Sunday, June 18, 2017

People Decide, Numbers Report Investment Success



Introduction

The actions of people drive investment results. Numbers are an abstraction of the various realities that people produce. Quantification is useful in reporting history, not motivation. As a long-term student of investing and the investment business, I have seen repeated failures of extrapolating a given set of numbers that produce very different results. At best past numbers are useful as to what has happened in the past of repeated results.

Why Repeated Numbers Won’t be Predictive

People are not machines. Most of us live, think, and emote in the current time period. While our memories do produce faulty or incomplete renditions of the past that we often use as judgments, we don’t always. We don’t follow the old paths, all the time because of change elements perceived or real.

Change Agents

I believe that the presence of change agents occasionally lead to change in behavior. Some but not all change agents are physical, emotional, political, and may be a result of new personalities entering the decision process; e.g., the titular or actual investment committee. Thus I believe it is useful to apply more weight to the study of people than numbers. (This is quite an admission for a green eye-shaded CFA® charter-holder.)

Investment Personalities

I suggest that it is worthwhile to practice the art form, not the science, of people watching with open eyes and empathy. The three useful areas of the study of investors are:

    • The specific investor
    • The collection of investors
    • Speculators called “the market” and financial intermediaries
    Each is quite different, intermittently changing, making false starts and reversals and are sometimes unwilling or unable to state clearly their intentions and motivations. Our good friends the technical market analysts and other quant type analysts and managers believe that their recorded actions are sufficient for predictive purposes. They will be right some of the time but often miss a major change in the mood.

    The Decision-Making Investment Committee

    As a practical matter for some individuals and institutions there is a singular decider who makes final decisions without benefit of external counsel. In addition they are legally empowered to make investment decisions,  consult with others and/or are heavily influenced by external sources. Having chaired, sat on, or served various investment committees, I have learned some investment committees, in truth,  make all the decisions. Others are essentially ratifiers of outsourced chief investment officers (OCIOs) or are driven by the chair or other dominant personality. What I have experienced even with a number of people on the formal or informal committee is: change one person, and the direction of the committee may change. The new person may be the change agent for a reluctant prior group, a dynamic leader, one with a different set of investment or management experiences. The informal committee may include a personal lawyer, tax accountant, neighbor, spouse, significant other or a friend of your golf buddy.

    “Time to Judgment”

    There are two interrelated statistical periods which could be the current quarter, year, length of term expected on the committee, lives of beneficiaries or eternity. (We have suggested that the portfolios be sub-divided in terms of payment streams into timespan portfolios from short operational needs all the way out to legacy considerations.)

    Measures of Success

    After the targeted investment period(s) are identified, a key question is what measures of success to use. The first duty of a fiduciary (and we are all fiduciaries for ourselves and others)  is to deliver returns sufficient to meet expected spending levels. Thus one of the measures is in real, after-inflation returns. If the beneficiary is tax paying, the payment to the beneficiary should be after taxes.

    That is the easy part. Much more difficult are the appropriate measures of investment success and prudence.

    Indices made up of individual securities were never designed to be prudent portfolios, but rather a measure of perceived central tendencies. To me these are inappropriate measures.

    Usefulness of Mutual Fund Performance Databanks

    I suggest the comparisons should be with other investors which are operating under the same constraints as the account. 

    My experience is that the most transparent Databank on performance is mutual funds. These can be segmented by investment objective, size, expenses, turnover, tax efficiency, consistency of performance and other factors. 

      
    In most periods the bulk of investment performances will be centered in the middle of the performance array. Thus I suggest to divide performance into quintiles. The beauty is that one can treat those funds in the middle quintile (40-60). Then an interesting analysis would allow one to examine the frequency of quintile performance by quarters over long periods of time or when the portfolio manager or policy changes. This type of analysis will demonstrate the investors patience. (Over an extended period of time a number of different investment philosophies will produce similar results, but quite different interim results.)



    In assessing the investor or investment committee, their actions over time will have a great deal to do with their ultimate success. The best time for them to make changes within their portfolios of securities or managers is when performance is so good that it is likely to be unsustainable. The other criteria for their future success is whether or not they are developing a long-term plan on how their assets will be managed beyond the Principal’s lifetime.

