Sunday, May 24, 2015

Avoid GDP and EPS


When the starting focus is wrong, many investors do not succeed. Though I can not judge the veracity of Socrates’ view that the unexamined life is not worth living, I believe the unexamined investment process is not worth continuing.

Starting with GDP

More supposedly learned people spend their working lives following and projecting the various Gross Domestic Product (GDP) statistics than any other measure. The academic community (within their institutions and within their satellites in business and government) start almost all of their future projections with a GDP growth rate. Yet it is rare for any annual or multi-year projection to prove to be accurate in terms of magnitude and occasionally direction. Thus most top down investment processes that start with GDP projections have not produced competitive results.

GDP traps

The basic fallacy of substantial reliance on GDP numbers is that a single number can represent the entire amount of economic activity within a geographic location. As a junior analyst at a trust bank, each of our company reviews required a comparison of revenues to a relevant generic measure. For many years the senior investment person was a well known and respected economist and the comparison was often with the GDP*.
          *At the time we used Gross National Product (GNP).

As industry analysts we were meant to contribute our estimates of various industry statistics. As a budding technology analyst among other sub-segments followed, I was responsible for estimating the growth in the production of timing devices. While clocks or other timing tools were inherent in the production of numerous technological products, we did not follow a single company that provided any numbers as to their production. Not even output for industrially important punch card clocks to determine employee hours were available. There was no focus on changing specific prices (e.g., as transistors were introduced into timing mechanisms). In addition, I suspect at that point there were more clocks and other timing equipment already being used in our military and thus their production numbers were not known or were classified. Similar detailed projections were required by other analysts.

For central authorities the cost and availability of gathering complete production numbers were, and are, beyond their capability. Due to the nature of governments to tax, I presume there has always been a sizeable unreported level of business which probably changed with the taxing authorities’ levels of competency, authority and integrity. I doubt that it was ever a constant ratio of aggregate economic activity. Further, I am guessing that everyday somewhere within an economy business people, farmers, and others are finding new and different methods to produce similar goods at lower costs and perhaps increased worthiness.

A “Man-made” metric

Today we live in a global and increasingly integrated world. GDP analysts utilize export and import statistics reported to them mostly based on tax and other regulatory data provided. While this may be a good attempt, it is a monastic view of a commercial marketplace where transfer pricing is an art form, some over-invoicing occurs as a way to move currency and there is not cross-border comparison as to how the same transaction is tracked in multiple countries.

In sum total, the reliance on GDP pronouncements by government authorities and media pundits seems to me to be a weak crutch upon which to base investment decisions. They are sound bite size, and excessively simplistic answers to the complex question as to how the economy and business in general are doing. As noted in my earlier posts, some of the Chinese political leadership do not trust GDP figures as they are “man-made” and not a direct extrapolation of economic activity.

Most EPS valuations mislead

Currently it is fashionable to quote Professor Robert Shiller’s Cyclically Adjusted P/E (C.A.P.E.) as a valuation metric to determine how expensive the stock market is. Liz Ann Sonders of Charles Schwab** recently produced a study entitled “Devil Inside: Dissecting the Most Popular Valuation Metrics,” which does a fine job pointing out the problems with this ten year average inflation-adjusted earnings per share of the S&P 500 price/earnings ratio. The problem that I have with relying on this as a tool is though it may make life easy for students and pundits,  the earnings used are only the reported earnings and it is looking backward.
            **Owned personally, and/or by the private financial services fund I manage

Beginning at least some 80 years ago Professors Benjamin Graham and David Dodd taught in their Securities Analysis courses that the first thing the analyst was to do in analyzing an income statement was to reconstitute it, removing all the non-recurring sources of income and expense. Eventually the accounting profession caught up and started to disclose the various reported non-recurring factors; e.g., profit and loss of investment sales by industrial companies.

