Category Archives: Shaping a portfolio for 2011

is a bond fund exodus beginning?

December 23, 2010 By in Current Market Thoughts, ETFs Vs. Mutual Funds, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , Leave a comment

money is starting to flow out of bond funds

The Investment Company Institute, the trade organization of the the mutual fund industry, reported on Tuesday its weekly estimate of the money flowing in and out of the industry’s products.  The current report covers the week ending December 15th.

The equity news is the same as it has been for a long while–investors are taking $2 billion or so out of domestically-oriented funds each week and putting a somewhat smaller amount into foreign/global funds.

The real changes are coming on the bond side, both taxable and tax-exempt.

Over the past month or so, municipal bond funds have lost a total of $14 billion to net redemptions, presumably on worries about credit quality

For the past two weeks, for the first time since the collapse of Lehman in late 2008, taxable bond funds have had sizable withdrawals–$1.3 billion in the period ending 12/8 and $4.9 billion in the week of 12/15.

Why is this happening?

Bond yields are rising, as investors sense that the worse cyclical effects of the financial crisis are behind us.  Economic indicators and corporate reports are suggesting the US economy is stronger than the consensus had thought.  Markets are concluding that we’re past the cyclical lows for interest rates and that the Fed may begin to restore a normal (read: higher) level of rates sooner rather than later.

This means bond funds are potentially facing a headwind that will likely produce capital losses.

Where is the money going?

That’s not clear.  Some mutual fund consultants, like EFPR of Cambridge, Massachusetts, say the bond fund withdrawal money is going into equity funds.  Others are suggesting that it’s being parked on the sidelines in money market funds.

The ICI data, which cover the entire US mutual fund industry, don’t show either.

The ICI releases a separate weekly report on money market fund assets. That shows money market fund assets as being flat since the beginning of the month.  Assets held by retail investors are actually up slightly.

As mentioned above, the ICI data have shown a continuing small loss of money from equity funds over the past couple of years.  There’s a sharp shift within the equity category from US to non-US, but a net drain nonetheless.  That hasn’t changed.

So where is the money going?

A Bloomberg article that talks about he ICI numbers speculates that some is going into direct purchases of bonds.  This makes some sense:  you avoid the management fee mutual funds charge; and, unlike funds, individual government bonds mature–and you get your principal back.  I  suspect this is being done by individuals, not the institutions the article suggests, however.

I think a large chunk of this “lost” money will eventually end up in the stock market, either through individual equity purchases or stock ETFs.  Why?  Historical patterns suggest stocks are flat to up during a cyclical rise in interest rates, while bonds fall.  Also, to the extent that customers are withdrawing money from load mutual fund organizations–and Bloomberg suggests this is happening at places like Pimco–and forfeiting the sales charges they have paid, this suggests a certain finality to their actions.  My guess is that such investors are taking out a fresh sheet of paper and rethinking their asset allocations.

If so, we should see evidence of a more equity-friendly attitude as the new year begins.  Given that taxable investors typically greet January by selling winners they have nursed into the new tax year, a large inflow of new money should be easy to detect.

 

 

 

 

 

equity position size (ll): you and me

December 22, 2010 By in Constructing a Portfolio, Fixing mistakes, Portfolio management, Position sizes, Shaping a portfolio for 2011, Strategy Tags: , , , , , Leave a comment

It’s much easier to write about how professionals deal with the size and number of positions they hold in their portfolios.  That’s because money management firms create products that have certain risk parameters and leave it to customers to decide whether they want the product or not.  It’s impossible, however, to write very specifically for individuals without knowing anything about their financial circumstances and psychological makeup.  So you should take what follows as general thoughts rather than specific advice.

two issues to figure out

I think there are two aspects to the question of position size for non-professionals.  Both stem from the fact that stocks are risky investments. One is objective, the other subjective.  They are:

–Your own objective financial situation, given your age, income and accumulated wealth.  The question is how much risk–and the associated possibility of loss–can you afford to take.  Determining this is what financial planning, whether you do it yourself (probably using the tools on a discount broker’s website) or hire a professional to help you, is for.

For a twenty-something, having 90% of savings in stocks and having one or two positions that are each 5% of equity holdings is probably ok–assuming you’ve done appropriate research.  The two big equity positions amount to 9% of the person’s accumulated wealth.  By far his largest asset, however, is probably his human capital–his lifelong earning potential–rather than savings.  He has plenty of time for a risky investment to work out or to recover from even a large mistake.

