Sunday, February 7, 2016

Long-Term Investors’ Telescope vs. Traders’ Microscope


“It is a puzzlement” reminds me of a phrase from the wonderful stage show “The King and I.” With so much negative market news, I find it easy to close my eyes to my professional responsibilities (which is to produce at least acceptable results for many years in the future). Perhaps like the King of Siam in the musical I should be conscious of Chinese culture and its messages. In the Chinese calendar we are entering the Year of the Monkey. This is the year that we are to be confident as well as curious and the year is to be a great problem solver. Further this year is the year of the Fire Monkey who is strong and resilient. I will try to utilize these traits as I look through the traders’ microscopic focus to set up the intuitive leap to use the long-term investors’ telescope.

Microscopic Attention

Many published pundits are using the falling stock markets in both the US and China as leading indicators of an oncoming recession, forgetting Professor Paul Samuelson’s quip that the stock market has forecasted nine of the last five recessions. Globally, purchasing managers are reporting more strength than weakness. Nevertheless, stock prices for large-cap stocks, with the exception of utilities (+ 8%), have fallen mid to high single digits through Friday. Smaller market capitalization stocks  have declined greater, Russell 2000 ‑13%, NASDAQ Composite ‑13%,  and the KBW Bank Stock Index ‑16%. What is causing these double digit declines if not a rapidly oncoming recession?

One of the lessons we learned from  the surprise of an earlier default of Russian treasury paper was that firms whose trading capital fell had to quickly reconfigure their trading books to fill the vacuum caused by the absence of value in their Russian holdings. This was called contagion. I believe that today we are experiencing a form of contagion. When energy and other materials stocks cratered, many portfolios found that the percentage in equities was above their mandated limits so they became price-insensitive sellers. They sold what they could which started with their most liquid stocks, but if they had to sell the smaller cap stocks because of the Volcker rule they found many formerly large dealers could not provide liquidity for many of their less favored customers at prices without further discounts. Until a bottom is achieved discounts tend to produce more discounts. In a similar fashion contagion is now a world wide phenomena.

Thus whether we like it or not, all of us are global investors as almost all of our economic activities are affected by foreign supply and demand for goods and services including securities beyond our home markets. Fidelity is running an ad for its international funds where it proclaims that only 26% of the world’s publicly traded companies are in the US and 80% of global GDP comes from non-US countries. Because of these concerns I look at numerous local markets first to see if they are opportunities and second how they are impacting my home market. The Shanghai Composite Index on a year to date basis is publishing a 22% decline. (I wonder what will be the value of the companies that have had their stocks suspended or what might happen to prices when the institutions can break loose from their restrictions on selling?) Nevertheless, there are apparently some more attractive markets than the US; Mexico is up 0.6% and Korea is only down ‑2.2%.

In terms of potential direct impact on US stocks in the financial sector, I am noting that in London Life Insurance stocks are down 17%, Banks
‑17% and non life insurance stocks ‑7%. I suspect that we will see more transatlantic deals like ACE and Chubb with or without tax inversions.

Long-Term Investors’ Telescope

For many long-term investors the 2015-2016 market decline is giving back some of the house’s money which has been gained over the last five and ten years if not longer. Even at today’s prices many long-term investors are sitting with doubles or more on their purchase price. Some of these investors have net cash flows into their portfolios or some disappointing positions. If their successful holdings still double, but are down measurably from peak prices, it might be quite prudent for these long-term investors to add to their winners. If they have too many opportunities relative to their ability to buy, they may want to examine the currently published results of the stocks in the S&P500. According to the S&P Index service while 8 of the 10 sectors reported better than estimated revenues only 3 reported “beats” in terms of per share earnings. In order of their % gains, they were Technology, Health Care, and Financials.

Four bulge bracket investment banks reported to a credit rating agency that they expected a healthy bond issuance in 2016 because the companies were borrowing money for buybacks and paying dividends. Most of the issuers have more than enough cash already to pay for these, but they do not want to pay additional taxes on repatriating the money. From my standpoint as a long-term investor I would prefer them to modernize and expand their capacity to improve both their volume and productivity. Thus, I believe there is sufficient available capital to build another leg on our economic growth. This is not to say that between now and the expansion we could not have a down
because as one of the writer’s in the UK’s Telegraph remarked, “Someone actually could know something about a near-term recession.”

