Sunday, July 24, 2016

Future Winners Found By One Word: Adaptive


Introduction

While securities analysts are essentially statistical historians, fortunes and reputations be they financial, business, political or military are made by change agents. Most of these changes are not self-evident initially to the change agents, but come about through seeing what is and most importantly what isn't obvious. Seeing what isn't is not enough for success. (Many of my security analyst friends are frustrated by their lack of confidence in the stock and bond markets because their valuation metrics are not working. They are not adapting to the markets structures and valuations and may miss out for a time.)

What is needed is a series of actions to create the somewhat poorly defined solution. For most of those that are called brilliantly creative, it has to do with adapting what already exists but re-purposing it for the new challenge. By definition these change agents are future-oriented and not content with merely repeating the past, no matter how cherished the past routes have been.

For lots of reasons, I believe we have entered a period when we will see new approaches to current problems. These approaches will cobble together some of the past elements with new understanding of the implications of technology.

Learning from the Military

The study of war should be about how to conduct new military operations better than the old methods. For many years the American Civil War was the classroom for the German General Staff. They studied the campaigns of Stonewall Jackson and William Tecumseh Sherman in particular. From them they adapted the concepts of maneuver and column movement. They applied these brilliantly during the first and second World Wars in Belgium, France, and Africa.

During the period between the world wars, our own US Maine Corps developed  both the Raiders doctrine and Personnel Landing Craft as well as the use of aircraft for close tactical support for frontline Marines. They were adapting some of what they themselves had studied against indigenous forces and what was present in the era, but would also be needed in the next global conflict.

Whether BREXIT Succeeds or Fails May Depend on Adaptive Approaches

The "Remain" campaign was based on the current economic factors. The "Leave" movement was based on what the English saw and didn't like.  Assuming an unfriendly divorce, the success of Leavers will depend on their ability to find new ways to make their society and economy survive and grow. Much of the Remain pitch is that the City of London, their one square mile financial district, will lose the right to "passport" their deals into the EU. In Saturday's Financial Times, Charles Leadbeater writes an article of five different scenarios for a post BREXIT era. They go from the collapsed City to London becoming the best of all major financial centers. The final one is dependent upon the people involved adapting to the situation with new technology, but in some ways also a throw back to the medieval Hanseatic League of northern, largely German Cities and London.

The Finance Minister of Luxembourg currently is warning the EU not to underestimate the UK. I believe their success will be the Brits’ ability to change the game by adapting some of the better practices and technology from around the world. As a contrarian with lots of time, I would rather be a buyer than a seller now. The new leadership is encouraging. However, as with all adaptations, there is likely to be some mistakes, but the failure to adapt is likely to be worse.

“Equity: The Film”

It is said that men traditionally resist change whereas women by nature are forced to be adaptive to change. One of the major corners of the financial community that has lagged behind the publicly traded investment houses and banks has been the Private Equity shops. Thus I am looking forward to the premier of a new movie entitled "Equity" which is about a private equity shop with a dominant  woman. The financing for the award-winning film was arranged by Candy Straight with twenty-five other professional investment women. We have known Candy since her days of heading acquisitions for a major pharmaceutical firm through a number of private equity shops and as an independent director of several mutual funds. These women are a great example of being able to adapt to difficult and challenging situations.

   
Large Cap Investments

My wife Ruth and I both have had a long term familiarity with the two corporate "Generals,” General Electric and General Motors. As a young analyst, I spent most of one year going through just about all of the major groups within GE. Ruth comes from Detroit and worked for a major auto parts supplier and raised money from the Detroit business community for the local symphony and local public television. Thus both of us have had a long term familiarity with the two "Generals.”

At one point I joked that the two should merge under the title of General Inefficiency. Clearly for many years the Generals lived in their own world and eventually lost earnings power, market share, and pride of place. But today each is in the process of evolving and adapting to both their somewhat reduced condition and also from more modern leaders.

In the past when I saw GE in a fund's portfolio (it was widely held) I treated it as an investment warehouse to store part of the portfolio until better investments could be found. GM couldn't shake the cyclical tag, and was far less owned by mutual funds, but was a comfortable holding for mutual insurance companies and trust banks. Both of the Generals evolved financial subsidiaries that traded on their parents’ credit rating and commercial relationships without outstanding success except as a recognition of their size. Both of the Generals today have evolved to somewhat smaller, but still giant, multinationals that are producing earnings on a regular basis from most of their activities. Both have benefited from adapting numerous of the business practices of overseas leaders.

