Sunday, August 21, 2016

Do You Need to Update Your Thinking?


Many institutional and individual investors are frustrated by the current levels of stock, bond, and commodity markets. These frustrations have led to inaction in addition to a state of anxiety. Most professional investors and many individual investors have had direct academic training and they and wealthy individual investors have had indirect or passed-along academic investment theories. With the major central bankers of the world experimenting with various forms of quantitative easing (QE) which has not had the desired effect, most of the reliable past investment measures have not been working.

As part of our responsibilities for managing accounts investing in mutual funds, we regularly have discussions with fund portfolio managers. Recently I had an in-depth conversation with the lead portfolio manager in a group that I have visited with since the 1960s. In discussing her financial services holdings she used the very same ratios and thinking that I have heard from this group for more than fifty years. I was struck that the fund's great long-term success was based on a very traditional approach that predates the current QE era and may explain why it is not enjoying its normal performance leadership position.

Recently Michael Mauboussin, now with Credit Suisse, published a list of ten attributes of successful investors which I have further edited:

1.  Be numerate (understand accounting)
2.  Understand value (present value of future net cash flow)
3.  Think probabilistically (nothing is absolutely certain)
4.  Update views
5.  Beware of behavioral biases
6.  Know the difference between information and influence
7.  Position sizing

Analysis of Financial Services Opportunities

Almost all financial services stocks are selling below their book value per share, and so the argument goes they are cheap now and will go up in price in the future. Under the current environment I am much more inclined to view their value is what they are selling for, as many traders believe. Book value is not a valuation metric but a reflection of historical costs of tangible assets. In the destructive era of QE some portion of loans not yet non-performing will become non-performing and thus their historic asset value is less by some to-be-determined amount.

The managers and owners of financial services companies claim that since the financial crisis the firms have added to their capital base and improved their efficiency and credit controls but their valuations have not improved since the crisis, even though their returns on assets and capital has. When interest rates normalize (read higher) their returns will rise, but probably won't get back to historic levels. Putting all of the current factors together these stocks are probably worth what they are selling for at the moment. However, under a higher interest rate scenario these earnings could be substantially higher. My view is that the current owners have in effect an option to benefit from normalization of economic conditions. Thus, the shares are priced right for the current environment, but with a potential "kicker" for the future.

One of the problems in using a balance sheet/book value approach is one is only dealing with tangible assets. As both a buyer and a seller of financial services companies, I recognize that the intangible assets are often worth as much if not more than the tangible. Think of this as "brand value." Among financial services stocks in the publicly traded market, I suggest that JP Morgan* has brand value and Bank of America* and Citi* do not. I would clearly pay for JP Morgan without its balance sheet, but wouldn't for the other two. Even Chase's* credit card business has brand value. Goldman Sachs* has brand value in excess of its balance sheet. Just track how well quite a number of ex-partners and senior managers have done in raising money for their new ventures after leaving Goldman. I find it difficult to say the same thing for other firms, with limited exceptions for Morgan Stanley*.

 Opportunities for Financial Services

Anytime there is a flow of money, there is an opportunity for some financial services organization to make or to lose money. Currently there are concerns as suggested by Moody's* that aggregate corporate earnings in the US is unlikely to top the record 2014 level until 2018. John Authers of the FT suggests that if one wants earnings growth, one should escape reliance on US sources. Fund money is already following fund performance. For the year 2016 through last Thursday, Emerging Market Equity mutual funds’ average is up + 18.50%, Emerging Market Local Currency Debt funds +16.62% and Emerging Market Debt funds in hard currency +13.56%. This is a worldwide trend with the second largest sales of ETFs based in Europe pouring into Emerging Markets. Cross border trades create a need for foreign exchange transactions which can be very profitable for financial services firms. In terms of the growth in emerging market debt, professional buyers conduct these through carry trades with US Treasuries and other elements as well as substantial use of margin. Most of the Emerging Market activities have been in Latin America +36.7% (Brazil + 68.4%) and the following list of countries all with gains exceeding + 20% : Russia, Colombia, Thailand, Indonesia, Hungary, Pakistan, and Chile.

