Money Management Lessons

Introduction

Successful money managers do much more than select winning stocks. They use weighting of their selections, timing of their transactions, partial trading actions and timely admitting of mistakes.

Lessons from Berkshire Hathaway

On Friday the investment press was full of stories from the latest release of Berkshire Hathaway’s transactions for the quarter. All of these reports focused exclusively on the names of the stocks that were bought and sold and none on the structure of the overall equity portfolio. Thus, their readers missed the opportunity to learn how the portfolio is managed.

The company has at least eleven equity reporting elements excluding the investments in their retirement accounts. Many equate the company to an open end mutual fund, which is a mistake for in all of my work on US and foreign registered funds I have never seen a portfolio that truly operates on the same basis.

First, Berkshire’s equity portfolio is part of a complex series of holding companies which include fixed income securities, liabilities, and substantial float of “temporary” money that can be invested. Second, with rare exception there is no pressure to liquidate assets to meet immediate redemption orders. Third, one of the great assets the company has is its brand. In times of financial distress on the part of others, the company can demand very high returns for the use of its money to prop up the market value of large, high quality companies which may be viewed as in distress. Fourth, the company can be extremely patient and at the same time make very rapid decisions without the need for committee or board actions. (These are some of the reasons that I am happy to be a long-term shareholder for a fund I manage and personal accounts.) In my mind these attributes are worth a premium over book value or if it were a fund, net asset value.

Regular readers of these posts have learned that I count the lessons that I learned at the race track as important guides to my professional investment practice. Let me define a winning day at the track, which is an enjoyable day in a pleasant surrounding and walking away from the track with more money than I had before I got to the track. As Yogi Berra is reported to have said, “You can see a lot by observing.” I have seen numerous “horse players” that have cashed winning tickets, but at the end of the day they are not qualified for my definition of having a winning day because they go home poorer. Their mistake was not in failing to pick winners, but in handling their money poorly. Often they made too many bets, spent too much in meals and other entertainment, increased the size of their bets to obtain break even and accepting of low odds by backing favorites.

In general Warren Buffett, Charlie Munger, and their two investment managers are guilty of these mistakes in managing the Berkshire stock portfolios. As of June 30, 2015 the reported total of the stock portfolio was $ 107.2 Billion. Only four stocks represent 62.38% of the total, and another eleven stocks represent 27.01%. This last group of eleven individual holdings were each 1-5% of the portfolio. There was another 11.61% spread through 31 names. While for some purposes I like concentrated mutual fund portfolios, I can find very few that would be this concentrated and they would have redemption problems where Berkshire does not.

In looking at their recent trading history one sees that many of the positions are traded somewhat actively; enlarging and contracting the size of the position and often changing the tax cost basis of the holding. These are done for investment purposes not to accommodate flows which is often the case with funds. While Berkshire is a prodigious net cash generator, I do not expect that there will be a large flow into the current equity portfolios as the latest 100% acquisition absorbs a good bit of the company’s preferred cash cushion or strategic reserve which can be deployed within 24 hours on a potentially highly profitable rescue mission. Perhaps most importantly, after due consideration, Berkshire will liquidate a holding at a considerable loss and admit that they did faulty analysis rather than blame external events.

If I were to recommend a Berkshire-type strategy for a managed account today, it would have a sufficient opportunity reserve to be able to take advantage of rapidly attractive situations when others are fearful. Further, I would use investment judgment in weighting my portfolio, something my older brother has been saying for some time. I would be selective in my diversification by only one or a few stocks in a sector, typically the best of breed. I might have some very small explorative positions with a sense of how long I would be willing to hold them. Most importantly I would try to be disciplined to admit analytical mistakes and discard losers regardless of costs.

Another valuable lesson from the Racetrack

On Friday there was a long and glowing obituary for John Nerud who died at 102 after saddling over 1,000 winners as a trainer or farm manager. He was the best and worked for a great and generous owner. The lesson is that one can get the horse wonderfully prepared to win the Kentucky Derby, employ one of the best jockeys and give him good instructions. In this case when Willie Shoemaker was leading with Gallant Man, the jockey mistook the finish line and stood up briefly in his stirrups and let another horse win the Derby. A few weeks later Gallant Man won the much more significant Belmont Stakes proving that he was best three year old in the country. The lesson is that bad things unexpectedly happen and we should not expect perfection in our choices, even when they are eventually proven to be correct.