Taxable Accounts Own Under 30% of US Corporate Stock

One of the characteristics of the US stock market over the last several years is that Large Cap stocks have outperformed the Mid and Smaller Cap stocks in price appreciation but not in earnings growth. Their attraction has been a throw back to the investment warehouse concept which is reinforced by superior liquidity. One of the reasons for the superior liquidity in the face of declining trading desk and floor capital is the shrinking direct participation of taxable individual accounts. In 1965, which was after my year-long research on GE, taxable accounts owned over 80% of US corporate stock. Today it is under 30%. The more, relatively small players in a marketplace, the safer it is for those in the center providing liquidity. Many of  the other Large Caps carry higher price/earnings valuations than the Generals and are equally challenged to find growing revenues. With both the Generals showing some signs of adapting to better business practices and hopefully accounting practices, their relative positions in the Mega Cap world could generate higher relative price appreciation from a historically depressed price level. The main reason that the Generals suffered the prior price declines (and in the case of GM bankruptcy) is their failure to adapt to present and future conditions.

Two Warnings

I have been stressing the need to adapt. This is not to be confused with a need to adopt. The difference is to add and modify one's own principles. Adoption is wholesale acceptance of the adopted views. This may well be the difference between a merger and an acquisition. Too often the second is one where the acquirer takes no prisoners. The acquisition is to do things the way the acquirer wants. A true merger is when both sides adapt to each other's thinking and procedures and there is a melding into a successful marriage. This is the exact opposite of the Broadway show with the title "I Love You, You’re Perfect, Now Change." The key is not capturing but working with.

The second warning is while I am optimistic for long-term investors, I am concerned by what I believe is a consideration that sidelined investors are now coming back into the market. For the first time in at least one year, many of the financial media outlets are celebrating that money is rolling into mutual funds. As usual, it would be useful to dig deeper. The entire gain in assets came from Exchange Traded Funds (ETFs). Most of that money went into a few fixed income ETFs. I believe the bulk of the ETF flow is from trading-oriented organizations. By the way, four of  the largest transaction volumes on the NYSE this week were ETFs. The money going into fixed income products now is unlikely to be long-lasting when interest rates start to rise. Thus I am warning that the inflow is likely to be found to be short-term rather than long-term investors.

Question of the Week:

What new approaches have you adapted to?
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Sunday, July 17, 2016

Implications of “That Was The Week That Was”



Introduction

I am not by nature an Anglophile, but there is much that investors can learn from British History and culture beyond BREXIT. Many years ago there was a television series entitled, “That Was The Week That Was,” or  “TWTWTW” which was a satirical take off on the rather pompous reading of news on British television. As with many theatrical productions from the UK, the concept was brought across the pond and for quite awhile we enjoyed an American version.  Investors last week viewed their own global version of TWTWTW.

One of the standard lessons in geopolitical writings is that war is in effect carrying out policies by other means. Commercial and cultural changes are carried out through international conflicts. I believe that in the future historians will view BREXIT as the beginning of the next phase of global commercial and cultural changes which will dictate different investment policies.

But first we need to live in the present and so on to what may have been a turning point for investors in the TWTWTW.

TWTWTW

I believe that the US stock market action on July 8th, my birthday, was a gift to most equity investors globally. The putative proof of this is the performance of stocks in the last week when the Dow Jones Industrial Average continued to rise to new highs each day and the broader Standard & Poor's 500 rose for four days and just missed a new high on Friday. Some will say the price movement was just a return to a "risk on" attitude. I see it differently for the following reasons:

1.  Instead of the prior stock price leaders continuing to be the performance leaders, it was the laggards that recovered.

2.  Based on stock and bond prices, many of the Index funds also underperformed on a relative basis. (This is not surprising in that most of these indices are anything but truly diversified in terms of quality of issuers.)

3.  In a similar fashion many of the alternative portfolios also under-performed

4.  Many of the non-fully participating institutional and individual investors are complaining that valuations are not at the expected levels for good entry points. They are historically correct, but they are in two traps; first too many financial statements are overstating earnings on a continuing basis. The second trap is that they are only looking at near-term results and at best, next year's expectations not a prolonged view of the future in terms of the issuers and their own needs. (The latter is addressed in the context of the TIMESPAN L Portfolios®.

The Changing Marketplace

Not all is completely rosy. Both the equity and to some extent the high quality fixed income markets are being driven by Exchange Traded Funds (ETFs), and similar vehicles are growing less fast than in the recent past. If the week is an example, ETF investors are riding a bus that is being passed by faster individual cars.