* Owned personally or in a financial services fund I manage.

Perhaps the biggest opportunity for financial services organizations may occur with a new Administration in Washington. While one is reluctant to believe any of the political rhetoric from any politician, it does seem that it is likely that massive infrastructure spending programs will be announced. If these get funded, it will likely mean more bond underwriting at the federal, municipal, and commercial levels. Other increased expenditures that will generate buying is likely to be on defense, education, and health.


There are substantial opportunities for the financial services organizations to make or lose money, but most of the gains will be earned by groups that have talent in excess of their financial resources. Successful investing in this arena will be based on business type analysis not solely on financial statement ratios.
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Sunday, August 14, 2016

Can Stocks Move Higher if Bonds Don't?


Unlike "data dependent" economists or media pundits, the jobs of portfolio managers and securities analysts is to attempt to make money for their clients. The past is useful in categorizing what has happened in various periods but our job is to make decisions today about what may happen in the future. The question before me today is: when the bond market is no longer rising can stocks go up in price?

Bonds Drive Stocks Since 2000

John Authers, the very perceptive columnist in the FT Weekend edition compares the performance of bonds to stocks since the prior peak in 2000.  His conclusion is that while stocks performed impressively, bonds did extraordinarily. He further points out that on the basis of inflation-adjusted returns, stocks under-performed bonds by 50%. From a shareholder's vantage point the only positive thing that various measures of quantitative easing (QE) has done is it raised the stock price level as measured by the popular indices. As a matter of fact the surge in the Federal Reserve's balance sheet caused by their bond buying is about equal to the growth in the value of the gains of the stock indices since March 2009. This would suggest that the gains in the stock market were in effect paid for by ballooning the Fed's balance sheet rather than enthusiasm for growing earnings or dividends. No wonder these market gains are called the most unloved bull market.

Bond Market Concerns

There is increasing acknowledgment that the global experiment with QE has not propelled various economies to expand. At the moment the Fed is not increasing its bond buying levels and is telegraphing future interest rate hikes. Already US rates are rising. In the last two weeks Barrons' Best Bond Yield average is up 5 basis points which is the same amount that the average of the nations' banks have raised the rate they pay on Money Market Deposit Accounts, (MMDA). Looking to 2017 one assumes that the Treasury will be issuing bonds to pay for the large or the largest infrastructure program ever by the federal government as discussed by the two main candidates.

Based on history, health, expected restructuring of one or both main parties right now it would be wise as to view the next administration as a one term occupant of the White House which could tie in with a likely recession during the term. Alternatively, according to at least one good technical market analyst a potential peak stock market will occur somewhere over the next six years.

Through the Mutual Funds Lenses

The S&P 500 with dividends reinvested is up +8.40% and the Dow Jones Industrial Average is up +8.64% for the year to date through August 11th . While the average sector fund is up +13.79%, the average US Diversified Equity fund is up only  6.33%. One can see short-term the attraction of bond funds over stock funds when "A" rated bonds are ahead by +8.56%, "BBB" funds +9.60% and High Yield (so-called Junk). +10.71%. However, if one is concerned about intermediate or longer term periods one sees a very different story. In the intermediate five year period on average only the "BBB" funds have a compound growth including their dividends over 5%. They earned 5.34% or essentially their interest payments compounded. On the other hand the average US Diversified Equity fund was up +8.42%. This suggests that over most intermediate and longer time periods stocks have outperformed bonds.

All too often market commentators take the raw net flows into mutual funds as a sign of what investors are thinking and currently supporting; e.g., putting money into fixed income funds and products. These views may prove to be incomplete and naive. At one point in time the bulk of mutual funds sales were made to individuals for long-term investment needs. Somewhere around 2/3rds went into Stock funds and the rest into Balanced and Fixed Income funds. For the most part funds were sold through salespeople or directly through the funds. Within each sale there was a built in redemption usually when the investment need was met or for some unexpected emergency. Today, I believe this type of completion is the main reason for redemptions, not dissatisfaction. What is different today is that selling forces find it more profitable and less burdensome to sell other products to retail individual investors. Thus it appears that money is moving because of dissatisfaction. This will be less of a factor going forward as most of the new money going into mutual funds is for retirement plans and a growing number of tax exempt institutions. This could lengthen the average holding period in funds.

