The World of Large Mutual Funds

The World of Large Mutual Funds            

We can all go down together, but I can’t let them go up without me.

Justin Mamis

The manager of a large mutual fund had to report to his boss about his fund’s performance over the last quarter. His fund was down 3 percent over that time frame while the SP500 was up 10 percent. The fund’s mandate was mid to large cap growth with value. They both worked for a large institutional bank (so you know where this is going). The fund manager’s boss asked him what the hell he was doing. Both of their bonuses were hanging in jeopardy. The manager explained he was trying to position the fund into a lot of under followed names that had a good chance to increase in value over the next 2 to 3 years. “Christ”, his boss said, just put the money where everybody else is putting their money. That way we will stay near the index and won’t be noticed. The fund manager said he was trying to make money for the unit holders over the long term. The boss told him “we’re not here to make money for other people we’re here to increase our assets under management so we can make more money for ourselves. It’s important we make our quarterly numbers.” He went on. “We do this by blending into the crowd so we can keep our jobs and collect our bonuses.”

“But I just read this blog on the internet about something called Wager Value”. The boss blew his top. “Wager Value, what the hell is that?”  Maybe I should send you down to inhuman resources for a re-orientation. The fund manager finally agreed to do what the boss wanted. As he left he noticed several other mutual fund managers hiding behind the drapes in his bosses’ office, trying not to be noticed, meanwhile his boss was thumbing through a dictionary trying to look up Wager Value.

Okay, maybe I’m being unfair here. I didn’t mention any of the various investment committees that the fund manager would have to pass his stock ideas through. But it all leads back to the same thing, closet index hugging. Something to keep in mind next time you have to pay your management fees for a fund that is just trying to match the market over the longer term, minus fees of course. Small wonder the herd effect is alive and well in the stock market.

Core Holdings and Portfolio Management

Core Holdings and Portfolio Management

Okay, it’s the spring of 2015 and you can see the stock market has far more risk in it than reward. You hold say 20 stocks. You have the bulk of your money invested in some solid dividend growth stocks. These are your core holdings. The types of stocks you want to hold on to. Why? Yield on cost! Remember the post awhile ago about dividend growth investing. These stocks are providing you with a growing stream of income that should only increase in the years ahead. Your core holdings have a tendency to be larger in market cap (but in my case, not too large) more established in their markets, and are the cornerstones on which your whole investment portfolio rests. They are like old familiar friends. You know in the long term you can count on them on being there.

This leaves everything else. You may want to lighten up on some positions or sell others outright before the market deteriorates further. Try to focus on the stocks in your portfolio that don’t pay a dividend. If you’re right about the risk in the current market place, you might be able to buy some of them back at more attractive prices. I know this sound’s like market timing but I urge you not to think of it that way. Focus on the risk that presently exists in the market and act accordingly. Maybe sell or pare back on your non dividend paying stocks that are over extended (way above their long term moving averages).

This is more of an art form than anything else and once you gain some experience in the market the process will become clearer to you. My advice is not to rush (like I do sometimes) and take your time and enjoy the journey because that is what it is.

One more thing. This selling or lightening up on positions to manage your risk is strategic and long term in nature. Most of the time investing involves just sitting tall in the saddle while you mosey on through town. If you cut down on the number of decisions you make you will find yourself making less mistakes and going through less stress in the process and that can only be a good thing.

The Nature of Market Tops, Part 2

The Nature of Market Tops, Part 2

Going back to June, 2015, in truth the markets had been weakening long before June. In August 2014 (almost a year earlier), the adv/dec line had made a double top (stopped making new highs) but the momentum indicators (momentum is a leading indicator) were showing serious weakness. Both intermediate and long term momentum had put in much lower tops on the second top made by the adv/dec line in late August. The market was preparing itself for its October swoon in 2014. After the market sold off in October, it put in a v shaped bottom and shot right back up again. But the ensuing market that followed was a different market. Sure the indexes that everybody watches were making new highs. But the underlying market was much weaker. Long term mom barely inched up past the lows made in October and looked anemic. Intermediate term momentum was capped at the 50 percent level after pushing the 100 percent level the previous summer. The distribution top carried on through the winter and spring of 2015. Risk was at a elevated level at this time with little reward in the offing. I saw all of this and turned a blind eye to it. I didn’t want to believe it so I stopped looking at it. Such is the importance of psychology when investing in the markets.