For a sixty-something, on the other hand, having two 5% positions is probably also ok–relative to one’s overall equity holdings.  But that’s assuming the person in question has an age appropriate asset allocation. In most circumstances going into retirement with as much as 90% of your savings in equities is crazy.

–Your temperament, your tolerance for risk and–a factor I didn’t really understand until I stopped being a full-time money manager–the amount of time and effort you’re willing to devote to studying the companies whose stock you hold and following corporate developments.

I’ve often listened to casino company CEOs trying to position their gambling services as entertainment.  They joke that if you spend $500 on opera tickets you get a few hours of music but, unlike a casino jaunt, you have absolutely no chance of leaving the performance with any of the money you came in with.

As far as the stock market is concerned, this is a “Know thyself.” issue.  If you’re going to act on “hot tips” from a friend or from some guy on TV whose background and track record you know nothing about, you’re entertaining yourself, not investing.  You’ll probably lose your shirt.  So keep positions to negligible amounts.

One other editorial comment:  there’s a whole generation of Americans on the verge of retirement, whose pension savings are in IRAs or 401ks or other defined contribution pools of money.  We’ll likely live for thirty more years.  But there’s no monthly check in the mail from the company we worked for, like our parents had.  Our lifestyle will depend on the investment results from savings we’re responsible for managing.  Not taking much time or interest in doing so is probably not the greatest option.

let’s say you want to invest, not just entertain yourself

1.  Investing is a craft skill–like being a baseball player or a carpenter.  It doesn’t require you to be an Einstein.  It is experience-intensive, though.  This means you have to do your homework and serve an apprenticeship.  You start by investing small amounts, keeping records of your decisions, analyzing your results and thereby figuring out what you’re good at and what you’re not.  Even the best professional investors aren’t good at everything.  But they know they do a few things very well and stick to them.

2.  I’m not a fan of paper portfolios.  I don’t think they have enough meaning.  If you wanted to be a professional baseball manager, better to manage a high school team than to be in a bunch of fantasy leagues.  Start with tiny amounts of money.

3.  Over years of training portfolio managers, I’ve found that inexperienced managers always have great difficulty in making position sizes large enough to make a difference to performance.  As I mentioned in my post yesterday, a 50 basis point (.5%) position is probably not going to affect overall portfolio results one way or another.  It’s a waste of time.  In addition, if you have nothing but 50 basis point positions, you have to watch 200 stocks.  That’s an impossible task–and you’ll probably be killed by not catching your mistakes in time (that’s another topic, but trust me, it’s true).

For most seasoned professionals–growth investors, anyway–their top 10 positions make up around a quarter of their portfolios.  If you were to analyze it, the rest would probably look a lot like the manager’s benchmark index.  So the portfolio will likely rise or fall on the ten stocks big positions.  The task of monitoring them is manageable.  And if two outperform the benchmark by 20% each in a year, the manager will have about a 100 basis point gain vs. the index (it probably won’t be exactly 100 bp–it’ll depend on whether the market is going up or going down).  For US managers, that’s usually enough to put you in the top quartile.

4.  I think individual investors, once they’ve gotten enough experience to make intelligent judgments, should consider taking a (modified) page from the professional’s book.  This means:

–invest most of your equity allocation passively, through index funds or index ETFs

–complete your equity holdings with a small number of individual stocks (I have around a half-dozen, but I’m willing to spend a lot of time monitoring them)

–determine a maximum position size. Consider both the possible impact of a losing position on your equity holdings and on your overall savings.  If you’re, say, fifty years old and subscribe to the rule that your equity holdings should be the same percentage of your total savings as 100 – your age (which I think is a reasonable first approximation), then you have 50% of your holdings in stocks.

Suppose the individual stock you have the most confidence in were to be 5% of your equity holdings.   If that stock went to zero, you’d lose 2.5% of your wealth.  Is that acceptable?  If that is, then I think a reasonable approach to active management would be to establish three 3% positions and have the remainder of your equity holdings passive.

You should, of course, have a plan for what happens if your stocks go up, as well as for what you’ll do if they go down.  But the action you derive from determining a maximum position size is that you begin to trim the position if you’re fortunate enough to have it reach 5% of the equity total.  You don;t just let it grow.

