Our Biggest Risk: Change - Weekly Blog # 492

Introduction

The proper function of active portfolio management is to be aware of possible forthcoming change and to anticipate its arrival.  It is this very function that we are least prepared to accomplish well and therefore the biggest single risk that we and our investors share. They at least have the benefit of being able to blame their professional managers, but since they selected the managers this is self-deception.

Why are we so unprepared to anticipate and take some advantage of future changes? In an over-simplification, the description is the differences between Art and Science. There is a great amount of art in what scientists do, and artists utilize science, often well. The difference in its simplest form is the scientist starts with existing formulas and focuses on what is there. Some artists focus on what is not apparent and perhaps what in their mind should be.

In the portfolio management world the scientists are guided by specific or at least implied facts that have repeated themselves enough so that they become rules, laws, or the current term - factors. All of these are a product of a mental prison. The prison can be labeled EXPERIENCE. If the timing of these “portfolio scientists” is propitious they may make relatively small gains.

The gigantic gains in terms of rewards or avoidance of pains comes from sensing what is not readily seen by most at the time. In the recent two weeks I became focused on long-dead geniuses. The first was the Nobel Prize for the efforts led by professors and laboratories of the Jet Propulsion Lab that Caltech manages in proving Albert Einstein’s 100 year old theory as to the impacts of gravitational waves in space. (This achievement only took over 1000 people and over $ 1 Billion NASA dollars and a strong contrarian view.) Nevertheless within a few weeks after the beginning of its operations, they were able to detect a number of collisions of black holes that release a huge amount of measurable energy.

Last night my wife Ruth and I enjoyed a magnificent musical performance conducted by the incomparable Xian Zhang and the New Jersey Symphony Orchestra playing Beethoven’s Emperor Concerto for Piano and Orchestra. Beethoven is another example of a genius well ahead of his times. What I didn’t  know was when Beethoven composed this piece in 1809 he anticipated the development of the modern piano different from the one of his day. It would take a half century before the present day piano arrived.

Today we are the beneficiaries of these geniuses’ work; one and two hundred years ago they saw what was not  seen by the rest of their professional colleagues. Perhaps for us in the portfolio management business the lesson is avoiding some of the penalties from using outdated instruments and thinking.

I have been concerned as to how to prepare for future changes and how they will impact future generations of beneficiaries of the art of portfolio management.

Future Political Changes

In last week’s blog I alluded to both the French and Russian Revolutions and that the early leaders of dramatic changes were replaced by more radical leaders who appeared to be able to more quickly accomplish structural changes that were promised. Today on every continent we have leaders who have sold themselves to the voters and other decision-makers as change agents that are being bogged down with the lack of sufficient political power to accomplish their promised goals. At some point, if the inability to make major structural changes continues, the present crop of change agents will be replaced either through the voting box or more violent means either from the Right or the Left. My fear is that due to technology and global economics we could enter a post-national world that may look like City/States with defense, military, and economic alliances. In such a world, the force of law on contracts may be quite different than what we are enjoying today. 

I don’t know whether the changes will be good or bad or more likely both. Neither do I know who will be the winners and losers. What it does suggest is that it may be prudent to be widely diversified not only in terms of geographies, but economies, and perhaps most importantly, the rule of law and taxation.

Financial Structure Possible Changes

Most of the readers of this blog and I are much more focused on equity investing than fixed income investing. The historic reason is that stocks are where we can profit the most. We tend to forget about the bond market. This is a mistake for three reasons:

1.  The bond market is bigger than the stock market around the world.

2.   Equities are leveraged directly or indirectly by the borrowings of governments, businesses, and individuals.

3.   The basic contractual laws were developed to establish “fair dealing” between lenders and borrowers which is also the basis for rules for equity owners.

Today, the size of unfounded  and contingent obligations question to the lenders that each and every future dollar or equivalent will be paid on a timely basis without significant increases in taxes and other transfers.

One of the tenets of being a contrarian investor is to get increasingly concerned about one sided markets. In many countries, (including the US) there has been more money going into bond funds than stock funds. These funds and many retirement funds are buying bonds pushing their prices up and yields down. Historically the differences in yields were an indicator of perceived risk. What are the financial markets saying when the yield on US Treasuries are 2.3% which is the same yield as the market is placing on emerging market stocks? Now the best thing that can happen to the owner of Treasury paper is to get paid the maturity value upon its liquidation, nothing higher. Over the next ten years the dividends on Emerging Market stocks can rise or fall. Clearly the Emerging Markets have trade, product, and currency risks that the Treasury paper does not. The equity market appears to be much more discriminating as shown in the yield table of equity indices below:

Below 2%	2-3%	3-4%	Above 4%
India	Japan	France	Australia
S. Korea	Mexico	Italy	Russia
China	Germany	Sweden
US	Brazil	United Kingdom
	Canada	Spain
	South Africa

Each list starts with the lowest yield, the most favored country in the yield range.

