Longer to Rise, Faster to Fall - Weekly Blog # 544

Mike Lipper’s Monday Morning Musings

Longer to Rise, Faster to Fall

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

One of the most critical tasks for good analysts is to anticipate both the near and far term futures. We know that we will be wrong some of the time in terms of direction and frequently and will be in error on the numbers themselves. We take comfort that our fellow prognosticators, the weather people, are still employed. Both of us tend to have better records than either economists or politicians. The reason for the better record is not that we are brighter, but that we are constantly looking for surprises that could cause trend reversals. The others are much more comfortable in extrapolating the present into the future.

Each day and each week I look for potential surprise elements that I occasionally share with you. To put some perspective into my observations I place my views in different time slots, which may be useful to our subscribers even if you haven’t adopted our sub-portfolios of different time spans.

Most of the US market indices are near their historic previous high points but appear to be laboring in an effort to go higher. My friend, Byron Wien, said that the “market could move somewhat higher, but that a major surge is unlikely”. Byron was not in the US Marines with me training in the undulating hills. My experience is that it takes a long time to get up a steep hill, but the fall on the other side happens quickly. This matches our historic market experience and reinforces my belief of identifying different time spans for different tactics. The rest of this blog contains inputs that I received this latest week, broken down into times when they appear to be most important.


Need for Operational Cash or Short-Term Considerations 

The picture is mixed as shown below:

• September slow-down in sales orders

• Jump in wholesale inventories (could be tariff or price increase related)

• Generally rising stock markets in US, China, and Japan

• Closing daily stock price gaps for DJIA and S&P 500 

• Center parties losing some power in Germany, France, and Italy

• US restaurant shortage of experienced staff

•  Of the larger investment objective averages, the following beat the S&P 500 index funds for 2018 year to date: Small-Cap Growth, Health/Biotech, Large-Cap Growth, Science & Technology, Mid-Cap Growth, and a number other popular fund objectives. Leader-ship is broader than just the FAANG stocks.

• Only three types of fixed income funds gained over 1% on a total return basis year to date: Loan Participation, High Yield, and Ultra Short Funds. As with most other fixed income funds, net asset values were flat or down, leaving only their dividends on the positive side.

• In the past week, five of the six best performing indices were commodity related indices. The two best currencies were viewed as commodity currencies. 

• There was a significant slow-down in net sales for the world’s open-end funds between the first and second quarter. According to a compilation done by the Investment Company Institute, the $584 billion net sales in the first quarter was down to $194 billion in the second quarter. This was materially less than the $609 billion in the second quarter of 2017. Even so, the fund industry is a powerful force in the investment markets, with global total assets of $53 trillion.    

Until the End of the Next Recession and Market Decline:

• Byron sees the next recession after the 2020 presidential election, but the stock market may anticipate earlier.

• Jeremy Siegel, Wharton Professor and Consultant to Wisdom Tree (*), believes “stocks are overvalued and bonds are enormously   overvalued on a long-term basis.”

• Studying mutual funds since the 1960s and knowing their history before then, it is very rare to find a professional investor that es-capes a major decline and then is successful in re-entering the stock market at a propitious time. Cash makes us too comfortable.  

Legacy Investing: Stay in the game

• John Authers, one of the most read columnists in the Financial Times, has written a column on what he has learned from investing his fund journalism prize in 1992 and the good record it produced. He invested in a mutual fund which had a good investment record, which he continues to hold. The points he has learned are: 

• There is not a great deal of difference in performance over the long-term between an actively managed middle of the road fund and an index fund, if it existed at that time.

• He and most investors have a home country bias.

• One should expect portfolio managers to change and for there to be changes within the management company itself.

• Jason Zweig, another old friend, recounted in the weekend edition of The Wall Street Journal that there are periods when various markets outside of the US perform better than the domestic market. He believes that the trend of US investors investing in funds invested outside of the US will be rewarded. As pointed out by a manager at T. Rowe Price (*), foreign markets from a US prospective have less tech growth stocks and thus their markets are selling at a lower valuation.

• I have made the point to an investment group that I participate in, that currently a good way to hedge US holdings is to invest long-term into China, either directly or from my standpoint thru mutual funds.

My Conclusions:

Investing is like predicting the weather. It’s almost impossible to predict the levels of the market, particularly with shifting levels of sentiment and liquidity. Getting the trends right is often the best one should hope for.

As most artist’s don’t exactly know which of their works will achieve lasting acclaim, we should recognize that it is at best an art form or an intelligent gamble when properly managed.

Investing with different approaches for different time spans allows one to have more tools than a single portfolio with a single strategy.