Another Numbers Lesson

Many value managers make their case on the basis that their holdings are selling at low multiplies of stated book value.  While I am a believer in buying something at a discount from what a knowledgeable buyer would pay for the asset, I have little confidence in the book value calculation. Book value is derived from the balance sheet of the enterprise. These are largely based on historic costs on periodic impairment decisions by the company on the advice of their auditors. Rarely are assets written up, declines in market share are not recorded, contingent liabilities are not deducted, the value of expiring patents is not noted, etc. The auditors prepare balance sheets for creditors not equity owners. Too many investors equate book value with the total net asset value of funds. They understand that when they redeem their open end mutual funds they will be paid out on the basis of the current net asset value.

However, they fail to look at the way the market values net asset values of closed end funds. Open end and closed end funds use the same calculations and auditors. Because investors, through their brokerage firms, must find a ready buyer for their closed end sales, the market functions to bring buyer and seller together at an agreed price and time. Currently the discount on closed end funds to their net asset value is approximately 10%,  my friends at my old firm Lipper, Inc., tell me. Thus my starting point in looking at book value for companies before I reconstruct is to assume a 10% discount from stated value. After reconstruction of an updated appraisal of what a knowledgeable buyer would pay for the company my estimated book value is very likely to be higher or lower of stated book value. To me this is the proper approach for so-called value investors as distinct from “quants” who don’t see beyond the published financial statements.

Question of the week:
What circumstances would lead you to sell or to buy Berkshire Hathaway? 

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Copyright © 2008 - 2015

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

“Data Dependent” Portfolios

Introduction

Future interest rate moves of the US Federal Reserve are described by its members as “data dependent.” This is meant to suggest that when a statistic reaches a certain level, a future action is ordained and carried out. The immediate present (or actually slightly old) figures determine the future according to these economists and other politicians of the top-down persuasion. Considering how bad the record is of the Fed’s predictions, it is a “puzzlement” why these predictions are given so much credence that some mythical king of Siam might wonder.

What is even a bigger puzzlement is why so many investment performance reports start explaining their performance based on the latest data dependent pronouncements. Strange that so many so-called professional investors dwell on the current price (yield or P/E) level and not what as an investor I am really interested in. What I care about is the terminal price of my investments.

The terminal price of my investments is difficult to guess, but that is exactly what I will use to meet future spending needs, whether I am acting as an individual or a fiduciary for a public or private endowment. To determine my terminal price I will need to project the range of the most likely future price trends for the investments. Estimating my place on these price curves will be determined by the range of my likely factors including spending/saving habits including health-related, some actuarial assumptions and probable reactions to cyclical markets. Not a single one of these unknowns is easy to determine. Nevertheless, each one of us unwittingly does this at every buy, sell, or hold decision we make or we allow to be made for us.

A Helpful Took Kit from the Racetrack

When we are besieged by too many questions it is useful to break them down into logical groups. At many US racetracks there are up to ten individual races a day. This translates into about 100 horses trying to win. Luckily for the handicapper, or if you will the analyst, the horses are only trying to win their specific races. These races are divided by length of the race from short to long distances, age of horse, racing experience of the horse, prior level of winnings, and whether the owner is willing to sell the horse at a specified price. One could take conditions of the race as a determinate as to which of the myriad factors on each horse that is to be considered for a bet. Out of this you could come up with a single or a very limited number of probable winners for the race. That is half the job at best. Moving away from the past you should look to see whether the horse looks healthy and is being ridden by a jockey (portfolio manager) that is experienced with this horse and others who run the same way.

While there are numerous other factors, the final decision on what to bet and how much to bet is a function of the odds or the weighted opinion of others compared to your own views. If you are in total agreement with others even if you win, the payment odds after the track's take and taxes are deducted won’t be very large. On the other hand, if your analysis leads you away from the crowd’s choice as most great portfolio managers do, your payoff will be larger but you will suffer the indignation of hearing about the brilliance of the popular choice. Racing and investing are not like picking a winning political candidate. In politics it is guessing what the majority will do rather than picking the most qualified.

