the structure of the S&P 500, and why it matters…

…to us as individual investors, for the portion of our assets we choose to manage actively.

As of the close of trade in New York last Friday, the Standard and Poors 500 was weighted, by sector, as follows:

IT      24.0%

Financials      14.8%

Healthcare      14.1%

Consumer discretionary     12.1%

Industrials     10.1%

Staples      8.1%

Energy      5.8%

Utilities         3.1%

Materials     3.0%

Real estate     2.9%

Telecom      2.0%.

The goal of active managers is to have better results than the index (I could say “an index fund,” but the two are the same, less the small fees an index fund purveyor charges).  We’ll only have different results if we have different holdings than the S&P.  And if our holdings aren’t different–either different names or different weightings (or both)–we can’t be better.  In order to be different our first job is to know what the index looks like.  The list above is a first cut.

Let’s rearrange it to show the sectors in order from the most sensitive to general economic activity to the least.  I’m going to divide the sectors into three groups, from those that do best in a red-hot world economy, those that will still do well with so-so growth, and those that have the most defensive characteristics–meaning they do their best relative to the index when economies are contracting.

 

most economically sensitive

Materials      3.0%

Industrials      10.1%

Energy     5.8%

————————————-total = 18.9%

economically sensitive

IT      24%

Consumer discretionary     12.1%

Financials      14.1%

Real estate         2.9%

————————————-total = 53.1%

defensive

Healthcare     14.1%

Staples     8.1%

Telecom      2.0%

Utilities     3.1%

————————————-total = 27.3%.

I’ve stuck Energy in the most sensitive segment.  Recently it’s been marching to its own drummer, as the big integrated oils restructure and as the crude oil price yo-yos up and down.  Ultimately, though, I think in today’s world oil is just another industrial commodity that’s not that different from steel or aluminum.  Put it somewhere else if you disagree.

This isn’t the only reordering we could make.  We could also arrange the index by market capitalization in order to either emphasize big stocks or small ones in our holdings.  But this is the most common one professionals, and their institutional customers, use.  Personally, I think it’s also the most useful way to think about the index.

 

To my mind, the most striking thing about the S&P 500 is that it is mostly geared to a rising economy.  If we think recession is brewing, tiny changes in holdings aren’t going to make much of a difference in relative performance.

Another–very important–point is that if you have a portfolio that’s, say, 10% Healthcare, and your benchmark is the S&P 500, you’re betting against Healthcare as a sector, not on it.

 

 

 

 

 

 

 

Cyber Monday

I think the most interesting thing about this year’s Black Friday/Cyber Monday is that, despite the weekend’s decreasing overall relevance for American shoppers, business has been unusually strong.  This is likely in large part because consumers in the aggregate finally–eight years after the bottom of the economy (and 8 1/2 years after the bottom in world stock markets)–feel confident that the recovery is real.  Yes, we still have serious regional, educational and other demographic disparities.  But the typical consumer appears to feel that his/her job is safe and that family finances are enough under control to allow a return to more-or-less normal spending.  This is an important positive economic sign.

If this is correct, then it’s probably also time to begin to sort through the Wall Street wreckage in the retail sector.  I’d be particularly inclined to look at bricks-and-mortar, where more open wallets are likely to make the greatest positive impact.

 

By the way, I’ve been shopping online for a RAID array.  While I was looking on one site, a price comparison app told me that the item I was thinking about was substantially cheaper at Wal-Mart (WMT).  The WMT site told me that I would get $35 off the purchase if I applied for a credit card and bought today–both of which I did.  Almost immediately I got an email that said my purchase had been cancelled, but gave me a phone number to call for an explanation.  I did.  After about 10 minutes of waiting, when I was next in line for an agent, the line disconnected.  I ended up finding the item for the same price and with much faster delivery from B&H.

WMT may be a more formidable competitor for Amazon than it was a year or two ago.  And the AMZN price for what I wanted was 50% higher than WMT’s!!!  But WMT still has a ways to go, at least handling high-volume online days.  That’s probably more a positive than a negative for the stock, however, since there’s still considerable scope for improvement.