Question of the week: In which of the next 12 quarters will the recession start and end?    
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Sunday, January 31, 2016

Seven Critical Questions


There were many times in history when a war council was assembled to determine military strategy. For many profit-driven and non-profit groups the modern equivalent is the formal, or in some cases the informal, investment committee.  I sit on a number of these as well as chair others either for compensation or as my contribution to a worthy cause. If properly structured with bright successful investors these can be rewarding experiences. I urge my fellow professional investors to participate in these activities.

General Agreement Can Be Problematic

If there is unanimous decision as to a cause of immediate action, without substantial discussion, then there is no need for a decision making group. In effect, that is a single decision-maker with only a “Greek chorus” of ratifiers.   On the other hand, after substantive exchange of contrary views, there is nothing wrong with unanimous decisions by those that actually participate.

For future actions there may be more benefits from the discussions than from the initial decision.

Critical Topics for Future Decisions

Currently unresolved topics include the following:

1.  Can the large amount of global government debt be slowly and carefully liquidated?  Or will it, based on history, only be solved by a harsh and climatic panic-type contraction?
Which is more likely?

2.  While not likely near-term, what are the odds of a meaningful recession during the next President's term, no matter who is sitting in the White House? 

3.  How useful is our professional experience in light of rapid change in market structure with increased central bank manipulation worsened by conflicting regulations and court cases?

4.  In view of the above questions along with the large number of players, high relative fees, and low general market returns on the upside, have the chances of successful hedge fund investing materially changed?  
Are there any good consistent short sellers?

5.  Is there above market risk in the private equity funds that have recently become so popular with institutions? Do these instruments add any more value over the market (S&P500 or NASDAQ* stock/index) when multiplied by their leverage?

6.  Are there too many venture capital pools?

7.  What are the appropriate time horizons for various portfolio investments?  (Have you considered the principles of my Timespan L Portfolios®?)

Investing in Services

According to published economic data, the two largest global economies in terms of number of labor and possibly revenues, the US and China, have both become service economies. The challenge for us as individual stock and fund buyers is to find future successful service companies. I would avoid one definition that a well-known consulting firm used:  “asset light” which propelled them to be a bull on Enron. Utilizing the correlation indicators I discussed in my last two blog  posts, January 24, "Usual Models Force Investment Errors" and January 17, "Statistical Correlations are Costly, " I would be guided by companies that could be considered talent rich; e.g., Goldman Sachs* and Apple*. Both have a high level of customer/client orientation. They seek long-term, if not lifetime relationships. To some degree they focus as much on the after-sale as the initial transaction.

*Securities that are owned either in my private financial services fund or personally that may or may not be appropriate for others.

In the pitches of advertising agencies and other marketing companies the costs of marketing campaigns are justified in terms of the lifetime benefits of securing a customer. This attitude is certainly true for a number of mutual fund management companies that we currently own. This mindset may be less true today than in the past or in the future.  The potential turnover of clients makes investing in service companies a challenge, but in many cases worthwhile.

Present Portfolio Hurdles

Reliance on the wrong statistical tools can lead to faulty results. As this blog is being written on the eve of the Iowa caucuses, there is something that can be learned from the past wrong calls of polling pundits in the UK and Canada that used a technique called a probability sample, which projects the accuracy of polls from a limited number of observations of an incomplete sample of participants. I believe there is a similar risk if one follows many of the comments of stock market pundits opining on the current market. 

Unappreciated facts that are hiding in clear sight:

Despite the fact that the popular stock market indices posted minor total return gains in 2015, the average stock declined. The entire reported gain was due to a couple handful of stocks. Some stocks in 2015 lost two years of prior gains. Does this mean that we have already been going down since the second quarter of last year?

Asset allocation or equity hedging has become much more difficult and may not be as worthwhile as many were taught to believe. Two examples: 

(A) The Economist magazine each week tracks 44 country or regional markets; for the week ending January 27th only 3 were up and for the period since 12/31/2014 there were only two positive with no overlap among the gainers.

