Sunday, November 22, 2015

Selecting by Market Cap Can be a Trap


Selection and diversification policies should be based on meaningful investment filters. To win and maintain accounts most institutional investors need to surmount brief discussions with consultants, “gatekeepers,” investment committees and similar part-time investors.  To make those that hold the keys to the managers’ revenues satisfied and retained, is to make comparisons easily understood. Only a weak client relationship will focus primarily on performance. This way of thinking was driven home to me last week.

Market Capitalization Traps

During the week I met with two investment committees, entrepreneurs and their advisers, and two publicly traded fund management companies in New Jersey, Monaco, and Toronto. In each case present and future investment performance was at the heart of the discussion. The comparisons used most often pivoted around easily definable groups, such as market capitalization. For instance Small Caps, S&P500 (which is essentially Large Caps,) or MSCI World Ex-US (again Large Caps).

Questions from the Audience

In Monaco I was asked how much should a portfolio hold in Small Caps. At that very moment my dilemma became clear. In the audience there were CEOs and their advisors/investment bankers from about twenty hopeful companies. Clearly it would have been foolish to perpetuate the dream that all similar market cap stocks or funds  could become holdings in a prudent portfolio. In answer to a question I did suggest for that particular audience that in my construction of the Endowment Portfolio within the TIMESPAN L PORTFOLIOS® depending on other factors a reasonable range for Small Caps could be between 15% and 40%.  Depending on facts and circumstances, a different range of small-cap investing could be considered.

Good and Bad Small Cap Stocks

One of the advantages of the give and take of question sessions is it makes you search for a quick suitable answer. Hopefully in my case it leads to a more thoughtful review of the topic. After much thinking and considering marketing factors, I know what I should have said. Small Caps are not a separate and distinct asset class. There are good Small Cap stocks and bad ones, and buying a stock just because it is a Small Cap is unlikely to give an investor a competitive investment.

Investor Selection Screens

More meaningful selection screens should be a function of the present and future enterprise risk and reward. The results should then be married to a separate analysis of the stock. To me the single most important risk element is that of the co-venturers, those presently and likely to be in the stock. What is the risk of one or more other sizable co-venturers moving in advance?

Another element would be the present price discount as to the future. There are countless other filters including some proprietary measures that can be used as screens. What I look for regardless of size are companies that are in businesses that I have some competence in; e.g., money managers vs. biotech where I believe that my view of the future is not already in the price.

Research Cuts at Major Banks

Having indicating my preferred way of analyzing securities, I believe that we may be entering an era when there will be bigger discovery value in Small Caps than what we have seen in the last decade. This week The Financial Times had an article reporting that research staffs at major banks have shrunk perceptively. This was not due to a view of the declining value of the research effort, but rather a reaction on the need to pay for increased compliance costs combined with restrictions lowering profitability on the use of the mandated regulatory capital. The cutback in the banks’ analytical forces will probably result in less analytical work to add new names at the edges of their portfolios, however the cut-back may also create opportunistic buying occasions.

Most banks need to have as good analytical coverage as possible on their clients’ holdings. As mutual funds are completely discretionary they can more easily add new names with appropriate research coverage.

Travel Cuts Too

Within 24 hours I flew in the business class section on an 80 minute flight going back and forth from Munich to Nice. On each flight there were people dressed in investment clothing of bankers and family office types carrying financial publications on the way to and from Monaco. In each case the business class section was less than half full. This may be normal German tight expense control particularly on such a short flight, but I had the impression that this was something of a new experience for them.

 Investor Opportunities

In Monaco I was the keynoter for an investment conference where there was only one representative of a major bank. The decline of major bank research and conference/sales participation may be an opportunity.   I think small cap buyers will have fewer competitors in finding good investments as these companies are the major contributors to domestic job growth.

This Week’s Concerns

There are a number of topics that I will be working on during the shortened Thanksgiving Week, as follows:

1. Trying to understand the dichotomy between favorable indicators for the stock market and cautionary signs for the bond market; e.g., a sharply falling Barron’s Confidence Index (an inverse indicator for the stock market) VS.  best quality bond yields dropping 14 basis points. This compares to only a 5 bps decline for intermediate credits, a widening of High yield spreads, a dearth of ratings upgrades and low reported core revenue growth.

