The long term history of making money in the market does not follow the majority with their money. Simply put, choosing not to conform to what others are doing.
Winning in the market means converting some of the wealth of others, often the majority, to our own. This maneuver requires the use of different approaches and tools than others use.
Sector bets do not produce the best results
The academic course in Securities Analysis is taught as a complementary course to accounting, or worse, macroeconomics. Both run on past history and have very little to do with future movements of companies, stocks, or economies. More useful studies would instead focus on earnings and securities.
Too often, stock selection processes seek out companies that appear to belong to the same industry, as measured by misleading government data. As a junior analyst, I was assigned to the steel industry. I quickly discovered that although the number of steel companies was small, it was a mix of companies.
You can divide the group based on the location of its headquarters and proximity to critical resources, typically coal, or growing customer base. In this case, one investor did much better with steel-strapped Chicago-based Inland Steel, rather than Pittsburgh and the coal country of West Virginia.
Another noteworthy distinction was the cost and quality of the work. At the beginning of the outsourcing of the production of the wage bill, commercial banks occupied a preponderant place. However, with overtime, they lost market share and eventually lost the entire market to independent payroll service providers who provided better services.
They provided more help filling out payroll tax returns and offered lower prices because their labor was not paid like bank-type overhead. Today’s payroll market is dominated by service companies with extensive and modern IT systems that are good at maintenance. (Our accounts have ADP.)
A final example is that of computers. Most of the big industrial companies made the first computers, the biggest and the best being IBM, a stock that my grandparents owned. The key to their success was not just proper technology, but superior rental prices and excellent sales engineers. IBM’s best salesman regularly showed up on Wall Street and was a missionary salesperson.
However, the industry has moved from massive main frames occupying large air-conditioned parts to desktop personal computers whose parts could be produced in low-cost regions of the world and could be assembled elsewhere.
Dell began by taking customer orders for computers that could be customized and air shipped to customers. Today, many believe that Apple (held in our accounts) is the leading company.
This is the result of the late Steve Jobs’s emphasis on style and ease of use. His most significant achievement, however, was choosing his successor, Tim Cook, a renowned expert in supply management and development.
What relatively few investors appreciate is its global network of Apple Stores and a growing mail order business generating repeat customers, essentially building its own annuity business. (Remember that American automakers had market-level price-to-earnings ratios when customers replaced cars every three years with newer models.)
Some of the less common securities analysis methods include:
- Pay more attention to insufficient supply than excess demand.
- Focus on the differences in manufacturing approaches and costs.
- Understand the personalities of key operational people versus known leaders and their educational biases.
We don’t create winners, losers do
No matter how far-sighted and smart we are, to achieve great results we need others to create attractive entry prices and unreasonably excessive exit prices.
Using them as working hypotheses, I get nervous about the institutional and individual money flow into private equity / debt (private capital).
For many years there were more good private companies offering a stake in their attractive future than there were potential investors. They have attracted investors with relatively low entry prices.
Recently we have seen a reversal, with huge flows of institutional and individual money seeking to exit public markets and enter private markets. By definition, entry prices have either increased directly or companies have had to take on senior debt before generating returns on private capital.
There is so much reversal of traditional roles that one of the oldest buyout companies, with an excellent long-term track record, converts some of its US and European investments into a publicly traded fund. For some of its investments, Sequoia exchanges cash.
One of the worrisome concerns in the retail market is the number of new advisors who have entered the market. They have increased the number of funds and are spreading more investment talent. In response, T. Rowe Price, an experienced private sector investor, purchases an existing manager to secure the talent needed in an increasingly competitive market. (Held in the accounts of the Financial Services Fund)
A number of well-known academic and institutional portfolios have reported performance above 40% for the fiscal year ended June 30. Some are probably reporting private investments at least a quarter late.
I’m assuming the performance for the year ended March was better than the year ended June 30. Most investors have not done as well and as a result some are likely to cram into an overheated private market with scarce investment talent.
The story of ROIs is that it’s extremely rare to find a manager who can consistently return more than 20%, which is roughly three times the growth in industrial profits. Organizations that reported more than 40% profit undoubtedly benefited from lower entry prices and better terms than those currently on offer.
I am a long-time member of the investment committee of Caltech, an in-house managed investment account with talented staff. They capped their exposure to buyouts and venture capital.
I applaud this decision because of the track record of hedge fund performance. It shows that even very good hedge funds suffer when a minority of hedge funds have serious liquidity problems.
This was partly because of debt, but some of their holdings also belonged to business interests desperate to liquidate some of their excessively indebted holdings created by falling prices. This is a classic example of others causing some investors to perform poorly.
Moody’s is also concerned about the rapid growth in the number of inexperienced managers offering private equity vehicles. The credit assessor has been criticized for the exponential growth of CMOs. (Moody’s has recovered, and again this week it was selling at an all-time high. Moody’s is owned by our managed and personal accounts.)
Historical probabilities of a bear market in stocks
There is wisdom in the saying that history does not repeat itself (exactly), but rhymes. The ebb and flow of markets are driven by emotional excesses, with investors responding to various stimuli.
I have already mentioned a pension fund manager who managed to liquidate his equity portfolio after gaining 20% ââin a calendar year, reinvesting the proceeds at the start of the following year. He produced a record without significant losses, with reasonably good gains on the upside.
We may be approaching a “rhyming event”. I feel more comfortable taking a contradictory point of view when supported by large-scale numbers. U.S. Diversified Equity Funds (USDE) have combined total net assets of $ 12.4 trillion, representing 2/3 of total equity fund assets.
According to my old company’s weekly report, the average gain since the start of the year was + 21.01%, compared to a 3-year average gain of + 19.21% and a 5-year average of +16, 76%. More worryingly, only 4 of the 18 separate investment objectives in the USDE category produced annualized growth rates of more than 20% over 5 years.
Of the 14 sector equity funds, only 2 grew by + 20%, and only the average of global sector funds increased by more than 20%. At the individual fund level, only 3 of the 25 largest funds produced growth rates of 20%. Over the same 5 year period, the average taxable fixed income fund gained 3.34% and the average high yield bond fund grew 5.47%.
Recently, a number of endowments have reported gains of over 40% for their June fiscal years, thanks to successful private equity / venture capital investments. Some of these private investments were reported on a journal basis. Keep in mind that in many cases they performed spectacularly until March and have been relatively stable since then.
The cyclical nature of human emotions suggests that when earnings growth doesn’t support high valuations, we are likely to have a “rhyming event.”
Former President of the New York Society for Security Analysts, Michael Lipper was President of Lipper Analytical Services, which hosts the global line of Lipper indices, averages and performance analysis for mutual funds. His blog can be found here.
The opinions expressed by Citywire, its staff or its columnists do not constitute a personal recommendation to buy, sell, guarantee or subscribe for any particular investment and should not be taken into account in making (or purchasing) abstention) from any investment decision. In particular, the information and opinions provided by Citywire do not take into account the personal situation, objectives and attitude towards risk of individuals.