At the moment I believe we are climbing a wall of increasing worries. It’s like climbing a series of difficult hills, always aware that most declines are marked by surprises which lead to a quick fall.


Question: how do you see the long-term outlook?


(*) A long position is held either in a private financial services fund or a personal account of mine and do not represent a recommendation

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


Did someone forward you this blog? To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com


Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

From One Week to Eternity with Reason - Weekly Blog # 543

Mike Lipper’s Monday Morning Musings

From One Week to Eternity with Reason

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Investors’ Dilemma
“Buy and hold forever” is an easy and dangerous command that investors’ issue to themselves. The one guaranteed aspect of life and investing is that conditions change, often in surprising ways. Because making investment decision is frightening, there is a natural tendency to make as few decisions as possible, recognizing that we might be wrong. This ignores that everyday an action is not taken is a decision in itself. The one sure bet is that the conditions that underlie any decision are likely to change, both for the investor and the investments, be they individuals or institutions.

One way to deal with a big problem is to break it up into a series of smaller problems. That is why I trademarked the TIMESPAN Lipper Portfolios TM. This approach allows the individual and portfolio manager to select the appropriate strategy and tactics for each important time slice. (I would be pleased to discuss this application to subscribers’ own needs.)


Professional Portfolio Managers’ Commercial Dilemma
Professionals are hired to think about and do something with the money entrusted to them. Since thoughts can’t in and of themselves be measured, many investors evaluate their investment advisers solely or largely on the activity of buying and selling in their accounts, when at times it makes more sense to do nothing. (Dividing the long-term records into high and low turnover managers, the low turnover managers tend to produce better investment performance records.)


What to Act on and When?
The key is in the straw, that is the final straw that breaks the camel’s back. The more risk averse among us may prefer to wait to a time closer to the final collapse. Again, both the professional and individual investor should be conscious of impending changes to the investors’ condition.

Evaluating the changing conditions of the underlying investments each week, I peruse lots of hard and soft data in an attempt to understand their implications for the various time spans for which we are responsible. The rest of this blog is devoted to what I looked at in the latest week and why they might have longer term implications. 


Markets

• US stocks appear for the second consecutive year to outperform US Treasuries. This is the longest such period since 1922-28. (Caution warranted)

• The six largest countries (G6) are again spending a smaller portion of their GDP this year than they did in 1948. (We won’t be able to fulfill the population’s demands if we can’t deliver goods, services, and people inexpensively and efficiently. This could be an opportunity.)

• By 2050 the cohort of 65+ will more than triple. (Potentially important for both the real work force and healthcare). Adding to these trends is the likelihood that babies born today will be alive for one hundred years.

• Each week The Wall Street Journal publishes weekly price changes for stock indices, currencies, commodities, and Exchange Traded funds. In the latest week, the top three performers that all rose approximately 7% were commodity related and were down considerably earlier in the year. The next three largest gainers were foreign stock markets that likewise were recovering from earlier declines. (I am wondering how much of these extraordinary gains are from short covering. The general characteristics of the six are sudden/rapid changes in perception, low level of present market liquidity, and the availability of margin to support derivatives.)

• NASDAQ(*) reported that the trader who defaulted on $134 million of derivatives will pay back the default. (This probably reassured the derivative market that we aren’t facing a mini repeat of the Long-Term Capital Management insolvency). 

• There is a published market rumor that Mass Mutual Insurance is selling Oppenheimer Management for approximately $5 billion, which would equate to 2% on assets under management. This would be considered a good price in today’s market. (If the rumor is accurate, the buyer is also in the business and can use some of the investment and marketing talent. Insurance companies have regularly entered and left the mutual fund business. Cross-selling is more difficult to do well, resulting in volatility and risk)

• The Dow Jones Industrial Average and the S&P 500 developed price gaps. Most of the time prices can’t move much until these gaps are filled. (Short-term caution) 

• The market was unexpectedly kind to my examples of the type of stocks that would be suitable for adult children that are not focused on investing (Berkshire Hathaway (*) and those suitable for grandchildren as a long-term change agent BYD (*)  

Bonds

• According to a Barron’s, an index of high-quality corporate bond yields has broken through 4% vs. 3.19% a year ago. According to the perceptive Marcus Ashworth of Bloomberg, this could be caused by there not being enough high-quality European debt to meet the demand in a period when European companies are growing at half the rate of those in the US. In addition, it is expected that for the next several years there will be little to no net new German government issues. (If this is correct there are two likely results. The first is greater demand by Europeans for US debt and second that US companies will issue Euro backed debt. American companies have substantial European operations and sales.)