2. In a reaction to some negative to flat performance results around the world, except in Japan, many marketing driven managers are becoming advocates of alternative investing. While there are a few quite successful practitioners, most are not producing significantly positive results and those that are garnering returns are doing so below the funding needs of their fiduciary accounts.

Disaggregating the performance of these groups may be a useful exercise. In the week ending Thursday the average US Diversified Equity Fund gained 1.32% with none of the alternative fund averages doing as well. This may be explained either by their total expense ratios being higher than the average funds or the fact that some of their extreme tactics are not working; e.g., 161 Dedicated Short Biased funds fell -3.22%. Some alternative funds may use leverage to magnify their results, 194 Equity Leveraged Funds gained 3.52%. For the year to date the short funds declined -7.47% and the leveraged funds dropped -6.75% as compared with a minuscule loss of -0.12% for the US Diversified  group and most alternative funds producing less than plus or minus 1%.

Question of the Week: What are your thoughts on the two topics above?

Thankful Harvests

As we move into the traditional harvest season, Ruth and I celebrate our blessings with family and friends on our Thanksgiving. This year we will be particularly aware of those less fortunate and particularly those who have lost dear ones through the violence of the last week.

Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, November 15, 2015

No “All Time” Growth Stocks Exist
IBM: Yesterday’s Apple


My blog post of November 1, 2015, was entitled “Rising Earnings Do Not Make a Growth Stock.”  In keeping within the topic of looking for sustainable growth, being a confirmed contrarian is useful at times like this when I search for a contrary value. Sometimes this approach produces good results. At the moment many people are giving up on growth investing in general but chiefly in healthcare, tech (particularly Apple*), China and other emerging markets and many consumer goods/services companies.

*Held personally and/or by the private fund I manage

Many of today’s portfolio managers and most individual investors don’t know during my investment lifetime there was one very prominent growth stock that was the Apple of its day, International Business Machines or IBM. In last week’s blog post I suggested that critical investment and business management courses could be focused on Berkshire Hathaway; I believe every investor who is going to devote a significant portion of his/her portfolio should also have a course on IBM. (This thought was triggered by a lengthy article in a Sunday New York newspaper on the company’s attempting to a bring a style focus to its products. As usual with this paper it was an incomplete piece which neglected to track the major shifts in how IBM’s shareholders have viewed its stock over time. The change of their attitudes mirrored many of the changes in the operations of the company.)

A Personal Note 

My Grandfather who led his own brokerage firm for the first twenty or so years of the 20th century told his grandchildren about being one of the few outsiders other than company executives to attend a dinner with the then CEO Tom Watson and many of his family who were placed at each table. My Grandfather was not a security analyst, (at that time called statistical people), or a technologist of any type. He was impressed with the reported growth of the company and was impressed with Mr. Watson. On the basis of this appreciation and friendship IBM played a prominent role in many investment accounts for my family. When my brother and I became professional investors, we urged with some trepidation that the oversized positions be reduced as the market had placed a higher value on IBM’s growth than we did.  At the present time I don’t directly own any IBM and it is not a prominent position in our much larger investments in mutual funds. Perhaps, as the company evolves to more of a service company we should own the stock, but I hope more of our growth oriented mutual funds take positions in IBM.

I have had three other interactions with IBM that colored my evolving views on the company. The first was that while in the US Marines (as often the case in training as one of the smallest Marines) I was assigned to carry and fire a Browning Automatic Rifle (BAR). It was the only automatic weapon the infantry squads carried. It was considerably heavier than our usual rifles particularly with its ammunition. During World War II IBM converted its factories to war production including BARs.

The second interaction was when I was setting up my performance analysis service, I wanted to have our own in-house computer rather than continuing to rent time on a trucking company’s mainframe. Not surprising  my computer associates talked me into going on the waiting list for the IBM 360 computer. Perhaps as part of the sales effort I was invited to spend close to a week at a school for IBM clients which was very interesting in terms of theory and a tour of its manufacturing line. (I must admit that the most long-term benefit of the school was for me to get to know the soon to be president of a client who was executing a major turnaround of a slowing great old name in the mutual fund business. He succeeded.) After returning from the school I was as usual impatient to move ahead and not wait six months for delivery. So I cancelled the order and had a Wang (which was good for us) operating within a few weeks.