The other misconception about fund flows is the inclusion of the transactions of Exchange Traded Funds [ETFs] and similar products as they presumably have the same kind of holders as mutual funds. For instance in the latest week some $0.6 Billion net came into the combined Equity fund base. What is more significant is that $3.6 Billion came in from two large Index funds. My guess is that most of this money is from hedge funds and other traders who are using Index funds to hedge their individual securities shorts and will sell their ETF positions once they cover their shorts. In the same week on the fixed income side $3.5 Billion went into Fixed Income ETFs, $1.3 Billion in High Yield ETFs and $1.0 Billion flowed into High Grade ETFs. (All of fund flow data is from my old firm, Lipper Inc., now part of ThomsonReuters.)

The First Question: When Interest Rates Go Up Will There be Buyers?

For some time investors in bonds and credits have been able to make money through price appreciation caused by new buyers in addition to the income generated. A period of rising rates will cause fixed income products to get lower prices. I believe there will be a meaningful reduction of flows into these products.

Second Question: Where Will the flows Go?

Long-term investors particularly retirement programs and endowments have a long-term need to generate sufficient income to meet their obligations. If they can not generate the needed funds they will seek investment vehicles elsewhere. Various forms of equity may become more attractive.

Third Question: Why Will Stock Prices Rise Significantly?

Perhaps the best answer is that very few of the market professionals believe that it will. Many of these "experts" have been wrong on Brexit and the rise of various extreme political candidates. Interesting there is relatively low risk because of the previously mentioned unloved bull market. One of the few brave commentators is James Paulson of Wells Capital Management whose latest letter is entitled "Stock investors should look a yonder" where he makes the case for a global economic bounce. He sees a bigger chance for dramatic earnings improvement outside of the US. We have been buying International Equity funds that have portfolios that have lower valued securities growing faster than many domestic funds.

Fourth Question: What is Needed for the Market Bears to be Correct?

As there have always been down markets, we have learned to expect them. Even though we have not had a major decline for sometime, we need to be watchful for such a calamity. For example in a 31 month period from March of 2000 to October of 2002, the NASDAQ Index fell some 78%. While it is interesting that today it is selling above its March 2000 level, it is instructive to note that on a year to date through July 20th, 71% of its gain was achieved by ten stocks. And yes it took 25 years to recover from the 1929 peak. These kinds of declines have been proceeded by extended period of excess enthusiasm which we have not yet seen in at least seven or perhaps even sixteen years. Using price histories that go back hundreds of years some are looking for the next big one to drop over 50%. While this action could happen anytime, at least one technical market analyst believes it is most likely between 2018 and 2022. This somewhat ties in with the next presidential campaign which may be even more concerning than the present dance.
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Sunday, August 7, 2016

Bet on Experience, the Future, or Both?


Securities sales people tell me that their customers think the current market phase will continue into the indefinite future. This could well be because the peddlers are conscious of the legal and financial risk to them and their firms of failed predictions of the future. (Media pundits and politicians are not similarly constrained.) To be fair it is easier to think about the future as an easy extrapolation of the present as this is how most of our brains are wired much of the time. The neuroeconomists at Caltech suggest that many brain functions are essentially memory banks of experiences of the individual and/or accepted others. 

The accepted others that inhabit our brains are most often those that are considered experts by some. Often these "experts" are just recapturing past experiences rather than successfully addressing the future. For example, the venerable magazine The Economist has opinions on a wide breadth of topics, usually economic or political in nature. In the July 30th edition it extended its "expertise" to the probable winners of the PGA Championship which was held at our local golf club Baltusrol. The magazine listed the predictions of the top ten finishers plus two others. Sadly for those who followed this "expert" opinion, only six made it into the top 15 or a hit ratio of 40% which is a little higher than winning favorites at most racetracks. Most importantly the magazine never mentioned the ultimate winner, Jimmy Walker. As an "expert" predictor it failed just as it did on the outcome of the vote on Brexit. But in each case it could have questioned its own predictions if it was more conscious as to what was happening in its field of study.

