No, as I write this, my daughter Akasha has left East Africa for Turkey, and by the time you receive this newsletter, she will be in Buenos Aires, Argentina. She is collecting college credits, business experience and language proficiency as well as a confidence that I think will make her very employable when she graduates in nine months.
If I say to someone, “everyone should go to college,” “a government job is a good job,” “don’t worry about the sharks” or “Africa is safe,” I am merely expressing my opinions, which are, of course, subject to comparison and analysis against the facts. A good friend of mine, a computer wiz who has the highest government security clearance, and I were chatting about the media a few months ago. Topics of discussion included Fox News, Huffington Post, Facebook, various magazines, newspapers and websites, and how we “want” our information. He said something that I felt was profound and upon analysis seemed true, though I found it a bit disturbing: “People [now generally] go to the media for ‘opinions,’ not facts analysis or ‘news.’” He went on to describe how the political machine works: Make strong statements (regardless of whether they are truthful or factual), and get them out there quickly – then the opposite side must “prove” them wrong.
I have four boys. When five-year-old Patrick hits three-year-old Henry, Henry hits him back. Patrick then runs to Mom or me crying, “Henry hit me!” When asked about the hitting, of course, Patrick is much more articulate than Henry, and as every parent reading this knows, we end up with two kids in “time out.” The results – no real justice, and a couple of boys who are learning the importance of being “preemptive” with the facts.
As I have often said, every trend has on average 2,300 counter-trends. Detroit’s problems bring headhunters to the city to seduce its talented highly skilled workforce into working in Atlanta, Chicago, Pittsburgh or Tokyo. Detroit’s faithful, however, feel that they are having their talented lifeblood “stolen” away. As a kid who was born in Detroit, I marvel at how Detroit has gone from unstoppable, vibrant, proud and prosperous to bankrupt. I love Warren Buffett’s advice about studying failure to learn about success. Detroit, as we know, had 40 years of shortsighted decisions, some might say a laziness manifesting in a death by 1,000 cuts. When the city moves past the blame, victims and wallowing in its woe, it will regain its vibrancy. It may take 40 years, but it has the geography and infrastructure to regain its strength. But it will be much different. When I was a kid in Detroit in the 1960s, if we saw a “foreign car” in a parking lot or on the street, we regarded it as taking jobs from our friends’ dads rather than as a opportunity for the U.S. auto industry to “up its game” and build practical, reliable, elegant and smaller fuel-efficient vehicles. Back in that era, the overall opinion was to “do nothing and just wait it out.” This “head in the sand” method of managing change is the most popular from what I see. It served Detroit management, union employees and government officials who could not admit that they were not responsive to the tide of higher gas prices, poorer quality and expensive cars in the first place, so they were chagrin to admit they dropped the ball.
Two major Detroit players, one from business, one from philanthropy making big investments in Detroit:
The Player: Dan Gilbert, Detroit Native, Founder of Quicken Loans
The Project: Revitalizing two square miles of downtown Detroit
The Investment: $1B for 3m sq ft and counting of downtown real estate
The Player: Kresge Foundation
The Project: Detroit Future City, A Roadmap for recovery built with the input of 150,000 Detroiters
The Investment: $150m over five years
Most governments, cities and industries are reactive systems, which means they wait until things get really bad before modifying their behavior. As Detroit was starting down the dysfunctional road to ruin, W. Edwards Deming, the Total Quality Management/Systems consultant, tried to step in with a realistic vision of what Detroit’s great industries needed. The story goes that Deming could not get anyone in Detroit to listen to him, so he went to Japan where they were eager to learn how to build quality cars, with quality systems, and quality training and people.
Deming’s writings and philosophy were the magic elixir of “what makes a company successful.”
Needless to say, his teachings were embraced by the likes of Toyota and others and the rest is history. There is no management philosophy that has influenced me more. So when it comes to my kids, Wall Street, presidents, oil companies, hospitals or political parties, whether they hire a PR firm or not, it is important to know the preemptive power of opinion.
