Classic: Get to Know the Holders’ Hands, Part 1

Note: this was published at RealMoney on 7/1/2004.  This was part three of a  four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.  If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.


Investing Strategies

Different investor groups in the market have different patterns of funding and disbursement.

Understand those patterns to read market action more clearly and see what trends might emerge.


Recently, the firm I work for held a large amount of the common stock of Phoenix (PNX:NYSE). As the stock rallied, I kept moving out my sell target, because the technicals on the stock were so compelling. There were no analysts saying buy, there were a few saying sell and the short interest was high. The company was doing all the right things and the stock had great price momentum, but the valuation was just too high. I wanted to sell, but I couldn’t figure out when.

Finally, on Feb. 21, the stock price began to rally on no news. Going to the message boards, I discovered that there was a momentum investor with a radio show who was making one of his occasional television appearances, and was touting Phoenix. I went to our trader and said that we had our chance. There was a group of valuation-insensitive buyers buying the stock with abandon. I said, “Ride the ask [offer stock at the asking price], and if you get any thick bids near the ask, hit them.” (Read: If there are aggressive large bidders, sell to them at their level.) We sold our position in two weeks, without disturbing the market; we were able to get an average price of about $14.25. (Our trader is top-notch.) Today the price of Phoenix is about 15% lower. The momentum investors choked on the stock that we (and others) fed them.

Why did this work for us? We understood two aspects of how Phoenix traded very well: the fundamentals and technicals. The fundamentals taught us what fair value should be, but the technicals taught us how investors would react to movements in the stock price.

Every investor has a mode of funding and a mode of disbursement. The funding and disbursement modes affect how long and under what conditions an investor wants to, or is able to, hold his position. Some examples will illustrate general principles of these modes. I will describe the ways that various classes of investors fund their investments, how their investments are held, how they are liquidated and how all of this affects what kinds of investments they can use from both an asset class and liquidity standpoint. I also will attempt to explain how the behavior of some classes of investors can become temporarily self-reinforcing, leading to booms and busts.  Finally, I will try to give some practical advice along the way as to how you can benefit from the behaviors of different classes of investors.


1. Banks and Other Depositary Institutions

Banks make promises to depositors. Some of these promises are absolute; some are contingent on external events. Bank regulations exist to make the keeping of the promises more certain (or, in modern times, keep the guarantee funds solvent). Banks have to keep adequate capital on hand to provide a margin of safety against insolvency. The amount of capital varies on the immediacy with which deposits may be withdrawn, the degree of equity/credit risk of the assets and how well the asset cash flows are matched to the liability cash flows.

Liquid assets must be set aside to meet the amount of funds that may be withdrawn immediately with little or no penalty. The more that is set aside, the lower the risk and the lower the profit. If the assets are materially longer or contain more equity risk than a money-market-like investment, there may be a loss when the assets are liquidated to pay off depositors. In general, the cash flows of assets must be matched to the liabilities that fund them, at least in aggregate.

This biases banks to hold primarily short- to intermediate-term, high-quality fixed-income assets: bonds, loans, mortgages and mortgage-backed securities. These are generally safe investments, but banks are fairly leveraged institutions. If the market moves against their investments and their capital cushion gets eroded to the point where their ability to operate becomes questionable to regulators (or customers), the banks might be forced to sell investments into a falling market in order to preserve solvency.

The first motive of a financial institution is to survive; the second is to profit. When the first motive is threatened, even if there is a good possibility that the institution will survive and make more money if it retains the assets that now are perceived as risky, in general, the risky assets will get sold to assure survival at the cost of current profitability.

To return to a concept I discussed in the first column I wrote for RealMoney, Valuing Financial Slack in the Steel Sector, banks with a high degree of leverage relative to the overall riskiness of their assets and liabilities possess little in the way of financial slack. Volatility in the markets that cuts against their position harms such companies. They end up becoming forced sellers and buyers.

Banks with financial slack can enjoy volatility. When the markets are dislocated, they can make room on their balance sheets to wave in securities that are distressed and temporarily trading below intrinsic value. During times of volatility, the strong benefit at the expense of the weak, whereas weak firms outperform during periods of stability. As an example, after the real estate crisis in 1989-1992, the banks that did the best over the whole cycle were those that did not become overleveraged, did not over-lend to marginal credits and had diversified operations. During the crisis, they had the flexibility to lend in situations of their choosing at favorable yields.