• The Financial Times devoted a full page to large private equity shops that have become even larger factors in the private debt market. These and other non-bank credit providers have taken significant market share from the traditional bank lenders by employing heavyweight deal makers, thus improving the certainty of closing with less stringent terms (covenant-lite) in exchange for higher interest charges, which in some cases are floating rates. Moody’s (*) has noted that 80% of the currently marketed issues are covenant-lite. Howard Marks is quoted as saying “The seven worst words in the world are: Too much money chasing too few deals.” (If there is an actual or rumored sudden credit market problem involving leverage or derivatives, it is very likely that the stock market will feel it.)

Trade

• The three fastest growing export markets for the US since 2001 are: China 580%, Hong Kong 140%, and Mexico 140%. (In looking at the three leaders I wonder how the transshipment numbers are handled. The whole practice of global supply chains makes looking at national data questionable, at least to me. Are Apple (*) cell phones US, Chinese, Korean, Taiwanese, or Japanese products?

• In 2016 Asia outpaced North America in patent filings by more than 3 to 1. (There is a legitimate question as to the commercial value of some of these patents.)

Mutual Funds

• Utilizing the Lipper Investment Objective Fund Indices for the week ended Thursday, the leading categories were: Precious Metals +4.59%, Global Natural Resource +3.15%, European Funds +2.60%, Financial Services +2.37%, Pacific Region +2.32%, and Emerging Markets Stock funds +2.05%. In each case these categories are recovering from earlier poor performance. Not a single one of these categories beat the S&P 500 Funds Index +10.83% on a year to date basis. Small-Cap Growth +21.48% and Health/Biotech +20.64% almost doubled the market measure, but they are also playing catching up for longer periods of underperformance. (There appears to be much greater selectivity required to come up with a top performing investment objective. This suggest narrowness of leadership, which is more prevalent around peaks.)

• The dominance of very selective ETFs is probably due to a relatively small number of trading organizations like hedge funds or leveraged investment advisors. For example, one ETF drew in more net inflows than all other equity ETFs. The SPDR S&P 500 took in $2.7 billion for the week compared to a total net equity fund inflow of $2 billion. The figures are from my old firm, now a part of Thomson Reuters.

Working Conclusion
There are short-term trading opportunities and after at least a measurable downturn, longer-term opportunities.


(*) A position in these securities are owned in the private Financial Services fund that I manage and/or I own personally.
       

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

Did someone forward you this blog? To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

Crashes & Cash - Weekly Blog # 542

Mike Lipper’s Monday Morning Musings

Crashes & Cash

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

      

Did we Escape the Rumblings of the Next Crash?

Was the Financial Times headline: “Traders lost bet blows hole in post-crisis safety net” the announcement of the Arch Duke’s murder? The loss results from a more than $160 million default on margined futures trades at the NASDAQ(*) clearing house facility. Morgan Stanley(*), UBS(*) and Norway’s State Oil Company will have less than 48 hours to cover their defaulting counterparty. We think they will, but the size of their risks may give the professional market cause for concern as to the general risk in the market place. The implications of this default may take a while to be grasped fully. It took about six months from the Arch Duke’s death before the armies started to move and begin World War I.  Earlier this week I was asked by a group of retired, semi-retired, and active portfolio managers and analysts to give a top-down view of the market. My first point was that we should all prepare for a coming bear market. I hope my timing was not too prescient.

(*) A long position is held in these securities either in a financial-services fund I manage or in personal accounts, if not both

Current Odds Favor Upside

A very good friend gave me a book this week titled “Financial Market Bubbles and Crashes” by Harold L. Vogel. In the book the author lists 12 characteristics of a bubble, some are present, but not the complete list. (I will supply the list to any subscribers that send to me an email.) As bubbles are much more an expression of extreme sentiment than financial and economic data, I pay attention as others do to measures of investment sentiment. As I mentioned in the past, I look at a sample survey of the American Association of Individual Investors (AAII). Three weeks ago the most popular choice was bullish at 43.5%, by this week the bulls represent only 32.1%.

The Growing Risk Side

One of the traditional causes of bubbles is that there is too much borrowing. Too often this borrowing is used to buy or leverage financial assets, not operating assets. We have that set of conditions today, where major corporations are borrowing to buy their stock. While there has for a long-time been borrowing for home and auto financing outside of the bank and bond markets, it has recently grown much faster. Almost every major financial institution is utilizing the credit market and/or raising money for it. We are seeing a good number of these companies raising money on easier terms than in the past. This week the spin-off of Thomson Reuters (*) to a joint venture with a number of private equity funds led by Blackstone was able to sell paper which allowed the equity owners to receive dividends without the permission of the credit holders. This is a global phenomenon. BYD(*), a Chinese car and battery manufacturer asked its equity shareholders to allow their company to guaranty the debt of their auto finance subsidiary. 