Applying Data Dependent Factors to Racetrack Tools to Win

One of the reasons we developed the Lipper Timespan Portfolio concept is that different data points have vastly different impacts on portfolio orientation. For example, demographics are unlikely to have much impact on the investment performance for the next five years. Bear in mind that in the last five years today’s equity funds (now numbering 14, 834)  rose +11.79%.  Taxable fixed income funds (now numbering 4831) gained, including income, +3.66% in the same period. However, when I look to invest money for a minimum of ten years I am struck with the fact in 2014,  Germany & Japan’s average age was 46 years, Italy & Austria  44, Canada was 41.7, Russia 38.9, Australia 38.3, US 37.6 and China 36.7 years old.    

On the other hand Nigeria and Uganda averaged 15 years and three several other African countries averaged 16 years. India was in the middle with an average age of 27.

To avoid a political collapse which can lead to military problems, we will need to aid in the retirement of the senior populations of the so-called developed world which suggests that taxes on the productive sections will go up. For the teenagers in Africa we will need first to feed them, then educate them to find useful jobs with a future. 

Currently almost all general portfolios are invested largely in the Northern Hemisphere and in developed countries. We don’t have ten years to make the shift if we want to be ahead of the data dependent crowd betting on low return solutions. At some point we will need to understand demographics as we answer the cover of this week’s Barron’s, “Commodities: Time to Buy?” In building our longer term portfolios, we need to recognize that increasingly people will be living in or very close to cities, not in the country. This should refine our investments even further.

For most investments you can see a lot by just looking.  Earlier this week, in walking relatively few blocks into the local business district I saw a uniformed workman with a meter rapidly going from home to home. When I caught up with him, he announced without breaking stride that he was a meter reader and the day was so pleasant that he wanted to finish his task. Years ago, as an electronics analyst I followed companies that were developing remote meter reading that could be done from some base station. I was pleased and somewhat dismayed that my brief walking companion still had a job. I don’t know that if he had been replaced by technology he would go to the mall or the downtown where stores were looking to add sales people.

Last year I told someone that I could assemble a world class investment organization knowing a large number of investment professionals that were out of employment or were unhappy where they were. Enough of these individuals have now found their conditions have changed that I feel I could not back that statement up today. From my friends currently running financial groups I hear they are finding it difficult to find the right type of people to hire.  Because of our educational systems' failures we are likely to have increased structural unemployment such as the meter readers or the children recently graduated with liberal arts degrees. Nevertheless our economy is showing signs of strength. The five year and under portfolio is likely to enjoy both improved results and a measurable downturn which hopefully will come later.

Question of the week: Which will come first, DJIA 32,000 or 10,000?

__________    

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Copyright © 2008 - 2015

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

Flat Earth Wrong Again

Introduction

Because most people in the Fifteenth Century were focused on the difficulties of their lives, it was easy for them to believe that they and their neighbors were the center of the world. Their view of the world was limited by the height of the tallest mountain and the depth of the deepest valley. Thus it was easy to believe in boundaries that they could see. From this vantage point it was simple to believe that the earth was flat and was the center of the universe. To some degree investors and political leaders have the same view today. We have been trapped in a flat general stock market that experiences significant daily to weekly volatility before reversing to attempt to breakthrough either on the up or downside.

Low Volume Trading

These movements use up a lot of energy in expressing hopes and despairs. Having grown tired of this dance to nowhere, many investors have shut down their transacting activity. At most the low trading volume absorbs the net additions to investors’ cash flow or provides a trading arena for those who believe that they possess superior trading skills. Thus, we have created an investment audience who believe that not much will dramatically change until they perceive a major and probably unknown stimulus. They have returned to the flat earth view.

Open Your Eyes

One of the jobs for the long-term strategic investor in companies, securities, and people is to examine daily inputs of change to discern what could change and what are the odds on that change would occur.   One of the lessons that I learned through handicapping thoroughbred horses for a specific race was to deal with absolute uncertainty by assigning relative odds on each potential bet and comparing my personal-generated odds compared with other players/investors to find where I saw a better than normal opportunity that others did not see. Therefore I learned to look for early indicators of transformative disruption that others did not take into consideration. Like some of those in the Fifteenth Century, I looked far wider than others. I looked beyond the statistical measures such as reported earnings, present yields and last transaction prices. The following items are what I am now seeing.