In addition, to determine fundamental earnings power, one of the tasks that I did some sixty years ago was to “normalize” tax rates and where possible put all competitors on a similar rate which in effect reduced the impact of different balance sheet structures. More difficult was to model all peers on the same inventory accounting system such as LIFO vs. FIFO, etc. Most difficult was adjusting for various unusually large year- end sales and expenses that under other conditions could have appeared in the following years. To me the real benefit of this numbers crunching was to force on me that I was viewing a painting depicting someone else’s view of reality rather than reality itself.

This jaundiced view of reported earnings was reinforced years later when I had to deal with mergers & acquisitions. There were significant differences in the views of the buyers and the sellers of a company which led in part, to a dissimilar valuation that motivated each, and in many cases varied from public perceptions as to the value of the deal. In effect, the beauty of the deal was in the eyes of the beholder.

Having helped some financial organizations make acquisitions, the real focus was identifying the range of likely future earnings. The buyers were buying what they thought about the future, both without major changes and with changes that the acquirer expected to make. In almost all cases this led to a bargain purchase with a valuation below the valuation that the buyer’s stock was selling at for at the time of the purchase. Keeping the point of view of potential acquirers in mind, I estimated what I thought long-term future earnings might be in my purchases of individual securities and various funds. Thus, I am a future oriented investor along with others beyond the halls and bypasses of academia.

Three steps to take

1.  Adopt the appropriate valuation measure for each account. Some investors appear to be more comfortable in the past as they fundamentally believe that the current and future will be an extrapolation of the past. Of course the trick here is to pick which past. You could start with the Eighteenth Century, or perhaps 1926 when the first tracking services became evident, or a rolling ten year C.A.P.E. model. You could use a period since last the major peak or troth, or chart when new leadership of a company or country came to power or use another timespan.

2.  Use selection approaches that are appropriate for the timespan. For example in our four Lipper Timespan Fund PortfoliosTM, we will be much more focused on short-term GDP pronouncements and reported earning valuations in the first two portfolios, Operations and Replenishment. In both cases we recognize that a significant downturn is a matter of major concern. As the timespan lengthens we become more future earnings-focused and more interested in changes of demographics and psychographics than in GDP. Thus within our Timespan Portfolios, the shorter timespans will be much more influenced by cyclical factors,  in the intermediate timespans secular trends and in the Legacy Portfolio likely disruptions to historic extrapolations.

3.  An important advantage of investing through a portfolio of funds is that select smart managers that have well thought-out, but different investment strategies are available. This third step is critical to avoid locking into a single philosophy. The one absolute positive as to the future is that every investor and investment manager will be wrong from time to time (or if you prefer, premature). The risk when this happens to all of us is to overreact with an abrupt reconstruction of investments. By instead using a selection of sound, good managers, most of the time the total portfolio will benefit and move toward its funding responsibilities.

Question of the week:

What are the three most likely future changes that your investments can tolerate and what are the two that would force major changes to your investments?
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Sunday, May 17, 2015

Are You Suffering from Input Overload?
Think Digital, but Judge Analog.


Over the last week or so my wife Ruth and I have been with music lovers, including donors and professional musicians where much of the discussions have focused on the musical scores. The very term leads me to think of financial scores. Both are performance measures and there are well-recognized parallels between music, math/science and investing.

All three cultures contain enormous amounts of individual facts (and fictions masquerading as facts). If we paid complete attention to all of these our constrained brains would become overburdened. Instead we choose to narrow our focus to segments; e.g., nineteenth century symphonies, organic chemistry, or equity mutual funds. Even these segments are too large for individual attention, so we tend to array these participants in a statistical rank order. Thus, we become a captive of the digital world order.

Music favorites

In deciding which rendition of a piece of music is their favorite, people choose based on memories. What we may remember is the total effect of the last time we heard West Side Story or Beethoven's Fifth Symphony, which is the result of the orchestra, conductor, venue, acoustics, and importantly our particular location physically and emotionally. Since the sum total of these digital inputs can not be algebraically experienced, the resulting feeling of satisfaction is an analog reaction.