    Measuring “The Markets’” Personality

    A look at history will show that a high percentage of the time markets move within reasonably well defined price and valuation boundaries. Unfortunately, these periods produce pedestrian returns. It is the extreme periods which might be 10-20% of the time that will capture the big gains and losses. These periods are often tied to perceived external changes. Europe enjoyed a long period of economic expansion due to the use of Latin American gold that was brought back which made their currencies stronger and created inflation. Wars can be both good and bad for stock, bond, and commodity prices at different times. Discoveries of natural resources and technology can create important changes and reversals. The very same factors that cause dramatic change in one market will not in others due to the mood of the market. There are times almost every item will be positively at other times the same items will be viewed negatively.

    At this moment the US stock and bond markets are highly priced but showing relatively little momentum except in certain narrowly defined sectors. There are two elements that other times would cause some concerns, but may not presently.

    The first is what economists call a “Minsky Moment” after an economist that many felt should have been awarded a Nobel Prize. His concern was for the unbridled growth of speculative borrowing/lending. This is the type of activity where the borrower expects to roll over the debt and not generate the capital to pay it back. Some are focusing on China’s industrial and real estate debt. I am concerned of the attitude of various governments and non-profit institutions here in the US who intend to cover their fund raising needs through new debt that they expect to be rolled over.

    The second element is an examination of the daily price chart of the NASDAQ Index in the Wall Street Journal. (This is a technology-driven index. Technology prices have now risen to the peak level seen in March of 2000.) If the prices do not fall appreciatively, it could lead to what the technical analysts at Merrill Lynch describe as a failed pattern. These two elements may be “straws in the wind” and blow away, but watching people’s changing moods will have some impact on near-term prices.

    Financial Intermediaries’ Personality

    We used to live in a world of single purpose intermediaries. They were either transaction-oriented, making their money largely through the bid and asked spreads and/or commissions or advisors which earned largely through percent of asset fees. Theses are now being effectively combined into multi-purpose entities. Within the financial community many former service providers are now competitors. Through this homogenization process the prices for services has come down but it is not clear that the quality and integrity of service has improved. Banks have morphed from being financial services department stores to perhaps the full financial services mall. If money is involved, so will be the banks. On a real estate basis we are seeing many of the old temple-like head offices becoming restaurants or event spaces which has happened in New York and Philadelphia. (We had a graduation lunch for a magna cum laude grandson in a space that used to be the main banking hall for the First Pennsylvania Bank, the fist bank in the US until it merged.

    While some of the intermediaries have large amount of capital it will be used primarily for them to make money for themselves rather than for their clients. They are hiring PhDs from Caltech and other leading research schools to convert their processes from seasoned employee functions to automation. There is not the same service attitude from machines and call centers that were previously bestowed on us by the familiar faces of yore.

    The great damage sustained in major declines was suffered by investors who feel abandoned and dumped their good investments. With fewer people who have the investors best interest in mind to consult, there is a probability that a number of investors will believe that they are condemned to live through their own Minsky moment.

    Question of the week: How well do you think your financial service providers really understand your needs and will be there when you need them in a general market meltdown?    
    __________
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    A. Michael Lipper, CFA
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    Sunday, June 11, 2017

    "Smart Money" vs. the Weight of Money



    Introduction

    One can divide people into two groups: the insecure and those that attempt to manage their insecurities. As we get older we all make physical, psychological, political, and financial mistakes among others. Almost all veteran investors are insecure to some extent about their investments. Because of our insecurities we look for guidelines to avoid making bad mistakes. Unfortunately we often ignore guidelines and signs with which we disagree. Instead, we search for guidelines and signs which we agree.

    Smart Money

    Due to our investment insecurities we search for and want to follow "Smart Money." Those people that are recognized as being successful as investors have so-called Smart Money in their investments.  One of the reasons in my prior life as a provider of mutual fund performance information that I was frequently quoted in the press was that the media and other pundits wanted to identify winning funds in order to focus on what those funds were doing at the time. Rarely was the discussion about how they were smart. 

