Gathering Thin Reeds?

Many of you know that I spend time gathering “thin reeds” and try to weave them into a favorable “investment bouquet.” This is a strategy Fidelity’s Peter Lynch took to its zenith in an era gone by. Recall the story Peter told about how he stumbled into Magellan Fund’s (FMAGX/$96.12) investment in Hanes, when he first heard his wife rave about a new product called pantyhose. Indeed, Peter Lynch was a great observer of what was going on in life and invested accordingly. I have discussed such methods with Putnam’s Jerry Sullivan, who worked for years with Peter and to this day incorporates many of Peter’s strategies into the mutual funds he manages. One of Jerry’s funds, which I own, is Putnam’s Multi-Cap Core Fund (PMYAX/$18.11). This “thin reed,” or observation, concept first struck me while reading the book “Reminiscences of a Stock Operator,” published in 1923. The book is about the exploits of Jesse “the boy plunger” Livermore’s rise to be the greatest speculator on Wall Street in the 1920s. One of the lessons gleaned from the book was related by Livermore after visiting two different railroad companies and observing (there’s that word again) that one of the CEOs was dashing off memos on gold inlayed paper. The second CEO was writing on already used bills of lading to scribe memos on the back. Obviously, Livermore bought shares in the second company. The book is layered with similar lessons and if you have not read it, the book was ranked 15th on Fortune’s 75 of “The Smartest Books We Know.”

More recently, near the March 2009 “lows,” a financial advisor (FA) told me about his friend who is the CEO of Bank of the Ozarks (OZRK/$35.50/Strong Buy), which is followed by one of our banking analysts. As I recall the story, George Gleason, who I have never met but the FA knows, was/is an extraordinary banker. As CEO of OZRK he eats and sleeps banking, always thinking about how to do things better than anyone else. In fact my friend told me other than ballroom dancing, which he is alleged to be excellent at, he does not golf, boat, etc. All he thinks about is banking. In retrospect I wish I would have listened to that “thin reed” and bought the stock.

This morning I review such “observations” because as Yogi Berra said, “You can observe a lot by just watching!” To this point, while seeing accounts in San Francisco recently, I read a story about Boston-based Fidelity having a good year in 2014 from an earnings and revenue standpoint, but that they were losing assets to passive investments, aka index funds, ETFs, etc. Here the observation is that this is what you see at infection points where individual investors are doing the exact wrong thing at the wrong time. The inference is, what investors should probably be doing is the opposite. They should likely be selling their passive investments, after a few years of out-performance, and redeploying those funds to “active” money managers. Intrigued by this observation, I asked my friend Bob Doll, strategist and portfolio manager at Nuveen, on the conference call we did for Raymond James advisors last Tuesday, that exact question. To wit, “Bob don’t you think we are at the stage of the secular bull market where investors should be moving money into actively managed funds and away from passive funds?” While I could not write as fast as Bob spoke, his response went something like this:

Absolutely, for the past few years it’s true most portfolio managers have not outperformed the passive indexes. But, I think we are at the stage of the bull market where it is going to be tougher for passive investments to outperform well thought-out active management strategies, as stocks grind higher rather than bolt higher.

While Bob didn’t go into the reasons for that view, a recent story in The Wall Street Journal did. The article was titled, “The Case for the Active Mutual-Fund Manager” by Michael A. Pollock. Mr. Pollock began with, “Index funds clearly have won the hearts and minds of many investors.” A paragraph later he writes, “Little surprise, then, that last year, people yanked $98.58 billion out of actively managed U.S.-stock mutual funds while putting $71.34 billion more into ‘passive’ ones that merely track an index.” Hereto, the observation for the contrary investor is that participants should be doing the opposite. The article goes on to state five reasons why you should consider active management at this stage of the bull market (as paraphrased):

  1. Investors have flocked to dividend-paying ETFs for income as yields have fallen. Such ETFs, however, are often focused too narrowly on certain sectors. Such ETFs only sell a stock if it no longer fits the mission. Meanwhile, if market sentiment shifts away from that sector, it can hurt its performance. An active manager could limit the impact of such shifts by diversifying.
  2. If the markets start trading sideways, like they did from 2000 – 2008, nearly two-thirds of active managers of large-cap funds beat the S&P 500.
  3. Bond yields are likely headed higher. Since yields move in the opposite direction of bond prices, if rates are going higher it could be risky to own an ETF that closely tracks a broad bond index.
  4. ETFs make it easy to get non-U.S. exposure. But those ETFs tend to be based on market capitalization weighted indexes that tilt toward the largest foreign markets, often exposing investors to weaker markets like Russia and Western Europe. Active managers can fare better by diversifying away from such markets.
  5. If you are worried about volatility, active managers have more ways to play defense. They can own higher-quality stocks and trim positions as valuations rise. They don’t have to have the “pedal to the metal” when markets are going up, and they can put a brake on more quickly when markets are going down.

Boy, talk about volatility. This year the volatility has been intense. That should come as no surprise to readers of these comments because we entered the year noting, “The models that served us so well last year suggested a rocky start in the first few months of this year combined with more volatility.” And, the volatility continued last week, although I am chagrinned to observe the media only tends to call it “volatile” when stocks go down. But last week stocks went up, as expected, imbibed by my anticipated last-hour Greek deal and the fact the S&P 500 has been pointing the way higher with its new all-time high of two weeks ago. While I have lamented I wish the D-J Industrials (INDU/18140.44) and Transports (TRAN/9131.16) would confirm the SPX’s highs with new all-time highs of their own, I have often written I think the oodles of internal energy that has built-up in the equity markets would eventually be released on the upside. And, that is exactly what happened last Friday with the Industrial’s new all-time high. Now, what we need is for the Transports to better their all-time closing high of December 29, 2014 at 9217.44 for yet another Dow Theory “buy signal,” the multifarious such “buy signal” since our “it’s the bottom” call of March 2, 2009.

As for investment ideas, in last Wednesday’s Morning Tack I featured a number of stocks from Raymond James’ research universe that were/are accumulating large amounts of “intangible capital,” and are also favorably rated by our fundamental analysts. Our friends at the astute GaveKal organization have made a “religion” of unearthing these types of companies, which is why I own their mutual fund (GAVAX/$14.24) managed by another friend of mine, Steve Valenti. More on this GaveKal point in tomorrow’s Morning Tack.

The call for this week: The index to watch is the D-J Transportation Average to see if it confirms the Industrials by making a new all-time high of its own with a close above 9217.44. Speaking to upside breakouts, while all but one of the S&P macro sectors are overbought, Utilities being the exception, there were two Select Sector SPDR Funds that broke out to new highs last Friday. Those two were the Industrial Select Sector SPDR Fund (XLI/$58.16/see chart 1 on page 3) and the Healthcare Select Sector SPDR Fund (XLV/$72.18/see chart 2), both of which screen well on my algorithms. Attentions for this week will also be on the plethora of economic releases because only two of last week’s 13 economic reports beat estimates. As for earnings and revenue estimates, of the 1680 companies that have reported so far, 61.1% have beaten earnings estimates and 58.1% have beaten revenue expectations. This morning the preopening futures are lower (-4 SPX) as participants contemplate more conflicts in the Ukraine and a Greek reprieve that may pave the way for an exit from the EU. As well, European banks are set to fail the Fed’s stress test, Turkey basically invades Syria, the refinery strike extends, and the port strike seems to have a pleasant ending.


(c) Raymond James

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