The third interaction was that IBM was using our mutual fund data within their domestic pension operation. The domestic side did not control the retirement activities for the foreign affiliates. The domestic people asked whether we could help with providing statistical guidance for the separate foreign plans. At that time we had too little that we could do to help them, but the request reinforced the need  for non-US fund data in my mind. This in turn led to opening of offices in London and Hong Kong and the eventual sale of the data operations to Reuters Group. All of these interactions demonstrate to me that IBM is a multifaceted jewel that has been evolving for 104 years and like the blind men feeling the elephant, each interaction is informative, but incomplete.

A Brief Financial History

The original people of IBM came out of National Cash Register and formed a punch card reader and related products producer. The company that they formed had more debt than equity when it was publicly traded. Thus IBM started its financial history as what was then called a “watered” stock. We would call it junk. (The term ‘watered stock’ came from the stock yards where cattle were bulked up through large consumptions of water.) One of the functions of the punch card reader that was the company’s initial main product was reading punch cards of employee hours. Thus at one point it is possible that IBM was the largest clock producer in the US. During the Depression era the financial conditions were so stretched that the company paid its clock repair people partly in company stock. Years later some of these workers had multi million dollar portfolios for repairing time clocks. During WW II as much as possible the company’s manufacturing base was converted to war work. During the war some of IBM’s research was on the beginnings of the computer. Initially Tom Watson was not a believer in its commercial development. He is quoted in 1943 as saying, “I think there is a world market for maybe five computers.”

As shown in last week’s post on Berkshire Hathaway, analysts need to pay attention to legal, accounting and tax elements. IBM conducted its foreign activities in IBM World Trade which for a number of years was not consolidated fully into the company’s financial reports. Many of us analysts performed this task, including calculating the overall tax rate. One of the mistakes many early analysts made is that they thought of IBM as a manufacturer. In truth most of its revenues after the War until relatively recently were from leasing computers directly to ultimate users or third-party leases. Due to length of the leases one could project with a high level of certainty what future revenues would be. The leasing activities were helped greatly soon after the War ended.  Prudential loaned IBM at that time a very large $100 million for at least one hundred years. Thus IBM which was in effect a finance company, but was viewed as a leading institutional growth stock with a high multiple.

By the time I came to Wall Street in 1960, IBM was probably the single largest holding in most trust-quality portfolios. (Hence my family’s over commitment to the stock.) The company had competitors including Sperry Rand which had major support from General MacArthur for use in re-building Japan. None of the other competitors had IBM’s installed base of leasing revenues so they competed on both price and technology. Often the competition came down to IBM’s image, financing, and a good sales force against lower prices and faster machines. In addition, IBM’s sales force included sales engineers, think of Ross Perot. In response to the competitive pressure, the firm bet its future on a new computer system the 370 which eventually succeeded, but with lots of additional expense which hurt the relative stock price. Over time the fall in the stock price was halted by the dividend yield.

Thus over its history the IBM stock was viewed as an extremely leveraged speculation, an essential business manufacturer, a high quality growth stock, an income stock, and a turnaround candidate.

What Makes a Growth Stock

In essence a growth stock is a stock that many market participants will trade higher into the future. This is usually expressed as earnings per share growing faster than the market.  I take a different point of view as follows:

1.  All growth is cyclical and for some future periods each item will under-perform.
2.  I am not interested primarily in statistical measures. I am primarily interested in growth...of my capital.
3.  Combining the first two points I want to own value stocks that become growth stocks and growth stocks that become value stocks.
4.  To accomplish these goals I have two valuation metrics. The first is the long-term prospect of dividend growth. (The only reason for buy backs is to benefit management with their short-term employment contracts and remove some of the takeover target value.) The second metric is the strategic value of the company to a knowledgeable buyer.

Why is Growth Important Now?

In these posts we have introduced the Timespan L Portfolios®. We will need to populate at least half of the Endowment Portfolio with Growth investments, and even more in the Legacy Portfolio. As of the twelfth of November the only major mutual investment objectives both US and non-US showing positive performance are growth funds of varying market capitalizations; Large-Cap Growth +4.9%, International Small/Mid-Cap Growth 4.34%.