The Downside

The first thing any investor should do is to look at the odds on losing money. In every transaction there is a buyer and a seller. Each side has his or her own motivation for the trade, but both are forcing themselves to do this trade at this time and at this agreed on price. Both could be correct for themselves because they have different time frames for their judgments and/or different plans for their money.

Lots of Great Sales, Few Great Buys

Having both bought and sold securities and financial service companies I sense the buyer of companies is more long-term oriented particularly if the buyer believes he or she can dramatically improve the profitability of the seller’s merchandise. The seller is more currently oriented, feeling that the price offered more than adequately pays for the present risk and rewards available. As someone who has been following the financial services business for more than fifty years it is my impression that there have been relatively few great buys and a lot of good sales. Today there is an increase in the number of insurance-related and data services providers that are selling out, often for cash and some stock. Broadly speaking, financial services is only about one-quarter of the available stocks, however the business of financial services is critical to the workings of all economies. Therefore, to me the odds of a security price downturn in the near to intermediate term is going up. This is reinforced in the fact that the number of business start-ups is way below what would have been expected after a six year economic expansion.  Should you care?

This focus on the time of judgment combined with operating conditions that are funded by investments is why I have trademarked the name Lipper Time Span Portfolios. The concept rests on four portfolios of stocks, funds, and managers. The first or Operational Portfolio is designed to fund current operating needs for a period of a couple of years. As a downturn may not recover within this period, concerns about a downturn are very important. The normal hiding places today like short-term high quality paper unfortunately do not pay enough to cover at least my perceived level of inflation, particularly after all taxes. Thus, some level of equities should be included, but with a manager or investor that will quickly liquidate once a downturn has begun. We will focus on the other three portfolios as part of the upside discussion that follows.

The Coming Upside

History suggests that for America, there will always be an upside. The only question is when will it occur and will it happen as a breakthrough of the upper limit of the current flat market or will we experience a once in a  generation breakdown first. I remain optimistic and reasonably fully invested in equities and equity funds. I have four reasons for my optimism.

The first is based on all the exciting research technology on and off the campus at Caltech as well as what I hear about Carnegie Mellon. The marriage of technology with the biotech world will lead to faster and better treatments for many of the world’s debilitating illnesses and untimely deaths.

The second reason which is very short-term is based on data from the American Association of Individual Investors, which surveys its members frequently. The latest AAII survey displayed in Barron’s shows only 21.1% Bullish and 40.7% Bearish. These kinds of readings often occur at reversal turning points.

My third reason is based on recent developments in the commodity markets. The performance of many commodity managers for the period ending in June and extending into July has been extremely poor. Many investors are fleeing these funds with a number of the funds closing. Commodities are priced based on their scarcity value. With many commodity producers withdrawing their capital from the production of various commodities, and large numbers of skilled and semi-skilled labor being laid off, eventually supply will sink below demand - especially when global demand picks up. At the racetrack occasionally a long shot surprises and comes in first. In some races it makes sense to look for long shots when the crowd has driven the odds down below their reasonable probability on their favorites.  A few, well chosen long shots become logical small bets. Commodities will likely be such a bet in the future. More importantly, the future rise in their prices will signal a rise in general global demand which should be good for the rest of the portfolio of stocks, bonds, and real estate. I can not guess the timing, but it is probably closer than those who are fleeing commodities today believe.

The fourth reason for my optimism is because informally I have managed portions of my portfolio in the mode of the Lipper Time Span Portfolios. As in the example above, I have some money to meet current spending needs for a couple of years. Eventually this portion will be spent. The next portfolio concept is the Replenishment Portfolio to create the new Operational Portfolio. This portfolio is structured so that it can remain reasonably fully invested through the next major downturn seeking to avoid the risk of being too late.

The next portion of the my Timespan Portfolio money is the Endowment Portfolio, which should see my younger wife through her expected long life spending needs. The securities and managers used are similar to what are in the Endowments Portfolio that I see or manage. The final portfolio or the Legacy Portfolio is designed to meet the needs of the family and charities.

Conclusion

The earth is not flat, nor for that matter round as more popularly portrayed, but spheroid with bulges around the equator and a bit flat at the poles. The flat earth believers were wrong, but the common belief today is not quite accurate which gives to some an information advantage. It is often a point of view based on more thorough information that leads to good long-term investing.

Question of the Week: How have you segmented your long-term investments?   

__________   

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.