As investment manger I must realize that “opinion” usually will fail in the fight against truth, but on a short-term basis, the perceptions created by opinion’s drum beat often rule. And as my mom jokes, “Ya know what it said on the hypochondriac’s tombstone?. See, I told you I was right.” So eventually, even hypochondriacs can claim victory for their perceptions.
Investigate Before You …
When I mention to friends and others about my daughter Akasha’s internship in Ethiopia, I often receive a funny look and follow-up questions about her safety. They, like most of us, see the “news” (usually bad) about the “horrors of Africa,” like AIDS, cholera, malaria and hepatitis, not to mention the risks of robbery, kidnapping and other unsavory things that could befall a pretty, young woman in untamed Africa. Statistics and facts do not prove out a rational reason for a general fear about Africa – some areas are safe and others are not.
Likewise, if you read the New York Post you would think twice about going to New York City. And I am sure many would-be travelers to the U.S. think we are a bunch of paranoid, “shoot first, ask questions later, let God sort out the innocents,” gun lovers. We live here and understand the randomness of the violence and would not worry [much] that some vigilante is going to shoot our baggy-pants teenager in a hoodie if he happens to be on their street looking for directions to Disneyland, or trying to find Uncle Fred’s home after a long car ride through Florida. The maxim, “Investigate before you … invest” comes to mind, as it is a good maxim to live by.
Lightning and Sharks
On July 6, 2001, an eight-year-old had his arm bitten off by a shark while swimming near Santa Rosa, Florida. Soon afterward, a New Yorker was attacked while vacationing in the Bahamas, and on July 15, a third attack happened to a surfer in Florida. This all led TIME magazine to title its July 30, 2001, issue “Summer of the Shark.” Florida leads the nation in shark attacks, and based on data gathered over the last half-century, you are 50 times more likely to die from a lightning strike than a shark attack.
Assessing risk in investing is again about sorting through to find the reality among the “hype” of the crowds, those with something to sell and all the “normal” psychological influences that lead investors astray. Fear and greed are the two forces that tend to get the most attention, but I think many investors fail because of laziness. Laziness comes in many forms but, when it comes to investing, laziness is when we don’t take the time to first investigate the investment and its merits, understand our natural tendency to want to oversimplify the complex subject of investing and our desire to procrastinate. Buddhism, which emphasizes right thinking, practice and work as part of its philosophy, has as its “Pope,” the Dalai Lama, who says, “Laziness comes in many forms, all of which result in procrastination.”
“Naturally there are different species of laziness: Eastern and Western. The Eastern style is like the one practiced in India. It consists of hanging out all day in the sun, doing nothing, avoiding any kind of work or useful activity, drinking cups of tea, listening to Hindi film music blaring on the radio, and gossiping with friends. Western laziness is quite different. It consists of cramming our lives with compulsive activity, so there is no time at all to confront the real issues. This form of laziness lies in our failure to choose worthwhile applications for our energy.”
~ Sogyal Rinpoche,
in The Tibetan Book of Living
Some Will Get Lucky, But Hard Work Usually Wins
I do not want to discuss the importance of time, study, temperament, experience and analysis in the pursuit of positive investment performance. When it comes to investing, I think this “lazy” issue has more to do with the “thinking and thought process leading to the [investment] decision.” It is very hard work to give up bias, culture, opinion and such in the pursuit of finding out the truth. We humans are wired to want to be accepted, so we will follow the crowd even when we may disagree with it. Why do we support our universities, political parties, churches, businesses or schools even after we discover they breach adherence to our most respected virtues. Laziness, as His Holiness Dalai Lama defines it, results in procrastination, so we acquiesce to the consequence of our inability to accept the facts. Not looking for and accepting the “facts” is a recipe for failure when it comes to investing.
