Sunday, October 19, 2014

The Failure of Investment Failures


This past week I had several opportunities to chat with Tom Rosenbaum, the new president of Caltech; in one session he asked for suggestions as to what additional subjects should be taught. I suggested a course that covered most of the world’s major scientific failures. My thinking was that there may be a common theme to what has gone wrong. I later realized that this was a half-baked idea. On the one hand the very nature of most scientific discoveries is through experimentation. Some scientists however keep changing various elements until they get the result that they want to achieve or recognize that what they did produce is surprising and a good but unintended result. What is often missing from this application of the scientific method is that there is no attempt to learn from what went wrong or at least what did not turn out as expected. 

In the investment world we also examine why something doesn’t work out as expected. As many regular readers of these posts are aware I believe that essentially I learned security analysis at the race track. In some ways my most valuable time (after not cashing a winning ticket) was spent re-examining the prior records of both the winning horse and my losing bet as well the actual racing conditions. I often found that I had overlooked some critical set of facts and my expectations were sadly out of kilter. I humbly suggest that the 2014 investment performance through this week gives scope to look at a number of investment theories that have not produced the expected results. We should not fail to learn from these failures.

Friday's failures

After a week of significant global stock market losses, on Friday the Dow Jones Industrial Average (DJIA) rose +1.63% easily beating gains of +1.29% for the Standard & Poor's 500 and +0.97% for the NASDAQ. I believe the message from this data is that more of the gain was achieved in the indicator with the smaller number of securities which would demonstrate to me some lacking of enthusiasm for most securities. This view is reinforced by looking at one of the DJIA components, JPMorgan Chase*. On Wednesday the stock hit its low for the week at $54.26, on 37.9 million shares. On Friday the stock closed at $56.20 on 19.5 million shares or little more than half of its high volume day.  Don’t look at Friday’s rise as the beginning of a major recovery.
*Owned by me and/or by the financial services fund I manage

A number of my market analyst friends suggested that the pickup on Friday was to correct a significantly oversold condition and represents a sales opportunity rather than a buy opportunity. This pattern is present in numerous countries' stock markets. Those focusing on the US expect another test of the recent Standard & Poor's 500 lows. Nevertheless they perceive a good chance for a substantial rally in the winter; but a failure to go to a new high in late 2014 or early 2015 would suggest the potential for a major decline.

Mis-reading fund flows

Many market participants jump on aggregate net fund flow data to ascribe a level of demand for stocks and bonds without understanding the broader implications. First, the published data is often based in part on the net differences between fund purchases and sales. To me there is an analytical difference between a $10 Billion net inflow made up of gross income of $11 Billion and gross redemptions of $1 billion compared to a situation when $25 Billion is incoming and $15 Billion is leaving.

Further some analysts add the flows of Exchange Traded Funds (ETF) and conventional mutual funds together. There are two problems with their approach; the first is mutual funds are typically owned by individual investors directly or through financial  institutions that are long-term in nature, like the accounts that we manage, whereas many ETFs are owned by hedge funds and other short-term trading accounts. In the week ending October 15th, $17 Billion were invested net into equities by the ETFs. Of this, approximately $12 Billion were invested net in S&P500 ETFs. The analysts at my old firm Lipper, Inc. believe that a good bit of this inflow was created by the authorized participants who are largely brokerage firms and other institutions who offer these shares to short sellers in exchange for the interest earned on the short positions. The net effect of this activity is that a major portion of the supposedly supporting purchases to the broad market are betting on a decline.

US fund investors redeem domestic funds

For the last six months fund investors have been redeeming US oriented funds and buying International funds except those that focus on European investments. I believe that fund investors like much of corporate America are concerned about the near-term future for the country. The failure is to treat fund flows as a single-dimension.

Poor economic analysis

I write this post from Washington, DC, where the US Congress sits in the Capitol, a building whose inhabitants usually do not understand capital and the need to make it.