Build Cash

One of the other points I made to my fellow members of this investment discussion group was to build cash. At current short-term interest rates one is much closer to breaking-even with inflation than in the recent past. There are other advocates of the value of cash. Charlie Munger and Warren Buffett at Berkshire Hathaway(*), while still buying a few companies and stocks, have built up over $100 billion in short-term investments. They have a very promising record of getting very high returns by coming to the rescue of very large, generally quality companies, in periods of distress. Reviews of Howard Marks’ new book speak about the optionality of cash. This means that he can deploy it to quick advantage.

Two Other Points Made

With the Chinese stock market falling, it would make sense to buy some of their better companies, or well managed mutual funds specializing in Chinese stocks as hedges against existing US and European stocks. If they go down further in value, the odds are favorable that the other holdings will go up in relative value.

The second point, in opposition to the focus almost exclusively on current prices of stocks and derivatives, is to practice some time span diversification. Only for example, one could take some of the asterisk names as being appropriate for middle age children without a great interest in investing. One of the mentioned stocks might also be appropriate for grandchildren in the hope that they will live in a less polluted world.

If YOU NEED HELP

We can discuss your needs and swap ideas  

  

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

Did someone forward you this blog? To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

Extreme Popularity Creates Risk - Weekly Blog # 541

Mike Lipper’s Monday Morning Musings

Extreme Popularity Creates Risk

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Risk from Other Owners
Too many investors focus their analysis on the risks to the issuer of their securities, as well as external factors like the political economy. The big lesson learned from major price declines is that the single biggest risk comes from the other owners in the securities. When it comes time to sell in a period of high anxiety, the other owners become competitors until the exit is completed. That is the missing lesson from the series of articles on the price collapse in sub-prime mortgages, Long Term Capital Management, Lehman Brothers, and the Reserve Fund. In each case the specific liquidity problem of the issuers triggered a market liquidity crisis for other securities and markets.

The history of big crises is captured in those three letters =big. Due to the popularity of investing in a security or type of security which absorbs liquidity on the way up, there is often insufficient capital to provide liquidity on actual or rumored mass exits. In other words, at the point of contemplated or actual exiting, there are few to no buyers left.

Could we be approaching such a situation in the credit market? Will it stampede the corporate bond market and possibly the stock market? Will the stampede include some bank capital positions? Maybe.

When? Now or Soon?
Timing is the most difficult tool in the investing art form. As with our favorite portfolio strategy of sub dividing a portfolio into separate time spans, there are three different approaches depending on time spans. Randall Forsyth in Barron’s stated “Since 1950, September has been the worst month of the year for the Dow and the S&P 500”. That is the immediate worry period.

The great economist Hyman Minsky identified that periods of stability bread instability. This makes sense, as far too many investors take current conditions and extrapolate them into the indefinite future. That is a lazy way of thinking. Change occurs every day, most of it small, but the increments add up leading to an unrecognized reality, until there is a shock of some sort. Investment committees and wealth managers are particularly susceptible because they are planning finite periodic distributions.

The longer-term change is a slow recognition of a faulty set of assumptions. There is one visible today, utilizing mutual fund performance data from my old firm Lipper, Inc, presently a part of Thomson Reuters. For the last five years there have been two trends that  cannot continue forever and have been contrary to investors best interest. For the last five years through August 30th, the average US Domestic Long-Term Fixed Income Fund has grown at the rate of +2.55% per annum, in contrast to the average US Diversified Equity Fund which has grown +11.11%. During the same period there has been a net flow into bond funds and a net redemption in equity funds. The biggest net redeeming group has been Large-Cap Growth Funds, which gained +15.78%. Possibly, those that guide investors will wake up during the next decline and sell out of their fixed income funds, which presumably will go down less than the stock funds, and recommit their assets to stock funds. (Some may overcome the relative pleasure of losing less, but most won’t until much later.) Even in executing this maneuver, they will probably still be behind most stock fund investors who stayed through the period.

The Two Biggest Risks
The first is that we have moved from a pattern based on business cycles to one based on capital cycles. Almost all activities used in inflation defenses have become directly or indirectly leveraged by the use of borrowed money or float. The financial community, in order to supply the necessary funding to make the system work, has moved from sole reliance on stocks and bonds to rapidly expanding the use of credit instruments. Most brokerage firms and other investment organizations have entered the credit markets as packagers and sellers. The competition to become the dealer in the paper has become intense and has led to weaker covenant constraints in the underwritten bond market. Many of these instruments are traded in private markets, with little public price discovery. These are conditions that could well be a ticking time bomb under the whole financial market. There will be actual or rumored defaults on these instruments.