–determine a minimum active position size, as well.  This is a much trickier topic than it appears on the surface.  I think positions below 1% of your equity holdings are a waste of precious analytical resources.  Let’s say you set that as a minimum size.

The complexity arises this way:  suppose you start out with a 1% position and the stock drops by 20%.  Do you average down and restore the position to 1%?  …or do you say you’ve made a mistake and sell?  A lot depends on your own level of self-awareness and your tolerance for risk.

As for myself, for example, bitter experience has taught me that if I have a large position that goes against me and I average down, disaster quickly follows.  So when a large position performs poorly nowadays, I either decide to hold on or to sell.  I never add.

On the other hand, averaging down is a standard tool of most value investors.

So alhtough it’s important to have worked out a plan, though, it will depend a lot on you as to what the plan actually is.


a turning point for bond funds? …stocks, too?

December 20, 2010 By in Convertibles, Current Market Thoughts, Preferred Stock, Recent Market Action, securities markets, Shaping a portfolio for 2011, stock market, Strategy Tags: , , , , , , , , Leave a comment

I’ve been noticing commercials on financial TV and radio–why I turn on the functional equivalent of the WWE, I don’t completely understand–for gold.  They tend to go like this:  NOW is the time to buy gold!!!  Why?  …because it’s 4x the price it was ten years ago.

In other words, buy because prices are very high.  That’s crazy.

Bond funds have had a similar pitch over the past few years.  Faced with near-zero, emergency low, interest rates, which imply sky-high bond prices, bond fund managers invented a marketing pitch that became known as the “new normal.”  The thrust is that we are in a post-apocalyptic world, where the earth’s economy has been scorched and will be incapable of growth anywhere on its surface for, say, a decade.  Therefore, buy bonds, avoid stocks.

Interestingly, bond funds haven’t had much trouble popularizing this view.  Bonds, like gold, have performed much better than stocks for a long time.  So bond funds have collected lots of assets and are big advertisers in the media.  And, of itself, the fact that rich and successful people would be predicting a global “lost decade” is a newsworthy story.

As I’ve noted a number of times, one characteristic of this point of view is that it’s very self-serving for bond people.  It’s the only scenario I can think o of where it doesn’t make sense to rebalance your portfolio–to take money out of the strong-performing, high-priced asset, bonds, and put it into the weaker-performing, lower-priced asset, stocks.

Cynics would say that bond managers just told investors a story that would keep them from taking money out of bonds, thus reducing the managers’ income.  They’d probably also point out the quiet diversification of Pimco, the largest bond manager, into stock funds about a year ago.  But, however implausible the idea might have been, it’s possible that bond managers actually believed it.  After all, there’s a powerful psychological tendency, that professional investors have to constantly fight, to screen out facts that call into question the way your portfolio is set up.  And after twenty-five years of almost non-stop success, it must be very hard even to conceive that things might not go your way.

Four factors are beginning to call into question the new normal/by bonds thesis:

1.  Economic growth, which has been very strong in the emerging markets (40%+ of the world), is beginning to pick up in a meaningful way in the US as well.

2.  Stocks are starting to outperfrom bonds in a meaningful way.  According to Barrons, over the past year, actively managed bond funds are up 6%+and their US stock counterparts are up 18%+ (compared with the S&P 500 being up 12%+).

3.  Individual investors have stopped putting new money into bond funds.  For some time, they have been selling municipal bond funds on concerns about credit risk.  But the most recent data suggest withdrawals are spreading to taxable bond funds as well.

It’s not clear what people are doing.  Some data sources show funds beginning to flow into equities.  Others indicate most is being parked in money market funds.

4.  Last week, the Pimco Total Return Fund, perhaps the most famous bond fund in the world (as well as the home of the “new normal”), has announced it will change its investment guidelines so it can put 10% of its money into equity-linked securities, like convertibles.  According to Bloomberg, many other bond funds have been investing in equities for a while and ar leaving Pimco behind in the dust.

my thoughts

I think these developments are bullish for stocks.

In the counterintuitive way that Wall Street thinks, it’s a little worrisome to have the last great equity bear, Pimco, capitulate.  Still, stocks appear cheap, the US is growing again, and the flow of funds data don’t yet show a great deal of investor enthusiasm for equities. It’s not to soon to start to worry that the best may be behind us for this equity cycle (after all, we are about to enter year three of bull market), but it’s way too soon to act.