(B) Looking through the SEC registered mutual fund lens at 95 separate mutual investment objective performance averages for 2016 through last Thursday, (before the sharp gains on Friday), there were 12 groups of funds that fell more than 10% and only one that gained 10%. The sole gainer was the average Dedicated Short Biased fund which over the last five years had an average loss of 18.46%, according to my old firm, now known as Lipper, Inc., a ThomsonReuters company.

For the last week the only major asset class to attract net inflows was High Yield funds. Some may call these “stock funds with occasional coupons.” For the longer term investor over the last five years the average High Yield fund produced a compound total return of 3.57% or probably less than half of its current yield at time of purchase. As a fiduciary advisor I have preferred using Equity Income funds. For the same five years Equity Income funds produced an average compound growth rate (assuming total reinvestment) of 8.09%. Taxable investors of the High Yield fund will pay ordinary rates on its income, however well over half of the average Equity Income fund gain will typically be taxed at the capital gains rate.
There are two intriguing market speculations facing the investor who is consciously investing internationally. The first is that knowledgeable Chinese experts believe that within a year most of the provincial leaders will have been newly appointed which will aid the carrying out of the Party's specific dictates as the economy is being shifted away from manufacturing to a services orientation.  The second is that the pound sterling has been very weak recently as the currency market appears to be discounting an exit from the European Union. For a yield-oriented investor, if Britain stays within the Union  this will provide an interesting kicker into a market where there are many sound companies which are sporting current yields of 4%.

The year 2016 should prove out the old Chinese curse "May You Live In Interesting Times," which can prove to also be profitable times for those investors aware of the opportunities and challenges ahead. 

I invite the readers of this post to contribute their views. The breadth of the thoughtful replies is an important indicator of how important these topics are. At this time there are no wrong answers other than unanswered questions.
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Sunday, January 24, 2016

Usual Models Force Investment Errors


In last week’s post I focused on too many investors that are not identifying the correct correlation models. Building on that foundation, this week I will focus on most investors, including professionals making investment decisions on today’s headlines rather than future potential prices.

Correlation Traps

Scientists who study how the brain works and those of us who have developed performance and fee tables recognize the need for comparisons. We are taught that higher ranked items are better than lower. Because rankings are so important, we prefer that the leagues be mathematically constructed, even though our choices of art, music, and significant others are not mathematically based. I will leave it to others to decide which mindset produces better results. Clue: My wife Ruth and I regularly go to concerts performed by the New Jersey Symphony Orchestra.

In the investment arena we measure nanosecond by nanosecond how well a stock or a fund performs versus market indices. (At my old firm, now known as Lipper, Inc., I convinced funds’ independent directors to compare with similar funds.) Because professional investors recognize that there are differences between companies, the popular approach is to measure companies that generally produce the same type of products or services.

This particular matrix approach did not help explain the performance of most security prices in the first three weeks of 2016. On the downward slide at least 80% or more fell, and on the not too inspiring recovery of this last week, a majority of stock prices rose from a Wednesday bottom. (See my friend Jason Zweig’s weekend Wall Street Journal article entitled “Market Capitulation is Nowhere in Sight (So Far).”

As a life-long student of investing and a professional investment manager, I am not satisfied with the comparisons normally produced as a jumping off point for analysis of investment decisions. This bears on fiduciaries and individual investors as well.

Starting from the premise that a stock and a company share the same name, but often not some of the same characteristics, I suggest for stocks (as distinct from whole company buyers) the perceived characteristics of the stock has more to do with its current and near-term performance than those of the operating company. I am suggesting that there are distinguishing characteristics that stock buyers and owners attach to a stock. All of these are far less mathematically defined than price indices, but like identifying the sought after traits of a life-long companion, lead to actionable conclusions. Because there is no easy math to guide us into putting a stock in a particular bucket, investors will reach different decisions at different times as to what is the single most important element.

Improved Correlation Elements

Over time I am sure that we will find other ways to group stocks and corporate bonds. The first four that I use are:


One example of the criticality of Demand was the sharp reversal on Wednesday which seemed to be driven by overturning the depressing view that the decline in the prices for oil and selected other natural resources was a fall in demand. Apparently investors understood that supply was in excess of demand temporarily which many feared was showing signs of a recession. The prices of crude oil and a few minerals jumping higher was a sign of increased demand from the global economy. (That supposed surge in demand could be right, but based upon my over half century of market experience there could be another explanation. Any time after a material decline is experienced in prices and then there is a sudden price spike it may well be caused by the covering of exposed short sellers.)