Globally the current job imbalance is reinforcing the focus on the lack of qualified workers to fill existing jobs. This indicates that there is a growing replacement of labor with capital, in part evidenced by machines. According to a recent advertisement by Fidelity, 80% of global GDP comes from non-US countries and only 26% of the world’s publicly traded companies are based in the US. Further a Bank of England economist suggests that up to 50% of the existing jobs in the UK could be replaced by smart robots in the future.

As a global society we need to support growth as a way to solve our growing employment problems. I wonder if the murderers involved in the dastardly attacks in Paris would have chosen a different approach to life and death if they were employed in a growth sector. 

Did you miss my blog last week?  Click here to read.

Comment or email me a question to

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, November 8, 2015

The Many Lessons from Berkshire Hathaway


Earlier this week I felt like I was accused. In a message from an investment committee colleague who is a retiring senior officer of an institution I was thanked for being a teacher to him. This upset me because I always wanted to be with the “good guys,” the students. For I believe I am a lifelong student of human behavior, particularly in terms of investments. In that search I am always looking for sources of knowledge and wisdom. One of the lessons I learned from my otherwise much too liberal education was that the Bible is more than an inspirational document about morality. Selective chapters and verses can provide lasting insights into economics, agriculture, military tactics and strategy, training, law, sociology, psychology, management development, and leadership among other lessons.

In a similar fashion, a continuing study of the ever changing Berkshire Hathaway can be very instructive as to how one should lead his or her investment life. As a long-term owner of the stock both in a private financial services as well as personal accounts, I attempt to read almost all that is published on the company. I am not totally successful as the amount published by the company is voluminous, including various commentaries by its twin leaders Warren Buffett and Charlie Munger. It is popular with some “arm chair” critics to cast doubt as to the current wisdom of various moves that the company is making on numerous multi-tiered chess boards.

The purpose of this post is to share with our community what I learned in reading just one document. Almost all of my comments come from reading and thinking about the 45 page 10-Q document filed with the US SEC addressing the third quarter of 2015. Please do not interpret this as a recommendation to buy the stock which would only be appropriate after a thorough understanding of one’s current portfolio, time horizons, and views. However, it is a recommendation to various colleges and graduate schools to use a study of certain aspects of the company including accounting, contracts, global economics, management approaches, personnel and personal development, insurance risk management, financial and economic history and developing a long-term, loyal shareholder base. 

Financial Services

While it is much more, Berkshire Hathaway is essentially a financial services holding and portfolio management company. For the quarter 80% of the revenues came from insurance and other related sources. This simple title covers many different activities. It is somewhat like celebrating a winning horse without recognizing the contribution made by the jockey, trainer, breeding and ownership elements including many whose names we do not know. Some may downplay its contribution, for in the quarter as insurance underwriting contributed only 9% of operating earnings. What they are missing is the generation of insurance float which at the end of the quarter stood at $86.2 Billion up $2.2 Billion from year-end. In many ways this is the single most important figure in the financial statement. The float was essentially the source along with operating cash flow that led to a $133 Billion investment portfolio housed within the insurance complexes. For those of us who grew up within the brokerage community, float represents margin debt without interest cost. If one applied all of the float to the total net assets of the company one could take a somewhat exaggerated position that the company is 33% leveraged. However, the key value of the float is as excess capital that can be applied in a matter of hours as part of, in essence, rescue missions for sound, high quality companies that need cash and Berkshire’s imprimatur and are willing to pay preferred dividends or interest way above markets rates plus equity “kickers.” These companies have included GE, Goldman Sachs*, Bank of America*, Dow Chemical, Mars, among others.

Insurance is not the only source of financial earnings for Berkshire Hathaway. If one looks through the activities of its railroad, utilities, and energy, the objective is to convert its own and others capital through operations into financial gains that are soundly leveraged. In the third quarter these activities produced 18% of total revenues. Finance and financial products represented the rest of the revenues even after a $764 million believed to temporary loss in derivatives

Messer’s Buffett and Munger clearly believe in the long-term attractiveness of financial services investing, which reinforces my personal biases. (Friday saw bank stocks rise sharply, with JP Morgan Chase* up 2 points on almost double the volume of Thursday, perhaps its timing is right) Berkshire has devoted some $ 48.9 Billion to financial services stocks with 74% in Wells Fargo and American Express. It believes in well chosen concentration; including the two mentioned above, some 58% of its equity investments are in just four stocks. The only one of which is showing a loss against purchase price is IBM which is down some $2 Billion from a cost base of $11.7 Billion.  Not being a registered investment company it is treating the decline as temporary and not writing down its value. (This option is available to private investors and not registered participants and could be a useful approach as long as the investor is highly confident of recovery to purchase price. While I might like to do this personally, I am afraid my clients’ financial people are more interested in immediate liquidating values to meet their funding obligations with money to spare.)

*Held personally and/or by the financial services fund I manage

In a somewhat different situation in terms of Tesco, Berkshire took a write down of $ 678 million, but did not sell the stock which shows that it lost faith in the ability to get back to purchase price but thought that this summer’s prices were unnecessarily depressed. Looking at fourth quarter UK prices Berkshire may be able to salvage some of its admitted loss.

Viewing Berkshire as a Source of Investment Inputs

I found the following nuggets useful to aid my broader investment thinking. I will be happy to expand upon any of these with our regular subscribers.

After a super-heated second quarter, I was not totally surprised that the summer proved to be slow for many of the operating activities. What did disappoint me is that in many of the financial activities sales slowed materially more than seasonally. This slow-down hit our financial services stocks particularly in the asset management business.

Luckily for Berkshire the big bet on Kraft Heinz paid off with the carrying value of this common stock, including additional investments, jumping to $15.8 Billion from $3.95 Billion at year-end. The characteristic boldness of the management is a hallmark of the way it understands the importance of moving decisively when opportunity knocks looking for massive capital deployment.

As predicted by Mr. Buffett, the reinsurance business has fundamentally become less attractive due to excess capital being deployed by new entrants into the business who are lowering premiums. For the nine months Berkshire Hathaway Reinsurance Group saw its underwriting gain drop to $247 million from $617 million for the prior nine month period. Once rates move back to attractive levels they are likely to return to the leadership of the big ticket business. The General Re subsidiary has analogous experience, dropping to $ 58 from $322 million operating gains in the same periods. The ability to tolerate these cyclical swings shows the benefit of the overall financial strength even with GEICO suffering a sharp increase in accident claims in the first half of the year ($213million vs. $746 million) before level results occurred in the summer driving quarter. One of the acknowledged skills of the company’s activities is risk management. In the long run it seems to know which risks the company should take. For example, it will undoubtedly turn the $130 million insurance property loss in China this year to higher revenues next year with substantial rate increases.

As part of its large diverse holdings of operating companies, managers are responsive to problems as shown below:

1. In response to a 37% decline in NetJets, it paid penalty fees for canceling aircraft purchase orders.
2. Sale of unprofitable operations within Fruit of the Loom.
3. One of the transportation companies is in the business of leasing cranes, the decline in the US business was being offset by gains in Australian infrastructure gains.

One of the reasons I believe that a study of Berkshire is appropriate for many MBAs is what they can learn from studying both the company’s mired accounting policies and capital development. In the first case the company made two $1.7 Billion acquisitions this year. In the first the Van Tuyl Group, now known as Berkshire Hathaway Automotive, will amortize the purchase goodwill. (The timing to participate in both the shrinking of the dealer community and getting close to peak annual auto sales seems good.) At the very same time it bought AltaLink a Canadian distributor of electricity which Berkshire will not amortize the purchased goodwill. By definition these two acquisitions will produce significantly different booked returns even though economically they perhaps should be similar.

The final revealed tool in Berkshire’s tool kit (which most investors are not aware of) is the ability of Berkshire to swap some of its security holdings which have appreciated in price, for some very specific operating subsidiaries of that company. This is a classic example of swapping investment assets for operating assets. I suspect that not only are these transactions tax free, but the new operating assets will be carried at the original costs of the transferred investments. This is another example that the stated book value of $151,083 for each “A” share is vastly understated under any reasonable liquidation program. To my mind the 20% premium that Mr. Buffett has suggested for buybacks would be a real bargain.

Bottom Line

I opened this post with an initial view of the Bible as a good teaching device for many subjects. However, in the end to be completely accepted it requires a good bit of faith. Because of the creativity and brilliance of Warren Buffett and Charlie Munger and the complexity of their structure and accounting, a somewhat similar level of faith may be required.

Question of the week: Will you share what lessons can be learned from a study of Berkshire Hathaway?  
Did you miss my blog last week?  Click here to read.

Comment or email me a question to

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of

Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.