Some want to stimulate through throwing taxpayer money on infrastructure and other ways to fuel the US and other global economies. What they fail to understand is the only economic quantity that is of commercial concern to many of us is the opportunity to make money for beneficiaries. Both cash and credit are in surplus. If the politicians really want to invigorate the economy they should reduce the burdensome bureaucracy.

What are your investment failures?
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Sunday, October 12, 2014

Investment Survival Lessons


In an accelerating world, I find it necessary to always be learning. I hope to learn from almost every exposure I have. This week’s post is based on three inputs to my investment survival orientation:
1. Future vs. History
2. Markets vs. Economies/Governments
3. Levels of Patience Required

Future vs. History

In an always insightful column in The Wall Street Journal, Jason Zweig interviewed Professor Robert Shiller, the Nobel laureate in economics and the developer of the “cyclically adjusted price/earnings ratio” or CAPE. In the interview there is a particular bit of wisdom for all of us who are condemned one way or another to predict the future. Professor Shiller stated while the current level of CAPE “might be high relative to history, but how do we know that history hasn’t changed?” Asking the question is the wisdom not my answers. There are at least two reasons to believe the certainty of a top of a market.

The first reason is that we live in a very dynamically changing financial world. This is not the first time that governments and their central bank servants have been manipulating interest rates or modern day money; from the ancient times kings reduced the amount of gold and silver in coinage. Add to this that the trading markets have changed due to the use of capital restrictions, markets fragmentation, increased use of lightly capitalized derivatives and the communication of investment methods.

The second reason to question the utility of C.A.P.E. or any Price/earnings ratio measure is my training at the race track. When asked, the wagers who were putting enough of their money on a particular horse that would make the horse the favorite they would focus on one statistic almost to the exclusion of any others. (Favorites typically win only about 1/3 of the time.) With this as a background, you can sense my apprehension when entering the analytical business where the need was to quickly convey brief reasons to make an investment decision through the use of some term or label with the caveat that people would fully understand the limitations, construction, and the past record of misapplication.

Since almost every argument to do something in the stock market relies on a P/E ratio, I am increasingly suspicious of its utility. I prefer to understand operational revenue and pre-tax “pre-other” income growth. In addition, I look at net cash generation after debt service as comparative measures before focusing on an evaluation of management to handle future opportunities and problems. Further, because of changes in accounting reporting policies, in many cases earnings a few years back might look very different than today’s version. The calculators of C.A.P.E. use reported data for the S&P 500 companies which is just not good enough for me in the fight for investment survival.

Markets vs. Economies/Governments

While I am very sympathetic to Professor Shiller’s concern that history is not an absolute guide to the future, I do pay attention to technical market analysis. I have received separate, thoughtful warnings from analysts based in Chicago, New Jersey and London using individual tools and data that we are heading into the late stages of a long bull market. They seem to agree that it is likely that the current “correction” will be followed a rapid rise led by the late stage large-cap stocks. Nevertheless, one analyst has supplied some S&P500 benchmarks in terms of downside risks as shown:

a) 200 day moving average: 1905, breaking down from this level could bring more selling;

b) Down 10% from recent top: 1810;

c) Down 20% from top similar to 2011 or a cyclical decline: 1610;

d) Down 33% a la 1987 crash: 1350.

As frightening as these numbers are, they do not include a once in a generation decline of 50% which could take us below 1000 as compared with today’s level of 1906.13. The nice thing about market analysis is that you do not have to know what causes people to sell, just that they are selling in increasing volume and there is not a lot of incentive to buy. All three analyst sources have noted the deterioration of numerous global markets; e.g., German DAX is down -12.4% already. These market participants sense future problems that the various major governments and their central banks are not addressing. Perhaps the markets are suggesting that the Emperor is marching naked. 

Current moods of business people and investors are much more cautious than national statistics would indicate. One example may be helpful, Large Cap Growth stocks were up +2.21 % in the quarter vs. -6.39% for the much more economically sensitive Small Cap Value stocks. To show the importance of volume, on October 6th the stock of T.Rowe Price* closed at $78.14 on NYSE volume of 872,860 shares. At the end of the week the stock closed at $75.35 on volume of 2,643,245 or close to 3X the earlier day. The interpretation is that the firm’s income will suffer from lower assets under management due to market decline and fewer net sales.

In terms of investment survival I pay attention to the market analysts and have adjusted most portfolios that have a five year or less time horizon to be more cautious. However, each of these bright market analysts see that we are setting up in the long run a major expansion of stock prices and somewhat higher interest rates to which I agree. But this could be delayed by the political forces utilizing inaccurate data trying to create a recovery rather than seeing that they are a main cause of the current malaise. We may need new global leadership.

Levels of Patience

An advantage that I have is owning a large number of stocks of financial services companies either personally or in a private financial services fund that I manage. Thus this week I attended an Investors Day for Jefferies, which is now owned by Leucadia*, and is owned in our fund. In one way this has been a good holding in that it is up 143% since purchase years ago. In another way it has been a disappointing holding for the last 18 months with the merged stock just about where it was on the day of the merger. Luckily other holdings did better. However, in terms of lessons it may be worth a great deal.  My reason to continue to hold the stock is that I saw it as a unique player in a rapidly changing investment banking and institutional brokerage business with a largely attractive merchant banking portfolio, a significant net operating loss carry forward and new capital resources.
*Owned by me personally and/or by the financial services fund I manage

What I was counting on was the continued regulatory pressure on the major banks and their investment banking activities in terms of their use of their capital. I was further counting on a significant a number of successful investment bankers and other highly trained technical people seeking employment with an organization that could materially increase its market share through their efforts. Where my analysis was faulty was that these changes would have effect much more quickly. What I should have recognized is that it often takes two to three years for the investment bankers to bring in more revenues than their cost.

Judging by their underwriting and deals success many of the Jefferies bankers are on the verge of becoming profitable to the firm. I should have been more patient to see the expected improvement. It was easy to recognize the pressures on the majors and the deteriorating service levels throughout many of the organizations. This is why I suggested that currently one might not open new bank relationships due to pressures throughout the organization. I thought these pressures would immediately translate to more and profitable business to the non-bank competitors. It didn’t happen on my schedule thus I am reluctant to suggest purchase at this time. I will have to see not only operating earnings coming through, but also a steady decline in Jefferies compensation ratio.

PS: Last week’s suggestion that some of the money planning to leave PIMCO should consider reducing its allocation to bonds may be happening in that the flows this week into money market funds were unusually high. I would hope as equity ratios decline because of falling prices and other disappointments that new capital can be prudently introduced into expanded equity holdings.

Perhaps, once again I need to be more patient.

PPS:  Bloomberg Television Sunday night is showing a weak opening in Asian markets which followed a report from Business Insider that the Dubai Stock Market index fell 6.5%. Be cautious and do not try to catch a falling knife.

Question of the week: Do you have plans to increase your investments in stocks?
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Sunday, October 5, 2014

Bonds Equal Risks


In all of the PIMCO/Bill Gross excitement and speculation about what money will stay and what will go where, no one is asking whether some or all of the money should exit the bond arena. By self-appointment I am asking the question both as a professional investment manager and a member of a number of significant investment committees. There seems to be a fundamental belief that once serious investment money is devoted to bonds one can change managers, durations and credits, but the allocation to bonds is almost sacrosanct. I believe as Socrates believed, "The unexamined life is not worth living." My proclivity is, almost child like, always asking why.

The classic reasons to own bonds

Bonds are a contract to pay interest and principal in a timely fashion. Thus no uncertainty about the future. Bonds provide income which can be spent or reinvested (particularly in open-end mutual funds). Historically bond prices move inversely to stock prices. Bond prices rarely go down.

The Siren pull of Bonds is Global

Ever since the bottom of the stock market, if not before, individual investors and many institutional investors have been adding to their bond holdings at a much faster rate than the appreciating equity holdings. I see this rush throughout the mutual fund world in almost every country that has a sizable bond fund market. While the rush is understandable for those who suffered equity losses by selling in the decline or seeing their wealth on paper shrink, nevertheless, I find any stampede a bit scary.

While I don't often agree with the SEC, I was heartened to read what SEC Commissioner Daniel Gallagher said in a speech to the Securities Traders Association in reference to the $10 trillion US corporate bond market. Commissioner Gallagher said "It clearly looks like a bubble." He indicated that roughly one quarter of the total is owned directly by retail investors and 73% of the $3.2 trillion of outstanding municipal debt is owned by "small investors." I don't know whether the Commissioner's numbers include bonds owned directly in open and closed end funds, defined contribution plans and variable annuities. My sense is that direct and indirect holdings of debt issues represent ownership of over half by individuals. He felt that in their chase for yield they did not stop to understand the risks of what they owned.

Commissioner Gallagher made another important point which was in 2008 the average daily trading was $1.04 trillion and in 2013 dropped to $ 809 billion. I believe trading has constricted even more in 2014 due to government regulations restricting the size of inventories that major banks and broker/dealers can own in their market making activities. Greater demand and smaller capital bases are likely to lead to an increase in bond price volatility.

On a temporary basis, Money Market funds appear to be a resting place. Weekly numbers on flows into Money Market funds seem to be growing at a rapid rate this week through Wednesday, according to Lipper, Inc. my old firm. I find this encouraging on two fronts.

First, the former owners of PIMCO funds may be reassessing where they should invest. (I would hope that they will reduce their bond investment.) Second, investors have not been scared off in using Money Market funds despite the SEC's misguided attempts to prevent a run on these funds. (They actually made a run much more likely, I fear.)

What are the risks in bonds?

The first risk is that high-quality bonds can go down in price. Over the last 15 years the Barclays Bond Market Index fund on a capital basis fell in six years or 40% of the time. Please note that this calculation is ignoring the income produced. Unfortunately, most bond investors utilize the income produced for their spending needs. They are ignoring the fact that with long maturities issues, the reinvestment of the interest in the then current interest rate market can produce more capital than the eventual return of their principal when it matures. A slightly less foreboding view can be had at looking at the last 40 quarters for the Vanguard Intermediate Term Investment Grade fund where it declined on a total reinvested basis 12 times or 30% of the time.

Second, the potential gains of investing in high quality paper is not going to be large enough to restore the starting capital of a balanced account with at least 50% in general equities.

Third, there isn't much if any room for interest rates to decline and therefore add to the value of existing bonds. At some point the manipulation by the major Central Banks can not ignore the misallocation of capital to higher credit risk issuers which will lead to lenders demanding higher rates. My guess is that this will happen sooner than the governments are expecting.

Fourth, the traditional concept behind a balanced fund is that when stocks periodically decline, bond prices will rise as governments will force interest rates down. In a major way this can not happen now. Bond prices and stock prices instead of being inversely correlated will move in the same direction, but at different momentums.

Fifth, the bond investor craves certainty. However, we are living in an uncertain world. I believe that we are going to be surprised by one or more changes listed:
·       Inflation
·       Tax Realizations
·       Contracts abrogated by courts and governments
·       Unforeseen crises which change cash flows

Sixth, a popular measure of risk is, how much can I lose? With bonds there is, perhaps, for an investment manager, a bigger risk. Bonds are essentially contracts and they are expected to perform in a specified manner. If they don't for any of the identified elements listed above, the expectational gap could endanger career risk for the manager.

The weakness of "My Word is My Bond"

I grew up in a world where stock exchanges were run by their member communities which enforced personal verbal contracts. You did not have to like the counter-party to a trade but you believed that the counter-party was good for his or her contract. The community would not tolerate any breaking of the contract. Under the current environment I hope and believe that my word is taken as acceptable. With what is happening today I don't know that I would have the same reliance on someone's else’s bond!

Note that this post is solely devoted to bonds. For our readers who are much more interested in stocks, I will, on request, be willing to share a portion of my September report on our private financial services fund which comments on three holdings of current interest.
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Copyright © 2008 - 2014
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.