Permit me a few observations...

I don't trust indexes like the SP500 and the Dow Industrials.  I feel they can be too easily manipulated and yet they are the indexes the mindless media focus on or maybe the indexes they are told to focus on...who knows.

The adv dec line of the NYSE is of pivotal importance. It shows how the whole market of the NYSE is performing. By applying a few simple moving averages to it and generating some momentum indicators from those moving averages you can gain genuine insight into the state and health of the stock market.

The temptation is to try to predict the future of the market from these indicators. I feel that is a mistake. Ive already droned on about the fallacy of trying to predict the market (the ego, remember). I see it as a risk management tool. Something to help you weigh the risk reward condition of the current market place.

The object of applying moving averages to the advance decline line and generating momentum indicators from those moving averages is to filter out the noise of the market. This will leave you with the meaningful messages and signals of the underlying data. Pay attention to the signals, not the noise.

The Nature of Market Tops

The Nature of Market Tops

The markets have been going up for a long time and everybody has forgotten about the Lucky Idiot’s gun with its ten thousand chambers. You remember; that’s the gun that had ten of those chambers filled with bullets. But everything has been so good for so long everybody has forgotten about that. The indexes have been constantly pushing higher. The media is leading the parade cheering each new high in the indexes with firecrackers bursting and banners flying. Investors are out in the streets doing cartwheels or at least it just feels that way. But underneath the indexes, the market, the real market is giving way. The adv/dec line of the NYSE is slowly deteriorating. Its 39 day moving average is flattening out and turning down to the extent that the adv/dec line is now spending more of its time below that moving average. It might be mid June, 2015. After awhile the 39 day ma will move below the 144 day ma which in turn is slowly rolling over and headed down. The underlying market is unmistakably getting weaker, much weaker. It’s now early August, 2015. You know how this story ends.

The lords of the playing field (informed money) have been slowly distributing (selling) their shares out to the great unwashed (everybody else). Everybody who can buy has already bought and there is no way to go but eventually down. When the music stops the chairs will be full with no place to sit.

It’s been my experience to ignore the market indexes. Everybody follows them. There is no Wager Value in looking at them. Instead keep a close eye on the adv/dec line of the NYSE (based on common stocks only). You can get this information summarized neatly for you in the weekend edition of Barron’s. The adv/dec line along with its assorted moving averages and momentum indicators has Wager Value in that few people pay attention to it.

Process over Outcomes

Process over Outcomes

I’ve been pretty tough on left brain thinking so far. It is only because It’s so prevalent in the market place. Especially with the quants who think they can mechanically construct some algorithm that will manage their risk and do their thinking for them. However if everyone lived in the right side of their brain nothing much would get done. We would all just be floating around all over the place. So it’s really more about balance and utilizing both the left and the right sides of your head, making them more of a team rather than adversaries. Focusing on a investing process is more of a left brain function.

Every great athlete knows that to have a great performance they have to break down the mechanics of the body’s movement that produce the result they want to achieve. Likewise the investor should have an investing process he goes through based on his investment philosophy. Concerning yourself with the result is putting your attention on a future event. As soon as you do that the Ego, will be involved and start to mess things up. You will start to tense up and worry about achieving the result you want. Instead try to set up a process you go through and execute that process in the present. In other words be present here in the actual moment. What happens in the future is the result of the thoughts you are having at the present moment in time.

Your own investment process will develop over time as you gain more experience in the markets and learn the hard lessons of the mistakes you have made in the past. It will be a personal thing to each and every investor. Something he has come up with based on his own experience. The important thing to keep in mind is not to concern yourself with the future outcome as that is beyond your control. Just execute in the present knowing that if you follow your process the future will look after itself.

Pockets of Market Inefficiency

Pockets of Market Inefficiency

I’ve talked about the wager value of the small and mid cap sectors of the stock market but these market inefficiencies are more structural and part of the investing landscape. There also exist pockets of inefficiencies that are more transient and temporary in nature.