The stock markets appear to make significant distinctions that bond aggregates do not. There are some skilled bond investors working in the emerging market space. One that came to my attention this week has top three holdings in Kenya, Senegal, and Iraq. For lots of political, social, and religious reasons some investors might object to investing in these or other countries, their withdrawal as potential investors could reduce the number of buyers and make higher yields available to other investors.

As a contrarian I expect the flow of money into bond funds will be at best counterproductive,  if not producing meaningful losses. I am also concerned that the brokers and advisors who put investors into bond funds will lose face and clients for  their actions. Much of the flow into these funds comes from large broker dealers and large registered investment advisors. As much of the flows have gone into fund companies that also offer stock funds, hopefully the fund houses will be able to convert a significant portion of the residual bond investments into stock funds to preserve wealth and give the investors a chance to recover some of the expected losses. If this exchange happens now the scenario may work. There is a dreadful chance that the switch will happen concurrent with an eventual top of the equity market.

Equity Market Structural Risks

The European Union in January will put into effect rules that will have the effect of reducing payments for brokerage delivered research that may impact institutional trading around the world. From an investor standpoint this will likely remove the research support for many smaller companies which will lower their potential market value. This is occurring at the same time that in the US for various administrative rules and tax implications, the number of publicly traded stocks has been cut in half from the number of publicly traded stocks of years ago. It is much too early to tell whether the currently discussed tax bill and the desire of the Administration to reduce the burden of regulation will have a positive effect on stock prices. It would not be the first time that the unintended consequence of changes has the opposite impact to the government’s desires.

Investment Policy Considerations

As we may have entered a world where the historic factor type of rules based management may produce competitive results, it could be the time to drastically increase diversification. This is not just adding to the number of securities in the portfolio. It means having an increase in the number of themes used in the portfolios. It could well mean to begin a position in some of the currently worst performing segments such as agricultural commodities. It may mean to invest in local securities around the world. For us who manage portfolios of funds we may need to add new managers who think differently than some of our very successful present managers.

Bottom Line

We may have entered a period of structural changes that we need to recognize and begin to take actions to protect the assets of future generations.

Question to Dwell on: Can you evolve your thinking ahead of the headlines?    

__________

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Three Portfolio Political Risks - Weekly Blog # 491

Introduction

What should be normal for an investor and particularly for a portfolio manager of other people’s money after a particularly good investment performance, one should question what can go wrong. Traditionally, September is the worst performing month of the year. Not only was it a positive month in 2017, but most of our advised accounts produced better than their individual performance benchmarks.  Since we utilize fixed income funds, both bond and money market funds as buffers to equity fund performance, most of our accounts are benchmarked against the Lipper Balanced Fund Index which is reported daily in The Wall Street Journal. The long-term record of that index is to produce returns between 5% and 10% with most of the time in the 7%-8% range and these are the normalized expectations for this benchmark.  We need to keep in mind that that past performance is no indication of future performance, and that investing includes the possibility of loss of principal.

Some of our clients’ investments were in mutual funds that gained over 20% and a few in the 30% range. These funds were invested internationally and/or invested in the top five stocks in the S&P 500 or their international equivalents. As we manage diversified portfolios we also own funds that did not do as well as the top performers.

I mention these results as a prelude to my natural caution; I am casting around as to what can go wrong.

What should be normal for an investor and particularly for a portfolio manager of other people’s money after a particularly good investment performance, one should question what can go wrong. Traditionally, September is the worst performing month of the year. Not only was it a positive month in 2017, but most of our advised accounts produced better than their individual performance benchmarks. In the first 9 months of 2017 we are producing returns at two to three times normal long-term annual expectations. We have invested some of our clients’ money in mutual funds that have gains of over 20% and a few in the 30% range. Following what should be the normal reaction after such results I am casting around as to what can go wrong.

A lot can go wrong. At the moment the three most prominent concerns all have a political base. As a classically trained securities analyst,  I normally ignore the political world, in part I have observed that contrary to most people’s logic, news follows the market rather than the other way around. For example the so-called Trump Bump actually started in July of 2016,  not at the election time. One reason for generally ignoring the shifting currents of the political world is that I am a securities analyst, more comfortable with financial statements and operating conditions than attempting to be a political analyst.

