“Things are seldom what they seem” is an appropriate maxim for military reconnaissance, home buyers, merger & acquisition specialists, political and security analysts, and most importantly, long-term surviving investors. When surface observations prove to be accurate, popular rewards tend to be small, and when they are wrong, the penalties can be large. This week, I share three instances where a deeper understanding of what is popularly “known” are examined more broadly.
On Friday, the Dow Jones Industrial average fell 255 points, with 67 of those points in the last half hour. Before using these “knowns”, one should examine the makeup of the numbers and their implications. First, almost two-thirds of the decline was caused by just two stocks, Boeing (BA) and Johnson & Johnson (JNJ). Boeing’s fall is particularly significant because the DJIA is a price-weighted average and its fall disproportionately impacted the result, as it is the highest price stock in the index.
As an analyst/portfolio manager, the larger implication lies in reviewing the investment selection criteria. Statistically oriented pundits and marketers generally want to sum up the company’s results using factors such as changes in earnings, returns on equity or capital, revenues, or book values, etc.
Both the price declines of Boeing and J&J were responses to internal disclosures. In Boeing’s case, it was a reaction to emails from the chief pilot expressing doubts on the Max 737. In J&J’s case, it was the discovery of a single batch of contaminated product. Neither of these disclosures were, or could have been, captured by any known factors. Ever since investors have compared investments and managers, they have utilized screens to highlight and understand differences. Rarely was success the result of one management being smarter than others – it was often due to comprehending what was not captured in the statics, i.e., patents, customers, locations, etc.
In the following market factors for the week, I found issues of future importance, which I would be happy to discuss further with subscribers:
- There were price gaps from earlier in October in all three major stock indices.
- There were differences in the patterns of the high/low ratios for stocks on the two stock exchanges – NYSE 303/101 and NASDAQ 197/230
- On the NYSE, the volume of shares going up was very close to the number of shares going down.
“Plain English” can be Plain Wrong
Jason Zweig, in an always interesting column in the Wall Street Journal, described attempts by a member of Congress and the SEC to force mutual funds to issue a new four-page document in “Plain English”. Ironically, this is an effort to correct errors of judgement by both the Congress and the SEC. A generation or two ago, there used to be an active retail market for investments in most cities and towns in ground floor stock brokerage offices. Their longevity was a testament to the value they were providing. They existed because busy people who recognized their lack investment knowledge needed help, and the situation is no different today. In many cases, the customers – man or woman – provided good service to the investing public, and many of their recommendations proved to be profitable for both the investors and the brokerage firms. I believe the average retail investor’s returns were superior to those of today, in part due to lower interest rates. Perhaps unconsciously, the SEC destroyed this setup by removing fixed commission rates. (That is not to say that there weren’t some abuses and bad judgments made.)
The SEC has faith in the disclosure of “facts”, and the numbers are even better. For a while, it considered requiring funds to publish their beta numbers, urged on by the late and sometimes great Jack Bogel. Luckily, the requirement was dropped after being ignored and considered something of questionable utility. (It could have had some value as an annual or market phase measures.) Digital representation are an attempt to capture reality. While most critical decisions are reached through analog searches and comparisons, J.P. Morgan himself said that he did not lend based on collateral but on character. The new document cannot correct for a poor education. Many successful investors learned early about budgeting their time and resources, without which no four pager or four thousand pager will produce, on average, winnings.
When someone asks for my help with their investments, the first thing I should ask is how much time they intend to devote to investing. For those devoting “twenty minutes or less”, I suggest that they either find someone they trust to manage their money or just accept one or more fixed-rate investments. For the remaining few, I would be happy to introduce you to the multi-level set of investment arts.
“Follow the Leader” is Chasing one’s Tail – or Worse
As someone, with the help of a great staff, who probably created more lists of leaders and laggards than perhaps any other person, I can appreciate the media and spectators knowing who are at the “tops of the pops”. Unfortunately, people don’t evaluate all the short- to long-term time periods, or how quickly a name rotates from the leaders lists to the laggard roster. That is a mistake, but it is even worse to not notice the change in market conditions.
As an outsourced chief investment officer and a member of non-profit investment committees, I have seen a growing share of assets devoted to private equity and debt. In a recent article in FT Wealth devoted to family offices, a survey showed that over 80% are using private equity investments through funds or fund of funds. They are following the lead of certain Ivy League universities which have been investing in private equity for two generations. In the early years, these schools produced results superior to the public market. At one of these investment committee meetings, the members were presented with a book authored by one of the in-house chief investment officers, highlighting his success in investing in privates. That was then; today, most of the former leaders have completed a year where, in aggregate, they underperformed the public market measures. What happened? The structure of the market was changed dramatically by the SEC’s efforts to make investing easier.
The way investments are taught in most places focuses almost entirely or totally on the issuer of the securities. However, the company is only one of five forces on the price and utility of investing in the security. The others are the needs of the customer, the compensation for marketing, the profitability of the firms that provide investment management, investment banking and trading, the changing nature of the exchanges and the attitudes of the reviewers/critics.
The combination of generally declining profitability caused by the SEC’s elimination of fixed-rate commissions and the long-term decline in real interest rates altered the commercial needs of the players other than the issuer and dramatically changed the market for privates. For over two generations, brokerage firm equity/agency commissions were unprofitable. Their profits came from net interest on margin loans, dealing spreads, underwriting, financial advisory activities and investing for their own accounts.
This led the institutional sales force and, eventually, the retail sales force to shift to the sale of private securities, either individually or in packaged products of funds. In order to supply their sales forces, many firms got into the business of underwriting or offering private securities. They were often directly or indirectly paid in shares of the products they were selling. While a couple generations ago there were only a few in these markets, now almost all the firms that have survived are there.
At the same time, successful managers of private venture funds were regularly coming to market with new merchandise. Owners of private companies, therefore, had many underwriters and investors competing for an interest in their companies, leading to higher prices. That was sustainable if these companies went public at sufficiently high prices to create profits for all who participated in the build-up to the sale. It all worked as long as the IPOs rose in price long enough for all the willing restricted stock to be sold. In 2019, we have seen some IPOs break below the offer price and some have been withdrawn.
I have witnessed first-hand the success that Caltech’s investment staff and appropriate consultants have generally had with their privates. They have worked long, hard and smart. I am convinced that there are few groups that have a similar dedication to this effort.
One of the general lessons in investing is that it is difficult to make meaningful gains in crowded trades, and they can be very unprofitable if the crowd attempts to stampede out.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.