Everyone knows smoking kills, but smokers’ actions do not change for the benefit of their health. The same goes with investing. I am always amazed at how people will get riled up about some giant bank’s or broker’s unethical behavior, yet will still leave their investment accounts at the firm they despise. We are all busy, so I understand that, but when does being busy no longer work as the excuse and procrastination becomes the behavior.
Today, we have a lot going on in the world of economics, business, commerce and politics. We have our U.S. Federal Reserve looking to change leadership, our country [and many worldwide] caught in a 4-D quagmire of debt, deficits, [possible] deflation and demographic shifts. Change is the only constant and while I would like to say that is fact, I must admit it is “opinion,” because if we don’t challenge what we think is “fact,” we can start down the lazy road of thinking we have figured it out. All we need to do is look at Detroit to know that pride is the beginning of that slippery slope.
“Take nothing on its looks; take everything on evidence. There’s no better rule.” ~ Charles Dickens, Great Expectations
Managing expectations is a tricky undertaking for the higher-ups across corporate America, Wall Street and Washington. Their whispers, speeches and filings frequently drive knee-jerk reactions from the growing ranks of headline-obsessive, hyper-myopic trader types (and their computer algorithms). Such reactions, when extreme, can significantly impact stock and bond prices and screw up the value of lucrative stock options or even the job security of the typical C-suite exec. In the case of a certain soon-to-be-retired central banker, the stakes are even higher, with years of cumulative “wealth effect” engineering at risk of an unwind.
In most cases, the goal of these bigwig expectation managers is to smooth out the shock effect of potentially bad news. They attempt to achieve this goal with subtle preemptive strikes that gradually lower the expectations bar. For the most gifted in this art, the release of an otherwise crummy number might even be spun as a positive surprise by the time it hits the tape. Publicly listed company management teams, for example, are well-known for their efforts to manufacture positive quarterly earnings headlines. Some choose to low-ball guidance from the get-go, while others drop not-so-subtle hints to favored analysts should consensus forecasts be too high ahead of earnings time.
Engineering the “Beat”
A recent case in point is Alcoa Inc, the aluminum giant that is usually one of the first major companies to report earnings each quarter. In early July, Alcoa announced Q2 earnings of seven cents a share, a penny ahead of consensus estimates. The results earned management a polite golf clap from Wall Street, and most of the subsequent headlines dispatched from the mainstream financial media hailed Alcoa’s beat as a solid kick-off to the earnings season.
Few reports, however, bothered to note that the evolution of the consensus estimates until the final release resembled the double black diamond ski run in Figure 1. By guiding analyst expectations lower, what would have been a 35%+ miss to the consensus estimates of just one month earlier turned into a beat for the headline-munching momentum traders. These market participants, in most cases, could care less about “the rest of the story.”
Bernanke Brings Out the Verbal Cattle Prod
Now to be fair, today’s noise traders have plenty of other headlines jostling for their attention. Perhaps the most significant are those emanating from the grandest expectations manager in the universe right now, Fed Chief Ben Bernanke. It seems that Big Ben, unlike Alcoa and many of the companies that report earnings each quarter, actually sought to create a bit of a negative surprise. With concerns of froth emerging in certain asset classes, Bernanke brought out his verbal cattle prod in a May press conference and announced that the Fed might consider tapering its supply of monetary Percocet to the financial system. This provided a rude wake-up call to the trader/speculator herd, which was positioned, with leverage, for an extended period of accommodation.
“We are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.”
Ben Bernanke, May 10, 2013
The abrupt reset in expectations flowed quickly through bond, currency and stock markets, as interest rates moved sharply higher (Figure 2). Although several Fed officials subsequently attempted to soften their captain’s message, and Bernanke himself gave a mid-July speech that reiterated the Fed’s commitment to continued stimulus, the spooking of the herd had begun. And as happens cycle after cycle, only after bond prices fell (i.e., became cheaper) did the “retail” investors who tend to own bonds via mutual funds lock in their losses by redeeming their shares (see the recent trend of bond mutual fund outflows in Figure 3.)