Nevertheless the three biggest risks to stock portfolios emanate from political decisions. Remember that Bernie Baruch when testifying before the US Congress was defending himself and his transactions that were labeled speculative. Reminding the Members of the derivation of the verb ‘to speculate’ was to see far (into the future). Recognizing that I may be wrong about any one or all three political risks, I will discuss each in order. The order chosen is in the probability of happening and the inverse order of magnitude of potential risk.

Risk #1:  Top Potential Casualties

Politicians strive much more for power than policy. In a capitalistic society there is almost always conflict between political power and the power of money. Often it is hidden but rarely is it not present. The battleground between the opposing forces is public awareness which is in control of selecting the levers that make our society progress. The following is an incomplete list of industries that the federal government curtailed through various measures since the aftermath of our very destructive Civil War, in roughly historical order. After identifying the industry or company in parenthesis are the government actions.

Railroads (Interstate Commerce Commission on tariffs); Life Insurance (licensing by individual states); Banking (Federal Reserve and Federal Deposit Insurance Corp.); Steel (tariffs and labor disputes); Standard Oil (trust busting); AT&T (breakup) and commercial airlines (deregulation). I am not suggesting that some of these actions weren’t in response to public concerns, but in these cases the net results were to force the companies to drastically change their ways which may or may not have helped the public more than it hurt them.

As a very powerful Speaker of the US House of Representatives once stated, “All politics is local.” In most communities the movers and shakers typically are a small group with a lead the following sectors: Banking, Newspapers, Auto or Farm Equipment dealers, Doctors, Insurance Agents, Retail trade and Real Estate. If a number of these feel threatened by new types of competition, they have an easy access to their political leaders in Washington - particularly when their regular political campaign contributions are remembered.

Today the five largest market capitalization stocks in the Standard & Pours’ 500 are increasingly being looked at as threats to the established  commercial and therefore political order. The five are Apple^*, Facebook, Amazon, and the two classes of  Alphabet (Google). Their combined market cap is $ 2.9 Trillion or in the same region as the annual incremental addition to the US national deficit. Clearly their very market successes create envy, both in the financial markets and public sentiment. Much more important in my mind is each of the leaders can be seen as an unintended threat to the cabal that runs our political structures on both sides of the aisle. I will very briefly identify the threats that can be conceived: 

^*Held personally

Apple is encouraging communications at numerous different levels which is destroying land line phone companies, local newspapers, and local financial institutions. Facebook in the last US election was the source of both valuable and manipulated news.

Alphabet (Google) is the ultimate supplier of “authoritative” information putting our teachers and professors to shame.

Amazon has just about destroyed the local book store and is seriously hurting the retail trade. Its very success has driven its stock prices up at a greater rate than the rest of the stocks in the S&P500, accounting for perhaps 25% of this year’s gains in some measures. It also is one of the reasons that active managers who own more of these and similar stocks are outperforming the identified indexers as well as the closet indexers. European governments have been among the first to try and corral these companies and could reduce their residents’ use of these products (which has happened in China.)

I don’t know how the political power class will attempt to rein in the power of the new uses of technology, but they may only be as successful as the Luddites in delaying the march of automation. While at the moment I am worried and expect the rumors or actual governmental moves to force a give up of some of the large stock price gains, I am betting that these companies’ lobbying and other efforts will blunt any serious moves.  However, my tolerance is perhaps at the 33% level. If your level of tolerance is less, be aware of the perceived risk.

Risk # 2:  Repatriation: Pandora’s Box

Be prepared for disappointing results from the temporary repatriation tax holiday. Politicians and to some degree central bankers are steps behind investors and corporations in their recognition that we are in a post-national world. A good bit of the foreign earnings of US corporations has been generated from sales of products and services to non-US residents. To the extent that the foreign branches and subsidiaries have paid for their US capital and research services, the foreign activities represent potential spin off candidates. This is the case for a number of multi-nationals.

If they fall for the tax trap and bring all of the foreign earned capital back to the US, they are probably good candidates for sale as they don’t believe in their own future particularly if the bulk of the repatriation goes to buy-backs which helps the existing management and hurts future owners.

Often when we invest in a foreign to the US fund, we are investing in foreign multi-nationals. This is similar to when non-US residents invest in our funds. In truth all over the world, most large financial institutions invest in large caps globally. They assume that the companies will be managed to achieve the highest prudent return long-term, not to solve local tax issues to reduce the size of unwise deficits. It may take awhile for the politicians to recognize that investors have felt the need to defend themselves from their own local governments, at least by diversifying into different legal and tax jurisdictions. Whether we like it or not we have entered a post-national world. One can expect the politicians to fight it and try to refocus investors on their home market, but it won’t work unless they encourage the locals to make their market the most attractive in the world. This probably won’t happen, unless we drastically shrink the size of government and regulation. 