Successful investment choices

As much as it pains me to admit, my learning as a CFA® charter-holder has provided me with lots of decision inputs, but so far has not been much help in developing consistently winning portfolios.

While I may make imperfect projections of revenues, margins, tax rates, shares outstanding, earnings per share, relative valuations against markets, peers, growth rates, etc., the success of my investing for clients will be an analog of known and more importantly, unknown factors.

Unexpected or unusual combinations of  instruments

In most of our descriptions of Legacy Portfolio investments I have focused on equities or equity funds. However, in the hands of a skilled portfolio constructor/manager I could see the following other types of investments included: long-term commodity shortages, unimproved real estate, long-term TIPS, and currently unpaid royalties. When combined with investments in a combination of secular growers and the beneficiaries of disruption, any or all of these could make beautiful music together in the Legacy, the longest of my Timespan Fund Portfolios.

Question of the week: What lessons can you or have you learned from music?
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Sunday, May 10, 2015

Great Music Can Discipline Good Investing


The global equity surge on Friday was a political relief rally for stock owners.  The rise could restore the rhythm of alternating up and down months, with May being scheduled as an up month.  This cycle could be considered a possible link from the musical world to the investment arena.  Patterns or streaks in the investment world break down eventually, however great classical music goes on forever.  

Recently I was in Europe on a group tour with donors to the New Jersey Symphony  Orchestra (NJSO), and my wife Ruth, who is the orchestra’s Co-Chair. Before the official beginning of the tour we were in Geneva on family-related matters where I noticed a billboard for a concert of the local Orchestre de la Suisse Romande, which is the orchestra for the French speaking portion  of Switzerland. The orchestra’s visiting conductor for the night was Neeme Järvi, formerly the Music Director for the NJSO. We attended the concert and listened to familiar pieces by Franz Schubert and Ludwig van Beethoven which we heard
Maestro Järvi conduct in Newark, New Jersey. When we visited him and a portion of his large, talented family backstage, he was the same genial host we had known.
While in Prague (or spelled locally, Praha) we heard the Parnas Ensemble, a quintet playing highly spirited pieces by Mozart, J.S. Bach,
Dvořák, Bizet, and Brahms. What does this have to do with designing the correct components to an investment portfolio? Many of the pieces we heard were two hundred years old  and yet sounded new and exciting to us, even though we had heard them performed by individual soloists, quartets, quintets, chamber music groups or full symphony orchestras around the world. At each concert highly trained musicians interpreted the pieces in a different way so it was like hearing the music for the first time.

Turning to investment portfolios

Just as the musicians mix various instruments into their pieces, my structure of timespan portfolios can include real estate, commodities, fixed income securities, stocks from around the world, and my specialty mutual funds. A well-thought investment portfolio can be imaginative and fresh to a savvy investor similar to the experience one receives when leaving a concert that has produced evocative interpretations from old musical works. Similarly, a well chosen set of timespan portfolios can fill a deep and newly awakened investment need.   

Inter-relations between timespan portfolios

The structure of the first four portfolios is dependent on each of the Operational, Replenishment, Endowment, and Legacy Portfolios doing its job and relying on subsequent units to do their job. One of our perceptive readers, a professional portfolio manager, and one of my sons, asked the question, “How much of one's wealth should be devoted to each stage?” Unfortunately, there is no set answer.

The continual process of development

One begins sizing the initial timespan portfolio, the Operational Portfolio, with the first version of a funding needs spreadsheet starting with a two year spending budget estimate (including a reasonable contingency factor). Input by the CFO and/or external accountant is critical as well as the real planning officer, often the CEO.

The task of assessing the size of the second portfolio, the Replenishment Portfolio, is to make a somewhat independent judgment of the probability of the timing of the exhaustion of the Operational Portfolio, which is slightly dependent on the expected interest rate and cash flow in that account. This timing will determine the probable schedule of replenishment.