In the world of professional golf tournaments in the last year, Jimmy Walker was the fourth first-time winner of a major championship. In terms of Brexit, The Economist missed the growing disenchantment of large elements of the population with their central government.

I am going to make a gamble and share with you a bet on the future which is not currently popular and is against the views of a firm that I have the highest regards for and is an investment in the financial services fund that I manage. Goldman Sachs' economic research group has recently published a sixteen page report on “The Outlook for Post-Election Fiscal Policy.” It essentially suggests that little will change after the election and the new US Congress is seated.

Based on the last 8 or more years, this prediction is highly reasonable. Besides being a racetrack trained contrarian I try to be a good observer of our times. As with the Brexit vote and the winner of the PGA, I am wondering whether 2016 is a year of change, perhaps as dramatic as 1848.

Structuring for both Experience and Change

I believe the job of the portfolio architect is to position the long-term portfolio to produce reasonable returns relative to the risk of meaningful capital loss whatever the environment the portfolio vessel is traveling. I have developed a portfolio structure that is time sensitive to both experienced extrapolation and significant future changes. The TIMESPAN L Portfolios® can be filled with separate accounts, hedge funds, private equity/venture capital accounts, and real assets, or in our case, mutual funds.

Four Segments of TIMESPAN L Portfolios®

Lipper Advisory is working on one account that contains four segments which could be separate portfolios. In this case, the design underway calls for approximately 10% of the assets to be consumed over the next two years to meet grants and expenses. As this first pool is exhausted it will be replenished from the next portfolio of about 49%, from a portfolio that is generally mainstream and presumes that extrapolation of present trends work. This commitment is somewhat high in the belief that over the next five years (the expected duration of this portion) there will be a meaningful down market and at the same time emergency grants may be needed by some of the grantees. A greater portion of this portfolio may be in value-oriented securities and funds including Europeans selling at significant discounts to US stock prices. 

The third portion is to be focused on investments that will come into fruition in the future with a planned duration of at least the expected terms of the CEO and the investment committee. In this case approximately 31% of the assets would be so devoted. Most of the securities and funds selected would be headquartered in some 25 or so vital cities that have both a significant grounding in STEM education and a discipline of savings. Currently in addition to the US there is more focus in Asia, but awareness of selected innovative work is also being done in Europe and selectively in Africa and Latin America as well as Canada.

The final portion is a 10% commitment to producing capital including income in the distant future to give the next generation of leadership and grantees the wherewithal to continue the mission.

This structure should be modified to meet each client's specific needs in terms of ratio of commitments, asset allocation, manager selection and other needs. Over time modifications should be expected as conditions change.


Last week’s blog mentioned the beginning of my Apple investment, which occurred in the 1970’s not the 1960’s.

Question of the Year: Will 2016 - 2017 be a period of dramatic change, and what are you prepared to do about it?   
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Sunday, July 31, 2016

The Critical Difference Between Experienced and Expert

Selecting winners is part of my game. I am essentially a student of other's investment experience. The general failures to be ready for Brexit and the success of extreme politicians is a wake up call to understand the critical difference between experience and expertise which are also found in the art form of selecting long-term investment winners.

I have spent many enjoyable hours attending classical musical concerts of the New Jersey Symphony Orchestra and other great orchestras and too many painful hours at Operas. Both of these are experiences, but in no way could I become a professional musician. Time spent on an activity lengthens one’s memory of experiences.  Note that the combination of a great orchestra leader and a great orchestra can make the rehearing of a familiar piece seem new and exciting.

We never know what the future brings to us. Will it be an exact repeat of the past or something quite different? The difference in terms of satisfaction and progress can be quite different. Thus we build portfolios of mutual funds and other managers that have experienced experts who have the wisdom to recognize that something is quite different than the past. 