In addition, the structure of the marketplace is changing with capital being constrained by market makers and they are being replaced by hedge funds which from time to time play a similar role of absorbing temporary excessive flows. One can not count on the same level of support in periods of rapidly building tension than in the past. Too many people view volatility as risk and one should expect bouts of volatility which could be as much as six times what we are currently experiencing.

US Treasuries “Risk-Free?”

Global stock and bond markets are tied together and a problem in one can be disruptive to other markets. Government securities, particularly US Treasuries have been viewed as “risk free,” but because of their use as collateral for “carry trades” they can be forced to react to sudden changes in more speculative securities. Hedge fund professionals view that the Treasury market is increasingly crowded with other hedge funds not simple buy and hold players. In other securities we have seen auctions that failed to be completed. Due to changes in the structure of market capital providers it is possible that we could see a US Treasury auction fail. While on a long-term basis this would not be terrible, in a short-term it could shake the confidence of investors in most markets.

While I believe a portion of our money should be focused on the long-term and use future-oriented valuation approaches, I am very  aware that at some point in the future our old valuation techniques will likely determine the winners and losers.   

The Future through BREXIT and Henry V

The BREXIT referendum "leave" vote was carried by the North of England voters. Some of these had ancestors who were the long bow men that won the battle of Agincourt for Henry V. In this battle some 3500 Englishmen defeated 60,000 heavily armored cavalry led by the cream of the French society who were experts with swords and lances. The English archers impacted the French forces before they could close with the English, and thus won the battle and the war by changing to unexpected and better weapons. I believe this is a model for Mrs. May's government.

The combined arsenal includes currencies, tax rates and rules, lower cost of government and a more efficient bureaucracy, The current French President has already commented that the decline in the exchange value of the GBP was “not helpful.” Interestingly that the fall in the value was not led by the government but by a functioning marketplace that many European governments don't trust. Currently the cost of British exports is high because of EU taxes and regulations. In the months ahead, when freed from these burdens, export prices will drop and market share will grow as trade expands with the Western Hemisphere, Asia, and Africa/Mid East. (This could be a bit deflationary, but positive for consumers. Further, this is part of the trend started by the current leadership in China to favor consumers over production workers.)

I suspect that if the UK government can lower its tax burden, more companies will chose to headquarters there. We are likely to see more tax-motivated inversions from both European and US companies. One of the ways governments can lower their costs and improve the efficiency of delivery is to outsource to the private sector much of what they do now. Undoubtedly there will be a fair number of mistakes made and then corrected. Nevertheless, costs will come down and consumers will benefit.

Insufficient Retirement Capital & Other Challenges

Further I am guessing that the demographic problems the developed world is facing where the dependency ratios are rising, and where the number of laborers is becoming insufficient to create retirement capital for the retired will be solved by rapid changes in the guilds that control primary and secondary education. The fundamental issues are that in the modern world, businesses can not hire qualified workers and far too many of them do not understand how to work in a competitive society. The question is not the number of immigrants, but the ability to absorb them into a productive and growing workforce. This may well prove to be the biggest task for the new government, but if any nation can solve it, the Brits have now the best chance, because they must.

The New PM

It is quite possible that the second female UK Prime Minister will, in her own way, be as impactful as the first. I believe she has a good chance to lead the developed countries out of the wish for only 2% growth to multiples of that.

While history does not completely repeat itself, the current situation reminds me a lot of the time when Mrs. Thatcher became the Prime Minister. One of my early and important mentors on the New York commuter train, the late Arnold Ganz, became a real believer in her. Because of Arnie in the 1980s I started to invest in UK financial services companies and their investment trusts (Closed Ended funds). For the most part, some thirty years later they have proven to be a good investment. So today, I am betting that the long bowmen of the "leave" referendum will once again hit their targets against a larger group of “experts.”

Question of the week: Do you now have a view where the US Senate will lead the US?
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All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, July 10, 2016

Did Friday Begin a New Up Cycle?



Introduction

Market and economic historians like to date the beginnings and ends of various phases. They usually pick the ultimate peaks and bottoms of a statistical array. When possible I find it more useful to pick a date or a range of dates when attitudes change. If the financial markets are performing their function they should be discounting the future path not purely reacting to late reports of the economy. The problem is to define how far out in the future the markets are discounting. Most of the time markets look to different futures based on their needs for duration and safety of their segments.

