Institutional Investing in Uncertain Times

Categories: Drivers of Value
A. Michael Lipper, CFA

For three of the largest religions of the world, last week was an important week of cherished celebrations. Just as each of these institutions needs to look after its flock both now and in the future, financial capital investment for all should be thought of as a group of coordinated portfolios.

In my work with various non-profit organizations I have been an advocate of portfolios designed to address four different objectives:

  • The expected next two-year expenditure pool or the operating subsidy beyond current donations and earned revenues.
  • The replenishment portfolio, which is designed to replenish the operating subsidy over a relatively short period of five years. It is this pool that is at most risk to a market decline because it may not have enough time to recover from its former peak. (Depending on the likely term of current leadership, there may be greater sensitivity to leaving the organization as strong as when the current team came into its responsibilities.)
  • The legacy pool, which is designed to provide funding for the foreseeable future of at least the next leadership team. They need to be concerned with paying for the physical and human upkeep of existing facilities. The legacy portfolio can recover from periodic market declines.
  • The endowment pool, which is to recognize that institutions will need to provide services beyond their current framework, which may well mean a major desired expansion. The endowment portfolio needs to provide the necessary capital for expansion and thus must grow faster than its surrounding economy. Often, this can most readily be accomplished by taking advantage of periodic opportunities offered in declining markets.

Addressing the needs of the four portfolios is what I attempt to do for various long-term focused institutions and wealthy families that want to provide funding for three or more generations. Today my focus is on what changes may be needed for the second portfolio, the replenishment portfolio. If the other three are well structured, current problems and opportunities do not require much in the way of changes.

The issue today is the appropriate weightings of the negatives and positives that are lurking just below the horizon that most investment commentary is focused on.

Negatives discussed

I have often commented that if one scratches the wrist of an analyst, a historian will bleed. In that vein, the work being conducted at Caltech and elsewhere shows some work that passes for thinking and judgment is essentially memory. Not only because of my history lessons from the US Marine Corps, but throughout my study of financial and therefore political history I am struck with the increasing parallels with the political actions that led up to World Wars I and II.

In each case, initially the eventual protagonists did not seek armed conflict. They were indoctrinated by their general staffs on von Clausewitz’s principle that war is another way to accomplish policy goals. Both sides felt that they were under economic attack from the other side and the integrity of their promises to their allies was threatened. In both cases the United States was intent on not getting militarily involved and applied economic sanctions to slow down or prevent further expansions of the other side. In each case the US strategy failed. I am very hopeful that the parallels do not complete a triple disaster.

If external problems are not enough, the United States is in the process of hollowing itself out by adopting a very inefficient way to redistribute wealth through increases in minimum wages in the reported economy and changes in tax rates and regulations. The issue is very simple from a geometric point of view. Those currently in power look at a pie chart of wealth and want to change how it is allocated. The real way to put more money in people’s hands is to grow the pie to larger sizes.

If we are going to focus on redrawing the slices, our attention must be focused on the trade-offs between the slices. Unfortunately, those with less capital are more at risk to diminished purchasing power due to government sponsored inflation and the relative destruction of small local businesses. On the other hand, if the pie grows as a result of providing more goods and services to both internal and export markets, there will be more income at all levels for those who want to work.

So far, the reported earning season has been disappointing. This is particularly true when compared to a very robust fourth quarter in 2013. A careful analysis of operating margins (pre net interest income) is showing a minor contraction in many cases. As we progress through the year, the quarterly comparisons with those of 2013 will probably look less healthy. Outside of absolutely needed capital expenditures in the United States, an expansion in spending here is not expected unless the results of the 2014 election and the prospects for the 2016 election look favorable to both corporate and individual investors. Even in the case where domestic production is cheaper and more efficient than outside the United States, there is little headway in bringing more work and capital back into the country.

The financial community is always looking for an easy way to express an abstract thought. We love numbers because we can arbitrage against these numerical trends by purchasing below trend and selling and/or shorting above trend. This approach can last for a long time, far beyond its analytical usefulness. I am very concerned that in two cases these mathematical extrapolations are going to be increasingly found wanting.

The first is the very popular CAPE (Cyclically Adjusted Price to Earnings ratio) developed by Robert Shiller of Yale University. In his model he uses the reported ten rolling year’s earnings per share compared with current prices to determine whether a market is under or over priced.

As an analyst one of my frustrations is that the quality of reported earnings is evolving. Accounting rules have been changed to favor the use of financial statements designed for the benefit of lenders not investors. Further, almost every year there are substantive modifications in federal and state taxes. The plain truth is that long past results are not much use for investment these days by strategic or ordinary buyers. I suggest that these simplistic calculations can lead investors to believing that there is not a valuation risk in today’s markets.

The second questionable measure is a purported measure of risk called by its symbol, VIX. S&P reported that various ETFs that were meant to go up when volatility increased did not. As a matter of fact, the inverse instruments did. More importantly, we believe that risk of large losses is not effectively measured by volatility. Over the last twenty or more trading days, numerous biotech and internet-oriented retailers suffered significant price declines that they had not experienced before. This suggests to me risk of large losses is more likely a function of the rate of past price gains and excessive current valuations.


When one strips out the impact of governments at various levels, there is considerable evidence that the private sector is somewhat haltingly growing in many countries. Interestingly, the United Kingdom, with a somewhat more orthodox economic policy, is leading the way. This is very much worth watching for global investors because the FTSE 100 price chart appears to have created a triple top going back to the 2000 year. If it were to decisively go through the 2000 peak, a chart pattern would be created that the market technicians would believe becomes a base for a massive expansion.

One sign that a long-term focused financial institution believes that there will be more money flowing into financial management is the purchase of Nuveen by TIAA-CREF. The intention is to keep the acquisition separate and under present management. This is important because the buyer recognizes the value of the existing management and projects that the individual and institutional markets will grow faster than the general stock market. With its resources, TIAA-CREF could have hired a bunch of people to do the same jobs as the Nuveen people do — but it didn’t.

On Monday, the Boston Marathon was run. A year ago it was disrupted by terrorists’ bombs. Like New York after the 9/11 attacks, Boston is coming back showing the resilience of the American people just as we showed once our political leaders fumbled us into the two world wars.

In looking beyond a period when the markets lead our economies down, there is an increasing belief that a major boom is ahead for us. The applications of technology and energy production and use will change the structure of how we live and I suspect, invest.

Applying Time Horizon Portfolios

While I will be happy to discuss specifics with our readers, let me briefly outline my suggestions.

Operating Portfolio: An Operating Portfolio to cover at least two years of planned expenditures should be kept in high quality short-term instruments of limited duration.

Replenishment Portfolio: A Replenishment Portfolio, which normally would look like a sound balanced fund, reduces its risk portion by going into somewhat limited in duration, high quality fixed-income with high quality (probably large-cap) equities in equal proportions. If the market gives an opportunity to buy high quality securities at prices significantly lower than today’s prices, I would be willing to dramatically raise the stock portion.

Legacy Portfolio: Outside of a small trading reserve, a Legacy Portfolio should be equity focused. This could include some high yield bonds or even bankruptcy paper, but not at today’s prices. Entrepreneurial companies that are dealing with expanding markets would find a natural home in this portfolio.

Endowment Portfolio: An Endowment Portfolio should be focused on companies that are currently disruptive and smart. They are currently disruptive by dramatically changing pricing due to technology. Many small companies may fit within this portfolio.

In our investment practice we intend to fill these four Time Horizon Portfolios with mutual funds and similar SMAs.

Which negatives and positives do you agree/disagree with?

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