As with the current concern for contagion in Emerging Market bonds, stocks, and currencies, it may be time for similar fears in the credit markets. The contagion risk is not primarily in the instruments themselves, but in the capital structures of both the leveraged holders and the market makers. When a holder of damaged or defaulted paper recognizes the problem, its immediate need is to restore its capital cushion. Typically, the way they do this is by selling their most liquid holdings to raise as much cash as quickly as possible. A sudden and desperate need for capital in one market often flows into other markets. Thus, it is possible a credit market problem can cause disruption to the bond market, which in turn can affect the stock market. Remember, most of the time investors and traders value their holdings relative to other securities. If the other securities are weak it impacts the value of their securities.

The second big risk, and this is over considerable time, is the cost to the ultimate beneficiaries of our wealth, which in times of stress may withdraw from the combat of investing. Cash becomes too comfortable and low-price opportunities are missed, sacrificing future earnings growth. These losses are much larger than the temporary losses resulting from riding sound investments down before they revive.

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

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

Selecting Good Equity Mutual Funds - Weekly Blog # 540

Mike Lipper’s Monday Morning Musings

Selecting Good Equity Mutual Funds

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Labor Day recognizes the value of human labor in our society. In this sense I want to recognize the value provided in the labor of equity portfolio managers and the perhaps even more difficult labor of selecting them as investment managers for fiduciary accounts and laborers who are direct and indirect beneficiaries of mutual funds.

In a teratological sense it has to do with the search for good and great managers, as well as the differences between the two. The differences between the two are not primarily the difference in skill level, but a difference in the type of skills. As is often the case, the difference in skills is not a difference in intelligence or effort, but one of personality. I will discuss selecting great managers in a subsequent blog.

A good bit of my effort in managing fiduciary accounts is directed at the selection of mutual funds intended to be held for an extended period of time. These mutual funds are often held through multiple market cycles to meet the long-term payment needs of beneficiaries. The task is to effectively screen through the 8,391 US Diversified Equity Funds and 4,487 world equity funds. I generally exclude the 2,264 sector and 5,901 mixed asset funds. Sector funds are better used with a market-timing overlay once the core of a diversified fund portfolio is in place. Mixed asset funds generally do not combine top skill sets in selecting stocks, bonds, and allocations. I prefer to use separate funds for each of those tasks.

One of the reasons many analysts of investment performance look to mutual funds as a laboratory, is not necessarily due to their skills, which aren’t bad, but due the longevity of the performance histories. Most funds have performance periods from inception to termination and every conceivable period in between. Furthermore, their portfolios are available periodically, with some delay. What makes the mutual fund laboratory even better is that there is a good sample of management companies (publicly traded), allowing for a better understanding of the economics of managing the fund and perhaps the incumbent motivations.  This is the laboratory that I have devoted a lifetime to following. Thus, I use my more than fifty years of working with this data and knowing many of the key players in my search for good and great funds for investment.

Finding Good Funds
To set the stage, a good place to start is performance, particularly relative performance as absolute results are too variable for sound analysis. The study of most statistical universes suggests that they produce bell shaped curves, with most of the participants gathered in the middle. For analytical purposes, the standard marketing approach of dividing performance into quartiles places inordinate importance on the 49th to 51st percentiles, which is why I much prefer to use quintiles. For any given time-period the relative rank of those in the middle quintile is not generally a good measure of skill, but of accidental or racing luck, which is not often repeated. In studying performance I see significant differences in the approach of the top and bottom quintile performers, which is worthy of further analysis.

In using relative rankings the length of the performance period is critical. Most often marketing needs focus on a single calendar year, five years, or even ten years. (The three-year period is often a trap, as the market frequently goes in a single direction during that time, often with no measure of performance in a down period.) In selecting funds for long term investors we are mostly interested in long term performance over different market cycles. For the most part, only commercially successful funds have very long-term records. We have developed a secondary analytical tool where we look at the frequency of quintile performance for each quarter, for five or ten-year periods. Episodic quintile placement for any given quarter, while an aid to understanding a fund, is not significant. What can be significant is both the frequency of placement and the trend in placements.

The Influence of Management Companies
Mutual funds are in the business of producing management fees for the owners of their management companies. This reality leads to the race for fund awards, particularly those awarded by the media. This often skews their views to the short-term. The commercial needs of the management company owners avoid fifth quintile performance, if at all possible. With the cyclical nature of performance, the unspoken prohibition against poor performance in a quarter often has the effect of reducing the chances of top quintile performance, which frequently occurs in the period following a decline. Further, in many cases this reduces the chance that the fund will have a great long-term record. However, it could still be a good fund for its investors and a commercially successful fund for the owners of the management company, its distributors and other influencers. A wise management company, no matter what the market serves up, will attempt to have at least one fund that is currently doing well, taking some of the performance pressure off good funds currently doing poorly. Poorly performing funds might create good buying opportunities for a savvy fund investor and their advisor.

