Sunday, December 10, 2017

Same Answer to two Questions Disturbing? - Weekly Blog # 501




What drives stock prices? In this sound bite world of media and academic pundits what drives stock prices is earnings per share. The progress of e.p.s. determines the appraised value and therefore the future price.

What is the most massaged number of all that is published? You guessed it, earnings per share. When was the last time that a modern chief financial officer or CEO knew one year in advance the number of shares that will be divided into the reported net income on an average number of shares or year-end number of shares outstanding? To be honest, net income, at best, is a representation of a perceived reality. Revenue recognition is a semantic guess. The value of inventory consumed and the remaining value as to what is left is heavily influenced by current or year-end prices and the recognition of taxes currently owed to various taxing authorities. In truth e.p.s. numbers are not manipulated necessarily with malice.

This reality suggests to me earnings should not be the sole measure of a stock’s value or perhaps not even the leading measure of future prices.

I am led to this view after reviewing Berkshire Hathaway’s* investment experience and looking at a number of 13f reports reviewed by John Vincent as well as my own long-term portfolios. In each there are some losers. In general from the time the losers become big losers they disappear or have a greatly diminished percent of the portfolio due to the rise of the winners.
*Held in the private financial services fund I manage

Warren Buffett claims he does not make future earnings projections. Even if he did I doubt that he would have much confidence in ten and twenty year projections. Then what is the rubric or rubrics he uses? I believe staying within his circle of competence it would be based on his understanding of the nature of the business that the company is considering acquiring. In 2000 he purchased a big position in Moody’s Corp. that was spun out of Dun & Bradstreet. The current price of Moody’s is fifteen times his cost. This is a clear example of thinking long-term, with an understanding of the functions and quality of a potential investment.

Not long after Berkshire’s purchase of Moody’s, I independently bought the stock for the private financial services fund that I manage. When I bought this stock I believed that I understood the nature of the credit rating business and the essential need of the company’s clients for its services. I also knew a little about its management compared to its main competitor. It was the quality choice. Thus, investing in the highest quality of an essential business worked well for me. I did not project earnings, recognizing that most of the analysts reporting on the company regularly underestimated current earnings. As I was a bit late in my purchase, the current price of Moody’s is only eight times our cost.

There is another lesson from this experience. It is not just finding a great investment, but continuing to hold on through both the changes within the investment, the market, and the needs of the account. Both Berkshire and I sold some of the original position along the way for reasons that proved to be wrong. Thus the same level of diligence needs to be practiced as we, in effect, re-purchase our liquid investments everyday.

Challenge Ahead

Perhaps too many of the portfolio managers that I speak with, while concerned about the near-term future due to the identified unpredictability of events, are not raising their cash levels. In numerous cases the hesitation to act dynamically is due to career risks. As a contrarian long-term thinker I have already accepted the realization that there will be a stock price decline ahead of us which may be combined with a recession, fixed income collapse or military actions.

There remain two critical questions. First, the size and duration of the decline, and second, should we trade in and out of the decline or do we stay pretty much fully invested to benefit from both the recovery and the expansion beyond?

As usual I look at the current data and the misdirection that most are following. Economists and politicians are being led by the lack of sufficient productivity, actually labor productivity. This is defined as revenues divided by wages. Governments around the world have found within their constitutions a “requirement” to create jobs. In particular they want to create jobs for union workers and other politically active individuals with eyes on the next election.

While these are important, they are not addressing problems that are broader and deeper in scope than unemployment which can be summed up in different measures of productivity.

In all of our societies there are more consumers than workers. What has happened all over the world is that consumers are buying more and better quality products and services due to both technology along the way and world trade. I suggest, unaided by government or perhaps in spite of government, consumers are better off today than ever. Clearly more is desired. If we create jobs that raise prices and/or reduce quality, that is a step backwards.

The second productivity measure which is not highlighted globally is the productivity of capital, particularly retirement capital. I do not know of a large government retirement plan that is fully funded against any standard, let lone the fact that we are all living longer and our last years are very expensive. We must support increased investment into retirement capital vehicles but this will have the effect of lowering current consumption.

Net Flows into Mutual Funds and ETFs

The next set of numbers that is not getting enough attention is the net flows into mutual funds combined with flows into ETFs. Domestic Equity funds particularly Large-cap Growth and Large-cap Core funds have been in net redemption for a considerable length of time. Despite the average performance of Large-cap Growth funds this year is close to a gain of 30%, they are in net redemption. This is largely an aged base, as the fund holders who were sold Growth and Core funds years ago are at the stages of life where they need the money for other purposes. This is not new and has been happening for decades. What is new is that the long- term profitability of selling funds and managing accounts invested in funds has changed.

But there is a more important message from net flows. Global and International funds are adding assets at almost the same rate as the Domestic-oriented funds are being redeemed. What this is saying is that the Domestic funds are suffering from the lack of sufficient retirement capital. Plus today’s active fund buyers are hedging their retirement against a perceived long-term decline in the value of US assets. This is backed up by the current yield on long-term government bonds. There are ten large countries with ten year government bonds. The yield on the US ten year is second highest of the ten. This means that the market participants view that there are eight better places to invest their bond money and will take lower yields to insure their safety on a post-inflation basis.

Equity = Opportunity/Risk

At the current global level of interest rates we will be far short of filling the retirement capital deficit. The best opportunity to fill the gap is equity. Equity has imbedded within it both opportunity and risk of loss. In general the larger, more mature corporations have the least risk but also the least investment returns, as shown below utilizing the three S&P market capitalization indices’ investment performance since 12/31/1999:
S&P “Market Cap” Indices                        
        
Index
Average %
Range: High to Low %
S&P
500
+80.20
+  194.89 to (51.36)
S&P
400
+327.10
+  874.74 to (69.38)
S&P
600
+376.74
+1198.12 to (95.89)
 

This table suggests that mid and smaller market cap companies can produce higher returns than the more mature, larger companies in general. The market risks are greater also, but not relative to the size of the gains.

Betting on Change

None of us know for sure what the future may bring, but the wise equity investor hopefully recognizes changes earlier than many others. There are many possible disruptive changes which could impact all of us. I am not sufficiently knowledgeable to have an appropriate view on autonomous driving vehicles but they could change or disrupt almost every element in our societies. It is the marriage of technology and lifestyle changes.

There are a number of other disruptive forces that can change our world, hopefully for the better by addressing the two missing productivity measures.  Because I believe that some of these changes will occur, I will continue to be largely an equity investor.

Question: What are the changes that you are expecting?
__________
Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.

No comments: