Sunday, April 13, 2014

Shallow Investment Pitches Lead to Strike Outs

Book value may not be valuable...Changes in reported earnings per share is not growth...Putting into practice fund selection...Where are we now?


I am focusing today on the kinds of “elevator comments” that one hears in the lift (to use the British expression) designed to lead to a purchase of particular stocks or funds. Often the pitcher is pushing growth or value securities based on published corporate numbers and current prices. Some of these pitch people earnestly believe that given a simple numerical relationship and current prices is all that an investor needs to know to make a good decision. These are very much the kinds of people that Benjamin Graham and David Dodd warned about in their seminal tome Security Analysis. At this particular time in the market investors are weighing what to do following what has been successful tactics of buying on dips. Or in contrast, using any rally as a good time to lighten up their portfolios. They should judge whether they are happy with the quality of the supporting research.

Book Value may not be valuable

Occasionally one hears that a stock or a portfolio manager should buy a stock or a fund that is selling at prices below stated book value. In our consumer society nothing sells more easily than saying it is available at a discount. All too often what is being said is that the current price is below the last published book value, without any discussion of what comprises book value. Book value, as most of readers know is a single per share number that encompasses the net worth of the company as stated on the balance sheet. The accountant’s job in preparing a balance sheet is to look at the historic costs of the assets purchased reduced by periodic deductions for the use of the assets and to portray the known debts owed to determine the net worth. 

One of the first things that Professor David Dodd taught me was to reconstitute the balance sheet for current investment purposes. This would exclude all elements of goodwill, raise questions as to the immediate value of elements of inventory, machinery, buildings among other items. Further, future liabilities for taxes and pensions (including tenure when appropriate) would quickly reduce the quick sale value of the company. In periods of rapid price changes and accelerating technological changes old assets may lose value very abruptly. In today’s world the costs of bank branches is probably not worth the prices reflected on most bank balance sheets. This is not always the case. One of my successful investments was in a chain of local cigar stores. In Manhattan, where I grew up, in almost every neighborhood  “high street” to use the British term for retail commercial thoroughfares, these cigar stores had prime corner store locations. As tastes were changing, smoking cigars were in a steep decline so were the operating earnings of the company which did not have much debt outstanding. All of the local shops were in long-term leased space.

When the company finally recognized the inevitable collapse of its business, its prime real estate locations were of considerable value so that when the company liquidated the shareholders were richly rewarded. Many current investors are hoping that will be the future pattern for Sears and Kmart. When a stock that has a reasonable following of qualified analysts is selling at a steep discount to book value or for banks in terms of net tangible value, I believe that the current market price for the common shares is probably more representative of value than book or tangible value. On the surface things sell in relation to where they are currently perceived. However, because liquidation is a long process discounts of 25% from book value is not unreasonable for a negotiated multiple year liquidation. Thus, book value to me is the beginning of the conversation in the elevator not the end.

Changes in reported earnings per share is not growth

Besides selling at a discount for book value the other main “elevator pitch” is growth. “This year earnings will be up 15% and more next year, with that kind of growth the stock should sell for at least 10% higher than today’s price,” is the way the story goes. Again a competent analyst will look at the composition of the expected growth to determine the value that should be ascribed to the shares.

In a recent communication to Deutsche Bank’s US fund holders it showed the composition of its expected 2014 earnings growth for US, European and Japanese companies. In the US, they expect a 9% gain with 3% coming from buybacks and no profit margin improvement; for European stocks they are looking for earnings gains of 12%; and 13% for Japanese companies. In each case they are looking for very low buybacks and a 3.4% margin expansion in Europe and 1.5% in Japan. The analyst in me would not give any growth credit for buying back shares which benefits management more than long-term shareholders who would prefer reinvestment into expanding businesses. Thus I would look to a possible growth increment for US stocks, if their estimates hold up, of only 6%. Considering that both European central bankers and those in Japan are trying to introduce more price inflation into their cyclically depressed economies I do not value at face value the expected margin improvement in Europe and Japan. These brief analyses do not show any increase in the level of risk undertaken, but as Jamie Dimon has said and proven, risk is inherent in their business and I would suggest in all businesses to some extent. Further if the economies are expanding risk appetite will likely expand as well. For JP Morgan effective risk management is a top priority I am not sure that it is an equal concern in most companies.

On a longer-term basis earnings growth will be dependent on whether the companies are serving continuously growing markets and the pace of disruption. There are at least two disrupting trends that will change the dynamics of future earning progress. 

The first is the concept of walk up business for bank branch locations. Banks are redesigning their branches into smaller footprints  which will be more sales stores offering assistance with automated devices may be a way to defeat the newer financial organizations which have no branches. A number of formerly retail clothing locations are increasingly relying on the web as their main sales outlet. Both of these trends have significant implications for mall operators. 

The second trend (which will take a somewhat longer time to be important) is the global energy deflation in terms of costs. Not only is this based on the increased use of natural gas but also more productive sourcing of oil and possibly newer forms of energy. This may well be recognized now as utilities are the only major equity sector that is up on a year to date basis, +8.9%. Because much of utility earnings are regulated the lower cost of energy will lead to savings for their larger customers and possibly to their retail customers.

Putting all into fund selection practice

Again I have two suggestions. The first is to address the accounting issue head on. I am sure that there are a number of analysts who are skilled at reconstituting balance sheets and income statements. One that we have used is Charles Dreifus of Royce Associates, a subsidiary of Legg Mason* who regularly takes deep dives into stocks for both his Small Cap and Multi-cap funds. These are funds that are organized for long-term investors.
* Owned by me personally and/or in a private financial services fund I manage

A second approach which we have practiced for some of our managed accounts in building a portfolio of mutual funds is dependent upon a willingness to accept different performance leadership at different times during the cycle. In its simplest form funds are picked because of their value orientation the way a strategic buyer would look at the underlying holdings, for example secular growth funds that utilize the cyclicality of growth around a positive trend, and funds that are focusing on disruptive products, services, and sales procedures. The art form is modifying the weight of the three components based on client risk appetite.

Where are we now?

As regular readers of these posts know I have been concerned about a forthcoming peak market followed by a significant decline. Up until mid March I did not see the elements of a final parabolic rise that I believed was a precondition for a major decline. I was wrong looking at the market in terms of major aggregates; e.g., Dow Jones Industrial Average rather than sectors and subsectors for incredible performances for major over-valuations. There are ten Biotech companies whose stocks are selling 1000 times current sales. Internet retailers are selling at 5.7 times their current stock prices whereas the S&P 500 is selling at 1.6 times current prices according to a recent column by Jason Zweig in The Wall Street Journal. I am using price/sales as a measure to avoid dealing with questionable accounting or the absence of current profits. This last week we have seen a measurable decline in these extended issues. Only future history will tell us whether these price movements are sufficient to declare a peak in the entire market. If we have experienced a top, the fall is likely to be on the order of 15-20% for the general market, not the supposed once in generational drop of 50% or more as we saw in 2008. The key to watch is whether the subsequent recovery picks up volume and speculators who think of themselves as investors start discounting rosy projections for the latter half of this decade. When and if this does happen it will meet the enthusiasm requirement for a peak.

Question for the week:
How enthusiastic are you on your accounting proficiency?

Sunday, April 6, 2014

Signals or Static Perspective?


I can’t avoid thinking like a US Marine this Sunday. We just received the notice of the memorial service for General Carl Mundy who was the 30th Commandant of the USMC and my fellow classmate in Basic Officers Class. As Marines we learned to observe every detail about our surroundings and most particularly about our enemies. As in the battle for investment survival, which requires a degree of investment success, we also need to observe all elements that are visible and look for those that are beneath the surface. We know that each day or week could hold the clues to future actions. The difficulty that I face is separating meaningful signals from day-to-day statistical static. Carl did these well both in battles and in his post active duty service and I will try to emulate his skills.

First quarter 2014 mixed messages

Extrapolating the large gains achieved by equity funds, particularly the Small Capitalization funds with significant holdings first in technology and second in financial services, one would have been prepared for a continuation of these trends. On the surface there were very few surprises in the first quarter based on the financial headlines. Yet the natural order of performance was quite different. The leading performing large asset class was commodities, not across the board but a number of industrial and agricultural goods, in addition to gold and energy had positive results. Under normal circumstances this kind of price behavior would indicate inflation and significant shortages of supplies. But this was not the case as the central bankers were complaining about the lack of inflation to provide economic stimulus that the fiscal authorities were not.

Focusing on the next best asset class for some, which was taxable bonds, the best performing fund group was those funds that had mostly “A” rated corporate bonds in their portfolios with an average gain of +3.94%. They were followed by funds with somewhat lower credit rated bonds (BBB) which gained +3.32%. Somewhat surprising in a period of expansion, the third best bond category was the High Yield or junk bond funds up +2.75%. They normally lead in bullish times as in the last twelve months with gains of + 7.32%. What may be happening is that the wave of acquisitions that were being financed through high yield paper may have created supply bigger than demand. Further, those with a historical perspective may have felt that the yield spread versus the poor performing treasuries was too narrow. All of these results suggest to me that the fixed income and commodity investor was acting cautiously, but was questioning the value of the US government’s paper as well as the reality of inflation production.

The equity funds also sent out mixed and not very strong signals. Of the 31 equity investment objective classifications tracked by my old firm, now known as Lipper, Inc., four produced slightly negative results and five positive results. The losers were hurt by disenchantment with growth regardless of size (Small-Cap Growth -0.47%  and Large-Cap Growth -0.11%). The gainers were led by two traditional bets against the future lower value to the US dollar and/or increased inflation. The average Precious Metals fund was up +12.28% but still down -29.29% for the trailing twelve months. The second best was the Real Estate funds +8.13%. From a macro point of view the most surprising performance was from the average Utility funds +6.69%. This result was clearly better than any bond category. Often utilities are viewed as bond substitutes. The fourth best was Health/Biotech at 6.69%. The fifth best was the Mid-Cap Value funds up +3.14%. The other twenty two equity funds had gains below 3% or under the results for both bonds and commodities.

The ends of March

As indicated in last week’s post I detected a significant change in equity leadership. This change is better defined when one examines the month of March performance. The four worst performers were the Precious Metals funds -7.82% giving up some of their recovery, Health/Biotech funds -5.30%, Large Cap growth -3.22% (all of the growth fund categories declined in March). A good further explanation for their declines was the fall of -2.67%
in the Science & Technology classification.  Science and Technology has driven a good bit of the Growth funds' performance. Clearly the old war horses of the 2013 leadership in healthcare and technology were no longer producing bigger dreams for their owners. The new leaders seem to be very specific in terms of their own merits even though there appears to be greater attraction to value-oriented portfolios (see April observations below). British funds seem to be reading from the same playbook being used in the US.

If one is following the script of an aging bull market the switch to larger caps that have perceived value safety nets beneath them makes sense. However, if the next market collapse proves to be spectacular, we will need to have sudden, sharp, parabolic price explosion on the upside. That kind of performance is normally needed for a 50% decline. Without such a runup, the next decline is more likely to be in the neighborhood of  25% which is not enough to dislodge sound long-term investment portfolios.

Early April flows and ratings pluses

Being indebted to my old firm for flow data,  I can see some interesting cross trends if I parse the data carefully. The traditional equity mutual fund had net estimated inflows for the week ending on Wednesday of $2.2 billion; however $1.6 billion were non-domestic stock funds. This would indicate that only about $600 million was betting along with the Administration that good things are in the offering for the US economy. Some of the money leaving the US may be going to Europe on the basis that Moody’s is regularly raising western European credit ratings, that business is improving and the price/earnings discounts to comparable US stocks makes them attractive. I suspect a smaller piece is going out to buy Asian stocks that are recovering somewhat from their prior fall. In term of investment objectives, the traditional mutual funds buyer put the bulk of their net money in Large Cap core funds which category included index and closet index funds. Some of that money probably came from the $429 million net outflows from the Large Cap growth funds. These shifts were aligned with our prior observations.

What are most interesting are the flows into the ETFs. Their assets are considerably smaller than the traditional mutual funds, but they managed to put more money, $3.2 billion into their equity funds of which $2.5 billion were in non-domestic portfolios. The domestic fund investment benefited from a $941 million flow into a large S&P 500 index fund which appears to be a “parking lot” type of investment, rather than a long-term commitment.

Why focus on mutual funds?

First, mutual funds around the world, according to the Investment Company Institute (ICI) have $30 trillion dollars under management. In many markets they are the most transparent institutional investor. Often some of the 76,200 funds are managed in the same fashion as the other institutional accounts in their shops. Thus an analysis of what mutual funds are doing gives one useful intelligence as to what is happening in both the institutional mind set as well as the general investing public.

Second, I spend most of my working hours focused on the proper selection of funds for clients as well as our extensive charitable activities. Third we eat our own cooking, as we invest in these funds for my family along with a private fund that invests in mutual fund management company stocks and other financial services providers.

My question for the week is:

How prepared is your thinking for the next market decline? Please let me know, for General Mundy would expect me to look at any moving object that was somewhat visible.

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A. Michael Lipper, C.F.A.,
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Sunday, March 30, 2014

Strategic vs. Tactical: Follow the Lines and Spots

Tactical value investing...Was last week a tipping point?...Possible oncoming worries...Mutual funds holders: is your asset allocation correct?...Correction to last week’s post.


Even to this day the academic world presents concepts on a black or white board or perhaps on a flat computer screen. Therefore in our minds’ eyes we tend to translate investment strategies in terms of continuous lines. We know that the objective is to end with more money than we started. Our experience quickly teaches us that there are many lines that can produce the desired result. In an oversimplification we contrast a perfect growth model that starts low and finishes at a peak. The line can be a perfect 45 degree slant or look like a hockey stick, flat to slightly down before an explosive burst that takes the line to its zenith. There are many variations of this plot, but we can label the group as growth oriented.

Tactical value investing

A second set of graphs are designed to produce the same result, but want to avoid the risks of falling off, at least temporarily, the growth curve. In this exercise there is a second discipline beyond finding securities that go up in price and that is the need to buy at a price spot that will rarely lead to a loss. This second approach achieves this goal by buying value at least in current terms and is called value investing. One might call it also tactical in the sense that timing is critical to successful entry points.

One of the advantages I have compared to most managers is that I can invest in what I think are currently the best Growth mutual funds and the best Value focused mutual funds. The key to this decision process for the client/investor is to get the appropriate time horizon correct in mixing the strategic Growth funds with the tactical Value funds. Read further and you will detect the questions that we deal with in attempting not only in getting our fund selection right, but also the right mix of Growth and Value. 

Was last week a possible tipping point?

Short-term performance is normally the equivalent of static on a poor radio device. However, every key turning point starts with a given day or week. Also individual funds can have a somewhat dramatically different short-term performance than their peers which would indicate that the outlier is doing something different. Thus, I am starting to question as to whether we have experienced a turning point. During the week, Value funds were off slightly less than 1%. Most Growth funds were down about 2.5% but Small Company Growth funds were down almost 4%. A couple of our very successful specific Growth fund holdings that were up 40-50% in 2013, declined in the range of 4-5% for the week. There could be individual corporate elements that caused these above-average declines or could it be for some reason certain investors were cashing in pieces of their Growth fund winnings, but leaving their Value focused holdings untouched?

Broadening the question to all equity funds, according to the Investment Company Institute (ICI) the net new cash inflow on a year-to-date basis through February was only $43 billion vs. $52 billion last year. Perhaps, more instructive is the weekly estimate from my old firm which estimates that the weekly net flow into equity mutual funds was $1.7 billion and the weekly outflow from Exchange Traded Fund (ETF) was $2.1 billion. In an oversimplification one might say the mutual fund buyers are long-term oriented riding up the curve of past incredibly good performance and the ETF sellers (often driven by brokers) were reacting to various news items. This dichotomy is also reflected in Friday’s flow of money into rising stock prices on the New York Stock Exchange (NYSE) of $2.2 billion compared to $0.9 billion in declining stock prices; whereas the more dealer oriented NASDAQ market was much more in balance with each side moving $1.3 billion.