The risk is that when repatriation for sound reasons does not produce the flow of money into the US that the politicians were expecting, the politicians won’t see that they are the crux of the problem. Most likely they will wish to penalize international investing, which will be counterproductive and hopefully won’t last too long.

Risk # 3:  Lessons from French and Russian Revolutions

The overall theme of recent elections in India, Great Brittan, US, France, Germany, and possibly Japan and Catalonia is that voters are angry as to their current position and want change. Many, if not most, of the current leaders were seen as change agents to solve the perceived deep problems. However, the problems are indeed deep and have been growing for forty to eighty years, Thus, they won’t be solved quickly in all likelihood. That is where the risk comes to the surface and the fearful lessons from the French and Russian revolutions. In each case the initial uprooting was led by a middle class leader who was attempting to fix the old system. It didn’t happen fast enough and there was some mismanagement of resources due to inexperience. In a short time the awakened masses lost patience. The mob or perhaps an organized crowd consumed the change agents and became enthralled with more radical leaders. For forty years I have been expecting a wave of change agents which could have come from either the right or left. If they can’t produce quickly, they will be replaced. The replacement can come from either extreme, but almost certainly will be extreme. This threat can only be headed off if the change agents get some quick early victories and start to come up with some extreme approaches themselves to head off more extreme approaches of the new radicals.

Question:

What are the three political risks ahead of us?        

__________

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Cyclical and Secular Concerns Vary with Time Horizons - Weekly Blog # 490

Introduction

“Horses for Course” is a racing expression which indicates that horses run differently at different racetracks. Not only different courses but different lengths of race. As is often the case, what is true in the analysis (or handicapping) at the track is also true in the selection of managers, securities, and investment strategies. These concepts were the genesis of my developing different timespans to be used for managing investment portfolios.

In the first two timespans, Operating and Replenishment, significant financial losses are difficult to overcome and thus cyclical considerations dominate. The longer term Endowment and Legacy portfolios assume periodic declines, but that long-term secular trends will dictate their future performance.

As we appear to be entering a period of switching gears from complacency or frozen in place, to one of growing enthusiasm, the prudent investor should increasingly wonder what could go wrong. Of the myriad of possible future events it is unlikely that one can accurately predict what will happen. At the current time I feel an obligation to point out possible unanticipated problems.

I will first focus on possible cyclical problems that can impact investment performance through an intermediary period of roughly five years and thus cyclical factors. In the second part of today’s blog I will focus on Asian, African, and Latin American factors that could impact the longer term secular trends.

Cyclical Factors for the Intermediate Term

As Professor Robert Shiller points out, almost everyone acknowledges that a recession will happen. He further states at the moment that not too many investors are concerned about a future recession. The popular securities indices are regularly reporting new high levels. However, the best performing of the three indices, Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 (S&P500) and the NASDAQ Composite (NASDAQ) is the last one by a considerable margin, as small companies particularly those involved with information technology including Apple^* performed well. While the NASDAQ is slightly reporting new highs, it is not demonstrating a major breakout after hitting a new high and thus it may be questioning the strength of the move. This is not particularly upsetting because as in the past, Apple shares sell off after new product announcement run ups. As a long-term owner of these shares I am much more focused to see the level of sales and deliveries in its fiscal second quarter ending in March 2018. While some market rotation is healthy if it does not include a strong NASDAQ performance, it would be demonstrating the “animal spirits” are getting tired.

^*Held personally

Market leadership rotation is normal and expected, but when one or more of five sectors or asset classes lead, it will be an indication that investors are deserting the central forces of the economy. If you possess trading skills the five sectors could be very productive. If you are like the most of us who move in and out late, be very careful. The five in alphabetical order are Bonds, Commodities, Energy, Gold, and TIPS. If you are an accomplished player, play. If not it would be time to build reserves, particularly if you are managing a current or replenishment account.

As mentioned last week the gains in earnings being reported for the first half of 2017 are due to expanding profit margins. Earnings per share are growing faster than revenues which are growing slowly and in some cases very slowly in the second quarter. To create sustainable earnings and employment we need to see revenue generation pick up.

The potential expansion in the level of enthusiasm for stocks may be heralded by the decline in neutral sentiment in the latest AAII survey, dropping from 36.7% last week to 32.7% this week, and a roughly similar increase in bearish attitudes. This suggests to me we can see an important increase in volume which in and itself engenders more volatility.