There is no hard math as to the allocation of capital to each of the four separate portfolios. Assuming that spending can be limited to 3% of capital, the Operational Portfolio should get two years of spending or 6% of the total. In the current time period, I am assuming no real income generated over minor administrative expenses will be paid out.

The Replenishment portfolio normally should have a five year timespan during which one should expect at least one period with a 10-20% decline. Making the bold assumption that on average, equity markets continue to rise about 9% per year, it is reasonable to assume that in aggregate, including any decline, they could produce replenishment capital of about 6% of the portfolio value. On the basis of this logic and on assumptions given, the Replenishment Portfolio should represent 50% of the capital of the account, assuming no additional contributions. (If in cash, additional contributions could substitute for some of the estimated rates of return.)

The Endowment Portfolio

Utilizing the above general example, there remains 44% (100% minus 6% minus 50% =44%) to be split between the Endowment and the Legacy Portfolios. How the split is made may be a factor as to how the current generation of senior management perceives the identified long-term needs of the account organization. If the organization has been regularly investing for its future, or if the family grantor perceives that the existing family members will receive enough without ruining their incentives to be productive, the bulk of the 44% might go into the Legacy Portfolio for expected but unknown needs/opportunities.

Even when heavily invested in equities, an endowment account is typically going to be judged on its long-term generation of income, including realized gains. A Legacy Portfolio should be judged on its ability to grow its capital.

Music lessons for investors

There are many ways to hear a great piece of music, but hearing the different approaches gives the listener a broader array of benefits and can lead to different choices for different listening pleasures. The same thing can be said at analyzing different portfolios with some of the same positions. A number of so-called active portfolios might hold shares of Apple, Google and IBM. For sake of discussion, assume that each holding represents 5% of the total portfolio and in aggregate 15%. (I know of no such fund portfolio.) One might expect that portfolios with similar holdings would produce roughly similar results. This is rarely the case, for the other 85% of the portfolio is likely to produce meaningfully different results.

There are many answers as to why funds perform differently. When I was consulting with the independent directors of fund groups trying to judge whether they should renew investment management contracts, I pointed out important differences beyond performance and holdings. I will admit relatively few directors wanted to listen to the whole piece. Some of the elements I mentioned to them were as follows:

1. How well did the managers follow instructions in the prospectus
    and from the board?
2. The impact of differences in fees and expenses.
3. Different flow characteristics.
4. Management of critical personnel + backup development.

Let me over-simplify a comparison of Warren Buffett/Charlie Munger of Berkshire Hathaway and Peter Lynch, the great long-term portfolio manager of Fidelity's Magellan Fund, who had similar performance in some years and from time to time actually owned a portion of the same stocks. Both Buffett/Munger and Lynch had professional disdain toward economic projections, but they each played to different tunes. Buffett relatively through securities he owned, his large positions made him technically an insider with holdings of 10%+ of the voting securities. Because he had the use of the long-term float of other people's capital, he was leveraged. Peter was very conscious that his good investment  performance was bringing to Magellan bundles of capital, with Magellan becoming the first equity fund to have assets of over $100 billion. Peter was very conscious that as easy as the money came in it could go out, as learned by the managers who followed him. The portfolio swelled at one point to perhaps 1800 individual issues, including 130 with the initial name "First" (as in Savings & Loans and Savings Banks). At one point he had three traders working effectively just for Magellan’s accounts.

In assessing investors' risks with these managers, Buffett represents a leveraged, highly concentrated balanced portfolio which he personally owns as a 50% principal in the company. To an extent his favored investment period was and is forever. Magellan was going to be only as good as its short-term performance with a broad equity portfolio.

While these three great minds made great investment music which seemed similar; just as one hears the difference between great orchestras playing from the same score, the results were quite different. A careful analyst of portfolios needs to understand the differences between outcomes and casual features.
Question of the week: What are the differences that you think are important other than past/present outcomes?
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