On a technical note:

If history is any guide, the current active manager outperformance of the S&P 500 can’t continue.  It would explain, however, why professional equity investors appear to have closed up shop for the year a couple of weeks earlier than usual.

I haven’t looked to see what kinds of equity-linked securities bond funds are buying.  But S&P companies typically don’t issue convertibles.  So the risk exposure the funds are taking on may be somewhat different (probably higher) than what one might expect.

the Fedex 2Q11 (ended November 30th) results

December 19, 2010 By in Current Market Thoughts, earnings conference calls, Industry Analysis, Inventory Cycle, Shaping a portfolio for 2011, Stock ideas, Strategy, Transport Tags: , , , , , Leave a comment

the results

Yesterday I listened to the FDX 2Q11 earnings conference call, which was held before the market opened in New York last Thursday.

FDX reported earnings of $1.16 a share on revenues of $9.63 billion.  The revenues were up by 12% year on year, the eps less than half that.  Earnings per share also just barely hit the bottom of the range of $1.15 – $1.35 that FDX guided analysts to when it reported 1Q11 results on September 16th.

Despite the close call, FDX raised its guidance for the full fiscal year from a range of $4.80 – $5.25 a share to a new range of $5.00 – $5.30.

The company did caution that its third fiscal quarter is always vulnerable to bad weather, of which the midsection of the US has already had plenty so far this month.  So it’s not yet clear what the quarterly breakout of the earnings will be.

details

The International Priority (IP) business, notably deliveries from Asia to the US, continued to grow rapidly, with revenues expanding by 14% over a year ago.  Notably, the domestic parts of the FDX distribution chain grew at about the same rate, and benefitted from improved operating efficiencies.

So what went wrong?

1.  After what was reported as only three hours of deliberation, a jury in Indianapolis awarded now-defunct airline ATA $65.9 million in its suit against FDX that it wrongfully terminated a long-term contract with ATA to transport US troops.  A reserve for this judgment–FDX said nothing on the call about a possible appeal–clipped about $.15 from eps.  That’s also the main reason the IP business had flat year-on-year operating income.

2.  FDX overestimated the strength of the IP business during the second quarter.  It extrapolated the frantic rate of shipment growth of the spring and summer into the fall.  But that didn’t happen.  Revenues in the IP segment grew by 23% y-o-y in 1Q2011 after an almost 30% gain in 4Q10–but decelerated to 14% growth in 2Q11.  (True, comparisons are affected by the fact that FDX’s business really began to pick up from recession lows in the second quarter of last fiscal year.  But FDX guidance still anticipated better than what it got.)

3.  FDX is now projecting a better full year than it was three months ago.  I’ll get to this in a minute.  Because of this, it is also projecting bigger bonus payments to employees than it was.  Therefore, it made a higher provision for bonuses in 2Q, and presumably also had to make a catch-up accrual for 1Q.  FDX mentioned this as a factor but gave no further details.

why the slowdown in the international business?

In ordering from suppliers, a merchant faces two complementary inventory risks:

–he can order what he is confident he can sell plus some more, and risk the expense of holding excess inventory for longer than he wants or selling it at clearance prices, or

–he can order only what he knows for sure will sell–or maybe less, and risk losing business as customers come into the store and find the shelves bare.

FDX wasn’t 100% clear on the point, but it seems to believe that retailers got cold feet as they planned for the holiday selling season.  They collectively made the cautious decision that the risk of being out of stock was much more acceptable than the risk of having excess inventories.  So they slowed down the pace of their new orders from Asia.

They are now finding out, too late to do anything about it, that customers are in a much better spending mood than anticipated.  As a result, store inventories will be severely depleted by the end of December.  This means, in FDX’s view (I think they’re right) that there’ll be a mad rush to restock early in the new year.  That will be very good for FDX.

In addition, FDX clearly believes that world economic growth is beginning to gain momentum and will continue to do so for at least this year and next.

my thoughts

I haven’t done enough work on FDX to have an opinion about it as a stock.  Clearly, earnings are going to improve, both as the global economy expands and as the costs of resuming normal operations–restoring pay and benefit cuts for employees and reactivating planes mothballed in the desert during the recession–now being charges against income–fade from the financials over the next couple of quarters.  To me, the real question is how much of that good news is already reflected in today’s stock price.