2. Insurance Companies

Insurance companies are like banks but generally have longer funding bases and typically run at a higher ratio of surplus to assets. Insurance companies typically have more ways to lose money than banks, and potential cash flow mismatches in the longer liability structure require more capital to fund potential losses. In principle, the higher surplus levels and the longer liabilities should allow for investment in longer-duration assets like equities, but the regulations make that difficult. Surplus is limited; what gets used for equities can’t be used for underwriting.

As a counterexample, consider what happened to the European insurance industry in 2002. European insurers are allowed to invest much more in equities than their U.S. counterparts can. (Berkshire Hathaway (BRK.A:NYSE) is an interesting exception here.) As the bull market of the 1990s came to an end, European insurers found themselves flush with surplus from years of excellent stock-market returns, and adequate, if declining, underwriting performance. The fat years had led to sloppiness in underwriting from 1997 to 2001.

During the bull market, many of the European insurers let their bets ride and did not significantly rebalance away from equities. Running asset policies that were, in hindsight, very aggressive, they came into a period from 2000 to 2002 that would qualify as the perfect storm: large underwriting losses, losses in the equity and corporate bond markets and rating agencies on the warpath, downgrading newly weak companies at a time when higher ratings would have helped cash flow. In mid-2002, their regulators delivered the coup de grace, ordering the European insurers to sell their now-depressed stocks and bonds into a falling market. Sell they did, buying safer bonds with the proceeds. Their forced selling put in the bottom of the stock and corporate bond markets in September and October of 2002. Investors with sufficient financial slack, like Warren Buffett, were able to wave in assets at bargain prices.

This principle may be articulated more broadly as, “The tightest constraint dominates investment policy.” As an example, an insurer that already was at a full allocation on junk bonds could not take advantage of the depressed levels in the junk bond markets; such investors were biting their nails, wondering if they would make it through alive. Another example occurred in 1994, when the most volatile residential mortgage bonds were blowing up. Insurance companies that had a full allocation to that class could not buy more when prices were at their most attractive. Companies and investors that rarely bought the “toxic waste” of the residential mortgage bond market began scooping up bonds at discounts unimaginable previously. A number of flexible investors, including St. Paul (now St. Paul Travelers) and Marty Whitman both ventured outside their ordinary investment habitats to benefit from the crisis.


3. Defined Benefit Pension Plan

Defined benefit plans need cash to fund payments to beneficiaries. The amount and timing of the benefit payments vary with plan demographics (sex, age and income), physical roughness of the industry and the specific plan provisions (e.g., late retirement, early retirement, etc.). Inflows to DB plans depend on funding levels and the financial health of the company sponsoring the plan. For an individual DB plan, the cash inflow and outflow characteristics will help determine the plan’s asset allocation, together with the risk tolerance of the plan sponsor.  The more risk-averse a plan is, the less capable it is of funding inflows, and the older the plan’s participant population, the larger the proportion of assets that will go into bonds and other safer investments.

For all DB plans in aggregate, though, the cash flow and demographic characteristics mirror those of the Old Economy. DB plans were created back in the days when the relationships between employer and employed were more fixed than they are now. In the current era of more short-lived employment relationships and with the average age of participants in DB plans rising, these plans face several challenges:

  1. Net cash outflows are getting closer.
  2. There are fewer cash inflows.
  3. Plans are being terminated (or converted to cash balance plans) due to cost, economic weakness and inflexibility.

DB plans are major holders of equity and debt in the U.S., but they are not as great a force as they once were.  Defined contribution plans (i.e. 401(k)s, 403(b)s, etc.) are bigger now. The relative decline and aging of DB plans has had, and will continue to have, two effects in the market. First, because of aging, there will be a greater relative demand for bonds. Second, DB plans have always had a long investment time horizon. That is shrinking now. DB plans tend to resist trends in the market; they tend to rebalance to a fixed asset allocation, which leads them to buy low and sell high. DB plans were the ones selling equities in March 2000 and buying in October 2002; their rebalancing strategies insured that. As DB plans become a smaller fraction of the investor base, markets will become more volatile due to the reduction in long-horizon capital in the market.


4. Endowments

Endowments plan to survive forever. Forever is a tough mandate.