Too often we think of supply in terms of the items mentioned above, but I am more concerned with the delivery bottlenecks that are developing and are lengthening distribution times of various products and services produced in the US.

Regularly the number one or two major worries of small businesses are their inability to find qualified labor at reasonable wages. As consumers, people are experiencing delays which is annoying and could be a cause for imports remaining strong even with the escalating dollar. In answer to these concerns, there were discussions as to the impact of robots and artificial intelligence at Davos last week. The shares of companies that are seen to be addressing this supply of qualified labor will be in demand.

Time has two very different buckets. The first has to do with the aging process that can’t be accelerated; nine women can’t have a baby in a month  nor can anyone produce 12 year old Bourbon in a year. Similarly, waiting for the next CEO can require patience. The second bucket is the time proclivities of various shareholder and bond holder groups.

At one point an important group of institutional shareholders were the general accounts of Life Insurance companies who held these securities against the expected maturities of their insurance policies. Often growing defined benefit pension plans had somewhat similar needs. Today hedge funds with currently shaky performance need quarterly successes. Sound defined contribution plans (401k) invested through prudent mutual funds are somewhere in between in terms of time sensitivities or at least the ones we have managed. The nature of the shareholder base for any stock is likely to influence its price behavior.


In many respects the recognized talent in a company is the most difficult and often the single biggest differentiator for many stocks. Currently there are three major US investment banks. Because of regulatory changes and the persistent low interest rates all three are cutting employment. The leader (while perhaps slightly increasing its annual cull rate) is still hiring a significant number of bright accomplished young people. The second, managed by a former consultant, views people as one of the ingredients to making profit goals and is cutting deeply. The third with a slightly different business mix has raised senior executives’ compensation because they executed well. From time to time I have owned all three, though I now only own the first in our private Financial Services fund.  

One of the reasons for this belief in talent is what I have learned about the discovery of the Ninth Planet, one of the only three identified in modern times. The work was done at Caltech and started with a couple of graduate students who found compelling elements in the sky. Their professor of Planetary Astronomy went down the hall to discuss what the students found with an assistant professor of Planetary Science. Thus they combined observation and theoretical science to confirm the existence of the Ninth Planet. It is just this sort of cooperation of in-house experts in a maturing organization that I look forward to in a smart, talent heavy organization.

Interesting enough all three investment banks are now selling below their published book value which does not carry talent as a balance sheet item. Certainly in the case of the first and quite possibly the other two, if I could buy just their talent and none of their other assets and liabilities, I think I would.

Entry Point Microscope vs. Terminal Telescope

For my sins I sit on a number of Investment Committees and chair some. At this point my fellow members are focused on reading the current “tea leaves” about the near-term conditions including the likelihood of further market declines. Considering their brains and experience they are probably right in the short-term. My frustration is that this microscopic focus is preventing them from acting to position some of the money we are responsible for by investing in the future.

There is no question that a microscope will provide much more accurate measurement than even a thirty meter telescope. However, part of every fiduciary’s responsibility is to provide benefits to the last beneficiary. Since these institutions are designed to be eternal and some of the families that we serve expect eternity, we should be looking to the future. We can not be as precise about 10-50 year futures as we can be about tomorrow’s opening price, however that does not relieve us of our responsibilities to future beneficiaries. I am reasonably confident that this is the right time to invest for the future.

As a contrarian, I like that most investment professionals are focusing on current market and economic conditions. Historically, one can age a “bull market” by how far out investors are discounting the future. The focus on this quarter’s earnings or the next rate hike or the number of producing drilling rigs is reassuring to me. I have lived through periods when investors were using five to twenty year projections for their investment decisions.

A study of great investors depicts that many have been lonely in their exposed positions before achieving success. While I recognize that there are numerous flashing caution lights, such as the sudden drop in the confidence index published by Barron’s each week of the spread between high quality and intermediate quality bond yields, I am comfortable with some money for some clients investing for the long-term. You probably should as well.  
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