Be that as it may, FDX is a large, sophisticated company.  Because of the business it’s in, it has unusually good insight into the workings of the world economy.  It sees, directly or indirectly, manufacturers’ production plans and retailers sales experience.  And it must already have a good feel for the tone of business for the next several months.  I happen to think the company’s view of world economic growth is correct.  But, unlike my guesses, theirs is based on a wealth of commercial data that few other entities have.  So I think FDX is evidence that it’s still right to be bullish.

 

 

Wells Fargo: US economic recovery ISN’T sub-par

December 13, 2010 By in Current Market Thoughts, inflation vs deflation, Inventory Cycle, Recent Market Action, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

a better than average recovery

A month or so ago, I wrote about the thesis of Jim Paulsen, the chief investment strategist for Wells Fargo, that the US is actually doing a bit better than average for economic recoveries over the past twenty-five years.  The perception that the economy is relatively weak comes, in his opinion, from comparing apples with oranges–from comparing this recovery with all post-WWII economic rebounds, not with those of the last quarter century.  This latter group, however, are the only ones that occurred with an economy like we have in the US today.

Anyway, I’m suddenly on the mailing list for Dr. Paulsen’s monthly commentary (Thanks, Wells Fargo!).

a new angle

In his December comment, Dr Paulsen expands on his idea of a “back-loaded” economic recovery.  I don’t necessarily intend to talk about Dr. Paulsen every month, but I think he is making some interesting points.   They argue that we will be seeing accelerating economic performance out of the US economy in the months ahead.

women entering the workforce

In a nutshell, Dr. Paulsen’s November observation is that the US economy of the 1950s through the mid-1980s had a faster potential rate of growth than we have today because in the earlier period  the large-scale entrance of women into the workforce acted as a significant tailwind that we no longer have.

the effect of inflation

In his December commentary, Paulsen makes the additional observation that the switch from the inflationary mindset of the Seventies and early Eighties to a disinflationary one of the Nineties and beyond also has a significant effect on the behavior of corporations.  As he puts it, in the earlier period, “sales always rose and prices could always be increased.”  Therefore, it made no sense to worry about staffing levels or the size of inventories.  Price increases would always ensure that companies could report a satisfactory, and rising, level of profits.

The world has changed dramatically since the Sixties and the Seventies.  The Fed’s thirty year long fight against inflation has stamped out in customers’ minds the idea that prices inevitably rise.  In the new environment, a company has got to concentrate on keeping costs low and increasing productivity.  Hiring increases and capacity additions come only as a lost resort.

my thoughts

In my view, Dr. Paulsen’s observation about inflation is basically correct.   In fact, the old inflation-prone world of the Seventies is so foreign to today’s experience that it’s hard for people who didn’t experience it to comprehend how or why the economy ran the way it did back then.

But there are also a lot of other things different about the Sixties and Seventies:

–the industrial firms in Europe and Japan were still rebuilding after WWII

–trade barriers were much higher than today

–therefore, there were far fewer true multinationals, who aimed at selling large amounts of stuff at moderate prices all around the world

–electronic products, where performance always gets better while prices decline, were a much smaller percentage of industrial production

–the rate of technological change was much slower (so fewer worries that bloated inventories might become obsolete)

–there was no Internet and no online commerce

–there was no supply chain management software, so managements had little of today’s ability to analyze and control operations.

Yes, the Fed’s actions in the Eighties destroyed expectations of inexorably rising prices.  But the world is much more complex now.  Change is faster and competition is much more intense.  So cost control and productivity increases are essential for firms to remain competitive.  And today’s managements have powerful tools that allow them to dramatically curtail operations–as they did in late 2008 and early 2009–confident that this is the profit-maximizing thing to do.

good news

Today’s coin has another side, however.  Cost cutting and squeezing more output from a given amount of capital equipment can only go so far.  At some point, firms have to add people and plant in order to continue to grow.

Jim Paulsen thinks, and I agree, that we’re now at that point in the current recovery.  Productivity growth has been slowing for a while.  And there’s substantial evidence that companies are beginning to hire at a faster rate.  If so expect profits for publicly listed companies to accelerate in the months ahead.