 

 

 

William Ackman and Automatic Data Processing (ADP)

Pershing Square, the hedge fund founded by well-known investor William Ackman, established a position in business services company ADP earlier this year.  Arguing that ADP was poorly managed–a problem Ackman said he could fix–he nominated himself and two associates for election to the board of directors of the firm.

Results of voting were released last week.  None of the three Pershing Square nominees were elected to the ADP board, despite Ackman being recommended by the three major shareholder advisory firms (the other Pershing Square nominees were recommended by two of the three).

Ackman has proclaimed this result as a victory for him, in that his nominees received about a quarter of the votes cast.

I’m not convinced.  Here’s why:

In early days of my career, institutional investors generally didn’t pay much attention to voting on corporate proposals. Generally, if they voted, they cast their ballots with management.  In the early 1990s, though, the SEC criticized the industry for this attitude and strongly reminded investment managers of their fiduciary obligation to study corporate issues carefully and vote their shares in the best interest of their customers.

 

I witnessed the early days of dealing with this new requirement.  Time had to be found for a meeting of all the portfolio managers who held a given stock. Consensus was very often hard to come by.   On the other hand, having having a money manager cast votes on both sides of an issue was at best a dubious proposition.  Lots of lawyers, both inside and outside counsel–none of whom had any clue about the relevant investment issues–had to get involved, as well.  A real mess.

 

Proxy solicitation firms saw a chance to radically transform their business.  They began to provide third-party voting advice, which was formulated by newly-hired teams of specialists in investment law.  These services were an instant hit.  Portfolio managers could get back to the work they knew best; investment management firms could rest easy, knowing that their taking advice from an objective third party would be a good  defense against any complaint they were not taking their fiduciary obligations seriously.

For at least the past twenty years, the policy of money management companies has been to follow the advice of firms like ISS, Glass Lewis and Egan-Jones, unless there are very strong reasons to do otherwise.  All three recommended that institutions vote to elect Ackman to the board.  Yet, despite the fact that institutions own 83% of ADP’s shares (according to Google Finance) neither Ackman nor the rest of his slate were elected.

This is not even a moral victory, in my eyes.  Just the opposite–it’s a surprisingly weak showing.  Of course,  the fact that the shares of JC Penney (JCP) are now trading below $3, can’t have helped.  JCP was another high-profile turnaround target of Pershing Square’s at $25 or so a few years ago,

Snap (SNAP) and Tencent (0700:HK)

Yesterday, as part of its disappointing quarterly earnings announcement, SNAP revealed that Chinese internet giant Tencent has acquired a 12% stake in the company.

This is considerably less than it seems, however, for three reasons:

–US securities law requires that an acquirer make a filing–called a 13D–declaring its intentions once it has built a 5% voting interest in a publicly traded company.  It must also report every +/- 0.5% change in its ownership interest as long as the total holding remains at 5% or above.  Based on this rule, a quick reading of the Tencent headline suggests the Tencent move up came in at least one large chunk and fairly recently.  Not in this case, however.  SNAP has issued only non-voting shares.  So the SEC filing requirement doesn’t apply.  In fact, Tencent says it has acquired the stock in the open market over a lengthy period.  Therefore, the 12% stake is not a this-week vote of confidence by Tencent in the SNAP management.

–the stake was acquired in the open market, not from SNAP directly.  Therefore, the large amount of money Tencent spent on SNAP shares did not go into the company’s coffers.  It went to third-party holders exiting their positions.  So, yes, Tencent took out sellers who might otherwise have put downward pressure on SNAP’s share price.  But SNAP did not receive the benefit of a substantial cash injection.

–also, the fact that these were open market transactions does not signal the strong commitment to SNAP that a direct purchase of a block of shares from SNAP would have.  Tencent could disappear from the share register just as easily as it appeared.

Broadcom (AVGO) and Qualcomm (QCOM)

(Note:  the company formerly known as Avago agreed to buy Broadcom for $37 billion in mid-2015.  Avago retained its ticker symbol:  AVGO, but took on the Broadcom name.  Hence, the mismatch between name and ticker.  That deal is on the verge of closing now. Presumably AVGO’s recent decision to move its corporate headquarters from Singapore to the US is a condition for approval by Washington.)