Selection Begins with Elimination
In the search for equity funds likely to result in low portfolio turnover, you must find funds that are likely to be in the portfolio in the future. We first create a universe of funds that has over the last ten years performed at least half the time in the second and third quintiles quarterly. (Those that performed better are candidates for the great funds category, which will be discussed in the future, as they have different characteristics than the steady-eddy good funds. Those with poorer quarterly ranks should be put aside as potential turnaround candidates for future study. Recognize that in utilizing the 40 quarter filter, we are looking for a fund that is in the second and third quintile at least half the time rather than beating its peers 40% of the time.) The ten-year period should begin with the fifth calendar quarter after the lead portfolio manager has assumed responsibility. The investment strategy should also have remained reasonably consistent in order to avoid both a start-up period, when the fund is not fully invested and has primarily cash on hand, and a replacement period where a new manger needs to change the old manager’s portfolio. Performance is the initial attraction but is far from the only or even the main consideration in fund selection.

Other Considerations
Most of the other preferred critical characteristics require one or more visits to the portfolio manager and others at the fund site, as well as understanding:

• The philosophy behind the investment strategy
• Management controls applied to the manager and portfolio
• Functions the manager is responsible for e.g. analysis, marketing, department and firm management
• The long-term psychic and financial rewards and risks influencing both the manager and the organization
• The level of manager involvement in the analysis of good and poor performers in the portfolio

The next set of criteria depend on the boards of the fund and management company.

• Are most of the board comprised of successful investors?
• Do some of the board have experience managing intellectual property producing individuals?
• How friendly are the directors with management?
• What are the firm’s business prospects and how will that impact the fund?
• Is the group communicating effectively?

The Importance of Comfort
Dealing with humans and being a student of history, we know that everything won’t go well. This is the exact point where comfort becomes critical. News events like a change in portfolio management, a significant change from external sources, or poor fund or market performance can shake one’s confidence in the analysis and raise questions as to why the fund should be held. (Perhaps one should also be concerned with fund or market performance that is too good.) Additionally, many other people need to remain comfortable with the fund: the portfolio manager, the investment management of the group, the distribution channels, the regulators, and all members of the investment committee.

We Can Help
For a few of our subscribers I would be happy to discuss your fund/manager selection process confidentially.

You Can Help Us
Please add to our knowledge of finding great funds and managers as we prepare our blog on selecting great managers. 

Forthcoming Blog: CHANGE INEVITABLE, PROGRESS NOT

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

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Short & Long-Term Inputs to Successful Investing - Weekly Blog # 539

Mike Lipper’s Monday Morning Musings

Short & Long-Term Inputs to Successful Investing

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Last week may have been important to both time frames below.

Short-Term
Followers of the US stock market should recognize that analytically the most important news of the week was not that the Standard & Poor’s 500 rose slightly to a new peak exceeding its January top, but rather that it finally caught up with record highs for the Dow Jones Industrial Average and the NASDAQ Composite. What could be more important to short-term market performance is how equity mutual fund averages performed. Many institutionally oriented investors believe that the S&P 500 with its higher market capitalization is “the market”. However, during the week ended Thursday, the average S&P 500 Index fund underperformed most actively managed mutual funds (13 out of 20 US Diversified investment objectives, 17 out of 28 sector fund averages, and 23 out of 25 global/international fund groups). This view suggests to me that investors are becoming more selective than the capitalization weighted market. If this continues we could see a frothier market, which is characteristic of a late stage stock market.

Long-Term Better Financial Reporting
The President favors higher stock prices and not downside volatility. To him stock prices going up are an indicator of present and future growth. When prices periodically go down, he views it as short sited and an overreaction to the publication of unfavorable earnings reports. To him, if there were fewer reports there would be fewer declines. This is not supported by a review of traded markets around the world in all kinds of instruments, from real estate, to currencies, bonds, and stocks. I am delighted that most investment professionals disagree with the President’s view. One of the earliest was Lee Cooperman of Omega and like me a former president of the New York Society of Security Analysts. Later in the week my old friend Bob Pozen, a former President of Fidelity and former member of the US Government and a Professor at MIT, wrote an Op-Ed piece in The Wall Street Journal which expressed a similar view. The WSJ, on its editorial page, was also against changing to semi-annual reporting.