    As part of my investment management responsibilities for clients, when I interviewed various "winning " portfolio managers and some of their key analysts about both their thought processes and their selections, I was disappointed. All too often their research was shallow and focused only on incremental changes of significance. In many cases their current success was due to market rotation and relative value compared to then-popular securities. Some analysts and portfolio managers were truly perceptive and were deep thinkers. In my search for enlightenment I found a number of very smart investors who were not in the public eye. Often these and some of the portfolio managers of publicly traded funds did mostly their own research and were not reliant on brokerage research. On the other hand, I was unimpressed with those that followed the portfolio changes made by Warren Buffett, Peter Lynch, John Templeton, and John Neff. Their reported activity was sufficiently delayed from the time of transactions and at different than current prices. Further, their purchases typically fit their specific portfolios needs.

    One approach to finding smart money is the basis for a good bit of technical market analysis. In a flat or down market a stock price (along with an increase in its volume) goes up, which can be recognized in charts, there is a belief that someone or a group knows something that the rest of the market does not. Therefore, they may be smart money. We will only know when the surge in its stock price ends.

    Weight of Money

    I was introduced to the importance that some professionals place on "The Weight of Money" many years ago as the leader of a group of analysts on a global trip largely focused on mining investments. When we were in Australia, one evening I got a call from a client of our firm from Tokyo who intently interviewed me as to the reactions of the analysts to various companies. After we talked for quite awhile I asked him why he was so interested about the analysts’ reaction rather than what I learned about the companies. He had a very good global internal research department and probably was the best single client of most institutional brokerage firms. Further, both he and I recognized that while my analyst companions on the trip were more than competent, they were not for the most part "the lead" analyst in the stock.

    Our Tokyo-based client explained to me that the change in the amount of buying or selling in a stock could have a disproportionate impact short-term on the price. The weight of money rather than fundamentals could have more impact. As he was a manager with traditionally very high turnover in international markets, his focus on the aggregate views on a stock made sense to me.

    The Weight of Money Can Mislead

    Often what could properly be described as the weight of money is mistakenly labeled smart money. There were three instances in the last week when the weight of money might have given investors the wrong signal. The first two operate out of the best single investment laboratory that I know in terms of practical analytical skills. Early in the week it was reported that the British bookmakers had an 85% belief that the Prime Minister would get the mandate she wanted. This was foolishly taken as an analytical conclusion. Bookmakers have no particular forecasting skills. What the 85% represented was that 85% of the money wagered on the election saw a significant Tory victory. I suspect that the majority of the money bet came from in or around London and was not geographically dispersed. Bookies made a similar miscall in terms of the BREXIT referendum.

    The second misread was the betting on The Belmont, the longest race for three year horses in the US. The beaten favorite came in second with final odds of 5/2. (Which means if the horse wins, the bettor wins $5.00 for every $ 2.00 bet.) The winner paid $5.00 for every $1.00 bet or twice the amount on the favorite and was the second favorite. At the racetrack, the pari-mutuel payoff is similar to the old bookmaker’s calculation of the different level of moneys bet less taxes and track compensation. This is a dollar weighted input. With only a cursory look at the local newspaper’s pre-race article, my intellectual choice was the eventual winner in part because he was more rested than the favorite and there was enough early speed in the race that the favorite and a number of other horses would be slowing down in the home stretch when the leading jockey in New York was giving a brilliant ride on the winner. Favorites don't win often enough to pay for their losses.

    The final misread from those who rely on the weight of money argument occurred on Friday which may be an echo of a substantial decline of many years ago. Up to Friday the five following stocks: Facebook, Amazon, Apple*, Microsoft, and Alphabet (Google) represented 41% of all the gains earned by the stocks in the Standard & Poor’s 500 through the end of May. Thus 59% of the gain came a net basis from some 495 other stocks. While these five were not the most heavily owned stocks in the index, they were substantially owned. One study indicated that among large mutual funds, over 80% of them owned at least one of the five. Many probably owned Apple as it is the stock with the largest market capitalization. On Friday these five as well as many tech companies fell more than many other stocks, even though the Dow Jones Industrial Average was up a little bit. It is possible for awhile that the five may give up their performance leadership as part of normal rotation.
    *   I have been a long-term holder of Apple shares in a personal account.