AVGO and QCOM

AVGO is a company that has very successfully grown by acquisition (my family and I have owned shares for some time).  Its specialty, as I see it, is to find firms with excellent technology that are somehow unable to make money from either their intellectual property or their processing knowhow.  AVGO straightens them out.

QCOM, a firm I’ve known since the mid-1990s, seems to fit the bill.  The company makes mobile processors for cellphones.  It also collects license fees for allowing others to use its fundamental and important cellphone intellectual property.  QCOM has been in public disputes over the past couple of years with the Chinese government, which has forced lower royalty payments, and with key customer Apple, which is threatening to design out QCOM chips from its future phones.  As I see it, these disputes are the reason the QCOM stock price has stagnated over the recent past.

the offer

AVGO is offering $70 a share in cash and stock for QCOM, a substantial premium to where QCOM shares were trading before rumors of the offer began to circulate.  The current price for QCOM (I’m writing this at around 10:30) of $63.90 suggests that the market has doubts about the chances for AVGO’s success.

Standard tactics would be for QCOM to seek another buyer, one that would keep current management in place.  Since an overly pugnacious management has arguably been QCOM’s main problem, my guess is that a second bidder is unlikely to emerge.

If I were to try to participate in this contest (I don’t think I will), it would be to buy more AVGO.  I believe AVGO’s assertion that the acquisition would be accretive in year one.  So it’s likely to go up if the bid is successful.  If not, downward pressure from arbitrageurs would abate.  On the other hand, I don’t see 10% upside as enough to take the risk QCOM will find a way to derail the bid.  After all, it has already found a way to anger Beijing and 1 Infinite Loop.

GE, death cross and golden cross

In one of his early books, Peter Lynch, famed manager of the Fidelity Magellan Fund (during the time when that fund had the strongest record among domestic growth funds), wrote that no one ever gets fired for buying IBM.

That is to say, many run-of-the-mill portfolio managers will stick with “safe” high-client-recognition large cap names long past their sell-by dates.  Why?   …because they think there’s less career risk for them in doing so than there is in holding earlier stage names where there’s much more upside but a bigger chance of going down in flames.  In my experience, that risk comes less from the company itself than from the PM’s not doing the continual securities analysis needed to monitor a smaller firm’s prospects.

The “safe” strategy, according to Lynch, generates at best mediocrity.

GE is a fascinating case (of the train wreck genre) in point.

As I see it, the company grew by only about 10% a year in what one might call its last  “glory days” in the 1990s.  That lackluster performance was fueled in large part by the creation of a finance division that specialized in lending to less than pristine customers.  On a stand-alone basis, the earnings from such a business typically garner only a substantially below-market multiple.  But it seems to me that GE boosters, led on by cheerleader CEO Jack Welch, never connected the dots and continued to pay super-generously for these results.

Welch’s successor had the unenviable task of straightening out the lumpy, aging conglomerate he left behind.  New management wound down the risky finance operations, but then decided to bet the farm on the consensus view at the turn of the century that the world faces a structural shortage of oil.  Ouch.

 

I have no current interest in GE as a stock.  My hunch, however, is that if I looked into the company I’d end up being more a buyer than a seller.  That’s for no other reason than it has been a dismal operating performer for a quarter century and there must be something of value inside a stock that has been beaten down so much over the past decade plus.

What prompted me to write this post, then?

 

dead cross and golden cross

I saw an article about GE by a technical analyst who asserts the stock is flirting with disaster. His argument is that a short-term moving average of GE’s stock price is just about to break below its long-term moving average.  Technicians call this a “dead cross,” a sign that investors are abandoning hope and will likely begin to dump the stock out without regard to price.

I have no belief in most technical indicators, including this one.  I like the name, though.  And if this prediction proves correct, I think it would provide a very good buying opportunity.

The opposite of the dead cross, by the way, is the “golden cross,” where the short-term moving average breaks above the long-term moving average.  This supposedly leads to strong buying action.