Nevertheless, I am pleased that the President may focus more attention on financial reporting and analysis. One of the least read documents is the SEC’s 10-Q report, which displays more complete financial statements than those in written press releases and includes the ever-exciting footnotes. Unfortunately, far too many investors look at whether sales and earnings “beat” corporately generated “guidance” or the average of publishing analysts’ estimates. Using any single standard is often wrong, as it is with one size fitting best for clothes or other decisions. To me, the way one should look at results can be broken down into three categories. What happened during the period both internally and externally that was beyond reasonable expectations? What were the results of management’s key performance indicators (KPI)?  What were the time periods that management was focusing on? And what did the balance sheet reveal about capital risk?

What Unexpectedly Happened?
Most investors are aware of headline events and expect management to be able to conduct their business appropriately. What they may not comprehend is how these events directly impact both current results and changes to internal forecasts. This is particularly important for internal events in terms of people, prices and policy changes. It is unrealistic to expect companies and their leaders to be on auto-pilot. To an important degree the future valuation of a company is tied to how it handles unexpected changes. Smart competitors already sense what the competition will do when things change, so it would not hurt a company to give some clues as to the impacts of unexpected changes to their owners.

Key Performance Indicators
Often when I start looking at a new company I try to find out what the more important KPIs are. Whether I agree as to their importance is not germane, what is important is how management thinks. All to often in a digital world the KPIs are shown as numbers in a dashboard setting. However, some of the most critical needs are qualitative assessment of people, including successors, customer development, and product & service quality. Nevertheless, a dashboard approach is useful if it can be kept to a single well-thought-out page and  should be an abstraction of what the great merchants carried around in their heads. As an example, while I like details more than most, there are a few things that I care about everyday, like the quality of reports, levels of service to clients, development of people, the schedule of new product development, and the operating cash in bank accounts. Notice, for me I was primarily focused on operations rather than the direct value of my ownership. In my analysis of some publicly traded companies, CEOs are much more concerned as to the appropriate value for their ownership and options. There is nothing wrong with that, it just addresses the appropriate time periods for investment analysis.

Time Periods for Judgment
While we all dwell on multiple time periods, we tend to manage mostly to a single time-period. There are two lists shown blow to highlight the most logical time periods to make judgements. The first is for companies and the second is for individuals. Reporting should focus on the most important time period that management is using to make their decisions:

Business
Type of Activity              Period                                   Comments
Business Enterprise      Each Day                              # days/size of losses
Fashion Firm Season    More than one a year
Financial Groups           Economic or Market Cycle
Cycle Developers           Maturity or Final Payment

Personal
Type of Activity              Period                                     Comments
Politician                         Next election
Statesman                       Next Two Generations
CEO                                  Planned Retirement             Voluntary
Parent                               Children off family payroll

Risks to Capital
Almost all press releases exclusively discuss revenues and reported earnings, with some attention given to earnings under GAAP. Apart from very occasionally listing book value, there is no identification of capital risk. It is this very concern that the founders of modern security analysis, Graham and Dodd, were most concerned with in security selection. Today’s book value incorporates many of the items that had questionable liquidation value during the depression years. These include raw materials and work in process inventory, goodwill, and intangible assets. If one eliminates these, over values real estate at historic prices, and under depreciates capital equipment, the stated value of equity is in many cases materially reduced. These are not generally a concern in periods of expansion, which likely won’t last forever. I believe we may enter a period where costs will be driven up by cost-push inflation, with slower demand-pull price increases. Thus, margins will be under pressure and balance sheet values may be questioned. At this point in time I can not with certainty predict such a period or the diminution of balance sheet values. However, out of a concern for prudence one should be aware of that possibility. Hopefully future reporting will recognize this need and make us aware of these issues in their quarterly reports.


Questions for the week:
What periods are important to you in your investment decisions?
Do you spend any time looking at the balance sheet and cash flow statements of your investments?
 


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

Did someone forward you this blog? To receive Mike Lipper’s Blog
each Monday morning, please subscribe by emailing me directly at
AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

People Make the Difference – Weekly Blog # 538

Mike Lipper’s Monday Morning Musings

People Make the Difference – Weekly Blog # 538

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page  2018 -

Factor Investing

I have often been told that given an earnings growth rate a bright investor can tell the appropriate price/earnings ratio, leading to a prediction of the right future price of a stock. In only a slightly more complex approach there are a number of investment products or funds being offered that are driven by an identified factor or a collection of factors. As these are new vehicles they are being pitched as something brand new and superior to the traditional methods of security analysis. Investors have for a number of generations used various statistical measures as a filter to determine better than average choices for additional investment analysis.