If prices become negative this week we may have either seen a tipping point or we have just received some meaningless statistical static.

Oncoming worries

The job of a good analyst is to look beyond the headlines. The market will assess the current headlines, but analysts should look beyond. In brief, I am currently focused on three elements of the food picture. The first is that the preferred inflation statistic the government and the Fed look at strips the price of food and energy out of the consumer price indicator. While these can always be volatile, they usually stay within some bounds. Currently the price of food is skyrocketing, partly due to weather conditions, but I would suggest a continuing conversion of agricultural assets to other purposes. 

The rapidly increasing price of food is putting pressure on all families, but particularly on those with little or no income. Even with the big increase in the numbers of people utilizing food stamps, people are being squeezed. As bad as they are now, they could get worse. Most of us don’t realize where our food comes from and even if it comes from local sources, food prices move on global scales. 

One of the stories not being told about the situation in Ukraine is the plight of the farmers. Even before the hostilities many farmers there were heavily in debt to their suppliers of feed and other materials. Compounding the current problem is that under current conditions they have lost five different ports for their exports. Ukraine is one of the largest exporters of wheat and the odds are that they won’t be able to make deliveries to the normal customers. English translation: the price of wheat on our tables is likely to rise.

The third food related worry is predictions that there is a 50% chance of a series of repeated storms, some of these are known as “El Nino.” If these were to hit this would disrupt food production in India, China, and Latin America all of whom produce food for American and European tables.

Mutual fund holders: Is your asset allocation correct?

I have an allergic reaction to following the crowd. However, in general the way long-term mutual fund assets are allocated makes sense in terms of balancing growth opportunities and tactical value holdings. They have allocated approximately 69% of their long-term assets to equity funds and 27% of that total in consciously labeled Internationally oriented funds. The 69% is down from greater enthusiasm earlier and the international component is growing. I use the term ‘consciously labeled International’ as many so called domestic funds have up to 30% in non-US domiciled companies and some of the remainder are invested in multinational companies that through their foreign based operations and/or exports are serving non-American markets. I believe on a long-term basis this is wise as the relative future of our standard of living is likely to decline more due to greater education, work productivity, and savings than here. Our UK friends have recognized this for years and there are hardly any significant UK domiciled companies that are not globally focused. We are seeing the same characteristics in many European companies as well.

The 31% of mutual funds invested in fixed-income is a bit of a problem for me. There are two reasons to own fixed-income securities. The first is to generate necessary income that is not available from other investments. The second is as a strategic reserve if the equity portion falls dramatically. My problem is one of timing. At some point in the future the interest rate repression of the major global central banks will ease up and perhaps terminate. Interest rates will then rise to a level that recognizes both the deterioration of purchasing power of current money and appropriate payment from undertaking credit risk. At this point, if not before, bond prices will decline, damaging the strategic reserve value of fixed-income. Some fixed-income holders would be better off converting most if not all of their long-term fixed-income positions to well chosen dividend paying stocks and funds. If the current income is insufficient to meet current prudent expenditures, the law now recognizes that total return, including stock price appreciation is an appropriate source of income. Some bonds and other credit instruments that have equity-like characteristics, including risk of loss of capital, could be substituted for long-term high quality bonds as long as the investors recognize that the central banks have coerced them to take more risk.

Correction to last week’s post

There was an error in some editions of  last week’s post relating to my discussion of applying the “Rule of 72” to how long it would take to reduce by half (instead of all) the spending power of  principal amounts through the application of a 2% inflation rate. The correct answer is 36 years.  I thank the sharp reader in the UK who called this to my attention and I appreciate the notice of where I make a mistake of thought or proof-reading.  

Question of the Week: for you to ask yourself and perhaps share with me, so that we both can learn:

How are your assets allocated and where would you like them allocated at the end of the year and in five years?
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.