Experienced, Not Expert

The so-called "experts" who predicted the English would vote to remain within the EU and the political pundits who had extreme confidence that the central political forces would keep centralists in political power proved to be experienced not experts. They are not alone in this distinction. Today numerous professional investors including many of the bright analysts and portfolio managers that I have known for over fifty years are very frustrated by the current stock and bond markets. One regularly hears that this is the most unloved bull market. Based on past experience, the current levels are not only unattractive but close to being beyond "nosebleed" levels because past standard ratios are flashing danger signals. The reasons they stay invested are the two abbreviations “TINA” and “FOMO.” (There Is No Alternative and Fear Of Missing Out.)

I like attending repeat performances of music, politics, and investments. I get unnerved with the new, that for which we are not prepared.

Perhaps sharing a Marine Corps tradition with my battle trained Marine Recon. (Reconnaissance) brother has caused me to expect and look for change. In addition, being a senior trustee of what has been recognized as the world's leading research university, Caltech, has very much focused me on looking forward to dramatic changes.

Dr. Simon Ramo

An example of the type of leaders that Caltech has produced is Si Ramo who was entrusted by the US government along with his partner to create a company that developed the intercontinental ballistic missiles which not only gave us many years of strategic security but was an important contributor to our space program. This past week the University, where he was a trustee, celebrated his life having recently died at 103. 

As Dr. Ramo was a globalist, an entrepreneur as well as a member of Caltech's investment committee he might well had noticed that in the first half of 2016 the S&P500  had a small gain of +2.69%,  where Brazilian Dividend Aristocrats were up +82.34% and an index of Low volatility Bovespa stocks were up +77.74%.  Not only did some Latin American stocks do well but many Canadian stocks were up 20% or more. I believe he might have brought up to the investment committee whether these results were just recoveries from deeply depressed markets or had some future portents.

Let me give examples of a very successful experienced portfolio manager with a leading ten plus year record and a single stock that proved that most investors were not the experts that they thought they were.

Many Thought He Was a Great Manager

In the 1960s there was a mutual fund manager whose picture was on various magazine front covers and was world renowned. I studied his portfolio over the years. With rare exception he picked stocks from a list of 120 large cap stocks usually having a portfolio with a list of 60 names. His record was such that he was able to leave one of the strongest mutual fund management houses and start his own fund company that subsequently went public. In the 1970s the market changed as did the market structure and in the end his company disappeared. My analysis is that he was well experienced for the markets of his time, but did not have the expertise to recognize the changes that were occurring or know how to play the new game. (Sound familiar?)

The single stock was one that could well become an entire course in a business school. Started in a garage, the company produced a differently focused computer and developed many new pioneering products, thus creating new market segments over several year, but its financial picture suggested that probably it would go bankrupt.  Its president was fired. Over the next several years he learned to be a businessman and a technological leader and his newly founded company was acquired to bring him back to the company he founded. 

Over the next two decades the company created new products for markets that didn't exist until the new products opened the doors to new markets. As the company became recognized for its technological, stylistic, and business successes, it became the single most valuable company in the world's stock market. This was surprising to many professional investors who came to the party late and as often happens sold out when normal cyclical patterns emerge.

This month, while down from record levels, its earnings came in better than was expected by the virtual cottage industry that now follows the stock. Thanks to dumb luck I have owned a few shares of Apple since the 1970s in part because of the life-changing attitude that my late daughter who was learning-disabled daughter had with the Apple II computer I bought her. She enjoyed working on a device that was intuitive and patient as well as forgiving. The ability to change people's lives suggested to me that this was something different than a number of other computer companies that have subsequently disappeared.

Both of these examples illustrate the difference between experienced and expertise. (Not mine, but Steve Jobs and Tim Cook.)

To some degree we are all captives of our and other’s experiences. However, as investors we should be looking forward to finding elements of expertise.

Are you doing this, and will you share how you are doing it? 


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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.