Inflows to endowments are uncertain, and outflows are fairly constant. They have spending formulas, the most common of which has the charity spending a constant percentage each year, usually 4% to 6% of the endowment. (In the old days, say 10 years ago, most formulas allowed charities to spend income, which was defined as dividends plus net capital gains.) Within these constraints, endowments behave like defined benefit plans.


5. Mutual Funds

Mutual funds do not face any fixed funding or disbursement. Their flows come from retail money chasing past performance. Managers that do well face the blessing of attracting more funds, which they hope will not dilute their returns. Managers that do poorly have funds withdrawn from them, forcing them to liquidate investments that they otherwise think are promising. If a manager is a big enough investor in a given company’s stock (think of Janus’ concentrated portfolios), this can have the effect of worsening performance as liquidation goes on, or boosting the already good performance of managers that are receiving cash inflows to a concentrated fund.

These tendencies become more pronounced the better or worse that performance gets. When performance is near the median level, say, within the second and third quartiles, performance-driven fund flows are small. For many mutual fund managers, this gives them the incentive to never drift too far away from the benchmark, whether that is an equity index or an average portfolio of peers. There is safety in the pack, even if there might be more grass to eat further from the herd. It is rare for a mutual fund manager to be fired for being mediocre.


6. Index Funds

What is true of regular mutual funds is also true of index funds, but the difference between the two helps illuminate a basic idea on demographics. Aside from taking market share away from active managers, when do index funds receive and disburse funds? The answer lies mainly in the demographics of investors.

When investors are younger, they invest surplus cash. When they are older, particularly after retirement, they liquidate investments to generate cash. Given the demographics in the U.S., the excess return for merely belonging to the S&P 500 has been roughly 4% per year over the past 15 years; index funds have received disproportionate large inflows relative to the market as a whole. Aside from that, in aggregate, active equity managers benchmark to something that approximates the S&P 500. Belonging to the S&P 500 ensures a continuing flow of capital.

Or does it? What will happen near 2020, when aggregate investment behavior changes from saving to liquidation?  Belonging to major indices may not have the same cachet as investors liquidate their holdings to fund present needs. What was 4% positive in the 1990s could become 4% negative in the 2020s, absent a continuing move toward passive investing.

I don’t have a firm answer here, but I do have suspicions. I would be cautious of too much index exposure 15 years from now, to the extent it can be avoided. (And of course, this will be anticipated several years before the flows turn negative.)


7. Unleveraged Private Investors

Sometimes private investors feel disadvantaged vs. larger institutional players, but there are advantages that unleveraged private investors have that institutional players often don’t: the abilities to invest for the long term, concentrate and do nothing.

Institutional investors are subject to the tyranny of constant measurement because they manage money for others. As I have noted before, measurement affects how a manager invests, particularly when it might affect the amount of assets under management, or the receipt of incentive fees. This encourages managers to be both short-term in their orientation and more like an index. It also encourages hyperactivity; clients often expect a manager to make changes to the portfolio even when doing nothing could be the most prudent policy.

Unleveraged private investors can make aggressive investment decisions. They can concentrate their portfolios or consider more esoteric areas of the market. They also can back away from the market if they feel that opportunities are absent. Finally, they can buy and hold, which is not always an option for institutions. They can’t always ride out long but temporary dips in the price of an asset.

That an unleveraged private investor can do these things doesn’t mean he should. Using these advantages presumes a level of expertise in the market well in excess of the average investor. Most investors are average and should index. Those with skill should use it to their maximum advantage, realizing that they are taking their own financial life in their hands; the risks to such an approach are significant, but the same is true of the rewards.

Unleveraged private investors have needs for cash. Some will need it for college, retirement, a second home, etc.  The sooner that an investor will need to liquidate a significant portion of his portfolio, the more conservative the portfolio must be to achieve those spending goals. Looking at private investors in aggregate, this would mean that as the baby boomers approach and enter retirement, there might be a tendency for the overall willingness to take risk in the markets to decline. Also, once the baby boomers are in retirement, assets will have to be liquidated to support them, which will be a drag on the markets at that time.


In the second part of this column, I will describe how the funding and disbursement modes of three more key groups of investors affect the market, \and how balance sheet players and total return players further mix up the market forces. I’ll also use the Long Term Capital Management crisis to illustrate how illiquidity can shape and shake the market.