    Perhaps the five are the modern equivalent of "The Nifty Fifty" which was a group of approximately fifty stocks that out-performed the general stock market from the late 1960s into the peak in 1973. As with the current five, The Nifty Fifty started their ascension coming out of a bottom. Most stocks reached their peak in 1968 but the averages did not top out until 1973-74 period. While there is some disagreement as to which stocks were in the fifty, the criterion was either a JP Morgan list of one decision stocks (only buy, never to sell) or the highest price/earnings ratios. There was a great overlap between the two lists. A number of the companies had very bad investment performances after the peak. Some were merged out and a few filed for bankruptcy. However most survived and a some prospered; e.g., Walmart.
      
    I do not know what the future holds for this year's five leaders. I do know that if a portfolio has only a partial interest in the five, below the commitment in the various indices, it is the equivalent of being short that particular name if the name rises in price relative to the index. Historically, the stocks with the highest price/earnings ratios can fall the most. On an immediate basis Friday's decline closed the remaining price gap which made the best performing index, NASDAQ, vulnerable.

    An Important Caution

    S&P Global has lowered the credit rating of Massachusetts because it has not been building reserves that were required by the state legislature. This should be viewed as a general warning that eventually there will be a need for these reserves. It may be a number of years away from a significant economic recession with a market decline. I am sure that it will happen, as it always has as a correction from too much leverage in the system. I am not worried about the aforementioned five stocks, as most appear to have large cash reserves. I am concerned about others who often have an increased demand for their services when the general public are having difficulties.  In some cases this could cause partial or total liquidation of their investment portfolios. The time to add to one's fortress is when the sun is shining.

    Questions of the Week:

    1.  What Smart Money signals are you finding?
    2.   Is the weight of money important to you?
    3.   Are you building your reserve?
    __________
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    A. Michael Lipper, CFA
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    Sunday, June 4, 2017

    Signs of Enthusiasm, China Concerns, Centurions are Coming



    Introduction

    Because I like to think about different timespans as an improved way of managing money, I look at different stimuli in terms of impacts on those timespans. The focus of most commentators is on the short-term, which can be described as until the next performance reports all the way out to the rest of the market cycle. Some focus on intermediate periods that follow after the current cycle. And very few will focus on the long-term needs in terms of their responsibilities. Nevertheless, it may be useful to arrange some of the stimuli that bombard us each day.

    Short-Term

    On the very day of the publication of the statement of President Trump  “Pittsburg Not Paris,” the three major US stock indices went to new highs. The enthusiasm for stocks is global with five markets showing 2017 gains of over 20% through Friday: NASDAQ +27.06%, Bovespa +25.57%, Hang Seng +24.87%, IBEX 35 +22.31%, and FTSE 100 +21.9%. While a number of the gainers are being driven by advances in Emerging Markets, it is not as usual supported by or led by commodity prices.

    Based on past history, two cautionary notes should be observed. The first is a reported statement from an old friend and "bubble watcher" Jeremy Grantham: "The US market has entered an era of permanently higher valuations." (A look at history questions whether any valuations can be permanent. This is Bull Market talk.) The second was noted in Barron's based on the work of Bespoke which commented that April margin balances were the fourth consecutive month of record levels. Bespoke observed that the last two bear markets have occurred after margin balances have peaked.

    At the moment I view all of these inputs as cautionary signs. In the past, important peaks have been the result of greater amounts of enthusiasm with higher performance numbers, new "geniuses" and considerable leverage. I am not predicting this, but at prior peaks I have seen a number of mutual funds that reported gains of +100% or more. At this time we do not see people changing their lifestyles and marriages based on their new theoretical wealth.

    China May Dominate Intermediate Periods

    The generally accepted view is that China will become the globe's number one economy within the foreseeable future. My own opinion is to always be cautious about generally accepted views, they have proven to be wrong too often in the past. In addition, the Chinese economy and society are highly leveraged operationally and financially and things can go wrong. At the moment, I feel confident that China will become the most important variable in determining future investment policies around the world. With those thoughts in mind I will summarize two important inputs. The first is from our friend Byron Wien's reaction to his recent trip to Asia (including China) speaking with institutional investors. The second are the views expressed by the portfolio managers and investment strategist with which I visited recently.