Immunity No, Opportunity Yes
During this period, our client portfolios have not been immune to the price action of interest-rate-sensitive securities. We own bonds, utility stocks, precious metal mining stocks and real estate investment trusts across many of the portfolios we manage. This is especially the case for strategies where a significant recurring income stream is important to client goals. The market prices of some of these holdings declined with the jump up in rates, although importantly, the dividends and interest distributions they generate for us continue to come in as planned. As such, and given our team’s base case for modest-at-best global economic growth and strong demographically driven demand for “income” investments over the medium term, we have been active buyers in select areas most dislocated by the recent volatility. In particular, we’ve been finding very good value in an assortment of closed-end bond funds.
The Closed-End Fund Advantage
As a quick reminder, unlike the managers of open-end mutual funds, which must contend with the constant disruption of shareholder purchase and redemption requests, closed-end funds are a completely different animal. Their structure does not allow shareholders to buy or sell shares each day from the fund companies at net asset value as their open-end cousins do. Instead, they are traded on exchanges and provide their managers a stable base of capital to work with.
This stable capital base is a critical difference during times like these. It allows closed-end fund managers to focus on positioning portfolios for long-term total returns rather than managing the redemption requests of panicky shareholders. Another critical difference between closed- and open-end funds is that the former, trading on exchanges as they do, can see their prices trade at significant premiums (in times of greed) or discounts (in times of fear) to the value of their underlying holdings. This characteristic creates an additional driver of total return potential as such discounts usually compress back toward net asset value over time. Figure 4 summarizes select metrics for two of the largest fixed-income closed-end fund holdings in FIM Group-managed accounts.
Not Banking on a Rate Pullback, But There is a Case to Be Made ...
Of course, another rollover in interest rates would also boost returns for these closed- end bond funds, but we are not banking on this. We expect good total returns from the income generated by each fund’s holdings and the normalization of discounts that are now unusually wide. That said, there are certainly cases to be made for a sustained period of low rates. Historically, 10-year U.S. Treasury rates have largely followed the path of nominal economic growth. Figure 5 shows this relationship over the last four decades (orange line = GDP growth, white line = 10-year U.S. Treasury yield). If the growth trajectory of our still debt-choked economy, with nominal GDP now running at an anemic 3% or so, continues to slip lower, a renewed slump in interest rates is quite possible.
Lambda Lambda Lambda
Demographic trends also support the case for continued low rates. Figure 6 shows a metric known as the “yuppie/nerd” ratio of 20- to 34-year-olds divided by 40- to 54-year-olds. The theory here is that the younger “yuppie” cohort is more likely to be at a stage in life where they are borrowing for things like homes, cars and student loans (driving bond yields higher). The older “nerd” cohort, in contrast, is at a point where they are paying down debt and allocating more to bonds in their investment portfolios (driving yields lower). While there are many factors that may change the future behavior of these cohorts, the historical correlations between the yuppie/nerd ratio and bond yields are fairly strong. And based on U.N. demographic projections, this metric is expected to rise only modestly in the decade ahead. In other words, if the demographics = destiny crowd is right, the recent surge in bond yields triggered by the Bernanke taper talk may ultimately lose momentum against a longer-term demographic headwind.
So to recap, despite the best efforts by those in positions to influence consensus expectations, there will be times when shifts in these expectations are anything but orderly. From the perspective of a patient, value-focused investor, this disorder can produce compelling opportunities amid the herd’s confusion. We are finding such opportunities in the current environment, particularly with beaten up closed-end bond funds. These positions, we believe, will generate good long-term returns from both the income streams of their underlying bonds and the compression of their above-normal discounts. And if the economy’s growth path continues to slip or if the yuppies/nerds behave in a similar fashion to their predecessors? Well, then we might just have to give the ol’ Dickens upgrade to these closed-end bond funds, shifting our internal return expectations from simply good to...great.
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