Friday could have been such a turnaround in market sentiment. The surprisingly strong markets could have been a function of realizing that in the long-term, Brexit could produce some positive results that the “experts” who were wrong in their referendum forecast were similarly wrong in their completely one sided forecasts as to the consequences of a vote to “leave” the EU.

On Friday, July 8th , two price movements contrary to each other were reached. (This was not in celebration of two birthdays, The Wall Street Journal and my own.)  The S&P 500 came within one point of its all time high price reading a bullish sign. On Friday the yield on the ten year US Treasury hit an all time low. Normally a low high quality bond yield is a sign that investors will accept a very low yield for safety because they fear that the worst is forthcoming. These twin occurrences on the very same day suggest to me two things. First, that different segments of the market are discounting very different futures. Second, that past valuation approaches are no longer working. (In future posts I will raise  questions as to the relevance of unadjusted financial statements.)

Fund Performance Numbers Reveal

On Friday the Dow Jones Industrial Average gained +1.4% and the S&P 500 was up +1.53%. Since the indices are not burdened with either low returning cash or expenses including commissions they often perform better than managed funds. Despite having cash redemption reserves and tactical reserves plus expenses, average Large Capitalization Core Equity funds as well as Large Cap Growth funds equaled the S&P 500 daily performance with the average Large Cap Value funds performing 10 basis points better at 1.63%. My old firm, Lipper, Inc.,  did not provide to The Wall Street Journal an analysis as to the performance of the ETF universe broken down by investment objectives, but it is my impression that the bulk of the ETF assets are in passive Large Cap vehicles who probably did not equal the average performance of the active Large Caps. For those of us who manage portfolios of funds we were pleased to see Mid and Multi-Cap funds on average rise between +1.96% and +1.65%. The big winners of the General Diversified funds on Friday were the Small Caps on average up over 2% led by the Small Cap Value Equity funds +2.25%.

If these relatively better results can be maintained they will answer the rather dour forecasts for the fund industry by Barron’s and McKinsey and some others. Like the Brexit Leave experts they do not study the fund and asset businesses very well. They focus on net redemptions which is the net result of an aging fund ownership population needing more income and perhaps less volatility. These negative reports also highlight poor sales due to the higher profit sales of competing products who over the long-term on average haven’t produced good results.

As someone that invests both in mutual funds and fund management companies, I am delighted to find negative indicators. As I have said in the past, negative indicators tend to be more consistently wrong than positive ones. However, to be fair and balanced I need to remind my readers I could be guilty of confirmation bias which only sees things that favor my point of view.

Brexit Updates

Fitch is reporting that beneath the surface, pre-negotiations are already going on across the channel. Whitehall is already reaching out within the UK government circles and the commercial world to look for experienced analysts and negotiators. We suspect many of the old countries of the Commonwealth are already seeing an opportunity to increase their trade with the U.K. on more favorable terms with the elimination of various EU rules on British trades.

I believe too many people see the local reactions as anti-globalization. I suggest when you again look at the data, one can see a fundamental reaction to expensive governments who impose their social expenditures  on to the commercial world which pass on their costs to the consumers in higher prices. For instance, in the US we are currently seeing wage and benefits rising faster than sales which is causing profit margins to decline. I believe all over the world the costs of big government are depriving consumers money which could help them in addressing both their education and retirement needs which are growing faster than their economy.

Modern Lessons from Europe

As readers may know, I have drawn the parallel between Brexit and the 1848 disruptions. The one person that played the most successful role for the next forty years was Otto von Bismarck, the consolidator of Germany who successfully played on each political side from time to time and maneuvered the other nations brilliantly. He has many great quotes and lessons attached to him. The first is the basis of my continuing analysis of good and bad performance. “Only a fool learns from his own mistakes. The wise man learns from the mistakes of others.” Hopefully these blog posts aid in that effort. The second quote is very useful for most of the world which will go through contested elections from now through the end of 2017: “ People never lie so much as after a hunt, during a war or before an election.”

The third lesson is the failing attempt to unify Europe from the time of Julius Caesar to the present. We should be able to relate to this problem when we look at how many large mergers actually work. Takeovers initially have a better chance but only if in the end they enlist the taken over into the new structure and leadership.

Working Conclusions

Brexit will lead to vital changes in trade, politics, technology and most importantly of all, consumption. From an investment view point we should try to spot as many winners as possible because only some will be long-term winners. Thus an active portfolio management strategy has the best chances of reasonable rewards and relative safety.

Question of the Week:

What are the questions you would like to ask me? 
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Did you miss my blog last week?  Click here to read.


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