To use a term from tennis, a trap is an unforced error. In our arena of investments a trap is a concept/thought that leads us to significant losses of capital, or worse, opportunities to make sound productive investments.
Last week I had the opportunity to address ASCOSIM, an organization of Italian investment advisers. My talk in Milan included a brief list of ten concepts in structuring portfolios of collections of mutual funds. Email me at MikeLipper@gmail.com, and I will send you a copy of the ten slides which might promote useful conversations with investors.
I mention this journey to highlight one of the advantages of spending sixteen hours in an airplane over the course of two days: the ability to have ample time to read, think, and write.
In the world that I inhabit of professional investors and their competent advisers, there are many opportunities for mistakes of judgment. During my flight home from Milan, I kept wondering why these smart people make dumb, unforced mistakes. In thinking about the mistakes that I and others have made, I realized that we all fell into traps.
Most of these traps first started with the principles we utilized. We use tools for the impatient. Instead of celebrating data diversity, we use labels as a way to bunch information so we can quickly narrow our focus to making a selection from a pre-sorted list of alternatives. We believe that we can reasonably predict the relative outcome of the labeled alternatives — for example, “growth,” “value,” stocks, bonds, developing markets, and a whole bunch of other classifications. Our problem is the comfort brought by these and other navigation skills. One example is the ability to predict with a high degree of certainty our arrival time on an airplane trip covering more than five thousand miles with greater precision than our arrival time in our daily land-based commuting.
In math and physics we are taught by problem solving and experiments that there is only one correct answer, and to get it all one needs is to follow the prescribed formula. The focus of this post is the current traps that I see smart and perhaps very smart people falling into. They are examples of using labels that can lead to traps. They are not listed in any particular order. Pick your own trap, as we all do.
We all enjoy the warm feeling when we believe that we have bought a bargain. We want to pay a price at a significant discount from its true value. There are two traps here. The first is that we can mathematically determine the exact true value of something, including securities. The second is not being concerned with the seller’s motivations, which could well change our evaluations and results.
One of the ideas that I hope to get over to the incredibly smart Caltech students (including doctoral candidates as well as post-docs) that I will be addressing this week is that the person on the other side of the trade may be even smarter and may have better information.
Successful Young Investors
Having grown up in the investment business, I have experienced and benefited from the battle for investment thinking supremacy between young analysts, portfolio managers, and investors, and those who are older. Wisdom is not chronologically based, but the work being done at Caltech and elsewhere indicates that memory plays an important role in judgments. The cyclicality of markets and investment themes over time reinforces the need to avoid obvious risks. It has been many years since the general stock market has risen significantly above previous peak levels, thus many of today’s enthusiastic investors have only had the experience of the decline and recovery phases of the last five and ten years; they think a bull market is a new phenomenon. They don’t see that within every surge of higher prices and volume there are built-in time bombs of future problems. Some of these rises will produce spectacular results. Enjoy them, perhaps participate, but don’t count on today’s gainers getting you out ahead of time of their collapse; it will be new to them. In other words, it could be a trap.
Book Value’s Trap
Many purveyors of investment products use a corporation’s book value as a measure of investment value. People tend to forget the calculation of book value is a balance sheet measure of subtracting the liabilities from the assets found on the balance sheet to get the equity and translating that to a book value of a corporation. This may be like choosing a new friend solely based on their precise phone number. Remember that the assets are shown on the basis of cost to acquire them if it is demonstrably below their current market value. The liabilities are based on the size of known obligations. People tend to forget that the book value they were taught in college or graduate school — as well as the CFA exams — is a teaching device, not a measure of reality.
A Better Way
As someone who has both bought and sold intellectual property companies and also advised others to do so, I have found book value is only of use in comparing other transactions when their true value is unknown. When one is privileged, or perhaps burdened, to get into the mind of the driver of the transaction, one sees an entirely different set of algebraic calculations. The first is what would be the cost to recreate that portion of the subject company’s customer relations and sales? This is then compared with the potential buyer’s estimate as to what it would cost to build the desired value itself and how long would it take.
The Trap of Overlooking Human Factors
All businesses have inherent problems, usually involved with human relations. What will be the costs and trouble in dealing with these? Most importantly, can the buyer supply the talent needed to solve these issues? Along with those questions, what are the balance sheet assets really worth to a particular buyer? One of the more difficult imponderables in evaluating an acquisition or disposal is the reactions to the announcement. What will the customers think and, long-term, what will they do? What will the “good” employees do, what will the various regulators and communities attitudes be, what effect will the acquisition have on the acquiring company, will the combination lead to enhanced talents or to a talent drain? These are just some of the questions that should be determined.
Moving to the liabilities: Do they reflect all the reasonable contingent costs, including retention bonuses, possible adverse law suits and tax consequences, costs to shut down and move facilities and people, unmet needs for research and development, and other elements of essential research? As one can see, there are real differences between the real value of a company and stated book value. This is not to say that book value is meaningless. If one can make the tentative judgment that the sum total of the missing factors is similar to the same or related questions of other transactions, the relative multiple of book value of other transactions is a somewhat useful guide as to the trend of deal pricing. (When I know more, I prefer to use the metric of price times sales. Stratifying companies that are worth one half of their sales, or even better one times, two times, three times, and more, is a good measure of what buyers believe the future value of an acquisition is.) My bottom line is that present valuation is a good current guess of future valuations, but you should not rely on book value as a sole measure.
Predictability of VIX
S&P Dow Jones Indices publishes monthly comments on various indices. In its latest commentary the first point was as follows:
“The VIX is down over the past month and the current reading of 12.84 suggests that the potential for significant moves lies only to the upside. . . . The Australian, Hong Kong, and Canadian VIX equivalents are also down, a pattern repeated elsewhere across developed markets.”
In its simplest terms, the VIX is a measure of the implied volatility of S&P 500 Index options. Often market professionals view the level of the VIX as a measure of fear operating within the market place. Considering the absolute closing high for the VIX was 80 in late 2008, one can see that currently there is not a great deal of price pessimism in the marketplaces around the world. As a contrarian, this is exactly when a negative surprise could be its most potent. The sell off thus far in January, which appears to be worldwide, may be the trap that was sprung on those that use immediate market movements to predict future trends including turning points.
The Failure of Stock Investors to Pay Attention to Bonds
Stocks can surprise both positively and negatively. In most cases, the best thing that can happen to owners of bonds is that they receive timely payment of interest and principal. Thus bond prices are more sensitive to potential bad news than the stock market. As a stock investor, I am aware that bond prices can be a useful warning device for me. Changes in credit ratings are often a coincident indicator of bond price movements. Nevertheless, they can be leading indicators for the general stock market prices. Moody’s* has published a schedule of quarterly downgrades and upgrades. For the 4th quarter of 2013 there were 78 high yield downgrades (68 upgrades) and 21 downgrades of investment grade issuers (12 upgrades). The extreme downgrade readings were 303 for high yield and 93 for investment grade.
The current preponderance of downgrades in an economy that is meant to be recovering is a cause for one to be cautious about committing new money to the stock market.
Please share with me the traps that you have avoided and which ones are you wary about now.
*Owned by me personally and/or by the private financial services fund I manage.
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A. Michael Lipper, CFA
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.