When stocks are plunging and market conditions appear obviously bleak and fear holds sway over all of the market participants it can be a good time to go shopping for value. Chances are what you buy will continue to go down but rest assured you will get a good fill and you will see that price again back on the way up. Just try to pay less for a stock than what you feel it is worth. They will be out there. During a market plunge there will often be levered investors facing margin calls who will be forced to sell out their holdings. This will have nothing to do with what their investments are worth. The stocks they sell are basically on sale for anyone who has the capital and confidence to take advantage of the situation. Quite frequently after the plunge has run its course the markets will be sold out (everyone who could sell has already sold). So all the money that was in the market is now on the sidelines. If the market fails to go down anymore while the news remains bad chances are the worst is over. At this time the tiniest bit of buying will lift the markets up. When the markets recover as they always do, there will be a great influx of money back into the mutual funds who in turn will be forced to put it to use (back in the market). Prices often surge upwards because of this. Not a very efficient market is it?

When the time horizon of your anticipated change in value extends out beyond a year or so, you can copper the short term tendencies of the other market participants. In other words while they are focusing on the next quarter, you can be investing in companies that are growing their businesses for the long term (high ROE and ROIC).

Finally when the markets fall into the trap of unanimous opinion, its time to fade the market and do the opposite (like George Castanza in my favorite Seinfeld episode). This situation often describes market tops that are slowly distributing their shares out to the unwitting public. See my posts on the Current Market Environment and the Hidden message in the Stock Market.

One more thing to bear in mind. Justin Mamis wrote about this years ago. In a bear market or a bad correction, the future market leaders will often bottom first. Now I'm not sure this is true or not as I've never conducted any research into this idea but its something to bear in mind. And if you see any stocks that are going sideways while everything else is going down well that's a message in itself. relative strength works. In the long term I think the markets get it right but in the short term pockets of inefficiency exist for the astute investor to take advantage of.

Portfolio Management, Concentration or more Diversification

Portfolio Management, Concentration or more Diversification

  

There are two investors. Investor A runs a concentrated portfolio of five to eight stocks. He does all of his own due diligence. He accesses sedar.com and reads the annual and quarterly reports of the companies he's interested in. He inputs the companies metrics and ratios into a spreadsheet looking for trends over the last few years of the company's performance. He goes over the proxy statement and reads the bios of management and collects info on their compensation packages. He reads the M,D&A in the annual report to get management's views on where the company is headed and how they are going to get there. He reads the various press releases about the company published on sedar. He visits the companies' website to see if he can glean further clues about the prospects of the firm. He may even contact the company's customers and suppliers (fischer's scuttlebut) to gain further insight in how this company is viewed from the people they do business with. This investor still has to deal with his own psychological makeup as well as make sure he has a margin of safety when he buys his stocks. All of the information he has gathered about the companies he owns is his way of managing his risk. And finally he tries to take advantage of wager value in exploiting the market's inefficiencies and underused information. I'm almost out of breath just writing about all of this. Investor A in some strange way loves doing all of this. It is his process. He focuses on his process rather than the outcome. He likes to be in control and in charge of his destiny and his affairs. 

Investor B prefers to steal/borrow his investing ideas from other people (fund managers). Rather than handicapping the company he spends the majority of his time investigating the fund managers he wants to follow.  He insists that they run small concentrated portfolios with low portfolio turnover. He may even do some due diligence of his own but it will be at a much reduced scale than that of Investor A. He is more likely to visit morningstar's website to get the information about the companies he's interested in. He is a big believer in utility (putting in little while getting back a lot). He too will have to consider his psychological mindset, there is no way around that. Psychology trumps everything else put together. He will also insist on a margin of safety in the price of the stock he buys. He will handle his risk management by holding 15 to 20 or more companies to compensate for his lack of knowledge of the stocks he's holding in his portfolio. He will exploit the randomness in the market knowing that some of his stocks will do well over time and some won't. He is not bothered by this, he knows that even the best investors are only right about 66 percent of the time. He is out to make money over the long term just as Investor A is but he handles his risk in a different way. And he will use wager value in following fund managers who invest in the small to mid cap space where market inefficiencies are more apt to be found.  

There could even be an Investor C whose approach lies somewhere between the extremes of Investors A and B. The market is a multi-faceted place where there is no silver bullet. Every investor has to find the approach that is right for himself.