My real concern for the intermediate future centers around the bond market which is larger than the stock market but can be much more sensitive to short-term events. I don’t know what can create a bond market bear market, but the following are thoughts that needs to be understood:

·       The little understood bank for central banks, the Bank for International Settlements, has noted that many governments, including the US, are only identifying contingent liabilities in their financial statements. These include unfounded pension and medical costs. One potential concern of mine is a large size of unprofitable investments by China in building its One Belt One Road Initiative (OBORI) in neighboring and other Asian countries.

·       Yields on high grade corporate bonds are rising which means prices are falling slightly, showing some lack of demand. At the same time yields on lesser quality bonds are holding up, showing an increase in demand.

·       Just as yields go in the opposite direction, the contrarian in me suggests that flows follow performance late and stay too long. In almost every country that has a mutual fund business there is an increase of substantial size in the flow into bonds. They are easy to sell to people in view of the low manipulated rates dictated by central banks that impact commercial banks’ deposit rates. This excessive flow is augmented by the large number of financial groups offering new credit funds without sufficient experience in non-bank lending.

In sum, I grow increasingly wary in crowded markets.

For the intermediate term investor I see more performance/career risk than we have seen in sometime. Perhaps, we will escape but by the next US Presidential Election the odds are that we are going to be tested.

Secular Concerns for Longer Term Investing

For only long-term investors to consider in their third (Endowment Timespan) and their fourth (Legacy Timespan) portfolios are some surprising inputs from a two day visit to Mumbai, India. To fulfill two speaking engagements at a very busy time of year, my wife and I flew into Mumbai Thursday night and left on a redeye Saturday night. The purpose of the two speeches was to have discussions with Indian mutual fund CEOs, portfolio managers, independent investment advisors and distributors of funds. There are forty fund houses with thirty four reporting their net asset value in the paper. I made the point that they have only penetrated 3% of the households where in the US the penetration is over 40%. In addition to focusing on mutual funds, I had hoped to find some good long-term investments for our family accounts. I knew it to be a long shot in that the Indian stock market for the year to date is the best performing large country market. I was impressed with the quality of the Indian professionals that inhabit their market and compete with a relatively small number of foreign funds that are devoted to investing in India.

As with many adventures and experiments, there are surprises generating from some disappointments in the initial objectives. On Saturdays there are two major financial newspapers published in India, (The Economic Times and Financial Express) which have articles of interest that could impact future investing in India, China, Africa, Latin America and other Emerging Markets.

The following are briefs from the points of views expressed without any additional research or separate opinion from this traveler:

“Africa Sees India as Key Growth Partner” is the title to an article that contrasts with the way India is viewed as compared with China as a source of development spending. According to the article "Recent media reports have carried allegations that Chinese business houses are treating African workers as slaves...." India on the other hand is viewed as a collaborator with the locals. The article mentions an Indian-Japan-Asia-African Growth corridor as an alternative to China's One Belt One-Road Initiative (OBORI). Apparently the Chinese focus is natural resource development for export principally to China. The Indian-Japanese-Asian effort focuses on rural development and agriculture, energy, and  education. In addition they are interested in quality of life issues and within the region, connectivity. This is similar to the development practices that are found also in Latin America. (India itself is beginning a campaign to improve the lot of its farmers through the application of technology along with capital.)

The Indian Post Payments Bank next year expects to equip a large portion of its postmen with equipment including biometric readers, a debit and credit card reader, plus a printer. Thus home dwellers will be able to quickly and safely pay various bills.

"Chinese Government Plays Cupid to Help Youth Get Married" is an article about 100 million young people in China that are not married. The government is sponsoring a blind date service. It specifically suggests that marriage will aid in future development.

SBI Life this week had an IPO and produced two interesting details, for this the largest life insurer in India. The first is the offering was oversubscribed by a 3.58 times ratio led by institutional buyers. What was of interest to me is that High Net Worth Investors only utilized 70% of the allocation available to them and retail investors used just 85%.  From my standpoint the most interesting numbers were that in 2016 the Indian Life Insurance industry penetration was 2.7% and this compares with 7.4% for Korea, 5.5%  in Singapore, and 3.7% in Thailand.

Can you imagine what more I could discover if I spent another week, month, or years in India? Seriously, my very brief visit highlighted to me that investors should not isolate the impact of single nations in making decisions. China, India, Africa, and Latin America as well as the rest of the Emerging Counties are linked in many ways that need to be understood for successful long term investing. 

__________

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

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.