recent annual meeting of Berkshire Hathaway (BRK-A), (BRK-B); he personally owns JPM, but invested heavily in Wells Fargo (WFC) and US Bank (USB) for Berkshire Hathaway. Up to this point my reluctance to add JPM to the fund is based on what I perceive to be a requirement to a higher standard of selection for the fund than my personal account. To the best of my knowledge, JPM has by far the largest single gross investment in derivatives of any publicly disclosed financial institution. My focus on the gross commitment, adding the long and short positions rather than netting them, is based on closely examining trading desks that have experienced simultaneous problems in both their long and short books. Further, I will admit I am not comfortable with my lack of full understanding of these instruments. Thus despite the fact my family has dealt with the JP Morgan organization for three generations and has great respect for some of its present leadership, my lack of sufficient understanding of the use of derivatives has prevented me from owning the stock of JPM in my managed fund.

Known knowns

On Friday after the Thursday evening announcement, the price of JPM shares crashed -9.28%, with a record 217 million shares traded. Shares of Citigroup (C) declined -4.24%, Goldman Sachs (GS) -4.19%, Morgan Stanley -4.17% and Bank of America (BAC) -1.95%. (Both Goldman Sachs and Morgan Stanley are in the fund and the others are owned personally.) At least as of this weekend, the combined wisdom of the marketplace is that JPM has a very specific problem on its hands. The two investment banks that have become bank holding companies may have somewhat similar problems. There is a view that Citi is similarly hobbled and Bank of America’s price already recognized lots of its problems.

Before this announcement, I was trying to better understand JP Morgan. Thus, I was reading its massive reports to the SEC. In a section entitled Treasury and CIO Selected Income Statements and Balance Sheet Data, a couple of items struck me as significant. The first was securities gains in the first quarter, which were up 344% from the prior year, to a total of $453 million. This item was footnoted to reflect repositioning of the corporate investment securities portfolio. Clearly this was a highly volatile component to JPM’s earnings and something of significance was going on. The post-quarter disclosure of an estimated $800 million loss in what may have been fifteen days (as reported by some) compared with the first quarter’s securities gains, is a further indication of the type of volatility that one could expect. The second figure that caught my eye in this table was that at quarter-end, the aggregate investment securities portfolio totaled $375 billion ($362 billion averaged for the quarter). While the size is staggering, the return for the quarter was only 1.3%, hardly a worthwhile return considering what we now know to be the early second quarter risk.

Known use of derivatives

Based on what we have already learned or suspected, the London CIO office was not primarily focused on making money, but on hedging the bank’s credit exposure. As of March 31, 2012, JPM had a total credit exposure of $798 billion, up from $776 billion at the end of the year (again relying on the report to the SEC). At the end of the quarter the bank had credit derivative hedges just shy of $30 billion to hedge their perceived credit risks. Perhaps one clue to the mid-April to early-May large losses is that JPM had net credit derivative hedges of almost $11 billion against $22 billion of credit exposure to central governments. During this period, the news flow and foreign exchange rates were negative to many central governments.

Known unknowns

The media has reported that very senior officers of the bank, including its much respected CEO, were involved with twice daily conferences about this unfolding situation. Some were dispatched to London to personally get a hand on the situation. Various government agencies were alerted to the growing problem. One of the issues to be determined is why JPM’s vaunted risk control measures did not alert or stop the mounting losses. One report has as a contributing factor the switch to a different index as a benchmark. This change proved to be faulty, and there was a switch back to the previous indicator. The Financial Times reports the index used is the Markit CDX.NA.IG.9 which is comprised of 125 North American credits that were investment grade at the time of their inclusion in the index. The net notional value for the index has surged from about $90 billion to $150 billion at the end of April, according to the FT.

Conjecture analysis

Note that the notional value of the reputed index at the end of April was about $150 billion. The size of JPM’s credit exposure (excluding its exposure to central banks) is approximately $776 billion. If, as is believed, JPM was trying through the CIO to reduce its overall credit exposure, the near-term market was too small to accommodate a safe withdrawal. If a swarm of hedge funds saw one big insistent player on one side of the market (as was reported in the news media) they could profit by being on the other side, and make the exiting more expensive. I believe this is the reason why JPM will take its time exiting its position and possibly exposing itself to greater losses.

Unknown unknowns

Various politicians and media pundits are calling for increased capital rules and size restrictions. If they are successful, they may cause more rapid and for some, disastrous change. I believe that we are in an early stage of radically changing the financial structure of our world. I believe we have insufficient equity capital to create sound long term jobs, and this has been true globally for many years. Whatever progress that has been made is largely due to individual, corporate and governmental borrowing. The money has been borrowed from different elements of retirement capital at each level. The net result in the current periods of interest rate suppression is that current retirement capital is insufficient to pay for our longer-lived lives. Anything that raises the costs of banks will raise the cost of borrowing at all levels, impeding meaningful long-term job growth. Higher interest rates will drive inflation higher, particularly hurting the non-working retired population. Over the last several years we have paid this group low interest rates, and now when rates recover to something like a normal level, the inflation-induced, devalued currency will hurt their real spending power. We are creating two new economic class sub-sets: first, those that no longer are earning their keep and second, their grandchildren with large education loans. Thus, the issues surrounding the losses at JPM have wider impacts.

Investment Implications

1. As many of our readers are aware, I have a certain allergy to what I call crowded trades, where too many are trying to do the same thing at the same time. JPM is very much involved with a series of crowded trades. To some degree this fear, excluding the IPO dances, makes me more interested in smaller companies.
   
   
2. Our political leaders are trying to repeal history. Throughout recent times, certain banks have failed. Their failure hurts their equity owners, some of their debt holders and possibly some uninsured depositors. These are momentary disruptions in people’s lives and practices. But in almost every case that I am familiar with, new or expanded banks replace the failed bank. Society, perhaps wounded, progresses.

I will be completing my 200th blog post in early June. Are there are any particular topics you would like me to readdress in my weekend musings? If so, please email me early in the week with your thoughts.

Did you miss Mike Lipper’s blog last week? Click here to read.

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog.

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of MikeLipper'sBlog.Blogspot.com