    Byron Wien's China Briefs

    • Capital formation is growing 4% with inflation at 3%.
    • Leverage is the major problem with total social and financial borrowing  250% of GDP.
    • Interest payments are 14% of GDP.
    • Shadow banking interest rates are 14%.
    • Regulators will permit banks to convert non-performing loans into equity.
    • Return on equity for private companies has dropped from 18% to 9%.
    • Equity market valuations are high at 20x with meager growth.
    • Middle class expected to reach 60% by 2020 from 43% in 2015.
    • Population is rapidly aging and expected to reach 370 million in 2050 vs. 170 million in 2015.
    • Healthcare expenditures are 5.5% of GDP.
    • Life Insurance covers 2% vs. 10% in developed markets.
    • The solution to excess industrial capacity and jobs is "One Belt One Road."


    Matthews Asia's Mindset

    In response to the expected downgrade of China's credit rating, Moody’s* points out that the bulk of the excessive leverage exposure is in the largely State Owned Enterprises (SOE). I believe most of these loans are held domestically by government owned or controlled banks. The key social issue is jobs. Luckily the majority of employees work for private companies that are profitable. Actually the private companies are growing their earnings, but the periodic waves of speculation have been reacting to both global and internal political trends depressing their prices. (This is just the opposite of India, the best performing large market this year, where earnings have not met expectations. The enthusiasm for the current political and monetary conditions has driven the stock market higher.)

    *Held in the private financial services fund I manage

    Matthews Asia sees future opportunities in both Micro caps and some of the under-followed "A" shares. In its portfolios that invest in China, Matthews Asia is investing in both the creation and the use of technology applied to health care and related aging needs. With China being such a big part of Asia's future, one would assume that in the long-run Matthews Asia believes that China will be a positive for Asian investing.

    My long-term concern about China is that the global history of railroad and port building with too much leverage can create unexpected volatility.

    "Beware of the Centurions" in the Long-Term

    If my memory of military history is correct, in the conquering armies of Rome the key maneuvering units were comprised of one hundred men commanded by a Centurion. It was the Centurion that transformed a diverse group of undisciplined men into a well trained disciplined military unit. We are entering an era when an increasing number of people will be at least 100 years young, and we and they are unprepared for this transition. A thoughtful piece by John Mauldin alerts us to the demographic fact that increasingly we will be dealing with people that pass the century mark. As individuals and as a society we are not prepared for this change. For example when Social Security was initiated in this country it was based on the belief that men would retire at 65 and die at 67. This was conservative in that people born in 1930 had a life expectancy of 56 for men and 62 for women. Compare that with life expectancy for those born in 2007 to be 103 and 104 respectively, in the US. This is a global phenomena with six other developed countries’ expectancies in the same range. Japan is the leader with 107 years.

    One of the unspoken conceits of investors is that they are not the average person. To the extent that they can prove that by being wealthier, the top 20% on average in terms of wealth, are expected to live five years beyond the average. The poorest are expected to die two years earlier than the average. I can understand the distinction because of diet, less risky manual labor, and quality of health care. I don't know what assumptions are built into these projections as to the developments in medicine, agriculture, working conditions, and psychological health. Further my basic training at the Racetrack and the US Marine Corps questions trusting averages but has a distaste for being in the middle of any group.

    Regardless of the projections, as societies we are not doing a very good job of caring for the present seniors. Fundamentally the reason for this is we have insufficient dedicated capital. This is a global problem impacting all the developed world and many of the developing countries. Almost every government-sponsored pension plan is underfunded to meet the present retirees, let alone prepared for the Centurions.

    Strange as it may seem, I see this is an opportunity for investment gatherers and managers. As Centurions grow in number, increasingly they will exercise their votes at both the local and national levels. I expect at some point we will evolve into a two level tax system where there will be charged a higher level for consumption spending, perhaps some type of VAT, and a lower bracket for retirement spending. Whether any unused capital can be passed on without a tax, I don't know. Further our laws and practises will react to some concept of age discrimination in favor of utilizing the best people for the job in one form or another. Unless we do something, the Centurions will weigh heavily on our productive capacity.

    Critical Investment Question: Rank which is most important to you and your investments: (a) short-term market outlook, (b) impact of China, or (c) providing increased retirement capital. Please share your thoughts with me.
    __________
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    A. Michael Lipper, CFA
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    Contact author for limited redistribution permission.