Modern Portfolio Theory (MPT)

There is very little that is brand-new in investment analysis. Nevertheless, we periodically receive marketing messages that extoll these new methods as a better way to make money. This reminds me that a number of years ago, based on now recognized faulty academic research, we learned about Modern Portfolio Theory (MPT), which actually was not modern in identifying different rates of change in stock price momentum. MPT was identified hundreds of years ago and had very little to do with portfolio construction and management, other than stock selection. The theory before and after its publication did not regularly produce investment success, but did generate marketing success.

Better Tools for Investment Success

What then are better tools for investment success?  A continuing study of successful investors suggests that the biggest help is the analysis of people at three or more very different levels. Behavior of market participants, buyers and sellers of specific products and services, and finally important portfolio managers, which can improve investment success. In each case the study of these areas has been helpful in the past and I suspect will be so in the future.

Market Transactions

There are a group of market analysts and their followers that focus intently on stock transactions to identify recognized patterns of past movements being repeated currently. For these so-called technical analysts the key to success is the improved chance of being right. They are not interested in the known or unknown motivations of the buyers and sellers, just that their actions follow past trends. This type of analysis is more popular when there are fewer new factors or information introduced.

Looking back to Friday August 10^th, the three major stock price indices - the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 and the NASDAQ Composite, all opened below the last price of the previous day and over at least the next four trading days did not bridge the price gap. Most of the time a price gap needs to be closed before the dominant trend can continue. Some of the price gap of the DJIA was probably filled last Friday, but the gaps in the S&P 500 and the NASDAQ Composite remain open. The continued existence of gaps suggests that the forward price movement for the bulk of the US stock market will be limited and will only rise through their past peak at some point in the future. 

From my vantage point, the predictability of gap filling is measured by the quality of the analysis of the market technicians.

Customer Analysis

Successful investors often place their bets on their perception of future changes. My wife and I had the pleasure of spending time this week with Ralph Wanger and his wife Monique. Ralph for many years was the portfolio manager of the very successful Acorn Fund. The fund initially invested in smaller companies that in numerous cases became mid-cap leaders. In discussing a number of his very successful investments it became clear that in addition to studying a great amount of relevant financial data, Ralph had a deep understanding of the people at various companies.

In one example, he noticed that a company’s logo had become a body tattoo, establishing a body of trust with its customers that might give the company enough time to execute a well-founded turnaround plan coming out of bankruptcy. Many sound turnaround plans take too long to reach fruition as existing and potential customers’ patience is worn out waiting for the new and improved products. In this particular case with the tattooed bodies, the present customers and the potential customers waited for a couple of years for Harley Davidson’s new and significantly improved motorcycles. Ralph recognized the potential power of the relationship that the tattoo created,  buying the needed time for recovery. He also had a similar population of patient investors in his Acorn Fund, I was one of them. A number or factor driven investors would not have participated in the stock rise, which multiplied its worth many times over.

Earlier in the week I met with the CEO of a statistically driven company experiencing some disappointing results. While not close to bankruptcy, it is in a multiple year plan to evolve with its big company clients into an enhanced relationship. They perceive, along with a number of their leading manufacturing clients, that many of them are becoming service companies. An auto manufacturer is in the after-sale service business as well as in the financial services businesses.  It is their successes in these businesses that is becoming equal to or more important than the success of their new exciting models coming off the production line. These are some of the required elements being implement in order to increase customer loyalty and market share. They are mission critical for both the manufacturer and its statistically driven suppler, for both the auto company and other companies too. I am withholding my investment judgement as to whether they will succeed in a major way, but I am looking for changes rather than extrapolations.

Need for Tolerance

At any given time the investment process produces winners and losers. I am comfortable with this result from learning basic securities analysis at the racetrack. There I learned that if you bet prudently you can walk away at the end of the day by properly selecting only a few races, varying betting procedures so that you can afford to lose more races than you win. You walk away a winner overall because the money won was larger than the money lost. I apply the same philosophy to investing, particularly with the use of mutual funds. But perhaps more important than the money earned was the knowledge acquired. When something turned out differently than expected, the key knowledge gained was the analysis of what happened. There was a growing recognition that all the actors, either on two legs or four are not perfect and can make mistakes, some surprising on the upside. The key to future racing and investment success is to learn what happens unexpectedly. This allows us to tolerate the unexpected and most importantly to tolerate our own and others’ mistakes while learning to manage our expectations.

I would be happy to discuss your expectations and suggest some things that you may wish to consider. Please contact me, as we both might gain from this learning experience. We would be glad to help with the selection and management of funds to fulfill your needs.

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

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.